Regal Rexnord Q3 2023 Earnings Call Transcript

Quartr
Provided by Quartr
November 2, 2023

There are 9 speakers on the call.

Operator

Good morning, and welcome to the Regal Rexnord Third Quarter 2023 Earnings Call. All participants will be in listen only mode. After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I I'd like now to turn the conference over to Robert Barry, Vice President, Investor Relations.

Operator

Please go ahead.

Speaker 1

Great. Thank you, Alan. Good morning and welcome to Regal Rexnord's Q3 2023 earnings conference call. Joining me today are Lewis Pinkham, our Chief Executive Officer And Rob Rehard, our Chief Financial Officer. I'd like to remind you that during today's call, you may hear forward looking statements related to our future financial results, Our actual results may differ materially from those projected or implied due to a variety of factors, which we describe in greater detail in today's press release and in our reports filed with the SEC, which are available on the regoraxnor.com website.

Speaker 1

On Slide 3, we state that we are presenting certain non GAAP financial measures that we believe are useful to our investors and have included reconciliations between the non GAAP financial information and the GAAP equivalent in the press release and in the presentation materials. Turning to Slide 4, let me briefly review the agenda for today's call. Louis will lead off with his opening comments and an overview of our 3Q performance. Rob Rehorde will then provide our Q3 financial results in more detail and provide an update to our guidance. We'll then move to Q and A, after which Lewis will have some closing remarks.

Speaker 1

And with that, I'll turn the call over to Lewis.

Speaker 2

Great. Thanks, Rob, and good morning, everyone. Thanks for joining us to discuss our Q3 earnings, to get an update on our business and for your continued interest in Regal Rexnord. Our Q3 can be characterized by strong controllable execution against an end market backdrop that became weaker than we in the quarter, causing us to fall short of our sales and earning expectations for the quarter and for the year. Our strong execution is most evident in our cash flow performance.

Speaker 2

We generated 100 and $52,000,000 of free cash flow in the quarter, keeping us firmly on track to hit our target of at least $650,000,000 For 2023, even with the lower sales and EBITDA expectations. What we generated in Q3 Plus some cash on hand allowed us to pay down $185,000,000 of debt, Which is further lowering our interest expense forecast. Our team also delivered roughly flat Adjusted EBITDA margins down 10 basis points versus prior year on a pro form a basis As our top line fell by 8.5% on a pro form a organic basis, implying a deleverage rate of 22%. We also made significant progress Balancing the portfolio towards our most profitable growth opportunities by reaching an agreement to sell Our Industrial Motors and Generators businesses for cash proceeds of $400,000,000 which is on track to close in the first half of 2024. Adjusting for this sale, our enterprise gross and EBITDA margin should rise We should be able to accelerate our balance sheet deleveraging.

Speaker 2

At the same time, we believe our Associates in these businesses will benefit by joining an organization that is more aligned with a growth strategy in Global Industrial Motors and Generators, which should allow them to excel in the future. We have clearly transformed our portfolio With gross margins 4 years ago in the mid-20s to achieving mid 30s gross margins today and a clear path to 40% gross margins, which will be helped by the industrial sale. As much as I am pleased with our Controllable execution in the Q3, I am disappointed that our financial performance is falling short of prior expectations, A dynamic largely explained by weaker end markets. Our sales in 3rd quarter were up 24 point 5% all in, but down 8.5% on a pro form a organic basis. 4 of our top 5 end markets representing roughly 50% of our sales were weaker than expected.

Speaker 2

This weakness was also apparent in our order rates, which on a daily pro form a basis were down 10% in the quarter. We did face a fairly challenging 24% 2 year stack to compare on orders, But performance was below our expected mid single digit decline. Normalizing global supply chains continued to impact orders, but a more cautious channel And in some cases, weaker end user demand were also factors. Our orders and sales performance resulted in a quarter end backlog that remains above our normal levels In IPS and AMC, with PES levels now close to what we would consider normal. Book bill was 0.94 in the quarter.

Speaker 2

In October, we did Start to see early signs of improvement in our order rates, particularly in IPS, Which saw modest year over year growth and sequential growth in PES and AMC. This makes us cautiously optimistic that we may be approaching an inflection point. Though an improvement versus what we saw in the Q3, our current guidance assumes 4th quarter orders Our flattish to slightly down versus prior year. Despite third quarter top line pressures, Margins in the quarter were strong. Our adjusted gross margins came in at 34%.

Speaker 2

The 3rd quarter adjusted EBITDA margin was 20.6%, down 10 basis points versus the prior year on a pro form a basis. 2 of our segments also achieved nice year over year adjusted EBITDA margin expansion. PES was up 3 10 basis points to 19.7 percent and pro form a margins at AMC rose 100 and 30 basis points to 24%. Drivers include price cost, Improved operational efficiencies, various eightytwenty initiatives and disciplined cost management by our teams. Where we struggled in the quarter was IPS, which saw margins fall 3.30 basis points versus prior year.

Speaker 2

The principal driver was mix pressure, much of it tied to short cycle weakness in the higher margin aftermarket channel. But another factor also emerged during the quarter, which relates to PMC footprint synergy realization. Those who have followed us for some time know that we like to set ambitious operational targets And then work with discipline and urgency to achieve them. I think our track record on margins in particular Demonstrates our ability to execute in this manner. However, during the quarter, we decided to incur higher cost To minimize customer disruptions related to our footprint actions.

Speaker 2

This decision is resulting in some temporary pressure But to be clear, there is no change to the permanent reductions to our cost structure that our PMC or for that matter, our Ultra footprint synergy actions are expected to bring. Rob will elaborate on this topic a bit further in discussing segment performance and our updated outlook. However, in total, I am pleased with our team's performance in the quarter, and I want to thank all of our associates For their disciplined execution in a tougher end market environment and for their hard work and dedication to making Regal Rexnord Stronger every day. Shifting focus, you may recall that each A couple of minutes discussing aerospace and defense. Our A and D division, which grew 27% in Q3, sells highly engineered components used in commercial aerospace, air and land based defense, helicopter and space exploration applications.

Speaker 2

These markets are positioned to benefit from strong secular growth tailwinds tied to making air travel more sustainable To countries addressing rising geopolitical risk and to our OEM customers prioritizing suppliers With lower risk supply chains. In the realm of aircraft sustainability, we see greater electrification of Commercial and military aircraft, the introduction of alternative fuels and increased use of hybrid propulsion systems. As global geopolitical tensions rise, countries are enhancing their domestic defense capabilities, which is driving demand for our defense products. And in the wake of recent periods of global supply chain disruption, Customers are shifting their business to supplier partners with better managed, lower risk supply chains. All of these trends play to Regal Restonard's strength.

Speaker 2

We have been making meaningful investments In R and D, in engineering and in talent to significantly raise our new product vitality and production capacity and thereby ensure we are well positioned to continue addressing our customers' needs effectively. I am pleased to share that we have solid momentum. As you can see on this slide, our Aerospace Business sales are tracking up 20% in 2023 and roughly 1 quarter of this growth Reflects outgrowth tied to the new product investments the business has been making. Through the combination of our legacy Regal Aerospace Business with that of Rexnord PMC and now Altra's Aerospace Businesses, We have a more comprehensive product portfolio and a scalable global platform and footprint To expand from selling components to also providing vertically integrated electromechanical motion control solutions. Today, after only a couple of quarters since the transaction closed, the combined Regal Rexnord A and D businesses have a robust funnel of Synergistic bid opportunities.

Speaker 2

When it comes to our ability to provide differentiated service levels to our customers, Our manufacturing footprint and supply chain are increasingly a competitive advantage at a time when Such reliability is critically relevant to customers. To this end, we recently completed construction State of the art manufacturing facility in Chihuahua, Mexico. We're tapping into highly skilled local labor pools In a region that has become an aerospace center of excellence for many of our customers, expanding our capacity to address rising Demand while improving our service levels and increasing the value we can offer to our customers. I should add, the facility also incorporates a range of state of the art energy and water efficiency features in its design, Supporting our commitment to be good corporate stewards of the environment. So when we step back Connect the dots on the power of our A and D portfolio, differentiated, highly engineered products, Deep domain expertise, long standing customer relationships and opportunities to leverage The combined capability of Regal Rexnord's total portfolio, we see a business position for strong outgrowth into the foreseeable future.

Speaker 2

And with that, I will now turn the call over to Rob to take you through our 3rd Quarter segment financial performance and discuss our latest guidance.

Speaker 3

Thanks, Louis, and good morning, everyone. I'll also begin by thanking our global team for their hard work and disciplined execution at a time when we are facing challenging end market headwinds. Now, let's review our segment operating performance. Starting with Automation And Motion Control or AMC, organic sales in the 3rd quarter, pro form a for the Altra acquisition were roughly flat to the prior year, reflecting strength in the data center, aerospace and medical markets tempered by weakness in general industrial and global factory automation, particularly the short cycle booking ship business. I will also point out that year to date organic sales growth for the AMC Segment is up 5.1% on a pro form a basis.

Speaker 3

Adjusted EBITDA margin in the quarter was 24%, in line with our expectation and up 130 basis points versus the prior year on a pro form a basis. The margin performance reflects pockets of strength in mix positive markets such as data center, aerospace and medical, along with favorable price costs, strong operational synergy realization and discretionary cost management. Orders in AMC on a pro form a organic basis were down roughly 20% in the 3rd quarter on a daily basis with book to bill at 0.86. We expected orders to decline in the quarter versus prior year as supply chains lead times and inventory levels Normalize. However, order intake was lighter than expected in our book ship business as more cautious general industrial end markets Pushed out inventory replenishment orders.

Speaker 3

This was most pronounced in our businesses with factory automation exposure where blanket orders and inventory buildup Had been more significant. In October, book to bill tracked at roughly 1.1, which we are pleased by, But the order mix is still weighted more towards new projects with longer shipment dates versus in quarter book in turn. For perspective, AMC's 3rd quarter order decline is against a 2 year stack just above 40% And this segment's backlog at the end of the 3rd quarter remains the most elevated of all our segments, roughly 50% above normal. While this level of backlog gives us optimism, it's longer cycle waiting will likely benefit AMC in 2024. In fact, dynamic of weak short cycle orders, mainly in automation exposed businesses versus stronger Long cycle orders and backlog in automation, aero, medical and data center was a key driver of AMC's flat third quarter sales.

Speaker 3

We expect this dynamic largely to continue in Q4 as well before starting to improve in early 2024. Turning to Industrial Powertrain Solutions or IPS. Pro form a organic sales in the 3rd quarter were down 3.7% versus the prior year. Growth in the quarter mainly reflects weakness In the Global Industrial and Ag Markets, partially offset by strength in Energy along with Metals and Mining. In particular, our book shipped business was down more in the 3rd quarter than anticipated, which was driven mostly by destocking.

Speaker 3

Adjusted EBITDA margin in the quarter for IPS was 21.7%, below our expectations due to weaker mix and volumes, net of Favorable price cost and synergies. Mix in particular came in much weaker than our original expectations and presented a significant headwind to The weakness in short cycle industrial has a disproportionately large impact on our Standard products, which are often sold through distribution intend to carry well above average margins. At the same time, some of the IPS markets seen strong growth, such as metals and mining, tend to drive demand For certain low mix products, the good news is that the channel for standard product is destocking and when it rebounds Order to incur higher costs in IPS aimed at maintaining quality and service levels for our customers during a period of peak manufacturing Footprint actions related to our P and C merger synergies. We are currently in the process of rationalizing Manufacturing Facilities. And during the quarter, we encountered lower than anticipated labor productivity in the catch plants, That is at the site into which we are consolidating production lines.

Speaker 3

We estimate these higher customer service Assurance costs are impacting IPS by approximately $16,000,000 in the second half of this year, weighted roughly sixty-forty between the 3rd Q4. While these costs are masking some of the synergy benefits, They are temporary and in no way impact the permanent level of synergy savings that we ultimately expect to realize from the PMC and Altra transactions. Pro form a organic orders in IPS were down 4% in the 3rd quarter On a daily basis and book to bill was just above 1.0. In October, book to bill once again tracked at 1.0 and orders were up low single digits. For perspective, IPS' 3rd quarter order decline Is against a 2 year stack of nearly 30% and the segment's backlog at the end of the 3rd quarter remains well above normal.

Speaker 3

Turning to Power Efficiency Solutions or PES. Organic sales in the 3rd quarter were down 19.1% from the prior year. The decline was driven by significant channel destocking activity And weaker demand in the North America residential HVAC market, weakness in China and Europe and destock pressure in the U. S. General commercial market.

Speaker 3

These destock pressures were anticipated and PES' sales performance is directionally consistent, albeit modestly more severe versus the expectations we outlined On our last earnings call. The good news is that we now believe destocking in residential AC is mostly behind us. Although as the heating season begins, we believe there is still likely still too much furnace inventory in the channel. The adjusted EBITDA margin in the quarter for PES was 19.7%, up 3 10 basis points versus the prior year period and modestly ahead of our expectation. Key contributors to the PES margin performance were favorable price cost, improved operational efficiency, Lower freight and favorable mix, partially offset by lower volumes.

Speaker 3

We also continue to selectively deploy eightytwenty across the business to move away from lower margin Quad 4 business and focus on growing our Quad 1 business to better serve our most valued customers. Overall, strong margin performance despite sizable top line headwinds achieved through disciplined execution by our PES team. Shifting to orders. Orders in PES for the Q3 were down 9% on a daily basis. Book to bill In the Q3 was 1.0 and tracked at 0.97 in October.

Speaker 3

On the following slide, we highlight some additional financial updates for your reference. Notably, on the right side of this page, You'll see we ended the quarter with total debt of $6,500,000,000 down $185,000,000 And net debt of $5,900,000,000 down $124,000,000 versus the end of the second quarter. Net debt to adjusted EBITDA is 3.86 and our interest coverage ratio is 3.24 times. Free cash flow in the quarter was very strong, coming in at $161,500,000 up from $111,100,000 in the prior The teams continue to do a great job improving free cash flow performance aided by improving working capital And in particular, by lowering inventories, where we continue to see lots of additional opportunity. Moving to the outlook.

Speaker 3

I'd like to start by providing an update on how our Principal end markets are tracking versus our expectations earlier this year. The table on this slide shows our end markets, The percent of our sales each represents from largest to smallest and in the 3rd column, our growth expectation for each end market as of the first quarter, which also guided our 2nd quarter expectations. The 4th column indicates how the market was tracking as of the 3rd quarter indicated as stronger, Weaker or as expected versus our prior expectation. You can see that 4 of our top 5 end markets, Specifically, general industrial, consumer, food and beverage and commercial are tracking weaker versus our prior expectation. The 4th of the top 5 non residential construction is tracking largely as expected.

Speaker 3

These end market Developments are the reason we now expect 2023 organic sales to be down roughly 6% on a pro form a basis versus 2022 and versus our prior expectation of being down slightly. Finally, in the last column to the right, We are providing an early look on how we are thinking about end market growth rates in 2024, which we will update again when we report Q4 and provide our complete 2024 outlook. You can see that we expect generally more favorable end market conditions next year. A few things in this call that I would highlight. The consumer market, which largely reflects our residential HVAC business, Move from red to green, implying an inflection to lowtomidsingledigitgrowth.

Speaker 3

The non res construction market, which Largely reflects our commercial HVAC business is forecast to be flat to slightly up. The significant declines we're experiencing this year in food and beverage are expected to subside. The commercial market, which was expected to be flattish in 2023, but has been much weaker mostly due to destocking is expected to slightly improve in 2024. And finally, we expect to see continued healthy end market Growth in a number of our secular markets, including aerospace, medical, alternative energy and data center. As you can see on this slide, we are revising our guidance for adjusted earnings per share to a range of $9.05 to $9.25 versus a prior range of $10.20 to $10.60 The change primarily reflects weaker end markets as outlined on the prior slide, mix and to a lesser The decisions we made to minimize customer impacts as we move through the peak period of PMC Synergy related footprint moves in IPS.

Speaker 3

Revenue for 2023 is now expected to be approximately $6,250,000,000 versus $6,500,000,000 previously. On a pro form a basis, 2023 revenue is expected to be approximately $6,700,000,000 roughly 22% previously or equivalent to the pro form a 2022 adjusted EBITDA margin despite the top line pressures we are seeing. This represents an approximately 8% reduction on an EBITDA dollar basis, a smaller Lastly, we are reiterating our expectation for generating at least $650,000,000 of free cash flow this year, despite the reduction in EBITDA guidance. As a reminder, our capital deployment will remain heavily weighted to debt reduction. Finally, at the bottom of this slide, we present our standard below the line modeling items, some of which have changed slightly since our last update.

Speaker 3

On this slide, we provide more specific expectations For our Q4 performance by segment to make it easier for the investment community to understand our near term financial expectations for the business. While we do not plan to provide this level of detail going forward, we thought it would be useful given the newness of the resegmentation along with the segment specific headwinds we experienced in the Q3. Notably, we assume revenues for the enterprise are down slightly versus 3rd quarter, mainly as we continue to experience headwinds in short cycle industrial, in factory automation and in China and Europe, partially offset by strength in data center, aerospace, medical and energy, along with metals and mining markets. We expect adjusted EBITDA margins to be up modestly versus Q3 aided by line of sight in our backlog to modestly improve mix, Improved plan efficiencies, cost actions implemented late in Q3 in response to weaker end markets And lower customer service assurance costs in IPS versus in Q3. In summary, We are disappointed to be lowering our guidance, but we are pleased with the way our teams are managing what is under their control, in particular around cash flow and P and L deleverage rates.

Speaker 3

As we look ahead to the next couple of years, we remain motivated By the tremendous opportunities for value creation before us, from delevering the balance sheet to progressing to approximately 40% gross margins And 25% adjusted EBITDA margins into working the many strategies underway to improve our outgrowth. Before we conclude, I'd like to connect a few dots on our cash flow expectations and the associated value creation opportunity we envision. If you look at the strong momentum we have on cash flow generation this year and how that level can grow next year On further sizable progress lowering our inventory, picking up an extra quarter of Altra cash flows Since we only owned Altra for 3 quarters in 2023, plus stepped up synergy benefits, not to mention using the proceeds From the industrial transaction to further pay down debt, it really does start to create a nice picture. Using the majority of this cash flow To reduce our debt and lower our interest costs has a couple of key implications. One is a nice boost to EPS growth even before considering any help from end markets or our many growth initiatives.

Speaker 3

The second is a nice potential benefit to our Equity as debt becomes a smaller portion of our capital structure. At a time when end market noise is running high, I would urge investors to also keep these And with that, I would now like to turn the call back to the operator, so we can take questions. Operator?

Operator

We will now begin the question and answer session. Our first question comes from Mike Halloran with Baird. Please go ahead.

Speaker 4

Good morning, everyone.

Speaker 2

Good morning.

Speaker 5

Yes, let's start

Speaker 4

on Slide 12 and kind of wrap what you're seeing today Into why there's confidence in next year. You look at the year over year read on 2024 and It certainly reads more positives than some of the in quarter trends that you were highlighting. So as we think about that picture you're painting for 2020 How much of that is just destock comps? How much of that is in Regal's control with some synergy benefits on the revenue side Or some drivers of outperformance versus fundamentally thinking the market is going to get better from an end market perspective and any color you could give there would be great.

Speaker 2

Yes, great, Mike. Thanks for the question. We are feeling a little bit more bullish about 2024 and A big part of that is the destock. And the destock especially in the consumer space. We're not expecting a significant Rebound in demand, if any for that matter from an end user demand perspective.

Speaker 2

But because of the destock we lived through in 2023, We expect positive momentum going into 2024. A lot of our markets That are more secular driven, aerospace, data center, medical, alternative energy. Those are going to continue to be strong into 2024 and our efforts to Expand our servable market with new product in those markets is going to help us as well. And then when we look at a couple of other markets, For example, non res construction, which I think could have some additional tailwinds around some of the stimulus In the United States, as well as the investments in data center, we will we're very well positioned there. On top of that, I would say we're bringing up new products, air handling products, products to For the heat pump market, both in the United States and in Europe, as you probably know, we do not have a strong The dental HVAC position in Europe, and so this will be opportunity for us next year.

Speaker 2

So overall, we're Feeling that 24 should be a bit stronger. Short cycle industrial is a bit of a question mark for us right And we certainly saw more than we expected destocking in Q3 and a little bit More slowdown in demand. We expect that destocking though is ending and certainly IPS' orders Being up in October year over year gave us some confidence. But hopefully that helps you understand that we're thinking about 2024 And we'll give much more guidance on this at the end of our Q4 earnings in July Excuse me, in January.

Speaker 3

The only thing I would add, Mike, to that is that you also asked about synergies and how that might help benefit the business as well. And so I would add that we do expect to realize the $65,000,000 in synergies here in 2023. And then there's another $90,000,000 of synergies in 2024, which is about $45,000,000 for PMC and carryover And then about another $45,000,000 for Altra. So that's how you get to that extra $90,000,000 That will certainly help on the bottom line as we move through 'twenty four.

Speaker 4

That helps. Thanks for that. And then is there any way to quantify what the destocking impact was this year in Dollar terms, percent terms, anything to help understand the magnitude?

Speaker 2

You know what, Mike, it would be a little bit of a guess for us. We're saying probably about 2 thirds of the Headwind in PES was likely due to destock this year. And then I would tell you, the headwinds that we saw in IPS in Q3, I'd say 2 thirds of the headwinds specific to Q3. And the on the Factory Automation side of AMC, I'd say about 2 thirds as well was destock specific to Q3.

Speaker 4

Okay. Thank you. Last one then. Maybe just talk about the operational headwinds you saw in the quarter. As you're going through these, I think it's natural to have quarters where everything doesn't go smoothly and you have to make some adjustments.

Speaker 4

So I suspect that I'm just more interested in understanding why you think this is not going to linger into next year And if there's any remediation that's necessary here, I'm going to guess no, because again, I think you directionally have your hands around it. But Anything that you've gotten from a lesson here that we can take forward and comfort level that this is behind you once you exit the year?

Speaker 2

Yes. So thanks, Mike. And we do think we have our arms around this. And we do not expect these inefficiencies to continue into next year. First of all, I want to emphasize that our goal is always to execute any of our restructuring actions with 0 customer impact.

Speaker 2

And our track record has been pretty strong here. When you look back to our 303 Plan a couple of years ago, we actually reduced 23% of our manufacturing Square footage and close 21 facilities and had very little customer impact. And so that was the decision In Q3 is that there were actually 4 site consolidations going on at the same time. A couple of them were a little bit more complex than we anticipated. And so we took on more Headcount and inefficiency at the receiving plants to ensure that we could Have high quality and service levels to our customer.

Speaker 2

About half of that will reduce in Q4 And it will go away fully into next year. And so it gives us an ability to think about the planning of next year A little bit differently. We still have every expectation to achieve our synergy objectives, but this learning gives us to be better prepared because we'll be making moves next year as well. And so right now, we Feel good about our approach. I'm proud of our team and the decision they made in Q3 And I feel confident that we'll have this behind us by the end of the year.

Speaker 4

Thanks for that. Track record speaks for itself prior to the quarter. So really do appreciate

Operator

The next question comes from Julian Mitchell from Barclays. Please go ahead.

Speaker 6

Thanks and good morning. Maybe my first question was just trying to think about next year again. So it sounds like based on Slide 12 and some of the commentary around synergies that a kind of a base assumption should be maybe Flat to slightly up core sales. And then on the EBITDA front, we have the €90,000,000 of Synergy incremental and then maybe sort of, I don't know, dollars 80 ish million maybe from sort of Base EBITDA from the acquisition. And then on the rest of the sort of base business, Should we get some operating leverage there?

Speaker 6

Are you accelerating any cost cutting? Or for now you think it's safer just Sort of assume the quarter of Ultra year on year and then the synergies.

Speaker 2

Yes. So I think the way you're outlining it here makes a lot of sense and is how we're thinking about 2024. Now To be clear, Julian, we go through our operating planning in the November time frame. So we'll give a lot more guidance on this In January, but I think you are painting the appropriate picture. I would Tell you that from a PES standpoint, those stronger margins that we saw over the last couple of quarters will continue into next We did consolidate one factory in PES, so we have lower fixed overheads.

Speaker 2

So there will be, I would say, continued nice leverage in our PES segment. And then really, the Commentary around the synergies effects, mostly IPS, but somewhat AMC as well. And as you can imagine, when things slow, we tend to get very operationally focused And we tightened our belts. And so there will be some cost save that continues into next year also. So overall, the way you're describing it It's a great starting point.

Speaker 6

Thanks very much. And maybe just my 2nd follow-up would be around in terms of when you look at the history of Ultra and your own 3 of the sort of some of the base motion control businesses. Thinking about the sort of typical downturn duration is Maybe 3 or 4 quarters, and you're obviously Now in the second half of this year, IPS, I think you're in the Q3 of that downturn now AMC, you're in the First one, it looks like. So are we assuming based on history and sort of your best guess, it's maybe a sort of a 4 ish Quarter downturn again on core sales or is there something different about this downturn versus history?

Speaker 2

Julian, I'm not sure we want to try to call the cycle here. I do think we're coming out on PES. There's a slight slow in IPS in parts of AMC, although other parts are Very strong. Medical, aerospace, data center, up double digit for us and feels really good. We're going to stay very focused on what we can control and we've got a lot of levers to pull.

Speaker 2

The only difference I'd say perhaps from the past is that the supply chain normalization that's going on and The incredibly strong backlog that we still have in IPS and AMC, AMC's backlog is probably 50 plus Percent over our normal AMC run rates and IPS is about 45% Over normal run rates and therefore I don't we're not forecasting it's going to be A large impact because of those strong backlogs where we stand today going into Q4 and next year.

Speaker 6

Thanks very

Speaker 2

much. Sure. Thanks, Julian.

Operator

Our next question comes from Jeff Hammond from KeyBanc Capital Markets. Please go ahead.

Speaker 5

Hey, good morning, guys.

Speaker 2

Good morning, Jeff.

Speaker 5

Can you hear me?

Speaker 2

Yes. Good morning.

Speaker 5

Just maybe to step back, I mean, I think after the Altra deal, you talked about $18 in earnings, maybe $15 if the end markets were flattish. Leverage kind of 2.5 to 3, I think exiting 2024 and then Margin targets, I'm just wondering with this reset, how maybe we snap the line a little bit differently on some of those long term targets?

Speaker 2

Yes, Jeff. I think the way you described it is pretty spot on. What we came out with is that A statement of we have a path to 40% gross margins and 25% adjusted EBITDA margins. And with the divestiture of industrial, That path is even clearer and maybe a point above as I shared in my prepared remarks. A plan to get to $1,000,000,000 plus of free cash flow, we feel good about that.

Speaker 2

There are still Some levers to pull around trade working capital. And so then it comes down to the Sales, our original planning would have gotten 4% to 6% organic sales growth to get to $18 And I think you're right. It's slightly over 15 at flat sales. Now, we expect Through the next couple of years that the markets will rebound and that we'll see some sales growth. What that is?

Speaker 2

I'm going to not opine upon right now, but we would expect markets to rebound. On top of that, significant investment at Going on right now doubled our vitality in the last 3 years. We have an intention to double our vitality in the next three That will help us through expanding our served market with new products, very focused on over surveys Our A customers and our A products and so that will help us accelerate growth. So right now, we're not ready to come out with an update on the top line. We would expect growth.

Speaker 2

It's likely not the 4% to 6 That we were thinking a year ago could be, but it's going to depend on where market is and then we're going to definitely outgrow market

Speaker 6

is our expectation. And I would just add that the

Speaker 2

other side of your question, It is our expectation.

Speaker 3

And I would just add the other side of your question around the leverage as we kind of move through the cycle. We absolutely have a clear path To continue to reduce our debt and get our leverage rates down to that that we talked about during the longer term despite reduction that we might see in EBITDA. So it's very strong free cash flow generation expected going forward to do that.

Speaker 5

Okay. And then just shifting gears to HVAC, it seems like most of the OEMs kind of It didn't really surprise anybody. I think they were all kind of claiming destocking has run its course, which is maybe good for you guys. But I'm just surprised by the magnitude of kind of the miss and trends. Just I don't know if that's did you not appreciate the magnitude of the destock?

Speaker 5

Was it more aggressive? Are there some share dynamics? Is there more some product line simplification? Just what are the moving pieces on the miss there? And then just On this refrigerant change, some guidelines came out.

Speaker 5

Just are you kind of indifferent to that or how does that impact? And As people redesign, how are you feeling about share opportunities? So a lot of questions on HVAC, but thanks.

Speaker 2

Yes. So, first of all, I think it's important to remember that resi HVAC is only about 30% of our PES segment. We do feel like the AC side has gone through its destock. We expect furnace to be to go through in Q4, maybe a little continuation into Q1, but not significant. The bigger issue that we saw and surprise in Q3 was around the general commercial space And the slowdown in demand and the destock that we saw there.

Speaker 2

And so that was really more of the pressure in Yes, then it was a resi HVAC pressure. Now with regards to the refrigerant change, This should be an opportunity for us. It's just all of our OEMs will need to redesign to meet that change. And We have the right product, whether it's our ECM motors, which tends to be a mix up. It's our air moving solution, which tends to be a mix up or it's our drive solution, which is a new technology that we brought to bear that's going to help That system overall system requirement with the new regulations will be a mix up.

Speaker 2

So all in should be a positive. Now the one piece that we're not quite clear on is the EPA guidance around What the shipment allowance will be as of January 1, 2025? And could that cause some headwind in 'twenty 4, because the OEMs are further destocking, but they're going to have to go to a new system and our components And subsystems really fit well to support them in achieving those new system requirements. So hopefully, I answered all those questions, Jeff. Happy to follow-up if you have anything else.

Speaker 5

No, that's great. Appreciate it

Speaker 2

guys. Okay, great. Thanks, Jeff.

Operator

The next question comes from Nigel Coe of Wolfe Research. Please go ahead.

Speaker 7

Thanks. Good morning, guys. Good morning, Nigel. Good morning. So on the 4Q guidance, by the way, Nice start doing this.

Speaker 7

He's not going back. You have to give us the quarterly guidance from here on. But Rob, looks like you've taken the approach of seeming essentially flattish Sequential sales and margin. And I'm just curious, just given that this is a very new portfolio, I mean, how would you expect This is normal seasonality. How would the 3 segments normally track?

Speaker 7

I mean, I think PES, we understand, would normally be Down, but how would the other 2 normally track?

Speaker 3

Yes, I think, so first of all, on the sales side, slightly down Sequentially is the way we would look at that. As it comes to the margins, we do expect to be a little bit better on 4th quarter margin Versus Q3. When it comes to the seasonality, there isn't a lot of seasonality based on what we've seen with the supply chain disruption. And so we're not expecting a lot of seasonality. Our order rates support that conclusion and our backlog Certainly support that.

Speaker 3

So that's why we're thinking about it. There's not a lot of seasonality in any of the businesses right now. And that's the progression quarter over quarter.

Speaker 7

And of course, we're assuming flat sequential from a very depressed base with destocking. If you had to put a line in the sand And say this is the quarter when we expect destocking to the essentially done. When do you say, would you say it's 1Q next year? I mean, any thoughts there?

Speaker 2

From a PES perspective, we would say we would expect it to be likely done at the end of this year. What I like about our portfolio is the diversification of the portfolio. So it's a little bit difficult, Julian, to answer that question without doing it by segment and in some aspects Having to do it by division, but let me try to simplify. From an IPS perspective, we would actually expect Much of that destocking, we're getting through it. And again, it would be a Q4.

Speaker 2

The factory automation side of AMC, we're still Honestly, trying to get a little bit more clarity on that. Now, we got some strong orders in October, but they were a bit more longer cycle. That's Going to help us in 2024. So, we're getting our arms around the business. I think as the quarters progress, we'll give you more clarity, certainly on the factory automation piece of the business.

Speaker 7

Okay. And then a quick follow on. Just to be specific, in 4Q, what is the synergy capture you're modeling From PMC and Altra?

Speaker 3

Sure Nigel. The PMC we're About $13,000,000 in the 4th quarter and Altra about $10,000,000 so about $23,000,000 overall. Remember that for the PMC side, As we said, we do expect to get about $6,000,000 or so of those additional costs to maintain our service levels and may mask Some of that benefit on the PMC side, but the synergies are still permanent and absolutely Expected to be realized in the quarter. So a total of 23.

Speaker 7

Great. Thank you.

Speaker 2

Great. Thanks.

Operator

Our next question comes from Christopher Glynn from Oppenheimer. Please go ahead.

Speaker 8

Yes, thanks. Good morning. So, Louis, realizing that the October pickup isn't a trend yet, Just curious to dig a little deeper, what channels, what was the nature of the pickup, particularly I'm curious if those Channel partners that destocked in the most in the Q3 are where you're seeing the October pickup?

Speaker 2

Yes. So, and the simple answer, Chris, and good morning is, yes, Those that we saw slowing down in Q3, we did see a start of a pickup in Q4. But you're right, 1 month does not make a trend. And so we'd like to see that continuing. That's partially why we also are forecasting this Quarter to be modestly down sequentially from Q3.

Speaker 8

Okay. And in terms of inventory rebalances, how would you compare what you're seeing in distribution channel versus With OEMs because hoarding and gathering was systemic for a little while there. Now that lead times are better, obviously, we're on

Speaker 3

the other end of that.

Speaker 2

Yes. So I think There's still some room in OEM. And whereas I think the distribution channel has More quickly try to readjust.

Speaker 8

Okay. And are there specific Conversations with distributors or is it just too fast moving and contemporaneous to Bring that to bear on your general comments that the distributors are moving through destock faster.

Speaker 2

We have pretty clear visibility to our industrial distribution channel. We see their sales out. We see their inventory levels. We see their calls. Probably why I was a little more Unclear around factory automation is we don't have that level of clarity in factory automation.

Speaker 2

And although I can assure you with The ultra businesses that we now own as part of Regal, we will get that clarity in time. It's just that we don't have that quite yet. But from a IPS standpoint in particular, we know what our distributors are holding for inventory that the majority of our We know where they stand with sales out and with their orders on us. So good clarity there. Sure.

Speaker 2

Thanks, Chris.

Operator

This concludes our question and answer session. I would like to turn the conference back over to Mr. Lewis Pinkham for any closing remarks.

Speaker 2

Thank you, operator, and thanks to our investors and analysts for joining us today. As you heard this morning, while we are facing more challenging end market headwinds in parts of our business, our Regal Reschner Our team is effectively managing through them. But what keeps us excited is our ongoing transformation, Executing our path to top quartile gross margins to generating over $1,000,000,000 in annual free cash flow over the next couple of years To rapidly deleveraging our balance sheet and to the outgrowth acceleration, we are confident we can deliver by Raising our new product vitality and by executing our many eightytwenty growth initiatives. In short, many levers we can pull to create tremendous value for our key stakeholders. Thank you again for joining us today and thanks for your interest in Ringelbroch Nord.

Operator

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

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Earnings Conference Call
Regal Rexnord Q3 2023
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