Ingersoll Rand Inc

NYSE:IR

Earnings Call Transcript 2022-Q2

[Operator]

Good morning, ladies and gentlemen, and welcome to the Ingersoll Rand Second Quarter 2022 Earnings Call. Our host for today's call is Matthew Fort, Vice President of Investor Relations. [Operator Instructions]

I would now like to turn the call over to your host, Mr. Fort. You may begin sir.

[Matthew Fort, Vice President, Investor Relations]

Thank you and welcome to the Ingersoll Rand 2022 second quarter earnings call. I'm Matthew Fort, 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'll 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. For today's Q&A session, we ask that each caller to keep to one question and one follow-up to allow time for other participants.

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

[Vicente Reynal, Chairman & Chief Executive Officer]

Thanks Matthew, and good morning to everyone. Moving to slide 3, I would like to start by welcoming Matthew to his new role as the Head of Investor Relations after several successful years leading our power tools and lifting business as a finance leader and helping to return the business to profitable growth and a strong margin profile. In addition, I am also very happy to welcome Kathryn Freytag as our new Chief Information Officer. Both appointments demonstrate the deep bench of talent that we continue to develop at Ingersoll Rand.

I would also like to say thank you to our employees worldwide for exemplifying our purpose through an ownership mindset and entrepreneurial spirit and delivering on our customer needs. Our teams continue to impress me on how we're leveraging our own IRX process to outperform in the most challenging macro environment.

Our performance in the second quarter and year-to-date exemplifies how our employees think and act like owners. Demand remains very strong as we sit here today. And when we see the supply chain risk and geopolitical and macroeconomic uncertainties continue to be a concern, we stay focused on what we can control while leveraging our strong balance sheet and operational mindset to deliver on our own 2022 commitments and beyond.

We also remain very agile in this environment and you will see today how we continue to accelerate organic investments for growth around innovation and demand generation. We also remain committed to our capital allocation strategy that is very focused on inorganic growth through bolt-on acquisitions. And today we're highlighting three new acquisitions that are very well-aligned with our stated M&A strategy and will enhance the quality of our portfolio.

Starting on slide 4 staying true to our five strategic imperatives where operate sustainably is at the center, we continue to align our portfolio to sustainable high-growth end markets supported by global megatrends. There are four points I would like to briefly highlight on this page. First, is that we have a simple two-pronged approach of growing sustainably and operating sustainably. Second, we released our 2021 sustainability report in June highlighting our progress across all aspects of our sustainability journey and how we continue to remain on track to hit our 2030 targets.

Third, our efforts have resulted in another upgrade from MSCI to AA from A, which puts us in the upper quartile of our peer group. It is also worth noting that we now have moved from a BB rating to a AA rating in less than 2.5 years.

And this recent upgrade was done before the release of our 2021 sustainability report so we will be watching carefully and we will expect to see continued positive momentum in our ratings from the other sustainability rating agencies.

Last, I want to remind everyone to save the date for our Annual Sustainability webcast on September 22 where we will provide a comprehensive update on our current efforts around sustainability.

Moving to slide 5, we want to highlight today an exciting innovation, which is a testament to our commitment to sustainability and organic growth through differentiated technology.

Later this year, we will officially launch this first of its kind water treatment system called Ion Solutions. This is a very compact solution in the box where a small compressor and liquid pump technology from Ingersoll Rand are combined with our own patented cold plasma technology to produce nanobubbles that contain a high concentration of oxygen.

This innovation allows for chemical-free disinfection and enhanced oxygenation of water. You can see some of the incredible benefits this technology produces on the slide including higher disinfection efficacy and increased oxygen concentration all while delivering and driving a lower total cost of ownership and footprint.

We're officially launching this product later this year for indoor farming as well as water disinfection applications and we will continue to expand our reach into other high-growth sustainable end markets like medical, food and pharma.

What excites me even more is the speed in which the team has moved to develop and commercialize the Ion Solutions technology. Through the utilization of the Ingersoll Rand Execution Excellence or IRX, the team moved from the acquisition of the technology and IP behind Ion Solutions to the launch of the product in less than 15 months. In addition, the development was self-funded within the PST segment and we continue to increase our investments in R&D to drive future organic growth opportunities like this.

Turning to slide 6, we're also very pleased to highlight the most recent inorganic investments which remain our top priority from a capital allocation perspective. Our M&A funnel remains very healthy and as of the end of Q2 2022, the funnel remains over five times larger than it was in Q2 of 2020.

Earlier this week, we announced the signing of three bolt-on acquisitions, which are well aligned with our strategic and financial criteria. In addition, these three companies have grown on an aggregate of more than 20% CAGR over the past three years.

Let me quickly walk through the signed deals. First, Holtec, which is a leading provider of on-site systems that generate high-purity nitrogen gas. This is a great example of a bolt-on acquisition that extends our addressable market to very close adjacencies within the ITS business.

In this case, the nitrogen generation can be connected to a compressor and produce nitrogen on site. And there are huge benefits for this including the elimination of large nitrogen storage tanks at a customer site which typically also requires frequent refilling via trucks. In addition the purity and quality of the gas can be much better controlled on site with a drastic reduction in costs.

Second is Hanye, which is a manufacturer of dryer technology that has served as a long-term OEM partner of our ITS Asia Pacific business. Hanye brings differentiated and patented technology to our China compressor business. Both Holtec and Hanye are great examples of expanding our solutions and offerings in the broader compressor ecosystem to better serve our customer needs.

And finally Hydro Prokav an India-based manufacturer of progressive cavity pumps and retrofit spare parts. Hydro Prokav generates more than 80% of its revenues through the sale of aftermarket parts and serves as a complementary addition to the recent Seepex acquisition to further penetrate the growing market in India. We continue to be very prudent in our sourcing and execution of M&A deals as illustrated by the single-digit aggregate pre-synergy adjusted EBITDA purchase multiples for these three deals.

In addition we expect to have several more bolt-on acquisitions to announce in the second half of the year as shown by the fact that we have eight additional deals under LOI. As a result, we're confident from being able to reaffirm our stated target of 400 to 500 basis points of annualized growth coming from M&A.

I will now turn the presentation over to Vik to provide an update on our Q2 financial performance.

[Vik Kini, Chief Financial Officer]

Thanks Vicente. Moving to slide seven. We continue to be encouraged by the performance of the company in Q2. We saw a strong balance of commercial and operational execution fueled by IRX demonstrating our ability to operate in a very agile manner in the current environment.

We remain on track to deliver on our $300 million commitment in cost synergies from the merger. In addition as we've indicated many times we have a funnel that stands in excess of $350 million and we are ready to take incremental actions if warranted by macroeconomic conditions and market activity.

Total company orders and revenue increased 10% and 13% year-over-year respectively driven by strong double-digit organic order growth in ITS and low single-digit organic growth in PST orders. The company delivered second quarter adjusted EBITDA of $335 million a 15% year-over-year improvement and adjusted EBITDA margin of 23.3% a 50 basis point year-over-year improvement and 60 basis point improvement sequentially from Q1.

Free cash flow for the quarter was $165 million despite ongoing headwinds from inventories due to the global supply chain as well as the need to support backlog. Total liquidity of $2.4 billion at quarter end was down approximately $700 million from prior quarter driven primarily by the execution of our capital structure strategy which we will discuss shortly. Our net leverage is 1.1x a slight improvement of 0.1x from prior quarter.

Turning to slide eight. For the total company Q2 orders grew 15% and revenue increased 18% both on an FX-adjusted basis. Overall, we posted a strong book-to-bill of 1.11x for the quarter. We remain encouraged by the strength of our backlog which is up over 40% from last year.

Total company adjusted EBITDA increased 15% from the prior year. ITS segment margin increased 70 basis points while the PST segment margin declined 390 basis points driven by the impact of prior year acquisitions as well as the impact of investments for growth such as the Ion Solutions innovation highlighted by Vicente and the impact of China lockdowns in two PST facilities.

When adjusted to exclude the impact of M&A completed in 2021, PST margins declined by 190 basis points. It's important to note that both segments did remain price cost positive in terms of dollars in the second quarter, which speaks of the nimble actions of our team despite ongoing inflationary headwinds.

Finally, corporate costs came in at $35 million for the quarter, down year-over-year primarily due to lower incentive compensation costs and general cost savings and prudency offsetting incremental investments we made in the area of demand generation and IT. Adjusted EPS for the quarter was up 17% to $0.54 per share. The tax rate for the quarter was 23% and we anticipate the full year being approximately the same.

Moving on to the next slide, free cash flow for the quarter was $165 million despite a $92 million increase in inventory to support backlog. CapEx during the quarter totaled $21 million. And leverage for the quarter was 1.1 turns, which was an 0.1 turn improvement versus the prior quarter. Total company liquidity now stands at $2.4 billion based on approximately $1.3 billion of cash and $1.1 billion of availability on our revolving credit facility.

Liquidity decreased by $700 million in the quarter, which included deploying $621 million to debt repayment, $153 million to share repurchases and $8 million to our dividend payment. As Vicente mentioned, M&A remains our top priority for our capital allocation. Our funnel remains robust and active and we would expect M& A to be our primary usage of cash here in the second half of the year.

On slide 10, we show in more detail the strategic changes we have made to our capital structure. In an effort to create a flexible and efficient capital structure, we took a number of actions within the quarter. First, we paid down the entirety of our euro term loan of $621 million. The debt paydown is consistent with our financial policies to prudently manage our gross debt and our commitment towards achieving investment-grade credit ratings.

We also executed a combination of interest rate swaps cross-currency swaps and interest rate caps to better balance our fixed to floating interest rate ratio and our currency mix of our debt. In addition, strong cash generation of the business, along with a strong balance sheet, enable us to execute on our growth strategy across all economic conditions.

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

[Vicente Reynal, Chairman & Chief Executive Officer]

Thanks, Vik. Turning to slide 11, our Industrial Technologies and Services segment delivered strong organic revenue growth of 14%, including approximately 8% price and 6% volume growth year-over-year. Adjusted EBITDA rose 13% year-over-year, with an adjusted EBITDA margin of 25.4%, up 70 basis points from prior year, with an incremental margin of 32%. Organic orders grew 11% with a strong book-to-bill of 1.11.

It is also important to note that on a two-year stack, the ITS segment organic orders grew more than 50%, which is higher rates than the Q1, 2022, two-year stack of approximately 40%, meaning that thus far we continue to see accelerated demand for our products.

If we move to the individual product categories, each of the below figures includes the negative impact of FX, which you can see was about 5% headwind across the total segment. Starting with compressors, we saw orders up in the high single digits. A further breakdown shows orders for oil-free products grew in the high teens and oil-lubricated products grew in the low single digits. The Americas team delivered solid performance with orders in North America up approximately 10%, while Latin America was up low 20s.

In Mainland Europe, down low single digits, due primarily to FX headwinds. And a further look into our leading indicators like demand generation lease shows stable growth in Mainland Europe.

Despite nearly two months of lockdowns in Shanghai China the Asia Pacific team delivered orders in the mid-teens. This was driven by low double-digit growth in China and mid-20s growth across the rest of Asia Pacific.

In vacuums and blowers, orders were down low single digits on a global basis, driven mainly by FX we spoke about before and also a tough comp, even we saw mid-40s growth in orders during Q2 of 2021.

Moving next to the Power Tools & Lifting. The Power Tools & Lifting team delivered strong performance, with orders for the business up approximately 20%. And this marks their largest quarter for orders since Q1 of 2015.

Looking at the sustainable innovation in action portion of the slide, we're highlighting our next-generation oil-free compressor. With the patented aerodynamic impeller design, this innovative centrifugal compressor is approximately 15% more efficient than the oil-free rotary compressor it will typically replace.

This technology is a perfect example of how we are continuing to address our customers' sustainability needs and goals by driving productivity through improved efficiency and reduce energy costs, decreasing the Scope 1 and Scope 2 greenhouse gas emissions.

Moving to slide 12, revenue in the Precision and Science Technologies segment grew 6% organically. Additionally, the PST team delivered adjusted EBITDA of $78 million, which was up 9% year-over-year, with incremental margins up 11%. Adjusted EBITDA margin was 26.8%, down 390 basis points year-over-year.

As illustrated on the table in the bottom left side of the page, the decline in adjusted EBITDA margin is driven primarily by the impact of prior year acquisitions which drove 200 basis points of the decline. In addition, the impact of investments for growth, such as our hydrogen business and the ion solutions product line that drove 80 basis points of decline and China lockdowns, where the other largest discrete driver had nearly 60 basis points, given the impact due to China facilities in the PST segment.

Organic orders grew up 2% year-over-year, as future comps were challenging due to the prior year COVID related demand, primarily in the Thomas Medical business. Adjusting for the COVID and the one-time large non-repeating orders, normalized organic orders were up approximately 9%.

And on a two-year stack organic orders were up 22%. It is also important to note that in Q1 of 2022, the two-year organic stack was approximately 19%, again showing some sequential acceleration of demand into Q2.

Since the Investor Day in November, one of the key questions we have been asked is how we expect to achieve the mid-30s EBITDA margin profile for PST. On the bottom right-hand side of the page I want to illustrate, why we continue to believe a mid-30s margin is achievable and we remain committed to delivering that in the medium term.

As you can see 25% of the portfolio is already above 35% EBITDA margins, with another 40% of the portfolio that is around 30% margin. That leaves us with a few targeted businesses that are at or below 25% EBITDA margin with the vast majority related to new acquisitions and early-stage innovations.

We believe we have significant opportunity for margin expansion across the entire portfolio and we have a proven track record of margin expansion in both newly acquired assets and within our core business.

And let me point out to three examples. The first example is Seepex and illustrates how we plan to improve businesses that are in the less than 25% EBITDA margin bucket. As you recall, we acquired Seepex in September 2021, which had mid-teens EBITDA margin at the time of the acquisition and has already improved to the low 20s in less than two quarters.

The next two examples point out to how we can continue to improve businesses that already have some very high EBITDA margins. First, Air Dimensions, which was another recently acquired company in Q4 of 2021, which in less than two quarters have gone from mid-50s EBITDA margin to low 60s EBITDA margin. And then there is our legacy Gardner Denver Medical segment, which we now call our Thomas business. This is a core business where we have shown an ability to grow its EBITDA margin from the high 20s in 2018 to the low 30s by 2021 and where it remains today. Overall, we continue to see a strong runway on margin expansion across the entire PST portfolio and we will use IRX to ensure proper prioritization of actions and nimble execution.

Moving to Slide 13. Once again we're raising our full year guidance. We're raising our organic growth guidance for the total company to 11% to 13%, which is a 300 basis point increase from our prior guidance. The raise comes entirely from our IPS segment. The organic growth increase is offset by the negative impact of FX. FX is expected to now contribute headwinds of approximately 5% versus a headwind of 2% in prior guidance. And this leads to a full year 2022 revenue guidance at 11% to 13% total growth.

We're also raising the adjusted EBITDA guidance to a range of $1.395 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. And although, we don't provide quarterly guidance the best way to think about the back half revenue and EBITDA facing is that the distribution between Q3 and Q4 is similar to what we saw in prior year.

We expect pricing to improve slightly from the first half to the second half, as we continue to work through backlog and we do expect the price cost spread to improve in the second half of the year. As a reminder, the new acquisitions mentioned on Slide 6 are not included in this guidance as the transactions have not closed.

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 strong results in the first half 2022 including record second quarter performance that was better than our expectations. 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 again 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 shareholders. And our balance sheet is very strong and with our disciplined and comprehensive capital allocation strategy, we remain resilient to have the capacity to deploy capital to investments with a high return on capital as we continue our track record of market performance.

With that I will turn the call back to the operator and open for Q&A.

[Operator]

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

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

Hey, good morning, everyone.

[Vicente Reynal, Chairman & Chief Executive Officer]

Good morning, Mike.

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

So a couple of questions here. First question, Vicente you talked about constructive or positive leading indicators that give you confidence in the demand through remainder of the year at least. Maybe you could just dig into that a little bit more quoting customer conversations and what really – what some of those leading indicators are that are making you feel that level of confidence.

[Vicente Reynal, Chairman & Chief Executive Officer]

Yes Mike I think one of the most important I'll say leading indicators for us is what we have spoken in the past about demand generation, qualified leads, which as you know we have a very unique marketing engine to be able to grab a lot of good new customers. And as we saw through the quarter, we continue to see pretty good stability on the marketing qualified leads that the team is generating. And as we kind of move into July, we actually even saw acceleration in some areas and some end markets and regions. So that's kind of what gives us confidence. And as we look into the order momentum into July also pretty strong – continue to be fairly strong.

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

Thanks for that. And then good color on the capital deployment side of things. On the LOIs and what you're seeing in the pipeline, could you give a little more context to size of the transactions and if there's any change to the type of things you're pursuing at this point?

[Vicente Reynal, Chairman & Chief Executive Officer]

Sure, Mike. I mean I'll say that very excited about what we see in the pipeline. I mean very solid funnel. You saw that the three transactions that are highly strategic I mean great growing companies, good technologies, addressing – expanding the addressable market. I mean it kind of hits all the marks and even also with the financial criteria.

And as we look through the other eight that we have in the LOI, I would say similar to what we have been doing over the past kind of 12 to 18 months, which kind of bolt-on tuck-in in nature, great returns, good growing companies, elevating the portfolio of the company and one that we see can be highly – highly strategic for us to continue accelerating the growth.

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

Thanks for that, Vicente. Appreciate it.

[Vicente Reynal, Chairman & Chief Executive Officer]

Yes, thank you, Mike.

[Operator]

And we have a question from Julian Mitchell. Your line is open.

[Julian Mitchell, Barclays Bank]

Thanks. Good morning. Maybe just wanted to try and understand the sort of the second half EBITDA outlook a little bit more clearly. So when we're thinking about the sort of weighting between third and fourth quarter, are we thinking the third quarter is maybe a sort of high 20s share of full year EBITDA? Just trying to understand the margin ramp. And then by segment, any color you could give us on how much the margin step-up into the back half your split between ITS versus PST?

[Vik Kini, Chief Financial Officer]

Yes. Julian, this is Vik. I'll take the first part of your question, I'll let Vicente answer the second. I think in terms of your first question in terms of I think you asked about the phasing of EBITDA in Q3. Yes, you're actually, right. I'd say, mid- to high 20% in terms of the phasing. And what we would probably say -- very consistent to actually what we've been saying all year is that the phasing throughout the year in terms of the quarters, is actually very similar to what you saw last year, in terms of the phasing -- in terms of the Q3 and Q4 weighting of EBITDA. So that's probably, a good proxy it's.

[Vicente Reynal, Chairman & Chief Executive Officer]

Yes, and maybe Julian in terms of the segments, I mean if you think about it, kind of first half to second half, which is the way sometimes we like to look at it is that think about ITS. Flow-through in the first half, was approximately in the 30s. And as we get closer to the 40s for the second half, and that's going to be driven, primarily through a better pricing realization that we already have action, as well as some kind of continued movement in terms of the merger-related productivity savings, that -- so think about it it's already actions, that you could call it that we have so to speak in the back or already action.

And then from a PST, I think when you look at the data again, same thing first half to second half flow-through, in the first half was kind of in the low 20s with an EBITDA margin generating in the first half in the high 20s, kind of 28% range. And as we go into the second half, EBITDA margin should expect to grow closer to the 30s, which leads to that incremental flow-through of the 50s.

And again when you think about the big pieces, it's fairly similar in terms of, better price realization given the actions that we have taken for the PST segment. It's a lot around the M&A synergy realization, for the deals that we closed, in the second half of 2021. And also for the PST, is kind of some of these known repeat China lockdown volume mix, and absorption related issues. So again, it feels like fairly doable and the team is executing to all those actions that we need to get done.

[Julian Mitchell, Barclays Bank]

That’s really helpful. Thank you. And then just my follow-up would be around the IT&S EMEA orders progression, how comfortable do you feel with that and the demand outlook in that ITS compressor piece. I realize the order numbers, you put up are including FX, and sort of stripping that out it's a little bit healthier. But are you seeing any change in demand on that piece? And then PST, how long does that kind of COVID headwind last?

[Vicente Reynal, Chairman & Chief Executive Officer]

Yes, Julian, from an ITS EMEA, no change in dynamic. As we see even here with our leading indicators. As you very well pointed out, I mean the Q2, pretty well affected by the FX. And that's why when you can even see it Q1 to Q2 sequentiall, I mean FX, Eurozone was like a 5% to 6% headwind impact. So, yes, I mean FX -- but even with that the team continues to outperform pretty well and confident on the execution, what the team continues to outlay in the coming quarters. From a PST perspective, in terms of COVID, you're going to see one more kind of meaningful comp here in the third quarter. That should be relatively about the same, to what we saw in the second quarter. And then basically, after that we should be kind of clear in the goal I mean, in the fourth quarter.

[Julian Mitchell, Barclays Bank]

Thanks very much.

[Vicente Reynal, Chairman & Chief Executive Officer]

Thank you, Julian.

[Operator]

Our next question comes from Nigel Coe. Your line is open.

[Nigel Coe, Wolfe Research]

Thanks. Good morning, everyone. Just to put a finer point on that third quarter phasing, Vik is that -- I mean my dumb math would get me to $375 million of EBITDA. Is that in the right zone of where you see things?

[Vik Kini, Chief Financial Officer]

Yes, Nigel I think that may be maybe a little on the higher side. If you were to use kind of a mid – I'm going to say mid plus 20% phasing in Q3, I think you'd be in the right zone. So, maybe a little on the high side, but you're not dramatically that far off.

[Nigel Coe, Wolfe Research]

Okay. So like $350 million, $360 million. Okay. That's very helpful. Thanks. And then on the PFT side, we've talked about the margins a fair bit. You called out the COVID order headwinds. And I'm wondering, when do we start to lap that impact? I think, there's four points to orders. And how is that floating through to revenues and margins? So are we seeing a headwind there as well?

[Vicente Reynal, Chairman & Chief Executive Officer]

Yeah. Nigel, so we'll see one more quarter here in the third quarter of the same kind of COVID head related one-time from last year. And so what you see in the third quarter should be fairly similar to what we saw here in the second quarter, from an order and revenue perspective.

[Nigel Coe, Wolfe Research]

Okay. I’ll leave it there, guys. Thanks a lot.

[Vicente Reynal, Chairman & Chief Executive Officer]

Great. Thank you.

[Operator]

Our next question comes from Joe Ritchie. Your line is open.

[Joe Ritchie, Goldman Sachs]

Thanks. Good morning, guys.

[Vicente Reynal, Chairman & Chief Executive Officer]

Good morning, Joe.

[Joe Ritchie, Goldman Sachs]

A couple of quick ones for me. Just trying to understand, I think with a lot of our companies like, how this – the fact that like base metal pricing is starting to deflate and how that ultimately impacts the P&L out in 2023. So, I'd love to hear some thoughts just around, how much of the pricing do you think you're going to be able to hold on to versus potentially give back? And what happens, do you think to your margins if you do see some deflation from a cost input perspective?

[Vicente Reynal, Chairman & Chief Executive Officer]

Yeah, Joe, I'll say that, the way we think about it is that, we're not – we have not historically given out any pricing impact. And the reason being, all the price increases that we have done even this year, and last year have been list price increases. And the way to think about it too as well our customers, they don't buy, the same type of product every month. I mean, they buy, a compressor now, and they just probably buy another one five to eight years later.

So it's kind of difficult to compare that kind of price to price perspective. I mean, clearly against, the market they do, but that's why we want to continue to create that highly innovative solutions and differentiated technology that will allow us to command that premium price. And so as we think – and we look forward. Yeah, I mean, we're pretty excited to that you're starting to see some of these kind of base commodities kind of dramatically reduced. What we have here for ourselves, and we told the teams here for the second half is assume inflation stays constant and kind of work on what you can control, which is price and execution and productivity. And as we go into 2023, and we get a better visibility of what that deflation could happen, yeah, I mean, we see that that could be a great margin expansion for us on an ongoing basis.

[Joe Ritchie, Goldman Sachs]

That's great to hear, Vicente. And maybe just – I know, we talked a little bit about the PST margins. I like the walk that you guys did on slide 12, the year-over-year walk. If you take a look at those four buckets, M&A growth China, and then other, and you think about 3Q, how should – like maybe just talk me through like the buckets and how those buckets change in the third quarter. I'm assuming that, your PST margins are maybe down modestly in 3Q on a year-over-year basis?

[Vik Kini, Chief Financial Officer]

Yeah, Joe, I'll take that one. So, if we kind of think about the three buckets, the way I probably describe it is, first starting with the biggest one the impact of M&A. First and foremost, we do start to lap the M&A. Obviously, the biggest drivers in there were coming from Q3 of last year's acquisitions, particularly Seepex being the biggest one, and we've highlighted that one a few times. So, obviously as we lap that, and clearly with some of the higher synergy expectation that, we expect to see that will start falling off.

So again, we would expect to see the impact of M&A start to dramatically reduce here in Q3 given that we only had a one-month impact last year -- sorry one-month impact this year in terms of the timing of when we purchased it.

The impact of China lockdowns, we really wouldn't expect to see that repeat at all. Obviously, that was a very nuanced in Q2. The good news here is exiting really through June -- exiting June, our China facilities particularly in PST, we're operating right back on track and we don't have any expectations of any concerns here in Q3.

In terms of the investments for growth, yes that definitely will still be part of the equation. I think it will be -- you should expect it to be dramatically different in terms of Q3. A lot of these are areas like for example our hydrogen business and the Ion Solutions business that was highlighted in the deck. And those will continue. These are great innovations things that we're really excited about, one that we continue to invest in and execute on frankly since last year even through this year. So again, I think that's how the three major buckets play themselves out. And then as Vicente indicated here, the price/cost spread will continue to get better for PST not just in Q3 but also in Q4.

[Joe Ritchie, Goldman Sachs]

Super helpful. Thanks guys.

[Vicente Reynal, Chairman & Chief Executive Officer]

Thanks, Joe.

[Operator]

[Operator Instructions] Our next question comes from Rob Wertheimer. Your line is open.

[Rob Wertheimer, Melius Research]

Hey, thanks and good morning, everybody.

[Vicente Reynal, Chairman & Chief Executive Officer]

Good morning, Rob.

[Rob Wertheimer, Melius Research]

My question is actually going to be on innovation and the cold plasma is something -- it sounds very interesting and how differentiated it is. And I really just wanted to see if you could review your innovation sort of process changes that have gone on and any metrics you want to share on pacing change and so forth? And then breakthrough innovations, may be slightly different. I don't know the oil-free is a known industry thing. I'm not sure if this is evidence of a different program that's been ongoing or whether it's kind of a lucky opportunity or if it's a more widespread effort? Thank you.

[Vicente Reynal, Chairman & Chief Executive Officer]

Yeah, Rob, so very intriguing questions. I'll say that the innovation on the cold plasma technology it is highly differentiated and pretty unique. And actually, you go out there in the market and we'll be able to talk more about it is the only one that has all in its own -- in its self-contained unit, not only the ability of creating disinfection, but create ability of accelerated oxygenation in the water, which is kind of particularly very, very important for hydroculture markets and hydroponic markets and things like that. So I think it's going to be really strong. We have built a very strong IP around it. And so we have a very big area in terms of IP protection around that. And again speaks volumes to some of the things that we've been wanting to do, which is kind of a combination of several Ingersoll Rand technologies such as compressors and pumps into additive technology that can actually create a very unique solution. And again here is just one great example.

In terms of how we think about innovation kind of the cadence of innovation. We spoke, I think it was back at the investor conference how from an ITS perspective and we kind of gave a bit of a highlight that innovation accelerated dramatically when the combination of the two companies and we continue to do a lot of that work around global product summits that we have with the teams. And so I think it's a very exciting piece, which is fairly recently here -- a couple of weeks ago we had our strategic plan review with the teams. And one of the core characteristics of the review in every business it was around intellectual property and IP and patented technology because we believe that we have unique technology that can be application-driven and protect that as a protective IP.

In regards to that breakthrough technology and particularly to the centrifugal I think it's just one example where again you take kind of core technology such as centrifugal compression that it is very unique for oil-free products. And in this case oil-free compression.

And again we've created some IP protection around the aerodynamics of the product inside and how the air flow moves inside. So, again, we feel that that allows us to create differentiation and energy efficiency. So, a pretty unique model that we leverage IRX all in its own to drive the process.

And I would say that this Ion Solutions the cold plasma was one great example. Acquired some IP, developed the IP, utilized IRX processes as a way to out-execute the product and in less than 15 months we went from concept to launch of a product which is pretty impressive.

[Rob Wertheimer, Melius Research]

Great. Thank you.

[Operator]

We have a question from Stephen Volkmann. Your line is open.

[Stephen Volkmann, Jefferies]

Hey, good morning guys. I just wanted to ask about kind of what you're seeing in terms of the supply chain and sort of the productivity impact of that. And I'm just trying to figure out if there's been any kind of margin headwind due to all these issues that we're seeing?

[Vicente Reynal, Chairman & Chief Executive Officer]

Yes, I would say Steve absolutely a margin headwind because if you think about it we don't have all the components at the right time at the right place. So, yes that creates the factories to do heroics in terms of reconfiguring and try to maybe prebuild a piece of the compressor put it on the side and then wait for the part.

So, yes, absolutely. We've seen productivity hits due to the inefficiencies on the supply chain. And I think one thing we'll say is that we still see supply chain constraints and issues. So, I don't think that everything is perfect. I think what our teams are doing with the utilization of the IRX and the processes is incredible from the perspective that they're able to outperform.

I mean and you saw that very clearly with the team in ITS in China that just basically outperformed dramatically to even some of the expectations that we had when they came back with the lockdown. But yes, definitely some headwinds.

So, to your point, it's a very good point as we go into maybe 2023 and beyond, we should see maybe the better efficiencies or productivity due to the ease of the supply chain being more stable.

[Stephen Volkmann, Jefferies]

Right and obviously that's exactly where I was going with this because it feels like for 2023 demand will be whatever it is but you should see some margin tailwinds from sort of normalization of supply chain at some point presumably. And then maybe price cost also turns positive. And so maybe it feels like incrementals could be pretty robust in 2023.

[Vicente Reynal, Chairman & Chief Executive Officer]

Absolutely.

[Vik Kini, Chief Financial Officer]

Yes, I would agree. I mean I think the only thing to add to what you said there is we're pretty encouraged that price cost actually has been -- we've actually been positive the entire time from last year even through the first half of this year. We do expect it obviously get better into the second half of this year.

And then potentially, as Vicente indicated earlier ,if commodities start to deflate the next year and given how we deploy price, we definitely see that as a potential tailwind into 2023.

I think the other thing we should probably mention here is and you see it -- you saw it in the financials that clearly as a result of the supply chain, obviously, inventory continues to be at elevated levels. And I think our supply chain alleviates here. We obviously have a meaningful opportunity from a cash perspective in terms of deploying that inventory.

So and the good news is the backlog is there to do it for the back half of this year. So again it's just a matter of us continuing to execute and seeing a little bit more normalization in the supply chain.

[Stephen Volkmann, Jefferies]

Super. Thank you.

[Vik Kini, Chief Financial Officer]

Yes. Thanks Steve.

[Operator]

Our next question comes from Nicole DeBlase. Your line is open.

[Unidentified analyst]

Yeah. Thanks. Good morning guys.

[Vik Kini, Chief Financial Officer]

Good morning Nicole.

[Unidentified analyst]

Just maybe going back to the comment you made about July orders Vicente like you mentioned some acceleration in certain regions and markets. Can you elaborate a little bit on where you guys saw things improved?

[Vicente Reynal, Chairman & Chief Executive Officer]

Yes Hi Nicole. I figured that we'll get the follow-up for sure yes. I think – Nicole, I think we -- it was -- to be honest it was fairly broad-based if I were to categorize it. I'll say that we saw -- we're starting to see more I guess release so to speak for the some long cycle projects.

So we're seeing that some of these kind of large projects that have been in the pipeline and there's been a lot of conversations they're getting released. So we're seeing some good momentum on that as -- and some of these are energy transition-related and/or expansion of capacities and also in some cases onshore into as well.

So we're seeing some good momentum on that perspective. But to be honest it was fairly global from a global perspective across all regions and very exciting movement in the U.S., China but even also in Europe. So I think it was a fairly broad-based here, Nicole.

[Unidentified analyst]

Thanks Vicente and Vik maybe just a follow-up on the comment you just made about free cash flow. Can you talk a little bit about the path you see in the second half to get to the 100% plus conversion? Like is this very 4Q weighted based on your plans for reducing inventories?

[Vik Kini, Chief Financial Officer]

Nicole, I'd say it's probably second half weighted. It's probably the best way to say it. If you look -- last year is probably a good example. Typically we are seasonally more second half weighted. I would say that's probably a combination of two things.

One, following the profitability of the company as well as the typical movements in working capital, I think in terms of this year sure you are going to see probably a stronger fourth quarter comparatively speaking.

But yes, a lot of that is also predicated on the working capital let's call it continued rightsizing which inventory obviously being the biggest piece. You kind of see that through the first half that we have built a meaningful amount of inventory about $200 million I'd say for the first half headwind from a cash flow perspective.

But despite that we're actually quite pleased with generating $165 million of free cash flow still in the second quarter. So again, pretty pleased with the execution of the team despite what I would call working capital headwind. But the good news here is we have the backlog and the path to be able to execute and free up that cash.

[Unidentified analyst]

Thanks Vik. I'll pass it along.

[Vik Kini, Chief Financial Officer]

Thank you, Nicole.

[Operator]

Our next question comes from Vlad Bystricky. Your line is open.

[Unidentified analyst]

Good morning guys. Thanks for taking my question.

[Vicente Reynal, Chairman & Chief Executive Officer]

Good morning Vlad.

[Unidentified analyst]

So maybe just on the capital allocation front, a lot of good color around obviously the three deals you've announced and then the additional LOIs on the bolt-ons. But can you talk about just given how leverage has come down, how you're thinking about your appetite for larger deals especially given maybe some increased noise in the macro backdrop?

[Vicente Reynal, Chairman & Chief Executive Officer]

Yeah. I'll say, Vlad when you look at our funnel -- the funnel characteristics that we have are still fairly talking bolt-on in nature. So I'll definitely speak in terms of what we see today in the funnel is nothing around those one billion plus acquisitions and not because they might not be out there but because we're being very focused more on this more bolt-on in nature deals that can be highly accretive to us.

[Unidentified analyst]

Okay. That’s really helpful Vicente. Thanks. And then maybe just going back to the organic growth outlook here. So you took your organic growth outlook up on stronger IT&S growth. So can you just talk about what's really changed in the environment since 1Q? I mean, investors are more focused on a potential slowdown and worried about the macro, but you're seeing organic growth accelerate. So can you just talk about the drivers and how you think about the sustainability of that growth trajectory beyond the back half here?

[Vicente Reynal, Chairman & Chief Executive Officer]

Sure. I'll say that maybe to keep it more or less simplistic in nature is that we're seeing definitely better price acceleration and realization. You saw how sequentially Q1 to Q2 we improved price, I mean, almost 200 basis points in terms of price whether ITS or PST. So again we -- and those are actions that we have taken that is already built already in the backlog. So basically shipping the product and realizing that higher price realization that gives you that increase in organic, as well as also as Vik said that price cost margin amplitude that will continue to get better in the second half.

And to the volume, organic volume is then in terms of the just again supply chain constraints getting released and be able to accelerate some of the shipments from being able to deliver to what customers want. So again it's better price realization and better supply chain coming to a better movement here for us that allows the factories to produce a product.

[Unidentified analyst]

Great. That’s helpful Vicente. Thanks.

[Vicente Reynal, Chairman & Chief Executive Officer]

Thank you. Thank you, Vlad.

[Operator]

We have a question from Nathan Jones. Your line is open.

[Nathan Jones, Stifel]

Good morning, everyone.

[Vicente Reynal, Chairman & Chief Executive Officer]

Hi, Nathan.

[Nathan Jones, Stifel]

I wanted to start off with a question about the long-cycle projects Vicente. You talked about some of those getting released and helping to drive the order book. I think by the time those projects get to ordering products from Ingersoll Rand, they're likely to go ahead regardless of the macro backdrop. Can you talk about any information or insight you might have on some of those larger longer cycle projects that might be -- might have been in the planning stages that maybe customers are reconsidering with higher interest rates, macro uncertainty or anything like that? Have you heard anything about customers reconsidering or delaying moving forward with earlier stage projects like that?

[Vicente Reynal, Chairman & Chief Executive Officer]

I'll say Nathan to be honest, it's an interesting question, but I would say that nothing that we see dramatically customers just put in a big pause and rethinking. I think on the contrary, I will say that because of current energy prices being so high and the fact that our technology allowed us to drive this energy efficiency and improvements, we're seeing customers making the acceleration of let's just get it done here now because they see energy prices to be high for the longer or kind of medium to longer period of time of perspective.

So I think that again this cause benefit equation that we have with our products and solutions and how our teams are positioning that from a total cost of ownership to the customer that equates to a better carbon footprint for our customers. It is actually seeing some good momentum on getting projects even more through the accelerated pipeline in my view.

[Nathan Jones, Stifel]

Thanks. Maybe for Vik. On the capital structure swaps caps, can you talk about any detail you can give us on notional value how it impacts the interest expense here in the short-term? And what the plans are for maybe putting actual fixed debt in place over the next couple of years here. Just any details you can give us on your intentions with the capital structure?

[Vik Kini, Chief Financial Officer]

Yes, sure. So, maybe just for completeness here, I'll kind of just summarize kind of what we did here. But we did a number of things here in the second quarter to, I'd say, execute on our capital structure strategy. And it's important to note that ensuring that we're on our continued path to an investment-grade credit rating, and we obviously want to make sure that we're cognizant of balancing further interest rate exposure by balancing our fixed to floating ratio as you indicated.

And so what we did was, I'd say, three distinct things or three to four distinct things in the quarter. One we did pay off the full amount of the euro-denominated term loan, which was in dollar terms $621 million. Then we executed €1 billion USD to euro cross currency swaps three-year term. And 50% of that swap to fixed, 50% swap to floating. And then, the final piece is we executed $1 billion of US dollar interest rate capped at 4% on the base interest rate. So again, we've meaningfully changed a fixed to floating ratio here in the context of where we were exiting Q1, for example, to where we are now exiting Q2.

And I think in the context of -- your kind of second part of your question, yes, I mean I think this is just a step in the consistent evolution of our capital structure. As indicated here, we do continue to see a path to investment-grade credit rating at which point in time clearly we would expect the nature of our capital structure to continue to evolve and change at which point we'll probably go into more of a fixed rate structure at that point in time.

The good news here is the maturities of our debt towers right now are all out to 2027. So that gives us some time here to continue to both evaluate but execute and change that structure. And I think the good news here is we still have a considerable amount of flexibility as well as coupled with the strong free cash flow as well as with the -- I'd say, the amount of cash and liquidity we have exiting Q2. It gives us I'd say, a lot of flexibility to continue to execute on our capital allocation strategy, which you heard from Vicente. Obviously, we'll continue to be very M&A-centric. And clearly, the funnel continues to support that.

[Nathan Jones, Stifel]

And maybe just the bottom line what's the quarterly run rate for interest expense?

[Vik Kini, Chief Financial Officer]

Yes, you'll probably be, I'd say, closer to the high 20s in the back half of the year on average, roughly speaking…

[Nathan Jones, Stifel]

Good.

[Vik Kini, Chief Financial Officer]

From legislative perspective.

[Nathan Jones, Stifel]

Thanks very much.

[Vik Kini, Chief Financial Officer]

Thanks Nathan.

[Operator]

[Operator Instructions] And we have a question from Joe O'Dea. Your line is open.

[Joe O'Dea, Wells Fargo]

Hi. Good morning.

[Vicente Reynal, Chairman & Chief Executive Officer]

Good morning, Joe.

[Joe O'Dea, Wells Fargo]

I wanted to ask on the M&A contribution to growth based on the deals this quarter and then based on what you have under LIO, when you think about the framework of the 4% to 5% annual target and given kind of what's in motion right now what kind of a contribution you think that's setting up for next year. Are we looking at something better than that based on the number of deals that we're looking at here?

[Vik Kini, Chief Financial Officer]

Yes, Joe, I think the best way to think about this is maybe two pieces. One our commitment and what we still are reaffirming here today is the ability to execute 400 to 500 basis points on an annualized basis of inorganic growth.

So let me take it in two pieces. You can see in the guidance, we still are committed to about $225 million of in-year impact. Now the reality is that's largely coming from the deals that you saw already announced primarily in the second half of the last year as well as you'll see -- remember we did one small bolt-on in the first quarter a business called Jorc. So that's really what's driving the $225 million. The three deals that were announced earlier this week they are actually not in guidance yet, because they have not been closed. We expect them all to close in the second half of the year.

And based on what Vicente indicated the LOIs and what's in the funnel again the annualized impact of those deals as well as the one we just announced, again, we would expect to get to 400 to 500 basis points on an annualized basis. So we actually see that whether you want to look at the in-year impact of revenue, the annualized impact of what we expect to be able to purchase this year all of us -- all of those lead to the 400 to 500 basis points whichever way you want to look at it, which is actually setting us up nicely here, if I'd say, the M&A impact to revenue as we go into 2023.

So again, I think, Joe depending on how you want to look at it, it actually probably leads to the same answer, but I just want to make sure we understand that the three deals announced here earlier this week, they're technically not in guidance yet and they won't be until we actually close the deals.

[Joe O'Dea, Wells Fargo]

Understood. And then circling back on the ITS Asia Pac orders and up low double-digits China mid-20s rest of Asia. Can you talk a little bit about the degree to which you have insight into outperformance in the market? Some of what's driving the growth that you're seeing in the region there?

[Vicente Reynal, Chairman & Chief Executive Officer]

Yes, Joe, I mean, according to the teams there's actually not a third-party report in Asia Pacific or in China, but you can do a lot of triangulation. And yes, I mean, according to our teams, we continue to outperform what we see in terms of our peers from a compressor perspective I say.

And I think also the team continue to leverage really well the technology that we have around vacuums and blowers and really expanding that penetration in the market where our market share is today fairly small. So we have a very big great opportunity to accelerate that.

And the last piece, I'll say Joe is that our team in the Asia-Pacific, the ITS team has been incredibly agile in terms of being able to take the technology that we have in our kind of pilot of old technologies compares well as vacuums and really move pretty quickly to create applications to those areas where they're seeing kind of the good areas of growth momentum. So I think this is something that I would say, still is kind of not that well understood externally, but the fact that we have these kind of great technologies that you can make them applicable to the end markets and to the growth trends that you have. It is something that is unique to what we have in our portfolio. And that has been pretty well executed by our team here in Asia Pacific and in other regions, but particularly China, the team has done a phenomenal job, just to execute into that strategic aspect.

[Joe O'Dea, Wells Fargo]

Got it. Thanks very much.

[Vicente Reynal, Chairman & Chief Executive Officer]

Thank you.

[Operator]

And we have no further questions in queue at this time. I will turn the call back over to Mr. Reynal.

[Vicente Reynal, Chairman & Chief Executive Officer]

Thank you, Paul. I'd like to say a few things here at the end. I just want to say that, I'm very proud and we're all very proud of the work our teams have done over the second quarter and the first half of 2022. I mean, in terms of performance and navigating in this challenging macro environment, you can see that, Ingersoll Rand continues to be very financially strong, operationally fit and our business is quite resilient.

And more important, our culture of agility and ownership, I mean while leveraging IRX is the essential piece to our continued momentum. And we importantly want to highlight that we continue to build a stronger team for long-lasting performance. And with that, we're super excited about the announcements of Mark Stevenson and Michael Stubblefield to the Board -- adding them to the Board. I know, both will add incredible value, as we continue to transform our company. So with that, I just want to say thank you for your continued support and look forward to speaking with many of you here soon. Thank you.

[Operator]

This concludes today's conference call. Thank you for attending.