Regal Rexnord Corporation (RRX) Earnings Call Transcript & Summary

Good morning, and welcome to the Altra Acquisition Call. [Operator Instructions] Please note that this event is being recorded. Now, I'd like to turn the conference over to Mr. Robert Barry of Investor Relations. Please go ahead.

Great. Thanks, Nick. Welcome, and good morning, everyone. Thanks for joining us today on short notice. On this call, we will be discussing Regal Rexnord's agreement to acquire Altra Industrial Motion. Before we begin, I would like to highlight a few things. First, Altra issued a press release this morning announcing the transaction in addition to select anticipated third quarter 2022 financial measures based on currently available information. Altra's press release also indicated that it will announce its third quarter earnings on November 3, but in light of the transaction, it will not be hosting a conference call to discuss those results and has also withdrawn its 2022 financial guidance. Second, given the announcement of the transaction and its timing relative to the planned release of our third quarter financial results on October 31, we pre-released select anticipated third quarter 2022 financial measures, also based on currently available information. These results are available in the transaction press release we issued this morning, which is available on our Investor Relations website. Please note that we will not be discussing anything related to our third quarter results on this call. As a reminder, Regal Rexnord is scheduled to report our third quarter earnings after the close on October 31, and host our third quarter earnings conference call on Tuesday, November 1 at 9 am Central Time. Details are also available on our Investor Relations website. Now, I would like to remind you of the disclaimers on Slide 2, and on Slide 3, we provide additional information related to our use of certain non-GAAP financial measures. Turning to Slide 4, joining me on today's call are our presenters, Louis Pinkham, Regal Rexnord's Chief Executive Officer; and Rob Rehard, Regal Rexnord's Chief Financial Officer. Louis and Rob will share some prepared remarks, after which, we will be happy to take your questions. And now, it's my pleasure to turn the call over to Louis.

Great. Thanks, Rob, and good morning, everyone. Thank you for joining us to discuss today's news. This is an extremely exciting day for both companies. We announced today that Regal Rexnord is acquiring Altra in an all-cash transaction valued at slightly less than $5 billion, which we are confident will create significant value for all our stakeholders, our shareholders, our employees and our customers. The combination brings together 2 highly synergistic businesses. As many of you know, Regal Rexnord is a global leader in Motion Control Solutions, Industrial Powertrains, Electronic Motors and Air Moving sub-systems. Altra is a highly innovative player in motion control and automation technologies. Adding Altra to Regal Rexnord will create a world-class automation solutions and industrial powertrain provider, better positioned to profitably grow. Notably, post the acquisition, over 35% of our sales will be to end markets with attractive secular growth tailwinds, and we see this rising to approximately 40% over the next few years. Among the many strategic and financial benefits of this transaction is unlocking $160 million in annualized run-rate cost synergies. We believe that by bringing our 80/20 skillset, continuous improvement mindset and a rigorous plan-do-check-act or PDCA management approach to Altra, much as we have done with the great effect at Regal Rexnord, we can unlock tremendous value. This includes significant additional upside from cross-marketing synergies and other opportunities to accelerate profitable growth. As we did after our 2021 merger with Rexnord PMC, we will plan to quantify these cross-marketing synergies at an appropriate time after the transaction closes. The combination will also create meaningful value for customers of both businesses by significantly broadening our automation portfolio, bolstering our industrial powertrain offering and accelerating our digital strategy, so the combined enterprise is better positioned to address customers' increasingly sophisticated digital and industrial IoT needs. Financially, the transaction is expected to generate highly attractive returns, including a strong return on invested capital, substantial free cash flow, adjusted EPS accretion in the first year, and double-digit accretion thereafter, enviable gross margins and significant EBITDA margin expansion driven by, among other factors, the sizable cost synergies. In short, we think acquiring Altra represents a highly compelling capital deployment opportunity that can deliver tremendous value for all of our stakeholders. The transaction provides significant immediate and long-term financial benefits to Regal Rexnord, and I'll highlight a few here. Post the combination, we expect our 2022 pro forma revenue to approximate $7.2 billion and our gross margin to be approximately 34%. With the significant cost synergies we're anticipating, most weighted to cost of goods sold, Regal Rexnord now has a clear path to a 2025 gross margin of 40%, which we believe would be top-quartile performance across the U.S. industrial space. The $160 million of annual run-rate cost synergies stem from actions we plan to take during the first 4 years after closing and help drive approximately 500 basis points of adjusted EBITDA margin upside by 2025 to over 25%. Also, likely to be top-quartile performance among our peers. Additionally, the transaction is expected to be accretive to our adjusted earnings per share in year one. The degree of accretion is expected to increase to double-digits in subsequent years as synergies accrue, and we make progress reducing our debt levels. With strong cost synergies as well as cross-marketing synergies, we expect that ROIC will exceed 10% by year 5 after closing. We believe cross-marketing synergies can be substantial, but outside of factoring a conservative estimate for them in the ROIC calculation, they are not included in our financial forecasts at this time. Before drilling down on some of the key strategic and financial benefits of the acquisition, I would like to briefly step back to put this transaction in the appropriate context. As those of you who have been following Regal Rexnord know well. Over the past 3 years, we have made meaningful progress transforming our business. By leveraging 80/20 and LEAN, infusing a lot of new talent into the organization and always adhering to our values, we have dramatically improved our cost structure and increased transparency and accountability throughout the organization. We have also been investing for sustainable growth and have established a very solid foundation for better serving our customers by developing differentiated products and solutions that our customers value, value evident in our gross margin expansion. While our journey to a faster growing and more profitable Regal Rexnord still has ample runway, successful progress against our key initiatives have been delivering clear results. Notably, we exceeded handily all the key targets set at our 2020 Investor Day, some of them well ahead of schedule. We have also made transformative progress driving inorganic growth, most notably through our 2021 merger with the Process & Motion Controls business of Rexnord, a transaction valued at $3.7 billion. As you can see from the merger scorecard on this slide, we are outperforming on all key metrics and a year post closing, the integration is ahead of schedule and synergy realization is above plan. I should note that our performance on the organic and inorganic fronts are more noteworthy, given our team's execution in the face of COVID, and unprecedented inflation and supply chain disruptions. I believe our track record of operational performance gains and high return capital deployment are also evident in our stock price outperformance measured on a total shareholder return basis. And it was against this backdrop and with a clean balance sheet and very strong free cash flows that our team look to further our transformation journey. That step is the transaction with Altra that we announced today. On this slide, we enumerate the many compelling reasons why adding Altra helps advance our transformation. The first is that adding Altra's Automation & Specialty business fundamentally transforms our burgeoning automation business into a truly premier global player, and in doing so, opens a host of new growth vectors for us in automation. The addition of power transmission technologies enhances our already-strong industrial powertrain offering, in particular by enhancing our capabilities in clutches and brakes where we currently have a solid but more focused offering. Altra accelerates our digital and industrial IoT strategy, which we envision becoming increasingly relevant to profitable growth going forward. A strong shared culture, focused on serving customers and embracing a continuous improvement mindset; greater exposure to secular growth drivers, in particular factory automation, alternative energy and warehouse and logistics; and for the first time, critical mass in the medical market, to name a few examples. Sizable cost synergies worth an estimated $160 million on an annual run-rate basis by year 4. Plus significant additional upside from cross-marketing synergies. ROIC expected to exceed 10% by year 5. Adjusted EPS accretion in year-one post-closing and double-digit accretion thereafter. Lastly, robust free cash flow generation, which comes with our commitment to de-lever the balance sheet in an expeditious manner. The end result is a more resilient enterprise with stronger cash flows and enhanced margins. Now, I'd like to turn it over to Rob, who will walk you through a brief overview of the transaction and financial considerations.

Thank you, Louis, and good morning, everyone. As you can tell, we're really excited about this transformative transaction. Now, let me run you through some of the transaction highlights outlined on this page. Regal Rexnord is acquiring Altra for $62 per share, implying a $4.1 billion equity valuation and roughly $5 billion enterprise value, when assuming the approximately $860 million of net debt outstanding as of September 30 of this year. This represents an adjusted EBITDA multiple of 13.6x on a trailing 12 months basis or 9.5x when including estimated run-rate cost synergies. The transaction consideration is 100% cash, financed with existing cash on hand, plus new debt. The consideration and valuation also evidences strong price discipline. While the headline price we are offering does represent a significant premium to where Altra's shares have been trading, our perspective is owning the business for the long-term. And so price movements tied to the ebbs and flows of the macro cycle are something we evaluate, but are not necessarily the primary consideration for us as strategic owners. And we believe the transaction value on an adjusted EBITDA basis tracks in line with recent representative industry transactions. Finally, we believe the multiple we are paying looks very attractive after factoring in synergies. From a financial impact perspective, I will reiterate a few key points, accretion in the first year post-close, compelling synergies, significant cross-marketing synergies, ROIC greater than 10% by year 5 and very strong cash flows. Before leaving this slide, I did want to highlight a few additional items. One, we have a fully committed financing package to fund the transaction. We are committed to de-levering to our 2x to 2.5x target zone with urgency, and expect to be between 2.5x and 3x in our first full year of owning the business or 2024. From a timing perspective, the transaction, which is subject to regulatory approvals, Altra's shareholder approval and customary closing conditions is expected to close in the first half of 2023. And with that, I will hand it back to Louis.

Thanks, Rob. One of the transaction's most significant impacts is unlocking a host of new high margin growth vectors in automation. As you can see on this slide, our legacy automation business is roughly $200 million of sales, which includes our ModSort conveying sub-systems, our conveying and pelletizing offering that was part of the Arrowhead acquisition and our Thomson Paralleling Switchgear and Automatic Transfer Switch business. The addition of Altra's A&S business takes automation-focused businesses at Regal Rexnord to over $1 billion, of which roughly 70% are sales into markets with secular growth tailwinds. A&S is a great business today. But we believe that by further leveraging 80/20 and LEAN, and a highly disciplined approach to product management, we can serve its highly valued customers more responsibly and with a more robust portfolio, and in doing so, accelerate its growth and profitability. As those who have followed us know, one of the primary reasons we merged with Rexnord PMC was unlocking the tremendous growth potential from selling industrial powertrain, a representative powertrain is pictured here. It includes a motor and the critical power transmission components that connect the motor to the work being done. Adding Altra makes our already robust powertrain offering even more value-add, by enhancing our capabilities in clutches and brakes. In addition, Altra deepens our domain expertise in certain additional applications end markets, making our powertrain value proposition more competitive in a broader range of end markets. As you can see on this slide, across a number of perspectives, the addition of Altra enhances the diversity and growth characteristics of our portfolio. On a pro forma basis, Motion Control is roughly half of the portfolio. Automation represents about 15% and our legacy air-handling and motor businesses become roughly 30%. For reference, residential HVAC goes from 15% of the legacy business to just over 10%. Consistent with the lower resi HVAC exposure consumer exposure falls from representing about 16% of the portfolio to 12%. Notably, warehouse rises from 3% to 9%, while factory automation in general industries in the medical end markets start to have critical mass for us. In aggregate, sales into end markets that we would say should benefit from secular growth tailwinds rise from roughly 30% before the transaction to above 35% on a pro forma basis, which we have plans to grow to more than 40% by 2025. Lastly, general industrial remains our largest end-market exposure at 19% pro forma, down slightly from our prior mix. Geographic diversity does not change materially from the current Regal Rexnord profile. Next, I'd like to spend a moment providing a bit more color on the substantial synergy benefits of this transaction, which are expected to drive value for shareholders, and support and enhance pro forma financial profile. We plan to take actions by year 4 after closing that are worth $160 million in annualized run-rate cost synergies, driven by procurement, distribution efficiencies, footprint rationalization and SG&A. As you can see in the chart on this slide, we expect to take actions worth an annualized $40 million in year 1, primarily driven by procurement and SG&A savings with further savings from purchasing and footprint-related actions accruing in years 2 through 4 post close. Importantly, beyond these cost synergies, we also see significant incremental cross-marketing synergies enabled by the combined business having a broader product offering, enhancements to our industrial powertrain offering, a more robust digital and industrial IoT capability, and a stronger service in the aftermarket support network. The pro forma business will generate very strong free cash flow, which as you can see builds on the legacy of robust cash generation at both Regal Rexnord and Altra and will then be enhanced by merger synergies and other anticipated operational improvements. In addition, we see an opportunity to bring down the inventory levels at both businesses, which has swelled due to global supply chain disruptions. The full inventory benefits of supply chain normalization are not in our current forecast, but presents significant additional potential upside and an accelerated pace of de-levering. Also quantified on this slide, both businesses have very manageable leverage rates going into the transaction, and it will be our top capital deployment priority to return to a leverage ratio in the 2x to 2.5x range in an expeditious manner. Based on our current forecasts, we see pro forma leverage declining from 3.9x at close to between 2.5x 3x in 2024. Lastly, I want to be candid and acknowledge rising concerns among investors about a weakening global macro outlook. This dynamic was also on our minds as we evaluated this opportunity. So as part of our diligence, we conducted a number of sensitivity analyses around EBITDA reduction and further interest rate hikes to stress test our ability to service the debt. And we came away highly confident that the debt we are planning to take on to fund this acquisition is manageable, aided by the strength of cash flows in the underlying businesses, and the fact that in a downturn, free cash flow at both businesses tends to get a boost from lower working capital requirements. In addition, the sizable backlog at both businesses provides us some added revenue visibility in the near-term. In evaluating Altra against our disciplined M&A criteria, you can see on this slide that the acquisition checks every box. The business sells products with proprietary technology into end markets with secular growth tailwinds. Altra raises our gross margin trajectory, aided by strong longstanding brands with leading market positions, underpinned by technology leadership. As I discussed, the fit with our culture is strong and particularly attractive to us, the ample opportunities we see to leverage Regal Rexnord's strengths deploying 80/20, LEAN, and a strict plan-do-check-act management cadence to drive meaningful operational improvement. That's especially true in PTT, but we see opportunities in A&S as well. All these attributes are reflected in the deal's attractive projected financial metrics. Return on capital exceeding Regal Rexnord's average cost of capital by over 200 basis points by year 5; adjusted EPS accretion in year 1; significant cost synergies as well as sizable cross-marketing opportunities. Looking ahead to integration, the leadership team at Regal Rexnord and the integration team in particular have proven capabilities. These capabilities stem from decades of experience managing M&A integrations, both at Regal Rexnord and in roles our leaders have held elsewhere. I believe the strength of these capabilities has been clear in the team's success integrating Rexnord PMC as well as Arrowhead, where integrations are ahead of schedule and synergy realizations above plan, despite executing in an incredibly challenging operating environment. We will run a similar playbook to integrate Altra as we used with Rexnord PMC, including leveraging a dedicated integration team, defining specific KPIs relevant to our goals, and instituting a regular cadence of review, which occurs at least monthly at Rob and my level. To ensure activities are on track, and that corrective actions are defined quickly, if and when performance deviates from plan. We bring the same PDCA management approach to the integration team's performance as we do to each of our operating segments. So this is our vision, and really our expectation of what the pro forma Regal Rexnord will look like in 2025. Some of you may recognize this slide from our recent Investor Day, where we outlined targets. We are now updating them to incorporate our initial views on the impact from adding Altra. I think you will find these metrics compelling. Over $8 billion in sales, a path to 40% gross margin, an adjusted EBITDA margin above 25%, $18 of adjusted earnings per share, annual free cash flow approximating $1.1 billion, and over 40% of our sales in end markets with secular growth drivers. And I believe that when considered in the context of our execution track record and our stock price, Regal Rexnord offers an incredibly attractive investment opportunity for our shareholders, tremendous professional opportunities for our associates, including our future colleagues at Altra, and an even more attractive value proposition for our customers. In summary, I hope you agree this is a highly strategic transaction with a compelling value proposition, from new growth vectors in automation and an enhanced industrial powertrain offering to further strengthening our free cash flow generation and providing a clear path to de-lever quickly, we are extremely excited about the opportunity to acquire Altra and continue our journey to building a faster-growing, higher-margin, more cash-generative and higher return enterprise. And with that, Rob and I are happy to take questions. Operator, please open the line for questions.

[Operator Instructions] First question comes from Mike Halloran of Baird.

So first, just how did the deal come about? Was this negotiated just between the 2 of you? Is there anything else going on here? And just any kind of color on the background.

Thanks for the question, Mike. We have admired Altra for a long time and there is just such a complementary product offering on the Motion Control side of the business and we really like the Automation & Specialty side of the business. We especially like their position in the markets where they have significant secular tailwind. This came about because of that. As you know, I've been CEO for 3.5 years and we are always looking at our portfolio and feel that there was a really nice fit with Altra. We have reached out to Altra about 4, 5 months ago, but really started the discussion in earnest a couple of months ago.

That's helpful. And then a couple more financial questions. On the leverage levels, I certainly acknowledge and appreciate the comments you made on your ability to pay debt down quickly. Just, are there any covenants associated with that and kind of mix of fixed, floating or is it too early to know that as of now?

Yes, Mike, this is Rob. So after close, we do expect net debt to adjusted EBITDA ratio of 3.9x. We've certainly got great free cash flow generation which we expect to delever as we talked about down to 2.5x to 3x by 2024 and then get to our target range shortly thereafter that. We do expect that we'll have a mix of both fixed and variable debt and very manageable over the timeframe and with much of it prepayable and definitely payable very quickly after we close as we've talked about and there is certainly no risk as we talked about, we flex the business through various sensitivities, no risk of breaching those covenants through any of those scenarios.

And what are the covenants?

Right. Yes, so we -- 4.875 is the top of the range and then getting back down to 3.75.

Okay. Helpful, a couple of others here. What was the process in getting to the '25 targets, which is taking your Analyst Day target, their Analyst Day targets, putting together, was there some other sort of rigor associated with it? Just want to understand the process on that side.

No, I mean that's a good starting point, Mike, but then through our diligence of being able to come up with the cost synergies and I think we have a very disciplined process that we've proven out with the PMC merger of identifying and then acting on them. And so pulling that together along with recognizing the opportunities within the industrial powertrain to drive incremental growth through cross-marketing. Again, that's not embedded in our numbers, except for achieving the 10% ROIC by year 5 with a conservative assumption on the revenue side.

But if I have to look at it loosely, it's -- on the revenue side, you essentially did the targets from the Analyst Days. And then on the margin side, comparable, but you have these really attractive synergy things you're layering on top of it. And then you got this kind of last bucket of optionality that's not part of the target, is that a loose a fair summary?

Perfect, perfect.

Okay. Last one...

No, that's just...

That's awesome. Thanks for this. Last one for me then, when you think about the portfolio now, obviously you've had assets that have widely be considered something that you don't necessarily need part of your portfolio long-term. Now that you've got the Altra assets, could you maybe answer or think about that a little bit more broadly? Has that -- has what -- has the definition changed of what needs to be part of your portfolio over the long-term and any thoughts along that side?

Mike, we are continuously evaluating our portfolio and as I said in the past, I love all of our businesses and we believe that we can create value in all of our businesses. And so right now, we have not made any further portfolio decision.

And the next question will be from [indiscernible] of Goldman Sachs.

Maybe just one question on the regulatory front. We know that AIMC is mentioned as a competitor in your 10-K. Maybe if you can just give some color on the market share with Altra coming in the base and any risk from the antitrust standpoint. And if there is like some potential chance of some non-core asset divestment?

Here's what I can comment on. Very complementary businesses between Regal Rexnord MCS and the PTT side of Altra with numerous competitors, with overlapping products in numerous end markets. We will be fully prepared to provide regulators the information they need to assess the transaction and its merits and beyond that, we'll leave it to them to evaluate the transaction.

And then just one on the installed base, we know that in Motion Control, your installed base stepped up pretty significantly with the PMC acquisition. Just any color you can provide on what does this do to your installed base and aftermarket revenue opportunities post that?

It absolutely increases them and fairly significantly, but here's how I would think about it. When you look back on the PMC deal, there was strong overlap in distribution, very little overlap with OEMs, less than 10%. We are expecting the same here with the Altra transaction and what this does is it opens up additional markets and access to additional customers where we will take our full portfolio of products. And as you know, we did not come out when we acquired -- when we merge with PMC with sale synergies, but we did announce this year $30 million of incremental sales and a goal of $125 million by year 4. We expect very similar here, however, we will not provide fuller clarity on that until we have acquired and spent probably 6 to 9 months with the business. So I hope that helps.

Our next question will be from Jeffrey Hammond, KeyBanc Capital Markets.