Steve Tusa: Right. So that would actually be an easy comp for next year in those businesses, assuming things recouple the trend line.
Craig Arnold: Well, I mean, nothing is easy. And it’s certainly probably too early to put our hand on the scale and predict what’s going to happen in Europe during the course of 2024. But you’re right. I mean, given the fact that those businesses are weakening, assuming the market stabilizes and the inventory destocking is behind us and we certainly have embedded some of that in our Q4 outlook, yes, it should be a relatively better year for sure in Europe.
Steve Tusa: Great. Thanks a lot. Appreciate it.
Operator: Thank you. And the next question is from Chris Snyder from UBS. Please go ahead.
Chris Snyder: Hi, thank you. I wanted to follow-up on some of the data center commentary. So I think you said negotiations up 4x in Q3, so building as the year goes on. Is that increase in conversations all driven by AI? Are you seeing a broadening base of customers that are talking to you on the data center topic? And then when we think about the AI tailwinds, is there any benefit in 2023? Or is the tailwind from that really more 2024? Thank you.
Craig Arnold: Yes. No, appreciate the question. It’s obviously a topic that’s gotten a lot of attention. And I’d say that I would tell you, first of all, while AI and ChatGPT have gotten a lot of publicity of late, it’s not new. I mean, it has been around for some time. And so we have historically seen some benefit of AI embedded in the data center market. I’d tell you that, number one. Secondly, as I said in my outbound commentary, yes, the AI-centric bids and orders were up 4x, but we had a 61% increase in hyperscale in general. And that is really across the broad data center market. And so without a doubt, AI will be an accelerator of growth. But the broader message is essentially more data, more information, more insights requiring more data centers. And those numbers are big and growing as well.
Chris Snyder: I appreciate that. And then maybe just following up on the intersection of orders and backlog. Orders in the Americas have obviously moderated for about a year now. And your guys have built electrical backlog pretty much every quarter over that time period. So as we kind of look forward, do you expect the company to start meaningfully working into that backlog? Or are we just kind of in a period of maybe sideways backlog levels into 2024? Any color on that would be helpful. Thank you.
Craig Arnold: Yes, appreciate the question, and it’s certainly one that we’re spending some time trying to work through ourselves. I mean, orders have moderated. We talked about in the Americas, but we also were comping a 36% increase from last year. And so moderation off of a really big number last year, and the backlog does continue to grow. I think it’s really, in many ways, kind of the $64,000 question. It’s backlog is a function of how much demand you’re getting versus your ability to satisfy that demand. And at this point, I can only tell you based upon what we’ve seen and experienced to date is that we’ve not been able to materially eat into the backlog. We will at some point. I mean, this cannot go on forever.
And we are adding some capacity. For sure, that’s going to help resolve some of the lead time issues and the bottleneck issues. And so we would expect backlog at some point to turn negative in absolute terms because keep in mind, we’re up 3x. We’re running a backlog of $9.4 billion in our Electrical business, $3.1 billion in Aerospace, but $9.4 billion in Electrical, and that’s 3x the historical backlog levels. And so yes, one, it’s a function of the fact that markets are good. And – but secondly, it is a function of the fact we got to get out in front of some of these capacity planning things so that we can satisfy all this demand. But at some point, backlogs will turn negative.
Tom Okray: Yes. And this is what I was trying to get at in my prepared remarks, just to amplify it a little bit more. And this is where we’ve modeled the scenarios of meaningful order intake decline on a year-over-year basis. And given how big the backlog is right now in the backlog coverage, the 3x, as Craig said, we think even with meaningful year-over-year order intake decline and robust organic growth, this is going to take us several quarters into 2025 before we get back to historical levels, so…
Craig Arnold: And I would say we probably never get back to historical levels if you think about it in terms of absolute terms, right? We will be better, but we will never probably get back to a $3 billion kind of backlog. It’s a bigger business we will need. And so we will run a bigger backlog simply to support the fact that it’s a large, large business. But what we certainly would expect to, at some point, start eating into the backlog.
Chris Snyder: Yes. Thank you.
Operator: Thank you. The next question is from the line of Nicole DeBlase from Deutsche Bank. Please go ahead.
Craig Arnold: Hi, Nicole.
Nicole DeBlase: Can we just talk a little bit about the capacity investments that you guys are making and just the cadence of when that’s going to start kind of phasing and coming online over the next several years?
Craig Arnold: Yes. So appreciate the question, Nicole. And I would tell you that some of these investments have been made already. And we already are bringing on new capacity in products like circuit breakers and the like. Other investments are just now in the early phases. If you think about some of the investments that we are making in transformer capacity in voltage regulators, and that capacity is probably order of magnitude 12 months to 18 months out. So, it does vary depending upon which particular piece of the investment that you are referring to. But I would say, in all cases, the commitments have been made. In all cases, we are looking at essentially those aspects of our business where we obviously have more capacity – more growth, more backlog than we certainly have capacity to serve it.
And at this point, our teams are kind of geared up for ensuring that we execute it well and bring this capacity online. It allows us to continue to grow the company and take some market share.
Nicole DeBlase: Thanks Craig. And then just on free cash flow, thinking about how this progresses into 2024. Can you talk a little bit about your plans to reduce working capital and other major puts and takes that could influence conversion next year? Thank you.
Tom Okray: Yes. Appreciate the question, Nicole. I think the important thing is to look at year-to-date when you are looking at operating cash flow and free cash flow. I mean we had a good quarter, but year-to-date, we are up 73% in operating cash flow and almost 90% in free cash flow. And if you look at the improvement levers for year-to-date, it’s about split between higher earnings and better working capital. And if you recall, last year, we said we were investing in our customers and investing in the growth and believe that was the right decision. In the back half of last year, we started getting more efficient with working capital. We expect that to continue going into 2024. We are happy with our free cash flow margin this quarter of 16%.
But we have got a lot of opportunity to improve in terms of inventory days on hand, getting better in terms of DSO, our cash conversion cycle. So, we are not stopping here, we are happy with our progress, but we have got a lot of opportunity for better cash flow going forward.
