Bodycote PLC

LSE:BOY

Earnings Call Transcript 2022-Q4

[Stephen Harris, executive]

Good morning, everyone. It's good to see you in person. It's the first time for quite a while. So thank you.

The first thing I'd like to sort of just [indiscernible] best of, I think I'm probably the luckiest Chief Executive in the country at the moment. And the reason for that is, I've not just got one CFO. I've got 2, right? I mean how good can it get? Dominique Yates obviously, is retiring. And welcome to Ben. He's coming in to fill his shoes. And we're really looking forward to working together.

There's one thing I would just like to make a comment on is that those of you that are coming to our [ Swire ] on Wednesday, we will be passing the hat around to help defray the costs of Dominique's retirement present. And by the way, this is Bodycote, so cash only.

Turning to the business of the morning. The basic results here, we feel pretty pleasing. And we're going to take you through, as we usually do through the overview, which I will do, and then Dominique will come and do the financial review and then I'll comeback and do a business review and finally wrap up with a summary and outlook.

So moving to the financial highlights. Before I go much further through here, I just want to point out to you that we would like you, if you can, to focus on revenues, excluding surcharges. And that will be a theme through this because it's really about what's our underlying revenues and where we go to in the future. Reason for that is obvious, surcharges come and go. They don't contain any profit, price rises and volume growth here. So revenues in total, up 20.8%. Clearly, if you take it at constant currency, it's just over 17%, but that excluding surcharges piece is 10% growth just over. So that's the underlying revenue growth.

Operating profit up 19%. We've clearly got a strong balance sheet, and we're recommending a final ordinary dividend of 14.9p. And just to remind folks, for those who are new to the case, this makes the over 35 years' track record of uninterrupted dividend maintain or increase.

So moving on to key achievements. So clearly pretty strong growth in revenue and profit. The point I'd like to make here, which I'll come on to on the next slide is about inflation. And our price increases have fully recovered labor and general cost inflation. The surcharges, they cover the energy cost, and don't forget, energy for us is gas and electricity. And once we made it into the second half, I've introduced the surcharge machine, if I can call it that. It's now well tuned in, but we did have a shortfall in the first half of GBP 5 million.

Operating margins, which Dominique will expand on, basically 15%. But if you get rid of those surcharges again from the revenue only, it's 16.1%. And a theme here that you should be taking away is this good momentum in this business. And so that is something that isn't here and gone. This is something that we're seeing building.

And our carbon reduction strategy is working very well, and we'll talk more about that when I come back and do the business overview.

Just on the inflation point. So energy prices are now falling and so the surcharges are being reduced. We manage surcharges these days a month in arrears. So basically, when the indexes go down in the various countries, will drop the surcharge the following month. It would have been nice if we could have dropped the surcharge 6 months later, but unfortunately, that's not the way world is working and some places, it's 3 months arrears. But generally, it's 1 month in arrears.

The contractual indexation, you might recall that we have a number of contracts, long-term agreements where we are -- have indexation there to inflation for labor and energy and all kinds of things. They typically lag 6 to 12.

months. But what happened in the last half is the major customers that we have in this area, cognizant of the fact that energy was through the roof basically gave us out of contract price increases. Okay? So if we thought that the LTA is a long-term agreement, we're going to be a following wind in 2023, I would call it more of a following breeze because we've got a lot of it already in there.

As we go forward then, as the nil margin surcharges because remember, we're not taking any profit on these surcharges as they unwind, they impact revenue but not profit. That will drive margin expansion. On the price increases, they include profit and one of the questions people have asked me is, well, are you going to give them back? And the answer is no. They're enduring and they are permanent.

Now I'll hand you over to Dominique.

[Dominique De Lisle Yates, executive]

Thank you, Stephen, and good morning, ladies and gentlemen. Chart 8 summarizes the group's financial results. Revenues grew 20.8% at actual rates and 17.3% at constant currency. And this differential reflects the positive impact of a strong dollar, partially offset by other currencies, which weakened against sterling, notably the euro and the Swedish krona. At the profit level, the currency impact was marginally negative overall, and this reflects the fact that our euro and Swedish businesses have higher margins than our U.S. dollar business.

And while we're on the subject of exchange rates, as we stand today. And as Stephen has already alluded to, we would expect currency at the profit level to be a marginal tailwind during 2023.

The other obvious thing to highlight is the group margin, which fell marginally to 15.1% in spite of the significant increase in headline operating profit. And as Stephen has already covered, this is entirely down to the implementation of the nil margin revenue surcharges, which covered the energy cost inflation experienced. Underlying margins improved, and I'll come back and cover that again later and I'll also come back and talk about cash flow on a later slide.

Given the increased profitability and earnings, the Board has decided to recommend an increase in the final dividend from 13.8p to 14.9p. So an 8% increase in the final dividend and bringing the total dividend for the year to 21.3p, and given the improved earnings, we're back now above the 2-plus x cover that we target for dividend cover.

Chart 9 is a new chart showing the revenue bridge. Stephen has already covered how we've been managing cost inflation, but we thought it will be helpful to split the permanent price rise impact on revenues that Stephen has already talked about from the impact of the energy surcharges. So in this slide, you can see that the permanent price increases GBP 33 million there, boosted revenues by a little over 5%, while the GBP 44 million contribution from energy surcharges boosted revenue by a further 7%.

So when projecting forward, clearly, in light of the continued high levels of general cost inflation, you should anticipate that we'll have further permanent price increases in 2023 but depending on one's view on how energy costs will develop, you might expect the overall impact of the energy surcharges for the full year to soften somewhat from the GBP 44 million that we had through last year. But I'd say that all depends on how those costs develop through the year.

Chart 10 here shows the traditional headline operating profit bridge. In spite of the high and increasing levels of general cost inflation that we saw through last year, we once again covered the impact of general cost inflation with price increases as we have done every year going back to 2008, '09, I believe. And once again, we saw a decent drop through above 50% to the bottom line from the revenue volume and growth mix.

The P&L also benefited from lower bit charges from lower share-based payment charges. And this is someone I -- something I wanted to spend a moment on and highlight. The charge for the full year was only GBP 1.6 million in 2022. And that's GBP 3.4 million lower than the 2021 charge of GBP 5 million, reflecting the fact that the payout for the schemes in flight is projected to be well below target. The expected charge for a normal year in inverted commas and we haven't had many of them recently, would be somewhere in the GBP 6 million to GBP 9 million region.

So as we, hopefully, in 2023, look forward to a year when the global macro environment isn't experiencing another pandemic or another supply chain crisis or another cost of living crunch, each of which has, in turn, impacted the outlook for the last several years, then that GBP 6 million to GBP 9 million charge is the sort of level that we would expect the share-based payment cost to return to. So you want to take this into account when projecting forwards and estimating what you think our outlook for 2023 headline operating profit will be.

We clearly enjoyed the full benefit this year of the 2020 restructuring and the cumulative GBP 30 million annualized permanent cost reduction. And obviously, while we didn't see these items have a negative impact on the half 2 results, the half 1 energy surcharge implementation shortfall and the costly impact of demand volatility that we saw in the second quarter of the year still ended up having an impact on the overall full year result.

Chart 11 goes into a little more background on the margin. It shows that if we adjusted purely for the dilutive impact of the energy surcharge revenues, our net margin would have increased to 16.1%, demonstrating underlying margin improvement. And just to stress again, I think Stephen alluded to it, but that figure, that 16.1%, doesn't include us adjusting for the GBP 5 million surcharge implementation profit shortfall that we had in the first half. And that shortfall, we would not expect to recur. As Automotive volumes recover and Civil Aerospace revenues maintain their upward trajectory, we still fully expect to see group margins move above 20% in due course.

Chart 12 shows the divisional split. AGI profits are actually already back above pre-pandemic levels. And this is in spite of the fact that Automotive volumes are still well down on the levels that we were seeing in 2019. And this really demonstrates again the benefit of the restructuring cost savings from the 2020 restructuring program, which was itself focused on AGI and within AGI was also particularly focused on the European AGI business. ADE profits grew as Civil Aerospace business improved and we expect to see continued growth as the Civil Aerospace market benefits from the structural growth that Stephen is going to talk about a little bit later on the relevant Aerospace & Defence slide.

Chart 13, once again, we've seen strong underlying cash flow performance. Actual revenues in the last 2 months of the year were GBP 25 million higher than the equivalent period last year. And essentially, this explains the entire working capital outflow in the year as we typically have outstanding trade receivables about 2 months' worth of revenues. Obviously, the revenue uplift was fueled by energy surcharges, which were at their highest level during the final quarter as well.

And it's worth stating explicitly, I've already implied it, but stating explicitly that there haven't been any issues collecting our debts and the days sales outstanding actually improved slightly during last year. And you can also see proof of this to the fact that it was a relatively unusual working capital outflow occasioned by the price increases in the energy surcharges because the half 2 free cash flow was actually GBP 7 million higher than the comparable half 2 cash flow -- free cash flow in 2021.

So adjusting for the unusually high level of working capital outflow, the underlying free cash flow was GBP 110 million, and that's at around about the 100% free cash conversion rates that we would anticipate seeing in a normal year.

Chart 14 is just a reminder as to how we use our free cash in order of priority, supporting profitable organic growth, paying ordinary dividends, investing in acquisitions aligned with our growth strategy and finally, returning any excess cash to shareholders.

And finally, Chart 15 takes a look at the balance sheet. Net debt came down to GBP 33 million after paying GBP 39 million of dividends during the year. We've got plenty of liquidity, and we have still more than 4 years to run on our revolving credit facility. Headline tax rate of 22.3% was in line with our guidance. So very much everything in line here and plenty of optionality on the balance sheet.

Now I'll hand back to Stephen.

[Stephen Harris, executive]

Thank you, Dominique. So going into the business review here, top of the agenda in terms of the business view is, I'm going to talk about sustainability and in particular, carbon reduction and climate change.

So you can see our general stats up there. But one of the big things that we're focusing on is our carbon reduction program. We are signed up with the science-based targets initiative. We have a target to reduce our emissions by 28% by 2030. And we're investing in order to do that. Important point to make at this point is that our investments in carbon reduction have financial returns, not just carbon returns.

And if you move on to an item which not many people are talking about, except a number of our shareholders are very keen on this, is Scope 4. Not many people are familiar with that yet. And Scope 4 is basically avoided carbon. Avoided carbon means where we, as an enabler, can reduce other people's carbon. And that's actually a very strong part now of our sales and marketing toolkit. The fact of the matter is that we have a natural advantage over people that might do it themselves. And don't forget, at the end of the day, our biggest competitor is our customer because they could elect to do it themselves. They -- there's a natural order of things because they only produce for their own consumption, they're far more volatile than we are because we aggregate from many different customers. As a result, our utilization is much higher than this. And that's a factor which we'll come to later when we see how this works.

We have a lot of expertise. I mean, that's another point here. This is our core business. This is what we do. If you're producing a car or an aeroplane engine or a private jet, you aren't really an expert in this area, I would suggest, because you've got 5 -- 50,000 other things to worry about.

So let's just take that forward and say, well, how we've been doing so far because this is not something that we just invented yesterday. We've been on this case for quite a while. How are we doing in terms of reducing our own emitted carbon? So on Chart 16 -- 16 to 18. These are our 5-year trends for carbon emissions. I would far prefer to use the top one, which is our total carbon emissions. It's not weighted to sales. And that's because when you weigh things with sales, in other words, the sales intensity, you get all kinds of funny results.

So if you end up actually going the wrong way on your sales, going down, for example, your carbon intensity goes up because it doesn't normally vary with sales. What's really important, obviously, is to bring your total carbon emissions down. And that's something that we've been doing pretty well with, and we would expect them to keep going.

Clearly, we've got these targets from -- with SBTi, and we believe that we're well on train to follow that.

If I just move then on to something which I talked about Scope 4 carbon avoidance, this is a real-world example. This is one of our customers in Scandinavia. And the end result, and you can see at the bottom right of the slide is that when they were making a make-buy decision, which is quite important in this area, they decided to buy from us rather than do it themselves. And if you can save a customer 45% of the carbon emission and they're in Scandinavia, where these things mean a lot more to them at the moment than other parts of the world. They're very focused on carbon reduction. That's quite an achievement in my book.

Can you imagine what we would do with somebody in America or China? So just to very quickly explain this slide, I don't intend to go through it in a lot of detail because this is, unfortunately, a combination of a whole slide deck for one slide, so we're not going to spend a lot of time on here. But if you want to go through it, please talk to me later.

Basically, on the left-hand side of the slide, you've got the contribution of all the different elements to carbon emissions. And there's a whole slew of them that you get better carbon footprint just because we're running at a high utilization. And so the big arrow in the middle is that's all about just improved utilization.

And you can see for each element for this customer, what those reductions meant. And then if you add on top of it, that was 28% of the total. If you then add on top of it, items where our expertise comes to play, in terms of how you pack components, how you run gas supplies, all these kind of things. That added a further 17%. So we've got a total of 45%. In general, we would expect to be able to save up to 60% of people's carbon footprint.

Where are we at the moment with this? I will tell you that we're getting quite a bit of traction in parts of the world. But you would be shocked in terms of -- we've got thousands and thousands of customers around the world. And as I mentioned, Scandinavia is on one extreme. You would be shocked. The number of people still, they can't even spell carbon. So I was going to say this is a slow burn, but that's [indiscernible].

It's certainly having an impact and we are certainly seeing contracts that we're getting that we would not have got if we weren't using this.

I'd like to move on to Specialist Technologies now. Clearly, I mean, this year, we're demonstrating that we're outperforming. A point to note in Specialist Technologies is that we did buy a small HIP business, a very small HIP business, at the end of '21. It didn't come with any profit. It only came with sales. And that is in those growth numbers, okay?

Looking at Specialist Technologies in a bit more detail. What we've done this year is we're actually trying to spell out more detail in all these following charts with these Marimekko slides on the right, the graphs on the right. So Specialist Technologies are kicking up. That small green bar, for those of you that color blind, it's the light gray bar, that small green bar in 2022, those are the surcharges, okay?

Overall in this business, it's really getting traction. And you can see the spread on the right-hand side graph of what Specialist Technologies is exposed to across the piece. We'll come back to those specific markets with some further slides. And you'll see where these growth are going. But Specialist Technologies is -- some of you may be surprised, quite well established in general industrial.

The energy surcharge in Specialist Technologies is inherently less than it would be in Classical Heat Treatment because Specialist Technologies are inherently lower carbon footprint technologies. It's one of the things that's helping people switch over as well as the completely unique offerings in some of these technologies there. Remember, these are high-margin, high-growth technologies.

Emerging Markets. Same format, you can see much higher surcharges in Emerging Markets. You wouldn't believe the energy costs in Eastern Europe and in Mexico, places like this, not in China, but Eastern Europe, for sure, all the way down through Turkey, massive energy spikes. We completely covered it with energy surcharges. So if anybody thought we couldn't do this, Emerging Markets is an extreme example, we don't have a problem. 13% volume growth in second half year, and that was an Automotive recovery in Eastern Europe.

We've now started inking long-term agreements for electric vehicles. This is one of our target areas. Electric vehicles, it's quite an interesting situation. We always knew that geographic footprint for EVs are likely to be in the Emerging Markets. The problem we've had is in terms of getting actual revenue, these electric vehicles, what they try and do is initially start them up as a process, as a product line. and then they deploy them into the production area. So an LTA for us in EVs, which we've got some going down right now in Eastern Europe, it won't actually produce revenue for 3 years. That's how long it takes to ramp up these new product introductions. And China, obviously, has been affected by the lockdowns, but that is now easing.

So looking at Aerospace & Defence. This is an area where we do have very good visibility. I mean I think it's pretty clear that this is an area where you can see far forward. And in Civil Aerospace, excluding surcharges, our revenue went up 19%.

If you look at the underlying expectations going forward, it's for very robust growth in Aerospace & Defence. We do have long-term agreements where we're sole source. And it's Civil Aerospace, not Aerospace & Defence, sorry, no mistake. We've got long-term agreements, many of them are sole sourced on. We would expect this area to do very well off into at least the medium term, if not longer. And we support -- secured a number of long-term agreements specifically on the A320. So we're still expanding share in this area.

Let's move on to what I would like to call the joker in the pack, Automotive. Where is it going? It's quite hard to say. One of the things, if you look at the results announcements for various people around the world, some of the OEs, a lot of them are very bullish on '23. I would caution you, though, most of those results -- sorry, those bullish statements are about their free cash flow and margins. They aren't about the number of vehicles they're going to produce. So you have to read very carefully. And if you are relying on IHS forecasts and the rest, don't forget -- I'm not sure how accurate those forecasts are historically.

So Automotive is an unknown. We're only very early in the year on it. Where it's going, we don't know. What we do know is consumer demand, there's a lot of it. We are being briefed by the Automotive OEs that expect growth. It's just not there yet. When you look at our year-on-year growth, excluding surcharges, you might say, well, how come it's down, how could it's minus 1%. Please be clear, we had a very strong comp here in the first quarter last year. And it's only accelerated in a weakness and then flattened out, okay? So it's basically flat, and Dominique will explain that more.

The electric vehicle side, we're quoting more and more and more of it. Today, we don't have much revenue there, but it will come through.

General industrial. We've laid out the different market segments on the right-hand side here. Same format otherwise. I would suggest that the growth we've seen here is well above industrial production. And don't forget, our GI is really our proxy for industrial production. And you can see we're really -- we're beating that. One of the reasons for that is we've actually deployed a lot of new sales techniques and marketing, and that's helping us a lot.

And the other thing, of course, is that we've got a growing percentage of Specialist Technologies, and that's sort of kicking in, there's an afterburner there. It's broad-based. There's no real differences in geographies, excluding China. China isn't here for 2022. Who knows where it's going in '23, but 2022 China isn't normally.

The energy is now included in here, and you can see our exposure to oil and gas which we have none on our energy in terms of supply to us. We don't use oil. But in terms of what we sell to, oil and gas is quite a small part of our business these days. So our exposure to actual fossil fuels is quite low.

So when you look at the growth in this segment, it's not coming from oil, okay? Please be clear. The one thing that I talked about before was Tooling, and Tooling is a leading indicator, as I mentioned, for Automotive typically. And what have we seen in Tooling? We did see it growing. Its growth has peaked out a bit. It's still growing, but that was -- that's expected.

Tooling will typically lead Automotive unit production, car and light truck, a lot of it, by about 6 months or 6 to 9 months. And that would suggest that's an indicator testing well, a lot of the manufacturers were thinking that there's going to be an increase there because clearly, the Automotive supply chains have eased a lot. So that's positive.

The one negative piece in here as you see that segment industrial machinery, it falls into 2 broad camps in terms of machine tools. One is forming machines. Forming machines is related to Automotive mostly and then cutting machines. And cutting machines -- machine tools are actually used on a much wider basis. And they're a leading indicator for industrial production, in particular. We saw Q4, a sharp deceleration in the growth. So the growth didn't go negative, but the amount of growth really reduced fast in Q4. So that's a little sort of warning.

Why do we think it is? The -- some of the feedback that we've got is that people are just unsure what's going to happen for the economy. The macroeconomic outlook is making people unsure this is a CapEx-driven segment. And so there's been a holdup in machine tool capital investment. So with all these great things that are going on in all the other markets, there are a few things here that are showing, well, a little bit of caution, please.

Just looking about where we've been investing over the years, we've said this many times, into our higher-growth markets. And particularly, that is Specialist Technologies, of course, Emerging Markets and the structural growth markets of Civil Aerospace and electric vehicles. And this is where we've really been invested. We've been doing in the other parts of the business as well, but the majority is going into this part of the business for obvious reasons.

These are a list of the expansion that we're doing greenfield sites, capacity expansion, quite a lot going on, and we expect more. One of the people said to me about if you've got a bunch of CapEx, could you drive it faster? Not just one people, but a number of people have said that.

Historically, it's been a problem in Asia because we couldn't get land. Property prices were outrageous, everybody wanted property. And if you've been keeping up with China, the property markets collapsed. It's now pretty easy to get a property. And so I can imagine in the next few years, we will be accelerating in Asia, in China in particular, in terms of capital expenditure. Not right now, but it will be fair to come. We are building greenfields in China right now, but it will be accelerating going forward.

So in summary, a repeat of where we started. Just to make a point of this slide, the markets that we've been investing in the higher-growth markets, they now constitute 62% of our headline operating profit. So the rest of it is obviously only 40%, and it just shows you where this business is going to. I mentioned the fact we've got the headline -- the momentum in these markets and our carbon strategy is working extremely well.

The 28, our outlook, I'm not going to comment on the details here. We can take Q&A after this one, the outlook on the slide exactly the same as you've got in the press release and the report and accounts.

With that, we can move to Q&A.

[Andrew Douglas, analyst]

Andrew Douglas from Jefferies. The obligatory 3 questions, if I may. With regards to the commentary on A320neo wins and EV wins, can you just talk to us about what's driving that? Is that customer behavior because they want more LTAs? Are you willing to share because customers are going out of business, your technology is better or ESG? Can you just explain to me kind of what's specifically happening there? And I'm working on the assumption that there's tons more of EV opportunities. But what about Civil Aerospace?

[Stephen Harris, executive]

Okay. Do I have to push this button here? Okay. On the Civil Aerospace side, when we say A320neos, we don't actually mean the platform itself. It's landing gear and engines. It's mostly engines, right? And that is really about getting more share effectively. It's being farmed out. It was in in-house, some of this stuff has been farmed out. We don't call that outsourcing because the aerospace industry works a little bit differently. And we've basically picked up contracts as they put this work out into the supply chain. So it's -- there's no change in behavior. It's been going fine.

Interesting point here on pricing. I know a number of people have made noises about well, it's getting harder to put price increases through, particularly in Automotive and aerospace. I would suggest in a market where you are reducing your price by getting surcharges going down, it's much easier to get price increases that they're going to stay through. And if you think about the relative size of these things, our prices are very sticky. They're not something that we give away.

On the electric vehicles, the answer to your question is, yes, there is lots of it. The problem is, is when will it come to fruition?

[Andrew Douglas, analyst]

You also made reference to sales technique changes and increased marketing. Is that anything specific? Or can you just talk to us about what's happening there? Is that just more feet on the ground, better value selling? What's changed?

[Stephen Harris, executive]

That's commercially sensitive. I'm not going to answer that, okay?

[Andrew Douglas, analyst]

And then last one is the obligatory M&A question. Just you've got a good balance sheet. Clearly, you can buy back stock if you wanted to, but I think M&A comes ahead of that. What's the outlook for M&A, please?

[Stephen Harris, executive]

I think, first of all, what was it in 2022? I'll be quite clear about it. We did have a run at a couple. We didn't expect in -- particularly in 2022, the sort of exuberance that some folks had for acquisitions. So we failed. I mean, we weren't prepared to bet the farm on some of these things.

There are still a lot of acquisitions in the pipeline. But as usual, we will keep our discipline in terms of spend there. So...

[Andrew Douglas, analyst]

So just then on spend, what about quality of assets in the market? Because historically, you've been disappointed with the quality of that one?

[Stephen Harris, executive]

Yes, I know. But the -- if you look in Classical Heat Treatment, there are small bolt-ons. We aren't really chasing those, but there are 1 or 2 that we would have liked for years, they are now coming on the market.

In the Specialist Technology side, they are larger. And some of these businesses that I've talked about for years now, are coming to market, and we'll see where that goes. But this whole dislocation that we've seen in the economy and everything else, it is bringing things to market that haven't been there for 10 to 15 years.

[Stephan Klepp, analyst]

Stephan Klepp from HSBC. A couple of questions here. Energy surcharges, I mean we talk broad about that. I think the main question is, well, how is going to unwind? I mean you know as well; the energy prices came down quite strongly. You must have an internal view how the state is at the moment? And what's your picture for this year? Can you give us more color on that?

[Stephen Harris, executive]

Well, I know Dominique has got some numbers on this, but let me just put this to you. How cold is it going to be this winter? If you know that answer, you'd have a very good view.

[Stephan Klepp, analyst]

Okay. So we should assume as well that let's say, it's colder this winter. We see energy surcharges again in 2024.

[Stephen Harris, executive]

I would think we see it in Q4 of this year. And one of the reasons is if you think about the amount of gas, particularly in Germany and in Europe that we had in storage as a continent, it was much higher than it currently is. And we can't fill it up with LNG to the same levels because I think it was 86% wind. It's now at 62% or whatever, and it's virtually impossible to get it back to the same level. because there's now 0 Russian gas in time for winter. I don't -- my belief is nobody is going to run out of gas, but you're bidding against China now. Therefore, the price is going to be higher.

In terms of some more numbers, Dominique put some financial color on it.

[Dominique De Lisle Yates, executive]

Yes. So clearly, last year, we had GBP 44 million worth of overall surcharges, and that was well over half of that was in the second half of the year. We saw the spike stroke peak of energy costs in the fourth quarter. And Stephen covered in his slides, we do still buy 1 to 3 months ahead, depending on the market and what we can and can't do. We're buying 1 to 3 months ahead. So we're still in quarter 1 of this year, experiencing costs associated with that buying forward at quite high levels. In the first quarter, they've come down somewhat. And as we move into quarter 2 and beyond, then yes, that element of surcharges will come down. But as Stephen says, one of the big questions is, well, okay, where is it going to be as we come out of the summer?

[Stephen Harris, executive]

Just let me add to that. To be clear, energy surcharges are always positive, not negative. All right. So they won't go below 0.

[Stephan Klepp, analyst]

But it ties into my second question. I mean, you're alluding to in your presentation that 20% margins are inside. And when you're alluding to that, obviously, surcharges play a role, are you referring to reported? Are you referring to underlying? And what time frame is, I think you said in due course?

[Stephen Harris, executive]

Right. Let me answer that. And this is a road we've been on before. And we kind of hit the brick wall in '18, '19 when COVID hit. Historically, take surcharges out of the pictur,e, we would expect between 1% and 1.5% margin expansion a year. You can do the math that tells you when due courses. It's got quite a range, clearly, that tells you. It's not in 2023, just...

[Stephan Klepp, analyst]

Yes. I think nobody has in numbers at the moment. But okay, 2 more. On the ESG, you say you get traction in some markets. quite strongly. Can you give more color as well on the market? I mean, Scandi is one thing you mentioned but...

[Stephen Harris, executive]

Germany. In fact, just 2 weeks ago, we got a couple of contracts where they were going to do it in-house. And that's what we're talking about is it's really a make-buy decision. The idea of people shutting down their business and giving it to us is a concept that really isn't very valid because it takes a lot of time for them to crystallize the decision on that, and it just goes on forever.

But make-buy decisions are happening all the time. And really, the way of getting that business is to make sure it never goes in-house. And in Germany, we -- just 2 weeks ago, we had 2 contracts in the auto world, where we got them simply because we presented the carbon footprint, and they said, okay, right, you do it.

[Stephan Klepp, analyst]

Okay. So should we basically assume that this should accelerate over the years because we talked about it a year ago. Now we have a case study. Now your first win. So this is going to be a company, in fact, supporting as well the -- let's say, the tailwind from aerospace, et cetera, et cetera?

[Stephen Harris, executive]

Absolutely.

[Stephan Klepp, analyst]

Okay. And last one, sorry for a technical one. Again, free cash flow and margins. So last year, you missed the GBP 5 million in the first year -- first half year, you couldn't pass on those. Is it very simply that we can assume that you can recoup those GBP 5 million? We have a very low base then in the first half of the year. And that should be seen as well in free cash flow because with the unwind of the surcharges and obviously, the unwind of the accounts receivables, free cash flow should be much stronger this year then?

[Dominique De Lisle Yates, executive]

Yes. So as you do the bridge to this year, both in terms of revenue and profit and free cash flow, that GBP 5 million, all things being equal on a stand-alone basis would unwind.

[Stephan Klepp, analyst]

And the accounts receivable?

[Dominique De Lisle Yates, executive]

Well, the accounts receivable wouldn't change because the accounts receivable on a full year basis is what did we sell in November, December? And implicitly, this is a first half thing. So that wouldn't change that.

[Stephen Harris, executive]

It's Andre.

[Andre Kukhnin, analyst]

Yes. It's Andre from Credit Suisse. Can I just pick up on the ESG and that outsourcing theme? We have been kind of talking and tracking that closely. And I appreciate the revenue impact at this stage is pretty limited. But when you look at that whole funnel right now, that kind of maybe the whole size of inquiries that you've received, how does that compare to your annual revenue?

[Stephen Harris, executive]

Well, I don't have that. I don't have it in my mind, I haven't done that calculation. I look at the number of inquiries as opposed to how much they are because one of the problem that you get with these inquiries, if you're not actually quoting to the OEM often they duplicated. So it's not easy to see what actually is in the funnel and what is just a duplicate. I mean I've got examples, for example, in fossil fuel extraction, right now, we're bidding 6x in the same job. We just don't know it is the same job.

[Andre Kukhnin, analyst]

Right. I just wondered if -- what can we track? How we can kind of do more work on this because the market is 20% outsourced, 80% in-house. In theory, this could be really a game changer, this could be a multiple effect of ...

[Stephen Harris, executive]

Well, if everybody was interested in carbon reduction, yes. But if you go over the pond, once you talk to a buyer and engineer, they go carbon, what? What is that? So it could be a game changer. The question is how soon will the idea that this is something they have to do, take hold. So it's really, over time, how quickly it's going to go. It's clearly something that will accelerate and is accelerating. What penetration will make globally? I don't know what it is. Hopefully, it's before 2050, okay?

But it's clearly how long is a piece of strength. It's hard to measure really until you've got the business. And so I'm just giving you some anecdotes on it. I don't really want to give you a number. That's just a wild ass guess, excuse my French, but it is good, but I can't say when it's coming.

[Andre Kukhnin, analyst]

And if I can just change gears a little bit and talk about Aerospace & Defence, H1, H2 cadence. If my numbers are right, there was a bit of a slowdown in the second half in terms of organic growth. I think as year-on-year, but also when I look at the 3-year stack as well, you had quite an easy comp there from 2020. So I just wondered if there's anything there that we should be aware of and think about as we model H1, H2 2023? And I think similar on margin, there was a sequential bump up in margin, but not kind of as pronounced, which I presume is revenue driven, but I just wanted to dig into that a little bit?

[Dominique De Lisle Yates, executive]

I mean as always, with these things, you've got to go back and look at history. I mean as we came out of 2020, there was a lot of inventory in the Civil Aerospace supply chain. Now a lot of that unwound in 2021, but not all of it unwound in 2021. There was even -- there was still some hanging into the beginning of '22. So -- and clearly, the impact of that unwind was greatest in half 1 of '21, less so in half 2. So we've seen some recovery through '21, but then impacts the comps against which the '22 halves are measuring. So I don't think there's any slowdown, if you like, of the underlying growth in Civil Aerospace. And to the extent that you're right in any event, we're still talking about very strong double-digit growth. So it's all relative.

[Andre Kukhnin, analyst]

Okay. Got it. And if I may, just the last one on internal efficiency measures. You obviously had quite a nice benefit in 2022 of GBP 10 million. I know you've done a lot of heavy lifting already, but we also talked about ongoing efforts in terms of digital adoption and kind of tools related to that. So for 2023, should we think about a kind of separate discrete item on the profit bridge from that -- those internal efficiency measures? Or should we just roll that into the 50% drop-through ratio against general inflation?

[Dominique De Lisle Yates, executive]

Well, the digital adoption, no, because that's a longer cycle issue. In terms of general efficiency issues, it's early days, but one thing I should tell you is we do have some new blood at the top. They're bringing in new techniques. I don't mean blood at the very top, I mean, in the divisional presidents. And we've got some new techniques that have been brought in. Will they pay off? I don't know.

One of the things that we've been looking at and those of you that have been watching us for a while, we've talked about these 2 facilities that we've had in North America that have been a real boat anchor. We didn't improve them in 2022. There's potential that they will be improved in '23. But as yet, jury's out.

[Rory Smith, analyst]

It's Rory Smith from UBS. Just the first one on general industrial, now that we're thinking about that inclusive of energy. Could you just remind us what you think the splits are between Spec Tech and Classical within that broader segment?

[Stephen Harris, executive]

Do you have the numbers there?

[Dominique De Lisle Yates, executive]

Yes. Do you want to ask your second question while I'm looking at the numbers?

[Rory Smith, analyst]

Sure. Staying on general industrial, what the sort of trends you're seeing for the first 2 or 3 months of this year are on the kind of more leading indicator side so that kind of machine to...

[Stephen Harris, executive]

Well, one of the problems is that with the statistics, the more you segment it down, the more accurate it is. So you really can only take leading indicators from the large segments. If you read anything into, especially after 2 months, into something like medical, some of that, which is smaller, you're misleading yourself, you're kidding yourself. So the only 2 really that you can take any input from at this stage of the year is industrial machinery and Tooling, all right?

In terms of how general industrial is doing, it is doing -- at the beginning of this year, general industrial doesn't move quickly. So we're seeing exactly the same stuff that we saw in the second half last year. It's still on the same trend and it won't move quickly. It won't change direction quickly. But at some point, it will. Automotive can turn on a dime. General industrial generally doesn't.

[Dominique De Lisle Yates, executive]

In terms of the proportions within, if -- we're looking at energy, if I've understood you correct -- question correctly, energy, more than 50% of energy revenues is in Specialist Technologies. And for the nonenergy general industrial business, the Specialist Technologies contribution is just over 25%.

[Stephen Harris, executive]

When we say energy for this, it's quite interesting. A lot of that is industrial gas turbines because Specialist Technologies is in Civil Aerospace and land-based turbine is an ugly form of a plane engine. So a lot of the IGT is in Specialist Technologies. And the oil and gas side is not very well exposed at all to Specialist Technologies. The nuclear Specialist Technologies, renewable Specialist Technologies. So that is all towards IGT and renewables, except for subsea. And subsea is a Specialist Technology. And now you're going to ask us how much is that?

[Rory Smith, analyst]

I am going to ask you how much of oil and gas is subsea absolutely, and nuclear because I didn't see that on the pie chart, either it's quite small.

[Stephen Harris, executive]

It's on the -- it's in the renewables. It might not be a real renewable, but we put it there.

[Rory Smith, analyst]

And just if I could maybe ask a follow-up on the Scope 4 chart, and apologies if I've misunderstood this in any way. But it appears to me that you're suggesting you get 28% reduction in CO2 from a 35% increase in utilization. Is that 50% to 85% your improvement or from the customer? And is that an assumption that you've made that your customer is on average?

[Stephen Harris, executive]

No. So the way this works, is the customer tells us how they already have a process line doing this stuff. They're introducing a new product. So we went in and we did a study of their process slide. We measured how they were doing it. We then came back and calculated how it would be if we did it, using our utilization rates, our fill rates, our packing densities, our materials. For example, when you look at the fixtures and the jigs, they're using cast iron, we're using carbon fiber. What's the big difference? Carbon fiber doesn't pick up a lot of heat. And so you don't have the energy waste. You're not spending energy heating it up and down.

But essentially, what we've done is study their process, come back, show them our process and what the carbon footprint is going to be. That's the result, they gave us the job. Don't forget, on this carbon side, it's really a proxy for energy in many aspects, and that's cost.

[Harry Philips, analyst]

It's Harry Philips from Peel Hunt. Few things, please. Just an update really on CapEx and particularly growth CapEx. I mean, obviously, you had the slide splitting it out in terms of sort of momentum, but where might growth -- where might both of those go, guess inflation has sort of boosted up a little bit. Then just on the Specialist Technology margin, I mean, in the past, you very kindly split out the profit split. Maybe I've missed it, but I can't spy the Specialist Technology margin.

[Stephen Harris, executive]

If you look at Chart 27. It's not there.

[Harry Philips, analyst]

I shall look at Chart 27. Okay. And then just thinking about aerospace and particularly a lot of the sort of bottlenecking has been around sort of casting and forging and what have you. So I'm thinking about HIP capacity, thinking about Ellison. And I would imagine the Ellison guys are maybe a bit more chirpier than they might have been back in 2020 and so on.

[Stephen Harris, executive]

Why don't you take the margin point, Dominique, if you could?

[Dominique De Lisle Yates, executive]

Okay. Well, I'll start off with the CapEx. So CapEx outlook for expansionary CapEx. We've got various projects underway. We're building out additional HIP capacity. We've got projects in Emerging Markets in Eastern Europe behind electric vehicles, et cetera. So all in line with our strategy. It's a very difficult one to predict, though, in terms of timing. At this stage, I would suggest it's going to be somewhere from a cash flow perspective between GBP 20 million and GBP 30 million this year, but it could be more. It depends on -- it really depends on the timing of those projects.

As far as the Specialist Technologies, margins are concerned, and I guess you can more or less calculate this yourselves, they're not today at 30% plus. And that's really reflecting the fact that we didn't take any capacity out of Specialist Technologies because the long-term prospects for growth in Specialist Technologies is very good. What that means is that in parts of our business, particularly in HIP services, we have spare capacity today. We're very confident it's going to be filled in the next couple of years, we've got spare capacity today. Aerospace volumes are still 20% plus down on where they were in 2019. And inevitably, particularly in a business like HIP services where you have a big drop-through, that missing revenue, if you like, has impacted profitability.

So today, it's in the mid-20% overall on Specialist Technologies but it's coming back, and it will get back above 30%.

[Stephen Harris, executive]

So let's just talk about the capacity issue, and I'll go right to HIP. So one of the things you have to realize that HIP is a long-term business, you know that, Harry. So we do a capacity footprint plan that's out -- going out 5, 6, 7, 8, 9 years. And that's because if you want to buy a HIP, unless it's already installed like the business that we bought in Switzerland in 2021. Why did we buy a zero-margin business? It's because they're great assets, and we can put that business into our assets, and we can make money out of it. But those assets have gone into our strategic reserve. They're not deployed yet. Unless you can do that. If you've got to order a new HIP, your lead time is some -- to get it up and running, it's somewhere between 1 and 2 years. So if you don't forward plan your capacity, you would be in real trouble. We learned that lesson back in 2011.

But what we're seeing now then is starting in 2025, with our current footprint, we will be out of capacity in various parts of the world. So one of the things you saw on the capital investments, is expansion of HIP capacity now. And that is getting ready for it, plus the fact we've got contracts coming in, plus you've got people like Pratt & Whitney, getting market share, going up, we're doing work for them. So it's all contracted. Look forward, today, it's not heavily utilized, but it will be fairly shortly in terms of years.

In terms of Specialist -- in terms of S3P, we have no spare. So -- but that's always been the case. That's always -- we're always building S3P plants and expanding them because as soon as you put one down, it fills up. So that's -- the rest of the Specialist Technologies, utilization is currently not great. But because of the growth rate in this stuff, especially in the exposure to the aerospace and parts of GI, it fills up quite quickly. I hope that answers your question.

[Dominique De Lisle Yates, executive]

Also, just to round off on the Specialist Technologies margin. For '22 and '23, the hit business that we bought in Western Europe, the back end of '21 we bought revenue, but we knew it was a nil margin business. So as that revenue is transferred elsewhere as we shut the plant and we'll be shutting the plant sometime this year, then we'll get the positive impact of that rolling through into other plants at very nice margins and obviously lose the zero margin in the existing plant.

[Stephen Harris, executive]

Then just more color on that. When you add work to a HIP plant with no other costs associated with it, the drop-through is immense.

[Harry Philips, analyst]

So you can start thinking about 20% margins, therefore, for '24, but growth quite to that point here.

And just on -- because when you look at sort of LEAP deliveries and stuff like that, I mean, are you -- what -- where are you in that sort of production cycle? Are you already up to sort of 1,700 LEAP run rate? Or are you still ramping up towards that?

[Stephen Harris, executive]

So we cover the supply chain from castings and forgings right to finished engines. It's -- that's a 2-year timescale. So I can't tell you what our build rate those things are. But you can see from our sales there where we are -- we're above the background market here. And don't forget, we don't just sell into the new build, we do a lot of aftermarket, and that's from sort of flying hours, revenue -- RPKs. So that's a very difficult question, and you knew it was a difficult question, Harry, for us to answer.

[Unknown Analyst]

[ Colin Modi ] from RBC Capital Markets, it's a quick one. So Aerospace & Defence, clearly, very strong Civil Aero. I was wondering if you could update quickly on the defense side, how are you seeing things progress there?

[Stephen Harris, executive]

Yes, that's a nice question. Thank you. The defense side is quite interesting. So it got me fooled because I thought it was going to surge like crazy. And it hasn't. What we do in defense is mostly flying assets, and actually, the surge is not really anyway in flying assets. What we have seen is some areas of casings, but there's not a lot of money in that, clearly. So our defense revenues are pretty flat. And off into next year, year after year, that -- these contracts will come through. I was amazed at how long it takes the governments to actually sign off to get production going up. So we haven't seen it in '22. Don't really expect much in '23 which I got wrong because I thought we would. But thereafter, should be some. But defense isn't a big deal for us. It's only a small part of our Aerospace & Defence one.

If there are no more questions. Okay. Thank you very much, everybody.

[Dominique De Lisle Yates, executive]

Thank you.