Vertiv Holdings Co (VRT) Earnings Call Transcript & Summary

Okay. So here we are in the home stretch. We have our last presentation of the conference, saving the best for last, of course. We have Vertiv. So pleased to introduce 3 presenters from Vertiv today. We have Gio Albertazzi, the incoming CEO, currently COO and President of the Americas. We have Rob Johnson, current CEO; and we have David Fallon, CFO. The plan is to just jump right into the fireside chat. Just before I get into that, anyone in the room, just raise your hand. Let me know if you want to ask a question. And then to those that are listening on the line, either e-mail me or shoot me a Bloomberg message, if you'd like me to ask a question on your behalf, and I'm very happy to do that. So without further ado, let's go ahead and get into it.

So maybe Gio, we could talk a little bit about you stepping into the role of CEO. Maybe you could give us a sense of what you think will be your biggest areas of focus as you take on the role.

Absolutely, Ann. Good day, everyone. As we explained, we enter 2023 with strong backlog. So for us, extremely important it is that it is a very, very clear focus on operational execution. And this focus on operational execution, I'd say, characterizes and will characterize, let's say, my priority one, it will be one of my priorities as a see -- operational execution that translates in many things in terms of the service level, the productivity of our -- every aspect of the business. So a lot of intensity there and ongoing, not just a short-term focus. We come from challenging years in terms of because of what has happened in the market in terms of inflation. So we continue our journey of margin enhancement. So profitable growth is for me, a mantra. So we think we have taken the right steps and we continue to drive, let's say, without hesitation in that direction. Another dimension is important to all of us is free cash generation. So again, you can look at it as an aspect of execution, but execution with a clear target. We talked several times when it comes to Vertiv about the culture. So culture stays central in my plans -- my future plans to drive a high-performance culture with clarity. So we've been vocal about that during earnings call last October on 26, and we continue to keep our compass very, very clearly on it. But to get there together is obviously important to understand very well, our 2023 plans and the details. And I've been reviewing -- I'm reviewing, together with Dave, reviewing the plans of all of our elements of our company in all the regions. So a lot of focus there. This focus continues on holding our fixed cost constant. So these are the themes for me getting into the role.

Okay. Very clear. And I mean, Gio, I think you had quite a bit of success with operational improvement in your time overseeing the Americas. I guess, what have you learned from the operational improvement that you've driven in that business that you can apply to the total franchise?

Yes. I would say that the Americas, as we know read from what we have shared with the community in the last few calls, near particular focus in terms of operational execution. But one thing that we focused a lot of our attention on is the entire sales inventory and operational planning processes. So the type of plans and processes and cohesiveness in the organization that really link all aspects of running the business that align all players in -- within the organization and it's particularly important in times of growth and in times of challenging supply market such as the one we're in. I think the progress that we are experiencing in the Americas, as an example of the many things, the progress in this respect is something that we can apply globally. So albeit, we were starting probably from a lower level than average rest of the company. We are developing [indiscernible] that are strong and applicable across the board, but then the elements of my style in terms of very, very rigorous governance, very rigorous cadence will be something that will -- we will apply globally. So that's an example.

Okay. Very clear. And just so we know, is the plan for you to hand off your Head of Americas' role eventually, so that you can focus on being CEO or will you be wearing those 2 hats for some time?

No. The plan is definitely to hand over to a full-time President. And we have a search ongoing. I will not walk away rapidly, if you will, Americas' duty, whoever will step in the job will have my enduring support. So it will be, also in that case, a very rigorous handle and gradual handover.

Makes a lot of sense. Okay. So I want to dig into some questions on current trends, what you guys are seeing out there. So maybe you could just give a little bit of an update on the supply-chain situation. Have you seen improvement at all? Or is it more about just stabilization? And maybe you could talk a little bit more in detail about, at the component level, where you're seeing improvement and where items remain a challenge.

Yes. I think we have -- this requires a multifaceted answer. So we have seen some improvement in the -- in supply market and stability. We have done a lot as an organization in terms of multi-sourcing our critical components, we are still ongoing. That's kind of a supply-chain resilience staff that we are working. We made some strides, I would say that we're working with very, very stably and convincingly, components like fans that for us have been our Achilles' heel in 2022, we've made a lot of progress. But we know that in the market, there's still some components that are challenged if we take power, certainly conductors will continue to be challenging. And there will be other types of components that will continue to challenge us. But again, we are mitigating the risk through multi-sourcing. We are mitigating the risk with a more effective procurement action. And we are mitigating the effect, again, as I was saying, with a more robust underlying planning and forecasting processes. So we'll -- when will this end? We do not know really because that depends on the broader market. But we can tell that we should -- the challenge -- we believe the challenges will continue to -- throughout Q1 to a good extent, but we're increasing in control.

Okay. Got it. I think on the last earnings call, you guys downgraded the North America small, medium enterprise category to yellow from green on the earnings, I don't know what to call it, the end market map, I guess. Have you seen a slowdown in order quoting activity at all in that business? Or are you just really, just being cautious because that area has historically been more economically sensitive?

At this stage, is really about -- is about taken kind of a cautious posture in the way we give -- we color code the markets that we are so. So that's really the situation.

Okay, clear. In China, have you already made up for the revenue loss during 2Q associated with COVID lockdowns? Or is that still in process into the fourth quarter?

Yes, Nicole, this is David. So I would say, we probably recovered most of that by the end of the third quarter. All of those sales are somewhat fungible. So it's challenging to say, what specific sales were lost and what was timing and what have you? I would say, COVID lockdowns over there are not completely gone away. They're kind of like rolling blackouts. But I would say, we've heard some encouraging messaging over there, over the last several weeks, that those should mitigate as we go forward. So if we look at full year sales for China, I would not say that there would be a negative variance versus what we expected heading into the year because of the COVID lockdowns. Now with that said, there's still 6 weeks left. So you never know, but I think we're beyond that.

Okay. Okay. Got it. Order growth did decelerate sequentially in the third quarter. Is there any cause for concern at all? Or would you just chalk this up to increasingly difficult comps?

I think the comparisons are increasingly difficult, and we've been vocal in October already to say that the competitives, for example, with Q4 will challenging by virtue of an extremely high Q4 last year, order intake. And we talked -- we continue to talk about a normalization to levels that for us sustainable, of course, but the normalization vis-a-vis, the order trends or the order intake that we experienced when the entire industry was adjusting to increasing lead times and reducing -- rapidly reducing availability of capacity. So everyone was ordering far more out than they would normally, and that's the anomaly. So we see more of a normalization of the situation. So the competitives will be -- we'll need to take that into account.

Okay. Okay. Fair. And I mean, is the bottom line here with -- I mean, the comps is much more difficult in the fourth quarter. Should we be braced for orders to turn negative year-on-year potentially?

For the fourth quarter, yes. Another way to look at it, though, is just so you understand the impact of this year-over-year comp. On a raw-dollar perspective, our orders in the fourth quarter are expected to be relatively flat with what we saw in the third quarter. So the fourth quarter of last year, I think orders were up 50% versus the prior year. And Americas alone was up 100% versus the prior year. And just continuing on the Americas' theme, if you look at Americas on a stand-alone basis, orders in the fourth quarter will be down 20% versus the fourth quarter last year, but actually up close to 10% sequentially. So that just kind of helps quantitatively understand some of the impact that the year-over-year comps are having.

Of course, yes, on the backlog, is still at record levels and has grown sequentially for some time now. So it's just comps.

Yes. We'll have an all-time record sales quarter by a significant margin here in the fourth quarter, and our backlog should be relatively flat at the end of the year versus the end of 3Q.

Okay. That's great. I guess as we continue to mine for anything negative, have you observed any notable order deferrals or cancellations?

I would -- as we mentioned when we were together on the 26th of October, nothing that is outside the norm, I would say, or the normal behavior of the industry.

Okay. Okay. Great. And I guess what is the lead time on new orders at this point? Like are you guys potentially booking some projects out into 2024?

It really depends on the type of business, sometimes the verticals we serve, all the product lines. So our lead times in the next -- absolutely normal circumstances, any times are normal, but you can go from days to quarters, can be measured in days or quarters. So the situation is not different here. So albeit probably extended more than normal. So there certainly is some backlog being created in 2024 right now. But it's a broad array of lead times and also lead time requests of our customers.

Okay. Okay. Understood. So I have to ask about data center CapEx. I think there's some concern from the investment community about the durability of CapEx. Just because we're seeing tech companies struggle a bit more, lay off employees, which we haven't seen in a very long time. So how are you guys feeling about data center CapEx? And at what point might it be at risk?

Well, we are in a secular trend, as I was saying. We -- what we see in the market is continue -- the demand will continue to be robust. And beyond that, it would be, at this stage, speculation for us that we're not only better assessing than any in the room would be, quite honest.

Okay. Okay, fair. And we talked a little bit about enterprise and how you guys have been a little bit more cautious about the outlook for enterprise because of the economy, which totally fair to have that view. I guess any thoughts on hyperscale versus colocation as customer segments with respect to demand strength.

Well, I'd say that what we said about the demand in general applies also to those 2 segments. And the individual dynamics are specific to the individual customer. But nothing, let's say, that would make us have a different statement than the general statement about market demand continues to be robust, and that's what we've said.

Okay. Okay. So maybe moving on to some of the competitive positioning sort of questions. I guess you guys have spent a lot of time over many years, developing the IT channel product and the channel partnerships. Would you say, you're now happy with how this has come together and what you offer to the market and where you're selling through? Or is there still more work to do?

I believe we still have work to do and channel continues to be a growth -- an access of growth for us. And while going down that path, it is about continuing to reinforce our portfolio. We're not done. We are certainly in a much better place than we were a couple of 3, 4 years ago and even a year ago, but more can be done. I think we are satisfied with some of the achievements, but more to be done. It's an important access of growth for us and it will stay that way.

Okay, clear. When you think about growth investments, does R&D -- or I don't know if you want to look at it as total R&D or R&D as a percent of sales. But does it need to step up versus your expectations for 2022?

Do you want to maybe comment with some of the numbers?

Yes. So if you look at expectations for this year, I think R&D -- foreign exchange has kind of made a little bit of a mess of all our numbers, but it will be in the $2.75 to $2.80 range from a total dollar perspective, that's up about $20 million from prior year when you do various adjustments. It's a little challenging. We've always said, we were trying to get to 6% of sales and we are climbing above 5% and then mid-5%s. And then we got a bunch of additional sales from pricing. And then also, we did the E&I acquisition. So if you do the pure math, it's probably less than 5% and we'll probably have to re-anchor everybody from a percentage basis. But my anticipation, at least for the next several years, is that we'll continue to step up R&D as a dollar perspective, but very much related and inherent in our fixed cost constant philosophy is our full intent is to pay for those increases with reductions elsewhere. So I would say, nothing has significantly changed as it relates to the strategy with R&D. Believe me, we have a lot more projects, profitable projects we can invest in than contained in that $2.80 number, but it's probably safe to assume, at least for the next couple of years, we'll see continued dollars step-ups in that number.

Okay. That's helpful, David. And maybe just -- how has the customer response to E&I have been so far? And do you think adding power distribution to the portfolio has created a big market share gain opportunity?

Yes. Let me take it. The answer is, yes, certainly, it's -- we believe in this acquisition. And as time goes by, we are even more convinced, that was the right thing to do because that gives us the strength across the board of the power across the powertrain. So it's very strategic for us. So customers are -- customers certainly are very, very happy to have that conversation with us. And we have with us, quite a successful company. So I couldn't be happier about the decision we took a year ago approximately.

Okay. Got it. So now let's go ahead and move on to some questions on margins, which is a very hot topic these days, obviously. So you've embedded a pretty big step-up in core operating margins in the 4Q guidance from, I think, 9.1% in the third quarter to somewhere in the 13%s to low 14%s in the fourth quarter. Can you just remind us, what are the major drivers of this step up? And what are the major risk factors as you see them?

Yes. I would say the 2 primary drivers and a similar story for the full year is price and volume. So we continue to get price and we continue to burn down the year-end backlog from 2021 that had lower pricing. And I think in the fourth quarter, our pricing increase is $135 million or something versus prior year. So price is definitely a key lever and the other is volume. So there's a significant step-up in Q3 to Q4 from a volume perspective. I think that's probably at least have probably a little bit more than half of the increase from in Q4 from an AOP perspective. And that volume allows us to leverage our fixed cost. So if you look at -- look forward to 2023, we probably would be mentioning similar attributes that would allow continued margin expansion, but certainly pricing and volume.

Okay. Okay. Got it. And I guess with that said, is volume then the biggest risk, like if you don't get the supply that you need deliver on that volume in the fourth quarter?

It is. And the backlog is there, the orders are there. And certainly, if we could have an infinite amount of supply. I'm not going to say, we would have an infinite amount of sales, but it would be significantly higher. And as Gio mentioned, we are optimistic. We continue to see improvement. But there are many, many parts. Gio mentioned the power semiconductors, which -- where visibility does not extend out as long as we would like. So it's still maybe an hour-to-hour battle like it was earlier in the year, but it's certainly still day-to-day, week-to-week. And I would say that's probably the most significant risk from a volume perspective.

Okay. Makes sense. And then I think historically, if we go back to years ago before you put this new pricing focus into place, the goal was to kind of get to like $20 million of annual pricing contribution at the revenue line, which always kind of struck me as quite low for this business. But now that you've enacted this new pricing philosophy, does that mean that this $20 million target should be thrown out the window and we should expect something much higher on -- or, I don't know, higher, maybe not much higher on an ongoing basis?

Yes. One of the comments we had recently is about, what we call the pricing muscle that we have developed, and we did not have before, as an organization, at least in a widespread manner. So -- and we do not -- yes, believe that we have done in terms of making that muscle stronger and stronger over time. So we are definitely in a position we were not before in terms of our ability to drive price and that will continue. So the answer is, it will be high.

Okay. Okay. Got it. And I guess a question I get pretty often from investors is just the stickiness of the price actions that you've taken so far. Are there any parts of the business that could be at risk of pricing rollbacks, especially based on what you're seeing from a competitive perspective and especially as we move into an environment where hopefully input costs will stop going up as much as they have been?

Clearly, one cannot think about price in an industry independently of what happens in is. So that will be dilution if that was the case. So let's see what the dynamics are. But again, what we have learned is to be very rapid and incisive on the one hand, but also if we're capturing the value, the value that our products, our services deliver to our customers. So that certainly translates into a price, it certainly translates into a price advantage. And then let's see what the dynamic of the industry are, but it's a much bigger strength than we were before. And again, the -- another element is kind of from a contractual standpoint, we're in a much stronger position than we work before.

Okay. Very clear. Going way back to when we were working on the initiation of coverage for the company. I remember, a big piece of the margin improvement focus was growing the aftermarket revenue and service attachment rates. I feel like that's just maybe taking a little bit of a -- it's been on the back burner and it's probably because you've just been focused on communicating to the investment community about price cost. But is that still the growth in aftermarket revenue and service attachment rates? Is that still part of the Vertiv story when it comes to medium-term margin expansion?

Yes. I have the fortune of having run for many years, the EMEA service business. So let's say, service comes natural. And you're exactly right, Nicole. We have focused a lot in our communication on what was more dynamically challenged if you will or needed dynamically to be addressed. But do not please mistake that for a lack of attention to our aftermarket services business. That is as well in focus and continues to grow. The service business is always more stable, whichever the dynamics of the markets are. So we'll not say, it spike up at the speed of light or down at the speed of light or it's ever down at speed of light, but is more stable. As an organization, it's very much on the D&A -- in our D&A. I can always do a better job, you can always do a better job, but it's very much in our D&A. It's very much in my D&A, I would say personally. I'm not very passionate but...

Okay. Understood. Great. Then I think a big part of the margin trajectory from here is opening the plant in Monterrey. So any sense of the margin opportunity associated with this over time, and how is the ramp-up process going?

The ramp-up process is going well in terms of capacity. It's actually, very well. The vigorous ramp-up as drive in there because it's still being impacted with some of the challenges and material challenges that I mentioned, but we're very happy about our trajectory and the very decision of being in Monterrey. When it comes to the margin impact, let me not comment there necessarily interact, but to say that this adds very meaningful capacity to a very meaningful part of our business, that is our thermal business. So we keep plowing that. It's certainly the right choice, was absolutely the right choice.

Okay. Okay. Got it. Moving on to our last topic. We're running a little bit short on time here. So free cash flow. I'm just going to leave this in a pretty general term, and David see how you want to answer this, but how should we think about the trajectory of free cash flow and working capital as we move into 4Q and into next year?

Yes. So we anticipate fourth quarter to be an all-time record high per quarter. I think between $250 million and $300 million, it was a relatively disappointing year from a free cash flow generation perspective. A lot of that disappointment centered around working capital. So all in, not just looking at trade working capital, but other working capital, I think we burned about $325 million or that's what's implied in our full year guidance. We normally -- and I guess there's never been a normal year, but between $75 million and maybe at a high end $150 million of working capital. So a lot of that was centered on inventory. So probably $200 million of that $325 million is inventory, and we have actions in place to address it. Now looking forward to next year, we'll have close to a $300 million head start as it relates to projected EBITDA. So EBITDA this year, give or take, about $550 million based on the guidance that we have out there for next year or outlook we have out there for next year of about $750 million at the higher end. If you have $100 million of D&A, you get about $850 million of EBITDA. So that's the $300 million head start. If you started that $850 million of EBITDA and look forward to interest, CapEx and taxes. This year, that's going to be about a $350 million outflow. That's going to go up next year. Interest rates are higher, we'll be more profitable, so additional taxes. So you probably can directionally plug in about $450 million for those 3 items. So before any changes in working capital, we have a starting point of about $400 million. So the plus or minus to that $400 million is going to be driven by what we do with working capital. We're optimistic, based on the actions we're taking today, including with inventory that we should do much, much better in '23 as it relates to working capital than what we did this year.

Okay. That's really helpful. Last question, we only have a minute left. The E&I deal was pretty big for you guys, I guess, how are you thinking about the M&A pipeline now and your appetite for doing deals, especially as you work through some of these operational issues and get execution back on track?

Well, as I have mentioned, execution focus, E&I, an extremely important strategic acquisition. So a full focus on making sure that, that is executed perfectly. But hey, we're sometimes -- opportunity come that have their own -- take their own time. So we stay visionate. But in this model, we're focused -- absolutely focused on making sure we make the best of the current -- the [ risk strategies ].

Totally fair. Okay. Well, we're out of time. Thank you so much for being here, guys. Really appreciate the conversation today and thank you for supporting the conference.

Thanks, Nicole.

Thanks, Nicole.

Bye.