Vertiv Holdings Co (VRT) Earnings Call Transcript & Summary

For those of you that don't know me, I'm Nicole DeBlase, the lead analyst for both multi-industry and machinery here at DB. I am very pleased to introduce Vertiv. Today, we have Rob Johnson, CEO; David Fallon, CFO; and Gary Niederpruem, Chief Strategy and Development Officer. The format of today's presentation is going to be fireside chat. Although before we get started, I am going to hand it to Rob for a few opening remarks. Now before we get to that, though, there is a chat box right below our faces where you can enter in any questions that you might have. And if there are questions there, I will read them anonymously to the entire management team. So with that said, over to you, Rob.

Well, thanks, Nicole, and thanks for you and DB hosting us today, and thank you to all the investors and company out there for taking the time to listen to our story. As I continue to say, I'm very excited about the industry we're in, where we're going and the continued progress that we have. That's been -- I hate to use the word unprecedented because people don't like that, but it has been unprecedented times with COVID and on the back of inflation and then just a lack of materials, but we'll get through it. And the good news is from where we sit and what we see and what we talked about at the Q3 earnings call is the market is very strong for our products globally and continues to grow in that way. And all the segments we participate in, whether it's the telecom industry, whether it's commercial, industrial, or whether it's in the data center business, we talked about enterprise now beginning to come back. Colo and hyperscale is growing, as you guys know. And then at the end of the day, we're very happy with the progress and the rate that we're making in our channel business. So in general, as someone I think mentioned on the earnings call, hey, I'm pretty upbeat, I am. The industry is great. We've gotten hit with a lot of body blows as all other industries are. But you know what, we're built to last and we're built to get through this, and we will and continue to drive through that. So back to you, Nicole. Thank you, again, for having us on today.

Of course, and thank all 3 of you for participating. So I guess maybe starting with the dreaded supply chain questions. We'll get those out of the way. So I guess when you step back and think about this unprecedented time, would you say that there are key learnings here where you would reconsider your -- the way your manufacturing footprint works, the way your supply chain looks? Or do you think that you're positioned appropriately?

That's a great question. I'll start off and then Gary and David can weigh in. But Nicole, what happened -- and actually, we learned a lot of lessons during COVID, right? And as COVID kicked in, we learned where the weaknesses were, if there were some within our supply chain, how many areas we rely on, where we had single-sourced vendors and learned something that regions do matter. And one of the things I love about the Vertiv footprint is we are truly not all the way, but in country for country, we do get broad components and things from China and Taiwan and Vietnam and other places as everybody else look. But we do manufacture for the most part in the areas we do business, at least, final assembly. But what we did learn to COVID is where we had weak links in our supply chain. We've moved, and this is pre-inflation and pre kind of lack of supply. We've begun to move our footprint around based on what we learned during COVID, which I think ultimately will help us. We were in the middle of doing that. I would say that the engineering teams and the supply chain teams have certainly understood and you learn who are your real partners and who aren't your partners as you get into constrained time. So that's a lesson we've learned. And then through all of this, we haven't been sitting still as a victim and saying, "Oh my gosh, we're just we can't get parts, so we're just not going to ship." We've been reengineering boards, we've been reengineering and qualifying other parts and suppliers. So I think out of all of this, certainly looking at a multi-vendor supply base, looking at regionally. For example, IGBT is a big supplier of those is in Vietnam. Vietnam, got to hit hard by COVID several months back and shut down for a month. And so we've really got to look at that and not only diversity in suppliers, but where the suppliers have second and third locations. You've all seen with the chip manufacturers, a lot of build that's happening in the U.S. now and a lot of promise for that and then a lot of promise in Europe. So I think everyone's kind of learned through this. But it's -- I think it will come out of it stronger and continue to understand who our true partners are, both from a customer perspective as we do get price, which I know we'll probably talk about, and from a supplier perspective, those that are willing to work with us and that we've been with and that will supply us what we need.

Got it. Okay. Very good answer. And I guess you led me right into price costs, which happens to be the next topic. So I guess you guys have said that if you carry forward your pricing actions and your cost headwinds into 2022, you're looking at like a baseline of a $5 million to $10 million net tailwind. But my understanding is that, that doesn't include what you may do in 4Q. So curious, thoughts on the potential for more pricing actions here in the fourth quarter or even beyond if inflation remains an issue?

Sure. I'll start off and then David, Gary. Gary pricings are globally and has really been chartered with this prior to this. And just for everyone out there, we've talked about price for the last year, 1.5 years, 2 years. It's a muscle that we didn't have a few years ago, and it's something prior to all this inflation we were going after. We needed to make sure we're getting paid for the innovation, paid for what we do. And for companies that don't have that culture or don't have that muscle, it takes some time. So we actually had a lot of practice prior to this as we go through it. That being said, it's not easy. It depends on what industry or what channels you go through. If you're direct selling, it's different than if you're going into the channel, which we're in all the businesses. As you know, our channels to market where in the IT side and so on. What we said, and we said it in the Q3 earnings call, I said it, that I was late to catch up price with inflation. We didn't expect it to be where it was at. And so we are a company that a portion of our business is direct sales. So we have a big backlog. A portion of it goes through distribution, where you can get price faster. We're probably more heavily weighted on the direct sales side. So it takes a little bit longer to work through that backlog and get that price. That being said, we've been working that and going. We'll continue, as I've told my team, and as we've talked to customers that, as inflation continues to rise, which who knows what it's going to do, I wish I had that crystal ball, we'll continue to take pricing action. So whether we're here in Q4, we continue to take actions. In some cases, it's monthly. Some cases, it's quarterly, and then working through that with our customers. Sometimes you've got MSAs, master supply agreements, that have a 2- or 3-year supply commitment and a price. So you've got to thread those needles carefully. Again, you find out where your partnerships really are there. But in general, I feel like we've got all regions engaged. China is normally a negative price for us and has been for a few years. And that's an area where the teams have to learn, yes, you can actually get price in China with innovation and doing the right thing. So we'll continue to do that. And I got to say that going into Q1, depending on what we see on the inflationary side of things. We'll do additional price increases. And I think the challenge or the right way to do it is you really got to sit down with your customers and explain to them what's happening. Everyone sees out the window, inflation is everywhere. But they don't necessarily understand how it impacts their products and what it impacts us. And our stance has always been we want to be fair, but we want to be fair and recouping what we've lost. We're not looking to make money during this time. We're just looking to recoup what we lost as a company. I don't know, David or Gary, any thoughts?

Yes. The only other 2 quick things I'd add, Nicole, is Rob is right. We -- in hindsight, we probably should have been a little bit more aggressive early in the year and coming out with price increases. But just to put it in a little bit of context, we had said in '19 and in '20, the business got somewhere between $20 million and $25 million of price on an annual basis. In Q4 alone, based on the earnings call we had in Q3, we've already signaled that we will have that much price at least just in Q4. So when you think about it, should we have done more? Yes, absolutely. But from an absolute standpoint, we're going to get a year's worth of price just in the fourth quarter. And then that's the tailwind that David had spoken about earlier in that $5 million to $10 million for next year. The second point then would be in your question, what else are we doing? We have just about launched additional pricing actions over the last 2 or 3 weeks in every region of the world. So we feel good that there is more tailwinds out there. How much that is? Yet to be seen, but there's definitely more tailwinds with the actions that we've taken just in the last couple of weeks.

Okay. Got it. And at some point, I mean, I feel like this has to be a little bit easier than normal because everyone sees how intense the inflation has been. But at some point, do you start to bump up against elasticity of demand issues? Are you hearing any pushback from customers about pushing through additional pricing yet? Or has that not really been part of the conversation?

It really hasn't been that. Our industry right now for data center growth is -- there's such a huge appetite. Certainly, everybody gets compressed margins. If you're a colo company building data centers for hyperscale, certainly, they got pricing pressure on them and then they ultimately have to live with these 15-year contracts. That being said, they still make pretty good money. So I would say no, it hasn't slowed down the rate in which people have deployed things because they've got to upgrade their networks, if it's in the telecom side of things. And as it relates to fulfilling the need for hyperscale and colo, the demand is there, and they may take it on the chin right now a little bit. If you took a look at the overall build, I mean, we're a piece of that puzzle, but they've got concrete and they've got steel and everything. Copper and plastics and prices going up. Roofing systems, you name it, it is out there. But we have not seen the demand slow down. What we have seen people do, however, is try to lock in longer-term supply slots. They're more worried about not getting supply than maybe necessarily a price. Again, that being said, nobody is just rolling over and giving us price. It's something we have to work through, price escalations for future price and contracts where we haven't had them on commodities as commodities shift up or shift down from that perspective. But we also targeted. It's not just across the board. We've got to look at areas where we have strength, where we have innovation and are we getting paid our fair share for that. So you'll see a pricing disparity between product lines and verticals that we serve based on their ability to take in or accept price.

Okay. Okay. Got it. Great answer. All right. And then just to confirm on pricing so that we can kind of get this issue behind us is this has all been list price increases, right? You guys haven't used surcharges as a component of the price increases?

We've done a combination of both. I would tell you that -- and you got to break it down in a couple of different areas. Freight is a big component of our overall pricing side of things, and we've got to make sure that we're getting covered for that. That's an area that we got to make sure we cover. And then as it relates to certain things in our backlog, if we have to go out and do spot buys, we're getting smarter about it and saying, "Hey, I can go do a spot buy and we're going to have to pay more. And if I have to pay more, then I need some more from you." Otherwise, lead times or this. So we're getting better at it. I wouldn't say we're going across the board and surcharge to everybody. What I'd say is we're working with our partners here to say, "Hey, we've got an issue. Do we want to get this sooner?" And it's not -- we're not playing the game, we're going to jump the line, if you give us some price or give us a surcharge and others don't. We're very much honoring what we've told people, but there are ways to get product to people faster, if they're willing to pay for that spot buy. So we don't take it on the chin and ultimately, our investors take on the chin. I don't know, Gary?

Yes. I think that's spot on, Rob. I think, Nicole, it's fair to say that the majority of the price comes from those price increases. But to Rob's point, there are other points in the system where there would be surcharges, freight increases, just controlling the discounts and multipliers that our own salespeople are able to have. Their rebate clawbacks, MDF co-op, maybe we don't spend as much in lieu of getting some price. There's a number of different levers that we've implemented. List prices is probably the biggest one, but it's certainly far from not the only one.

Got it. Okay. Very clear. And I have several investor questions here that I want to get to. I've not seen as many questions in any of the presentations so far. So let's see. This one is kind of relevant to what we've talked about so far. So I'll start with this. Have you seen any loss in market share due to supply chain issues? Or how -- or do you think this has been reflected across the entire competitive landscape?

Yes. So I think, in general, no major losses. That being said, everyone is affected across the globe, no differently than us as it relates to the cost and/or just the lack of supply. I interact with a lot of our major suppliers. And I know in a lot of cases, we're getting more than our fair share than what we've contracted to get because we've had that long-term relationship. And ultimately, suppliers got to pick who they want to do business with. They can't make everybody happy so they got to make some people happy. But in general, people are doing -- I'll give you an example. IGBTs, which is a main component in our UPS systems. All of our competitors use them and all our competitors need them, and there's only a handful of suppliers globally that do that. So we use -- tend to use a lot of those because we not only provide AC power, but we're also in the DC power business globally, where some of our larger competitors maybe aren't playing. So when I -- yes, we may lose a deal here and there to maybe some local suppliers or local companies that can maybe provide that. It's just because we couldn't provide it. We're being very straightforward and honest with our customers. If we can't hit their delivery date and they've got a hit it, we'll do everything we can to help them go somewhere else to get that. That's rare cases, but we'll do that because no use of me taking an order and then not delivering. So but I don't think it's a major theme. And if you take a look at our overall orders growth rate, it will show you that I think we're doing pretty well.

Got it. Okay. And then I've had this question from a lot of investors over the past few weeks since you guys reported earnings. So I think there is some concern that the 4Q guidance does require a bit of a step up sequentially in both revenues and margins. Can you guys just give the quick explanation of what is driving that sequential improvement into the fourth quarter?

Sure. David Fallon would love to answer that question, Nicole.

Well, I guess there's 2 components, and they're very much related. So the upset -- the step up in the sales side, yes, we've gotten the question ourselves saying, if you're participating in a market where supply is constrained and you're able to get a certain output in Q3, how can you feel confident that you can increase that output if your capacity constrained in 3Q? And the quick answer there is based on the planning, the preplanning with the suppliers as it relates to allocations. We've been in line for a certain amount of allocation in Q4 for quite some time. And we have really good visibility to the critical components that will support that higher volume to the extent that we feel very comfortable with the guidance we gave. So if you look at the margin side and the step of a margin, and this is very consistent with a theme that we talk about in the long run is fixed cost constant. So not saying that fixed costs are going to be exactly constant in Q4 versus Q3. There's generally a normal step-up just based on timing of some year-end expenses. But certainly, the increase in sales Q4 versus Q3 is much higher than the percentage increase in any kind of fixed cost base. So the margin improvement we're seeing is definitely directly related to the leverage of those fixed costs.

Okay. That makes sense to me. Got it. And then I have a few questions from investors on 2022. And I know it's early to talk about this, don't shoot the messenger. They're not my questions. But I've got one here asking, "How should we think about data center market growth next year and going forward? Could 2022 be a year of digestion? Or does strong growth continue?"

I'll start off and then Gary is really good at this one. But I would say, in general, and I've been doing a lot of traveling around. We see and we've talked about in the past, a build-out and digestion, then build out, and that's kind of a cycle that we've seen. We're in a long build cycle right now. And we think that's going to last for a bit of time because of the demand, the real demand. We take a look at absorption, capacity, all of those types of things. And this build-out is different than what we've seen in the past. And every colo, hyperscaler I talk to all agree that this is different. What makes it different is it's global, it's every parts -- every part of the world, we're seeing this happen. So -- and then put in the additional effect of the recovery or kind of the strength coming back in the enterprise of closets and things that haven't been touched for 2 or 3 years now that have to be upgraded for the Edge, if you will. Even if you're in the cloud, you still have to do that. So as enterprise comes back to the office, that type of thing on latency is becoming even more and more important. And then for us kind of the third thing is the channel side of things. The channel -- IT channel is an area that we continue to launch products into. We continue to work to take share there and continue to focus on that globally. Americas has done a really good job of coming up on plane there. EMEA's second kind of in line and then we'll work in Asia. So we look at those kind of 3 factors and say, "Hey, we're pretty bullish on what we're seeing out there for the foreseeable future." And that just based on the backlog today, based on what we're seeing customers in the pipeline and the orders that are still yet to come, this is -- this got some legs for a while. I don't know, Gary.

Yes. No, I think that's exactly right, Rob. And the only thing I'd add to that, Nicole, is it is certainly hard to predict what the market next year is going to look like. But I think if we -- we always sort of said 3% to 4%, 3% to 5% data center growth in our space through the cycle. I'd probably -- it's safe to say that it probably is going to be in the upper end of that range. I don't think it's going to be in the 2% to 3%. Whether it's 4%, 5%, 6%, still too early to tell. But I think our through-the-cycle range will probably be on the upper half of that range. That's certainly been the midpoint or the lower end from everything we see.

And the final thing there would be, Nicole, that a company would be, it's all going to be dependent on supply. We've got the orders. We've got the backlog. It's really can we get the components and when do things free up. And that could make a big difference booking in the year of how good it is or won't be is really dependent on access to the components.

Sure. All that makes sense. And I mean, you sounded pretty good in all regions of the world, but there is a question here about China. And is there anything that you're seeing concerning from a China standpoint? Or is it still all green lights everywhere?

Yes. So China, we talked about it on the call last. One area that's kind of been in a digestion mode is China had a real big 5G blowout kind of incentive at the beginning kind of the end of 2020, coming into '21, and we participated in that. I think we talked about a little digestion happening there. A lot of dynamics in China, right, as you can imagine, with the power outages and this and that. That hasn't necessarily affected us specifically, maybe some suppliers, but we've had to work with them. In general, China is robust. I know they've done some things with the hyperscalers there, the Alibabas, Tencents, Baidus, where they're kind of looking at their growth, how they're growing. But the market there is really kind of no different than the rest of the world. The number of cell phone users that are there, the number of people that want rich content, is inevitably going to drive that build-out. So it's -- China is always challenging. We've been there for a long while. We're getting our fair share of growth. And it's an area that we continue to invest in because we believe that being local there, manufacturing local, engineering local and selling local gives us the ability to be local there and allows us to have that potential competitive advantage.

Got it. Okay. Great. Next question from an investor on 2022. "Any early thoughts on contribution margins?" However, you guys want to frame that with and takes on margins, underlying contribution margins, I'll leave it up to you.

Nicole, I'd love to answer that, but David Fallon would be really upset with me. So I'll let him take that one.

Well, I have the preliminary 2022 right here. I probably just share the [indiscernible] ...

I'll take a [indiscernible].

Exactly. So we analytically, externally, we've always used 40% as a variable contribution margin. And that's different than a drop-through just from a semantics perspective, but variable contribution margin. So if you look at our sales, less direct material, direct labor, freight, commission and few other things, generally, we use, on average, 40%. Some regions higher, some regions lower, some products higher, some products lower. But 40% is a good starting point. Exiting 2021, it will be less than that. And that's primarily, if not entirely driven by the price/cost relationship. So getting back to that 40% is certainly dependent upon what we do with pricing and also what happens with inflation. But as a starting point, we're probably a little less than 40%. And then the offset to that, of course, is what happens with our fixed cost dynamic. And in 2021, we proactively invested between $60 million and $65 million in R&D and also growth initiatives. It is safe to expect that, that reinvestment and not necessarily Vertiv will be that exact amount, it could be more, it could be less. But there's going to be some reinvestment in ER&D as we strive to get to 6%. And these on all of the market growth opportunities, we will likely have further investment in growth initiatives. So it's really the size of that reinvestment that will drive what the ultimate contribution margin is or the drop. But it is a similar dynamic to what we talked to in 2021.

Understood. Okay. Very clear. And then we have a few questions on E+I. So the first is, "What made you decide to get into power distribution? In the past, you've said that you didn't need this." So yes, what drove the change in part as this person is asking?

Yes. So Nicole, I'll start, and then Gary can come in over top here. What I'd say is what we said and people often ask, well, because some of your competitors potentially have this low and medium voltage switchgear, do they have a competitive advantage over us? And of course, our answer always was they kind of break out the solution. And yes, while we saw some bundling, it wasn't a trend that was taking share away from us. That being said, it didn't mean that we didn't want to be in that segment of the business. And we were working on this property for over 4 years just so you know, but nothing we can signal to the market. We built a relationship here in order to get into the property. What we like about E&I, and it's not just a switchgear company, it's not like ASCO, which was switches for generators, this is actual power distribution, which you correctly said. They also have a leading position globally in busbar distribution, which not everybody in the switchgear business has their own busbar or busway. And they're a leading provider of that manufacturing that in over 3 locations around the globe. And then finally, the thing that was really intriguing for us besides -- and switching back quick to switchgear, they are one of the few providers of custom switchgear. A lot of standard switchgear and Gary has talked about the market for us being about $7 billion expansion. The switchgear market is much larger than that. But we're talking about a market that we can play in and actually add value. And so custom switchgear with custom controls, bespoke solutions for our customers is what's really needed. And there's more regional players, nobody that really has a global -- with the exception of E&I, really have a strong global position on that. And then the final thing, so we've got the switchgear, then we've got a leading position in busway, which we really like. And then we've got a really good position in modular. While we did a lot of modular business, A lot of that was -- we went to third parties, had them put it together and assemble that. With E+I, it gives us locations in Europe, locations in the U.S., locations in the Middle East, and we'll be adding locations in India to service the region. So those 3 things really made this an exciting deal for us. I still hold the same that a lot of times, they want you to unbundle the switchgear from the UPS and then put all that back together. So -- but this actually gave us an ability to participate in the market, a company that has a higher than industry average margins due to the fact that they have these nice custom quick solutions and totally vertically integrated company. And I couldn't be happier. I'm actually -- Gary and I are broadcasting from Ireland today. We're over here with our folks and working through the integration activities, which are going quite well. Gary, anything else?

Yes. I think Nicole, Rob said it beautifully. If I could summarize the whole thing, it would be we would have been just fine if we didn't ever do a deal like this. So it's not that we had to. It's that we wanted to. And we wanted to do it because to Rob's point, we think that there's more value we can provide to the customer base than anybody has done before. And so that was the reason why it's different between was it a defensive move? Absolutely not. Is it an offensive move? Absolutely. And I think there's a big difference in that.

Okay. Got it. And another question from investor, timely since working on the integration as we speak. How is the integration going? Any major surprises so far?

Gary, so as you're leading the integration, why don't you comment there?

I'd say it's going smoother than anything we've ever done, Nicole. It's going just fantastic. Look, it is going really, really well. Like anything, once you peel back the onion, there's always things that you learn. So we continue to learn a little bit more. We continue to know where we're going to have to put additional elbow grease and horsepower into. But in terms of the customer centricity, the vertical integration Rob mentioned, the feedback from the customer base has been unbelievable. And people know the engineers inside of E+I by name and say, "Hey, make sure you keep Frank or make sure [ Sally ] stays on my account." I mean so you don't get that level of customer pull without really having a truly customer-centric culture. So I think all of the strategic reasons why we wanted to buy it, still stand today. And when you look at our integration thesis around, yes, we'll be -- we underwrote the deal on a couple of different cost synergies. But really what will make this deal seeing is the revenue side of it. And so between taking E+I to Tier 1 colos, between the additional busway opportunities in the enterprise segment that Rob mentioned, e+I doesn't really do anything in Asia at all. So we'll be able to push them through our sales channels. So I mean, I think we're as bullish, if not more, than when we bought the deal when we bought the company. There will always be hiccups and stumbles along the way, but there hasn't been anything insurmountable by any means. And I think it has proven to be even better once we've been inside it than even before.

That's great to hear. One more investor question on E+I is here. And that's "You've embedded a bit of a hockey stick in your model for E+I revenues in 2022. How comfortable are you with that given the supply chain environment?"

Yes, I'll start and Rob and David can chime in. So I would say no different than on the Vertiv side. So they're wrestling with some of the same electromechanical pieces, specifically breakers is what they're fighting for, just like we are from time to time. So I think the demand is there, the orders are there, the pipeline is there. It will all be a matter of how the supply chain behaves in the first half of the year. So I would say it's not the shortest part of the world, but it is also not a 30-foot path. So the market just has to behave relative, and I think how Vertiv verdict behaves will be how E&I behaves when it comes to that. So I think generally, pretty good, but it will certainly depend on those electromechanical parts coming through.

Okay. Understood. And I know we're almost out of time here, but I did want to ask one question on free cash flow. So is there a path for the business to be able to generate 100% free cash flow conversion regularly over time? And I guess, what are the key drivers to get you there?

Yes, that's a great question. I would say there's absolutely a path there. You can look at the individual components. You can look at what -- start with what we're doing in 2021. And I would say there's probably 2 major headwinds this year. One, we definitely would get relief for, and that's the M&A cash expenses. So I think we guided to $205 million free cash flow, $45 million of outflow for M&A. So it gets you a $250 million. If you look at our net income -- our adjusted net income, it's over $350 million, right? So however, the math works, it's probably 65%, 70%. I would say the one outlier that we had this year is related to inventory, right? So we've done some really good things versus where we started several years ago with inventory levels. 1 year, we took inventory down significantly. It's grown about $130 million on a year-to-date basis and very strategically soft, right? And it's based on the supply chain dynamics. We are not constraining ourselves to hit any specific inventory targets. Now maybe we have too much, but we would much rather have $10 million too much or $20 million too much or $30 million too much, then have $1 million not enough, right? So we look at that going forward, and it may not be in 2023 -- or 2022, it may be 2023 as a significant source of rebalancing what we're seeing from a free cash flow perspective. And that should get us closer to that 100%. There's other things that we need to do. We've actually executed quite well this year with other components of working capital. AR days are down, AP days are up. So I would say the biggest hurdle right now is getting that inventory under control, and then we should be able to get closer to that 100%.

Okay. Got it. Thanks, David. So I think we'll go ahead and wrap it there. We're out of time. I really appreciate you guys attending today. It was great to have this conversation. I really enjoyed it, and have a great rest of your day.

Thank you, Nicole, and thanks, everyone, for taking the time. Appreciate it. Take care. Until next time.

Thanks, everyone.