Vertiv Holdings Co (VRT) Q3 2022 Earnings Report, Transcript and Summary

Good morning. My name is Bailey, and I will be your conference operator today. At this time, I would like to welcome everyone to Vertiv's Third Quarter 2022 Earnings Conference Call. [Operator Instructions]. Please note this call is being recorded. I would now like to turn the program over to your host for today's conference call, Lynne Maxeiner, Vice President of Investor Relations. Please go ahead.

Thank you, Bailey. Good morning, and welcome to Vertiv's third quarter 2022 earnings conference call. Joining me today are Vertiv's Executive Chairman, Dave Cote; Chief Executive Officer, Rob Johnson; Chief Financial Officer, David Fallon; and Chief Operating Officer and President, Americas, Giordano Albertazzi. Before we begin, I point out that during the course of this call, we will make forward-looking statements regarding future events, including the future financial and operating performance of Vertiv. These forward-looking statements are subject to material risks and uncertainties and could cause actual results to differ materially from those in the forward-looking statements. We refer you to the cautionary language included in today's earnings release, and you can learn more about these risks in our annual and quarterly reports and other filings with the SEC. Any forward-looking statements that we make today are based on assumptions that we believe to be reasonable as of this date. We undertake no obligation to update these statements as a result of new information or future events. During this call, we will also present both GAAP and non-GAAP financial measures. Our GAAP results and GAAP to non-GAAP reconciliations can be found in our earnings press release and in the investor slide deck found on our website at investors.vertiv.com. With that, I'll turn the call over to Executive Chairman, Dave Cote.

Our third quarter performance continues to support the profile of improvement that we presented in February of this year. Our financial performance escalated in the third quarter, as we anticipated, helped by a record level of price that was realized this quarter. We are doing things differently, especially in the Americas, and we are seeing that translate to an improved financial performance. I know demand is becoming a bigger question for all companies given the macroeconomic environment. Demand win was strong for Vertiv, the data center end market as a true secular demand story, data is just going to continue to grow. We continue to execute on operational improvements and I'm pleased to report good progress in Americas reflected in the adjusted operating margins improvement. The work in the Americas is far from done, but there are very encouraging signs. Our operational focus is paying off, and we anticipate this will be visible in our Q4 results in the Americas. We have another significant step-up in operational performance planned for this quarter. Similar to our last earnings call, David will walk you through in detail why we believe this will happen, and it will sound very consistent with our previous discussion. We made an announcement earlier this month on our CEO Succession Plan. Giordano Albertazzi is the name COO in addition to his duties as America's President till, we find a replacement, and will succeed Rob Johnson as the CEO on January 1 next year. I work closely with Gio and feel confident, he brings the right leadership and experience to drive Vertiv's performance. Anand, again, thank Rob for all he has done as CEO over the past 6 years in building Vertiv's strong competitive position and foundation for sustained growth. As we are in the final quarter of this year, I know attention is focused squarely on the setup for 2023. We've provided adjusted operating profit guidance earlier than usual for 2023 that represents a 60% increase over our current guidance for 2022. People have asked about our visibility given the world is a complicated place right now. While visibility isn't perfect, the management team feels confident in their ability to execute and deliver Q4 and what it portends for 2023, which should be a very good year for Vertiv and for our shareholders. So with that, I'll turn the call over to Rob.

Thank you, Dave. Starting with some key messages on Slide 3. We anticipated the volume ramp up in the back half of 2022 and we're certainly seeing it, with organic net sales up 20% in the third quarter, orders, excluding FX, were up 15%, which is even better than our preliminary orders number we provided earlier this month. We continue to see strong long-term market demand signals from our customers. Adjusted operating profit of $134 million was within the guidance range. Our improvement actions are taking hold, and we've seen the improvement building sequentially throughout the year. We delivered again on our price plan, realizing $110 million of price this quarter, and we raised our full year pricing expectations to $365 million. We saw price cost split $35 million year-over-year tailwind for this quarter. This tailwind will further strengthen into the fourth quarter and into 2023. Supply chain has improved over the last 90 days, even in some areas that have been hampering this, areas like circuit breakers, fans, and other certain electronic categories. Our work qualifying alternative suppliers is paying off, and these additional sources of supply support our fourth quarter volume projections. That being said, there are certain categories of power electronics that are still in short supply, and we expect them to remain so throughout at least mid-2023. Free cash flow is trending in the right direction, although we continue to carry high levels of inventory to support our increasing volume as fourth quarter is expected to be a record sales quarter for Vertiv. Orders have remained high, which is a great thing, but it has us carrying more inventory than expected. Fourth quarter free cash flow is expected to be an all-time record between $250 million and $300 million positive. And this should set us up, we think, for a great '23. We know our working capital is not optimized, and we are taking the full year projection down from our prior guidance, but we believe there is a significant additional cash benefit in 2023 and we have been working on plans and programs to make sure this happens. We are affirming the fourth quarter adjusted operating profit guidance of $230 million at the midpoint, which continues to support our view of a very strong fourth quarter and we believe a very good position and very well for 2023. Turning to Slide 4. This slide summarizes what we see in our markets by region. A few changes in Americas market view. Enterprise has moved to yellow, indicating a bit of caution, but is consistent with what we've been seeing in other global regions. The Enterprise market is exhibiting more caution given to the macro uncertainty, including the possibility of a recession, but still remains positive. The Communication market in Americas has been very strong for a number of quarters, and there's been a lot of investment associated with 5G technology cycle. While it's coming off those high marks, telecom carriers still invest, both in new technology and their existing network infrastructure. EMEA and Asia markets views remain relatively healthy as well. All in all, strong market backdrop continued for what we do. To note, we have been aggressive with our pricing actions for several quarters now, and we continue to see strong demand. We can get price and the ability has been demonstrated each quarter as we make our way through the year. Moving to Slide 5. We still feel good about customer demand with orders up 15% in the quarter, excluding FX, and that is compared to last year's third quarter, where orders were up 17% from the prior year. We have highlighted that we anticipate year-over-year orders declining in Q4. That is more a product of a challenging comparison to the prior year. If you recall, orders were up 51% in the same period last year. Fourth quarter orders, adjusted FX, are expected to be relatively flat in line with third quarter orders. We posted another record-breaking backlog at the end of September of $4.7 billion, which provides great support as we think about our 2023 top line. We continue to execute on our pricing plan and have delivered pricing consistent with our framework each quarter in 2022. Our pricing plan of $135 million for fourth quarter includes, 80% already in the backlog and 20% to be realized on book and ship, but those actions have already taken place. We are clearly demonstrating we can get price in our markets. Supply chain has been improving, clearly not without disruption, but seeing things improve. Improving external market conditions, coupled with the extensive work the team has been doing to qualify new suppliers is helping our situation. The one area that is still tight in some of the semiconductor categories we specifically use. We use specialized high-end semiconductors different from some of the categories where you've seen in the market, a nice improvement on those. While availability is slightly improving for us in the specialized categories, we expect this tightness in the markets to continue through at least mid-'23. Some good news as it relates to our fan supplier. They are fully qualified and shipping production parts to us. There is favorability in the commodity and freight markets. We typically have 1 quarter lag before that reads through our P&L, but we anticipate seeing more favorability in fourth quarter and going on into 2023. Even with some good news at our back, we did raise the inflation estimate for the year by $15 million, with $5 million being realized in Q3, and $10 million anticipated in Q4. This is related to 2 primary factors: one, our regional sales mix is more heavily weighted to higher inflation zones. And we're also seeing some additional inflation in EMEA, mainly related to energy costs. In summary, our markets remain healthy. While recession proof is a strong term, there is an argument to be made, as Dave said, data will continue to grow through these economic cycles. That data has to be networked, has to be stored, and has to be processed in data centers where our equipment is. We are the market and technology leaders, and we are getting paid for what we do. Supply chain pressures, as I mentioned earlier, are easing, and we're seeing that benefit and expect that to continue to improve. Coupled with the work we have done to onboard new suppliers, we are proving operationally each quarter, and you're seeing it in our financial performance. Now I'll turn the call over to David to walk us through the financials. David?

Perfect. Thanks, Rob. Turning to Page 6. This slide summarizes our third quarter financial results. Our net sales increased 21% from last year's third quarter and were up 20% organically, including 11% from volume and 9% from pricing. The E&I acquisition contributed $115 million, partially offset by $25 million from the sale of the Industrial UPS business at the end of last year. Foreign currency translation negatively impacted net sales by approximately $85 million, with about 2/3 of that in EMEA due to the weakening of both the euro and the British pound. Adjusted operating profit of $134 million was within our guidance range, but at the lower end, primarily due to an incremental $10 million foreign exchange headwind compared to what we assumed this past August. This foreign exchange headwind includes both translation and transactional impacts within the regions where we buy and sell in currencies other than functional. Compared to prior year, we generated an additional $3 million of adjusted operating profit with the primary drivers summarized at the bottom of this page. Of note, as promised, we flipped the price/cost equation from negative to positive, generating a $35 million tailwind in the third quarter. We expect this tailwind to strengthen to about $80 million in the fourth quarter as we continue to deliver on our pricing commitments. Adjusted operating margin sequentially improved to 9.1% in the third quarter from 5.9% in the second quarter as we continue our margin expansion actions, expecting approximately 14% in the fourth quarter, which would be a record quarterly high. Adjusted diluted EPS was $0.23 for the quarter, which was in line with August guidance, and $0.03 higher than last year, primarily due to the timing of income tax expense, partially offset by higher year-over-year interest expense, primarily due to debt pursuant to the E&I acquisition. Third quarter free cash flow was a use of $20 million. This use moderated sequentially in the third quarter from the second quarter. We anticipate free cash flow to be significantly positive, in fact, a record high in the fourth quarter. We spoke about an inventory reduction opportunity in 2023 on our last call, and we still believe this will happen. Supply chains are improving as our internal SIOP processes, both of which should contribute to lower inventory balances going forward. Next, turning to Page 7. This slide summarizes our third quarter segment results. All regions saw strong double-digit organic sales growth. The Americas region grew organically approximately 25%, equally balanced between volume and price. Americas adjusted operating profit of $115 million and margin of 16.2% were positively impacted from improved price/cost, but offset by higher investment in fixed costs, including to support the launch of our new Monterrey facility. We are encouraged with the margin improvement in the Americas from 11% in the first quarter to an expected 20% in the fourth quarter, an in-year increase of 900 basis points. Still significant work to do, still significant opportunity, but the operational improvements Giordano and his team have introduced are certainly gaining traction. Organic sales in APAC increased 17% from last year's third quarter, 70% from volume, 30% from price. Operating margins increased 150 basis points, primarily due to favorable price cost and volume leverage. Finally, on this slide, EMEA sales were up 14% organically, 2/3 of that from price and 1/3 from volume. As a reminder, EMEA had the most challenging year-over-year comparison as organic sales were up almost 18% in last year's third quarter. Inflation has been more pervasive in EMEA recently, at least compared to the other regions, especially related to energy and our price realization in that region did not fully offset these inflationary headwinds in the third quarter. As a result, EMEA experienced a small price cost headwind in Q3. We continue to evaluate this inflation and our pricing response, but we do anticipate price cost to be positive in EMEA for the fourth quarter, and we do anticipate a fairly significant step-up in operating margin in the fourth quarter as well. Turning to Slide 8. We summarize our updated fourth quarter financial guidance, reaffirming adjusted operating profit of $220 million to $240 million provided earlier this month. All metrics on this slide would be record quarterly highs and by significant margins, including free cash flow, which is projected to be between $250 million and $300 million. Of course, we still have to execute, and there is much work to be done to capture significant opportunity going forward, but as we have consistently communicated since the beginning of the year, this strong fourth quarter should provide a solid foundation for a very good 2023. This slide provides a lot of detail compared to last year's fourth quarter, and it captures the progress we have made in 12 months, notably the $135 million of incremental pricing. Despite this year-over-year improvement, probably more important for investors to understand the doability of the strong fourth quarter, is the incremental bridge from this year's third quarter, which we will cover in a couple of slides. Turning to Page 9. This slide summarizes our revised full year financial guidance, reconfirming adjusted operating profit of $450 million to $470 million provided earlier this month. As Rob mentioned in his key messages earlier, we are reducing full year free cash flow guidance by $125 million at the midpoint with approximately $60 million of that from changed expectations for year-end inventory, $30 million from lower expected EBITDA, and $30 million from lower expected cash collections. We had previously projected a more significant inventory reduction by year-end, but as we enter the fourth quarter with record projected sales volumes, and we anticipate continued strong volumes at the beginning of next year, we have reassessed those targets and will not press actions simply to hit a target. As mentioned, we have made good progress with SIOP, notably in the Americas. We have seen benefits from improved processes, and we still anticipate an inventory reduction at some point in 2023. Another driver of reduced full year free cash flow estimate is related to the delay of cash collection enhancements, including driving more significant advanced payments for large orders. This delay is temporal as we expect to see benefits from these actions in 2023. Nevertheless, fourth quarter free cash flow is expected to be a record quarterly high. $175 million was the previous high, and free cash flow will be an absolute focus for us in 2023. Certainly understanding that margin improvement will not translate into value creation unless we convert that into cash. Next, moving to Page 10. This is a format of a slide we shared back in August to provide transparency with our plan to achieve fourth quarter projections. The main drivers are similar to last time, with the most significant difference being the addition of some very volatile foreign exchange. The macro story is relatively straightforward outside of FX, our fourth quarter lift from third quarter should be driven by volume and price. We discussed the drivers of the volume increase last quarter, including the launch of our Monterrey facility, improving supply chain dynamics and normal favorable fourth quarter seasonality. The volume lift is more pronounced in the Americas and EMEA in the fourth quarter, but APAC is expecting a nice increase as well. Pricing is expected to provide an additional $40 million of operating profit in the fourth quarter with 80% of fourth quarter pricing already in backlog. Now of course, we still have to execute to achieve these strong results, but we certainly have clear line of sight to the fourth quarter performance, which we hope this slide demonstrates. Next, turning to Slide 11. We have very often discussed internally and externally, holding ourselves accountable to the quarterly sales and earnings profile we presented back in February. This slide visually captures what we said in February and how our results line up with that profile. February guidance is depicted with the bars, the blue being adjusted for foreign exchange. Our results, both actual and what we expect for the fourth quarter are depicted with the black line. As you can see, both sales and profitability trajectory profiles are very much consistent with our February guidance with our expected fourth quarter adjusted operating profit, when adjusted for foreign exchange, very consistent with what we said at the beginning of the year. So with that said, I now turn it back over to Dave Cote. Dave?

Hang on. 2.5 years of working remotely, and I still can't remember to hit the unmute button. I said a few things about Gio in my opening remarks, but I'd like to expand on that a bit. Gio is an industry veteran. He's an operator at [indiscernible] and he's been with Vertiv for over 24 years, serving in a variety of operational capacities and really given the terrific background to run a company. He drove significant operational and financial improvements while leading EMEA, tripling the adjusted operating profit in that region to over 18% in a 3-year period ending in '21. And we're seeing the early stages of a turnaround story shaping the Americas, where margin has sequentially been increasing. The SIOP process has been greatly improved. And a focus on creating a high-performing culture is apparent within the organization. He knows a lot about the industry and has a track record of performance in both Europe and the Americas, which together represent about 70% of Vertiv sales. His broad operational background and that success uniquely positioned him to turn Vertiv into a high-performing business. He is the right person to lead this company and at the right time. So I ask Gio to talk a bit about his work on the Americas, the key initiatives underway, and to provide some early thoughts on 2023 that provide an introduction -- a better introduction to all of you of our incoming CEO. So, Gio?

Thank you, Dave. Thanks a lot. I appreciate the kind introduction. I want to assure everyone the transition is well underway, and we expect it to be quite similar actually. That is correct, I'm an operator at [indiscernible]. It is my passion. I'd say it's my natural in many respects. And I think I can add considerable value. I'd like to share some things we've been working on in the Americas. Since March, we have done quite a lot, the full assessment, the transformation plan focused on getting price, ensuring leadership accountability, strengthening communication processes, operational excellence, systems and certainly fostering a strong sense of urgency. We have improved the SIOP process, have simplified the organization to focus on accountability and speed. We're driving the Americas regions towards a high-performance culture. Still in the early stages, but I'm encouraged by the sequential improvements we are experiencing. Let's turn to Slide 13. As I think about 2023, focus areas are clear and consistent with what we have been working on, margin improvement, price and cost, free cash flow generation, working capital improvements and profitable growth. We know the levers to achieve these objectives. We will have operational teams focused and accountable to meeting that. We will do so with a keen sense of urgency and rigor. Slide 14, please. And this slide shows some of our early thoughts on 2023. As you can see, visually, you should have more tailwinds than headwinds. Our backlog and order pace support healthy top line for 2023. End market demand is strong. We know how to get price. Additionally, we have some moderation of commodity and trade costs, and this year fixed cost will be held constant. Cash will be helped by overall improved profitability, but also from unlocking significant working capital opportunities. These objectives are well within reach. There will also be some headwinds, certain categories of electronics as Rob say, remain tight, and there will be inflationary pressure as it relates to energy costs in EMEA, as an example. That will not only impact us, but also impact our suppliers. FX remains volatile. There has been much discussion on potential recession. We don't expect it should have a big impact on our sales, but we are taking steps right now, for example, to restrict external hiring in anticipation. We believe that at the same time, sorry. But I like the view from here we can navigate these uncertainties, because we participate in a very -- in very good end markets. We are market and technology leaders. We have global scale. We have tremendous installed base, and we are very relevant with the key customers in our markets. We have a sharp focus on operational execution and excellence. We believe 2023 can be a very good year for Vertiv and Vertiv's shareholders. And candidly, as you may have picked up on this already in the last few minutes, I truly love this business and I indeed, I love the company profoundly. I'm very excited about Vertiv's future. And you can tell I have a lot of passion, sometimes my passion takes over, and I tend to overelaborate on things. Hey, my Italian heritage must mean something indeed. So please bear with me. Work item and the upcoming Q&A, certainly an opportunity to prove myself. But before that, I want to wholeheartedly thank Rob for all he has done for Vertiv in the last 6 years. It was a lot of heavy lifting to do as we became a Vertiv, a stand-alone company 6 years ago. Rob took what was almost a $4 billion start-up and transformed it into a growth company. We are the partner of choice of our customers, and we are very relevant across the entire market space. This happened thanks to Rob's leadership. We are grateful. So big thank you. Big thank you, Rob. With that, we will now turn the call over to the operator, who will open the line for questions. Thank you very much.

[Operator Instructions] The first question today comes from the line of Andy Kaplowitz from Citigroup.

Congratulations, Gio. Good luck to you, Rob. Maybe this one is for you, Gio. I know it's early in your tenure in the Americas, but maybe you could give us a little more color into what has been the low-hanging fruit that you've been able to consume in the Americas to help boost margin over the last couple of quarters? And what do you think is going to be more difficult to change and/or could take longer to change within the Americas organization versus your original expectations?

I would point to 3 things here, Andy. Certainly, a lot of focus on the pricing muscle that we reinforced dramatically. And I think we start to see the results. A lot of focus, as I said, on making sure that there is accountability and accountability happens also through very strong governance and a very consistent way of running the region operationally. One thing that we have done, and we've been vocal about is, a return to office by which we make sure that everyone cooperate and stays focused on delivering on our objectives. And it's a part of a cultural transformation towards making this truly a high-performance culture, not just the Americas, because entire plan is that has started to deliver the dividends, I believe. But then we can elaborate on other elements that are the improvements of capacity, opening the Monterrey factory being probably the most visible example, but think about a broader capacity enhancement effort that has gone through across the entire business. The job we have done on reinforcing processes. And I always like to mention and also Dave did talk about the SIOP, the sales inventory operations planning that is really the end-to-end glue that connects our ability to deliver to the ability of telling the customer -- sorry, the suppliers, what we will need in the future, all the more reasons crucial in times in which supply chain is complicated. I would add to the equation, the strong effort that we've been doing is, as we benefiting still doing to multisource critical components, all elements that have contributed is an orchestration. There's no one kind of a -- 1 super bullet here.

Very helpful, Gio. And then maybe just stepping back, can you give us more color into the market environment you guys are seeing? There obviously are a couple more yellows in the Americas now in terms of the markets you highlighted. Have you seen any deferrals in orders within your core Enterprise end markets? And could you elaborate on the stability of CapEx from Enterprise and Communications customers, particularly in the Americas? And what gives you confidence that cloud and colocation customers will stay green moving forward?

Yes. I would say that order cancellation is absolutely within the norm, what we -- within the norm or normal business cycle. So there, I'd say de minimis. What we have -- what we continue to see and have evidence, not just from our order intake, but also from the multiple conversations that we're having with all the relevant and large hyperscale and colo players, that Rob and I are doing also as part of the handover process, is that demand is there, and demand continues to be robust. On the Enterprise side, we just want to be a little bit more signal with some caution, but it's not for kind of an evidence of weakening of the signal. It's just that probably the macroeconomic environment might signal was a bit more prudent. But I remain quite positive about the strength of the market in the Americas going forward.

So Gio for Enterprise, it's not so much what you're seeing, but just prudent caution moving forward. Is that fair?

That's fair. That's absolutely fair. That's fair, Andy.

The next question today comes from the line of Steve Tusa from JPMorgan.

Congratulations. Can you just give us a little bit of color as kind of snapping the line today and looking at what price you have in backlog and where commodities stand? What -- how much of that bridge to next year is -- reflects kind of what's prevailing today from that perspective, price cost-wise? Just math.

Yes. Yes. Good question, Steve. This is David. I used to had to say this is David, because they would confuse Gary and my voice. I don't think they'll do that with Giordano. But -- so when you look at the progression of price through 2022, we consistently said we had to burn through the backlog that was included in pricing or the pricing that was in backlog at the end of '21. So I think 80% of our sales in the first quarter of this year, was in backlog at the end of '21. In the fourth quarter, only 20% of our sales will be in backlog from 2021. And as a result, you can see the significant increase in ramp-up of pricing during the year. So I think we had $40 million in Q1, and we'll have $135 million of year-over-year pricing in Q4. I don't want to say we've reached a level of stability with pricing, but certainly, as it translates into profitability in the P&L, the fourth quarter will really be that first quarter where we can demonstrate what we can do as it relates to pricing at the level that arguably, we probably should have been pricing at. So if you look at the wraparound impact for 2023 from pricing, and this just assumes that we keep the same pricing levels exiting Q4 into 2023, it's about $150 million to $200 million. We would expect to do better than that, because we continue with our pricing efforts. As it relates to inflation for next year, it's probably too soon. We certainly think there will be a year-over-year gross headwind from inflation. But from just about any perspective, we certainly would expect to be price cost positive next year, but probably too early to quantify what we think the impact will be for inflation.

So then I guess that's kind of like if we assume no inflation, that's part of the way there. I think there's a bit more of a gap you have to bridge. I mean, what are you assuming volume growth? Or are you like -- are there one-timers that reverse out of this year? Like, maybe just a bit more color on the bridge or any other items?

Yes. Probably too early to add a whole lot of detail to 2023. I know we put that $730 million to $750 million number out there at -- in August, and we reconfirm that. But as it relates to kind of filling in the details, it's probably too soon. And we'll provide a more robust bridge from '22 to '23 in February.

The next question today comes from the line of Jeff Sprague from Vertical Research Partners.

Maybe back to Gio. Gio, with the long history at Emerson and then through Platinum ownership and the like, obviously, you've seen a lot of ups and downs and kind of some turmoil in this business. I think you partially answered my question to your response to Andy, but just kind of stepping back, big picture. What holistically do you want to drive going forward? And do you have a comfort level with this kind of a longer-range forecast of this being upwards of a 20% margin business on an annualized basis going forward?

Well, clearly, I have confidence in what we have shared, and thank you for the question. The -- as -- and all time -- a long time, let me say, because I've seen the company evolve over time. And I would say this company that has still a big potential to -- a big potential to operate in a more effective way. Again, the focus areas as I was mentioning, really around operational execution, continued margin expansion. We have work to do as we're saying on working capital and very, very central is our cultural evolution towards the high-performance culture. Again, I've worked in many parts of the organization. So not only under a different brand, if you will, but also in multiple roles. So I believe I have an ability to lead the organization that is pretty advantages, let me say. And again, no magic wands, no silver bullet, it's a lot of focus on operational execution, on -- focusing on the things that matter to drive cash and to drive profitability. But again, it's enabling that with a cultural enhancement that we have started to drive.

And then on execution as David Fallon so appropriately said, you still actually have to deliver the guide. But can you give us a little bit more perspective on how much of the guide is in your hands as opposed just kind of executing on backlog versus real question marks about supply availability, maybe question mark still about Monterrey being able to fully wrap up -- ramp up, I don't know if you feel it, that's 100% where you need it to be. But if you were to come up short here in Q4, where would it likely be in your opinion?

Yes, Jeff, this is David. And there's still a ton of variables, and it's not only variables from a macro perspective, but within region. I think what we have said consistently over the last 2 or 3 quarters is that our issue is not a demand issue. The backlog is there. We have the orders. Probably the biggest risk is related to supply. And even though a lot of that supply has cleared up, notably with electronic components based on things we have done proactively, including qualifying new suppliers. And we talked a lot about the fan suppliers, but there still is a lot of volatility out there. And for a lot of these components, it's day-to-day, week-to-week. So we have better visibility than we had 60, 90 days ago. But I would still say there's risk as it relates to production and shipment. It's not necessarily a demand issue, I think we talked about fairly consistently.

Correct. And your question specifically on Monterrey, we are happy about the way the plan is unfolding. We have a great team, and the team are delivering on our plan. But again, as Dave was saying, it's the challenges around components, just exactly as said by him.

The next question today comes from the line of Scott Davis from Melius Research.

When you guys talk about adding new suppliers and like specking out new suppliers, it sounds inherently inflationary. I mean, you lose some scale, I suppose, with that supplier. How material is that when you think about your kind of bill of goods?

I would say that there is a counterargument to that. When you add supplier, you add bargaining power at the same time. So it is more than we see the 2 things that are pretty much offset.

Okay. That's surprising and good, positive. The follow-on question is just on the stickiness of price increases. Are there situations where if raw material costs go down, et cetera, you are mandated to give back some of that price when we get into '23?

Yes, Scott, this is David. In some cases, yes. So we've included material cost escalation clauses in some of our master sales agreements. And -- but there are bands included in those. So it's not dollar for dollar, penny for penny, they have to expand either upwards or downwards outside of that band. And to some extent, there will be some pricing impact, but we don't consider that a significant risk heading into 2023.

The next question today comes from the line of Amit Daryanani from Evercore.

I have 2 as well. Maybe to start with on free cash flow. Is the way to think about how much excess working capital inventory you think you're carrying right now? And do you expect all of that to sort of convert into free cash flow in '23, or would be a much more elongated time frame for higher free cash flow and more working capital optimization? So let's just understand, how much extra inventory do you have? And how does that normalization looks like through '23?

Yes. I'll start, Amit. So maybe I'd start with some facts. So our inventory level at the end of 2020 was about $450 million. We expect, at least on a GAAP basis, our inventory level at the end of this year will be around $765 million. So that's a $300 million increase in inventory, and that includes some foreign exchange benefit. So very clearly, inventory has increased each of the past 2 years. And very clearly at a level that is, as you say, in excess of what we need to run the business, we believe, on a go-forward basis. Now there are some contributory factors. Certainly, volume is significantly higher than it was when we exit 2020. And the supply chain has created many issues, not only for us, but many, many industrial companies out there. So it's hard at this point and probably premature to quantify what we think that benefit is, but it's something certainly we've been working on during the year. We could have probably taken that inventory level down a little bit lower at an exit point in 2022, but based on the significant volumes that we have to deliver this year and we anticipate heading into next year, we thought it prudent to not be overly aggressive. But with that said, because of the SIOP improvements, because some of the things we're doing with supply chain, we do believe there would be an inventory reduction at some point in 2023.

Got it. And then if I could just follow-up. If I look at the midpoint that you guided for December sort of the 2022 numbers, I think there's about $300 million of material and freight inflation that helped kind of a headwind, right? If you want to think about how much is material versus freight explicitly? And is it fair to assume that the freight cost has given what's happening in the world should start to trend lower and that at least would be nice tailwind in '23?

Yes. So I think for the full year, our material and freight inflation number's $305 million. I think that's what you're referring to. About 80% of that is material and 20% is freight. And we include both spot buys and the material inflation and premium freight in the freight number. And we, too, are seeing some of the favorable benefits of freight rates. I would say 90% of what we do is on contract as opposed to spot. So we won't see the benefit immediately, but we also have adjustment clauses in those contracts, which should favorably benefit us over time. And we would say certainly at the beginning of 2023.

The next question today comes from the line of Nicole DeBlase from Deutsche Bank.

I could just -- I'd like to just ask a modeling question, since you've been through a lot of the higher-level stuff. So I think it was -- Rob went through the -- sorry, I think it was Dave that went through the Americas margin outlook for 4Q. But -- what about Asia Pac and EMEA, like how much improvement are you guys expecting to see in the fourth quarter? And also any color on how organic growth stacks up by region, would be helpful as well.

Yes. So I think in the last presentation, we spelled out full year expectations by quarter for adjusted operating margin by region. We did not include that in this quarter, and we knew somebody would ask about it. So we have the numbers ready. Yes. So Americas, we're targeting about 20%. That's about 400 basis point lift from Q3. EMEA, and this is based on the expectation of being price cost positive in Q4, and also the benefit of volume leverage, we anticipate adjusted operating profit in EMEA to be in the mid-20s. So call it, 24%, 25%. So down from what we had previously disclosed because of the additional inflation that we talked about, but still, a significant increase from what we saw in Q3 and a very significant increase from what we saw in Q4 of last year. And APAC, we would anticipate being relatively flat in Q4 versus Q3.

Okay. And just anything on organic growth by the 3 regions as well, like, if there's a big divergence?

Yes. So I think organic growth for total Vertiv in Q4 would be 25%. And you got to take a step back and realize you're saying 25%. That's a big number. There is some divergence across the regions. I would say, certainly highest in the Americas, and that could be 30% to 40% increase driven by both volume and price. EMEA year-over-year is probably in the mid-20s. And I would say, APAC is probably up about 10%.

Okay. That's helpful. And just on the order backlog, how far out are you guys booking now? Are you like a long way into filling up 2023? Are you accepting orders for 2024? Just curious on lead times at this point.

Yes. Nicole, this is Gio. The majority of our orders now are 2023 and in particular, on the first -- on the first half of 2023. We have some second half 2023. And the -- beyond 2023 is just a minor -- it's just a minor part of our backlog today.

The next question today comes from the line of Mark Delaney from Goldman Sachs.

Rob, I appreciate all your help. Best wishes and Gio, congrats on the new responsibilities. First question is on the 2023 outlook. If there is a mild to moderate recession in at least parts of the world, do you think that kind of EBIT level you're guiding for is achievable?

Our goal would be to maintain profitability regardless of what happened to the top line. Our industry is certainly different than others. No one's recession-proof, but based on the size of our backlog heading into next year. And we certainly don't think the recession impact on use of data and building data centers is certainly going to be perfectly correlated for next year. So even in a recession, we feel pretty good about our top line. But if there are headwinds with the top line that roll through variable contribution margins, we'll take the necessary steps from a fixed cost basis to offset it. And our goal would be to maintain that $730 million to $750 million adjusted operating profit outlook regardless of any impact from the recession.

My follow-up question is on E&I. If memory serves me correctly, originally, that was tracking to something like $0.10 at the time of acquisition. I believe the slides, it ended up as a $0.02 contributor to EPS for this year. That's the latest assumption for full year EPS contribution from E&I. The question has something fundamentally changed around E&I compared to when you did the transaction? Or is this the same type of supply chain and some of these price cost issues that broader Vertiv investment you are dealing with, and over time, we should still be thinking of the same sort of longer-term benefits from the E&I acquisition?

Yes. Thanks, Mark. I would say from a strategic perspective, we're more excited about E&I and the positive contributions to Vertiv today than we were at the time of the acquisition. And part of the value equation there was based on revenue synergies. And I would say, our expectation for revenue synergies are probably 3x, if not more, what we had initially anticipated. Now unfortunately, that's not showing up in the numbers this year. So my depiction of E&I, probably rather crudely is a bad year, great acquisition. A lot of the issues that E&I is seeing from a profitability perspective this year are identical with what we have seen with Vertiv. So if you look at the operating profit margin profile quarter-over-quarter this year, I think it started at low teens in Q1, maybe 14%, and it should exit the year closer to 20%. And the story is similar. Inflation hit with a pretty good-sized backlog at the end of last year, and we were just a little bit slow in getting price. And if you look at the price we get in the fourth quarter, that's what really increases the margin from that low teens to 20%. So I would say, we are more excited today than we were at the time of the acquisition, and sometimes we get asked with if you had to do it all over again, would you still do the deal. And the answer is a very profound robust, absolutely.

Yes, 100% for this deal, 100%. I think it's strategically made sense and all the more reasons it makes a ton of sense, ton of sense now. So we're very, very happy about the decision made back then.

The next question today comes from the line of Lance Vitanza from Cowen.

The first is just to confirm regarding the new fan supplier, it sounds like that's really no longer perspective. You are receiving fans in volume; you're assembling them into products. Is that right? And have you shipped product with the new fans inside yet? Or does that begin later in the quarter or perhaps early in 2023?

We have -- Vitanza, this is Gio. We have absolutely started -- and that and other actions we've taken on the fan supply side of the equation are greatly improving our ability to deliver on the numbers. But the answer is yes, it has happened. Not only it is happening. It has happened.

Okay. And then definitely, you called out that some supply chain easing, which is, of course, good news. On the other hand, the semiconductors still remain tight through the first half of 2023. So my question is, do you see that tightness in semiconductors? Do you see that putting pressure on 2023 revenue? Or is that just putting pressure on the margins in AOP and so forth? And then if there's any sort of sense for what you think that AOP number could have been if it weren't for the tightness in the semiconductors? I would appreciate hearing your thoughts there, too.

Well, let me answer operationally here. So we have been dealing with a tight supply market when it comes to everything, IGBT, that type of semiconductor. And as I've said, we expect that to continue. So we will -- and we have been taking precautionary measures as well in terms of qualifying new suppliers. So we factor the challenges in our plans. And I don't know, David, if you want to add anything.

No. It would be really tough to quantify what the impact is. I mean, certainly greater than 0. And we're not talking tens of millions, right? So you see the size of our backlog, it continues to grow. And we think, we see the benefit of some of the very proactive actions we've taken during the year to address the issue. We see that in the fourth quarter. But you can't go back in time and fix the situation in Q2 and Q3. So it's in the hundreds of millions, if you look at lost revenue earlier in the year. That's kind of a ballpark. There's a lot of -- that's a multivariable equation, but suffice it to say, it has been very significant.

Our final question today comes from the line of Andrew Obin from Bank of America.

Congratulations and Gio, great meeting you. Just a question, there were headlines about an activist. If you could just sort of talk to us about what kind of conversations you've had with the activist? Any update or color you can provide to us?

Yes. It took the last question, Andrew. So good question. And we don't want to necessarily elaborate too much. The folks at this call, certainly on third quarter earnings. But I would say, we're actually very excited to welcome a new shareholder, a very large shareholder. A shareholder, who certainly, as they communicated their investment thesis, very consistent with our management thesis. And that is as a company operating in a great industry like we do, with the continued operational improvements and some of the things that Gio mentioned with a focus on developing a high-performance culture. There's considerable, considerable value here to unlock and it's all the things we've been saying over the last year or so. Their investment doesn't change our strategy or our priorities. Our interests are aligned, just like with any other shareholder. And as we execute and perform going forward, our interests certainly will continue to be aligned.

Terrific answer. And just a follow-up question. Just going forward, how do you think about the trade-off between increasing R&D investment and keeping your commitment to keeping fixed cost constant?

Well, that's clearly a constant trade-off that we are addressing day in, day out. And running every business is an exercise of allocation of scarce resource. And we are no exception. And we see a lot of value and innovation as we've been kept saying during the course of at least the last 2 years. So it is really a matter of allocation of priorities towards innovation. But also go back to what I was saying at the beginning around operational execution, operational execution for us means a lot of opportunity for efficiency. And the efficiency is assured, you can look at our efficiency as a source of funding for innovation, loosely.

This concludes our question-and-answer session. I would like to turn the conference back over to Rob Johnson for any closing remarks.

Thank you very much, and thank you, everyone, for your time today. As this is my last earnings call, as CEO of Vertiv, I want to take the opportunity to acknowledge and thank a few people. And I'd like to start with Platinum Equity for creating this opportunity and believing in me and supporting us through the turnaround of this great company. I certainly want to thank our customers. I know we've cost pain over the last year, but we're working through that and thank you for sticking with us and sticking loyal to our brand. The employees for all the work you've done and all the work you're going to have to do going forward. We've got a great '23 to look forward to. So I want to thank the employees, the Board of Directors with a special thanks to Dave Cote for the support and the mentoring and coaching. And of course, I want to thank all the shareowners for their support in Vertiv now and going forward. It's been an honor serving as CEO, and I'm more confident now than ever. The future of Vertiv and its ability to create long-term value for the stakeholders is the brightest days are ahead, and you're in great hands with Giordano as we go forward. So again, thank you for the opportunity to serve you.

The conference call has now concluded. Thank you for attending today's presentation. You may now disconnect.