Ingersoll Rand Inc

NYSE:IR

Earnings Call Transcript 2022-Q1

[Operator]

Hello, everyone, and welcome to the Ingersoll Rand First Quarter 2022 Earnings Call. My name is Victoria, and I will be coordinating your call today. [Operator Instructions].

I'll now pass over to your host, Chris Miorin to begin. Please go ahead.

[Chris Miorin, VP, IR]

Thank you, and welcome to the Ingersoll Rand 2022 First Quarter Earnings Call. I'm Chris Miorin, Vice President of Investor Relations. And joining me this morning are Vicente Reynal, Chairman and CEO; and Vik Kini, Chief Financial Officer.

We issued our earnings release and presentation yesterday, and we will reference these during the call. Both are available on the Investor Relations section of our website, www.irco.com. In addition, a replay of this conference call will be available later today.

Before we start, I want to remind everyone that certain statements on this call are forward-looking in nature and are subject to the risks and uncertainties discussed in our previous SEC filings, which you should read in conjunction with the information provided on this call. Please review the forward-looking statements on Slide 2 for more details.

In addition, in today's remarks, we will refer to certain non-GAAP financial measures. You can find a reconciliation of these measures to the most comparable measure calculated and presented in accordance with GAAP in our slide presentation and in our earnings release, both of which are available on the Investor Relations section of our website.

On today's call, we will provide a strategy update, review our company and segment financial highlights and provide an update to 2022 guidance. [Operator Instructions].

At this time, I'll turn the call over to Vicente.

[Vicente Reynal, Chairman, CEO & President]

Thanks, Chris, and good morning to everyone. Starting on Slide 3, Ingersoll Rand's unwavering commitment to our purpose of making life better is evident in the sustainability of our products, which help our customers reduce their energy consumption and water usage. We delivered another strong quarter in the first quarter with our teams leveraging the IRX process to outperform even with ongoing challenges in supply chain, accelerating inflation and geopolitical uncertainty. The performance in Q1 is attributed to our highly engaged employee base who think and act like owners because they are. Our latest engagement scores highlight this dynamic where we now rank in the upper part of the top quartile scoring over 500 basis points above the manufacturing benchmark.

And for the most critical question of how happy are you working at Ingersoll Rand, we rank in the top 10% of all manufacturing organizations. Not only are we focused internally but also on the needs of those outside our organization. Last quarter, we made a $1 million commitment to support Ukranian impacted by the work with humanitarian aid. Demand for our products and services remain strong with our backlog at an all-time high and our leading indicators showing resiliency in our markets. We remain attuned to the dynamic environment around us and are hyper-focused on executing on what we can control.

Moving to Slide 4. We've spoken before about how operating sustainably is embedded in our company and is intentionally at the center of our core values as it underpins our very existence. Ingersoll Rand makes life better for customers by making them more sustainable. We'd like to take time today to highlight that even in an uncertain environment, customers have significant opportunities to reduce their emissions and materially reduce their energy cost and water usage. And this is how we think about our sustainability strategy, growing sustainably by providing mission-critical solutions to customers that reduce energy and water usage and operating sustainably in the processes we employ to deliver those solutions.

We spoke at our recent Investor Day in November about the sustainability mega trend. And despite the uncertainty in today's market, we strongly believe that this trend will drive customer decision-making to invest on more efficient flow creation devices like air compressors, blowers and pumps, which has been an underinvested area over the past decade or so.

Turning to Slide 5. Our customers are increasingly realizing that air compressors and air treatment optimization is an essential opportunity to reduce their Scope 1 and Scope 2 emissions. Air compressors consume up to 30% of the manufacturing sites electricity. And with the recent significant rise in energy costs, this will continue to increase. Ingersoll Rand's products provide industry-leading efficiency that enables customers to reduce the energy cost from our compressors up to 50%, and air treatment solutions or dryers up to an incredible 90%.

As we have forecasted out our potential impact of our Scope 3 emissions, we have established a goal of helping our customers achieve a combined 15% reduction in greenhouse gas emissions from the use of our products, which equates to more than 40 million megatons of CO2. Our customers are becoming more educated about the impact that compressor optimization can have on their mission.

We have shown 2 examples in this slide of global leaders in both the consumer electronics and paper industries, who clearly identified compressor optimization as a top priority for greenhouse gas emission reduction in their latest sustainability reports. In addition to energy usage, our customers are also faced with water shortage and a need to improve water management and quality. And you can see at the bottom of the page, we're a global paper company and a world leader in consumer packaged goods have committed to reducing water usage by 25% and 20% per unit, respectively, a significant commitment. And one we're very well positioned to solve with our products.

Approximately 30% of our total revenue base is generated from products focused on improving water management, purification and reducing water consumption, and we're committed to helping customers save over 1 billion gallons of water annually through the use of our products.

Turning to Slide 6. Not only our largest customer is making buying decisions based upon opportunities to improve energy efficiency, but we believe that almost all of our customers take energy efficiency into account. Additionally, governments are now regulating energy conservation standards for compressors, and we anticipate these trends will continue to accelerate, and we intend to remain at the forefront of these requirements.

Last year, just in the U.S., we conducted over 4,000 compressor system audits, which is an increase of 60% from 2019. After the audits, we made upgrade recommendations based upon evaluations of energy efficiency and several other factors, and this led to $100 million in sales directly attributable to these audits. And this is a great example on how we connect and educate our customer base on total cost of ownership and energy efficiency. We estimate that 2/3 of our current global installed base could realize meaningful improvements in efficiency by upgrading their compressor system.

And with the midpoint of 15% energy efficiency uplift across that portion of the install base, a customer with a typical compressor system will realize on average a payback of less than 2 years at current energy prices. So you can see the savings here are real and meaningful and we're highly engaged in educating our entire customer base about this opportunity.

Moving to Slide 7. In addition to helping our customers progress on their sustainability journey, we're leveraging IRX to achieve our goal of being recognized as a top quartile ESG company by operating sustainably. Those efforts have delivered significant progress. And within the past 6 months, we've been materially upgraded by all of our targeted ESG rating agencies, including MSCI, Sustainalytics, S&P Global and CDP. And in fact, Sustainalytics and S&P Global now rank us in the top 15% of companies in our sector, exceeding our goal of becoming top quartile in half the time we had committed to it. But we're not finished with the journey. We're just getting started. We take our role as a sustainability leader very seriously, and we're committed to continuous improvement and progress towards achieving our other sustainability goals.

I would now turn the call over to Vik to provide an update on our Q1 financial performance.

[Vikram Kini, SVP & CFO]

Thanks, Vicente. Moving to Slide 8, we continue to be encouraged by the performance of the company in Q1, which saw a strong balance of commercial and operational execution fueled by IRX to overcome persistent inflationary pressures, a challenging supply chain environment, increased geopolitical uncertainty and lockdowns in Shanghai. Despite these challenges, we continue to remain on track to deliver on our $300 million synergy commitment with $50 million expected to be realized in 2022.

Total company orders and revenue increased 25% and 18% year-over-year, respectively, with strong double-digit orders growth in ITS and double-digit organic revenue growth across both segments. Our orders in the quarter were a record for the company and revenue was a first quarter record, setting us up for continued strength in 2022.

The company delivered first quarter adjusted EBITDA of $304 million, a 24% year-over-year improvement and adjusted EBITDA margin of 22.7%, a 110 basis point improvement from prior year. Incremental margins for the company were 29% despite the aforementioned challenges. Free cash flow for the quarter was $32 million and remained positive despite working capital headwinds in most notably an increase of approximately $100 million in inventory to support the growing backlog and elevated incentive compensation costs coming off of a strong 2021 performance.

Total liquidity was $3.1 billion at quarter end and cash was up approximately $400 million from prior year. This takes our net leverage to 1.2x, an 0.7x improvement from prior year and a slight increase of 0.1x from prior quarter.

Turning to Slide 9. For the total company, Q1 orders grew 21% and revenue increased 14%, both on an organic basis. Overall, we posted a strong book-to-bill of 1.22x for the quarter. We remain encouraged by the strength of our backlog, which is up approximately 70% from Q1 of 2021.

Total company adjusted EBITDA increased 24% from the prior year. ITS segment margin improved 70 basis points while our PST segment margin declined 260 basis points with the largest driver of the decrease coming from M&A. When adjusted to exclude the impact of M&A completed in the 12 months ending March 31, PST margin declined by 130 basis points, driven mainly by the impact of inflation, FX and product mix. It's important to note that both segments did remain price cost positive in terms of dollars in the first quarter, which speaks to the nimble actions of our team despite ongoing inflationary headwinds.

Finally, corporate costs came in at $29 million for the quarter, down year-over-year primarily due to lower incentive compensation costs and general cost savings while continuing to invest in critical growth areas like demand generation, and industrial Internet of Things. We expect corporate costs to normalize back to the low 30s in terms of millions of dollars per quarter for the remainder of the year. Adjusted EPS for the quarter was up 26% to $0.49 per share, and the tax rate for the quarter was 23%. We anticipate the full year being in the low 20s as well.

Turning to Slide 10. Free cash flow for the quarter was $32 million on a continuing ops basis, remaining positive despite the aforementioned increases in net working capital. CapEx through the quarter totaled $18 million, which is an approximately 25% increase compared to last year, further demonstrating our continued investment in the business.

Free cash flow included $8 million of synergy and standup costs related to the IR merger. Leverage for the quarter was 1.2x, which was an 0.7x improvement versus the prior year. And total company liquidity now stands at $3.1 billion based on approximately $2 billion of cash and $1.1 billion of availability on our revolving credit facility. Liquidity decreased by approximately $100 million in the quarter, which included outflows of $30 million towards strategic M&A, $101 million in share repurchases and $8 million for our dividend payment.

Our M&A funnel remains robust and active with 6 bolt-on acquisitions currently under exclusive letters of intent. We remain prudent and disciplined to generate strong returns on transactions with highly strategic and synergistic characteristics. But clearly, we have significant firepower to deploy to M&A, which is a strong driver of our compounding growth model.

I will now turn the call back to Vicente to discuss our segments.

[Vicente Reynal, Chairman, CEO & President]

Thank you, Vik. And turning to Slide 11. Our Industrial Technologies and Services segment delivered strong organic revenue growth of 14%, including approximately 6% in price and 8% volume growth. Both of those year-over-year while also demonstrating solid sequential acceleration on both price and volume.

Adjusted EBITDA rose 17% year-over-year with an adjusted EBITDA margin of 23.8%, up 70 basis points from prior year with an incremental margin of 29%. Organic orders were up 25% with a strong book-to-bill of 1.24x.

Starting now with compressors, we saw orders up approximately 30%. A further breakdown shows orders for oil-free products growing over 30%, and oil-lubricated products increased approximately 30%. The Americas team delivered strong performance with orders in North America up approximately low 30%, while Latin America was up in the low 40s.

In Mainland Europe, orders were up solidly in the with no material deceleration of note sequentially during the quarter, while India and Middle East were up in the mid-40s.

Asia Pacific continued to perform well with orders up mid-20 driven by mid-20s growth in China and high teens growth across the rest of Asia Pacific. In Vacuum and blowers, orders were up low 20s on a global basis. In the power tools and lifting business, orders for the total business were up high teens and saw continued positive momentum. As we discussed during the Investor Day, our demand generation capabilities provide us with the most forward-looking indicators of customer demand through the data-driven approach to developing marketing qualified leads or MQLs, and we gained an additional several months of insight by leveraging this data.

And we're aware of the uncertainty related to the global economy, but as we review MQLs across our business and across geographies each week, these indicators show double-digit growth year-over-year across all major geographies, including America, Mainland Europe, the Middle East, India and Asia Pacific. China has clearly been impacted due to the Shanghai lockdown, but even in the most recent weeks, MQLs are very near last year's level.

As I mentioned earlier, we're very focused in our approach to delivering sustainable innovative solutions. As such, I want to spend time a minute highlighting our LeROI gas compression business, which we acquired in mid-2017. Since then, we have been very focused on repositioning the portfolio of LeROI to further penetrate biogas market, which has seen strong growth as customers are able to capture gas emitted from sources such as landfills and cattle farms and monetize it as an energy source.

And as you can see on the page, the growth we have realized from these efforts has been phenomenal and continues to rapidly accelerate. Orders were over $100 million in the past 12 months. And revenue is expected to be more than double in 2022, bringing total organic growth of over 5 years to over 440%, and creating a post synergy multiple of the acquisition to around 1x.

We greatly exceeded our mid-teens return on capital target and expect to achieve approximately 70% ROIC by this year. LeROI is just a fantastic example of a highly strategic and synergistic company whose value has been unleashed in the transition from a family-owned business to ownership of Ingersoll Rand.

A few weeks ago, I get a chance to visit the LeROI team in Sidney, Ohio. And the transformation the team is making is very impressive. You can feel the energy, passion and engagement of employees as you enter the manufacturing floor. We heard a lot of feedback around how the ownership mentality we have and the equity we granted has positively impacted not only the performance we show here, but more important, the lives of many of our employees in a very positive way.

Moving to Slide 12. Revenue in the Precision and Science Technologies segment grew 12% organic with approximately 5% price and 10% volume growth. Additionally, the PST team delivered strong adjusted EBITDA of $85 million, which was up 27% year-over-year with incremental margins of 22%. Adjusted EBITDA margin was 28.6%, down 260 basis points year-over-year, primarily driven by the impact of M&A. And again, the segment was down 130 basis points, excluding the impact of acquisitions, with an adjusted EBITDA margin of 29.9% ex M&A.

Overall, organic orders were up 6%, which is on top of 13% year-over-year organic growth in Q1 of 2021. In addition, we continue to be excited about our funnel for the hydrogen fuel business, which now stands in excess of $100 million. The integration of Seepex, which we acquired in September of '21 continues to progress very well, with strong growth in new geographies and an acceleration of margin expansion into the low 20s from the mid-teens level inherited at the transaction closed just a couple of quarters ago.

I also had a chance to listen the Seepex team in the U.S. And once again, our unique approach to ownership brand is playing a very crucial role in accelerating engagement and performance. I left very excited about the future potential of Seepex as part of Ingersoll Rand.

A further example of our focus on sustainable innovative solutions is the Thomas pump brand. A compression technology, primarily targeting the life and science market with a $2.5 billion addressable market. Thomas pumps, they serve the patient care end market, both in facility through applications like ventilators and also at home through oxygen concentrators. Adjacent today is an in-vitro diagnostic end market. And we have leveraged our highly translatable technology to grow 40% within this market with a very strong focus on OEMs and with significant runway ahead.

We have recently secured several sizable orders from large pharma customers in the in-vitro space who designed our Thomas pump into their new products, which will generate strong recurring revenue over the customers' product life cycle.

Moving to Slide 13. After a strong start to the year, we're raising 2022 guidance. We're raising organic revenue growth 100 basis points from 8% to 10% driven by a 100 basis point increase in organic growth expectations from both the ITS and PST segments as compared to the original guidance. FX is expected to now contribute a headwind of approximately 2% versus 1% on the prior guidance. And this leads to a total company revenue up 11% to 13%.

We're also increasing the adjusted EBITDA range to $1.385 billion to $1.425 billion. We continue to expect free cash flow conversion to adjusted net income to be greater than or equal to 100%. We anticipate our adjusted tax rate to be in the low 20s and CapEx to be approximately 2% of revenue.

Lastly, we want to provide some color on Mainland Europe and lockdowns in Shanghai. During the quarter and into April, we have not seen any material slowdown in orders. In fact, we monitor our marketing qualified leads or MQLs as we said, fairly close and as they are really a leading indicator for order activity, and MQLs in Europe have been quite stable throughout 2022.

As for the lockdown is Shanghai, we're starting to see the ease of the lockdowns trending positively. We remain encouraged. But as you know, this is a fluid situation that we continue to monitor closely. And although we don't provide quarterly guidance, the best way to think about it is we are not making significant changes to the first half and second half phasing as compared to our original item as we're taking a prudent view in the second quarter due to the lockdowns in Shanghai.

Having said this, we still see continued Q1 to Q2 sequential growth in revenue and adjusted EBITDA, both expected to be modest.

Turning to Slide 14. As we wrap up today's call, I want to reiterate that Ingersoll Rand is in a very strong position. We delivered record performance in the first quarter, and our backlog provides momentum into the second quarter. 2022 is poised to be a strong year despite known challenges and dynamic market conditions. We will continue to remain agile and leverage IRX across every facet of our business to deliver on our commitments.

To our employees, I want to say thank you for your continued engagement and making thoughtful, action-oriented decisions like the owners that you are. This engagement continues to drive the accomplishment of our mission to make life better for our customers, the environment and the shareholders. Our balance sheet is very strong and with our disciplined and comprehensive capital allocation strategy, we remain resilient and have the ability to deploy capital to investments with the highest return on capital as we continue our track record of market outperformance.

So with that, I'll turn the call back to the operator and open for Q&A.

[Operator]

[Operator Instructions]. And our first question comes from Michael Halloran from Baird.

[Michael Halloran, Robert W. Baird & Co.]

Just some thoughts on backlog and what kind of visibility that gives you. So obviously, orders really strong, particularly in ITS. How is that expected to be cadenced out? What's going on with the backlog levels? And what kind of visibility does that give you on a forward basis as we sit here?

[Vicente Reynal, Chairman, CEO & President]

Mike, so clearly it gives us, I mean, obviously, much greater visibility than what we have been in prior years. ITS, as you know, has a portion of being loan cycle. And the way we may want to think about it is that kind of 20% to -- maybe 20% to 25% of that backlog being kind of more on the longer cycle perspective, which kind of gives us a good view into potentially 2023.

So I think it's -- we're having great visibility here, obviously, for the next couple of quarters and even greater visibility than what we have seen in the past as we go into 2023.

[Michael Halloran, Robert W. Baird & Co.]

So as part of the conservatism then less about what you're actually seeing from a demand perspective because you have that visibility in the backlog and it's just more uncertainty about when that backlog actually converts at this point in time? Or is there something else to the conservatism that you laid out in the guidance?

[Vicente Reynal, Chairman, CEO & President]

That's it, Mike. It's prudency, clearly, as we kind of navigate the ramp after the lockdowns in China and any continued geopolitical environment that might be happening out there that may cloud a bit of a shorter-term visibility. But I mean, I think it's -- you see it in the orders and the remarks that we made, momentum continues. Our marketing qualified leads continue to be pretty strong and resilient. And I think at this point in time, it's just more prudency based on what we're seeing.

[Operator]

Our next question comes from Julian Mitchell from Barclays.

[Julian Mitchell, Barclays Bank]

Maybe I just wanted to start with a question on the margin outlook. So you had 29% incrementals in Q1 and you're saying sort of mid-30s for the year. When we're thinking about the second quarter, should we assume that incremental margin year-on-year is maybe a little bit lower than Q1? That seems to you what you're saying, but just wanted to confirm that.

And then maybe in that light, sort of talk about price cost margin impacts, what was it in the first quarter and what you expect for the year?

[Vikram Kini, SVP & CFO]

Yes. Julian, I think the way you're thinking about it is quite accurate. So maybe I'll start with the price cost. So price cost from a dollar perspective was positive in the first quarter. I'd say on a margin perspective, not necessarily margin accretive, but we did cover inflation from a price perspective. We would expect the dynamic in Q2 to frankly be fairly comparable. Obviously, given a lot of the geopolitical situation as well as some of the outcomes of the Russian-Ukraine situation, clearly, that's driving some of the inflationary pressures we're seeing incrementally into Q2.

Worth noting here, though, that obviously, we've continued to recalibrate from a pricing perspective, and we would expect price cost to be more favorable and more positive and margin accretive more into the back half of the year. So that's kind of the way to think about it. But -- and your thought in terms of the incrementals being a little bit more subdued in Q2 due to that nature as well as the Shanghai lockdowns, that's correct as well in Q2. That will drive a slightly more subdued incrementals in Q2 specifically.

[Julian Mitchell, Barclays Bank]

And then just my quick follow-up would be around the orders expectations. So you had better orders than I expected in the first quarter given your comp. Sounds like orders are staying good into Q2. Just wanted to make sure that's correct. And then within PST specifically, the orders are up I think mid-single digit in the first quarter. How are you thinking about those looking out the next few months?

[Vicente Reynal, Chairman, CEO & President]

So yes, I mean I think orders continue to be actually fairly good. Clearly, as we go more into Q2, Q3, tougher comps, obviously. As you remember, last year, we were seeing that 30% and 40% orders momentum, but we still see very good momentum as we are moving here into the month of April.

And from a PST perspective, I think the way I think about it is, again, they're comping against that double-digit orders from Q1 of 2021. But if I look at it from a sequential perspective, actually on an absolute dollar, sequentially Q4 to Q1, we saw about a 10% increase in order momentum on the PST. So again, speaks pretty well as to no concerns on what the team is seeing and the ramp continues in terms of the order momentum, which obviously will lead to a better outcome here.

[Operator]

Our next question comes from Rob Wertheimer from Melius Research.

[Robert Wertheimer, Melius Research]

My question, you made pretty clear comments on Europe, and I just wanted to circle back there because it still seems like there's opposing potentialities where you could have a recession and the demand drop. And at the same time, Europe desperately needs energy efficiency, energy savings and solutions to the growing energy crisis. And so more qualitatively on your MQLs, can you just talk about time line? Is the issue, the energy spike, already started to impact plans for upgrades? Are people coming to you for that reason? Can you see it in your pipeline?

[Vicente Reynal, Chairman, CEO & President]

I think, Rob, what -- I think our teams will tell you that they're seeing an increase in requests from customers as it relates to how -- what else can they do from an energy efficiency perspective. I think a data point to think about it, we talked about the audits that we do in factories. And how -- when you think about it in the U.S., it's up 60%, the number of audits that we're doing, energy efficiency audits as compared to pre-pandemic levels back in 2019. We didn't come in Europe, but in Europe, we also do a lot of audits. And the audits are kind of similar in nature in terms of seeing good momentum in terms of growth.

So customers are definitely more attuned to it. We leveraged our demand generation engine to continue to educate the customers on what they can achieve. And so we're taking that advantage and continue to create a bit of a tailwind here for us.

[Robert Wertheimer, Melius Research]

Perfect. And then can you give any comments on -- maybe it varies a lot, but on the general time line and what your factory upgrade might be investigated, decided upon and delivered? I'll stop there.

[Vicente Reynal, Chairman, CEO & President]

Sure, yes. On the customer audits, you're trying to -- from the time that the customer request and we go and show up to the facility to the time that we provide a report, it could be a couple of months. We definitely want to gather a lot of good data points. And by the time that we kind of do the reports and provide this and communicate, I think the cycle could be roughly 2 months in order for us to get to that face-to-face meeting with a customer and agreeing what they may be making a purchase there.

[Robert Wertheimer, Melius Research]

Perfect. And then if they do the purchase, the upgrade, is that another few months? Or how long is lead time?

[Vicente Reynal, Chairman, CEO & President]

Yes, then it goes into the lead time. I mean, and clearly, we've got extended backlog now. So depending on the product could be -- yes, it will go into the backlog of the regular lead time of the product. So it could be another couple of months, yes, or longer.

[Operator]

Our next question comes from Jeff Sprague from Vertical Research.

[Jeffrey Sprague, Vertical Research Partners]

Just wondering if you could give us a little more color on the deal pipeline and specifically, the 6 bolt-ons that you mentioned here, maybe collectively the size and maybe what's the historical hit rate for you once you get into kind of the exclusive LOI.

[Vicente Reynal, Chairman, CEO & President]

Yes. Jeff, once we're in exclusive LOI, we don't find anything. I mean I said hit rate is pretty high. I'm going to say, maybe 90% plus. So we're confident that we're going exclusive with them, and we have done enough diligence but it's just a matter of kind of some of the final negotiating points.

In terms of deal size, think about these 6 bolt-ons similar in nature to LeROI by the time that we made that acquisition. So you can see that they're small in size, but not that every deal will be like LeROI. We want it to be always like that. But clearly, it shows that these bolt-ons can become significant good acquisitions for us over the period of time.

[Jeffrey Sprague, Vertical Research Partners]

Great. Understood. And then just a follow-up on the whole MQL kind of information insight that it provides. I wonder also if there's any update on kind of your hit rate there as you've tried to look further out and develop leads further in advance, just kind of what's going on kind of conversion lead to order. Or anything to...

[Vicente Reynal, Chairman, CEO & President]

Yes, just to give you a -- kind of to frame it up. I mean when we have a marketing qualified lead, it is what we consider to be a medium to hot lead. So it has been already kind of prequalified through a lot of the algorithm that we do internally and kind of with our demand generation, we'd like to call that artificial intelligence engine that we have. So it is higher than the typical close rate.

So if you think -- we don't explicitly talk about our close ratio as we think that's kind of strategic to us, but it's much higher than the typical sales call that we can make. So that's why we're very encouraged with just keep pushing MQLs. And at the rate of several thousand of marketing qualified leads per week, it's quite encouraging.

[Operator]

Our next question comes from Joe Ritchie from Goldman Sachs.

[Joseph Ritchie, Goldman Sachs Group]

So maybe just starting off, going back to the discussion around audits. I thought that was a really interesting discussion. So I know it's not an apples-to-apples comparison because 4,000 audits, your installed base I think, across your portfolio of products is something like 5 million. I'm just trying to think through this opportunity on a longer-term basis because I see $100 million conversion and that's pretty meaningful, like 2 points to your ITS growth.

And so I'm just wondering, is this something like a growth multiplier over the coming years, is this something you guys are hoping to kind of bank on going forward? Any thoughts around that would be helpful.

[Vicente Reynal, Chairman, CEO & President]

Yes, Joe. So I can tell you that the 4,000 that we made reference is only in the U.S. So yes, I mean, definitely many more as we think about it globally, from a global perspective. And yes, I mean, I think we're -- this is something that we're leveraging as another kind of what we call a self-help growth initiative. We think it's meaningful for the customers to learn more about what they can do.

It is something that we've been doing for a little bit of time, but we're getting really good at doing this not only for compressors but also for like blowers. So when you look at a company like Rontec in the pulp and paper industry, they're now doing a lot of these audits as well to think about energy as well as water conservation in the pulp and paper industry.

So yes, I think it's something that is very strategic to us. We're kind of unique on how we do it. We think some of the acquisitions that we're making, like Lawrence Factor a couple of quarters ago, it's another enhancer on how we're going to be able to do not only the air audits, but maintain the level of purity of air and efficiency and so on with remote connectivity testing.

So I think it's -- yes, it can be a good growth driver for us. It has been for us so far. And as we said on the remarks, 60% improvement from the number of audits that we did in 2019, pre-pandemic. So it's definitely an area of continued investment for us.

[Joseph Ritchie, Goldman Sachs Group]

Yes. No, no, that's great to hear, Vicente. I guess maybe my follow-on question, just on China. Just curious, like, can you maybe just provide some on-the-ground color size of the business for you guys? What are you seeing in the region right now? What's been the impact? And how are you thinking about it quantitatively for the guide?

[Vicente Reynal, Chairman, CEO & President]

Yes. So China for us is roughly 15% of sales, 1-5. And I think we said it before that we're really in the country for the country. So you could argue that roughly 90% of the product that gets sold in China is produced in China. And so therefore, the supply chain is kind of closed by.

We don't have a factory in Shanghai. Our factories are outside in Xuzhou and Wuxi and Busan. So these are kind of different cities that have not been fully impacted by the lockdowns as our operators can still go to the factory. In Shanghai, what we have is we have a distribution center. So it kind of has impacted maybe some of the distribution center that we do from -- which is mainly aftermarket. But most recently here, the government is allowing for some companies to actually go back, and we have been one of those companies that we have been allowed to go back.

So the situation here now is where we need now the supply chain to start ramping up. So it's not so much about us, but making sure that those suppliers that we have within the Shanghai region that has been locked down, that they're able to ramp up kind of as fast as where we have been able to. So I think it's just one of those that we're taking a prudent view as we go here in the second quarter and as we're able to work with our suppliers and be able to ramp that even faster and better. It will be, hopefully, some upside opportunity from the perspective of being able to support our customers in a better way.

[Operator]

Our next question comes from Nigel Coe from Wolfe Research.

[Vicente Reynal, Chairman, CEO & President]

Maybe Victoria, we move to the next and then come back to Nigel.

[Operator]

Our next question comes from Josh Pokrzywinski at Morgan Stanley.

[Joshua Pokrzywinski, Morgan Stanley]

Just to keep on the energy audit discussion for a second. I'm sort of wondering what the historical context is here, Vicente. We've seen sort of energy price spikes before. I think kind of going back at points in time, there's been a compelling payback analysis, but like we haven't seen customers move as much. I guess the current environment feels may be more different and more structural with what's going on in Ukraine. But like has this happened before? And what sort of the order of magnitude difference?

[Vicente Reynal, Chairman, CEO & President]

I think, Josh, maybe the 1 different variable that is maybe very new here is ESG and the 2030 and 2050 targets that companies are agreeing to. And you saw on one of our slides how we actually included quotes from sustainability reports from pretty large companies that basically talk about the compressor and the air treatment systems are their way for getting to their Scope 1 and Scope 2 activity.

So I think it's a combination of the multiple variables that, yes, energy has spiked in the past and that kind of may create a little bit of acceleration. But I think now the really fundamental change in the market is that, is the fact of these kind of ESG targets that companies are putting out and realizing that this underinvested area of compressors, blowers and pumps that consumes energy, there's now time to really upgrade that.

And the second variable could be around IoT and how the industrial Internet of Things and the remote connectivity is really accelerating that connectivity of the product to really enhance energy consumption and water usage even stronger. So those are the 2 variables that are very different now that really we think are going to create a better sustainable ongoing momentum.

[Joshua Pokrzywinski, Morgan Stanley]

Got it. That's helpful. And maybe that's part of the answer to my next question is this business and at other points in time, felt a bit more cyclical with this sort of macro backdrop, whether it's PMIs or specific disruptions in regions. What do you think is sort of the big difference now? I mean part of it is probably some of the sustainability stuff, maybe near shoring, maybe your own lead generation. But like if you had to focus on 1 or 2 things, either macro or micro, do you think are sort of driving the better order performance today than in past volatile period, what would you sort of break that down to?

[Vicente Reynal, Chairman, CEO & President]

Yes. I'd say, Josh, if I say in terms of things that we can control that we have been working on for the past several years, is how we have moved to better end markets, kind of what we call sustainable, high-growth end markets, whether it is food, beverage, life and sciences. We called that out in the Investor Day as the quality of life and how we continue to see that as we move more of our product by our own choosing to be able to play in those end markets, that provides a better sustainability.

The second one is, again, in terms of what we can control, it will be demand generation. We think that this is a really compelling competitive differentiator that is allowing us to reach this highly fragmented customer base in a much more highly cost-effective way and very, very efficient, allowing us to create this acceleration in market qualified leads that turn into sales qualified leads. And the way we like to say sometimes internally is that we're going to get -- we're getting our sales guys more ad bats and basically hitting more home runs than in the past.

And the third piece internally in terms of what we can control is, I'll say, innovation. I mean, you see how new product development for us is essential. And every quarter, we speak about how we've been able to create new technologies, new products, I mean, the Thomas pump in the technology and moving it into in-vitro diagnostics. Or even the LeROI compressor, which it was a very gas compressor oriented, and we moved that to a much more sustainable end market.

So I think those are 3 areas that we have in our control that are allowing us to have a much more sustainable ongoing growth.

[Operator]

Our next question comes from Andrew Kaplowitz from Citi.

[Andrew Kaplowitz, Citigroup]

I just want to follow up on something you just said. If you talk about the resiliency of IR's portfolio now versus a few years ago, I think one of the big initiatives you've had at the company post the RMT was to improve the aftermarket capability of the company. So how has you proceeded with that initiative? And how has the improvement gone over the last few years?

[Vikram Kini, SVP & CFO]

Yes. Andy, this is Vik. Maybe I'll start, and I can let Vicente on as well. You're absolutely right. I think if you followed the journey here for a few years, we made some very concerted efforts, I'd say, to eliminate a lot of the, what I'll call, cyclicality that was inherent in the portfolio previously. So you've obviously seen that with the divestitures, particularly with upstream oil and gas obviously being divested away from the business.

And then I'd say a couple of other areas now as we think about today and moving forward. One is the aftermarket piece, which you're absolutely right. We see a path to be above 40% from a total enterprise perspective, which is a more stable and recurring base of revenue, obviously, more profitable as well.

And I think the other one that Vicente just mentioned, and he gave a number of examples, whether it be the LeROI or the Thomas pumps, is what I'll call higher growth, more sustainable end markets. So you've seen a lot of push for areas, whether it be on the water side, whether it be on the lab life science, whether it be hydrogen, a lot of the applications that our oil-free compression technology goes into.

So I would tell you, yes, that's absolutely been a huge push and a very concerted effort. I think if you look at the portfolio today, even versus what the composition was from an end market perspective at the time of the RMT meaningfully different by virtue of both of those areas that we focus on.

[Andrew Kaplowitz, Citigroup]

And then, Vik, if I could follow up with you on cash flow. Obviously, started out seasonally slow in Q1, you mentioned $100 million investment in inventory. How are you thinking about working capital improvement as you go through the year to reach that 100% goal and should we sort of normal cadence from here?

[Vikram Kini, SVP & CFO]

Yes. That's thought on, Andy. Obviously, clearly, given the backlog and the global supply chain environment, you have seen a build of inventory here in Q1. I would say, obviously, right now, clearly, with the Shanghai situation and still kind of some of that supply chain unrest that's there, we would expect to continue to see working capital at probably a slightly elevated levels here, particularly through the first half of the year. So Q2 probably not being much different. And then the second half being I'd say about more of the normalization.

So I think by the second half, again, assuming everything continues to return to some semblance of normal, you would expect to see that seasonality probably come back in. And it's worth noting here that our cash flow is typically seasonal Q1 is typically the lightest and it does ramp towards the end of the year. We would expect no different this year. Just a little bit more exacerbated in the first half due to the inventory situation.

[Operator]

Our next question comes from Nathan Jones at Stifel.

[Nathan Jones, Stifel, Nicolaus & Company]

I wanted to start off with some questions around the backlog and lead times. I mean you've obviously had very strong book-to-bill ratios, very strong orders. But I'm sure you have more backlog than you would like at this point. Are you in lead times getting shorter, getting longer? Any color you can give us around how that's impacting the business and how that's impacting pass-through backlogs, et cetera.

[Vicente Reynal, Chairman, CEO & President]

Yes, Nathan, I would say and it actually varies by business and also the product lines within the businesses. So for example, we've now been able to have like the small compressors to reduce the lead time dramatically versus what it was in the past.

And so I think in the aggregate, you can think about lead time maybe about the same to slightly better with some kind of mix within those product lines that we have. So is our team working aggressively to try to reduce and use it as a competitive advantage? You bet, they are, yes.

[Nathan Jones, Stifel, Nicolaus & Company]

Do you think that your lead times are better or significantly better than the competitions and that, that is leading to market share gains?

[Vicente Reynal, Chairman, CEO & President]

I think it will vary country by country. Nathan, I mean, as you know, we're still in region for region or in country for country. It could vary country to country. And in some cases, like I said, I think if we have that opportunity to utilize our lead time as a way to have a competitive differentiator, we will.

[Nathan Jones, Stifel, Nicolaus & Company]

And just one quick one on the energy audits. Do you actually charge for those energy audits? Or do you view that as kind of a selling expense?

[Vicente Reynal, Chairman, CEO & President]

Yes. No, we actually do it as -- well, I won't say that it varies again, Nathan. In some industries, we're actually charging for some of that, minimal amount. What we do is only mainly because we just want to see the commitment from the customer in doing these audits. I mean sometimes, if you do it for free, they just don't pay the attention to it. So in some cases, we're actually charging. I mean -- but not to generate a profit on these audits. It's just more to create that conversation on what we can do to the customer.

[Operator]

Our next question comes from Stephen Volkmann of Jefferies.

[Stephen Volkmann, Jefferies]

Vik, I just wanted to go back to the incremental margin question, if I could, because I guess the second half is going to have to be pretty heady relative to incremental margins to kind of get to the 35% for the year. And I guess probably most of that's price cost. But I just want to make sure you have a conviction and visibility into that accelerating in the second half. And I assume the fourth quarter would be kind of the highest of the year, but just any comfort around that would be great.

[Vikram Kini, SVP & CFO]

Yes, Steve, that's completely correct. Yes. I'd say the incremental margins are expected to be obviously much better in the second half of the year than the first half. The major drivers clearly price cost is probably the single biggest driver. As we said, we would expect that price cost is going to be dollar positive in all quarters, but not actually margin positive, particularly in the first half. In the second half, much more so.

I'd say the other areas to note would be, one, we do have the $50 million of synergies that we are still expecting to see. Remember, those tend to be a bit more seasonal because the synergies we're seeing now are much more, I would call I2V-oriented maybe to a degree, footprint in certain areas. But they are very volume -- they show up on the volume shifts there. So obviously, they have the seasonality associated with them that, once again, would follow them more so in the second half of the year, it's seasonally stronger.

And the third area to note here is, remember, we do have the, I'd say, the synergies on the bolt-on acquisitions that we completed last year. And so we're taking -- a lot of that is in the Seepex business specifically. We're taking a lot of the actions now, and we'd expect to see a lot more of those in the -- actually in the margin profile more towards the back half of the year. So -- and again, it's -- obviously, it's probably worth noting that right now, particularly for those PST acquisitions, you didn't have them in the prior year for the first half.

So there is a bit of a nuance between first half, second half, once you start comping fully on the acquisitions, it starts to normalize a bit more. But those would probably be the 3 biggest drivers. Price cost obviously being the biggest of the 3 of them.

[Stephen Volkmann, Jefferies]

Understood. That's helpful, and I think actually sort of leads to my follow-on because I was curious about the 6 bolt-ons that you have in the pipeline. Are those likely to be margin dilutive? I know you can sometimes find some pretty good margin acquisition targets. But just curious if you actually get those over the goal line, how we should think about that mix?

[Vikram Kini, SVP & CFO]

Yes. Steve, I wouldn't -- so they're bolt-on in nature here. They vary in margin profile. And they also, I'd say, vary from a segment perspective as well. So we have a pretty good, I would say, mix across the portfolio. Not meaningfully, I mean, majority of things we're purchasing are in that 20%, 25% plus realm, typically speaking, but we typically have a very good path to how they will get to segment margin profile, if not better, within a 3-year time frame, if not better. And I would tell you the margin profile -- I'm sorry, for the return profile from an ROIC perspective on all 6 of these deals is completely in line with the targets that we've laid out previously.

So even if there is some slight dilution upfront, we would tell you that's something we feel like we can rightsize pretty quickly.

[Operator]

Our final question comes from Nigel Coe from Wolfe Research.

[Nigel Coe, Wolfe Research]

This time I'm here. Sorry, managing the calls. So I apologize for that, embarrassing.

I want to go back to the energy audits. I know you've touched on it a number of times here. But you said a 2-year payback, Vicente. I'm wondering how that looks specifically in Europe, just given how high energy prices are there. 2-year payback is definitely in the realms of a good CapEx ROI, but just wondering how that looks in Europe.

[Vicente Reynal, Chairman, CEO & President]

Yes. Great, Nigel. Yes, I mean Europe, clearly, with the energy cost being much higher, will be better than that 2-year payback. We don't want to specifically quantify region by region. But as energy costs will continue to rise, that is definitely kind of core to the mathematical formulation of getting that payback in there.

[Nigel Coe, Wolfe Research]

Okay. And then just I'm curious, I'm not aware of any specific credits or incentives at the manufacturing level. But are there any incentives that you're aware of that could encourage -- maybe get some customers over the line on replacements?

[Vicente Reynal, Chairman, CEO & President]

Nothing that I would say meaningful, Nigel, to be honest. No, nothing meaningful.

[Nigel Coe, Wolfe Research]

And then just finally on compressors, the legacy Ingersoll Rand i.e., train, you know what I mean. The old compressor portfolio was definitely a bit more oily than the Gardner Denver portfolio, larger, higher prices. Just wondering, what is the mix right now of energy centric end markets there? And so what trends you seen in those verticals?

[Vicente Reynal, Chairman, CEO & President]

Yes. Great. So this is actually one that very well fits in line to what we said before about moving to the sustainable high-growth end markets. So we're taking that technology of that large centrifical compressors into air separation like for hydrogen or for LNG. So these are kind of the kind of more what we call more into the sustainable end markets that we're seeing. Also food and beverage and also a lot of the new semiconductor expansions that you're seeing and the localization of the supply chain.

And the last one is electric vehicle production and lithium battery ion production. I mean those are kind of the end markets that we have pivoted away from oil and gas and into these better sustainable growth in markets.

So this is a great example on taking what we can control, which is taking the products and position them very well into end markets that are seeing better growth momentum.

[Operator]

This concludes our Q&A session. And now I'll pass it back over to Vicente Reynal for any final remarks.

[Vicente Reynal, Chairman, CEO & President]

Thank you, Victoria. I just want to say thanks to everyone for your interest on Ingersoll Rand. And to all the employees that are listening to here on the call who are shareholders and also to all of our shareholders, we want to say thanks again for the support. As you can see, we're a company very well positioned to continue to execute even in difficult environments, and we're always guided by our purpose of making life better not only for the planet, our customers, but also our employees and shareholders.

So with that, I want to conclude here and say thank you again, and talk to some of you soon. Thank you.

[Operator]

Thank you, everybody, for joining today's call. You may now disconnect your lines.