Vertiv Holdings Co

NYSE:VRT

Earnings Call Transcript 2022-Q2

[Operator]

Good morning. My name is Nadia, and I will be your conference operator today. At this time, I would like to welcome everyone to Vertiv's Second Quarter 2022 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. Please note that this call is being recorded.

I would now like to turn the program over to your host for today's conference call, Lynne Maxeiner, Vice President of Investor Relations.

[Lynne Maxeiner, VP. IR]

Great. Thank you, Nadia. Good morning, and welcome to Vertiv’s second quarter 2022 earnings conference call. Joining me today are Vertiv's Executive Chairman, Dave Cote; Chief Executive Officer, Rob Johnson; Chief Financial Officer, David Fallon; and Chief Strategy and Development Officer, Gary Niederpruem.

Before we begin, I'd point out that during the course of this call, we will make forward-looking statements regarding future events, including the future financial and operating performance of Vertiv. These forward-looking statements are subject to material risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. We refer you to the cautionary language inclusion in today's earnings release, and you can learn more about these risks in our annual and quarterly report, and other filings with the SEC. Any forward-looking statements that we make today are based on assumptions that we believe to be reasonable as of this date. We undertake no obligation to update these statements as a result of new information or future events.

During this call, we will also present both GAAP and non-GAAP financial measures. Our GAAP results and GAAP to non-GAAP reconciliations can be found in our earnings press release and in the investor slide deck found on our website at investors.vertiv.com.

With that, I'll turn the call over to Executive Chairman, Dave Cote.

[Dave Cote, Executive Chairman]

As I mentioned on our previous calls, we're taking 2022 a quarter at a time, with an escalating performance profile, as price increase is realized. It has taken time to work our way through the backlog, but as we do, performance escalate. The profile will look exactly the same as we outlined in February, but in substance, the story and performance are in line with that profile. And market demand remains robust. Our order rates reflect this strength, and as market leaders in these spaces, we are furthering the gap by accelerating our new product introductions.

We also continue addressing the operational areas, particularly, in the Americas that have caused shortfalls historically. While there are still some improvements to work through, the SIOP process in Americas is under the leadership of Giordano Albertazzi, is better aligned than ever. There's still work to do, but certainly it is in a much better place and continuing to improve.

There are other process improvements also being addressed by the new management team in the Americas. They are getting after challenging areas that have really become apparent during these recent periods of high volatility. The new management team is doing exactly what we need them to do, cleaning these up and resetting the base for a great runway ahead in the fourth quarter and 2023 in a very profitable part of the business, the Americas.

Third quarter is expected to be a sequential step up in performance followed by another expected large step up for Q4. I know some of you may question our ability to deliver the second half as presented in our guidance, especially a significant fourth quarter, but the team will walk you through why and how we believe that will happen as price realization improves and supply improves with newly qualified suppliers.

We remain on pace to achieve a significant step up in financial performance that supports the earnings profile we presented back in February. End markets remain strong. Inflation is starting to moderate. We are navigating supply chain challenges and bringing additional suppliers online. And price is sticking. With the anticipated performance profile we expect that 2023 can be a very good year for Vertiv and our shareholders.

So with that, I'll turn the call over to Rob.

[Rob Johnson, CEO]

Thank you, Dave.

Q2 was another step forward in delivering on our commitments for 2022.

Starting with some of the key messages on Slide 3, demand continues at a pace I've not seen in the 30 years of my career in this market. Orders were up 17% in second quarter, 11% from volume and 10% from higher prices with a 4% deduct for foreign exchange. Our customers are focused on securing supply in a tight market and we see that both in our orders and backlog, which firms up the demand outlook well into 2023.

Our adjusted operating profit exceeded the midpoint of our guidance. We continue to work through a number of key actions for improvement, but where we have fully implemented change, we are seeing the benefits take hold.

Key among them is our pricing performance. We have proved to ourselves, and now, hopefully to you, our investors, that we are a business that can get price. Our pricing plan remains at $360 million for the full-year.

Supply chain continues to be challenging, but we've made very good progress in securing qualified second and third sources of supply for key components. And we'll start seeing the benefit from that activity in Q3 and more fully in Q4.

Our new thermal facility in Monterrey Mexico has started production and we have a new fan supplier coming online that is committed to help us meet the significant demand we're seeing across the thermal management market.

Our work qualifying new suppliers is not only limited to fans. We have also qualified new breaker manufacturers, semiconductor suppliers and other suppliers. While there's still more work to do, we have been very aggressive in our actions to manage the challenging supply chain environment, most notably in the electronic components.

In light of the supply change conditions and in conjunction with the expected significant sales increase in the second half of the year, we have not been able to reduce inventory as quickly or as significantly as we anticipated and communicated to you earlier in this year. While we're expected to use cash in the second quarter, it was larger than we anticipated. Although, there should be an improvement in the next six months we are reducing our full-year expectations for free cash flow to range up $25 million of use to $25 million of cash generation.

As Dave mentioned, we made significant progress in our SIOP process globally, but we are especially happy with the progress that we've made in Americas and believe based on these improved processes, inventory reduction should be a significant source of cash flow in 2023.

While there are many moving pieces, we provided updated guidance for our adjusted operating profit, reducing the mid-point by $25 million. We have provided a detailed bridge on the changes on these slides on Slide 12 that David Fallon will cover shortly. There is some rebalancing between third and fourth quarter, but in aggregate, we are still on pace to deliver a very strong second half with a noticeable step up across key financial metrics.

Turning to Slide 4. This slide summarizes what we see in the market by region. No change in our view across our end markets versus what we saw in April, they are still quite healthy and very strong. Cloud and colocation remain robust. You have seen this in the cloud growth rates reported by all major cloud providers. AWS reported last week that their cloud business increased 33% in the second quarter and believes that we are still in the early stages of enterprise and public sector cloud adoption. Certainly, the growth in cloud market supports this view; data growth is not slowing down. Our view on the enterprise and small to medium business remain consistent from Q1 and we believe edge applications will continue to provide growth and lift for these markets. The communication market continues to see 5G investment and we're aligned with all the relevant players in this space.

In the commercial and industrial market, vital applications continue to drive growth and opportunities for Vertiv. The market outlook remains very healthy. It is likely our year-over-year order growth rate will moderate in the second half as the comparisons to prior year will be difficult. But I want to reiterate the end markets we plan in continue to be very, very good shape.

Moving on to Slide 5. Customer demand remains strong. Our order rate and backlog are a clear demonstration of this strength. We are delivering on our price plan and have implemented price actions needed to deliver the second half pricing plans, including that on our book and ship business. As I said earlier, supply chain continues to be challenging, especially in electronics. We do not expect this to abate in 2022. And we anticipate that we will see pressure at least through the first half of 2023. We have incurred higher costs for electronic components since we had to go to the spot market to secure some of that supply.

In addition, material and freight inflation was higher as absolute dollars for the second quarter, but generally in line with the adjusted for the higher volume. We've started to see some relief in commodity and freight markets. We typically see a benefit on this on a quarter lag, but expected to provide a nice tailwind for us as we go into 2023. We've made good progress in qualifying additional suppliers on key components and should start seeing additional supply hit our factories in late Q3 and further into Q4. This provides support to our volume assumptions for the ramp in Q3 and Q4. We have to add some fixed costs sooner than anticipated to support the volume lift in areas such as our new thermal plant in Monterrey, Mexico.

In summary, the market remains strong. Supply chain is still complex, but we are getting to the implementation phase for the new suppliers that should help alleviate sourcing pressures on the most critical components.

With that, I'll now turn it over to David to walk us through the financials. David?

[David Fallon, CFO]

Thanks, Rob.

Turning to Page 6. This slide summarizes our second quarter financial results. As you can see, net sales increased 11% from last year's second quarter and we're up 8% organically, including 2% from volume and 6% from price. The E&I acquisition added $114 million in net sales and was partially offset by a $60 million FX headwind, more than 70% of that headwind in EMEA. And we also had a headwind related to the divestiture of our industrial UPS business in EMEA and that was a $17 million headwind.

Pricing added $80 million in the quarter, which was in line with guidance and double what we saw in the first quarter. As we continue to burn through the lower price backlog and recognize more sales booked after we implemented substantial price increases late last year and earlier this year.

Adjusted operating profit of $82 million exceeded the mid-point of guidance but was $52 million lower than last year's second quarter. We list some of the components of this reduction at the bottom of the page, but in summary, there was $11 million or $10 million unfavorable price costs and $45 million headwind from FX and other, including a $10 million foreign exchange headwind, $10 million from direct labor, inflation and inefficiency in part driven by the supply chain challenges and approximately $20 million from cost headwinds in the Americas, primarily related to customer support costs, our sales incentive compensation program, and several other drivers. We expect to see continued year-over-year cost headwinds in the Americas in the third quarter, but we believe we have identified and addressed most of these issues as we will enter the fourth quarter and transition into 2023.

Adjusted diluted EPS was $0.10 for the quarter, which was in line with guidance.

Second quarter free cash flow was negative $232 million, while we expected a net use of cash. It was certainly higher than we anticipated. As Rob mentioned, we have not reduced inventory consistent with our expectations at the beginning of the year in part due to continued supply chain challenges, but also in preparation for the significant volume ramp in the second half of the year. We are improving our SIOP processes globally. And as Dave mentioned, notably in the Americas, and we expect to receive an inventory free cash flow dividend at some point in 2023.

Turning to Page 7. This slide summarizes our second quarter segment results. We saw sequential quarterly improvement in organic sales growth, adjusted operating profit, and adjusted operating margin across all three regions. The Americas region grew organically 6.6% or $37 million with most of that growth coming from price. We do anticipate more balance between price and volume in the Americas in the second half of 2022, including mid-teen year-over-year volume growth as we continue to qualify new suppliers and launch the Monterrey facility.

Americas adjusted operating profit of $82 million was negatively impacted year-over-year by price cost, higher fixed cost, including to support the volume ramp up in the second half and additional cost headwinds we referenced on the previous slide.

In APAC, organic sales increased 5.9%, despite the China COVID lockdowns, which we estimate lowered second quarter sales by approximately $30 million. Notwithstanding the impact of the lockdowns, adjusted operating profit for APAC was actually higher than our expectations as we were able to drive higher sale in other APAC up regions while managing fixed costs.

Finally, we continue to see strong growth in EMEA with organic sales up 13.3% with a good balance between volume and price. While inflation accelerated in the second quarter from the first quarter, so did our pricing.

Our second quarter net price cost in EMEA while still a headwind was less of a headwind than what we saw in Q1 and we expect price cost to be a significant tailwind in the second half of the year.

Moving to Slide 8. We summarize our updated third quarter guidance, which is about $50 million lower at the mid-point than our previous guidance. This slide summarizes third quarter versus last year, but likely more pertinent is an analysis of the changes from our previous guidance, which we provide in a couple slides.

Despite the reduction, third quarter guidance still reflects a material sequential step up from the second quarter across all of our key financial metrics with organic sales expected to be up approximately a $100 million, 70% of that volume and adjusted operating profit expected to be up almost $60 million at the mid-point.

Despite the reduction from our prior guidance, our third quarter expectations return us to an adjusted operating profit level from last year's third quarter, and will serve as a strong bridge to a substantial improvement in the fourth quarter and transition us into a very strong 2023.

Next turning to Page 9. This slide summarizes our revised full-year financial guidance, which reflects the $37.5 million lower adjust operating profit at the mid-point versus our prior guidance. Once again, we provide detail of this reduction on Slide 10, the next page, but from a macro perspective, it is driven by a $25 million foreign exchange headwind and an additional $12.5 million net from additional cost wins in various categories, partially offset by the benefit from incremental sales volume. And more on this on the next slide. But as Rob mentioned, at the outset, as it relates to free cash flow, we are reducing our full-year guidance to a range of positive 25 to negative 25 in part due to lower expected adjusted operating profit, but probably more significantly from change expectations with our expected inventory reduction.

We continue to improve our SIOP processes in, what is a very challenging supply chain environment, and we're encouraged that these improved processes will result in much improved inventory management, but the timing of the inventory reduction benefits will likely be pushed into 2023. Nonetheless, we are still anticipating significant improvements in free cash flow in the second half of the year and notably in the fourth quarter.

Now, turning to Slide 10. We provide additional detail underlying changes from our previous guidance. As you can see on the slide, foreign currency translation certainly driven by the strengthening U.S. dollar negatively impacted net sales by approximately $160 million for the full-year and adjusted operating profit by approximately $25 million.

We include some additional information on our foreign currency exposure on page 27 in the Appendix in this package. But just as a broad overview, over 50% of our sales are denominated in a currency other than the U.S. dollar. Changes in the Euro and British Pound have been more acute than other currencies and a result over 70% of our negative FX impact is in EMEA.

Moving on, incremental volume is expected to generate an additional $230 million of sales, so $100 million of that was in the second quarter. And these sales translate into $82 million of adjusted operating profit for the full-year. And there is a pronounced increase in volume in the fourth quarter, as we've increased sales expectations primarily in the Americas, based upon our success in qualifying new suppliers, and of course, the launch of the Monterrey facility.

Material inflation is up $20 million from our previous guidance, $10 million in each Q2 and Q3, primarily driven by continued higher cost for electronic components and spot buys. We anticipate this pressure to ease somewhat heading into the fourth quarter, as we continue to bring additional suppliers into our supply chain.

We have reduced profit expectations for E&I for the full-year by about $12 million. This is mostly driven by timing as shipments have shifted to the right and into 2023, but that business continues to improve and the demand environment continues to be strong with backlog at E&I up over 60% from year-end 2021, which pretend significant sales and profitability improvement heading into 2023.

We have increased our fixed cost estimates for the year by approximately $30 million. Most of this driven by timing as we anticipated adding some of these fixed costs in early 2023, but we accelerated the timing to support the higher volume in the second half and for early 2023. Some of these higher fixed costs are also related to IT spending as we continue to optimize our ERP system in the Americas.

And last on this chart, are other cost headwinds, primarily in the Americas, and as we mentioned, associated with any number of underlying factors, most of which we believe are transitory and addressable and should be mitigated as we enter the fourth quarter and pivot into 2023.

So in summary, on this Slide, current full-year guidance is about $37 million lower than prior guidance at the mid-point, $25 million of that related to FX. With $50 million of $37 million reduction in the third quarter, offset by an $11 million increase in the fourth quarter, and of course, the $2 million beat in the second quarter.

Next turning to Slide 11. We provide a sequential bridge from third quarter to fourth quarter for both net sales and adjusted operating profit, a $220 million increase in net sales, and a $113 million increase in adjusted operating profit. We understand that based upon our fourth quarter last year there may be some concerns with our ability to deliver a robust fourth quarter this year. To help allay these potential concerns, we provide this bridge which quantifies the sources of the uplift.

First, the higher volume is certainly supported by improved visibility in the sourcing, and as we've mentioned, the launch of the Monterrey facility, in addition, it's very important to understand we normally have a seasonal volume ramp from third quarter to fourth quarter. The $35 million sequential pricing benefit is driven by the continued burn of lower-priced backlog in previous quarters with a vast majority of our fourth quarter shipments from higher-priced orders from late 2021 and early 2022. We anticipate approximately $10 million additional adjusted operating profit from E&I in the fourth quarter, primarily from incremental volume which should flow through at higher margins, pursuant to improved pricing, similar dynamic at base loadof business. And finally, as we've discussed on the prior slide, other is driven by the ramp down in the Americas cost headwinds, partially offset by additional fixed costs.

So in summary the fourth quarter adjusted operating profit guidance of $253 million at the mid-point certainly represents a substantial quarter for us, especially considering the $13 million adjusted operating profit in the first quarter and the $82 million in the second quarter. However, we believe we are addressing two of the most pressing issues that drove lower first half performance, pricing and supply chain constraints and we have visibility and confidence in our ability to deliver these fourth quarter projections.

On the following Slide, so Slides 12 through 14, we will continue to be transparent with our communications around our plan and provide additional details for the second half. In February, we laid out an aggressive achievable plan through the first six months. Our high-level scorecard reflects $91 million higher sales, $25 million higher adjusted operating profit, $10 million higher pricing, and $5 million lower inflation. And likely more important, our expectations for the fourth quarter have not significantly changed from the beginning of the year.

On Page 12, this illustrates our current quarterly sales guidance at the top of the slide and our prior April guidance at the bottom. There are certainly a lot of numbers on this slide. I won't go through each and every one of them. But of note on the right is the increased volume growth from our previous guidance, higher across all three regions, but most certainly, most significant in the Americas as we have referenced.

Turning to Page 13. This slide summarizes our updated quarterly adjusted operating profit and margin guidance, a similar construct to the previous slide with current guidance at the top and the April guidance at the bottom. We've already discussed changes in guidance and the step up from the third quarter to a fourth quarter that would be a record high and by a wide margin for sales, adjusted operating profit, and adjusted operating margin between 14% and 15%.

Finally, for me, for prepared remarks on Slide 14, we show the expected quarterly 2022 progression of our regional adjusted operating margins. We have primarily focused externally on the recovery plan for the Americas, but as reflected on this slide, there is expected sequential quarterly adjusted operating margin improvement across all three regions. And even though not depicted on this slide the same is true for E&I. The scale of the improvement is more significant in the Americas and EMEA, as they were more impacted by inflation than APAC. But these charts illustrate that the entire Vertiv global team is driving improved execution. Clearly, we are focused on lock -- unlocking value on a global basis, and we know you are watching closely and we will continue to be very transparent with the status of our progress.

With that said, I turn it back over to Rob.

[Rob Johnson, CEO]

Thanks, David.

Turning to Slide 15 where we provide our expectations for market conditions over the next 18 months or so. And we share many of the drivers of optimism for 2023 that pretends to be a very strong year.

First, you've heard us comment on several times on the strength of the market we serve. All major cloud companies are growing strongly and continue to invest. Colocation utilization rates continue to be high. Edge demand and 5G rollouts will continue. And we are very well-positioned to win on both of those fronts. While we are certainly mindful of the possibilities of a recession, we don't think that blunts the growth of data, certainly not in the near-term or intermediate term. In fact, business could likely utilize more data in ways to enrich their business models and gain productivity across their operations in the face of recessionary conditions.

In summary, our demand remains strong. We are currently filling our backlog for the second half of the -- for next year and we expect these favorable conditions to continue. On the right-hand side of this slide, we provide a quick list of reasons to be optimistic about 2023. Our fourth quarter is shaping up consistent with our beginning of the year expectations, with pricing actions not only returning profitability to where we were prior to the challenging supply chain and inflationary environment, but to a higher level. In fact, we believe we are in a much -- we are much stronger company today and will be much stronger company tomorrow. Because of these events over the last 12 months and the results we are very encouraged with that we see for 2023. Although, we are not prepared to provide a lot of detail into 2023 expectations, we still need to execute and deliver Q3 and Q4 and there's plenty of uncertainty with supply chain and inflation.

To give everyone something to work with for next year, we directly expect that our adjusted operating profit to be 50% higher in 2023 than in 2022. Of course, there is still a lot of moving pieces and we will know more and we will update this expectation after our third and fourth quarters. So please view this as a preliminary guidepost as we look forward to a strong 2023.

Finally, on Slide 16, and again, the summary of our key messages for today. Sitting here one quarter further into 2022, I feel more strongly than ever that the process improvements we've made and implementing throughout the year give us the ability and the consistency to get price, coupled with the corrective actions we've taken in the Americas are going to result in a very, very successful future for Vertiv.

Without a doubt, the proof will be in the back half of 2022. I pledge to you that we are committed to executing well and transparently communicating our progress.

With that said, I want to thank our employees, our Board members for your continued support in our organization as we continue to make significant strides forward.

I will now turn the call over to the operator who will open up the lines for questions.

[Operator]

Thank you. We will now begin the question-and-answer session. [Operator Instructions].

And our first question today comes from Nigel Coe of Wolfe Research. Nigel, please go ahead. Your line is open.

[Nigel Coe, Wolfe Research]

Thanks. Good morning. Thanks for the detail. A lot to choose through here, that's for sure. So just wanted to run through, you mentioned some of the cost headwinds in Q3 -- Q2, leaking through to Q3 and then improve into Q4. I thought maybe we could just like dive a little bit deeper on that. You mentioned some of the cost headwinds in Americas we have the Monterrey facility, et cetera. So maybe if you can just run through that quickly, that'd be awesome.

[David Fallon, CFO]

Yes. Thanks. Thanks, Nigel. This is David. So there's really two categories. And we try to break those out on Slide 10. But first category is related to fixed costs and these are certainly tied, although not completely tied to additional costs to support the second half ramp up in volume. And some of these costs we anticipate to add at the beginning of 2023, but we've brought them forward. Most of these are plant-related costs, but also includes some engineering costs related to the qualifying of new vendors and parts. But I think there's probably a question if these would create a tail or a headwind for 2023. I think that $15 million we're expecting in Q4, you analyze that to $60 million versus the $30 million for this year would imply a $30 million headwind.

Some of these costs certainly are one-time related to support either a hard ramp in a plant like Monterrey or a soft ramp in many of the other plants that are seeing high volume. So I would not anticipate to see a significant year-over-year headwind related to fixed cost in 2023.

The other cost headwinds bucket, which we estimated about $18 million in Q2, $15 million in Q3. We truly believe these are transitory. These are very specific issues. We mentioned a couple of them in the slide deck. Customer support costs are also higher costs related to sales incentive plan. These are -- and there's a host of other issues that Gio and his team have been identifying and addressing over the last two quarters or so. And we believe we haven't identified. They'll continue to present a headwind in Q3, but we believe these should be fully resolved in the Q4 and from a year-over-year basis actually provide a nice year-over-year tailwind for 2023.

[Nigel Coe, Wolfe Research]

Okay, great. And I just wanted to just curious on the material inflation. We've got a $10 million clip to both Q2, Q3, and then that's neutral in Q4. Is that just kind of a more normalized purchasing pattern combined with some of these new suppliers on ships? I mean, any color there?

[David Fallon, CFO]

No, you're absolutely right. I think we've seen a little bit of stability, although there continues to be variability as it relates to electronic components. Inflation there certainly is higher than we anticipate it heading into the quarter. Yes. I think the light at the end of the tunnel is related to the new supplier qualifications that we're seeing that should come in online in the fourth quarter.

So I think if you look at the ramp up of new inflation, I think we saw $15 million in Q1 that ramped to $40 million in Q2 and we anticipate that $40 million in new inflation won't remain consistent in Q3. And we actually have implied in our guidance a $5 million dip in Q4, but still subject to change. There's still a lot of uncertainty and challenges with the electronic components. We are still relying to a certain extent on spot buys, but we believe we've taken some really proactive steps and initiatives to address that higher -- those higher costs we're paying and primarily through qualifying new suppliers.

[Nigel Coe, Wolfe Research]

Thanks, David. My follow-on is the free cash flow in the second half of the year, you mentioned the SIOPs improving in 2023. Just wondering the degree of confidence in executing on the second half free cash plan. And then, perhaps more importantly going into 2023, you mentioned inventory free dividends in 2023, does that suggests that you're confident -- you're converting of a 100% in 2023?

[David Fallon, CFO]

Probably not prepared to comment on a free cash flow conversion for next year, but we certainly are optimistic. Our beginning of the year guidance for inventory actually assumed a $50 million reduction from end of the year 2021. And that's a 2021 year-end number that was actually up fairly significantly from the end of 2020. In reality, we'll probably build inventory by about $100 million again in 2022. That's $150 million delta and there is other moving pieces, but that effectively explains the takedown in the full -- for the full-year number from $150 million to about zero at a mid-point.

There is definitely opportunity as it relates to optimizing our inventory levels. We are very confident that we are executing towards that opportunity through our SIOP processes and I would be very optimistic that we should have a reduction -- a real reduction in inventory or certainly from a DIO perspective in 2023. So we refer to that internally as a dividend and it should not only create a very nice one-time benefit from that reduction in 2023, but certainly on a ongoing basis as we look at our reviews.

[Operator]

Thank you. And our next question comes from Scott Davis of Melius Research. Scott, please go ahead. Your line is open.

[Scott Davis, Melius Research]

Guys, I wanted to talk a little about the Monterrey facility, if you will. This is -- this is a new thing, perhaps. But is the Monterrey facility replacing some higher cost capacity in addition to creating new capacity, and can you just give us a little bit of color on why it's needed?

[Rob Johnson, CEO]

Yes, Scott. Sure. We've seen a large uptick in our thermal business, especially with some of the innovative solutions that we've delivered. So it's really complementing. We're not shutting down any other capacity. It's really additional capacity for the additional volume that we're seeing. So we're -- this is the something we've been planning for a while and we think Monterrey's a great place to be from a cost perspective, but it is really to help the ramp and the demand that we see and the backlog that we have in the thermal business.

[Scott Davis, Melius Research]

Okay. I -- just to back up a little bit, there was, the Vertiv story was always pitched as if holding fixed cost steady, which is, the Dave Cote playbook who wrote a book on it. And now I think we've had multiple quarters in a row not holding fixed costs. So are we going to be back on that in 2023? I mean, where do you guys stand?

[David Fallon, CFO]

Yes, thanks, Scott. Oh, no, it's a great question. And Scott, I can assure you, that's not the first time that that question was asked, it's certainly been a focus here internally. We are still absolutely committed to holding fixed cost constant on a year-over-year basis going forward. The added fixed cost that we're seeing here in 2022, we -- that is more from a timing perspective; these are fixed costs that we had anticipated adding in the first half of 2023.

Just to put these fixed costs in perspective and the need for the timing, our second quarter sale at a annual run rate were about 5.6 billion. That's ramping up to 6.8 billion in the fourth quarter. And so we continue to focus on fixed cost. I think we have seen increases over the last couple years, but most of those increases are pursuant to operations in higher capacity and also ER&D.

I can tell you our administrative functions are absolutely constant from a fixed cost basis in 2023 versus -- or in 2022 versus 2021 and will continue to be, but we are selective with fixed cost and to the extent that it creates a future return including R&D, and from operational perspective, we'll choose from a timing perspective to sometimes accelerate those.

[Operator]

Thank you. And our next question comes from Jeff Sprague of Vertical Research. Jeff, please go ahead. Your line is open.

[Jeff Sprague, Vertical Research]

Thank you. Good morning everyone.

[Rob Johnson, CEO]

Good morning.

[Jeff Sprague, Vertical Research]

Yes, I also wanted to touch on Monterrey --

[Dave Cote, Executive Chairman]

Glad mate, on getting your name, right.

[Jeff Sprague, Vertical Research]

Yes, it's amazing Mr. Cote, really crushing it out. Hope you're doing well. Just wondering on Monterrey how critical this capacity is to meeting the top-line forecast here for the year? Is it -- and is the plant actually up and running and delivering commercial product yet, so kind of a second part to the first question is, are we on a ramp or we've got visibility of getting the revenues we need out of that plant in the back half.

[Rob Johnson, CEO]

Yes. Hey, Jeff, hi, this is Rob. Yes. Monterrey, first of all, is up and operating. It delivered even in Q2 some products to our customers. So we are shipping. And we are in the middle of a -- middle of a ramp with that going into Q3 and then a steeper ramp going into Q4. As long as we get the supply we feel confident with the way that plant is operating and it is needed to provide the necessary volume increase more so in Q4 for us, but we feel confident with the team, they've spent a lot of time down there, and so far so good with the product coming out of the plant right now.

[Jeff Sprague, Vertical Research]

Great. Then also just on cost side, what exactly is the customer support cost that you're talking about? Is this expedited freight? Is it allowances? What actually is going on there and what's the visibility of that moderating?

[David Fallon, CFO]

Yes, Jeff, this is David. So, it's a combination of things. In one example, we had to rent a crane, to facilitate the installation of the product into a customer site. So we continue to focus on our customers, and in some cases, will actually fit the bill as it relates to hitting timing. Some of those customers support costs are also pursuant to late deliveries, and in some cases, our contracts include penalties if we don't deliver product in the agreed upon amount of time.

So a lot of these things are certainly tied into the supply chain. We're still, kind of, day-to-day as it relates to the supply which creates a lot of uncertainty with delivery and some points we just have to catch-up, and spend some of our own money to hit some promise customer delivery dates.

So the reason this is tied into the new supply is a lot of those pressure should go away as we continue to qualify new investors. And we need to spread that risk over three or four vendors as opposed to one or two. It really helps planning out of plant and a delivery schedule and we think a significant amount of these costs should go away.

[Jeff Sprague, Vertical Research]

And sort of on that front, one last one from me, and I'll pass it. Just also, kind of, the internal operations of the company, as it relates to systems and ERP, you mentioned, still working on that. Maybe just an update on what needs to be accomplished and to what degree, if any? Has it -- still somewhat of a restraint on orders delivery operations, what have you?

[David Fallon, CFO]

Yes. I would say we are over the significant launch hurdle that you get with a lot of ERPs. That certainly created a noise in the fourth quarter, early first quarter. We have a fully functioning system. It's not perfect. Not many ERPs are a year after launch. But in conjunction with some of the issues that we have identified in the Americas over the first six months and we're still identifying we've actually have seen the system as a very useful tool versus the system we previously had to actually address those issues. And we continue to identify ways the system can help. And I would say we have a fully functioning system, but we'll continue to invest in that system to optimize the usage and to address issues as they come forward.

[Jeff Sprague, Vertical Research]

Great. Thanks for the color. And thanks, Dave Cote. Nice hearing you.

[Dave Cote, Executive Chairman]

Here to serve, Jeff, here to serve.

[Operator]

Thank you. And our next question comes from Andy Kaplowitz of Citigroup. Andy, please go ahead. Your line is open.

[Andy Kaplowitz, Citigroup]

Could you talk -- good morning. Could you talk about the progress you've made in getting the company more focused on pricing? And why pricing hasn't gone up at least a little with volume and inflation with the understanding that a lot of pricing was locked into backlog. At the beginning of the year, you obviously are seeing significantly more volume than you previously expected. You did raise your inflation forecast a little bit. So why can't you get a little bit more price as revenue and inflation goes up?

[Rob Johnson, CEO]

Andy, I'll address the first part just on our pricing. We feel from where we've been in the past as you know, we feel really good about the 360, we've talked about this year. That being said, pricing is now built into our D&A. How we go get it? That our process on a global basis, the approvals, when we raise price and we continue to look at that. Pricing was not just a one and done for us. We'll continue to evaluate where we have innovative solutions, making sure that we're getting the appropriate price we have for the market. So as we go through this year, into next year, we don't expect this to be something we responded to an inflationary thing, and we're done. We'll continue to refine the way we go about driving price.

So I would expect as we part of our thesis has been create great products that that solve real customer problems that are innovative and get paid for that. So we'll continue to work that as we go through it.

David can speak a little bit to why some of the inflationary stuff has the price as we drive it. We are getting to right now as we talked about into Q4, a lot of that old backlog falling away and a new price will begin to see in that. And it gives us a -- give us a nice uplift in Q4, but David?

[David Fallon, CFO]

Yes. Thanks, Rob. And Andy, we were fully anticipating that question from someone. So you're absolutely right as volume assumptions go up, so should the pricing. We made the decision because a lot of that additional volume is into Q4. We made the decision just to keep the pricing target at the 360, maybe so as to not overcomplicate things. But I -- it's absolutely fair to look at this as an opportunity for additional pricing based on that volume over and above the 360. But we also have not added in to this external model potential additional inflation that would also be associated with that higher volume.

So on a net-net basis it's probably a -- an opportunity. But there would be an offset with additional pricing and additional and inflation just mathematically from that higher volume. But when we looked at it, we felt like we just wanted to kind of keep the messaging simple quarter-to-quarter. And we've included that as a net opportunity in our bucket of net risk and opportunities that we see for the second half of the year.

[Andy Kaplowitz, Citigroup]

Sure, sure. That's helpful. And then maybe if I could take that conversation into 2023, you obviously stated that you expected 50% improvement in adjusted operating profit. Could you talk about as we sit here today or maybe forecast forward, how much backlog coverage you have on that improvement? I think you said you expect supply chain and/or electronic component headwinds to last well into 2023. So what kind of price versus cost or supply chain assumptions are you baking into in that initial 2023 expectation?

[David Fallon, CFO]

Yes. I can address that, Andy. So -- and I'll probably answer with a non-answer, so we're not really prepared to provide a whole lot of color at this point. It's still very early. As Rob mentioned on the call, we thought we deliver on Q3, Q4. But I certainly would include on the list of potential opportunity for next year pricing. And you can look at that just from the increased sequential pricing that we're seeing here in on a quarterly basis in 2022. There's going to be probably $150 million to $200 million carryover pricing benefit just by doing the calculus, right?

So as it relates to some of the other elements, notably backlog coverage, we're certainly -- we certainly have a robust backlog today to a certain extent we're filling backlogs for the second -- backlog for the second half of next year and with some of our products. So we're feeling really good from a demand perspective, but there's certainly we would place more uncertainty as it relates to inflation and the supply chain. As we have seen those are somewhat mercurial as it relates to month-to-month, quarter-to-quarter, but we believe we're doing everything we can within our power and being proactive to address it. But it's hard at this point to give any type of quantitative detail on what we expect for next year.

[Operator]

Thank you. And our next question comes from Mark Delaney of Goldman Sachs. Mark, please go ahead. Your line is open.

[Mark Delaney, Goldman Sachs]

Yes, and good morning, and thank you very much for taking the questions and appreciate all the detail and the presentation. First question is on the implied 4Q outlook. Maybe you could better contextualize how much turns or book and ship business you're anticipating in that guide and how that compares to typical fourth quarters?

[David Fallon, CFO]

Yes. I would say we have really good visibility certainly into Q3. And if you look at the backlog versus book and ship for Q4 it's likely higher than what we would see in other quarters. So -- and including for a fourth quarter, so a fairly significant ramp in Q4, at least from prior guide was not related to filling out a backlog. It was very directly related to have the capacity and the supply of components to ship that backlog.

So every quarter, and even into every month, there's a certain amount of book and ship business. But I would say we have really good confidence in fourth quarter as it relates to the backlog coverage. And for us, it -- and as Rob mentioned, a bigger risk would be the execution of the ramp of the Monterrey facility and also the additional fan supply. So we don't think demand will be an issue certainly for Q3 or Q4.

[Mark Delaney, Goldman Sachs]

That's helpful. And for a second question was on pricing and in particular pricing for 2023, maybe you can remind us how much of your negotiations are done toward the end of the calendar year, setting up for the following year. And kind of related to that to the extent input costs stay kind of where they are. Do you think you'll be able to hold onto all the pricing you've been able to achieve as you do go into 2023 or some of the customers going to say, oh, well, we'll input costs start going up. So I'm looking for a reduction next year. Thanks.

[Rob Johnson, CEO]

Hey Mark, this is Rob. Yes. The pricing actions have been done and been implemented for what we need to do. But as I mentioned earlier, we continue to look at additional opportunities for price, where we have innovative products and solutions. So I feel confident that we've executed on those, those have been put in place a while ago from that perspective.

As it relates to customers asking or looking to take the price down, it's kind of a similar phenomenon. We didn't get a lot of pricing on the backlog that we had. It was part of our problem. We had to burn through that. So expecting kind of the same thing to happen, that the hard purchase orders that we have today that people wanted the price that we set forth in those as we go-forward. So I don't expect that to deteriorate either as we go into 2023, if inflationary conditions go. We've bought inventory at higher prices. They understand that. So it's something that wouldn't keep me up at night that that we're going to see that that activity.

But we will continue, even in a deflation and pricing goes away environment, as I mentioned earlier. We'll continue with this pricing muscle that we have now to get price where it makes sense and we will be providing more value to the market. And that was a valuable lesson learned from us as we went through this whole activity, as that people do value the services and the products that Vertiv make.

[Operator]

Thank you. And our next question comes from Lance Vitanza of Cowen. Lance, please go ahead. Your line is open.

[Lance Vitanza, Cowen]

Thanks guys, and congratulations on the strong quarter. I wanted to ask you about E&I. It looked a little bit weaker than expected and the guidance as well. You mentioned during the prepared remarks some timing related issues. And I think you said that the asset continues to improve, but maybe you could clarify, if I'm getting that right? And in any case, if you could elaborate a bit on exactly what the issues are there at E&I?

[Rob Johnson, CEO]

Yes, sure. Hi, Lance. Thanks for the question. Appreciate the comments as well. With E&I, what we've seen, what I think David, kind of talked about and when he was speaking, is we're seeing some of the stuff pushed out of this year, pushed into next year, with some of the projects that they have.

E&I have it experienced, kind of a little bit later than Vertiv did the inflationary impact and then lack of supply on breakers, and then were not just like us, slower to get price. We feel all that's corrected. We're really are excited. David mentioned the backlog for E&I is up over 60% I believe since we bought them. So the activity is good. Think we've got the price now being built in the back -- in the backlog and then the orders that are coming forth. So I'm really still very excited, probably more excited about the asset now than when I was when we acquired it.

Yes, we had a dip and unfortunately it will go through this year with that, but we see E&I pulling out of this next year with the additional pricing. We have seen some projects shift, which happens in their business because they're heavily on the construction side of it, we have seen some of that shift and some of that will shift into next year. Hello, Gary, any other thoughts?

[Gary Niederpruem, Chief Strategy & Development Officer]

Yes. I think that's exactly right, Rob. I mean, yes, Lance, we're -- the amount of code activities pipeline, the joint development between the Vertiv sellers, the E&I sellers, the embracement of customer base it has had has been phenomenal and the only thing to Rob's point is, is really some of that switch gears some of the modular skidded power units that they sell, shipped it out to the right, some of them, because they supply some of it -- because the customers had readiness. But overall, it's actually coming up on plane just like we had planned earlier in the year.

[Lance Vitanza, Cowen]

So you're not seeing, just to be clear, you're not seeing any issues with how the integration has gone or anything that would make you feel less exciting about what you require?

[Rob Johnson, CEO]

No. Absolutely, the opposite. I think integration has gone really well. They had -- a couple of stumbles that they had was really pricing and getting components and they were kind of layer on both of those. Lot of people talk about breaker availability, the breakers drive a lot of the content in our products and we still see that as something that's not readily available. We have looked at additional breaker sources and have been qualifying them, but overall integration is gone well. And what I could tell you, as Gary mentioned on the back, on the actual funnel, the activity and the synergy with Vertiv, as we thought it would be is really there. So we never baked in any kind of sales synergy upside to remodel, but just what we thought would happen is, our sellers would pick this up, we would take it out to a wider audience to the enterprise and to a broader base of customers that we reach and touch. So happy with the -- very happy with the asset, happy with the management team there and what they've done. And I think this is going to smooth as it possibly could except for the getting prices quicker than we did and getting supply turned around. But overall, this fits in our portfolio very well.

[Operator]

Our next question comes from Steve Tusa of JPMorgan. Steve, please go ahead. Your line is open.

[Steve Tusa, JPMorgan]

Hey guys, how's it going?

[Rob Johnson, CEO]

Good. Thanks Steve.

[David Fallon, CFO]

Thank you, Steve.

[Steve Tusa, JPMorgan]

Good. So just on the on the backlog, I guess, trying to read the tea leaves a little bit here with the big revenue ramp in the fourth quarter. Do you expect book-to-bill in the second half to be above 1 in total? Obviously, it'll kind of modulate because of the big fourth quarter, but in total, do you think book-to-bill can be above 1?

[David Fallon, CFO]

Yes. We're still putting together our projections for orders for the fourth quarter. You can look at the second half sales number. I would say we would expect continued orders growth in Q3. Q4 poses a pretty good year-over-year tailwind. But I would say it would be plus or minus close to that one time book-to-bill.

[Steve Tusa, JPMorgan]

Okay. And then, just more philosophically, maybe a question for Dave, but how are we defining success at this stage? Is it kind of a hard line on this fourth quarter and the 50% increase for 2023, or is it, if we continue to have these costs that pop-up like they have in the third quarter, where the guidance is below, it kind of things keep getting pushed forward, if you come to the fourth quarter and things "slipped" into 2023, is that an acceptable outcome for you at this stage, or is there more of, kind of, like a hard line here now given what we've seen the last few quarters, acknowledging the sequential improvement is steady?

[Dave Cote, Executive Chairman]

Steve, I assume that --

[Steve Tusa, JPMorgan]

That's question for Dave Cote. Yes. Dave Cote.

[Dave Cote, Executive Chairman]

Yes.

[Steve Tusa, JPMorgan]

That's right.

[Dave Cote, Executive Chairman]

Yes. I would say it's not so much the number itself for the fourth quarter as it is the lead-in to 2023. As you know, this whole year has been one of having to transition through a backlog, be a hell of a lot more aggressive on price than we were and be a lot more aggressive [Technical Difficulty]. Okay. So this was at transition year for us. And the whole point was to get price, to get Americas fixed enough so that it was in a position where it could perform and to lead us into what I think is going to be a very good 2023.

And that's going to be --that that's the game that we're playing here is that, work our way into a position where 2023 onward we're in the kind of position to perform that we thought we were before. This has been a tactical year that we've had to run into. The strategy of the company is still right, still good. It's a great position and a good industry. Technology is good. We're still doing all the new product intros still increasing R&D spending. The trick here is been to get Americans fixed and to get price running ahead of total inflation, not just inflation for 2022. And that's the way it looks like it's coming together at this point. As I said, I feel good about the profile and feeling good about 2023, but that's the game for us.

[Steve Tusa, JPMorgan]

And anything lumpy seasonally about 2023, like if you did push out of 4Q into 1Q, I would assume that price cost that, kind of, stuff shouldn't be that lumpy, so that you should start 2023 on a pretty strong footing. If that's the case it would, kind of, reinforce what you see for 2023 or is 2023 a more backend -- just a backend loaded because of seasonality.

[David Fallon, CFO]

With the kind of lead-in that we should get from 4Q, we would expect 1Q to be markedly different from what it was this year. Dave, I assume you agree with that?

[Dave Cote, Executive Chairman]

Totally agree. And yes, the key there is the additional demand supply we're getting in the fourth quarter will certainly lead into Q1, Q2. So there's always seasonality but probably a little bit less pronounced next year.

[Operator]

Thank you. Our next question comes from Andrew Obin of Bank of America. Andrew, please go ahead. Your line is open.

[David Ridley-Lane, Bank of America]

Thank you. This is David Ridley-Lane on for Andrew. Hyperscale and colocation CapEx maybe more cyclical -- I'm sorry secular than cyclical, but historically enterprise and SMB CapEx has been tied to the broader economy. Wondering what you're hearing from the field from sales about enterprise pipelines. Have you heard anything about 2023 CapEx plans?

[Rob Johnson, CEO]

David, this is Rob. I'll start with that. And Gary, you can to chime in there.

What I'd say is, the activity in enterprise has been kind of stifled by the COVID and people still not fully going back to the office. So what we are seeing is a phenomenon as people go back to the office to refreshed their edge, their closets, that type of thing. So that activity has been fairly strong. The projects in that space are fairly strong from what we're seeing from the field on the enterprise side of things. Some of our larger enterprise data center customers continue to build and continue to have demand on us. So we -- I'm pretty bullish on what we're seeing, just what's necessary to update the enterprises and then expand the enterprises as we mentioned, data is not slowing down by any stretch and people are using data to drive more efficiency in there. And in order to do that, they're going to have to have the compute and/or the infrastructure to make that happen. I know Gary, you want to say something.

[Gary Niederpruem, Chief Strategy & Development Officer]

I think that's exactly right, Rob. So Dave, you're right. The cloud and colo that, that CapEx it's always hard to peg at any given quarter. So we look at more of the trajectory and the run rate of that, that all looks very healthy. In -- in the enterprise, there would not be a light CapEx number that gets published anywhere. So we do, we take a lot of that from voice to customer and from our pipeline and what we're hearing directly from the individuals into Rob’s point.

There we have not heard any conversations picked up anywhere around, hey, we're going to slowdown, hey, we're doing this, hey, we're planning for this in 2023, that looks any different than what we thought over the last couple of quarters. So we still think the enterprise edge IT channel, all that market is pretty healthy. The only one exception was China had a little bit of a setback in enterprise just because of the COVID lockdown that occurred in late Q1 and Q2. But they're coming out of that now. So we've seen that pipeline start to ramp up in enterprise. So everything we see in that area in channel, edge, enterprise are lumped all together, looks -- still looks pretty good in robust to us.

[David Ridley-Lane, Bank of America]

Got it. That's helpful. And then in the Americas region, that's really the key for you to have meaningful margin recovery. Can you just give a little bit more color on the internal initiatives that you have beyond sort of the Monterrey facility that would drive margin expansion go-forward?

[David Fallon, CFO]

Yes, yes. David, this is David. So certainly, if you look at the second quarter and some of the headwinds versus last year, so to kind of compare it prior to this higher inflation supply chain challenged environment. Price costs certainly played a role. The Americas was actually still negative price costs in Q2. I think it was about $10 million. We certainly feel like we'll address that with the additional pricing we expect to get in the second half of the year, but pricing will continue to be a lever. And we've never been super aggressive with pricing. And what we've realized is that we've left a lot of money on the table. We could have been pricing much more aggressively for a long while here and based on the strength of our products and notably our thermal products will continue to be aggressive with pricing. So that will continue to be a lever next year, even beyond offsetting inflation, whether from a dollar perspective or a percentage perspective.

But a lot of the other things I don't want to discount them by calling them blocking and tackling, but there are a lot of elements of operations that we have identified over the last six months or so that can be significantly improved. We talked a lot about the SIOP process. That's not only going to improve our ability to manage inventory. It will improve our ability to drive margin.

Capacity planning is another. The organizational structure continue to get benefits from ERP in driving process and putting additional tools in place. So going back to maybe the very beginning, this Americas region was built through a series of acquisitions that never were really integrated. We've done some of that over the last four or five years. And there's still a ton of benefit out there just by putting in place some improved processes. And I think we're already starting to see that benefit and we would expect an acceleration of those things in 2023 and beyond.

[Operator]

Thank you. There are no further questions at this time. This concludes our question-and-answer session. I would like to turn the conference back over to Rob Johnson for any closing remarks.

[Rob Johnson, CEO]

Okay. Thank you and thank you to everybody participating today and for your support. Our second quarter is another step forward in delivering on our plan that we detailed out last February. It continues to be a dynamic time in a macro environment, but we remain firmly focused on executing a strong second half, which will provide a strong setup for 2023.

Again, appreciate everyone's support and I'd like to thank everyone for joining the call today.

[Operator]

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