Allegion

Allegion reported second-quarter sales growth of 12.7% year over year from strong US growth and international acquisitions. Modest operating margin expansion resulted in 16.2% growth in earnings per share.

Why it matters: Allegion's Americas returned to considerable sales growth while its international organic sales shrank. Notably, Americas' sales volumes grew 4.9%, resulting in 8.9% organic growth with the remainder from price. US non-residential new and refurbishment construction remains a massive boon for Allegion's product demand. Its 1.2% international organic sales decline stems from a resolving ERP disruption layered on top of an unresolved macro problem; Germany, Allegion's largest European market, was cited to have weakening economic activity.

The bottom line: We maintain our $170 per share fair value estimate for wide-moat Allegion. Shares trade modestly undervalued after the convergence towards our fair value. In our view, the recovery in US organic sales volumes signals Allegion's North American business may finally return to sustained topline growth without a reliance on price hikes. We continue to believe Allegion's strongest competitive positioning lies within the highly fragmented US building access market and that it should focus its reinvestment and acquisitions within the country.

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We maintain our fair value estimate of $170 per share for wide-moat Allegion. Our fair value estimate equates to around 20 times our 2026 earnings per share estimate, commensurate with Allegion's historical 10-year average.

Over the next five years, Allegion’s top line should benefit from growth in the electronics product portfolio, rebounding new-home construction (after a slowdown in 2023-26), solid infrastructure spending (especially for mission-critical security products), and strategic acquisitions. We model the top line to grow at a mid- to high-single-digit rate over the next five years.

Allegion’s strong adjusted operating margins have been remarkably stable throughout the business cycle. In fact, they improved during the global recession despite a double-digit decline in sales during 2009 and expanded 20 basis points to 21% in 2020 despite a 5% drop in sales. After a decline in 2021 due to supply chain disruptions and rising inflation, adjusted operating margin (excluding amortization and nonrecurring expenses) expanded nicely over the last two years, reaching 22.1% in 2023 and 22.8% in 2024. Favorable price/cost and productivity have been primary drivers behind Allegion’s recent margin expansion. In our view, considering Allegion’s pricing power (a function of its wide economic moat) and strong execution, we think these levers will support future margin expansion. We expect adjusted operating margin will increase to around 24.0% by 2027-28 (excluding amortization).

We model a normalized through-cycle adjusted operating margin of about 22.5% in 2030 (our midcycle year). The final year of our stage one forecast is important for estimating a normalized midcycle margin level to prevent a fair value estimate from being based on cycle-high or cycle-low profitability. We believe the small step-down in our midcycle year appropriately accounts for Allegion's cyclicality.

The second stage of our valuation model assumes Allegion can generate a 35% return on new invested capital and 6% earnings before interest growth for 15 years after our five-year explicit forecast period. Our weighted average cost of capital is 8.4%, based on average systematic risk to equity, an 18% long-term tax rate, and an 87% equity weighting.

We think Allegion is well positioned to maintain its competitive advantages in the Americas business (representing around 90% of consolidated operating profits) over the next 20 years. We therefore award the company a Morningstar Economic Moat Rating of wide, supported by intangible assets and customer switching costs.

Despite formidable competition, Allegion has consistently capitalized on its brand equity, strong distribution network, and large installed base to drive excess returns. Since its spinoff from Ingersoll-Rand in 2013, we estimate it has generated average returns on invested capital (including goodwill) of approximately 24%, well above its cost of capital; that’s despite the lower margin and ROIC in its international segment. We estimate the Americas segment generated ROICs (including goodwill) in the high 40s to low 50s following the spinoff. However, increased acquisition activity and organic reinvestment thereafter caused segment ROICs to narrow to 30%-35%. We believe the Americas segment can maintain this range.

Allegion has a portfolio of well-recognized and long-established brands associated with superior quality and durability in both residential and commercial markets. Perceived quality and durability are critical considerations, since the cost of failure can be very high. Most notably, in North America, Schlage (locking systems), Von Duprin (exit devices), and LCN (door controls) hold leading or near-leading market positions in their product categories. We think Allegion’s brands have garnered meaningful brand equity, which supports pricing power. Indeed, we calculate that Allegion’s price increases in the Americas segment have outpaced inflation by over 150 basis points, on average, over the past 10 years. Allegion’s pricing power has supported strong profit margins throughout the business cycle.

Allegion has built a valuable network of channel partners in North America, which supports continued growth of its installed base. The firm has strong relationships with a large network of architects, homebuilders, security integrators, general contractors, and locksmiths that drive residential and commercial new-construction business and generate aftermarket sales. In our view, Allegion’s deep relationship with architects—often the primary decision-makers for commercial project specifications—has been a key factor in the firm’s strong commercial market presence. Architecture firms have increasingly outsourced the design and product specification of building openings to Allegion, which employs spec writers and has a proprietary software platform (Overtur) to integrate building opening specifications into architect workflows.

Allegion also has a strong foothold in big-box retailers (for example, Home Depot, Lowe's, and Menards) and e-commerce platforms (for example, Amazon) that further supports residential aftermarket replacement sales. Overall, we see Allegion's broad distribution network as a barrier to entry because we think it would be very difficult for a new entrant to quickly build these key relationships, especially without a strong reputation for quality and durability.

We believe Allegion benefits from customer switching costs, primarily in its commercial installed base. To earn the right to compete in the commercial security market, security product manufacturers must have a proven ability to meet or exceed stringent building code standards and manage the complexities of large-scale projects. With a deep expertise in building code standards, wide product breadth, a proven ability to design custom-configured solutions, and a long list of successful commercial projects, Allegion has earned that right. Its commercial record is one factor that allows the firm to capture incremental sales as its commercial customers expand or retrofit existing security solutions. The desire for continuity is another factor that drives high retention rates on add-on spending. When commercial customers expand or renovate their facilities, they generally look to preserve the existing aesthetics and maintain harmonious security functionality.

In our view, Latch, a multifamily security solutions firm, is a good example of a new entrant that has struggled to overcome the barriers to entry in the US commercial security products market. In our view, the firm lacks product depth and differentiation, distribution capabilities, and a track record to pose a serious threat to industry incumbents Allegion and Assa Abloy. We believe that Latch’s financial prospects are even more in doubt now that Allegion has made a stronger push into the multifamily market with its Zentra access control platform.

Although Allegion’s international segment has leading brands in certain markets, we believe the overall business lacks sufficient scale to generate durable excess returns. That said, management has expanded distribution channels, improved cost structures, and taken other measures to improve segment profit margin and ROIC. We project the segment will generate ROICs marginally above Allegion’s cost of capital over the next five years. Nevertheless, it accounts for around 10% of Allegion’s segment operating profit—too small to figure into our overall moat rating.

Allegion has a long history of developing innovative products that comply with building standards, and we expect that its product leadership and commitment to top-tier products that support burgeoning building initiatives will continue.

Allegion’s strong market position and pricing power in North America should continue to support stable, industry-leading profitability.

The convergence of electronic and mechanical security products and increased infrastructure spending should drive sales growth and margin expansion opportunities.

Allegion generates strong free cash flow and is a balanced capital allocator. The company can continue to use its free cash flow to increase its dividend, repurchase shares, make value-accretive acquisitions, and invest in leading-edge technology ventures.

About half of Allegion's revenue is tied to new construction. As such, a downturn in construction spending could materially reduce earnings and cash flow.

Allegion’s international segment is structurally challenged due to insufficient scale and is a drag on ROICs. Taking share from entrenched competitors in these markets could prove challenging.

As electronic security technology proliferates, Allegion must stay on the cutting edge of technology or risk falling behind existing competitors and new entrants, which could impair its pricing power and market share.