Church & Dwight Co., Inc. (CHD) CEO Matthew Farrell on Q4 2019 Results – Earnings Call Transcript


Church & Dwight Co., Inc. (NYSE:CHD) Q4 2019 Earnings Conference Call January 31, 2020 1:00 PM ET

Company Participants

Matthew Farrell – Chairman, President and Chief Executive Officer

Britta Bomhard – Executive Vice President and Chief Marketing Officer

Steven Cugine – Executive Vice President International and GNPI

Rick Dierker – Executive Vice President and Chief Financial Officer

Paul Wood – Executive Vice President, U.S. Sales

Conference Call Participants

Nik Modi – RBC Capital Markets

Bill Chappell – SunTrust Robinson Humphrey Inc

Rupesh Parikh – Oppenheimer & Co. Inc

Joe Altobello – Raymond James & Associates, Inc.

Stephen Powers – Deutsche Bank

Kevin Grundy – Jefferies & Co.

Jason English – Goldman Sachs

Matthew Farrell

Okay, gang. We’re going to get going now. Okay. Thank you all for coming today and thanks, everyone, who is dialing in from office or home. I’m going to begin with the Safe Harbor statement. I recommend everybody to read that at your leisure. Say who is with us today from management, we have our CMO, Britta Bomhard; our Head of International and Global New Products, Steve Cugine; our General Counsel, if you have any legal questions; Rick Dierker, our CFO; Rick Spann, who runs Supply Chain; and Paul Wood, who runs U.S. Sales.

All right. So here’s – I’m going to give you a short story right now. So you don’t have to really pay attention to the other 150 slides. We had a terrific year. This is the second consecutive year that our company grew organic sales 4%. The U.S. posted 4% organic sales growth and 10 out of 12 of our power brands grew or held share. International posted 9.2% organic growth and continues to be a juggernaut for the company.

And as we ended the year, organic growth returned to the Specialty Products business after two down years. Last time, we had an up quarter was Q4 2017. And the reason it turned positive is because the dairy market became healthy. And another encouraging sign is that domestic volumes turned positive in the fourth quarter. And finally, we had record cash from operations in 2019.

So now looking ahead to 2020. We’re calling 3.5% organic growth, and that is net of exiting the low-margin gummy private label business. And consistent with our Evergreen model, we’re calling 7% to 9% EPS growth and that is top tier in CPG.

Now I want to recap for a minute why Church & Dwight is a standout in the consumer space. Number one, we have an Evergreen model that our shareholders are very familiar with as our employees. Number two, we focus on cash. Number three, we have an ability to execute and that’s what drives our performance.

We deliver meaningful top line and bottom line growth year-after-year. We have a very lean company with the highest sales per employee of any of our peers, and that sales per employee stat is an underappreciated metric. We are innovators with new product offerings across many categories year-after-year and we’re becoming digitally savvy.

The 8% of our sales are online today and that does not include buy online, pickup in store. If we included that, it’d be much higher than 8%. But we made good choices when it comes to acquisitions. Those choices have led us to dry shampoo, gummy vitamins, women’s hair removal, water flossers and hair thinning solutions. So we believe there’s no better place to invest in CPG than Church & Dwight.

So here’s our track record. Let’s go to the next slide. Here we are. So look at our last three, five and 10 years, we delivered double-digit TSR returns to our shareholders. And if you look at 2019, 8.3%, and that’s on top of a 2018 that was plus 30%.

Let’s move on to the formal part of the program. So who we are, why we’re winning. Britta is going to come up and talk about them – give you an update for the master brand. And also Britta and I are going to ham and egg the consistent innovation story. Steve is going to come up and talk about international, I’ll kind of come back and tell you about animal productivity and how we run the company, and then we’re going to end with Rick on financials.

All right, first, who we are. So let’s talk about our Evergreen business model. This is in green not only in the hearts of our employees, but all of our long-term shareholders as well, 3% top line, 8% bottom line. And if you say, well, how’s it going for you? And you look at the last 10 years, the average organic sales growth has been 6 – 3.6%.

So where’s that 3% coming from? Well, it’s kind of 2% from the U.S., 6% international and 5% Specialty Products. We don’t always hit this in the market any one year, but that is the long-term algorithm. If you say, what are your brands? We have lots and lots of brands. Well, we have 12 power brands. And those 12 power brands account for 80% of our revenues and profits. And we have very well-balanced portfolio. A little bit more than half is – or consumer products part of the house.

For those of you at home, those are just couple of balloons going off. The personal care, 49%; household, 44%; and you can see Specialty Products at 7%. Now it’s a diversified portfolio, in that, 63% is premium and 37% is value. That means we perform well in virtually any economy. And we have a lot of runway for international. So international has been a juggernaut, as I’ve said, for the last five years, still only 70% of the company. So we’ve got a long way to go there.

And we do operate in the land of the giants. You can see, we have $4.4 billion in sales, all of our competitors are significantly larger than we are. We think this gives us an advantage. So we’re fast, we’re nimble. When you have only 4,700 – 4,800 employees, you can make quick decisions, you can move fast, your communication is easier, and you can adapt to change better. And we have a long history of acquisitions.

We’ve added almost $3 billion in sales since 2004 over the last 15 years, and a lot of that came from acquisitions. And we have very specific acquisition criteria. We’re only going to look for a brand that has number one or number two share, high-growth, high-margin, needs to be asset-light. We need to be able to leverage our supply chain footprint and they must have a sustainable competitive advantage.

And since the year 2000, so over the last 19, 20 years, we’ve acquired 11 out of our 12 power brands. In the year 2000, the only big brand we had was ARM & HAMMER. So what we say around the house is 12 brands today, 20 tomorrow.

Now why are we winning? We have five reasons. One, we’re in the right categories; two, we know how to grow shares; three, we don’t have a high exposure to private label. We’re growing online and we are on trend.

So let’s look at the categories. So if you look at the categories over the last four years, in general, our categories’ weighted average grow 3%. So this is the underpinning for the company’s long-term organic growth of 3%.

As far as growing share, this is our report card. You don’t get this report card for many CPG companies. but every year, we tell you how we’re doing. So for our 12 major brands, we maintain our growth share. And you can see this year for the first time 10 out of 12, we’re green. And we get lots of questions generally about the laundry category. So what’s the long-term trend in laundry? So over the last three years, we’ve had 120 basis points of share in laundry. The other winner was Procter & Gamble and Henkel has struggled.

Now, you know, as we go from quarter-to-quarter, you’ll have some questions on non-measured channels. Let me give you a sense for how big our non-measured channels for some of our categories. Most of these categories are going to be 70%, 80%, 90% represented on Nielsen. But if you go to the far right, you’ll see some of our more recent categories, power flossing, hair thinning and even electric – women’s electric grooming are all significantly less than 50%. So something to bear in mind going forward.

We have low exposure to private label. The weighted average share of private label for our categories is only 12%. Only five of our categories have private label exposure. And as you can see from the lines on that chart, you can see it’s relatively stable and we’re growing online.

Back in 2015, we were fourth quartile when it came to online sales. Today, we are first quartile. We hit our goal of 8% in 2019 and we have a goal to be over 9% in 2020, and we have lots of products – number one products on Amazon. And Amazon, of course, is the number one online retailer.

Okay, on trend. So we’re all through four of our brands and while we think we’re on trend. Take BATISTE, it’s a business we acquired in 2011. So dry shampoo was a convenient solution to women between wet shampoos. This was a business with $20 million in sales in 2011. If you look at what kind of runway do you have in the U.S.?

Well, in the U.S., 125 million women – there are 125 million women over the age of 18. Two-thirds of them don’t wash their hair every day and 13% of them today use dry shampoo.

Now, if you look at household penetration, it’s only 7.5% in the U.S. So that’s why we’re trying to figure out, well, how big could it be in the U.S. We look at the UK. The UK is the most mature dry shampoo market, that’s where it originated. So if we compare with where the U.S. is, the U.S. is in the middle innings. And we can see by in comparison to where the UK is that the dry shampoo market will double from $225 million at retail to $450 million over time. So being the number one dry shampoo means, we have a lot of runway ahead of us.

So next up is women’s electric hair removal. So we bought the number one women’s electric hair remover in FLAWLESS. So these are tools to remove – so I’ll go left to right, face, brow, leg and whole body. So women are looking for convenient ways to remove hair. And if you look at the household penetration, it’s only 2% in the U.S. and less than 2% rest of the world, so a lot of runway here for this business.

Next up is water flossers. We have the number power pulse and recommended by the ADA. So what’s the story there? We can do a show of hands. Everybody knows, 80% of the people don’t floss everyday, even though they should. And consumers are discovering water flossers. Water flossers are the easiest solution to flossing.

Again, look at household penetration. 22% in the U.S. not bad, but we think that could go as high as 48% if you just look at the penetration for electric toothbrushes. And then if you look at – in Europe, for example, it’s only 3% to 5%. So we’re just getting started with water flossers outside the U.S. Again, on trend, got a lot – lots of runway ahead of us.

Next up is gummy vitamins. You know the story pretty well. The gummy form is more appealing than pills and capsules. And if you go back to when we bought the business, the adult gummy form was 3% of the category. Now it’s 18%. And if you look at the size of the category, it just continues to grow. It grew from 2015 to 2016, 2017 from $800 million to $1.5 billion today, lots of runway.

And then finally, is hair thinning solutions. We have the number one hair fiber and the number one hair thinning supplement. We all know it’s on people’s mind. 40% of men and women have noticeable hair loss by the age of 40. So we have great solutions to that.

And now I’m going to bring up Britta to talk about the master brand.

Britta Bomhard

Okay. Hello, everyone. [indiscernible] So you might remember, ARM & HAMMER is by far our biggest brands. It’s more than a million – billion, sorry, dollar brand. So really important to us. And you might remember from last year, we presented our more Power to You campaign year in this iconic institution. Now, I know most of you are pretty skeptical. You’re a little bit like my boss. Is this really working? So I thought, why don’t I share a couple of results first.

Since we launched the campaign in 12 months, we’ve actually added 2.6 million households who are now buying ARM & HAMMER, and that’s an increase of 3%. And this picture you’re seeing is actually, it is currently nearly seven out of 10 households buying ARM & HAMMER. And if this room is representative, my ambition is actually to have three out of four households buying ARM & HAMMER.

So you might remember, there’s not many where the U.S. is as united as having three out of four people agree that this is a great choice. But what’s more important? You could now say, well, but you get them in via promotions? No. Actually, we have people spent more money on ARM & HAMMER, and you see here they’re spending 5% more.

So if you think about it, what is a great sign for brand health? More people buying it and spending more. So I think that’s very clear answer that ARM & HAMMER is very healthy and growing wonderfully, right?

There we go. And I think for those of you who saw it last year, you might want to note that we have ARM & HAMMER every single one of our brands and categories. And I want to show you a couple of how we communicate about ARM & HAMMER. And for those of you who have seen some of our cats, they just got cuter. So just have a look at the cats.

[Commercials]

That’s a really distinctive campaign and it’s working really well for us. You might not have seen this campaign, because we just recently launched our ARM & HAMMER dental campaign at the very end of last year, it’s a very hard one to break through. So I hope, A, you appreciate how different it is to a normal dental commercial you might see; and secondly, it also illustrates that this campaign works in no matter what category. So let’s look at that one.

[Commercials]

Challenged and check, how well the plaque removal is currently on what you use. And moving on to our next, you might know, if you’re not part of the Burning Man crowd, and I’m pretty sure most of us here in this room aren’t, then this one is what we say is a great deodorant.

[Commercials]

This is a broad spectrum of what we can do with the ARM & HAMMER campaign on every single of those different categories, playing to what’s important and what’s the consumer insight, but still bringing it all together and driving the overall 1 billion brands. So I think that’s pretty unique.

But I’m actually here to talk about something new. Well, it’s not too much of a rear wheel as it’s standing or sitting on all your tables, but our new CLEAN & SIMPLE laundry detergent. It’s clean, it’s simple, it’s smart and it’s powerful.

So what have we learned about consumers and you might have seen that in a few other areas. In food, the transparency in less is more in ingredients has already been quite established. And this trend is now moving from what people ingested to what’s on me and then to what’s around me. And this is where we have an amazing detergent, which has a no compromise, powerful, clean laundry with a simple ingredient list.

So none of the others offer that. And what’s even better of it and it’s a pity that my colleague, Carlos, who heads up our R&D, is not here today. But he and his team are really revolutionizing of how we look at making innovation.

One part is, there’s a very different innovation in culture. We are connecting the different teams around R&D and the different areas of expertise, a lot more risk-taking and obviously speed. And that’s what you can see here how we came up and looking at what’s happening in the food industry, it’s a very clear trend, which will come into the other areas. And that’s where our future works team actually discovered the CLEAN & SIMPLE formulation.

So what’s in there, or better what’s not in there? Because that’s what consumers are asking. So it doesn’t have dyes, no added preservatives, no phosphates, no brighteners and no parabens. It sounds pretty attractive, doesn’t it? But what’s in there is six Essential Ingredients: a hard-working cleaner, active stain remover, laundry booster, baking soda, of course, water softener and fragrance. And what is more and important, it has few ingredients, but it is as powerful as our best selling product, which is ARM & HAMMER with OXICLEAN.

And as we said, it has fewer ingredients not only as our own, but a typical average laundry detergent has between 15 and 30 ingredients, so we only have six. And here, less is more. But not only that, it’s also very good for the environment. So on the next iteration of laundry bottles, you will actually see this back label, which we’ll talk about our partnership with the Arbor Day Foundation, where we help planting trees for cleaner air and water.

This product is also being elected as a Safer Choice, so we have that endorsement, which is very important to reassure consumers. And we’re also using the Green-e, which says it’s 100% certified renewable electricity. And, of course, we’re one of the leading partners of how to recycle, which is in a lot of our labels and also graces this label as the bottle is fully recyclable. And now you wonder how will we tell consumers about it. So let’s have…

[Commercials]

I hope you noticed. We’re helping women making the right choices and we have very positive feedback, because it’s such a good way to get it from a trusted brand like ARM & HAMMER. And once we drive people to store, this is what they will see in the future. We have massive executions in stores and coming soon, Dollar General. Sorry, that was too quick, can you go back? Wait, if I can do that.

So what else do consumers want besides CLEAN & SIMPLE? There’s other trends, which are about sustainability and convenience. And Matt talked about online shopping, lots and lots of more people actually order online, that’s not as developed in the laundry area, because it’s difficult to ship big bottles.

So we have a solution for consumers who want convenience and sustainability, because we have launched ARM & HAMMER plus OXICLEAN, our best seller as a super concentrated laundry detergent. It has three times more cleaning power, but it has 37% less plastic and uses 30% less water. So, again, fully on a sustainability trend and available to consumers who prefer shopping on e-commerce.

I’ve talked a lot about ARM & HAMMER. We also have another exciting brand, OXICLEAN. And if I look around the room, except for everybody who is on my team today, you know that black clothes, dark clothes are very important. And about 42% of all wash loads get sorted into black, dark colors and we have a solution for that.

So OxiClean Dark Protect, which is specifically formulated for dark and black fabrics. So as we’re now in winter season, take a note, you might want to get one of those.

And with that, I hand it over to Matt, who is going to share insights on hair care.

Matthew Farrell

All right. Obviously, I’m the expert on dry shampoo. So if you’re somebody with normal hair and you pick up an aerosol can of dry shampoo, that’s okay, that might make my hair dryer. So we said, “Hey, what’s going to appeal to women with normal to dry hair?” So we said, “Okay, we’re going to launch Batiste Waterless Cleansing Foam. So this is something that you rub into your hair and refreshes your hair and dries in 60 seconds, and we have four different variants we’re launching right now.

And now WATERPIK. You also often hear us talk about WATERPIK water flossers. Well, WATERPIK, that business, we’re experts in water-jet technology. So that technology has been around for almost 50 years. And so now we’re coming out with a brand-new, the first-known FDA-registered showerhead. And the insight here is that, millions of Americans discuss massage with their doctors, it’s something that WATERPIK folks look into.

So here it is, WATER FOR WELLNESS, this FDA-registered power pulse showerhead. And we’ve done nine clinical studies. And what those studies tell us is that, these particular showerheads soothes muscles, they increase flexibility and they promote better sleep.

And here’s kind of a fun fact. The average shower is eight to 12 minutes. And what our consumers tell us is that, these benefits they start feeling after two minutes using these showerheads, really cool innovation.

Okay, I talked a little bit about FLAWLESS earlier. Women are look – are focused on convenient hair removal. So new product from FLAWLESS called NU RAZOR. This is waterless, whole body hair removal anywhere, anytime.

Now, floss, we’ve got a lot of interest in FLAWLESS on the part of analysts and shareholders. So let’s give a little bit of update on that. One major retailer right now, the reset has already happened from As Seen On TV through the wet shave aisle, and that’s happening in a lot of retailers. Why is that important? It’s because the traffic in the wet shave aisle is four times the traffic in As Seen On TV.

So this is launching right now with one major retailer, wherein after two weeks, the POS consumption is up 7%, and that’s just one major retailer. We know what kind of wins we have for 2020 and our total distribution point is going to be up 15% in 2020. And recall, if you read it in the press release that we expect the FLAWLESS sales to be up to 15% and this is part of the underpinning for that, as well as the NU RAZOR launch, we think we’re going to be in good shape for the coming year.

All right. Next up is natural toothpastes are growing 14 times the rate of the toothpaste category. So we’re introducing ARM & HAMMER Essentials Toothpaste, two different variants, and we’ve gotten really, really good reception from retailers, particularly the drug class trait.

Next up, men, this is TROJAN condoms, wait for it. Men wants to ensure their partner is satisfied. So we got a new product called G SPOT from TROJAN and we have an ad for you. Take a look.

[Commercials]

We always have a lot of fun with that TROJAN brand. By the way, whenever we have a meeting for new products, it’s the most – for TROJAN, it’s the most well-attended meeting in the company, if you look people sitting on the window sills.

All right. VMS, so vitamin. We have lots of line extensions coming in 2020, and we are addressing a lot more need states. And we’ve really picked up pace of innovation for vitamins. If you look at 2017 and 2018, we kind of averaged six new items a year. We had 22 new items in 2019. We’ve got 17 more coming in 2020. Too many to run through today. And we have more innovation coming in 2020 in other categories, so stay tuned. You’ll hear about those later in the year.

And next up is Steve to tell you our fabulous international story. Come on up, Steve.

Steven Cugine

Thank you, Matt.

Matthew Farrell

All right.

Steven Cugine

Excellent. So I’m pleased to be here to share with you the fabulous international growth story. So, as Matt already talked about, the Evergreen target for international is 6% per year. In 2014, we delivered $535 million in sales. We finished 2019 at $756 million in sales.

The important note here is that, we firmly believe that we’ve reached global scale. There isn’t a market that we’re not in today and where we can’t reach with ourselves through our existing subsidiary markets or through our GMG business. I think even more impressive than the size of the business is that we tripled the organic growth rate from roughly 3% to about 9%. So significant, the larger business tripling the growth rate.

This is an important chart that we show every year, but there’s some new information here. Our Global Markets Group is now 33% of the total business. For the first time, it is the largest segment within the international business, followed by Canada, Europe, three countries, Mexico, and Australia.

We have grown historically well above our Evergreen target of 6%. In 2019, we hit 9.2%, an outstanding year, and we leave the year with momentum delivering 10.6%. So we feel the wind at our back.

Let’s break that down in a little more detail. Our subsidiary markets delivered 5.2% and our GMG business, a whopping 19.2%. Our subsidiaries are largely in developed markets. So 5.2% in developed markets is really outstanding performance. Our brands are healthy, whether they be in emerging markets or GMG or in our subsidiary markets. So we’re excited about the performance of both of these businesses.

The GMG business is certainly an engine of growth for the division and for the company. Since 2014, when we initiated the start of our new growth strategy for international, this business has delivered 19% CAGR throughout its lifecycle. And again, 2019, we did 19.2%, lot of 19s in there. And it’s driven by our core brands. So we’re driving ARM & HAMMER, BATISTE, WATERPIK, VMS, OXICLEAN, STERIMAR, FEMFRESH and now FLAWLESS.

We continue to invest in building capabilities around the world. As you know, year in year out, I’ve been up here talking about the investments that we’ve made in Southeast Asia and then talk about China. We continue to make incremental investments in China, Southeast Asia, Germany, fast-growing market for us in Europe and in Central America.

We’ve taken the opportunity to localize the content that we give to consumers, because these brands need to show up differently market-by-markets, so they’re relevant. We’re investing, particularly last year and this year in technology, because Matt talked about speed of decision-making we feel is a differentiator for the company. That is also true in these very dynamic international markets.

We invest a lot in our GMG distributor training and regulatory affairs. We want to make sure that our partners in particular markets know as much as we do. We provide them innovation, case studies. That share case studies. So they are an extension of our family, and we think that is unique to Church & Dwight.

So we’re absolutely committed to 6% organic growth moving forward. We believe we have a runway for our existing brands. We have demonstrated our ability to grow acquired brands, WATERPIK, now FLAWLESS. Our GMG group will continue to post double-digit growth and we made investments in fast-growing markets that we think we can leverage. Because we feel that we have a scaled global business for the first time, we’re going to make a new commitment. And that commitment is not only organic growth, but we’re going to continue to expand operating margin year in and year out.

We’re going to take a big step change from 2019 to 2020. And part of our Evergreen target is to deliver another 50 bps of growth – of operating margin expansion. And that is on top of any incremental investments that we’re going to make to ensure that we have the capabilities around the world.

So in summary, one, we have the right strategies for growth. We’ve demonstrated that, we know that. Two, we have brands that consumers love around the world. Three, we built a management team that is outstanding and several of them are around the world are here today. So to them, I say thank you. And we feel that we’re just starting. But there is a lot of runway in international markets for Church & Dwight’s products.

Dropped the mic.

Matthew Farrell

That was another balloon for you at home.

Steven Cugine

I see.

A – Matthew Farrell

Wow, that was perfect punctuation mark. Okay, animal punctuation. So back to the algorithm – 3% algorithm, 2% U.S., 6% international and 5% for Specialty Products. Where is the 5% going to come from?

Well, we have a bulk chemicals business, which is bulk sodium bicarbonate and then animal productivity, 6%. How has that been working out for you? Not very well. Well, let’s talk about why is that.

So this one goes – flow on this. When you look at the top of the chart, that’s Specialty Products Division organic sales growth since 2011. So what do you notice? We’re up in 2011, down in 2012 and 2013. Up in 2014, 22.6%, down in 2015 and 2016, up in 2017, down 2018 and 2019, back up in 2020. And then below it, you say, “Okay, what was going on with milk prices.” And you can see, as milk prices recover, that’s when you see a green for the growth at a Specialty Products business.

So we knew that a few years ago, 2015, we said, “Hey, we’ve got to start moving into other species.” And in 2015, 99% of the animal productivity business was dairy. And today, that’s not true. It was 1% non-dairy. Today, it’s 27% non-dairy. So we think that we’re going to be able to flatten this out over time.

Now, why do we go into other species? Well, because of demand for protein and simply population growth. We have 7.7 people – 7.7 billion people today going to 9.8 billion by the middle of the century. And antibiotics are out of favor. And the consumers are telling retailers and farmers, “Hey, no antibiotics, no hormones, no chemicals.”

And if you look at the stats, you see that there’s a 40% decrease in the use of animal probiotics since 2015. So that bodes well for us, because we bought two businesses. One was called VI-COR, the other was Agro BioSciences. They get us into prebiotics and custom probiotics. We were in nutritional supplements for dairy. We then got into prebiotics and probiotics. So now we have a nice portfolio for not only dairy, but cows, swine and poultry.

So as I said before, the non-dairy business is 27% of animal productivity. Today, we think that’s going to have big growth in 2020. And we get lots of questions about milk. Hey, people raise their hands. Isn’t milk consumption in the United States on decline? Absolutely. So if you look at this chart here, the per capita consumption of 2015 was 174 pounds annually. More recently, it’s 164 pounds.

But if you look what’s going on with cheese, big offset to that. It takes 10 pounds of milk to make one pound cheese. And then when you comes to the Church & Dwight Conferences, you always walk away learning something you didn’t know. So when you think about milk, also think cheese. Cheese is a big offset for the decline in milk production. So the dairy industry does have growth ahead of it.

So we feel good long-term about our algorithm of 5%. We have the trusted brand. The ARM & HAMMER brand goes across prebiotics, probiotics, all of our products. We are aligned with the consumer trend, we’re now into multiple species, and all the growth is ahead of us, particularly internationally.

Right now, I want to talk about how we run the company. There’s five operating principles. One, we leverage brands. We have 12 brands that account for 80% of our revenues and profits. These are brands that consumers love.

Second thing, we’ve long been a friend of the environment. And I’m going to go into it a little deeper in a moment, and we leverage people. We have highly productive people in an environment, where people do matter.

And finally, we’re asset-light. We leverage our assets. Now if you do those four things well, you’re going to have really good returns. But because one of our competencies is identifying, acquiring and integrating businesses, we turn our good returns into great returns.

As I said, here are the brands. We have brands consumers love. As far as the friend of the environment goes, over 100 years ago, we started using recycled paperboard in our cartons. In the 1970s, we were the first and really only corporate sponsor for the first Earth Day. Actually 20 years later, in 1990, we’re still the only corporate sponsor of Earth Day, and we were the first to take phosphates out of laundry detergent.

More recently, we’ve been more focused on green global electricity demand supply by renewable sources by wind and power. And we’ve been planting lots of trees with Arbor Day. And we all remember from fifth grade science, that trees take carbon dioxide out of the atmosphere and they turn into oxygen.

All right. What are some of our goals. We want to reduce water and wastewater by 25% by 2022. We want to recycle more. We want it 75% by the end of this year. And finally, we want to be carbon-neutral. So 100% carbon-neutral by 2025, and that’s through having green electricity and also planting millions and millions of trees.

So that’s our goal today. We’re at 60% carbon-neutral. What that means is, we offset 60% of the CO2 that we put into the atmosphere. Okay. And we’ve been getting some recognition for that as well. We’ve regularly show up on list of Barron’s, Forbes, the EPA list of companies that are faithful to the environment.

All right. Now I’d just also mention highly productive people in a place where people matter. This is the statistic that is interesting. This is revenue per employee. So you can see, we’re on the far right. We’re over 900,000 right now on our way to $1 million per employee. And you can see where our peers are.

We think this is very representative of how lean the company is. And the thing that most people can’t tell about any company we invest in is, what is the culture. And the culture in our company is as follows. And we talk about this both inside and outside the company. It’s blue collar, high aptitude, underdogs. We’re digitally savvy, we embrace diversity and we like taking risks.

And because we – that is the environment within our company. And you can’t just snap your fingers, flip a light switch and create that. I didn’t create that. That’s been there for many, many years. It’s the greatest asset of the company. And I think that’s one of the reasons why we’re so successful year-after-year-after-year.

Now, we have tremendous financial literacy within the company. Most companies will focus on revenue and EPS. We also focus on gross margin. And that’s 25% of everyone’s annual bonus. And when it’s in your bonus, you ask questions like, “Hey, what’s gross margin? And how can we get it, because it affects me.”

And it’s – so how we get it is, we have a Good to Great program, that’s our continuous improvement program. We’re continually optimizing our plants, new products are launched with higher gross margins than the products they replace. And when we buy businesses, we make them better. We expand the gross margins of businesses that we acquire.

We have very simple compensation structure. You can see on the left side of the pie, net revenue and EPS. On the right side, we focus on gross margin, which is uncommon, as a metric within incentive compensation program. And cash from operations, we’ve long described ourselves as free cash flow junkies and we still are.

All right. I’m going bring up Rick to talk about financials now.

Rick Dierker

All right. Thanks, Matt. Good afternoon. So we’re going to go through three things. We’re going to go through the 2019 results for the quarter, for the full-year and then go through the outlook.

And before we do that, we’ll just start with Evergreen model, we – because we always do. 3% top line growth and 8% EPS growth. And then the drill down for that is 2% organic net sales growth, 25 basis points of gross margin expansion, flat on marketing as a percent, higher dollars typically with revenue growth. We leverage SG&A and we get to 50 basis points of operating margin expansion and then 8% EPS growth. So that’s the backdrop.

So how did we do? In Q4, you heard from Matt already, you saw in the release this morning, 4.4% organic revenue growth. Domestic was 3.5%, international was 10.5% and SPD for the first time in eight quarters with positive organic growth, which is great.

Adjusted gross margin was 170 basis points up. I’ll walk through the detail of that in a minute. Marketing was up 240 basis points. So that’s the highest spend rate we’ve had in 2019. Just $37 million more year-over-year. It’s a very significant increase. SG&A was up largely because of the acquisition. Our TSA agreement as well as the amortization with that deal.

Adjusted EPS was $0.55 versus the $0.54 outlook. So, on a revenue basis, the quarter was very strong, 4.4% and it was very strong even versus a strong year ago, 4.3%. So on a stacked basis, 8.7%. If you run your eyes across the page, 4.5% in the first quarter, 4.9% in the second, 3.5%, 4.4% and then 4.4% for the year.

So for the full-year, like I said, 4.4% domestic has a 4% in front of it, that’s fantastic. As Britta said, 10 of 12 power brands grew share during the year. Internationally, just heard from Steve, 9% is a great number and then SPD was minus 3%.

Gross margin was up 110 basis points. I’ll go through the detail gross margin in other slide. Marketing was up 10 basis points, that’s greater than our outlook. And then adjusted SG&A was also up for the same reasons I talked about in the quarter.

EPS was up 9% to $2.47 and cash from operations was up to $865 million, up 16% year-over-year, just a fantastic result, higher cash earnings and improved working capital, which leads to free cash flow conversion of 128%, which is industry-leading, and we have a slide on that.

So gross margin, just to walk you through the puts and takes. In Q4, plus 60 basis points, so that’s really the – we continue to get the benefit from price, as well as higher volumes. Inflation is a 50 basis point drag for the quarter, that has moderated a little bit since earlier in the year. Productivity programs are up 110 basis points. It’s been pretty consistent for the whole year.

And then acquisition, so there’s two parts of the acquisition, 50 basis points from owning FLAWLESS, 10 basis points is because they have a slightly higher gross margin in the company. The other 40 basis points is acquisition accounting. Remember we took that the revenue minus COGS, minus marketing, marketing profit, that’s one line in net sales from the period of May through October. And so when there is no offset, it’s a pure margin.

So gross margin expansion on a reported basis is 170 basis point. And then on a comparable basis, it would be 130 basis points. So that’s the quarter. And for the full-year, many of the same things apply and comparable gross margin expansion is plus 70 basis points. So just a fantastic year. We raised gross margin, I think, three times throughout the year.

So on to 2020. So 6.5% reported sales growth, that’s larger than 3.5% for organic plus the FLAWLESS impact. Domestic is a 3%, international 7% and SPD is 3%, that’s our outlook for this year for the division. Gross margin is up 10 basis points. If you exclude or if you make 2019 comparable with the excluding the FLAWLESS accounting, we’re up 50 basis points apples-to-apples.

Marketing is up 10 basis points. Again, we’re investing incrementally behind these brands and behind these big launches you see on the table today, as well as FLAWLESS. SG&A, we’re going to leverage by 10 basis points and operating margin on a reported basis is up 10 basis points, but apples-to-apples, up 50 basis points.

The effective tax rate is 21%. The effective tax rate for 2018 was 21%, for 2019, it was slightly below 21% and for 2020, we think it’s 21%. What does that mean? It means all of our EPS growth is largely the operating income growth. EPS range from 7% to 9%, mid-point is 8% and then cash from ops is $890 million. So, as Matt talked about this year as a record, we would have a new record for next year.

Okay. So here are some details on the outlook. We start with our 8% Evergreen model, 8% plus 2% accretion for FLAWLESS. Tariffs is a minus 1% drag. We’re getting a hit with tariffs 4B hitting FLAWLESS and our showerhead business to the tune of a drag of about 1% on EPS. Marketing investments for the new launch, that’s the 10 basis points you guys saw on the earlier page. And so that’s how we get to the mid-point of 7% to 9% and 8%.

We focused on gross margin for a long, long time, it’s a hallmark of this company. Gross margin, as Matt said, is in everyone’s bonus. Gross margin drives cash flow, cash flow drives valuation. So we had an inflection point of 44.4% in 2018, we recovered nicely in 2019 and we’re going to continue to improve in 2020.

So in 2020, here are the details. Plus 80 basis points as we continue to get some benefits carryover from price and as well as higher volume. Inflation continues to be a drag of 150 basis point, that’s largely pretty much across the Board from a commodity perspective.

I would say, commodities were flat to up, slightly up. Some examples for you, ethylene is up mid single digits, clay is up high single digits, we have PCR, resin as an example, which is high, up significantly. HDPE resin is flat. So we have some headwinds on inflation, tariffs are in that – is in that number as well.

Productivity programs are up 120 basis points, just getting very, very consistent with that. We’ve done some great work on the supply chain. And then the acquisition kind of making that apples-to-apples again shows you how gross margin on a reported basis is plus 10 basis points, but plus 50 basis points when you say it’s comparable.

Matt showed this slide earlier, organic sales growth, 10-year trend, 3.5%, which is fantastic. In 2020, our expectations are no different. 2019 was the first time since 2015 that we had a 3.5% outlook. And so we’re proud to say that we’re doing that, again, despite the pullback on private label and getting out of private label vitamins and a little bit of OXICLEAN laundry high promotion.

Okay. So just as important as volume, I mean, organic revenue growth is how we get there, right? So for the last 10 years, organic revenue growth was 3.5%, our volume growth on average is around 4%. You can see on the graph that we kind of inflected in 2019 and volume went down, right, and price mix went up.

And our outlook for 2020, 3.5% organic revenue growth, about 50-50 is going to come from volume versus price mix. Then marketing spend again is up 10 basis points. We’re one of the top 20 advertisers within CPG. So we just have a significant amount of firepower here that we put to use for our brands.

And then SG&A, on a reported basis, it looks like it’s gone up for the last few years. But when you strip out the acquisition, amortization, it’s actually very flattish. So we’re just really proud of this and 2020 is going to be no different. We expect to improve and leverage SG&A in 2020. We’ve had consistent strong adjusted EPS growth, so high single-digit, double digits with tax reform and again, high single-digit in 2019 and 2020. So our range is 7% to 9%, mid-point is 8%, the peer average is about 1% to 2%.

This is my favorite Slide, best-in-class free cash flow conversion. We spend a lot of time on this, because we believe cash flow drives value and Church & Dwight in 2018 was 124% free cash flow conversion, that’s free cash flow divided by net income, the peer average was 85%, a lot of companies target 90%.

Here is a new slide for you. Here’s our history over time. 125% in 2015, 130% in 2016, 123% in 2017, 124% in 2018 and 128% is what we just finished out in 2019. Our outlook for 2020 is 119%. So we just believe this is what sets us apart from our peer group to play in the 80s, 90s or close to 100.

And how do we do that? Well, we do it a couple of different ways. One is really strong cash earnings. The second one is our improvement in working capital, cash conversion cycle. We’ve gone from 52 days in 2009 all the way down to 18 days in 2020. If you strip out the last two acquisitions we’ve done, this shows you how good we’re doing it at really moving the needle in working capital, trying to get down to zero. That’s still a goal.

So we’ve gone – if you strip those two out, we’re at seven days today. Our baseline changes, because we’ve added these two new businesses that have a Chinese supply chain. So now we start off at 18 and we’ll continue to work through that number. But you’re going to see that we had great working capital improvement in 2019 and we expect no different in 2020.

And we have a very strong balance sheet. We ended the year, less than 2 times levered, 1.9 times, we expect by the end of 2020 to be about 1.5 times. We have significant financial capacity, right? When you’re 1.5 times levered by the end of the year, you have the ability to do deals.

Our prioritized uses of free cash flow has been the same for many years. Number one is TSR-accretive M&A. Number two is TSR-accretive M&A, but debt reduction is number two, and that’s where we’re going to use the cash for this year. Number three is NPD, number four is CapEx for organic growth, and then number five is dividends or buybacks.

We’re not a capital-intensive company. We’re bumping up about $90 million next year and that’s still less than 2% of sales. We have a great dividend increase in 2020, it’s 5.5%. This is 119 years consecutively paying a dividend And then here is a new slide for you. Over the last three years, our average in the peer group for dividend annual growth rate was 8% and that’s the top tier of all of our peer set.

And so with that, I’ll invite the management team up and we’ll answer any questions.

Question-and-Answer Session

Operator

A – Matthew Farrell

Well, all the hands are up, hands not even up here yet. Okay, Nik.

Nik Modi

I finally beat someone taller than me. So I guess, two questions. I remember, I don’t know, maybe it was 10 years ago, seven years ago, compaction was a pretty big deal for Church & Dwight from a margin perspective. So I was hoping to get some perspective from you on the new product launch and what that means for shipping costs and just packaging costs and how you think about that?

And then the second is, when it comes to FLAWLESS, I know there’s kind of conflict right between the As Seen on TV and the merchandising aspect. And so just thinking longer-term, is there a plan to like completely migrate this to a in-store and digital and online product where you don’t have that comp, because you guys have really execution, merchandising, display activity. So just – was hoping to get some clarity on the long-term plan there?

Matthew Farrell

Well, I’ll take that one first. Yes, I mean the plan for FLAWLESS system migrated from As Seen on TV brand and completely into the wet shave aisle and completely vacate that part of the store. Because in a lot of stores, it’s not in a very attractive place. So if you look at one major retailers by automotive. But when we bought it, we said no, this is a brand that’s going to have legs at long-term and it belongs to wet shave aisle. And one major retailer is getting behind it right now. So over time, that’s what you’re going to see happening. It’s happening right now in 2020.

Your other question was about compaction. So when compaction happen, there is one major retailer that drove that many, many years ago, that’s not on the horizon right now for the industry. I mean, right now, one would argue that the biggest form of compaction is pods.

So that pods at some point – if pods at some point plateaus, I think, it’s possible then we would go back to, it may be a major compaction for liquid laundry detergent, but that is clear enough on horizon right now. Were you asking the question about that new product…

Nik Modi

Yes.

Matthew Farrell

…that we have online. I’ll let Britta take a swing at that one and what the insight was around that.

Britta Bomhard

So I think you’re talking about the product I showed, that’s an e-commerce play, right? So it’s not in mass distribution, because I think I’ve said that, and you’ve seen our ambition to grow on the online class of trade, because that’s where all the consumers go and a lot of shopping happens. And currently, there is not a good loan resolution there. And that’s why we’ve developed this specific product for that class of trade, and we’re seeing phenomenal results.

Nik Modi

Great. Thank you.

Matthew Farrell

Okay. Bill?

Bill Chappell

Yes. Sticking on the laundry side, maybe first on CLEAN & SIMPLE. Can you give us a little more color. Is this incremental shelf space? How cannibalistic do you expect it to be? And then also, I mean – and maybe it’s in the plans, there is not a pod form coming out, I guess on the initial launch. Well, it seems that Tide is coming at you with the Tide Simply version of pods.

So maybe the thought behind that of is, are you seeing pods in your category start to level out where it’s not as important? Do you not see this as big of a threat? So any more color both around what the shelf space looks like and how you expect this to interact with the core brand and then also just from the pod standpoint, the competitive launch?

Matthew Farrell

Yes. So CLEAN – I’ll let Paul comment at some point, but CLEAN & SIMPLE, whenever you launch a new product in liquid laundry under the ARM & HAMMER brand, you’re going to have some cannibalization. But this one there will be some cannibalization, but net, it will be incremental to us and we think as well to the category.

As far as, are we going to move into pods for CLEAN & SIMPLE, we wouldn’t disclose what our plans might be with respect to the CLEAN & SIMPLE as a platform. Could it happen? Absolutely. Bill, I’ll let Paul comment as well some retailer reception to CLEAN & SIMPLE.

Paul Wood

Yes. I’ll be a little guarded just in the message, more for competitive reasons than I’m to avoid your question. But what I would tell you is, with every launch, we are going to have that cannibalization where you have the incrementality, absolutely. This one is a little different though, the story on this one of everything Britta showed in the marketing and the timing, what the consumers are looking for in the health and wellness front, just the other trends going on, makes us a very interesting story as you’re pitching it to get incremental space, different space, display space, other things in the store.

I would tell you, it’s happening as we speak right now, the resets, so I don’t want to give away what others are doing. But I’d encourage you the next couple of weeks to get out to a retail, loved to have retail with you and show you firsthand. This one is a little different.

I would also tell you on the insights front, we believe this isn’t just looking at the consumer within our set today buying another yellow bottle. This is going to get some attention on shelf from maybe you’re not buying it today. This is going to bring you in, the CLEAN & SIMPLE, the marketing grid has got behind it. You just saw fraction of it today. In the shopper marketing we’re doing with retailer is going to be a little special. So I’m excited, I’m going to temper my vocabulary here, but love to talk to you more on this one.

Matthew Farrell

Okay. Rupesh?

Rupesh Parikh

So I guess, just my first question with FLAWLESS, just curious what drove the shortfall in Q4. And as you look to this year, just want to get a sense, it seems like distribution is driving all the growth, just wanted to get a sense of velocity, the contributor. And then, also do you expect any inventory adjustments?

Matthew Farrell

Yes. So in the fourth quarter, we were down year-over-year. So business was $180 million in 2018, it was $186 million in 2019. We bought the business, we thought it would be higher by the end of the year. We know why – a couple of things we disclosed. We had an issue with one large retailer, Bed Bath & Beyond and we also delayed a launch into 2020.

Now as far as the consumption goes, consumption was down significantly in the fourth quarter. We expect that to continue, but to start to recover in the first quarter. And by the time we get to the second quarter, we’re in the new launch and also the new distribution, we expect consumption in measured channels, because measured channels in this – for this category is less than 50%.

But you’ll start to see in measured channels a year-over-year increase. And we think it’s going to build from Q2, Q3 and Q4. So I think a lot of the growth is ahead of us starting in Q2 as a result of the NU RAZOR.

Rick Dierker

Yes. And I would just add to that. From an organic growth perspective, right, we’re calling 50 basis points for tailwinds from FLAWLESS. In Q1, we think it will be flat to slightly down, and – but pretty much 90 basis points to 100 basis points of tailwind in the second-half and that’s how you get to the 50 basis points for the full-year for organic.

Rupesh Parikh

Okay, great. And then…

Matthew Farrell

Do you have another one, Rupesh?

Rupesh Parikh

Yes. One quick one. So just in your guidance, what are you assuming for the promotional environment?

Matthew Farrell

Okay. So on the promotional environment, we’ve talked about every quarter, and as many of you know the promotional environment generally talking about the household side of the house and not a personal care. And when we say household, it’s about laundry and we’re talking about litter. I’ll take litter first. The litter category is pretty tame right now as far as the promotional environment. So if you look at sequentially, it was pretty much flattish and even year-over-year, there is no story there. So we think it’s steady as you go in litter.

I think you got to keep in mind is that, in the litter category these hard fought price increases, it’s unlikely that the suppliers are going to want to deal that, that the hard one increased back to the consumers. So I wouldn’t expect that to change in 2020.

Laundry, same story. I mean, Q4 was our lowest quarter of the year, 25% sold on deal. And the category was 35%. And liquid laundry, little bit higher, it was 37% sold on deal. But two big suppliers would be Church & Dwight and Henkel both down sequentially from Q2, — pardon me, Q3 to Q4. And Procter was up, it kind of filled the void in the promotional space. We expect that to continue in 2020. Okay. Your next. Yes.

Rupesh Parikh

Okay. Thank you. Just on the – sorry, 3.5% organic growth, like and you’re exiting that you said is now out of the vitamin. So the vitamin business in private label, is that going to be – I’m assuming that growth was more dilutive to your growth or – it was actually growing faster. So that 3.5% on a more continuing space is like a 4%, or is not – is small relative to make – to move the needle?

Matthew Farrell

Yes. I’ll take a swing at this and then Rick can jump in. Yes. So we call it 3.5% for 2020. Our run rate in the second-half of 2019 as a company is 4%. We’ve said, hey, that’s going to accelerate by 50 basis points, because of FLAWLESS from 4% to 4.5%. So we have 100 basis points go in other way for two reasons. One, exiting private label vitamins and number two, we’re continuing to pull back on OXICLEAN promotions.

Now with that 100 basis points, the lion’s share of that is the vitamin business. We have stepped up our innovation over the last couple of years in vitamins. If you saw the Slide that we had earlier, you’ll see – if you went back to 2016 and 2017, we had like six new launches a year, 2018 – from 2019, we had 22 new launches and next we’re going to have 17 new launches. So – but this is the right time to exit our private label, it came into the company with the acquisition and it’s lower margin and we think it’s fine.

Rick Dierker

Yes. I would just add, that business was flattish, the private label business for vitamins, it wasn’t declining or anything like that. We just felt that, that wasn’t the right strategic choice for the company. So we decided to proactively get out of it.

Rupesh Parikh

And that is I think – that is accretive to margins, If I assuming right on exiting, to end that business or that’s not?

Rick Dierker

It’s – when you think about the scale and the size of that business, right, where – if we give you a sense of it, if we’re saying 100 basis points is going down for those two things, maybe two-thirds of that is the private label and one-third of that is the laundry stuff. So, any impact on margin is pretty minimal.

Rupesh Parikh

And following up on Bill’s question, if I may, on the CLEAN & SIMPLE, is that a margin accretive innovation or in the meantime you might have – like, what is the price point that you’re positioning at this point?

Matthew Farrell

Hey, Paul, do you want to take a swing at the price points?

Paul Wood

Yes. So the price points, this is going to be right in line with our existing lineup. So just as Britta was talking about the efficacy and it being equal, that’s how it will show up for shelf as well. And that’s a really big message that our retailers really resonated with them that it was going to be line-priced.

Rick Dierker

And then from a margin basis, we wouldn’t really say much, but it’s at brand average. Year one we have, of course, cost to drive volume for incrementality.

Matthew Farrell

Okay. Joe?

Joe Altobello

Thanks. Just wanted to get a bit more color on the increase in marketing spend, obviously a big in the fourth quarter, and it sounds like you’re looking for about a 1 point of headwind on EPS growth in 2020. What’s driving the increase? Is it bigger new launches and what particular brands is it going behind and are you shifting dollars away from promo into marketing?

Matthew Farrell

Is the question with respect to fourth quarter?

Joe Altobello

Fourth quarter and 2020 as well?

Matthew Farrell

Okay. Well, fourth quarter, we could see what was coming and we are doing well on top line and gross margin. So we have a chance to reinvest both in marketing and in SG&A. We call that all places we invested in SG&A. So obviously, we’re able to throw a lot of money behind on the brands. That – and that always helps you going into the new year. As your question about 2020, is the 10 basis points uptick?

Joe Altobello

Yes. More so that the 1 point of EPS headwind that you’re expecting to from launches?

Rick Dierker

The 10 basis points does represent the 1% EPS drag and it’s really for the new launches, right. The one on the table, we’ll really get behind that in a big way. The NU RAZOR for FLAWLESS get behind that in a big way. And then maybe, Britta, if you want to talk about.

Britta Bomhard

Yes. So we have a couple of exciting product, as you saw. So, for example, BATISTE foam, we are category leader and as you’ve seen, there is a huge household penetration opportunity, it’s also a new hair type. So we’re going to spend some money on educating consumers about a new way, particularly women with curly and dry hair.

Matthew Farrell

And maybe one more I had, I just thought of is, we showed you household penetration for WATERPIK in the U.S. versus internationally, and we found that it’s very responsive to advertising. And so now we’re going to start rolling that out in Europe and Canada and Australia. So that marketing investment is happening globally as well.

Joe Altobello

And just one for Steve. The increase in operating margin for international this year is pretty big. Is that coming from sales leverage among other things or cost savings programs? What’s driving that?

Steven Cugine

Yes. So I think there’s a couple of things. We had some expense in the year that we’re not going to recover. We feel like we’ve made investments on top of that, that we’re not going to repeat again in next year. I would say, that’s a large part of that and there is some mix as well.

Joe Altobello

Okay. Thanks.

Matthew Farrell

Okay. Steve?

Stephen Powers

Okay. I do have a question for Steve. But something Rick said earlier prompted another question. Why would FLAWLESS have any impact on organic regardless of what it does in the first quarter, given that you didn’t owner it a year ago?

Rick Dierker

It doesn’t. I was trying to give you a sense that on a reported basis in Q1, that it could be flat to down. The organic impact is 50 basis points for the full-year. All of that’s in the second-half, around 100 basis points.

Stephen Powers

Okay, perfect. And then internationally, maybe you could get a lot going on, but maybe you could rank order, the growth initiatives you have on top three, whether you think about it by brand, by geography or by category? And then as you think forward with the commitments or margin expansion as an evergreen, does that inhibit your ability to kind of press on growth as you have been or should we expect some deceleration back down toward that Evergreen’s six-ish level?

Steven Cugine

No, we feel really confident, I mean we see the business accelerating as you saw in 2019, and we see that continuing into 2020, again with less requirement for investments. Because we think we have the right kind of staffing level in each one of the regions, China was a big investment over the last couple of years, as we’ve built our own team in China plus we spent money on slotting, getting product into that market.

So we think all of that, whether it would be Latin America, which has been growing very nicely for us and in Asia-Pac, whether it would be China or Southeast Asia, we’ve made a lot of investments in the past. And now we think we can reap the benefits of continued strong organic growth without those investments repeating. That’s just – that’s why we feel, so confident that we can continue to deliver on the operating margin, because we’re going to get leverage in the P&L. So we’re going to get that on marketing and we’re going to get that on SG&A, for sure.

Stephen Powers

It is the growth investment skewed anywhere, I mean are you more excited about emerging markets about…

Steven Cugine

You know it’s a funny thing, and [indiscernible] is here. He runs our GMG business and he would say this year, we had strong growth in EMEA and in Latin America. Latin America is smaller for us, but fast growing. We made those investments in China, we saw very strong China growth in 2019 and we expect strong growth in Southeast Asia as well. Asia, in particular, we see is real growth engine long-term for the company, because we’re just still young and small, but growing fast.

Matthew Farrell

Okay. Swing to this side of the table, Kevin?

Kevin Grundy

All right. Kevin Grundy, Jefferies. I had a question on international as well. So it works out. So connecting the dots just to sort of pick up where you left off there, Steve, given that why the implied deceleration in the outlook for international and I don’t want to diminish 7%, which is outstanding. But you guys haven’t done a 7% in the past five years in the region and now you have a presence in China.

So I’m just trying to to connect the dots with that. And then more broadly, maybe, Matt, you can chime in the role on M&A and how you potentially see that longer- and growing your international business.

And lastly, from a capital planning perspective, when do certain markets you potentially consider moving them from the export model to the subsidiary model? What’s sort of like a tipping point? How do you think about that and implications from an income statement and from balance sheet perspective? Thanks.

Matthew Farrell

Okay. I’ll try to remember all that. Let’s start off with the current year. So, we have an algorithm of 6% annually. So we always go back to that, can we sustain 6% year-after-year-after-year. And if you look at what Steve has been doing in international is hitting out of the park.

And so, now we got a big plan for this year, you might say you’re sad because it’s not 9%, but we’re not a company that’s going to get way out over our skis. So we think we got a strong plan for 2020. We don’t view that as a deceleration, we look at that as we’re consistently now delivering above our algorithm.

You asked the question about international. So we have done some M&A internationally over the past few years. Viviscal was a – is an international brand. Our WATERPIK had some international as well. We bought the ANUSOL brand from J&J. And so we’re putting a lot of effort behind those and we get a lot of traction.

So Steve and his gang have done a great job, taking those two to international markets. So we’re continually scanning for things that we can acquire, and we can put into our infrastructure and leverage it. But we’re pretty fussy about what we’re going to buy. And as you know, you had a third one though, the third question.

Kevin Grundy

Yes, when does it tip to go direct?

Matthew Farrell

Yes. Okay, I’ll go – Steve can say what we’ve done in Germany.

Steven Cugine

Yes. So we look at markets where we can go direct and it really is all about SG&A leverage. So how concentrated is the retail environment. And in Germany, it’s quite concentrated. So, we were able to go direct in Germany and manage that P&L, so we get returns fast. My two buddies down here, they’re pretty disciplined about spending and returns, as you can imagine.

So you really need like a 20 to 1 relationship in terms of SG&A investment to sales growth. And so where the markets are young and highly fragmented from a retail environment, it takes a lot more SG&A to make that happen. So we know the underlying economic model for us, what we need to have to shift from an export market to a subsidiary market. And we’ll make those calls as we see fit, but that is not required for us to hit our evergreen target.

Matthew Farrell

Okay. All right. Same table, Jason.

Jason English

Good afternoon, and thank you. Two very different topics for questions. First, sticking on international, but with a supply chain angle. Can you update us on the status of tariffs on your supply chain and also whether or not we should be considering any risk related to the coronavirus in terms of supply and manufacturing of – whether it’d be the WATERPIK or I’m not sure where FLAWLESS is manufactured whether we should be cognizant of that as well?

Second is on private label. Could you size of 100 bps drag, how much of it is from the private label exit, any reason to think that may actually suck some capacity out of the industry and help your branded side? And is there also maybe on the other side of that, risk presumably a good time to exit would have been five years ago when you’re spending a lot of money to add capacity, I imagine you chose not to, because of, there was a risk tethered to it. If assuming that’s the case then why is that there no longer that risk?

Matthew Farrell

I’ll start with China. So we’re well aware of what’s going on in China, right now with the virus. So we have checked with our suppliers of both of finished products and also business like FLAWLESS and SPINBRUSH and WATERPIK. And right now, it looks like because of the extension of the Chinese New Year, there is going to be a one, maybe two-week delay in startup of those manufacturing sites. But because of our safety stock what’s on the water and also, you can overcome some of delay like that with air freight, that we don’t see a risk right now with what we know right now to quarter call that’s in the – it’s in the release. Good on that one?

Steven Cugine

Yes. And then on tariffs I would I try to talk about in my prepared remarks, a little bit. But that 1% drag on EPS is tariffs that’s really the four B list that went into effect on December 15, and we’re getting hit on showerheads and FLAWLESS. So you can do the math on what about 1% EPS drag is, but it’s a couple of cents.

And then your other question on private label vitamins of 100 basis points decline in organic growth, I had said about 60% is piece of the private-label vitamin beginning to exit, right? It’s a two-year process. So 50 bps of the 100 bps is from private-label vitamins. And I don’t know, Rick, if you want to say anything else about the supply chain in China or are you good?

Rick Dierker

Yes. Matt pretty much covered it. We’re working very closely with our suppliers. And what we know so far is the one to two-week delay that Matt referenced on starting up after Chinese New Year. We have ample safety stock don’t anticipate a material impact to Q1, but it’s something we’ll continue to monitor on a regular basis.

Matthew Farrell

Okay. All right. Okay. You’ve been waving your hand for a while.

Stephen Powers

Thanks, Matt. Wanted to talk about two different categories and just state of competition in laundry and cat litter, and then also your expectations for fiscal ‘20 between volume versus price mix?

Matthew Farrell

I couldn’t hear the very first part of it.

Stephen Powers

Laundry and cat litter, the state of competition.

Matthew Farrell

Oh, the state of competition in the laundry and litter category? Okay. Well, I mean you saw the chart with respect to shares in laundry. We had a great year in laundry. ARM & HAMMER was up. XTRA, for the first time in a longtime held share up a little bit. And OXICLEAN, we lost some share, but that was as not as expected because we pulled back on promotions.

You also saw from the chart the dynamics over the last three years, but who is winning and who is struggling. We think we have an unfair competitive advantage in the laundry detergent, because we have a value brand, that’s advertised, which is ARM & HAMMER. And ARM & HAMMER is $1 billion brand if you go across all of our categories. And actually we’ve done a wonderful job in positioning that product against Sun over the last couple of years and we continue to win distribution.

So we’ve got a long-term plan and we aim to be the number two supplier of laundry detergent at some point. In the litter category, litter is a function of innovation and we have been the innovator in that category for many, many years. And we think that over time that is going to bode well for us as far as growing share in the future.

I commented earlier about the promotional environment, it is pretty much – pretty tepid, I would say, in both categories. I don’t expect that to change in litter as we said, because we’re not going to deal back your price increases. And I do think that the reduction in the amount sold on deal in the laundry category is really de facto price increase, we want list price increases in laundry. But the pull back in promotions as a group over time is de facto an increase in price and it improves margins.

Steven Cugine

And Matt, if you want me talk about just how we advertise Oxi Laundry and what’s this done to the additives category?

Matthew Farrell

You can do that.

Steven Cugine

Well, sometimes myopically we just look at, Oxi Laundry is down a little bit in share, but we really didn’t take a broader brush and say since we launched OXICLEAN laundry, we’ve gone from a 42 share in additive to 56 share in additives. So we’re really happy with our OXICLEAN megabrand.

Matthew Farrell

I hope everybody paid attention to that. So if you go back and say, wow, OXICLEAN launched into premium laundry detergent and we’re sad because it didn’t work out. No. So in stain fighters, we had a 42% market share when we launched OXICLEAN over in liquid laundry, it went from 42% to 56% today. So all that effort paid off, and so we’re making a lot more money today. So that brand is alive and well.

Britta Bomhard

Can I add something. So you see…

Matthew Farrell

Let’s pile on here. This is good.

Britta Bomhard

Sorry?

Matthew Farrell

Let’s pile on.

Britta Bomhard

Yes, well, I love that brand. So I have to talk about brands. And I think you’ve seen the more power to you and what it does for us. We now have a similar and that’s work your magic on OXICLEAN, which is equally working extremely well across the different components of OXICLEAN. So if we have several very clear evidence the lifts after we advertise and then it’s across the different sub-segments of OXICLEAN as well. So I’m very confident, positive that OXICLEAN is a very, very strong brand and we continue to grow.

Matthew Farrell

Okay. All right. It looks like we might be done. Hey, I want to thank everybody for coming today. We had great questions and looking forward to talking to you at the end of the first quarter.





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Software AG (SWDAF) CEO Sanjay Brahmawar on Q4 2019 Results – Earnings Call Transcript


Software AG (OTC:SWDAF) Q4 2019 Results Conference Call January 29, 2020 3:30 AM ET

Company Participants

Otmar Winzig – Investor Relations

Sanjay Brahmawar – Chief Executive Officer

John Schweitzer – Chief Revenue Officer

Arnd Zinnhardt – Chief Financial Officer

Elke Frank – Chief Human Resources Officer

Stefan Sigg – Chief Product Officer

Conference Call Participants

Alastair Nolan – Morgan Stanley

Michael Briest – UBS

Gautam Pillai – Goldman Sachs

Knut Woller – Badder Bank

Charlie Brennan – Credit Suisse

Den Merkt – Barclays

Otmar Winzig

Good morning, ladies and gentlemen. Welcome to Software AG’s Analyst and Media Telephone Conference and webcast on preliminary fourth quarter and full year 2019 results. Last night, Software AG has pre-announced preliminary results for the reported quarter and fiscal 2019. This morning, we have published a presentation used in this call.

Today’s call will start with CEO, Sanjay Brahmawar; followed by Chief Revenue Officer, John Schweitzer; and finally CFO, Arnd Zinnhardt. The presentations will be followed by a Q&A session. Our board members Elke Frank and Stefan Sigg are also on this call to answer your questions. We will try to keep this call in the regular one hour timeframe and cover as many of your questions as possible.

Before we start, there are some housekeeping remarks. This telephone conference will also be broadcast by accessing webcast is via our Investor Relations Web site. The webcast will display the PowerPoint presentation charts related to this call. The same slides are on our website for download. After the presentations, you may ask questions. Please use only the dial-in phone number for posting questions. The dial-in numbers are also published on our Web site. For technical reasons, we cannot take any questions via e-mail during conference call.

The call and the webcast will be recorded and available for replay later today. With respect to capital market regulations, I would like to make the following safe harbor statements. Statements and presentations made in the course of the conference call and webcast include forward-looking statements based on the beliefs of Software AG management. Such statements reflect current belief of Software AG management. Such statements refer current views of Software AG with respect to future events and results and are subject to risks and uncertainties.

Actual results may vary materially from those projected here due to factors including changes in general, economic and business conditions, changes in currency exchange; the introduction of competing products, lack of market acceptance of new products, services or technologies and changes in business strategy.

Software AG does not intend to assume any obligation to update these forward-looking statements. Statements and presentations of this call and webcast constitute neither an offer nor a recommendation to subscribe or buy in any other way securities of Software AG and any of the companies that are members of the group at present or in future, nor does it form a part of such an offer and it should not be understood as such.

Statements and presentations of this webcast do not constitute an offer of sale of securities in the United States of America. The securities may not be offered or sold in the United States of America without registration for exemption, for registration in accordance with the U.S. Securities Act 1933 in its currently valid form.

Thank you for your patience. Now let us start, and I hand over to Sanjay Brahmawar, the CEO of Software AG. Sanjay?

Sanjay Brahmawar

Otmar, thank you and hello, everyone. There’s a lot of ground to cover today. You would have seen in our results and the new 2020 guidance we issued overnight. Before we dive into details, I want to take a moment to set the scene. Almost one year ago we launched Helix, our plan to transform our company and create a sustainable, profitable future for Software AG.

It is a bold plan for a big challenge; the challenge of investing and working with clarity to address under investment in our products, sales force and go-to-market; the challenge of building a new partner ecosystem to help us scale and grow; the challenge of transforming our culture and pivoting ourselves towards growth. This transformation is working. Everything I have seen in 2019 in our transformation, in our energy, in the winds we are securing and in the way we have risen to our challenges, makes me believe that we are as right to be bold today as we were 12 months ago. I am proud of our team and proud of the progress we have made.

The investments we made in 2019 have started to pay off and further clarify our way forward.

And further clarify our way forward. This clarity underpins our belief that now is the right time to make further investments in 2020 without losing sight of our medium term goal. It also helps us understand where and how to make that investment.

We exit year one having laid a strong foundation for our future. We have a clear market opportunity in front of us and we have a team that is match fit to chase and converted it. If we invest now to backup strengths and capture a market in takeoff mode, we believe we have the opportunity to deliver higher sales growth earlier than planned. 2019 has seen us focus our investment around four major work streams; product clarity, go to market effectiveness, our shift to subscription and turbo charging our partnerships. More than 95% of the work we set out has been done on track and has the potential to really move the dial on our momentum in 2020.

We have brought clarity to our product set. It was already best in class but too broad, too complex. Now, best in class is better, still and simpler to spell. We have dramatically simplified our offering, reducing 900 individually priced features and functions to 40 simple and easily understood bundles. We have created cloud offerings for every product set and our customers love what we are doing. Our product NPS is up to plus 40 for 2019 and plus 44 for Q4 both record highs.

With the new clarity around our product message has helped us significantly improve our sales effectiveness. There is hunger in our teams and we are shaking up the competitive dynamic of our sector. Our EMEA and APJ businesses are both now growing double digit. We now have a North American business, which is stable, predictable and ready for growth. Globally, we have won 342 new logos this year, representing 42% year-on-year growth and in the process displace competition from IBM, PTC, Apogee, MuleSoft, TIBCO and others to make a major impact in our market.

We have changed how we sell, transitioning with purpose to subscription. You can see the impact of these efforts in the new KPIs we introduced at our Capital Markets Day last year. For the full year 2019, our DBP business, including cloud and IoT, delivered 51.5% of its bookings through subscription and SaaS, up from 26.5% last year. 21% of its revenue is now subscription and SaaS, up from 11% last year and ARR here grew 10% year-on-year.

We have also invested in changing who we sell with. We started 2020 working hand in hand with fantastic partners like Adobe, Microsoft, AWS, Deutsche Telekom, and others. The power of these partnerships is beginning to show through in revenue with our first deal with Adobe Marketo, OEM closed Q4. Early days, but each one a brand new logo for us.

None of this has been easy or without challenge. No transformation of this magnitude ever is, but we are now a business that is fitter, shaper and hungrier for growth in every way. During 2019, we have seen the theory of Helix begin to translate into practice. I believe that the right thing to do in 2020 is to back our conviction, take advantage of our position and turn our hunger into real momentum and impact.

Our products, our sales hunger, our subscription model and our partner alliances all align with the way our market is moving. After 12 months of intense learning and focus, our people now think in the way our customers’ think. Elke Frank, our CHRO, and her team have started a tremendous cultural shift within our organization, pivoting to a new mindset across the company, something she will talk more about at our Capital Markets Day next week.

What we and our customers are now thinking about is change. Since 2000, 50% of the fortune 500 companies have been acquired, merged, or declared bankrupt. Their world has changed and now they must change too. In 2020, analysts expect global public cloud to grow by 17%. They also expect hybrid cloud to grow at the CAGR of 23% in the five years to 2023. KPMG tells us that enterprises have received the biggest budgets for 15 years to transform, automate, implement IoT, and tackle cyber security.

This world of change is where we fit and our products have a real role to play right at the center. As digital transformation gather space, our own transformation inside Software AG has positioned us to take share, innovate and expand our customer footprint. I’m going to come back to three specific 2020 opportunities for us before we move to the Q&A.

For now, let me move for a moment to the 2019 numbers. Against a backdrop of a year of significant transformation, today we are reporting a solid full year performance in line with our expectations for the Group. Group revenue and Group product revenue both grew 1% year on year at constant currency. That’s a solid performance against the backdrop of significant transformation in our business. Group EBIT was down 7% as expected with good cost control. And we delivered a non IFRS operating margin of 29.2% right in the middle of our guidance range.

At this point, I do have to acknowledge that our IoT performance was weaker than we had liked, up 38% year on year at constant currency, but not the growth we have pushed for. As we grow our IoT business from a relatively small base, we remain dependent on the timing of certain anchor deals to make our numbers in each quarter. Our Q4 performance in IoT saw a growth of 16%, which was held back by the slippage of one very large deal into Q1 of this year. That deal, another landmark five-year IoT agreement, has now been signed. It is an agreement with Schindler, the industry leading elevator and escalator manufacturer.

Schindler will adopt our Cumulocity IoT platform to connect more than 1 million devices and serve more than 1 billion users globally. Schindler is putting its trust in us to automate and customize innovations on a massive scale. I see this as another landmark step forward for our IoT business and a major show of faith in our industrial IoT capability. We fought hard to win it to beating competition from IBM and others.

In 2019, our pitch to help companies democratize their data secured us 79 new logos in IoT. In Q4, we saw new logo gains across all parts of our footprint. In the DACH, we landed a new IoT mandate with Trailer, a groundbreaking solar transportation solution developed by Deutsche Post DHL. Cumulocity will serve as the data backbone to a solar panel and factory powered fleet that is central to DHL’s target to achieve zero emissions by 2050.

In North America, Swift Labs joined our IoT customer list, selecting Cumulocity to help drive significant unit sales of a wireless IoT cellular platform in 2020. BSA, in Australia, chose to work with us to combining Cumulocity and web methods I/O to collect, analyze and act on vast quantities of data across its building and system footprint.

And remember, our IoT sales strategy isn’t just about land, its also about expand. NTT communications, a Cumulocity customer since 2017, agreed in Q4 to white label Cumulocity IoT as the foundation for its NTT things cloud. It’s also licenses our device connectivity and device management products, as well as our streaming analytics Cumulocity IoT Edge, and most recently the new Cumulocity IoT DataHub solution. Its wins like this that reminds me and make me a firm believer in our ability to drive IoT growth in momentum.

Looking at our IoT pipeline also gives me comfort. Our IoT pipeline is strong, both in terms of its absolute size and in terms of the quality and scale of opportunity within it. To qualify that for you, our 2020 IoT pipeline is now larger than ever, in fact, well over EUR100 million. We are seeing deals make up a meaning meaningful portion of the pie. As the only vendor in the market that can offer IoT capabilities, integration and integration flow technologies all woven together as one, I’m excited about our ability to continue growing in IoT, particularly with the market now beginning ignite.

So having built our foundation in 2019, 2020 for us is all about momentum. We can see our plan is working in product, sales and go-to-market, in our partner ecosystem and in subscription. With the wheels turning and our path becoming clear, I believe we are now in a unique position to bring forward some of the benefits of our transformation.

To achieve that, we believe it’s the right time to increase key investments in our sales efforts. Helping us reinforce and enhance our presence in key regions, we need to respond to the success we are having on subscription, investing to accelerate the build out of our customer success function. We need to put more resource into marketing, helping our teams continue their contribution to our newly energized pipeline. And with fantastic partners now in place, we also need to bring forward investments designed to truly activate our channel in a growing market.

You will have seen these investments captured in our revised guidance for 2020 and our targets for the medium term. Crucially, we expect these investments to lead to higher growth rate in our 2020 top line metrics than previously forecast. Conditions are such that these investments should allow us to capture more market share and grow faster in year two of our transformation than first thought.

The decision to invest now behind this growth opportunity has an impact on our 2020 margin guidance. But we believe this short term investment of margin is right if we are to deliver on a medium term potential. You will also note some changes to our guidance metrics, reflecting the business we have become. We will now guide on four KPI metrics going forward. One that remains a constant, our non-IFRS EBITA margin and three that are new.

These new metrics will not chart revenue in our three business lines, instead, they will chart bookings, the true way to measure our momentum as we evolve our subscription story. For 2020, we anticipate DBP ex-IoT bookings plus 10% to plus 15% year-on-year growth; IoT and Cloud bookings plus 40% plus 60% year-on-year growth; A&N bookings minus 3% to plus 3% year-on-year; and non IFRS EBITDA margin 20% to 22%.

Looking further ahead out towards 2023 and the medium term, we’re also updating our targets to reflect the inputs and outputs of our accelerated investments. We are revising our target for growth in our digital business from 10% of CAGR to approximately 15% CAGR. Our recurring revenue target within our digital business of 85% to 90% remains unchanged. Our free cash flow and consistent dividend policy guidance is also unchanged. And as we invest to accelerate top line growth, our medium term operating margin target is revised from 30% to a corridor of between 25% and 30%. These are investments targeted at growth. On the basis of the planned investments outlined today, we now target group revenue to cross the EUR1 billion mark in 2023.

Let me now turn to the wider business. As you know, our Helix strategy is segmented into three key pillars, which we call focus, execution and team. I’ve spoken in the past about the three pillars at distinct areas of work. The reality is that we entered 2020 in a much stronger position, because of the mindset and the momentum these three work streams together have created. I talked earlier about our products and I could talk about them all day. In 2019, we brought new innovation to market every single quarter, increased our development velocity by 37%. Our product leadership was recognized in 10 rankings by Gartner and Forrester. But good product alone means nothing. When we launched Helix, I was clear that the transformation we wanted to lead would be different from those of the past. This transformation would yield real behavioral change and nowhere has that change been clearer than in our go-to-market execution.

This has been a major lift but we’ve made major progress. John Schweitzer’s efforts have given us a much more Agile failed engine with which to target our 2020 goals. I want him to say a few words about this now and give a sense of where he’s going to take the go-to-market in 2020. Over to you, John.

John Schweitzer

2019 was a year of consolidate and expand the sales and go-to-market organization at Software AG. As a result, we’ve seen extremely good performance in EMEA, consistency in our APJ business and new stability and predictability in North America. The importance of our North America progress can’t be under-estimated. During 2019, we dealt with historic underinvestment in the region, moved away from negative behaviors hampering growth and developed a pipeline we can trust.

As Sanjay said, we now feel we can trust the business to deliver plan or better. How we sell has an expected direct impact on our ability to win in this marketplace, as well as landmark wins in the first three quarters with the likes of Michelin, Novo Nordisk, National Cancer Institute and FIFA. During Q4, we continued to take market share from our competitors and prove our ability to win.

In integration and API management we won contracts with Fujitsu and Siemens for our cloud-enabled webMethods.io offering. The agreement with Fujitsu and APJ will see us facilitate the integration of its business applications with those of its third party vendors. Siemens has chosen webMethods.io also as its hybrid integration backbone for its global MindSphere rollout.

Also during the quarter, we were proud to expand our relationship with Estes, a leading truck operator in the logistics industry. We enabled them to deliver end to end transportation and customer logistics solutions. We are already a mission critical provider to this longstanding integration customer. However, we are now providing our IoT solutions to help track their assets and other container attributes as they move their fleets around the world.

In business transformation, we expanded our relationship with Australia Post as it seeks to increase to the level of automation in its systems and processes. And we also expanded at Suncor, supporting a number of significant business architecture and strategic planning initiatives. In A&N, we continue our strong performance, expanding our agreement with Nissan, which already uses Autobots technology to manage its spare part system, manage its vehicle quantity requirements and run its dealer auction systems.

These wins give us significant momentum into 2020, but they also inform me of where go to market efforts must go next. First, there’s no doubt that the subscription model is helping us to be even more competitive. In fact, customers expect this contracting approach. Having played catch ups here in 2019, it is now helping us run right to the front of the pack on deals we couldn’t access before.

Looking forward, we will continue to step up our investments in delivering subscription sales, investing particularly in our customer success function and how we price impacted our solutions. The second, we’ll be working to accelerate our demand gen. As we sell our plans pipeline, I believe we are really on to something with these changes in our market approach, something Paz Macdonald, our CMO, will talk to more about at the CMD.

Last quarter, we talked about 40% contribution coming from marketing qualified leads. In Q4 that mark hit nearly 50%. Continuing to invest in targeted customer messaging, value based selling, and a more robust end to end lead flow is critical to our continued success. And third we’ll seek to ignite our partner channel to help unlock the power of these new routes to revenue.

During 2019, we began to work productively with a host of hyperscaler partners. These are organizations with which we can stay meaningfully together as a provider of choice to supplement all enable their existing offerings and grow together in the process. We are now working hand in hand with the industry’s most visionary names. Adobe, Microsoft, AWS, Dell, Deutsche Telekom, ADAMOS and others, who have put their faith in us because they know what we can do.

These relationships already — are already beginning to bet down and take off. The relationships with Microsoft and Adobe in particular have already started to show initial proof points. With Microsoft, our focus does that help their customers move applications and other workloads to Azure quicker. The customer value proposition is strong and the combined sales teams have already built a pipeline of more than EUR 20 million in Q4 alone. I expect to close the first year in this quarter. And with Adobe in Q2, we announced a strategic partnership to help companies, transform their customer experience by bringing together customer data across multiple enterprise systems into Adobe’s experience platform.

As a first proof point of this customer value proposition, we’ve matched a certified connector, integrates the user’s SAP service cloud solution or sales cloud solution with Adobe Marketo Engage, establishing a direct connection between the customer’s data and Adobe’s customer experience management tools. Customer demand has driven this innovation. The pipeline is building, and I am very happy to announce the first deals have been looked at close in Q4, 2019. We also continue to expand our influence in the areas of industry for that up, joining the open industry for alliance in August and continuing to build our position as a leader within ADAMOS.

Our Cumulocity solution now underpins more than 60% of ADAMOS IoT applications and growing stable open, leading-edge IoT solutions for adaptive manufacturing. All of this is a great source of confidence as we build towards our medium term goal of generating an meaningful portion of our overall revenue for our partner base. I intend to increase our investments in activating this channel in 2020. Something we’ll get more detailed at our Capital Markets Day next week.

Now let me hand over to Arnd, who will cover the 2019 financials in more detail and also add his technical perspective to our outlook. In particular, he can help you understand the different layers of investment as it relates to our margin guidance. Over to you, Arnd.

Arnd Zinnhardt

Thank you, John. Good morning, ladies and gentlemen and a warm welcome to our conference call from my side. In the following, I would like to focus on the analysis of Q4 and fiscal year 2019. For total fiscal year 2019, our results can be summarized as follows.

Adabas & Natural showed a fantastic year, and we experienced a growth of 3% of product revenue. This corresponds to the upper end of our guidance, which was positively adjusted after that three months in the year. Adabas Natural license even showed a growth of 7%. Our annual recurring revenue ARR is an important metric for our transformation, you know that. We grew ARR close to 10% for total digital. As expected during the year, the digital business was heavily influenced by our restructuring process in North America. Over the full year, we saw a decline of 3%, which is within the ballpark of our adjusted guidance.

At the end of the day, we must admit that our cloud and IoT performance was disappointing. However, over the year we saw a growth of 38%. Also we noticed a strategic deal slipping into one, Sanjay mentioned that already. And as we speak, this deal is closed. All parameters regarding net asset position and liquidity are in line with our expectation, such as cash flow, balance sheet ratios and net income. As you can imagine, I’m very happy to report that the operating margin is at 29.2%, which is north of the midpoint of our guidance range.

After these opening remarks, I would like to guide you through the numbers. Over the course of the year, we saw a continued tailwind of 16.5 million in total due to a slight euro weakening against the U.S. dollar. Based on our revenue mix, all other currencies affected the stated numbers only to a minor degree. As expected and communicated, the DBP license business recorded a result below last year’s levels.

The EMEA region contributed a strong growth, which was healthy indeed, while the restructuring in North America remains ongoing, and as John explained on track. For maintenance DBP excluding cloud and IoT, we grew by 3% for the quarter and — 4% for the quarter and 3% year-to-date in line with the license performance.

The revenue development for the three months confirms the revised fiscal year 2019 outlook we gave in summer. In 2019, digital excluding IoT and cloud, showed decline of 3%, which corresponds to the midpoint of our revised guidance. Regarding ARR, our positive development keeps marching on. In 2019 we were able to achieve a growth of 10% and posted the number to 340 million, this number puts us on track in our journey towards the business model that is driven by a high portion of current revenue.

While for the entire year, we continue to see sales and marketing spend at a higher level plus 7% we will observed the slide reduction for the quarter in line with less sales commissions being paid. The R&D extended senses were up for the year as well and increased by 4.5 million due to further investments into IoT and Cloud R&D tools. Let me close the analysis of this chart by referring to the cost of sales, this expense line increased by 12% for the year and 19% for the quarter because of our growing SaaS cloud business driving the related hosting costs up.

Now on to Cloud and IoT. Even though IoT Cloud grew by 38% it showed a week performance than expected. As Sanjay mentioned we were not able to close some major leads, which less to escape the revenue below guidance. As you would expect IoT Cloud is mainly driven by new logos, therefore, we still do face certain lumpiness here. On the positive note, we are winning projects that are strategic to our customers, like the ones that slipped into Q1 sometimes it’s required a bit more time on our part to convince the respective organizations.

2019 was a great year for all of us natural and as expected we close the year in this segment at the upper end of our adjusted guidance with a growth of 3% year on year. Maintenance the indicator for customer loyalty showed growth of 1% net of currency year-over-year and outstanding performance and a direct result of our hard work we have done in recent years.

Additionally, costs are well under control for the quarter and for the last 12 months. Consequently the margin remained on a very high level around 70% resulting in the segment revived up close to 160 million. Professional service business lines performed as expected over the final month of the year. The focus in the segment remains on supporting our strategic license projects and simultaneously closing monetary profitability. With a segment of 12% for the year I can present again a pleasing result.

The flattish revenue was in line with our expectation as we cut back on non-strategic services and shift resources to enhance implementation and partner support our co-products. As you may know, we have a big consulting organization in Spain which generates a total turnover of approximately 40 million. While we are delivering high quality services, major parts of their business are outside of our co-offering.

In line with our communication one year ago as well as in line with our new strategy, we have now sold the Spanish service operations to a Spanish consulting company which will operate as an implementation partner for Software AG moving forward. I am very happy to announce that together with our new partner Barbell, we can continue to deliver support to our customers at a very high level and b, we have found a partner who share our business values. They will give our employees a good new home as the possibilities for growth in their individual careers, which is a compelling.

Closing on the transaction is expected midyear 2020, under this assumption; the revenue impact will be around 15 million to 20 million for fiscal 2020. On this note, I want to ensure our Spanish customers that we will without any question, support them with our local Spanish product team also moving forward. We, as a Board of Software AG, view Spain to be irrelevant, interesting markets that we want to continue doing business in. During the first year of all transformation, total revenues for the growth of 1% of currency.

Our increased investments into sales and marketing predominantly in North America and central marketing lead to higher expenses of €7 million or 6% for fiscal 2019. In addition R&D expenses were up by 7 million year to date, mainly driven by an increase in R&D workforce of more than 100 FTEs. Despite the higher cost and thanks to all us from natural business line, we were able to achieve an attractive EBIT performance. The overall margin development for 2019 is in line with the expectation we shared with you at the beginning of the year.

Equally, the development of our operating margin was well in the range of our expectations. For the quarter, the delta between IFRS EBIT and operating EBITA, amounts to EUR 18 million, which may be termed as normal pattern. All in all, this leads for a margin which is North of the midpoint of our guidance.

The operating cash flow in 2019 developed as expected due to investments in conjunction with Helix the operating cash flow remains lower than in 2018, but remains at a consistently high level. The balance sheet, I can be short and crisp. As usual, our balance sheet is solid. In the interest of time, I will not give any comments, but obviously, I’m happy to answer any questions if necessary.

Before coming to my closing remarks, I would like to make some technical remarks regarding the guidance of 2020. The market success of a company must be derived from the customers’ adoption of its products. In this context, the development and the consumption model of its product is irrelevant. However, honoring IFRS standards the mode of deployment determines point in time when revenue is recognized.

Perpetual licenses are recognized upfront, subscription licenses for the first year of commitment and software as a service contracts are recognized for pro rata. So it becomes obvious that I FRS revenue is not the best metric to measure up sale success when using a mixed license model. Therefore, we introduced bookings as a new KPI to track customer adoption and to measure sale success.

The way we defined booking is a normalized three years commitment of a customer follow up products. It does not make any difference whether the customer consumes a product as a perpetual license, as subscription or as a service. At our Capital Market Day next week, we will dig into the concept in far more detail. However, to give you a first sneak view and to enable you to start building your models, let me give you two further explanations.

Number one, based on the assumption that the split between perpetual, subscription and SaaS is approximately 50, 40, 10 based on total bookings and the percentage of subscription with a one year cancellation cloth compare to subscriptions without a cancellation option. And therefore with an upfront license booking is assumed to be roughly 50-50. Group product revenue should be flattish on 2020. And secondly, we assume that Adabas Natural will remain predominantly perpetual.

Ladies and gentlemen, just a personal note at the end. I joined Software AG 18 years ago and one of the first is, I know that start is, I read in those days written by the then young financial analyst Gregory Ramirez, quoted, “Conditions far from excellent for Software AG”. I took the challenge. And at that time a lot of analysts like Adam Wood, Knut Woller, Stacy Pollard, only to name a few, started challenging me.

Some of your financial institutions from the years in 2002 no longer exists today. But you, as professional individuals, accompanied Software all the time. After 72 quarters, ups and downs some thousands of meetings and call with more than 5,000 people, countless kilometers on the road or miles on the road in the air and on the rail, some sleepless nights and sometimes hard times. I want to thank you all investors and analysts, for keeping an eye on me and for your encouraging and of course sometimes challenging words.

I enjoyed the interaction with you. Many conversations gave me food for thought and drove decisions I made. I have loved it. Many thanks also go to my colleagues and friends here in Darmstadt and all around the globe for supporting me over the years. And special thanks to Otmar. Happy birthday, Otmar who was my teacher at the beginning, supported me all the years and was a mirror of the financial market in uncounted discussions, especially when the quarter did not meet mine and your expectations. And was instrumental to win all the investor relations awards we received over the years. Many thanks to you all. Goodbye for now and hopefully [indiscernible].

Sanjay Brahmawar

Arnd, thank you very much. I just want to take a moment to recognize all Arnd has contributed to Software AG in its 18 years with the firm. He has been a source of energy, expertise and leadership to many and a true partner to me. He will be the same partner to Matthias as he helps bring him on board.

So to conclude, the key takeaway from today’s call should be that we are going to deliver growth in 2020 and invest in building momentum towards our Helix ambitions. We have stronger business with a clear market opportunity in front of us. Earlier, I had promised to highlight three particular opportunities I see open to us in 2020. So let me close on those now.

First there is the connected customer experience, connected customer enterprise. For 50 years quality, consistency and reliability have been key differentiators in our industry. Not anymore. Instead, customer experience is a starting point of all products and service redesigns. Our worked for Smart City Dubai proved that we notice and that we are able to position webMethods as the backbone of a plan to make Dubai nothing short of the happiest city on earth.

Second hybrid cloud and multi-cloud. Cloud isn’t easy or straightforward. Platform polarization creates real challenges for global companies. Multi-cloud is going to be the new norm and on premise will for some applications remain the standards. All of this complexity makes a thin, independent integration layer critical to success in the cloud. This is what Walgreens has already trusted us to provide. That is why Microsoft partners with us to speed it’s a real migration.

Third, there is operational excellence, the lifeblood of modern enterprise, data managing, analyzing, and learning from that data is a key challenge for all businesses. They only benefit from the data if they use it to learn quickly from custom insights and respond to them to stay ahead. To do this, they need to democratize their data so that the whole business can utilize it, not just a team of data scientists.

This is what Cumulocity, our IOT platform is doing for Nordex, optimizing its wind turbine operations through predictive analytics. It’s also where RS is helping Outokumpu, Europe’s largest stainless steel producer to improve its operations through data driven process mining. So three key drivers of opportunity, one stronger organization ready to target them, one strong product set with skin already in the game.

With that, I’ll hand back to Otmar for the Q&A.

Otmar Winzig

Thank you, Sanjay. Thank you all the board members that presented here. This took a bit longer than normal as a special day obviously but I promise as you get the 30 minutes of Q&A. Operator Hailey, please would you repeat the procedures that everybody can get in.

Question-and-Answer Session

Operator

[Operator Instructions] And the first question comes from the line of Alastair Nolan of Morgan Stanley. Please go ahead.

Alastair Nolan

I’ve got three quick ones placed. Firstly, on the IOT deal, which moved into the first quarter and you’ve now closed. Could you just confirm or maybe provide some more detail? Would you have hit your guidance range of 75% to 125% had that deal closed in, in 4Q. And then secondly on the bookings metrics you’ve provided. You mentioned it’s a normalized three year commitment. Is that essentially then converting it into what would be a one year number? And maybe could you just touch on the, the assumptions around the splits that you were making, and also confirm that you said group product do you expect to be flat? And then just finally on the upgraded guidance for DVP on the midterm basis, 10% to 15% given the, this division has been, I guess we haven’t seen all that much of an acceleration in growth just yet, what has given you kind of the confidence to upgrade that midterm guide?, So what kind of timeframe are we talking about? Thank you.

Sanjay Brahmawar

Alistair, it’s Sanjay. I’ll take the first one to just explain because recently just being as a CEO and completing the deal, this is a significant deal for us, a very important one as you know, we were working on in Q4. It is big enough to be able to sort of cover majority of the gap that we would have had as we progress into Q1 we will give you more details on this. But, we are very pleased and very proud to be chosen by Schindler as their global partner.

John Schweitzer

I take note of the next one. Booking normalized for a year. So the number that we have in the guidance, is it three years numbers Alastair, let me just give one example of how we calculate that. And I’ll give you two examples. The first one is a professional license of five years. Let’s assume that, then we’d basically take the total contract value, which is a five year contract obviously based on my example. Then we’ve got divided by five years intensify three in order to normalize that into three years. On the other side if we would get a two year contract and we know that we have a high retention rate of all our customers.

The retention rate of all our customers, we would divide this is the multiplied by three. So to also to take into consideration that’s the view we renewed offset the time. So it’s always normalized on, on three years. A group product it’s less that is — that is correct just confirm that. Based on the assumptions that I gave in my presentation and once again I’ll just repeat them. So the perpetual subscription and SaaS has a split between 50 perpetual, 40 subscription and the around 10 SaaS. And out of the 40 subscription 50% has no cancellation rate, and the other 50% of cancellation rates of one year. And this is the growth I think it goes to you.

Sanjay Brahmawar

So Alastair, back on to your question on digital and what’s giving us the confidence. I would say three things really. Number one is pipeline. Pipeline is exceptionally strong. We can see that our coverage in the pipeline is way above the three mark. We are obviously targeting to get to full, but we are we have very strong on our pipeline. IoT pipeline already gave you the number. It’s EUR 100 million already. So, it’s number one.

Number two is the wins that we’re having in the market. A competitive wins really, we beat Apigee and Michelin, we beat and we are replacing TIBCO and Hellman, we’d beat IBM at Schindler. So the — these wins are giving us a lot of, lot of confidence that our capability in integration and API management, and covering the hybrid landscape is really strong. And number two, it is the only independent two independent layer that companies can add.

And the third one is really about the strengthening of the sales team and what John talks about. This trends in the go-to-market, this stability in the go-to-market and with improvement of average, sales for seller is what is giving us confidence that we will be able to drive the DBB growth now finally for ourselves. Thank you.

Operator

The next question comes from the line of Michael Briest with UBS. Please go ahead.

Michael Briest

Just in terms of the — the guidance framework that you’ve talked to through the bookings expectations there aren’t. I mean from a revenue point of view. So you are going to be putting this one year cancellation in, so even if the customer signed a perpetual subscription deal, you would be in the P&L at least taking that as one year. Can you explain, what your assumptions are on the or whether that is the case and therefore the revenues will be one year subscription deals for the 40% that you’re assuming there. And then secondly, on the margin outlook, earlier in the year — earlier in 2019 you said there’s about 200 basis points to 300 basis point impact on margins from the subscription shifts. How we to assume that’s the case? And then the rest of this is discretionary investments, in which case, Sanjay, can you give a bit more color as to where that money is going? And how quickly those costs ramp up through the year? Thanks.

Arnd Zinnhardt

I take the first one Sanjay I takes a first part of second question then you take the second one. On the treatment of the individual contracts so let me start with the perpetual. The perpetual is 50%, I’ll see total business 50% and if perpetual deal the customer acquired us or right to use our software in perpetuity. By definition that cannot have a cancellation, regular full flow one year because you already acquires for — in perpetuity. So that’s the first element.

On the subscription side, he acquires the right to use the software for a certain period in time, typically a three years contract. It depends on whether we want to offer the customer is right or whether we do not want to have that. That has something to do with do we just implement a product for instance or is it customer already in use for many years if it’s already in use for many years, the risks that we are taking was offering an additional one year cancellation rate is very much limited because we know that the customer retention is extremely high. So therefore it will be decided on a one-to-one basis based on what we sold in the countries and what we feedback we received from the countries, this 50-50 split is most reasonable split between the two ways of setting up the contracts.

The technical squeeze, the second question, Michael. I was talking about 200 to 300 basis points in Q3 reporting. Actually, we even achieved a higher adoption of subscription Sanjay mentioned that in his speech. So therefore in the current budget submission and our forecast, which is a basis for the guidance, we assume a technical squeeze of 350 basis points plus/minus, and then the rest is incremental investment that Sanjay will talked about.

Sanjay Brahmawar

Michael, so the investments that we are putting into 2020, after seeing the 2019 investments really settle down and really supporting the foundation year. It’s mainly five areas, Michael. Now first one is a customer success organization because you know, our subscription success is obviously putting us into a different mode of engagement with the customers and we need to make sure that we’ve got a very strong success — customer success organization that manages the ongoing relationships.

Second is the partners you saw that our pipeline with Microsoft and Adobe, we are creating dedicated team on Microsoft a set of people working full time on Adobe. We believe these two primary partnerships will drive significant growth for us. So it’s putting the right kind of team to really drive these hyperscalers partnerships.

Number third is adding some sales capacity into geographies, primarily EMEA and APJ, I told you about EMEA, APJ. EMEA and APJ both are growing at 20% plus. And then fourth one is putting some money into marketing, which is to step up our demand generation engine. This is what John talked about. We want to really fill and flood our pipeline and support the sales execution.

And finally, we are putting some money into our culture and transformation. It is a very important part of making this transformation stick and making sure it’s sustainable and hence we have some money put aside to do that. So that’s, that’s the investment. I’m sorry your last part of the question was it about the phasing — And obviously the people addition that we want to do to get the impact in the year that is a front loaded or starts in Q1 and then obviously the spends like marketing and culture transformation, et cetera, all phased out in the year.

Michael Briest

And margin tough in 2020, is that assume?

Sanjay Brahmawar

That’s the margin range you mean or…

Michael Briest

So the 20% to 22% guidance for this year is the bottom 2021 being lower than that?

Sanjay Brahmawar

That is better the guidance, exactly.

Operator

The next question Gautam Pillai of Goldman Sachs. Please go ahead.

Gautam Pillai

So on the firstly can you give me an idea of the trend in bookings growth in the digital business in Q4 versus the 10% growth you have seen in the full year so that we can get my idea about the exit rate of growth. And secondly coming back to your comments on the raising of guidance for the digital business, can you talk about the different key products which is driving this good momentum and also the different moving parts in this guidance including marketing shifts which you’re assuming, and also can you talk about the underlying growth assumption for the IOT business within the digital guidance? And finally on the subscription transition, do you expect the transition to be more or less complete by 2023? In other words, will your majority of the 80% to 85% to 90% recurring revenues individually business be on subscriptions by 2023? Thanks.

John Schweitzer

So let me take two of those questions and then I’ll ask Arnd to talk a little bit about our exit rates. But first and foremost in terms of your point about our target around 2023. Yes, we are, we believe we are firmly on track for that target to get to that 85% to 90% recurring revenue. Arnd mentioned we already grew by 10%. So we’re at 70% now, which means we are well on track number one. Number two, what is the underlying growth of IOT business?

So I mentioned two particular trends. One was this connected customer enterprise, which is effectively bringing together the data and making sure products are connected to be able to create this experience for the customer. And it’s not just enough to deliver quality, it’s not just enough to deliver consistency and reliability. You have to be able to deliver this connected experience and all the data associated with it. And that’s where IOT growth is coming forward. We can see with the deals that we are signing, Schindler is a fantastic example of them connecting 1 million elevators to be able to offer not just the data for maintenance but also create in, in elevator experience for their customer, so that’s kind of one thing around the IOT.

The second thing of course is in terms of being able to drive solutions for other customers such as Deutsche Telekom or Telstra in Australia who created water management solutions. So it’s working with these partners and helping them build solutions for industries. That’s where the drive off the IOT is coming.

Last thing I would say on IOT, Gautam, is that the size of the deals are now getting exciting. We start seeing five figures, six figures, seven figures, and now eight figure deal. And this is really exciting now because it starts getting material. Now, the third question you had was on the key products, so clearly, you know, our emphasis is on integration, API management, IOT analytics. This together for us is about a $20 billion market size, which is growing at double digit speed. So this is where we continue to keep our focus. And we know we launched several new innovations in integration API management. We now believe that we are one of the strongest independent hybrid integration providers.

So this covers integration, API management and iPad. And then on the other side with IOT and self serve analytics. So that’s kind of the key product. And on the exit growth rate, so you’re right. The majority of the 2023 recurring revenue will be subscription, but please don’t forget that, which is obviously also recurring. And then the remaining portion of the maintenance out of the perpetual contracts that will be still around 23, like your base assumption is right yet.

Gautam Pillai

And on the exit rate of bookings growth in Q4?

Sanjay Brahmawar

On the exit rate of bookings growth is very much in line with our ambition of 2020. Gautam, so you know that we are forecasting between 10% to 15% on the DBP. So we have a strong development on integration and API management and of course our business transformation tools RS and Alphabet. Both have a — have a strong exit rate, which allows us to feel confident about the first half of 2020.

Operator

The next question is from the line of Knut Woller of Badder Bank. Please go ahead.

Knut Woller

A couple of actually, if I’ve done the math correctly, your additional investors around EUR 40 million this year, can you break out a bit, what of that is one time nature and what of that is recurring? So to get a better feeling for the — for the part that would stay on the P&L, and also in conjunction with that, just to double check on Michael’s question. So is there a commitment for margin expansion event from 2021 on and how should we think about the margin progression to get towards your mid-term target range of 25% to 30%. Then lastly, a question for John on the U.S. restructuring. Can we get here an update? You said there are still some spillover effects in 2020. So can we get just a feeling when that is going to be finalized? How much headcount that involves, and then I think we should — do if you find with the view that we should see continuing uptake in the momentum that we saw in Q3 and also in Q4 based on your currency contribution in U.S. dollar noted in your presentation also on the back of the moment sales cycles you have in that business. Thank you.

Arnd Zinnhardt

I’ll take the first one and then I hand over to Sanjay and then, I think John with the third one. The first one was regarding the 40, or let me call it EUR 40 million to EUR 50 million in investments most of them is recurring. So the majority of that is additional people. Joining Software AG with a big majority obviously in sales and sales related areas. So therefore these are costs that you would see also in ’21. Some of the non-people related costs. So out-of-pocket expenses, they are onetime, but they are a smaller portion out of the entire bucket.

Sanjay Brahmawar

On the question about the margin commitment towards our mid-term, first and foremost we are fully committed to our margin guidance that we’ve given for the mid-term to 25 to the 30. And of course, if you go now through the next years, we are still continuing our transformation to subscription. So, we will — we will continue to see a shift to subscription in 2021. But we will start seeing the return towards our margin expansion towards the 25 to 30 for the mid-term. So, now it’s a journey towards — towards our mid-term goal.

John Schweitzer

Yes, Sanjay, I can add. So on the North America side, extremely pleased as you’ve heard that over quarters now, last two quarters with the progress in North America, in the quarter in Q4 a we’re welcomed a North American leader, who has very strong industry experience across, medium, large companies that is going really going to help us with scale there. He’s really worked about as leadership team in the quarter as well as in Q1 here. So sub-reason leadership is in place. We’re attracting leaders from big competitors, I might add.

The other thing that’s really interesting, we’ve seen these large competitor salespeople and managers come to us in more recently with MuleSoft lockup expiring with Salesforce. So that’s an interesting trend. But overall I have the strength in North America I think really resides on the strength of the pipeline that type I was closed as I mentioned last quarter with building an expanding on it, the predictability of that business is improving a month, a month. And I think we should continue to expect that shrink continuous in more of a beat-and-raised scenario each quarter going forward.

Operator

The next question comes from the line of Charlie Brennan of Credit Suisse. Please go ahead.

Charlie Brennan

I’ve got two questions actually. Firstly a lot of the investor feedback that I’ve had this morning has all been around whether they should back management through this investment phase. And I guess at the back of people’s minds, they’ve got a previous investment into DBP that ultimately didn’t deliver the returns that people hoping for. I’m still not exactly clear on what the metrics are here, but the demonstrate the initial investment into 2019 is paid off and why further investment is going to accelerate growth. And I guess specifically if I think about Q4 momentum, it feels like it’s slightly weaker than Q3 momentum. Is there anything that you can say around pipeline conversion in Q4 or anything you can give us that gives us genuine comfort the business has been accelerating on an underlying basis? And the second question is just a clarification. Arnd can you just remind me what you said on the Spanish consulting business? Was it annualized EUR 14 million of revenue on the disposal kicks in at the half year, which is why there’s a 20 million impact this year?

Arnd Zinnhardt

I’ll just begin it with a second one because that’s easier. A good morning Charlie. Yeah, so the annual license revenue is 40 million, you’re absolutely right. And assuming that the closing will be done throughout the summer, it’s half year effect for this year, which makes it 15 million to 20 million.

Sanjay Brahmawar

I’ll address the first part of your question then I’ll ask John to make a comment on the pipeline from the go to market business. So your question around what is different in terms of what other metrics? So first thing I think what is different from this transformation compared to the previous one is we have actually gone and addressed the clear areas of undressed investment, particularly North America and fixed the problems that we’ve had for many, many years so that’s kind of one thing and taking some difficult challenges, broken them down and really address the root cause problems, that’s one.

Second thing is, what we are looking at as leading indicators that give us the confidence that this is going now in the right direction, Arnd talking about one, recurring revenue. Recurring revenue is building and growing and 10% up. The second one is the subscription transformation. Is it really working? Actually with that 56% of the new bookings that shows us that both the customers are buying in subscription left, it opens up new doors to us in subscription. That’s kind of the second one.

And then I think the third one is these wins in the new logos. The problem with us in the past was we were doing too much farming and as a result, we were not opening up the doors to be able to land and expand with 342 new logos we’ve added these new customers, net new customers, that actually allows us the opportunity to grow and expansion there is a net new customer for us. So those are the signs that basically tell us this investment is settling, paying and now giving us the platform to accelerate growth. So with that, I’m going to hand it to John who can make a few comments on the pipeline, the strength of the pipeline.

John Schweitzer

So let me maybe dovetail off of Sanjay’s comment on new logos. So 342 represents exactly 27% year over year growth. There’s a really encouraging sign, I’d just echo a comment there. Pipe conversion, yes, it’s up, for sure. But the other things I look at our average deal size, which is also trending in the right direction for me. The other, sort of KPIs and I use it operational levels around productivity and efficiency specifically if I look at the sales force or the percentage attainment, which is more an emotional metric from a sales, side of things but also participation. Participation rates are up, significantly meaning, how many of our sellers are selling something in the quarter. And so I sort of use that combination or these combinations of productivity efficiency to guide my forecast, my comments earlier today in the call.

Charlie Brennan

And can I just follow up with the third question? You keep talking about the medium term targets and I guess the margin target of 25 to 30%. What’s the timeline for your medium term? Does that align with 2023 target to deliver a billion of revenue?

Sanjay Brahmawar

Charlie, we are fully fixed on this medium term. When we started, we defined the five year journey with helix. So nothing has changed in the medium term. We are convinced that we can cross this billion mark in 2023.

Operator

The next question is from Den Merkt of Barclays. Please go ahead.

Den Merkt

Thank you for taking my questions. Previously as guided to a dip in revenues in 2020. Now you expect flat product revenues. What has really changed? Is it that the condition is slower? Is it because you expect now that half of the subscription deal will not have this one year constellation, right? Or is it simply you seeing better growth. And then secondly, I appreciate you’re planning to do most of the hiring now in Q1, but some of these cost risk will annualized next year. So if you’re now thinking about the OPEC space from 20 into 21, well this one off investments largely offset the annualization of the hiring costs or how should we think about OpEx growth from ’20 to ’21. Thank you.

Arnd Zinnhardt

So when I take the first one and to actually you go to your spot on your, was your comment. If you go to the midterm guidance, and let me just take this as an anchor point. Last year on our capital markets day, we were talking about a CAGR growth of 10%. Sanjay reported on a 50% expectation today. So therefore the incremental momentum on the top line basically drives also not just bookings but also impacts revenue positively. And this is why it isn’t slightly down flattish.

John Schweitzer

And your point about the costs, the operational costs that we are adding. First and foremost, the people that we are adding are basically, as I said in the two markets that are the growth markets for us, our growth is in the kind of hyper growing markets and we want to add more capacity. And the second thing is that in the customer success function, so indeed those costs will obviously carry on into 2020.

Then we are putting some obviously in increased investment right now into the areas of marketing and people culture transformation, which we need to do this year. And I don’t see that level of investment needed as we continue, because at the moment, we need to create a higher push in the demand generation and pipeline focus that we needed. So I think the main area that is continuing is primarily the people that we are adding in the two areas I mentioned.

Den Merkt

So excluding that cost inflation, the OpEx base should be relative flat from ’20 to ’21. Is that correct?

Arnd Zinnhardt

Yes.

Operator

And there are no more questions at this time. I hand back to Otmar Winzig for closing comments.

Otmar Winzig

Thank you, Anne. Ladies and gentlemen, now we will close this call and we all have other assignments, but I’m happy that we have got all questions into the extended time frame. Please let me remind you that we will offer more details and time for questions also at our Capital Markets Day in London next Tuesday, so February 05. In case you want to come, please sign up by mail to the IR department. Otherwise, you’re welcome to follow the main presentation during the morning via webcast. So thank you all for now for your participation and the strong interest in Software AG and goodbye and in London, we’ll speak to you again then. Bye-bye for now.





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Amazon set to become fourth U.S. tech company worth $1 trillion


Amazon.com Inc. is set to become tech’s newest trillion-dollar company, joining the four-comma club less than three weeks after Alphabet Inc. achieved the same lofty status.

Shares of Amazon were last up 8.2% in trading Friday, giving it a market value of just over $1 trillion. If the stock closes at or above this level, it will officially be worth that much. Amazon briefly touched $1 trillion in intraday trading on Sept. 4, 2018, but closed that day shy of the figure. It also was above $1 trillion last July intraday, but also fell short by the close.

The e-commerce powerhouse

AMZN, +7.38%

 obliterated its underwhelming forecast and posted $3 billion in profit with a strong fourth-quarter report, propelling its stock 12% in extended trading Thursday to a record $2,092 a share and sending it over $1 trillion.

See also: Amazon earnings return to growth in holiday season, sending stock soaring toward $1 trillion valuation

Also read: Amazon one-day shipping is a hit with shoppers — and it cost less than the expected $1.5 billion.

Amazon has reached the financial stratosphere in large part because of its booming cloud business. It said Amazon Web Services was responsible for $2.6 billion in operating profit, 67% of Amazon’s total, on revenue of $9.95 billion. Amazon expects its current first-quarter sales to be between $69 billion and $73 billion, year-over-year growth of 16% to 22%.

“There was little to complain about in this quarter, supporting our view of AMZN as our top pick in Internet,” Jefferies analyst Brent Thill said in a note Jan. 30. He maintains a Buy rating with a price target of $2,300.

Apple Inc.

AAPL, -4.43%

 was the inaugural member of the exclusive $1 trillion club in August, followed by Microsoft Corp.

MSFT, -1.48%

 last year. Alphabet

GOOGL, -1.48%

GOOG, -1.48%

 hit $1 trillion last month.

See also: Google becomes third U.S. tech company worth $1 trillion

The rising fortunes of some of tech’s biggest names come as the Justice Department and Federal Trade Commission investigate the business practices and dominant market positions of Amazon, Apple, Alphabet and Facebook Inc.

FB, -3.64%

 Indeed, Wedbush Securities analyst Daniel Ives on Thursday predicted so-called FAANG companies will lead the industry’s stocks up another 25% in 2020, and longtime Apple analyst Gene Munster believes Apple can reach $2 trillion in 2020.



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Illinois Tool Works Inc. (ITW) CEO Scott Santi on Q4 2019 – Earnings Call Transcript


Illinois Tool Works Inc. (NYSE:ITW) Q4 2019 Earnings Conference Call January 31, 2020 10:00 AM ET

Corporate Participants

Karen Fletcher – Vice President of Investor Relations

Scott Santi – Chairman and CEO

Michael Larsen – Senior Vice President and CFO

Conference Call Participants

Andrew Kaplowitz – Citi

Jeff Sprague – Vertical Research

Mirc Dobre – Baird

Ann Duignan – JPMorgan

Andy Casey – Wells Fargo Securities

Ross Gilardi – Bank of America

John Inch – Gordon Haskett

Jamie Cook – Credit Suisse

Joe Richie – Goldman Sachs

Steven Fisher – UBS

Nigel Coe – Wolfe Research

Operator

Good morning. My name is Julianne, and I will be your conference operator today. At this time, I would like to welcome everyone to the conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] Thank you. Karen Fletcher, Vice President of Investor Relations, you may begin your conference.

Karen Fletcher

Okay. Thank you, Julianne. Good morning, and welcome to ITW’s Fourth Quarter 2019 Conference Call. I’m joined by our Chairman and CEO, Scott Santi; and Senior Vice President and CFO, Michael Larsen. During today’s call, we will discuss fourth quarter and full year 2019 financials results and provide guidance for full year 2020.

Slide 2 is a reminder that this presentation contains our financial forecast for 2020, as well as other forward-looking statements identified on this slide. We refer you to the company’s 2018 Form 10-K for more detail about important risks that could cause actual results to differ materially from our expectations. This presentation uses certain non-GAAP measures and a reconciliation of those measures to the most comparable GAAP measures is contained in the press release.

Finally, I would like to remind folks, we have our Investor Day coming up six weeks from today on March 13 in Fort Worth, Texas. We encourage you to join us or listen to the webcast for an update on our strategy and long range plans. The link to access the webcast is posted on our investor website.

Please turn to Slide 3. And it’s now my pleasure to turn the call over to our Chairman and CEO, Scott Santi.

Scott Santi

Thank you, Karen, and good morning everyone.

The ITW team delivered another quarter of solid operational execution and strong financial performance in Q4. Despite some broad based macro challenges, we delivered GAAP EPS growth of 9%, operating margin of 23.7% and after-tax return on invested capital of 28.9% in the quarter. For the full year against the backdrop of an industrial demand environment that went from decelerating in the first half of the year to contracting in the second half of the year. We continue to execute well in the things within our control.

As a result, despite revenues that were down $700 million or 4.5% year-on-year, we delivered record GAAP EPS of 7.74 expanded operating margin to 24.4% excluding higher restructuring expenses and grew free cash flow by 9%. In addition, we were able to raise our dividend by 7% and returned $2.8 billion to shareholders in the form of dividends and share repurchases.

Equally important, in 2019, we continued to make solid progress on our path to ITW’s full potential performance through the execution of our enterprise strategy. Last year, we invested more than $600 million to support the execution of our strategy and further enhance the growth and profitability performance of our core businesses.

In addition, each of our divisions continue to make progress in executing well-defined and focused plans to achieve full potential performance in their respective businesses. We look forward to providing a full progress update on our enterprise strategy and our progress towards ITWs full potential performance at our Investor Day in March.

Looking ahead, ITW’s powerful and proprietary business model, diversified high quality business portfolio and dedicated team of highly skilled ITW colleagues around the world position as well to continue to deliver a differentiated performance across a range of economic scenarios in 2020 and beyond.

Now, I’ll turn the call over to Michael who will provide you with more detail on our Q4 and full year 2019 performance as well as our guidance for 2020. Michael?

Michael Larsen

Thank you Scott, and good morning everyone.

In the fourth quarter, organic revenue declined 1.6% year-over-year in what remains a pretty challenging demand environment. The strike at GM reduced our enterprise organic growth rate by approximately 50 basis points and product line simplification was 60 basis points in the quarter.

By geography, North America was down 2% and international was down 1%. Europe declined 1%, while Asia Pacific was flat. Organic growth in China was broad-based across our portfolio and up 7% year-over-year. As expected, our execution on the elements within our control remain strong in the fourth quarter. Operating margin was 23.7% intuiting 40 basis points of unfavorable margin impact from higher restructuring expenses year-over-year.

Excluding those higher expenses, operating margin was up 10 basis points to 24.1%. Enterprise initiatives contributed 130 basis points and price cost was positive 30 basis points. GAAP EPS was up 9% to $1.99 and included $0.11 from three divestitures and $0.06 headwind from higher restructuring expenses year-over-year and foreign currency translation impact.

The effective tax rate in the quarter was 22.8%. Free cash flow was 114% of net income and as planned we repurchased $375 million of our own shares during the quarter. Overall, Q4 was another quarter characterized by strong operational execution and resilient financial performance in a pretty challenging demand environment.

Let’s move to Slide four and operating margin. Overall, operating margin of 23.7% was down 30 basis points year-over-year primarily due to higher restructuring expense. Excluding those higher restructuring expenses, margin improved 10 basis points despite a 3% decline in revenues.

Enterprise initiatives were once again the highlight and key driver of our margin performance contributing 130 basis points the highest level since the fourth quarter of 2017. The enterprise initiative impact continues to be broad based across all seven segments ranging from 80 to 200 basis points and the benefits of the restructuring activities that we initiated early in the year are being realized. The majority of these restructuring projects are supporting enterprise initiative implementation.

Specifically our AV20 front tobacco execution. Price remains solid with price, while ahead of raw material costs and price cost contributed 30 basis points in the quarter. Volume leverage was negative 30 basis points. In Q4 as we always do. We updated our inventory standards to reflect current raw material costs as raw material costs in the aggregate have declined over the course of the year. The annual mark-to-market adjustment to the value of our inventory that we do every fourth quarter this year had an unfavorable impact of 30 basis points versus last year.

We also had a favorable item last year. It didn’t repeat this year for 40 basis points. And finally the other category which includes typical wage and salary inflation was 50 basis points, so overall solid margin performance again for the quarter and the year.

Turn to Slide five for details on segment performance. As you know, 2019 was challenging from an industrial demand standpoint and you can see that the organic growth rate in every one of our segments — seven segments was lower in 2019 than in 2018. At the enterprise level, the organic growth rates swung from positive 2% in 2018 two down 2% in 2019 with the biggest year on year swings in our CapEx related equipment offerings and automotive.

Speaking of automotive, let’s move to the individual segments. Results starting with automotive OEM. Organic revenue was down 5% as the GM strike reduced revenues by approximately two percentage points. Taking a closer look at regional performance. North America was in line with the three bills down 13% Europe was essentially flat versus bills that were down 6% and China organic growth was 11% compared to builds up one continued significant output in China reflects increasing penetration, particularly with local OEMs.

Moving on to Slide six, food equipment had a good quarter with organic growth up 2% year-over-year despite a tough comp of 5% organic growth last year. The service business was solid up 4% in the quarter. Equipment growth of 1% reflects double-digit growth in retail and modest decline in institutional and restaurants against tough year over year comp for both of those.

Operating margin expanded 90 basis points to 27.5% with enterprise initiatives, the main contributor. Test and measurement in electronics had a very strong quarter with test and measurement of 6% with 13% growth in our instrument business. The segment also experienced a meaningful pickup in demand from semiconductor customers. Electronics was up 2%. Margin was the highlight as the team expanded operating margins 330 basis points to a record, 28.1% the highest in the company this quarter with strong contributions from enterprise initiatives and volume leverage. Also in the quarter, we divested in electronics business with 2019 revenues of approximately $60 million.

Turning to Slide seven, welding organic revenue declined 4% against a tough comparison of 8% growth last year. North America equipment was down to 3% against a tough comparison of up 7% last year. The lower demand is primarily in the industrial business. While commercial, which includes smaller business and personal users, was pretty stable.

Oil and gas was down 2%, operating margin was 25.4% down 150 basis points primarily due to higher restructuring expenses. In the quarter, we divested an installation business with 2019 revenues of approximately $60 million which reduced weldings organic — with overall growth rate by 250 basis points in the quarter.

Polymers & Fluids organic growth was down 2% versus a tough comp of plus 4% last year. Polymers was flat, automotive aftermarket was down 1%, fluids was down 6%, operating margin was strong up 150 basis points driven primarily by enterprise initiatives.

Moving to Slide eight, construction organic revenue was down 1% with continued softness in Australia and New Zealand, which was down 4%. Europe was down 3% but the U.K. down 14%, North America was up 2% with residential remodel up 2% and commercial up 5%. Operating margin was 22.2% down due to the inventory mark-to-market adjustments and higher restructuring expenses.

In specialty, organic revenue was down 3% which on a positive note is an improvement from the past couple of quarters. As in prior quarters, the main drivers are significant PLS and the relative performance of the businesses we have identified as potential divestitures. Excluding these potential divestitures, core organic growth was down 1.7%.

By geography, North America was on 4 and international 3. We also divested a business in this segment with 2019 revenues of approximately $15 million and these divestitures reduced specialties of growth rate by almost 8 percentage point.

Now let’s quickly review full year 2019 on Slide nine and in a challenging industrial demand environment, organic revenue was down 1.9% with total revenues down 4.5% as foreign currency translation impact reduced revenues by 2.3% and divestitures by 30 basis points. GAAP EPS was 7.74 and included $0.09 of divestiture gains as well as $0.32 of headwinds from foreign currency and higher restructuring expenses year-over-year.

Operating margin was 24.1%, 24.4% excluding higher year-on-year restructuring expense as enterprise initiatives contributed 120 basis points, after tax return on invested capital improved 50 basis points to 28.7%. Our cash performance was very strong with free cash flow up 9% and a conversion rate of 106% of net income.

We made significant internal investments to grow and support our highly profitable businesses, increased our annual dividend by 7% and utilized our share repurchase program to return surplus capital to our shareholders.

A quick update on our various divestiture processes that overall remain on track. As a reminder, we’re looking to potentially divest certain businesses with revenues totaling up to $1 billion and are targeted complete the effort by year end 2020. The strategic objective with this phase of our portfolio management effort is to improve our overall organic growth rate by 50 basis points and improve margins by approximately 100 basis points. Not counting potential gains on sales, the plan is to offset any EPS dilution with incremental share repurchases.

In the fourth quarter, we completed the sale of 3 businesses with combined 2019 revenues of approximately $135 million generating a pre tax gain on sale of $50 million or $0.11 a share. In 2019, these businesses were a 20 basis points drag to our organic growth rate and 10 basis points to our margin rate.

In summary, a challenging demand environment — in a challenging demand environment, the ITW team executed well and delivered strong financial results, made solid progress on our enterprise strategy and agenda, including our organic growth initiatives and positioned the company for differentiated performance in 2020 and beyond.

On Slide 10, we wanted to give you a quick update on the progress that we’re making on our organic growth initiatives. We estimated the aggregate market growth rate or decline for each one of our segments and compared it to the segments actual organic growth rate in 2019. We also included the product line simplification by segment. As you know, full potential steady state PLS is expected to be about 30 basis points.

As you can see overall, we’ve made some good progress as our segments are all outgrowing their underlying markets except for specialty products. At the enterprise level, we estimate that we outpaced our aggregate blended market growth rates by approximately 1 percentage points. So overall good progress on our organic growth initiatives and by completing our Finish the Job agenda over the next several years, we expect to generate one or two percentage points of additional improvement in ITW’s organic growth rate.

As Scott mentioned, we look forward to providing a full progress update at our Investor day in March.

Now let’s talk — let’s turn the page and talk about 2020 and starting with Slide 11. First, we expect GAAP EPS in the range of 7.65 to 8.05 for 2020. Using current levels of demand, adjusted for seasonality. Organic growth at the enterprise level is forecast to be in the range of 0% to 2% for the year. At current exchange rates, foreign currency translation impact and the revenue associated with our 2019 divestitures at each of 1 percentage point headwind to revenue.

PLS impact is expected to be approximately 50 basis points. We expect to expand operating margin from 24.1% in 2019 to a range of 24.5% to 25% in 2020 with enterprise initiatives contributing approximately a 100 basis points. After tax ROIC should improve to a range of 29% to 30% and as usual, we expect strong free cash flow with conversion greater than net income.

We have allocated $2 billion to share repurchases with core share repurchases of $1.5 billion and additional $500 million to offset the EPS dilution from the three completed divestitures. Additional items include an expected tax rate in the range of 23.5% to 24.5% which represents a $0.10 EPS headwind and foreign currency at today’s rates is also unfavorable $0.10 EPS.

Just a quick word as it relates to the Coronavirus situation in China and we are obviously in the same position as everyone else. At this point, we’ve baked into our guidance a last week of production, assuming that we all return to work in China on February 10th. But obviously it’s too early to tell and we’ll continue to monitor the situation closely.

Overall, ITW is well positioned for differentiated financial performance across a wide range of scenarios as we continue to execute on the things within our control and make meaningful progress on our path to full potential performance through the implementation of our Finish the Job enterprise strategy agenda.

Finally, we’re providing an organic growth outlook by segment for full year 2020 on Slide 12. And as always, these are based on current run rates, adjusted for seasonality and are obviously influenced by year-over-year comparisons as we go through the year. It’s important to note that there’s no expectation of demand acceleration embedded in our guidance.

You can see that every segment is forecast to improve the organic growth rate in 2020 relative to 2019. The same is true for margins as every segments expects to improve their margin performance in 2020.

With that Karen, I’ll turn it back to you.

Karen Fletcher

All right. Thanks Michael. Julianne, we are ready to open up the line for Q&A.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from Andrew Kaplowitz from Citi. Your line is open.

Andrew Kaplowitz

Hey, good morning guys. I’ve got Mike. You had a big pickup in instrument in the quarter and in food equipments, which are CapEx businesses that you’ve tended to watch over the years. So while recognizing all the uncertainty that’s out there now, because of the virus there may be still some trade uncertainty, did you actually see some movement in CapEx decisions from the customers? And what does it tell you about 2020?

Michael Larsen

Well, I think Q4 certainly the growth rates and those businesses were better than what we saw in Q3. Part of that was a number of orders in Q3 that were deferred into Q4. And so I think it’s — in our view, it’s a little too early to talk about a pickup in demand here in those businesses. Certainly encouraging, but a little too early to tell Andy.

Andrew Kaplowitz

Okay. That’s helpful. And then, if I look at your enterprise strategy program, your margin benefit seems to be accelerating here. Now these programs getting mature, you would think that maybe they’d level off or decelerate. So I know you have your Analyst Day coming up, you’ll talk about this, but just continuing to get better on 80, 20 as you evolved in enterprise strategy. Is that really what this is and we expect you challenge enterprise strategy to be at least a 100 basis points, through that target date of 2023?

Michael Larsen

Well, I mean, let’s take one year at a time here. I think the fact that we are eight years into this current enterprise strategy and still generating a 100 basis points of margin expansion in 2020 is certainly encouraging. We’ve talked about before why that is, 80, 20 today is significantly more powerful than when we began this journey. We’ve continued to learn and gotten better from an execution standpoint. The raw materials that we’re working with in terms of the quality of the businesses are significantly higher after all the work we’ve done in the portfolio.

And so I think we’re really encouraged by the continued progress. We’re highly confident that we will reach our 20, 23 performance goals. 80, 20 will be a big — continue to be a big part of that, but it’s a little too early to tell what those contributions might be in 2021 and 2022. But you can rest assured that we are highly confident in achieving those margin objectives we’ve put out there.

Andrew Kaplowitz

Thanks Mike. Appreciate it guys.

Operator

Your next question comes from Jeff Sprague from Vertical Research. Your line is open.

Jeff Sprague

Thank you. Good morning everyone. Good to see that the divestiture activity picking up. Is it just that, some things kind of fell in place or do you expect actually the pace to be accelerated here? And can you remind us how many individual businesses are left? So these are all kind of one at a time transactions. I would take it.

Michael Larsen

Yes. So I think this is — the cadence here was in line with — the process that we’ve laid out. We’ve got a number of businesses. So three divestitures completed. I think when we filed a 10-K you’ll see that there are another three at this point that are in that held for sale category. And then there will be a number of businesses beyond that. So we’re making good progress in a little bit more challenging macro than what we had expected maybe going into this. But the most important…

Jeff Sprague

Which is slow the process down a bit.

Michael Larsen

Yes. I think, I was going to say, it’s probably slow things down maybe a little bit. I think the really important thing is we are — we’re still on track to achieve the 50 basis points of structural improvement in our organic growth rate and a 100 basis points of margin improvement, current expectation, we’re targeting to get those done by the end of 2020. And we certainly have a shot at that, but as Scott said, I mean, just given the macro backdrop that might get pushed out a little bit. But overall these processes are on track.

Jeff Sprague

Well, on the flip side of that, obviously you’ve been hunting for deals given that you’re kind of a cash rich strategic buyer, do you see things kind of getting easier? Is the pipeline filling up? Like what would you really expect to happen here in 2020 on the acquisition side?

Michael Larsen

Well, I think we have certainly been more active from the standpoint and we’ve talked about it before in terms of our willingness to consider adding to the portfolio, the right kind of assets. And we’re certainly I had — let’s just call it matched up by our activity in that regard in 2019 as is obvious. We didn’t hit on anything yet in that regard. And it’s a combination always of sort of the fit in terms of strategy and also sort of the valuation environment. And I would say the overall color in 2019 is that, we looked at some things that were interesting strategically that from a valuation standpoint didn’t hit the screen, didn’t meet the criteria. And we will continue to be active in assessing opportunities to add to our portfolios as we’ve talked about in the past. But we’re going to remain a very disciplined posture in that regard. And I have no doubt that we will very successfully add to our portfolio as we go.

Jeff Sprague

Great. Thanks for the color.

Operator

Your next question comes from Mirc Dobre from Baird. Your line is open.

Mirc Dobre

Good morning everyone. Just a quick question on the margin guidance. Have you factored in any restructuring at this point?

Michael Larsen

Yes. So the — at this point Mirc, we are guiding to margins for 2020 and that 24.5% to 25% range which includes restructuring. So on a year-over-year basis at this point we are assuming that restructuring will be flat and obviously we’ll see how the year plays out and adjust accordingly.

Mirc Dobre

Flat in dollar terms or in terms of margin drag?

Michael Larsen

Flat in dollar terms and margin drag and therefore EPS neutral.

Mirc Dobre

Okay. Then my follow up, I’m just trying to kind of wrap my mind on the buckets here. So, if I’m looking at the low end of your guidance the 24.5, I’m presuming that’s consistent with the low end of the revenue guidance or the volume that you’re providing. And I’m comparing it to sort of what you’ve done in the prior year. Can you maybe help me with a bit of a bridge here? Obviously you’ve got the enterprise initiatives or a 100 basis points that’s help. But there’s some other items to price cost, maybe some other things could be doing. How do we get to the high-end and the low-end here?

Michael Larsen

So Mirc, are you talking EPS or margins. What would you like to do?

Mirc Dobre

Just margin, not EPS, just margin.

Michael Larsen

Yes. So I think for 2020 we provided quite a bit information already. And maybe one way to think about it is, the initiatives contribute a hundred basis points. We have positive volume leverage baked into our guidance. You can look at historically based on Europe organic growth rate, what the impact might be there. Price cost, we’re assuming neutral at this point, maybe slightly positive and we’ll see how that plays out. The divestitures that we compete in ’19, that is a little bit of a favoribility to margins. And then I’d say the remainder here is, we’re going to continue to invest to support our organic growth initiatives. We’re going to invest in our people and we’re going to invest to sustain our core businesses as we always have. And so if you kind of look at the remaining buckets, 2020, maybe expect it to be similar to what we had in 2019.

Mirc Dobre

Got it. That’s helpful. And lastly, if I may, as you look at your segments into 2020, are there one or two that stand out to you as having more margin potential than margin expansion potential than average? Thanks.

Michael Larsen

Yes. I think, Mirc, this is really across the board as I think I said in my comments, we expect every one of our segments based on our bottoms up planning process, based on what they have told us really at the divisional level on up, we expect every segment to continue to make progress in 2020 over 2019.

Scott Santi

And I’d say that the other deltas that’s what you talked about before, which is the volume leverage component, right? The more growth we get, the more increase in the margin we’re going to get.

Michael Larsen

Yes. And I think you saw a good example of that. This quarter if you look at just the performance in test and measurement margins up, 330 basis points, two thirds of that was the volume of leverage and the enterprise initiatives. So you can see what happens in these businesses when we get a little bit of volume, a little bit of organic growth coming through. So…

Mirc Dobre

All right. Fair enough. Thank you.

Operator

Your next question comes from Ann Duignan from JPMorgan. Your line is open.

Ann Duignan

Hi. Good morning. Just looking at your segment, organic growth forecast, could you just walk us through the various segments and where you see the upside versus the downside risks?

Michael Larsen

Well, I’d say these are all, first of all based on kind of current run rates. And so, I think there are a couple of segments here that have a slightly wider range automotive OEM, welding, which reflects maybe a little more market uncertainty in those. I think food equipment has a measurement those look pretty solid, food equipment in that two to four range test to measurement one to three. And then, you can see the rest your polymers and fluids, construction specialty kind of in that low single digit at the mid point. So that’s kind of, I think how we characterize it. I mean, as you know, and this is a pretty uncertain environment, right? I mean this is — 2019 is a challenging year. 2020, we’ve got to — we have to see how this China situation plays out that we just talked about. And so as we sit here today, this is kind of our current forecast using the current levels of demand that we’re seeing in these businesses.

Ann Duignan

Yes. And in that context, I mean, you’re much closer to these businesses than we are obviously, but then polymers and fluids, I think of that business as being more consumer driven. And so can you just talk about all of the guidance for on the downside, the negative one?

Michael Larsen

Well, I think so polymers and fluid says about half of the businesses. When you say consumer-driven you’re pointing I think to the automotive aftermarket business. If you just look at kind of where retail numbers are in that space, they’re probably down slightly. We’ve had some challenges this year on the MRO side. Particularly more B2B, the fluids business on the MRO side, particularly in Europe.

And then, you also have a couple of other end markets that are not exactly very favorable at this point, including some petrochemical exposure. There is some Marine exposure and so overall, we’d say polymers and fluids flat in 2019 and slightly positive here in 2020.

Ann Duignan

Okay. I appreciate the color and then I’ll get back in queue. Thank you.

Michael Larsen

All right. Thank you.

Operator

Your next question comes from Andy Casey from Wells Fargo Securities. Your line is open.

Andy Casey

Thanks. Good morning. A little bit of a clarification on the margin walk, you called out several things, inventory restructuring, non-repeat of an item. Would those in the past typically be included in other?

Michael Larsen

Yes, that is correct. Okay. So the inventory adjustment, so just say, sorry, I need to interrupt you, but the inventory adjustment, it’s one that we make every year and it’s just that this year, because raw material costs have come down throughout the year that adjustments is a little bit larger than prior years as we mark-to-market the inventory. And so we decided to call it out as a separate item and kind of give you the transparency, the detail around that.

Andy Casey

Okay. Thank you. And then a few questions on the divestitures, on your earlier comment about the slower pace than expected due to the macro. Is that purely timing or are you encountering hesitancy from potential buyers of the assets because of the overall uncertainty? And then, for the three and the four sale category, you mentioned in the K, are they excluded from 2020 top-line guidance and what was their impact on 2019 margin performance?

Michael Larsen

Yes. So those — but let me start with that one. So the ones that you’ll see that are held for sale, we are assuming in our guidance that we are going to own those in 2020. So 2020 numbers exclude any further divestitures as well as any acquisitions. So this is really think of it as all in as we the businesses that we own today.

I think on your first question, I think it’s a little bit of both. I mean, I think some of these, it’s an element of timing. And I also think the…

Scott Santi

The process is taking longer.

Michael Larsen

Processes can take a little bit more longer, maybe that has to do with the desire to do maybe more due diligence. And then I think the other piece is there’s a macro backdrop. There is some uncertainty and so I think we’ve seen some of both of those, but and then I’ll just say finally, I mean we’re going to be disciplined as we divest these businesses. And if this is not, if this isn’t the right time to do it from an evaluation standpoint, we might defer some of these processes into next year. So we’ll keep you posted as we go through the year and get on these earnings calls. And we’ll get you an update on the processes.

Scott Santi

I’m just going to have these are all high quality businesses. So certainly on a relative basis there will another that — business that we think are the right fit for us long term, but these are not distressed businesses by any stretch. So these are quality assets that have certainly a lot of appeal. And as Michael said, to the extent that the macro environment creates a situation where we don’t think we’re able to treat it fair value, then we’re going wait to cycle out and we’ll get there eventually. But we’ve been able to do three so far. We’ve got another — all the three versions.

Andy Casey

Okay. Thanks. Just as a follow-up on that, the three that are mentioned in the K. Should we expect those to have a similar type margin performance to the three that you have already been able to sell?

Michael Larsen

Yes. I think they’re all pretty similar. I mean, there’s a range. The average maybe it’s the way to think about it is in that high single digits EBIT percentage. So that’s one way to think about it.

Andy Casey

Okay. Thank you very much.

Michael Larsen

Sure.

Operator

Your next question comes from Ross Gilardi from Bank of America. Your line is open.

Ross Gilardi

Hey. Good morning, guys. Thank you. I was just wondering like, clearly we are in a very choppy and e-challenging demand environment, but and you guys are continuing to expand margins even with that. But how do we — how is the company thinking about the 3% to 5% organic objectives and at some point it’s become counter productive to even be shooting for that in this type of environment. And can you remind us, where do you get to in your margins over the long-term in just sort of a flattish environment like we’re in right now versus the plus three to five.

Scott Santi

I think from the standpoint of our core growth rate objectives, what we are really saying essentially is that this is a business that should out grow the underlying growth rates that the markets we’re in from anywhere from 2% to 4% on an average basis over time. We’re in a situation right now where the market and our estimation of the blended market rate, these are — sort of using our best assumptions was down two and a half last year. So, in a normal, let’s call it a normal average GDP world of, you pick whether it’s two or three on a long-term basis and that’s where the three to five essentially comes from in terms of the overall expectations that we have for this company. And there’s nothing in this, call it industrial recessionary environment that would in any way change the view of what we think our long-term potential is. This is a highly differentiated portfolio.

We’ve talked before and again, we’ll get into a lot more depth on this at the Investor Day, but we’ve got the ability to generate at least the point of incremental growth from innovation. And other point from penetration is the simple math. That’s the bottom-line standard that we’re working to position ourselves to execute consistently on. And we’ve got a lot of businesses that are already there and then some.

So, the last thing we’d want to do is take a point in time set of market conditions and ultimately get us off of our long-term view of what we think the potential of this company is. I think from a margin standpoint, we’ve got — I’ll let Michael jump in here, but we’ve got a set of performance objectives out into the future that we’ve laid out in the past that we expect to continue to make progress again.

Michael Larsen

Yes. I think nothing has changed in terms of our view on the margin target as I said earlier. I mean, Ross, it might be helpful, the three to five, we know that we’re not going to grow three to five every year. This is over a five year period we’d expect kind of an normal macro. That’s the performance that we should be able to deliver. And with that comes to margins in that 28% range and you know, ups growth and in the low double digit, everything that we’ve laid out for 20, 23. So our views on those haven’t changed just given the macro that we’re in today.

Ross Gilardi

No. Thanks guys. I realize you’re still outgrowing your end markets. I wasn’t trying to pick on you for that at all. I was just trying to — with respect to your long-term margin target, really just to remind me how much of that getting there was coming from your ability to hit the three to five versus if we’re just in a flattish environment for the next several years.

Michael Larsen

Yes. I mean, again, I think the biggest driver here remains the continued strong execution on the enterprise initiatives. And then, there’s a reasonable assumption of some volume leverage that comes with that. And you saw that, like I said earlier, if you look at tests and measurements, great example this quarter, you got a little bit of volume leverage. We get a normal macro environment. We’re going to get there very quickly. I think that’s what we’re trying to say here. And over any five year period, we expect that we’ll average in that three to five range, but if we get a couple of really good years and we’ll get there faster than that.

Ross Gilardi

Okay. Since you mentioned, you reminded us of the semiconductors and I realize you weren’t factoring any pickup into your guide, but just ITW is obviously a great barometer for capital spending in general in the global economy. Are you seeing any signs of CapEx picking up anywhere or percolating or, it feels like discussions are getting a little bit more optimistic in any of your businesses?

Michael Larsen

No. Not at this point. I think, Q4 was really more of the same. This remains a pretty challenging, a pretty challenging environment, so.

Ross Gilardi

Okay. Got it. And then just the last thing I want to ask about is, you’ve seen a return of the outgrowth in your European and China auto businesses. China now for a couple of quarters are — do you feel like you’re back to the point where that is firmly kind of set to continue or does it feel kind of quarter to quarter at this point, just given the weakness in the end market?

Scott Santi

China is very solid. I mean, I think we have a long track record. The team has a long track record of outgrowing the underlying market there by a wide margin. And as I think we said in the prepared remarks big drivers are continued penetration with local OEMs and there is a lot of runway still. And if you just look at the projects that have been locked in for the next two to three years, we’re confident that that outperformance will continue.

Michael Larsen

Yes. I think on the question of Europe or North America, I think the issues now, we’re sort of using a very gross number in terms of builds and the underlying issues are given the volatility OEM to OEM in those builds and what’s going on in the quarter to quarter. It’s kind of — a bit of a choppy comparison. I think on a full year basis, it’s a better way to look at our relative performance in Europe and North America. We will be in a position to provide an update on that for ’19 at the Investor Day.

So some of the — my only point is, we have a big pipeline of penetration projects in Europe and North America and fully expect on, sort of, let’s call it even a medium term, that we will outgrow those markets by a minimum of two to four points. But some of the last things that have gone on over the last six quarters, both from the standpoint of how different individual OEMs are reacting to some of the current environment and how the supply chains react to those OEMs reacting. There’s some sort of real volatility that I think sort of mucks up some of the ability to see through the underlying progress. But we track our penetration on a per vehicle basis with each of the OEMs. And on that basis feel really good about our ability to continue to penetrate at a rate well above market all around the world.

Ross Gilardi

Got it. Thanks guys.

Operator

Your next question comes from John Inch from Gordon Haskett. Your line is open.

John Inch

Good morning everybody. Hi guys. Michael, just a quick clarification, the repo is going from 1.5 to 2, is that delta of 500 to offset the 1.35 of the divestitures you announced or…

Michael Larsen

Yes. That’s correct. So let me just spend a second on that. So kind of the — our estimate for surplus capital for the year is 1.5 billion, but that’s currently allocated to share repurchases. I think of those as kind of the core share repurchases. And then there’s an incremental 500 million to offset the EPS or the earnings that went away with those three divestitures. And to the extent that there are — hopefully there are further divestitures this year. We will adjust that share purchase number accordingly. So we could end up at a number that’s higher than what’s on the page today.

John Inch

Got it. Michael, is overall demand growth presumably begins to come back once we get past some of these China issues in this year and you’re spending probably dolls up a little bit consistent with what other companies might be doing. How are you feeling about your confidence level of maintaining or how should we think about, say, a 100 basis points of enterprise initiatives that actually came in the past when growth was better in the environment? Does it, is it one of those things where maybe the — you get better improvement because of the contribution benefits from improved growth by EI, enterprise initiative benefits sort of bounce back a little bit because of the spending or, , how would you think of the mix of that? I suppose an improved [indiscernible]…

Scott Santi

Yes. I’ll sort of piggyback on part of what Michael said earlier, which is — the enterprise initiative visibility that we have is really about one-year forward, so that those are discrete projects, certainly underneath a broader strategy that is largely around two things at this point, strategic sourcing and continued improvement in the quality of our practice of 80, 20 across the company.

And so what we’re saying now is, we’ve got another point in front of us in 2020 that certainly I can say with confidence if that’s not the end of it. But we will continue to have that as some additional sort of fuel to the profitability story here for a while.

The other thing I can tell you is on sort of the incremental contribution from organic growth as it accelerates. The best way I can frame that as I don’t see any way, we don’t generate somewhere in the range of 30% to 35% incremental contribution from every dollar of organic growth over and above enterprise initiative.

John Inch

Oh, that’s helpful. Yes, no, it definitely helps. But just lastly, Scott and Michael what are your — what would you say your top personal priorities are for ITW to accomplish? Maybe as we look back in a year on 2020, if there’s a way to sort of frame that out?

Scott Santi

You asked to go individually. Michael is going to say he don’t want to upgrade the quality of a CEO, but I think we’re at it. I think the biggest things that we’ve got to continue to do the thing we’ve been,, it’s certainly been the largest part of our focus for the last, I’d say two years now is really continued to accelerate our focus or not just our focus, but our execution on organic growth. And this kind of environment, it’s certainly hard to see the Interline progress. But I can tell you that all of us get up every morning thinking about, our Vice Chair, Chris O’Herlihy, Michael and I and everyone of our AVPs get up every morning thinking about what are we going to do today to help to continue to get this company towards our full potential from an organic growth rate standpoint.

I think the other activities around the enterprise initiatives are — there’s a lot of potential there. Those are certainly things that need some level of attention to continue the momentum for sure. But ultimately I feel really good about both the structural and strategic things we’re doing from the standpoint of organic growth acceleration. And I don’t think that changes in 2020 regardless of what the macro is doing at the moment. Michael to give you his answer.

Michael Larsen

Mine is exactly the same. I would just add, John, that at Investor Day, we obviously going to spend a lot of time on this topic of organic growth including, we’ll give you a progress update if you would call on the number of divisions that are in that ready to grow and growing category defined as consistently growing above market. We’re not going to — and we’ll share those numbers with you and you’ll see we made steady progress in 2019. And we expect to — as we execute on some really focused plans in 2020 to continue to make progress on that. So we’ll share those metrics with you and we’ll also give you some real divisional examples because that’s really where this work is taking place. To give you kind of some insights to what Scott’s talking about. The whole company is focused on getting the organic growth rate going and we’ll give you a lot more detail on that when we get together in March.

John Inch

I mean, the way you talked about Instron last time was very helpful. So yeah, very, very much looking forward to it. Thank you very much. Bye. Bye.

Operator

Your next question comes from Jamie Cook from Credit Suisse. Your line is open.

Jamie Cook

Hi. I think most of my questions been answered. Just clarification — or I guess two questions. One, on the welding side, I appreciate, your guide, just wondering, how you think about your organic growth guide relative to sort of what we saw in the 15, 16 time period and why we shouldn’t be concerned? What you’re seeing in the market to give you confidence that it couldn’t be worse than that?

And then my second question, just given all the restructuring that you guys have done and obviously done a great job improving your margins, but assuming the markets were weak or is there any change if your sales declined on how we should think about decrementals? Thanks.

Michael Larsen

Yes. I think on the restructuring, maybe I’ll start with that. I think, we’ll see how the year unfolds. And if market conditions deteriorate similar to what we did last year, we’ll pull forward some of these enterprise initiative projects specifically related to our 80, 20 front to a back pipeline. I expect we will play at the same way in 2020.

Welding, I think difficult comps. I’ll start there. That’s a business that was up 10% in 2018, it’s slightly down in 2019 at current run rates. We’re estimating down 2 to plus 2, and that’s really, as much as we know at this point. We know that in all of our businesses, regardless of what the environment throws at us, we will react accordingly. And manage the cost side of the equation as we always do. Like we did in 2019 and 2020 will not be different, but I don’t have a better — we don’t have a better crystal ball than you in terms of what welding might look like other than, we’re using current run rates and…

Scott Santi

And the underlying activity, it’s far from terrible in terms of the amount of…

Michael Larsen

Yes.

Scott Santi

The assumption going on. We saw a pretty big pullback in cap spending on, in welling and other places in ’19, but I think our assumptions for 20 or certainly not for improvement in the CapEx investment side of that. But I think steady state is a reasonable assumption given the underlying. And input we’re getting from our customers and we’re seeing in terms of the actual sort of consumption of welding consumables, et cetera.

Jamie Cook

Thanks. I’ll let someone ask a question. Thank you.

Operator

Your next question comes from Joe Richie from Goldman Sachs. Your line is open.

Joe Richie

Thank you. Good morning everyone. Happy Friday. So, my first question, I guess I’m trying to understand what comprises the low end of your guidance. Since it would imply deceleration in earnings at a time when you’re expecting, growth to be a little bit better and for margins to still be there?

Michael Larsen

Well, I mean, I think — like I said earlier, we were in a pretty challenging demand environment. And in the guidance range, what we try to do is account for a wide range of possible scenarios. I think the biggest swing factor here will be the overall demand environment. And so if things remain where they are you know, we’ll be likely closer to the mid point, if things accelerate from a demand standpoint, we’ll be at the high end or, or above. And if things slow further, we’ll be at the lower end. So I think that’s really the, the best answer. I can give you the remainder of the items, you know, the initiatives.

Those are — we’ve clear line of sight as I think Scott said earlier, do all the projects and activities and that’ll generate those savings. We know what the share repurchase program in terms of share count will do. Currency, tax we’re using, the rates that we gave you. And so I think those are — there’s a lot less variation around those. The swing factor here is whether the overall demand environment and in the near-term this situation in China that needs to be sorted out. And so we’re keeping a close eye on that. So that’s probably the best I can give you.

Joe Richie

Okay. That’s helpful Michael. And maybe — my quick follow-up here is, I’m thinking about the cadence both from a growth and from a margin perspective, is the expectation as we kind of start 2020, that growth remains negative and then turns positive as the year progresses. And then, specifically on margins, you guys front end loaded, your restructuring last year. How should we think about that 40 basis point impact in 2020 you’re going to front-end the 2020 as well.

Michael Larsen

No. That’s not the current plan. On the restructuring, I think it’ll be more kind of equally spread throughout the year. If the demand environment deteriorates, we can obviously adjust I think on your first question. So as you appreciate, we don’t provide quarterly guidance anymore. I think if you look at kind of historically at how organic growth and margins and EPS kind of plays out through the year. If you look at historical averages, you can get pretty close to a reasonable scenario here. I think in Q1, we have this added uncertainty around China. So we’ll have to see where the organic growth rate ends up. And then I think on margins, typically what you see in Q1 is some margin improvement year-over -ear. And then sequentially Q two Q three gets better. And then Q4 is slightly lower. So if you look at these historical trends Joe, I think you can — I think that’s pretty informative as you think about 2020.

Joe Richie

Okay. Thank you.

Operator

Your next question comes from Steven Fisher from UBS. Your line is open.

Steven Fisher

Thanks. Good morning. I know that the commercial construction piece of your construction business is not the biggest, but you’ve had some helpful and interesting perspectives on that in recent quarters. Just curious what your view is at this point, what you’re seeing and assuming going forward on a commercial piece.

Michael Larsen

Yes. So the commercial business can be a little lumpy on a quarterly basis. Really they’re related to the timing of projects. So 5% in the quarter was certainly one of the better numbers from that business. I think if you look at the full year the business construction and the commercial side is actually down low single digits. And so, I think we expect a current runway rates, it’ll be a similar to that in 2020. So I wouldn’t expect a significant acceleration in 2020 and again, the Q4 number at 5% is at the high-end of what this business typically does.

Steven Fisher

Okay, that’s helpful. And then just to follow up again on welding, where does the current run rate of business puts you within that range? Minus two to plus two. I know you said you’re, this is of the businesses where you’re assuming a wider range of outcome. So just curious where that — where it puts you in that range and because it, it does seem like, there could be some additional headwinds there. So I’m also wondering if within that consumable piece that’s keeping it relatively steady overall, are there some of the drivers that are more positive and some that are more negative.

Michael Larsen

Well, I think to answer your question, we try to do is bracket kind of the mid point of what the runway would suggest for 2020, adjusted for typical seasonality. So that’s probably the best I can give you pro welding. So, our capital goods to consumable ratio and welding is 60.

Scott Santi

I think as you know, our product mix, the geographic mix is quite different than some of our peers in this space. So we are more weighted on the equipment side. That’s where the technology is. That’s where the higher margins are relative to the consumable side. And you know, we’re more weighted towards the North American market, which represents almost 80% of our business.

Steven Fisher

And there’s no way within that segment the end markets that are driving the demand there. Any that are up in any that are down or you’re all seeing them kind of moving in the same direction?

Michael Larsen

No, I think, the industrial side, so think more heavy equipment. There’s certainly some contraction and demand there down those single digits. I think the commercial side, which is more the smaller businesses, personal users that’s more flattish at this point. And I think we gave you oil and gas earlier. Was I think down 2%. And so that’s probably as much color as I can give you a welding.

Steven Fisher

Okay. Thanks very much.

Operator

Our last question will come from Nigel Coe from Wolfe Research. Your line is open.

Nigel Coe

Thanks guys. Good morning. Thanks for taking me in. I think you have covered a lot of ground here. So I want to keep this kind of fairly high level. So, I think we now in the eighth year of maybe seventh, eighth year of the enterprise initiatives and obviously it’s been very successful. It seems like most of the benefits really come through on the SG&A line in the last sort of three or four years. You talked about strategic sourcing is a big 10 a driver this year, Scott and wanting to other things as well. But do you think that we’re now at a level where the benefits will come more in the gross margin line and maybe on top of that, do you think there’s more scope to take down SG&A below 16% going forward?

Michael Larsen

Well, I think so far contributions from 80, 20 and sourcing have been fairly equal, we divided I think under the go forward basis we may see a little bit more impact on the VM side. But, I think overall the important thing is what we talked about earlier, another solid 100 basis points this year and from the enterprise initiatives, what the exact geography will look like. We’ll see as the year unfolds.

Maybe a little bit more, like I said, on the variable side of things. But overall, what’s really encouraging is every segment continues to execute and identify projects, just look at Q4, the range of contribution here is from 80 to — all the way to 200 basis points and overall 130 basis points in the fourth quarter.

So that’s probably as much as, yes…

Scott Santi

I think the only thing I would add is the way this gets executed. We’re not going after some ratio on the P& L. We’re simplifying business processes. We’re improving how we execute. In terms of certainly from the standpoint of productivity and efficiency, but also benefits around how we serve our customers. So none of it is that says, okay, this project, or the focus now is SG&A, the focus is how do we, how do we better support sort of the quality pieces of each of these individual businesses. And so it’s hard for me to even think about your question in the sense of sort of where in the geography on the P&L, this is, we’re simplifying and improving the effectiveness of the overall performance of the business.

And it certainly is going to adjust the ratios on the P&L as a result. I’m sitting here kind of trying to think about your question and it just is kind of outside of how it actually happens. We improve our practices and we generate outcomes in terms of — and we’re, we focus on the top-line and the bottom-line and ultimately to improve the bottom line, those ratios all have to get better in terms of margin, but ultimately it’s not really focused at particular slice of the cost structure, but maybe that looks it up even further.

Nigel Coe

The ratios are not coming on inputs. I think I understand that. And then, just a quick follow-on, and this is definitely for Mike on the inventory. So the 40 bps adjustment, that’s a LIFO charge, is that correct?

Michael Larsen

Yes. I mean it’s really — it’s the mark to market of the inventory given that raw material costs have come down. So as we adjust the standards lower to reflect the lower raw material costs, that’s the impact that you’re seeing.

Nigel Coe

Okay. I’ve got a CPA, but inventory accounting is a way to escape me.

Michael Larsen

So, I can promise we will provide a lot of detail in the 10-K that should satisfy even the most advanced CPAs amongst us.

Nigel Coe

So, yes, I’m saying about CPA, but they just conceptually, the little raw material is closed through the price cost line, and then we’ve got a mark to market at year end, is that, does that sort of just in a very simplistic way to think about it?

Michael Larsen

In very simple terms, that’s how it works. Yes.

Nigel Coe

Yes. Great. Thanks Mike.

Michael Larsen

All right. Thank you.

Operator

We have no further questions. We turn the call back over to Ms. Fletcher for closing remarks.

Karen Fletcher

Okay. Thanks for joining us this morning. I know it’s a busy day for everybody. If you have any follow-up questions, just reach out and give me a call. Thank you.

Operator

Thank you for participating in today’s conference call. All lines may disconnect at this time.





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Marlin Business Services Corp. (MRLN) CEO Jeff Hilzinger on Q4 2019 Results – Earnings Call Transcript


Marlin Business Services Corp. (NASDAQ:MRLN) Q4 2019 Earnings Conference Call January 31, 2019 9:00 AM ET

Company Participants

Lasse Glassen – ADDO Investor Relations

Jeffrey A. Hilzinger – President and CEO

Lou Maslowe – SVP and Chief Risk Officer

Michael R. Bogansky – SVP and CFO

Conference Call Participants

Christopher York – JMP Securities

Operator

Greetings and welcome to the Marlin Fourth Quarter and Full Year 2019 Earnings Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions]. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Lasse Glassen, with ADDO Investor Relations. Thank you. You may begin.

Lasse Glassen

Good morning and thank you for joining us today for Marlin Business Service Corp’s 2019 fourth quarter results conference call. On the call today is Jeff Hilzinger, President and Chief Executive Officer; Lou Maslowe, Senior Vice President and Chief Risk Officer; and Mike Bogansky, Senior Vice President and Chief Financial Officer.

Before beginning the call today, let me remind you that some of the statements made today will be forward-looking, and are made under the Private Securities Litigation Reform Act of 1995. Such forward-looking statements represent only the company’s current beliefs regarding future events and are not guarantees of performance or results. Actual performance or results may differ materially from those projected or implied in such forward-looking statements due to a variety of factors including but not limited to factors described under the heading forward-looking statements and risk factors in Marlin’s periodic reports filed with the United States Security and Exchange Commission including the most recent Annual Report on Form 10-K and quarterly reports on Form 10-Q which were also available in the Investors section of the company’s website. Investors are cautioned not to place undue reliance on such forward-looking statements.

During this call Marlin may discuss various non-GAAP financial measures including adjusted earnings per share and adjusted operating efficiency ratio. Please refer to our earnings release for a description of these and other non-GAAP financial measures as well as a reconciliation of such measures to their respective, most directly comparable GAAP financial measures. With that, it’s now my pleasure to turn the call over to Marlin’s President and CEO, Jeff Hilzinger. Jeff?

Jeffrey A. Hilzinger

Thank you Lasse. Good morning and thank you everyone for joining us to discuss our 2019 fourth quarter results. I’ll begin with an overview of the key highlights from this past quarter, along with an update on the continued execution of our strategy that has successfully transformed Marlin from a micro ticket equipment lessor into a nationwide provider of capital solutions to small businesses. Lou Maslowe, our Chief Risk Officer will comment on portfolio performance and Mike Bogansky, our Chief Financial Officer will follow with additional details on our financial results as well as our business outlook and financial guidance for the upcoming year.

Marlin concluded 2019 with a strong performance in the fourth quarter highlighted by record origination volume, disciplined expense management, and excellent earnings growth. Total origination volume of 236.5 million increased 9.3% year-over-year driven by increasing customer demand for both our equipment finance and working capital loan products as well as solid growth in our direct origination channel. For the full year total origination volume of 877.9 million grew 18.7% year-over-year, more than double the prior year’s growth rate.

While the origination growth we experienced demonstrates the significant demand that exists for our financing products, market conditions during the fourth quarter created both an increasingly competitive pricing environment and a favorable capital markets environment. To this end these market conditions enabled us to offset the continued yield compression we experienced in our equipment finance product with exceptionally strong capital markets execution. Given our strong originations volume and a favorable capital markets conditions we sold a 114.5 million assets during the fourth quarter that generated an immediate net pretax gain on sale of 8.8 million.

As a result of these origination and capital markets activities Marlin’s net investment and leases and loans stood at just over 1 billion at year end and our total managed assets expanded to more than 1.3 billion, an increase of 17.7% from the fourth quarter last year. at the bottom line fourth quarter net income increased by 31% year-over-year with earnings growing to $0.69 per diluted share compared with $0.51 per diluted share for the fourth quarter last year. Intervening to our strong earnings performance in the quarter was our ability to carefully manage non-interest expense as evidenced by the significant year-over-year improvement in our adjusted operating efficiency ratio. Notwithstanding this our portfolio did experience higher delinquencies and credit losses during the quarter and we continued to closely monitor the portfolio and proactively manage credit performance.

For the full year net income of 27.1 million increased by 8.6% from 25 million a year ago and earnings per diluted share of $2.20 was at the high end of our most recently issued guidance. Overall I continue to believe that the fundamentals of our business remains strong and as we look ahead to 2020 I believe Marlin remains very well positioned for another year of profitable growth.

I would now like to move to an update on our key business transformation initiatives which are focused on driving growth and improve returns on equity by first, strategically expanding our target market; second, better leveraging the company’s capital base and fixed cost origination and portfolio growth; third, improving our operating efficiency by better leveraging fixed cost and scale and through operational improvements to reduce unit processing costs; and fourth, proactively managing the company’s risk profile to be consistent with our risk appetite.

I would like to share with you the progress we have made in each of these areas since our last call. First, in terms of expanding our addressable market we remain focused on providing multiple products and developing financing solutions to help small businesses grow. As part of this we have also broadened our go to market strategy by not only continuing to originate through our equipment vendor partners, but also directly with our end-user customers. While our equipment finance business continues to grow, we are particularly pleased with the consistently strong performance of our working capital loan product. Fourth quarter working capital loan origination volume expanded by 58% year-over-year to 31.3 million. For the full year working capital loan origination volume of 108.7 million increased nearly 46% over the prior year.

We also remain pleased with our efforts to provide financing solutions directly to our end-user customers. The key part of our go to market strategy is leveraging our relationships with our end-user customers including approximately 200,000 solicitable relationships the company has built with its small business customers over time. Our direct strategy identifies additional financing opportunities with these existing customers by offering multiple products that meet a broader set of their financing needs. During the fourth quarter direct originations volume increased to 50.4 million up from 40.4 million in the fourth quarter last year and resulted in a year-over-year increase of nearly 25%. This wrapped up a solid year for our direct business with origination volume of 184.6 million which was an increase of 29% over the prior year.

In addition, we continue to make headway on our second key priority, which focuses on leveraging Marlin’s capital and fixed costs through growth. Thanks to the strong origination growth we generated in the fourth quarter, along with very favorable capital markets conditions we followed through on the assets indication guidance we provided last quarter. Overall, we see asset sales as an opportunity to not only use our capital more productively, but also as a way to compete effectively in markets where the pricing does not meet our return requirements on a whole basis by allowing us to monetize the bulk of the net interest margin while simultaneously transferring the credit risk to others and releasing the capital and loss reserves held against the sold assets.

Asset sales also helped to further diversify our funding sources, as well as provide an efficient way to optimize our portfolio composition in terms of returns, credit risk, and exposure to particular industries, geographies, and asset classes. Finally, and most importantly, from a strategic perspective, asset sales allow us to continue to take full advantage of our total origination opportunity and to meet the financing needs of our customers by allowing us to intermediate or retain assets to our maximum advantage while also retaining servicing and the customer relationships in support of our direct business.

During this past year, our growing origination by volume combined with strong investor demand and favorable market conditions, allowed us to sell 310.4 million in assets that generated an immediate net pre-tax gain on sale of approximately 22.2 million. Importantly, and as I mentioned previously, we continue to service nearly all of these assets, which allows us to maintain an ongoing relationship with these customers in support of our direct strategy. In total, we are now servicing approximately 341 million in assets for our capital market partners.

Turning to our third area of focus, we continue to make strides in better leveraging the company’s fixed costs through portfolio and revenue growth and by improving operating efficiencies through ongoing process improvements and automation. On a GAAP basis, the company’s efficiency ratio was 43.2% for the fourth quarter versus 53.1% for the same period last year and 54.2% for the full year in 2019 versus 55.3% in 2018. Moreover the company’s adjusted operating efficiency ratio improved to 40.2% for the fourth quarter versus 50.9% for the same period last year and improved to 49.4% for the full year in 2019 versus 53.2% in 2018. Looking ahead to 2020 and beyond, we will continue to leverage our fixed costs through portfolio and revenue growth and look for ways to operate more efficiently through our various process renewal and automation initiatives.

And finally, we remain focused on proactively managing the company’s risk profile, such that it is commensurate with our risk appetite. As I noted earlier, we did experience higher delinquencies and credit losses in the quarter, which is a trend the broader industry has also been experiencing. In response, we are making underwriting adjustments to address underperforming areas of the portfolio and have also added collections resources in response to the upward pressure on delinquency that we and the industry are experiencing. Lou will provide more color on these activities in his remarks.

In summary, we wrapped up 2019 with a strong fourth quarter. During the quarter and throughout the year, we made good progress on both our near-term financial goals and longer-term strategic objectives. As we look ahead, we anticipate another year of profitable growth for Marlin in 2020 and I strongly believe that we are well-positioned to pursue the many opportunities that exist in the marketplace and to unlock value for our shareholders. With that, I’d like to now turn the call over to Lou Maslow, our Chief Risk Officer to discuss the performance of our portfolio in more detail. Lou.

Lou Maslowe

Thank you, Jeff and good morning everyone. Before I begin discussing the portfolio metrics for the quarter, I want to note that I will provide statistics for both the on book portfolio as well as the managed portfolio. The managed portfolio metrics are considered more indicative of aggregate portfolio performance and credit quality trends due to the 310 million of asset sales in 2019. Looking at the key asset quality metrics, equipment finance on book receivables over 30 days delinquent were 1.41%, up 13 basis points from the prior quarter and up 33 basis points from the fourth quarter of 2018. Equipment finance receivables over 60 days delinquent were 0.87%, down 1 basis points from the prior quarter and up 22 basis points from the fourth quarter of 2018. The managed portfolio receivables over 30 days were 1.22%, up 6 basis points from the prior quarter and 21 basis points from the fourth quarter of 2018. The managed portfolio over 60 days were 0.73%, down 4 basis points from the prior quarter and up 14 basis points year-over-year. For benchmark purposes, the November 31 to 90 day PayNet small business delinquency index, which was the latest available increased 3 basis points since August, and 18 basis points since December 2018.

Aggregate total finance receivables net charge off increased in the fourth quarter to 3% of average finance receivables on an annualized basis as compared with 1.99% in the prior quarter and 2.3% in the fourth quarter of 2018. Equipment finance net charge offs increased by 70 basis points quarter-over-quarter and 53 basis points year-over-year to 2.72%. On a managed portfolio basis equipment finance net charge offs in Q4 were 2.44%, up 60 basis points from the prior quarter. Included in fourth quarter charge offs was 900,000 that was specifically reserved during the third quarter, thereby eliminating the entire allowance related to the fraudulent activities within a specific dealers portfolio.

For benchmark purposes the November PayNet small business default index was 2.11%, up 5 basis points from August and 24 basis points from December 2018. Based on our experience benchmark data, as well as discussions with other lenders, we believe that very small businesses have been disproportionately impacted by the economic headwinds observed in the second half of 2019. Due to continued increasing delinquency and charge offs in the third quarter and fourth quarters, we performed a deep analysis into the drivers of the weakening portfolio performance. Our analysis revealed that there was a much larger increase in delinquency and charge offs during the second half of 2019 from the lower credit quality borrowers in our portfolio. Based on our analysis we’ve made underwriting adjustments for borrowers of lower credit quality.

Transitioning now to discuss working capital loans, fourth quarter 15 plus day delinquency decreased 14 basis points from the prior quarter to 1.75%, while 30 plus day delinquency increased by 8 basis points to 1.42%. Working capital loan net charge offs in the fourth quarter increased to 7.95% of average working capital loans on an annualized basis from 1.42% in the third quarter and 5.28% in the fourth quarter of 2018. As noted on the earnings call last quarter, the Q3 net charge offs were extraordinarily low and as we’ve noted in the past, losses in this product remain volatile from quarter-to-quarter. While the results in Q4 exceeded our target of 6%, the results remain highly accretive to earnings given the high yield of the product. We will continue to monitor results closely and make underwriting adjustments as needed to ensure satisfactory portfolio performance.

The allowance for credit losses was 2.15% of average finance receivables, up 29 basis points in the fourth quarter from the prior quarter. The increase in the equipment finance allowance percentage is mainly attributable to higher delinquency and charge off migration rate in the fourth quarter. Marlin will adopt the new allowance for credit losses methodology commonly referred to as CECL or current expected credit losses beginning January 1, 2020. Mike will provide additional details in his remarks, including an estimated impact of CECL on our projected 2020 results.

In terms of our credit outlook, we monitor small business sentiment utilizing the National Federation of Independent Small Business Optimism Index which while declining slightly in December remains in the top 20% of all readings in the index of 46 year history. From a portfolio performance perspective, we monitor a number of leading indicators, including PayNet’s absolute PD Outlook, which forecasts a commercial loan default rate for small businesses across the U.S. based on current macro economic statistics. PayNet’s latest data as of October is forecasting relative stability with the small business fault rate over the next 12 months that is five basis points lower than the forecast from the prior quarter and only four basis points higher than the prior 12 months forecast.

Given the market data I noted we expect portfolio performance to stabilize. We will monitor closely the changes that we have made to underwriting over the past six months to see that they have the desired effect. With that, I’ll turn the call over to our CFO, Mike Bogansky, for a more detailed discussion of our fourth quarter financial performance. Mike?

Michael R. Bogansky

Thank you, Lou and good morning everyone. Fourth quarter net income was 8.4 million or $0.69 per diluted share compared with 6.4 million or $0.51 per diluted share for the fourth quarter last year. For the quarter, yield on total originations was 12.43%, down 95 basis points from the prior quarter and up seven basis points from the fourth quarter of 2018. Fourth quarter yield on direct originations was 23.2%, down 118 basis points from the prior quarter, primarily due to lower yields on working capital loan. Yield on indirect originations for the quarter was 9.19%, down 91 basis points from the third quarter due to competitive pricing pressure and the lower interest rate environment, as well as the mix of our originations and lower yielding programs.

For the quarter, net interest margin, or NIM, was 9.44%, down 11 basis points from the prior quarter and down 32 basis points from the fourth quarter of 2018. Sequential quarter decrease was driven primarily by lower fee income and a decrease in new origination loan and lease yield, partially offset by lower interest expense. The year-over-year decrease in margin percentage was primarily a result of an increase in interest expense resulting from higher deposit rates and lower fee income, partially offset by an increase of seven basis points in new origination loan and lease yield.

We continue to experience an increasingly competitive pricing environment and we expect that this will persist at least through the first quarter of 2020. The current market conditions leading to competitive pricing pressures have also caused favorable capital markets execution and we will continue to evaluate our alternatives to optimize risk adjusted returns. Company’s interest expense as a percent of average finance receivables decreased to 2.36%, compared with 2.5% for the previous quarter. Interest expense as a percent of average finance receivables increased from 2.2% for the fourth quarter of 2018 due primarily to higher deposit costs.

Non-interest income was 13.5 million for the fourth quarter of 2019, compared with 10.4 million in the prior quarter and 7.1 million in the prior year period. The year-over-year and quarter-over-quarter increase in non-interest income is primarily due to an increasing gains on the sale of assets from the company’s capital markets activities. We sold 114.5 million of assets during the fourth quarter of 2019 and we realized strong execution gains driven by the current market conditions. As Jeff noted, this was a result of strong origination growth in lower yielding programs and it enabled us to offset some of the yield compression that we have experienced.

Moving to expenses, fourth quarter non-interest expenses were 16.4 million, compared with 17 million in the prior quarter and 16.4 million in the fourth quarter last year. We were able to achieve a relatively flat to declining expense base despite a 17% sequential quarter increase and a 9% year-over-year increase in origination volume respectively. During the fourth quarter of 2019, we repurchased approximately 47,200 shares of Marlin common stock for an average price of $22.26 per share. As of December 31st, we have approximately 9 million of remaining authorization available under the stock repurchase program that was announced in August of 2019. As we have previously communicated, we routinely evaluate capital allocation alternatives and we continue to believe that share repurchases are an appropriate use of capital at this time. Additionally, our Board of Directors declared a regular quarterly dividend of $0.14 per share payable on February 20, 2020 to shareholders of record as of February 10, 2020.

As noted on the last earnings call, we will adopt accounting standards update 2016-13 effective January 1, 2020. ASU 2016-13 replaces the current incurred loss accounting model for credit losses with a more forward-looking current expected credit loss model commonly referred to as CECL. Based on our portfolio size and composition as of December 31, 2019. We expect to increase our allowance for credit losses by approximately $11 million effective on January 1, 2020. This transition adjustment for adopting ASU 2016-13 will be recognized through equity and we’ll reduce total stockholders’ equity by approximately 8 million net of deferred income taxes of approximately 3 million.

Based on our expectations for origination volumes in the credit environment in 2020, we estimate that the adoption of CECL could negatively impact EPS by up to $0.25 per share for the full year ending December 31, 2020. The increase in the expected provision for credit losses in 2020 is due to the addition of lifetime credit losses and the loss allowance calculation, as well as a change in the recognition of end of term income for leases with residual value. The ongoing earnings impact from the adoption of ASU 2016-13 is expected to be larger in periods of portfolio growth, but it’s highly dependent on a variety of factors including but not limited to vintage portfolio performance, the timing of originations, forecast with economic conditions, the volume of our syndication activity, and prepayment speeds.

Now, turning to our business outlook for 2020, which reflects our adoption of the CECL accounting model, we are initiating earnings guidance for the full year ending December 31, 2020. We expect adjusted earnings per share to be between $2.17 and $2.27. As I said before, this reflects the impact from the adoption of the CECL accounting model, which could negatively impact earnings per share by up to $0.25 per share. Our earnings guidance is based on the following assumptions, total sourced origination volume growth of approximately 20% from 2019 levels with continued disproportionate growth in our working capital loan product. Portfolio performance does not deteriorate from the year-end 2019 experience and delinquencies and net charge offs remain at the higher end of our expected range. Net interest and fee margin as a percentage of average finance receivables of between 9.25% and 9.75%. That concludes our prepared remarks and with that, let’s open up the call for questions. Operator.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions]. Our first question comes from the line of Christopher York with JMP Securities. Please proceed with your question.

Christopher York

Hey, good morning guys and thanks for taking my questions.

Lou Maslowe

Good morning Chris.

Christopher York

So, Lou or Mike, could you elaborate specifically on the formal credit guidance, what specifically do you mean by performance is not expected to deteriorate?

Lou Maslowe

Well, I think if we, I will start Mike and if you want to jump in, you know the performance that we saw particularly over the last two quarters was higher than the first half. So as I look at the performance, Q4 was particularly high, which in my view is higher than I would expect for 2020. So, we’ve talked about our range being in a good economy from 160 to 190 basis points or so. I think the small business were at the weaker end of a good economy right now and how it’s impacting them. So I predict that the higher end of that range around 190, which is probably from a calculation perspective, maybe even a little bit higher than that when you take into consideration the actual math associated with this indication. But I think from my point of view that’s kind of the ballpark that we’re looking at.

Christopher York

Okay, just repeat that for me, 190, what is that referencing?

Lou Maslowe

So 190 is for equipment finance, because that is the upper end of the range that we’ve talked about in a good economy. So, I think we’re going to be in that higher end range that we talked about for equipment finance.

Christopher York

Okay, and then maybe on the allowance so, it does not deteriorate, so should we expect an allowance for loan losses which ended the year at 2.11% to be flat throughout 2020?

Lou Maslowe

Now that’s moving it to CECL, so I will pass that one to Mike.

Michael R. Bogansky

Yes, so Chris this is Mike. We thought we guided to an initial CECL impact of $11 million, that’s going to bump up the allowance percentage. All the things being thought but the credit environment not deteriorating, as Lou mentioned, is really a function of the provision that we would expect throughout 2020.

Christopher York

Okay, then reverting back to the 190 equipment finance delivered on delinquency, so then it does not deteriorate, should we expect net charge offs which ended the year at 2.19% on total finance receivables to be flat?

Lou Maslowe

Yes, so let me clarify my comments earlier, Chris. I was referring to charge off. Ultimately, you added that it’s our financial impact. Yes, so the range that we talked about for charge offs was in the 160 to 190 in pretty stable, good economy.

Christopher York

Okay, okay, that’s helpful. Alright, staying on expenses how should we think about your OPEX in 2020 as you chose not to provide formal guidance on that line but expenses have historically been volatile over the last couple of years, and then it was projected to represent an efficiency ratio of 45% in 2020?

Michael R. Bogansky

Yes, so we’ve provided the adjusted efficiency ratio in 2019 due to the impact that the leasing standard had on the gross up of our property tax on collectible expenses. So obviously our expenses do tend to be a little volatile and the fourth quarter tends to be a little bit lower expense rate. But I think if you look out into how we expanded from an efficiency ratio over the course of 2019 we would expect similar trending and that similar kind of an improvement in expense ratio or efficiency ratio over the course of 2020.

Christopher York

Okay, and then I mean, maybe just digging on the fourth quarter a little bit your press release mentions, having expense discipline so could you comment on what exactly you did take in the fourth quarter to manage OPEXs down?

Lou Maslowe

Well, the expense discipline that manifested in the fourth quarter is really a result of the actions that we took earlier in the year, and they are making their way through the expense base now. So we did announce certain actions at the end of the second quarter and it’s just been a continuous focused on expenses throughout the back half of the year. But a lot of those actions were initiated in the second, third quarters of 2019, and they’re starting to flow.

Christopher York

Okay, and then how much are you investing in your impact in then the online platform today?

Lou Maslowe

I mean, we’re continuing to make investments in our digital offering. I would say they’re at a more measured pace, but we initiated or reinstalled Salesforce.com a couple of years ago and we’re continuing to make enhancements to that platform. We’re continuing to make enhancements to our digital application offering. So you see those investments coming through, come through the investment — the investment line in the financial statements and I would say that we would expect to continue at that same pace throughout 2020 as we continue to refine our digital offering.

Christopher York

Okay, so then I mean, how should I or how should investors potentially understand maybe what’s causing the lack of efficiency and I think we thought we were getting efficiency ratio of 45% in 2020. Now I was thinking potentially that could be investing in tech. But what is potentially delaying some of the operational efficiency achievements that you initially expected?

Jeffrey A. Hilzinger

Yeah, I think, Chris this is Jeff, so we guided three years ago to a 45% operating efficiency ratio in 2020. You know, I think we’re going to end up being in the high 40s when it’s all said and done and I think the reason for that is because of the investment that we’re making in digital. I think what’s going to happen is, is that that investment in digital will ultimately allow us to be able to offer some additional products that sits somewhere between our equipment finance product and our working capital loan product. They can only be offered in a digital way because they’re operationally complex and that will end up being accretive to our NIM over time offsetting the difference between what we thought was going to be, a less digital platform, but at a better operating efficiency ratio to one where we’re investing more in digital than we thought. But that ultimately will have an expanded NIM as a result of the digital products that we are intending on introducing.

Christopher York

Okay, it makes more sense. Okay, on capital it increased year-over-year and consequently remains above your 50% equity to assets target. So do you expect to be more active in share repurchases than you’ve historically been or what other capital actions you consider to be more optimally managed?

Jeffrey A. Hilzinger

So we were — we did repurchase a lot of shares in 2019 and we have $9 million of remaining authorization under our latest authorization. So as I said in the prepared remarks, we do view share repurchases as an effective use of our capital at this time and we would continue to view that, especially given safe stack price.

Christopher York

Okay, and is there anything else on the capital actions that you consider to get close to that 15%?

Jeffrey A. Hilzinger

You know, we could hold more assets on balance sheet instead of syndicating them Chris but I think that the goal here isn’t to use the excess capital in a way that isn’t accretive to ROE, it’s trying to figure out how to get the capital in the business to be the proper size for the risk profile of the balance sheet. So, the big issue that faces the company is structural issue that based companies we’ve got this capital limitation agreement with the FDIC, which requires us to hold 15% capital at the bank. And if you look at the capital, the economic capital that was required and the securitization we did last year, it was much, much less than 15%. So I think the goal here is to try to get the actual capital and the business down to a level that’s more approximate to what the economic capital should be. But, we’re not going to be able to make significant progress on that until we get relief from the capital limitation agreement, which is a very, very important strategic objective for the company but it’s not one that we control.

Christopher York

Sure, yep and no doubt, that one’s existed for a while. Kind of combining my questions all together, the top line has been essentially in line with expectations, OPEX is on the higher with a little bit more help, more capital. I noticed your debt, your target return on average equity, which was supposed to be hitting 2020 at 18% to 20%, has now been changed to an unidentified long-term target. So how should investors think about that expectation for timing for this achievement to be hit?

Jeffrey A. Hilzinger

You know, I think that we are, with the way we think about it is that, you know, we’re going to be digitizing the platform over the next two to three years. And that the combination of common relief and digitizing the platform and removing the capital and increasing the margin in the business is a result of being able to offer these digital products, I think will ultimately get us to where the guidance was that we provided three years ago. But it’s, we’re in a much more competitive environment in the equipment finance business than we thought we were going to be when we provided that guidance to begin with. We think we have a really good litigant in our capital market strategy. But ultimately, I think the basic structure of the business needs to change from a calmer perspective to the amount of capital that’s in the business and we need to really make progress on digitizing the platform so that we can continue to offer more higher margin products to the platform.

Christopher York

Got it, and I don’t want to hog all your time. I’ll ask one last question and then hop back in the queue. So this is the toughest, but it is most important question here. If I take a look back, over the last few years, stocks essentially been flat, you have done a nice job on execution throughout multiple initiatives with Marlin 2.0. But why should investors expect any further execution to lead to a higher stock price and what else is in your control to improve stock performance?

Jeffrey A. Hilzinger

You know that is a good question. And, I don’t have a crisp answer to that. We’re repurchasing shares, we are removing — we are working to remove the capital limit agreement. We reduced expenses dramatically. We’ve got capital markets in place to mitigate the changing price environment. So, from our perspective I think we’re managing the levers that we control very aggressively. And we did so last year and we’re going to continue to do so next year. As to the stock price, we obviously view it as being significantly below the intrinsic value of the business. And it’s a huge topic of conversation both in the management team and with the Board. So it’s something that we’re thinking about and working to improve all the time.

Christopher York

Got it, yeah. Thanks for the candor, Jeff. I know it’s not an easy question. I’m sensing that some investors that you’ve been modeling 2.0, maybe losing confidence essentially will be reassured. So that’s it for me. I’ll hop back in the queue.

Operator

[Operator Instructions]. Our next question is a follow-up from Christopher York with JMP Securities. Please proceed with your question.

Christopher York

You can’t get rid of me. Just two follow up questions just specifically on the quarter. So, what are some of the qualitative characteristics that led to some of your comments on lower credit borrowers that throw the pickup in delinquencies in the second half of the year?

Lou Maslowe

Yeah, so first of all so that I’m clear this time it’s not just delinquency it’s charge offs. But, there were three parts of our portfolio that showed particular weakness in Q3 and even more so in Q4 that was transportation. Our broad based retail business, we refer to it as retail but its multiple industries that we solicit business from through our dealer partners and then lastly, our broker space. So, we talked last quarter we’d made changes to our transportation underwriting guidelines. We’ve continued to see deterioration as that market still is suffering from lower freight volume, lower freight rates, higher insurance costs. So we’ve made — we’ve tightened even further the transportation sector. We have basically completely eliminated other operators. We’ve limited transportation business to our commercial vehicle group and to two large partners whose portfolios are performing well, much of which is vocational anyhow. So we’ve really tightened up on the transportation fees I think sufficiently well at this point. But still, Q4 was weak and we had increased charge offs there.

In terms of our retail business and our broker business, as we did a deep analysis into that portfolio, we really saw a marked difference between the better half I would say of our credit quality in terms of the movement of the higher delinquency and charge offs in the lower half. So what we’ve done is we’ve made some pretty significant changes in terms of those transactions, lower grade credits that in the past might have been approved without personal guarantees, were now requiring personal guarantees. We’ve also increased the requirements in terms of the quality of those guarantors, both in terms of their credit scores, their personal credit scores and the revolving availability. So the analysis revealed to help us identify the steps we needed to take and we’ve implemented those changes.

Christopher York

Got it, okay, that’s helpful. Thanks for that color. Maybe Jeff, I’m trying to ascertain a little bit more of your comments on the competitive pressures. Maybe you could just qualitatively talk about what you’re experiencing there in equipment finance, if that’s the way kind of for me to look at an indicator of the competitive pressures, the decline in the weighted average new equipment finance still, I know your prepared comments talked a little bit about a mix and then obviously competitive pressures, so could you just help me understand a little bit more qualitatively what’s going on in equipment finance from a competition standpoint?

Jeffrey A. Hilzinger

Sure. So we could talk a little bit about equipment financing and then I could make a couple of comments on working capital as that market continues to evolve as well. So, the fourth quarter is always the most competitive quarter regardless of what kind of broader competitive environment you’re in. But in the third and fourth quarter, we definitely felt increased price competition and it’s — I think it’s — we saw in that late cycle, and the late cycle competitive changes usually occur first with pricing and then with credit. We haven’t seen the credit piece yet so it feels to us like there’s credit discipline that the industry is continuing exercise. But there’s no question that as platforms are trying to grow and trying to find a way to better serve their customers that there is margin compression that’s occurring. And it’s I think it’s particularly as banks with low marginal deposit costs continue to enter the equipment finance space and they continue to move down market.

That’s definitely I think having an impact on the — had an impact on the pricing that we experienced in the third and fourth quarter. And we made the conscious decision in the fourth quarter to beat the market current price in those platforms where we felt it the most. So it’s — we believe that because we have the capital markets capability, we can compete on that basis because ultimately we’re just intermediating the assets to a bank’s balance sheet anyway. And so it allows us to be able to retain control of our customers, to be able to service their needs, and it allows us to remain competitive, independent of our cost of funds relative to our competitors. So it’s not the perfect solution, but it’s a good solution.

Christopher York

Yeah agreed. And then maybe just comments on working capital and what you’re seeing there, you’ve got a confluence of potential competitors, so any comments on qualitative competitive pricing or pressure?

Jeffrey A. Hilzinger

Yeah. I think unlike equipment finance where it’s — there’s both a cycle impact and there’s also potentially a structural impact as these banks move down market, in the working capital case what we’re seeing is just the market is really maturing and I think there is while the product has it cycles yet, I think a lot of the competitors in that market are so data driven and they have — they really have a lot of data that they’ve accumulated over the last two or three years. And they’re discovering that, the better economic outcome is to reduce price a little bit and be able to increase volume. The market or the product is really becoming more mainstream. We see it with our customers as well. It used to be the product, the last resort, and we don’t see that anymore. And so you’ve got it, you’ve got tenders extending, you’ve got going from daily and weekly repayments, monthly repayments. You’ve got deal sizes going up. There’s a more specific stratification of credit quality and the way that fintech or all lenders are providing that product in the market.

So I don’t think it’s necessarily a bad thing. And I think we’re in a really good place to be able to evolve with it and to take advantage of it, because I think, the tailwinds that come from having the market or having the product use being more mainstream, it just all both rise is that as that occurs and there’s certainly going to be dog fights and competition and so forth. And, over time as everybody tries to settle into the place that they want to compete in that environment but there is good tailwinds in the working capital product because it is becoming a more — it’s being viewed and consumed in a more mainstream way.

Christopher York

Interesting, its great perspective and context. Thanks for all that especially on the industry and the market as well. I think that’s it for me. So thank you for being patient and taking by my exhaustive list of questions.

Jeffrey A. Hilzinger

Our pleasure, Chris. Thank you.

Operator

Thank you, we have reached the end of our question-and-answer session. I’d like to turn the call back over to Mr. Hilzinger for any closing remarks.

Jeffrey A. Hilzinger

Thank you for your support and for joining us on today’s call. We look forward to speaking with you again when we report our 2020 first quarter results in late April. Thanks again and I hope you have a great rest of the day.

Operator

Thank you. This concludes today’s teleconference, you may disconnect your lines at this time. Thank you for your participation and have a wonderful day.





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