Vertiv Holdings Co (VRT) Earnings Call Transcript & Summary

Great. We're going to move on here with Vertiv, the data center manufacturer, not the packaging company. And we have Giordano Albertazzi, CEO; and David Fallon, the CFO. Maybe we'll -- and my associate, Pat is up here, he's going to ask a few questions of you guys. But maybe if you just want to give a little bit of a -- just a couple of minute update on what you guys are seeing out there in the economy. You guys have seen some very strong demand. And maybe just some color on what you've seen recently with everything that's gone on in the last several weeks.

Well, what's going on in the last several days that I say is a little bit too premature to comment. But certainly, we come from a period of quite exciting growth in the spaces that we serve. And we serve an industry that is certainly an important secular trend. We see technology evolutions that are going in the right direction for what we do. AI certainly creating net increased demand for the industry as a whole and a technology transition towards higher density, and higher density means different types of loads, more loads and more challenges from a thermal management standpoint, an industry that is more and more focused on energy efficiency and enhance an industry that values technology increasingly more, all things that we like. And that's not only true for this part of the world, but this is true in general. So an industry that is going through some changes in the way orders are being placed. We -- as many industries experienced challenges in terms of supply chain, that expanded lead times in general. So our customers started to cover more and more months out with their orders, and that certainly created a very strong acceleration of order intake. So this is the context in which we operate, a strong industry with certainly a strong long-term opportunity.

Pat? Right away.

Great. So maybe we'll just start on the orders front. And clearly, you guys have built a very big backlog, provides good visibility here. Last quarter, you had a cancellation in that backlog. Maybe just talk about some of the protections that you have in place, should a customer want to come and cancel an order? And maybe specifically on that one, what drove that decision...

Yes. So our backlog is very robust and solid, and that's the nature of the backlog in our industry. What we -- especially for the large part of our market, that is data center, the orders that we get are for buildings that are being built and infrastructure that is already defined in terms of projects. So the majority is engineered to order, so very specifically connotated for our customers. Cancellations are rare, far between and unusual. That's why we wanted to be upfront and clear about that. So we'll not elaborate too much in that particular case for obvious reasons. We do not -- we'll not share information, specific information with customers. But there are moments in which some customers may decide to change their generic footprint, and how we -- they do -- they go about their investment. We want to make sure that we accompany them in their long-term trajectory. They will continue to build data center. We want to continue to be their partner of choice in this trajectory. So we do not see that as a change in the industry. We see that as a change in particular customers strategic priorities and design decisions.

What does that mean exactly? I mean, changed the generic footprint. Does that mean they're using somebody else's product? Or they're just designing it in a way that they figure out a different way to do the same thing with something else that your product would have done? What does that mean change the generic footprint?

Again, without going too much into the details because that would be revealing. It's not someone else instead of us, not absolutely. So the same cancellations or same type of cancellation. We now have touched other place in the industry. So I'll not elaborate further without the -- otherwise, I would go in details that would reveal too much.

But it's not -- is it a demand thing? It was kind of a -- see, you make it sound like it's kind of a, I suppose, a macro driver of a cancellation. It's more of a very specific customer decision.

This is a very specific customer decision.

Okay. Got it.

Very specific customer business.

That's helpful.

Do you have -- so that was, I guess, a unique situation. Are there -- what are the policies in place around that backlog if macro causes customers to decide to want to cancel an order...

Clearly, we have -- in general, we have clauses in our countries that are specific to the individual contracts and the individual situations. But again, this is not about us negotiating or going after if anything happens. It's about working with our customers and understanding what's next. The industry will continue to grow. Our customers continue to build. So if and when they need to rethink their way about building their infrastructure, we are there for them, to work with them. So I'm not worried about that part.

Do they -- are there down payments associated with these orders?

There is certainly down payment associated with many of the orders, not always the case, as every industry. Well, the industry actually evolved a lot. And certainly, we are main [ actor ] in this evolution. In the last -- up until recently, the industry would not think and operate with a down payment. That has changed. It certainly has changed for us quite systematically.

So orders last year, as we talked about, very good, sets up a tough comp, particularly in the first half of this year. As you think about the sales plans you laid out this year, what do you need to see from an orders perspective to be able to achieve those? I imagine a lot of that is coming from the backlog, but you still need some book and ship. So like how much of an orders headwind are you expecting to absorb to kind of meet your plan?

Let me answer in -- it from another angle. We entered the year with more than 70% backlog coverage, which is unusually high. And unusually high as something it's caused by that kind of extension of lead times in the industry that changed the behavior of many of our customers, of the players in the industry, not only with us, but with other components and infrastructure suppliers. So having said that, if we look at the guidance that we have given, that the book and ship components is relatively -- it's relatively small. And certainly covered by a normal book and ship. Don't forget, we have a large service business. And the large service business is a shorter cycle, clearly. It's really more of a book and ship type of business, even when it's a contract annuity renewal, but that's something that continues to happen as we go through the year. But clearly, our attention is on the long-term growth. And during earnings call, we were pretty adamant to explain what we think is happening in and out. So given a certain kind of a revenue growth path, we've been explicit about 2023 or beyond, but we will see kind of a whiplash, kind of a counter effect of the lengthening of the lead times with a slower order intake, as we were saying, especially in the first part of the year. But what we see today is not something that is in going to hamper our long-term trajectory and [ certainly not ] our 2023 trajectory. And we'll only kind of take the industry, and not just Vertiv, back to more normal backlog coverage and book and ship ratio during future years.

Do you think a lot of companies that have these big backlogs are kind of giving us some degree of visibility on where they see this year ending. I mean they're not giving a point estimate, but they're kind of saying it's below prior year levels or it's normal is here and it's going to kind of get halfway back. Like what's the -- any good color on where you'd expect what's normal backlog coverage and where you expect to be on that backlog coverage at the year end of this year?

We've been historically on a 35%, 40%. It varies a lot here year-to-year. So 70% is certainly an anomaly. In this moment, we know that we will be below 70%. I mean, that's absolutely a very fair expectation. We shocked...

Somewhere between those 2. Goal post...

It's not very enough, but...

But it won't be below normal. Won't be below normal. You don't think. Okay.

No. Absolutely not. I'll be shocked if it's below normal. But by the way, it will be good for the industry. I mean, in the industry that -- these are an anomaly, and the industry needs to adjust, I mean supply chains are normalizing. We are adding. We have added and continue to add a lot of capacity because, again, it's an imbalance between demand and capacity that generates the situation, very simple.

Yes. And I was trying to measure -- you said whiplash, I was trying to measure, is that like down 20% in the first quarter or first half, in terms of orders? You went like this...

We said -- I don't know exactly how deep kind of indicated. Don't read too much. Don't read too much because actually on my kind of the movement of my finger. But the fact is that 3 weeks ago, we talked about double digits, and we predicted that in Q4, and we were pretty accurate of that double digit, can be many things, but -- yes.

Okay. Maybe we could talk about some of the end markets in your kind of order end market chart. So you moved the I think the EMEA hyperscale [ colo ] piece to yellow last quarter. What drove kind of that move? Was there something specific?

Simply because we expect specifically in the hyperscale in EMEA is slower growth than we have seen in the past. This was just more to signal. It's never exact size, kind of a traffic light indication of demand is not an exact size. So in general, in that part of the market and in general in the hyperscale colocation market, so the upper end, the large data centers, we expect -- continue to expect growth as we said during earnings call, but let's say a reduction of growth speed, so to speak. So market will continue to grow. That's our expectation, but I don't know what's been in the past.

As you look at all those different markets, enterprise, cloud, Internet, maybe telecom, [ C&I ], all the markets. Are there any of those that you're also geographically that you think could turn red over the next quarter or turn green over the next quarter? Like what's on watch on the negative side or on the positive side?

I would say everything is on watch because we are very, very keenly looking at all the indicators and constantly talking with our customers across the board. We talked about a China reacceleration when we were at the earnings call. And again, I think that's coming to many industries, and we continue to believe that is the case, of course. When we took -- I talked about the colocation, colo cloud, if we talk about enterprise and enterprise data center, well, that will probably be more sensitive to the macroeconomics, but it's early to certainly to call. We have different views than 2 or 3 weeks ago. Telecom, it's yellow for us. We still are -- telecom is always driven by technology transitions. We have a big wave of 5G and 5G continues to be rolled out, but then in other markets, in the biggest markets. But -- so we do not expect any major differences in any of the market moment. We have no reason to think that there will be a big red coming up. But again, who knows what the last few days of news in the world, in general, will trigger. It's not specific to our industry.

No, understood. So drilling just into the one that's driven a lot of the growth here in the last few years, the cloud, the hyperscale one, colo. What do you guys look at on your dashboard as an indicator? Like I look at cloud CapEx, I mean -- but there's so much stuff in there, like in these big Internet companies, like I don't even -- like it's very hard to read, like we look at layoffs from these companies obviously over the last 6 months and people get worried about that. What are you guys looking at as an indicator on your dashboard?

We look a lot at layoffs, let's say, because that and the infrastructure are not necessarily on the same side of the equation, not necessarily the same business. We -- a myriad of things, of course, that principally how much pipeline -- new pipeline, we generate, how big are the pipelines relative to what the pipeline trends are pipeline velocity, but then we look at industry metrics like or indicators, like occupancy rates, very important, specifically for the colocation. And that's really kind of an acid test for the entire industry, and occupancy rates are very, very high. We look at the lease costs that are also up big time. So the industry craves for additional compute capacity. And what we see the AI acceleration is going to drive is more demand capacity. Those are the things that we see.

So kind of take the big colo guys that publish publicly and take their occupancy, take their lease rates. And you think that's a very good leading indicator.

That's a good leading indicator. And that of course...

It makes sense...

And then we work with them on the new projects. So we know what projects they have in their pipeline, and we work with them anyway, and we draw our conclusions.

We're hearing from like [ Amphenol and Tyco ] Electronics that there's some destocking in data center. It seems to me that they -- that those products probably got stockpiled, because they were -- they couldn't get switch gear, they couldn't get your stuff, so they were kind of taking what they could get? Or is that an early indication like of an impending slowing? How would you explain maybe the [ connector ] guys and the negativity?

I would -- I would have to defer that with -- I wouldn't necessarily be able here to connect those dots. So -- but a good point. We'll maybe take on that.

Because it doesn't necessarily make sense that you guys have a lot of inventory in the channel because you have a huge backlog and you haven't really been able to supply it. So...

But channel and hyperscale colo 2 very different -- 2 different...

Well, I guess I just mean some of these guys buy HVAC and they stick it on the site and they -- when would -- they just take it when they can get it, right, especially with components, but probably not with your stuff.

Not with our stuff. Yes. Our stuff is absolutely engineered to order, very often, or certainly highly configured to it.

Right. Right. Go ahead.

Maybe switching gears a little bit. So you acquired a business year or so ago, E&I. And just looking for an update on kind of that business, your expectations for growth and profitability into this year. And you had some cost overruns there in the fourth quarter. You've built a lot of backlog. What kind of visibility do you have to profitability of that backlog as we move forward into this year?

Yes. So switching gears for the -- for our switchgear business is very -- it's very appropriate. But -- so we explained the cost overruns in Q4 and increasing our ability really to understand cost and forecast, predominantly to do with one of the facilities. But more in general, we are extremely happy about the decision and the acquisition couldn't be more strategic in terms of our enhancement, of our value proposition. Our portfolio moved from being UPS manufacturers and DC power manufacturers to being able to deliver an entire powertrain for critical infrastructure, so phenomenal. Having said that, more to your question, how are you making sure that the business is going to yield in terms of growth and in terms of profitability the way you expect? We certainly are increasing the speed of integration. And with the speed of integration also our ability to manage more thoroughly and rigorously a business that was, of course built to serve a different type of purpose, not kind of a publicly traded type of running the business. But the business is very healthy, and the product is extremely well liked by our customers. So in the specific case, that unit was a little bit tricky. We have certainly our operations experts on site to make sure that everything is brought up to the speed that we like when it comes to rigor in running the company. Specifically, the backlog. The backlog that we have is backlog that we have built in the last more or less 12 months. And also for E&I, we did start that process of more rigorous price management that we had for the rest of the company. So I'd say that as we move forward, the more we move on, let's say, the better in terms of margin quality that backlog is and our, let's say, intelligence and accuracy, visibility on that backlog is certainly higher now than it was only 3 months or 5 months ago. So I'm confident we are heading in the right direction there. And again, the right direction is also testament to that is surprisingly good, beating our expectation acceleration in terms of sales synergies that we have experienced after acquisition. So I'm happy there.

I think you had put out or maybe we had a -- I thought you'd put out like a forecast for revenue and profitability when you initially did the deal. Are you kind of tracking towards those profitability numbers that you had out there from a margin perspective? Wouldn't it like 20 -- I don't know it was like a mid-20s margin -- it was like a high-margin business, I thought.

Yes. I think when we announced the deal, we were expecting adjusted operating profit percentage is in the mid- to low 20s, right? And we were trending mid-teens, mid- to upper teens as we went through the year, but the fourth quarter, of course, took that overall percentage down. But what E&I went through wasn't dissimilar to what Vertiv went through. So they had a decent backlog heading into 2022. But it was all priced based on orders that were booked in 2021, and they are exposed to commodities, copper, in particular. And so they saw that mismatch going into 2022, similar to what we saw. So I think the -- it was modeled at $130 million, $140 million of AOP, adjusted operating profit for '22. We guided to $80 million, and we came in south of $60 million. Now if we were to redo that model today, and it's a 5-year model, the exit adjusted operating profit would be higher today than it was when we put it together 18 months ago, and that's because of these sales synergies. So the sales synergies are -- and I think we talked about this in one of the calls last year, it was 3x what we anticipated. It's north of that now. So backlog in that business grew 150% during the year. So we're going through some challenges as it relates to integration, in particular, operational integration. But we talk it up as a great acquisition, a challenging year.

Is the -- does the guidance embed for this year, the $60 million has a lot of improvement? Or is it more in that out year?

No. We certainly anticipate -- driven by 2 things. We have been able to invest in that business to -- from a capacity perspective to increase the sales. And that was one of the issues we had in that particular manufacturing location. It just could not handle operationally the higher volume. So number one, we've invested in additional capacity. Number two, we've made some pretty significant strides in integrating it. So we would anticipate being north of the $80 million adjusted operating profit guide that we gave at the beginning of '22. We're not separately disclosing it, but we'll give updates as we go through the year as far as how we're progressing with that.

And the $80 million is a much higher revenue, though, right? So like...

It's north of $80 million. And the revenue will be north of what we guided at the beginning of last year as well.

Okay. Maybe it's a good time to kind of switch to margins maybe. As you think about this ties into margins, I think, as well as revenue. Just kind of remaining risk in your supply chain, like what you guys kind of the state of the environment in the supply chain, what you're watching, what are the key bottlenecks?

So certainly, a lot of improvements in the supply chain, like we referred to a few times. We -- really, really it was a whack-a-mole situation last year, really tough. I think not uniquely for us, many industries and certainly many peers in our industry are in a very similar situation. We did a lot to increase the resilience, multisourcing, what was a single sourced, an example. You've never done there, so we're continuing. And certainly, resilience will become a much central focus as there needs to also increasingly be a geopolitical resilience in the equation in any industry in the future. So a lot of attention there, but certainly a much more robust position for us right now. Better processes that has helped us to eliminate or reduce greatly the endogenous factors of complexity in the supply chain, but still a supply chain that is not -- that has not healed in general. Everything to do with power semiconductors, directly power semiconductors that we can buy for our power products or Tier 2 suppliers, or Tier 3 sometimes is still creating ripples in our supply chain. But the situation has greatly improved, but it's still a complex environment. And we expect that to remain so for the rest of the year -- at a different level than...

What about the fan assemblies for the thermal stuff?

Fan is, I think, a good example of how we're able to focus and address some of the big problems that we experienced. And we moved from basically single supply per each kind of a type of application or product to at least dual, if not 3 or 4 suppliers. So our resilience has increased dramatically there. But again, that is a component that will be impacted by semiconductor passive conductor shortages. But we believe and we experienced certainly much more stability by the virtue of the multisource that we have right now.

On inflation and price cost, how do you feel like you've kind of like you think you've set the guide appropriately given what you're seeing in kind of cost, commodities so far year-to-date? Any color on that part of the bridge?

Yes. So I mean going back 18 months or even more, we've had quite an experience with inflation just like every industrial. I think every time that we put a stake in the ground, inflation has kind of jumped over even last year, we thought we had a pretty conservative number, I think, $100 million hedge or buffer for inflation, and we ended up $40 million higher than that. So we definitely respect inflation. And I know there's a lot of conversations that things are taming, but we are not counting on that. So for the full year, we have $175 million of inflation built into our guide. $75 million of that is labor. And then if you break down material and freight, $130 million of material inflation, and we're anticipating about $30 million of deflation from a freight perspective. And a lot of that is ocean and air, but also over the road as well. But if you looked at the pure quantitative modeling of that, it wouldn't be $130 million. So we're anticipating or we're building into our model the continual increase velocity of inflation, and we're also building that assumption into our pricing. So when we price orders with our customers, and it's something that needs to ship in the fourth quarter or first quarter of next year, we're assuming continued velocity with inflation.

So if you snap the line today on kind of the raws, would you be in a better position? Or are you building in a little bit of hedge in the back part of the year?

Probably a common. I mean it's pretty uniform what we're assuming as it relates to that velocity of inflation. We pretty much know first quarter, but as it relates to 2Q, 3Q, 4Q, we just assume pretty consistent increase. So...

Increase.

Increase, yes.

And sorry, and just remind everybody how big your raw kind of material buy is?

Yes. So our total direct material purchase is between $2 billion and $2.5 billion. I think we had about -- and this is based on 2022. So we have about $4 billion of cost of sales last year. Of that $2 billion to $2.5 billion, about $600 million of that is metals. Most -- half of that being steel and maybe 1/4 of that being copper and the rest aluminum and lead combined. But as it relates to direct purchase of raw metals, coils and wires and that's probably the only 1/3 of that $600 million. So that is -- and the significance of that is that you have an opportunity to negotiate with the supplier if it's embedded in a stamping or a blanking. So oftentimes, there's a lag. And even in our raw material, we purchase, we buy on -- for steel, we buy off of an index based on the previous quarter.

Right. Based on the previous quarter.

Previous quarter.

Got it.

So maybe a year ago, it was kind of felt silly to talk about the midterm margin target because things have kind of rolled over a little bit. But the guide for this year, you're at 12%, I think. So you had always talked about maybe midterm in the mid-teens, 15%, 16%. Can you talk about what is the path to get there? Like what needs to happen? Is it just volume growth? Are there other levers, like what -- what are the kind of the moving pieces?

Let me talk here without, of course, being specific on what happens when and beyond what we have been specific about a couple or 3 weeks ago, but what are the levers really. Certainly, one that we mentioned is price. Delivery was very wobbly for us in the past. It's now pretty firm, it's pretty strong in terms of both price management, price approvals, but in general, ability to price the value that we deliver to our customers. So price is one. We have a large opportunity for productivity across the board in the organization. So that can be viewed as productivity in manufacturing, that can be viewed as and should be viewed importantly as productivity on the procurement side of the equation, but also in general, think about an ability to improve and make every process across the organization more efficient. I'll give you the example of the Americas, certainly, a very relevant example being a large part of our business. A year ago, we would probably be, let say, leaking [indiscernible] of an ERP implementation was a little bit tricky. Let's say -- let's say, that way. Certainly, a much better situation right now. But anyone knows that system implemented only 1.5 years ago under very difficult circumstances in terms of market and demand still harbors big opportunities of driving process improvement and process improvement is productivity. Productivity, you can look at in terms of our philosophy of fixed cost constant by which top line growth will be combined with by and large, a stable fixed cost base, all things that we now are in the range of possibilities for us. And we're very focused as a leadership to go grab all those opportunities. But also in the longer term, there needs to be a lot of focus on innovation and making sure that we continue to strengthen our value proposition. I was talking about the expanded portfolio and our ability to move up into the value proposition for what power -- the powertrain is concerned and then the ability to translate that into more price and more value for us and for our bottom line. So these are the ingredients.

How does that kind of come together in like an incremental margin on AOP, in like mid- to high single-digit growth environment?

Certainly the direction -- certainly in the direction that you were mentioning when it comes to the time lines or rather something like that is probably a little bit premature.

When will you -- will you have like an Investor Day or something where you'll kind of lay out the grand medium, long-term plan, kind of reset that a bit?

We are planning to have Investor Day towards the back end of the year -- this year.

Any questions in the audience?

So my question is on [indiscernible].

The question is with all the industry adding capacity, is there any concern around a break in the price discipline that the industry has had, given that there's been pricing pressure in the past. Is that about right?

Okay. Well, certainly, certainly, we come from a situation in which the demand and capacity were unbalanced. And that caused a lot of the problems that the industry is experiencing. A lot of the price that we have seen is not just that is a reaction to a non-presidential wave of inflation, not just in our industry, of course, but across the board. So as that wave will eventually normalize, and as David will explain, that's not -- we do not think that will be the case in 2023. So we continue to assume plan and price based on growing -- or continuing inflation. But over time, markets are markets. So markets tends to balance demand and supply, and now market will not be alien to that. Then at that stage, it will be -- the name of the game is what additional value you deliver to your customer and how good you are to translate that into a price premium, so that everyone is happy, us and the customer, because we all have a value creation out of that. When that will happen? I am not sure. I do not think it's going to be a short-term factor. Are we going to see irrational behaviors in the market? I think that this industry might experience so, but rational price we have is typically short lived, and I think that we will not be -- this industry will not be -- will be -- will not be an exception.

Very last comment, are you seeing any of that irrational [indiscernible].

We do not see irrational behaviors. Now we all anecdotally can mention a project that we scratch our head about, et cetera. But in general, the industry is behaving quite normally according to the new normal that we have experienced in the last year, 1.5 years.

One more question over here, then we'll call it.

Just starting to hear more about liquid cooling in a bigger way. Can you talk a little bit about that impact that might have on your business? And what do you think about the future of liquids?

We're very excited about the transformation the industry is going to go through. And liquid cooling is one ingredient. So never people should think about liquid cooling as an alternative way of cooling. But first and foremost, we have the broadest portfolio in the industry, and we make sure that will continue to be the case and basically offering every possible technology that critical infrastructure may need, including liquid cooling solutions. But think of liquid cooling as one of the ingredients. And typically, you will see hybrid data centers out there probably in 3, 4, 5 years or more. So that hybrid situation in which you will have coexistence of multiple technologies, more traditional air, liquid, direct expansion, I'll go probably too technical, certainly made the thermal management in a data center or anyway in general, digital infrastructure, a more complex problem to solve, one where orchestrations and management of the various components need to be done by those who are truly expert of the domain of cooling and thermal management for data centers. So we see it as a very cool engineering problem, but also and especially as a very good opportunity for someone with our experience and breadth of portfolio. And by the way, I think it's important to mention that we are today working with the major hyperscalers and the most advanced chip manufacturers really on solutions there because that's where the technology shift will be driven, and we have proof of concepts being built, et cetera. So very excited.

Thank you.

Well, thanks a lot.

Great. Thanks.

Thank you so much.