Regal Rexnord Corporation (NYSE:RRX) Q4 2022 Earnings Call Transcript

Regal Rexnord Corporation (NYSE:RRX) Q4 2022 Earnings Call Transcript February 2, 2023

Operator: Good morning, and welcome to the Regal Rexnord Fourth Quarter 2022 Earnings Conference Call. All participants will be in listen-only mode. Please note this event is being recorded. I would now like to turn the conference over to Robert Barry, Vice President of Investor Relations. Please go ahead.

Robert Barry: Great. Thank you, Andrea. Good morning, and welcome to Regal Rexnord’s fourth quarter 2022 earnings conference call. Joining me today are Louis Pinkham, our Chief Executive Officer; and Rob Rehard, our Vice President and Chief Financial Officer. Before turning the call over to Louis, I’d like to remind you that the statements made in this conference call that are not historic in nature are forward-looking statements. Forward-looking statements are not guarantees since there are inherent difficulties in predicting future results, and actual results could differ materially from those expressed or implied in forward-looking statements. For a list of factors that could cause actual results to differ materially from projected results, please refer to today’s earnings release and our SEC filings.

On slide 3, we state that we are presenting certain non-GAAP financial measures in this presentation. We believe that these are useful financial measures to provide you with additional insight into our operating performance and for helping investors understand and compare our operating results across accounting periods and in the same manner as management. Please see this slide for information regarding these non-GAAP financial measures, and please see the appendix for reconciliations of these measures to the most comparable measures in accordance with GAAP. Turning to slide 4. Let me briefly review the agenda for today’s call. Louis will lead off with his opening comments, Rob Rehard will then provide our fourth quarter financial results in more detail and discuss our 2023 guidance.

We will then move to Q&A, after which, Louis will have some closing remarks. And with that, I’ll turn the call over to Louis.

Louis Pinkham: Great. Thanks, Rob, and good morning, everyone. Thanks for joining us to discuss our fourth quarter earnings, and to get an update on our business, and thank you for your continued interest in Regal Rexnord. Last night, we reported strong results that evidence our transformation continues to gain traction. Organic sales growth of slightly over 4% for the enterprise reflects continued share gains and strong price discipline even as some of our end markets slowed. This share, we are gaining continues to be supported by our digital and e-commerce investments, new products and competitive service levels. This fourth quarter was also the eighth in a row of being price/cost positive, which, along with sizable M&A synergies, NPD mix-up and our ongoing 80/20 and lean efforts, drove 300 basis points of adjusted EBITDA margin expansion versus the prior year period.

I was also pleased to see our cash flow performance improve in the fourth quarter, resulting in cash flow conversion of 165%. Despite this strong finish, we did fall short of what arguably was an ambitious goal for the year. While the supply chain is improving, during the quarter, it did continue to contain us while making it costlier to maintain high service levels for our most valuable Quant 1 customers. In aggregate, a very strong finish to 2022. I think it is also important to acknowledge the first full year of Regal Rexnord as we continue to manage our portfolio and drive significant shareholder value. Sales were up 37% versus 2021, with organic sales up 9% year-over-year. Adjusted EBITDA reached more than $1.1 billion. We achieved 33% adjusted gross margins, right on track to our plans, and adjusted EBITDA margins improved 230 basis points from 19% to 21.3%.

Solid overall results. And for this strong execution, pursued with a sense of urgency as well as continued adherence to our Regal Rexnord values, I want to say a sincere thank you to our Regal Rexnord associates around the world. Now, I do want to take a moment and comment a bit further on cash flow because I am increasingly optimistic about our cash flow outlook. In addition to the EBITDA growth we expect in 2023, plus strong gains over the forecast period, we also see a significant opportunity to reduce working capital and especially inventory, both as the supply chain continues to improve and as we further mature our 80/20 and lean efforts. Our teams are becoming more disciplined about how they manage working capital. Some of this is happening through IT and logistics investments, such as a new global freight scheduling software, some is occurring through our M&A synergies.

In addition, I am excited to announce that we added a new member to my leadership team, our Vice President of Strategic Sourcing, who is bringing over two decades of global sourcing and supply chain experience to Regal Rexnord, and who, I am confident, will help us improve our working capital performance, continue to expand our gross margins by lowering our input costs and enhance the service level improvements that are helping us gain market share by reducing our lead times. In the spirit of what gets measured gets done, we are complementing this stepped-up focus on cash flow by making working capital performance and resulting free cash flow a larger component of our leadership’s 2023 compensation, creating a stronger link between incentives and targeted performance.

Cash flow is a critical driver of our value. But it becomes even more critical in the context of the leverage we’ve added to fund the Altra transaction, and I can assure you that my team and I will be over managing it. Turning to orders. We did see further pressure in the quarter, with daily organic orders down just over 10% on an FX-neutral basis. This was not a surprise directionally given softening macro indicators such as U.S. and non-U.S. PMIs, and what some of our large HVAC customers have been indicating on destocking. But, it was weaker than we anticipated in terms of magnitude as we entered Q4, particularly in residential HVAC. We do expect order weakness to persist in early 2023, especially in the first quarter when we face a tough compare.

And with supply chain improvements, plus heightened macro caution, our customers are likely reducing their stocking levels further. That said, we remain cautiously optimistic about our top line prospects. Not only do we have a diverse set of end market with balanced early, mid- and late cycle exposures, but we continue to have an elevated backlog, still up nearly 50% versus early 2021 levels. And we expect significant tailwinds from new product launches in 2023. As a reminder, we aim to double our product vitality in the 2023 to 2025 time frame. We also have sizable self-help tailwinds from Rexnord PMC and Arrowhead synergies, both on cost and revenue, and then anticipate significant M&A synergy upside once we close Altra. Rob will provide further detail on all the moving parts plus our 2023 expectations for growth, margins and earnings in his section.

But the bottom line is that our focus in 2023 and beyond remains on controllable execution between our ample backlog, helping new product pipeline, current and expected M&A synergies and significant ongoing 80/20 and lean initiatives, we have a tremendous opportunity to create value for our key stakeholders, our customers, our associates and our shareholders. And we believe this to be the case regardless of what the macro does. Shifting focus a bit. I’d like to provide an update on where we are with the Altra transaction. Since announcing the acquisition on October 27th of last year, we secured financing for the transaction, saw approval of the deal by Altra shareholders and made nice progress on the regulatory front. We were very pleased with our early January financing activities, which involved raising $4.7 billion in, 3-, 5-, 7- and 10-year unsecured notes.

The offering was greater than 4 times oversubscribed, which helped us achieve interest rates that were over 100 basis points lower than assumed when we announced the transaction. On the regulatory front, the waiting period on our U.S. HSR filing ended on January 12th, and a simplified regulatory review process was initiated in China in mid-January. China and other jurisdictional reviews remain in process, and we continue to expect that we will close the transaction in the first half of this year. We remain extremely excited about adding Altra to our Regal Rexnord team. We see tremendous opportunities to drive material cost and revenue synergies through this combination and create meaningful benefits for all of our key stakeholders. One of the many growth opportunities we envision with Altra is enhancing our industrial powertrain offering by adding certain capabilities that we lack, such as clutches, and expanding narrower parts of the offering, such as brakes.

Meanwhile, our current powertrain team continues to see great momentum in the market. As a reminder, this cross-segment, cross-functional team is dedicated to selling integrated industrial powertrain solution, and its focused efforts are driving strong momentum selling these highly differentiated subsystems. Pictured on this slide is a recent powertrain win. In this case, our Regal Rexnord powertrains are running clarifying tanks that are critical components of a large municipal water treatment facility. Our content includes Marathon Motors, Rex and Hub City gearboxes, Falk couplings and Rexnord bearings, in addition to providing custom fabricated baseplates and bearing pedestals. In aggregate, a 7-figure project win for the powertrain team.

What the customer needed and we were able to provide, is; first, integrated solution; and second, a solution that enhanced durability and energy efficiency. For our customer, this installation is over a $100 million project. So, they were eager to lean on Regal Rexnord’s application and powertrain expertise to provide these subsystems, plus commissioning so they could free up time to focus on other aspects of the project. In other words, we made it easier for our customer, and, at the same time, optimize the subsystem’s efficiency and durability. On top of that, our team brought this highly customized solution together with best-in-class lead times, doing our part to help keep the broader project on schedule. What we love about these differentiated subsystem sales is that conversations with the customer are more strategic, more focused on our technical capabilities and on efficiency, making this powertrain subsystem an absolute win-win for the customer and for Regal Rexnord, plus this win tees up other project opportunities and a strong MRO funnel for the future.

And so congratulations to our powertrain team for acting with urgency to deliver this great result. And with that, I’ll now turn the call over to Rob to take you through our fourth quarter performance in more detail.

Rob Rehard: Thanks, Louis, and good morning, everyone. I’ll begin by also thanking our global team for their strong execution, including delivering a very strong finish to 2022 in what remain a challenging operating environment. Now, let’s turn to our fourth quarter segment financial performance. Starting with our Motion Control Solutions segment, or MCS, organic sales in the fourth quarter were up 9.4% from the prior year. The result reflects broad-based growth, but with particular strength in the general industrial, energy, metals and mining, and aerospace end markets, partially offset by weakness in alternative energy, including lapping project activity in the China wind market. Adjusted EBITDA margin in the quarter for MCS was 27.8%, up 300 basis points compared to the prior year, primarily due to merger synergies and volume growth, partially offset by nonmaterial inflation, supply chain frictions, mix and FX headwinds.

Orders in MCS for the quarter were down 7% on a daily FX neutral basis. In January, book-to-bill tracked at roughly 1.2. Turning to Climate Solutions. Organic sales in the fourth quarter were down 10.7% from the prior year. The decline was driven by global end market volume headwinds, particularly in the North America residential HVAC market as large HVAC OEMs took significant actions to reduce inventories. These market volume headwinds were partially offset by pockets of share gain. To put Climate’s fourth quarter top line results in context, the U.S. residential HVAC business faced tough comparisons, including 15% growth in the prior year quarter and a two-year stacked growth rate of nearly 40%. While some top line pressure in the — while some top line pressure in the face of these difficult comparisons was anticipated, the headwinds in the quarter from OEM destocking activity were more severe than we expected.

We believe a weaker macro outlook, plus temporary near-term uncertainty around how the January 1st implementation of the new U.S. energy efficiency regulations would impact regional channel inventory levels, prompted a more cautious stance from our HVAC OEM customers. This dynamic likely continues to weigh on the first quarter as well, but we are cautiously optimistic that we’ll see improving conditions thereafter. The adjusted EBITDA margin in the quarter for Climate was 18.5%. While there was pressure on Climate’s EBITDA margins in the fourth quarter due to lower volumes and headwinds related to material inflation, nonmaterial inflation, supply chain disruptions and currency, the segment did realize a benefit related to the capitalization of freight variances that will unwind in the first quarter of 2023.

We continue to see a path back to margins in the high-teens to low-20s during 2023, though most of the improvement is likely to occur after the first quarter. Expected drivers of the forecast improvement include: one, launching mix positive new products, in particular, our Frontier compressor drive; two, mix tailwinds related to new U.S. minimum efficiency standards, or SEER ratings, which should drive greater demand for electronic — for our electronic variable speed motors; and three, significant productivity and restructuring initiatives, many tied to maturing 80/20 and lean efforts. Turning to orders. Orders in Climate for the fourth quarter were down 22% on a daily FX-neutral basis. Book-to-bill in January is tracking at roughly 1.2. Turning to Commercial Systems.

Organic sales in the fourth quarter were up 5.6% from the prior year. Growth in the quarter reflects strong performance in North America general industrial and the large commercial HVAC markets, partially offset by headwinds in China. The strength we are seeing in general industrial continues to reflect meaningful share gains tied to investments we are making in digital and the e-commerce channel initiative. The adjusted EBITDA margin in the fourth quarter for Commercial Systems was 17.6%, up 510 basis points compared to the prior year, reflecting some moderation in freight costs along with strong execution of our 80/20 and lean initiatives, partially offset by commodity and other nonmaterial product cost inflation. Shifting to orders. Segment orders for the fourth quarter were down 17% on a daily FX-neutral basis, or down 10%, excluding orders in pool, which continued to actively rightsize inventory during the quarter.

Christian Lagerek/Shutterstock.com

Looking to January, book-to-bill tracked at roughly 0.95. In Industrial Systems, organic sales in the fourth quarter were up 9.7% versus the prior year. Principal drivers include volume growth, largely tied to share recapture stemming from improved operating performance and service levels, along with end market strength in general industrial and data center. As expected, the business did see some weakening in China, which tempered the segment’s growth. The adjusted EBITDA margin in the quarter for Industrial was 12.2%, an increase of 650 basis points versus the prior year period. We continue to be extremely pleased with the performance at Industrial, which we feel is on a sustainable path. Orders in Industrial for the quarter were down 5% on a daily FX-neutral basis.

In January, book-to-bill was 1.0. On the following slide, we highlight some key financial metrics for your review. A couple of notable highlights. First, on the right side of this page, you’ll see we ended the quarter with a net debt to adjusted EBITDA ratio of 1.2 times. Second, our free cash flow in the quarter was $169 million, which equates to a conversion rate of roughly 165%. Our team did a great job improving free cash flow performance in the quarter. And while the result left a shy of our full year conversion target, we see significant opportunities to augment our cash flows in 2023, in particular, by lowering inventories as the supply chain improves. As we stated previously, our focus will continue to be on paying down debt with the improving cash generation.

Moving to the outlook, and please note that all of our adjusted earnings guidance excludes any impacts related to Altra. Let’s start with the top line. We defined our top line forecast by considering several factors: One, a weakening demand environment evident in our order rates; our record backlog; three, pricing dynamics; and four, continued success with our outgrowth initiatives, including expected new product launches, service level improvement and e-commerce and digital investments. To help illustrate how we’re thinking about market impacts in 2023, we’ve included a table on this slide detailing our principal end markets and our current views on how each is likely to grow this year. As noted in the table, the weighted average of our underlying end market growth assumptions is a 3.5% decline in 2023.

Beyond what end markets may be doing, we expect to deliver outgrowth of roughly 2 points, which equates to outperform in these markets by a little better than 50%. Our top line modeling also embeds a slightly positive impact from price, along with a modest headwind from currency, which brings our overall sales growth expectation to down roughly 1% at the midpoint of our range. At the EBITDA line, we anticipate delivering margin expansion of 50 to 70 basis points at the midpoint. Note that margin gains will likely be weighted to the back half of the year, with only modest improvements expected in the first half due to continued, albeit moderating supply chain challenges. Before leaving margins, a word on commodity inflation. While we saw prices of our principal commodities, steel, copper and aluminum, decline through the second half of last year, we are starting to see those prices moderate slightly higher coming out of January on a sequential basis.

Our outlook assumes relatively neutral commodity costs in 2023 relative to the way we finished 2022. We also assume that we will remain at least price/cost neutral and likely slightly positive throughout 2023. Moving further down the income statement, we factor below the line items as detailed later in this presentation to arrive at a range for projected adjusted earnings per share of $10.05 and $10.85, or $10.45 at the midpoint. I will highlight that we have nearly $0.50 of incremental year-over-year net interest expense embedded in our estimates, which reflects higher benchmark interest rates. To be clear, our net interest expense guidance excludes any new acquisition-related financing costs, and is aligned with the interest expense on our current business that we saw in the fourth quarter of €˜22.

In summary, we are choosing to air on the side of caution here as we start the year, but our confidence in the business remains extremely strong. We have line of sight to additional margin upside through our M&A synergy efforts, disciplined cost savings initiatives and a continued focus on 80/20 and lean. We are also gaining traction with our growth initiatives, especially our industrial powertrain cross-segment initiative, and we remain on track to double our new product vitality over the next three years, which is also expected to benefit our margins through higher mix. On this slide, as I referenced earlier, we provide some modeling items that should be helpful as you build out the income statement below the EBITDA line and model free cash flow.

Again, our $105 million of guided interest expense is for our current business only and excludes all Altra-related impacts. I’ll wrap up by saying that on the whole, we are very pleased with the Q4 results and our team’s ability to execute in what remained a challenging environment. While the macro outlook remains uncertain, our outlook for the company remains very positive, considering the tremendous amount of self-help we have in front of us on growth, margin and cash flow. And now, I’d like to turn the call back to the operator so that we can take any questions. Operator?

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Q&A Session

Operator: And our first question will come from Nigel Coe of Wolfe Research.

Nigel Coe: Thanks for the first question. I appreciate it. Good morning, everyone. So, first of all, congratulations on the financing for the deal. It looks like good terms there. But in terms of the down 2% organic, I think that’s the number you’re keen on here, down 1.5%, 2%. How does that look through the year? And I’m just — obviously, we’re cognizant of the challenges in 1Q, but any help on the phasing of that down low single digits would be helpful?

Rob Rehard: Sure. Thanks for the question. Let me do it this way. Let me give you the full — I’ll give you a guidance by — for the full company and the way that should work, but — and kind of how we’re expecting that to phase. But let me start by just giving you some segment guidance, and then what I’ll do is I’m going to give you the full year, and then I’m going to give you a little bit of direction on Q1 as the first half of the year, we expect to be relatively slow or slower, especially in Q1 and then more of the improvement coming in the back half. So starting with — by segment, and I’ll start with the top line, and I’ll start by each segment, Climate’s first. And for each one of these, the way I would look at this is, I’ll give you the expectation that’s embedded in our midpoint and then just plus or minus 200 basis points in the range.

So, Climate down mid-single-digit; Commercial down mid-single-digits; Industrial up high-single-digit; and MCS up low-single-digit. So overall, down about 1% at the midpoint, again, plus or minus 200 basis points for the range. Now, before I get into Q1, let me also just finish this section up by giving you a bit on EBITDA margins. So, I’ll use €˜22 as a jump-off point to full year €˜22. For Climate, margins up 0.5 point, give or take; Commercial, margins roughly flat to up slightly; Industrial, margins up as much as 0.5 point; and MCS margins up between 50 and 100 basis points. Now, I’m going to skip back to Q1 because it is unique. Similar to last year, where we had an outsized benefit of the cost roll, which was positive to the first quarter, this year, we’re seeing the opposite effect, right?

We’re seeing deflation, so it’s an expense versus income in the prior year. So with that being said, let me first start with top line. And I’m going to give you these numbers — these expectations, and think of this as more sequential to fourth quarter. For Climate, flat; Commercial, roughly down high single digit; Industrial, up high single digit; and MCF, down low single digit, again, sequential and also overall Regal Rexnord level down low single digits. So now let me move to — similar to what I did on the full year, let me give you the directional guidance on EBITDA margins. So for Climate, and this is again sequential, to be clear, roughly down 5 points; Commercial, roughly down 3 points; Industrial, roughly down 2.5 points; and MCF, roughly flat.

So overall, we expect to be down roughly 1.5 to 2 points. So again, first half, expect more pressure, especially in Q1 and more improvement in the back half. Hopefully, that is fairly comprehensive.

Nigel Coe: Yes. The answer was a lot better than my question, for sure. But we’ll kind of process this and come back offline. My follow-up question is on the Altra deal. The HSR waiting period over, is that equivalent to effectively getting sign-off from the — on that deal? And is there a possibility this deal could close this start of the quarter? Because I know you said first half, but does that — need to be one key close here?

Louis Pinkham: Yes. So Nigel, this is Louis. First of all, with regards to HSR, it’s a review process and the review process expired on January 12th. And so, that’s the process. Specific to could this close in first quarter, potentially unlikely. We still have — and regulatory really is the only outstanding item at this point, of course, because we had good success in the financing and U.S. HSR should be behind us. But we also have behind us Turkey, U.K. and Australia, however, still pending is EU and China. And as I said in my prepared remarks, China accepted a short form in mid-January. So, there’s typically a 30-day period from that. We also received FDI approvals from Czech Republic, Italy and the UK, and outstanding from Australia and Denmark, France and Germany. So really still on track with what we expected, we believe, first half. And so certainly, I’m giving you my thoughts that it’s likely second quarter, but we’ll see.

Operator: The next question comes from Mike Halloran of Baird. Please go ahead.

Mike Halloran: So just a clarification on all that detail, Rob, you gave. When you think about the underlying dynamics from an end market perspective, is the expectation that the — what is the expectation for those end markets front half versus back half at a high level? Obviously, I appreciate all the finite detail in there, but just maybe bring it a little higher level and just talk about the broad-based expectations for the underlying dynamics as you work through the year, and what’s embedded in guidance that way?

Louis Pinkham: Sure, Mike. And I’ll take this one. What we like about our portfolio is a very balanced early, mid and late cycle exposure. No question, we’re seeing slowing in that early cycle. Anything consumer-related is being slowing. And so residential HVAC, we’re thinking likely down high-single, low-double digit for 2023 and more weighted to the first half; pool down. Now pool — residential HVAC is about 15% of Regal. Pool is only about 2% to 3%, but that’s going to be about the same type of profile. Anything that’s a little later cycle, though, we’re seeing acceleration bluntly. Aerospace is quite strong. We expect solar, alternative energy to be strong. And then kind of relatively flat would be the commercial space, hospitality, power gen.

And we still feel pretty good about non-res construction. There’s some — a little bit of noise in some of the indicators, but non-res construction should be pretty strong in this first half as well. So, I hope that helps, Mike?