Earnings Call Transcript
Ingersoll Rand Inc. (IR)
Earnings Call Transcript - IR Q2 2022
Matthew Fort, Vice President of Investor Relations
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. I would now like to turn the call over to your host, Mr. Fort. You may begin, sir. 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. 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 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 and CEO
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 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 driving a lower total cost of ownership and footprint. We're 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 the 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 the 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 a 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, enables 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 and CEO
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 the 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 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 has 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
And our first question comes from Michael Halloran.
Michael Halloran, Analyst
Hey, good morning, everyone.
Vicente Reynal, Chairman and CEO
Good morning, Mike.
Michael Halloran, Analyst
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 the 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 and CEO
Yes Mike I think one of the most important 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, Analyst
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 and CEO
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, Analyst
Thanks for that, Vicente. Appreciate it.
Operator, Operator
And we have a question from Julian Mitchell. Your line is open.
Julian Mitchell, Analyst
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 address the first part of your question, and Vicente will handle the second. Regarding your inquiry about the EBITDA phasing in Q3, you are correct. I would estimate it to be in the mid- to high 20% range. We would likely say that the phasing throughout the year in terms of the quarters is quite similar to what you observed last year, particularly regarding the weight of EBITDA in Q3 and Q4. So that should serve as a good reference point.
Vicente Reynal, Chairman and CEO
Yes, regarding the segments, if we consider the transition from the first half to the second half, for ITS, the flow-through in the first half was around the 30s, and we expect it to approach the 40s in the second half. This improvement will mainly come from better pricing realization that we have already implemented, along with ongoing merger-related productivity savings. As for PST, looking at the data, the flow-through in the first half was in the low 20s, with an EBITDA margin in the first half around 28%. As we move into the second half, we anticipate the EBITDA margin to grow closer to the 30s, leading to an incremental flow-through in the 50s. Similar to ITS, this will also be driven by improved pricing realization due to actions we have taken for the PST segment, as well as M&A synergy realization from deals closed in the second half of 2021, along with some known issues related to volume mix from China lockdowns. Overall, we believe these targets are achievable, and the team is effectively executing the necessary actions.
Julian Mitchell, Analyst
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 and CEO
Yes, Julian, regarding ITS EMEA, there hasn’t been a change in the dynamics. We can see this reflected in our leading indicators. As you mentioned, Q2 was significantly impacted by foreign exchange, with a headwind effect of about 5% to 6% from the Eurozone when comparing Q1 to Q2. Despite this, the team has continued to perform strongly, and I am confident in their execution in the upcoming quarters. From a PST viewpoint, regarding COVID, we expect to see one more substantial comparison in the third quarter, which should be similar to what we observed in the second quarter. After that, we should be fairly clear in our goals for the fourth quarter.
Julian Mitchell, Analyst
Thanks very much.
Vicente Reynal, Chairman and CEO
Thank you, Julian.
Operator, Operator
Our next question comes from Nigel Coe. Your line is open.
Nigel Coe, Analyst
Thanks. Good morning, everyone. To clarify on the third quarter phasing, Vik, my rough calculation suggests $375 million of EBITDA. Is that in line with your expectations?
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, Analyst
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 and CEO
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, Analyst
Okay. I’ll leave it there, guys. Thanks a lot.
Vicente Reynal, Chairman and CEO
Great. Thank you.
Operator, Operator
Our next question comes from Joe Ritchie. Your line is open.
Joe Ritchie, Analyst
Thanks. Good morning, guys.
Vicente Reynal, Chairman and CEO
Good morning, Joe.
Joe Ritchie, Analyst
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 and CEO
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, Analyst
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
Sure, Joe, I can address that. If we consider the main factors, I would say the most significant one is the impact of mergers and acquisitions. We're now beginning to compare against last year's M&A, with Q3's largest contributions coming from acquisitions, notably Seepex, which we've mentioned frequently. As we move past that, especially with higher synergy expectations, we anticipate a noticeable decrease in the M&A impact in Q3 since we only had a one-month effect this year due to the timing of the acquisition. Regarding the effects of the China lockdowns, we don't expect those to recur. That situation was quite specific to Q2. The positive news is that as of the end of June, our facilities in China, especially PST, were fully operational again, and we foresee no issues in Q3. As for growth investments, those will still play a critical role, but we expect them to shift significantly in Q3. These investments focus on areas such as our hydrogen and Ion Solutions businesses, which were emphasized in our presentation. We are committed to continued investment and progress in these innovative sectors since last year and into this year. So that's how the three main factors are expected to evolve. Additionally, as Vicente mentioned, the price/cost differential for PST is expected to improve in both Q3 and Q4.
Joe Ritchie, Analyst
Super helpful. Thanks guys.
Vicente Reynal, Chairman and CEO
Thanks, Joe.
Operator, Operator
We have a question from Rob Wertheimer. Your line is open.
Rob Wertheimer, Analyst
Hey, thanks and good morning, everybody.
Vicente Reynal, Chairman and CEO
Good morning, Rob.
Rob Wertheimer, Analyst
My question is about innovation, particularly the cold plasma technology, which seems very intriguing and unique. I would like to hear your thoughts on the changes in your innovation process and any metrics you could share regarding the pace of these changes. Additionally, I'm curious about breakthrough innovations and how they may differ. I'm not sure if the oil-free aspect is simply a known industry feature, or if it reflects a different ongoing initiative, a fortunate coincidence, or part of a broader strategy. Thank you.
Vicente Reynal, Chairman and CEO
The innovation in cold plasma technology is highly distinct and quite unique. In the market, it's the only self-contained unit that not only offers disinfection but also accelerates oxygenation in water, which is crucial for hydroponics and similar markets. I believe this will have a strong impact. We have established a robust intellectual property portfolio around it, giving us significant protection. This underscores our goal of integrating various Ingersoll Rand technologies, like compressors and pumps, into additive technology to create a unique solution. This is just one example of our innovation strategy. During our investor conference, we highlighted how innovation accelerated significantly after the merger of the two companies. We continue to engage in global product summits with our teams, fostering this exciting progress. Recently, during our strategic plan review, a key focus for every business was on intellectual property and patented technology since we believe our technology can be application-driven and well-protected. A breakthrough, particularly in centrifugal technology, serves as an example where we've developed unique oil-free compression with strong IP around the product's aerodynamics and airflow. This differentiation supports energy efficiency. We've effectively utilized IRX to drive this process. For example, in our Ion Solutions and cold plasma technology, we acquired and developed the IP and executed the product launch in less than 15 months, which is quite impressive.
Rob Wertheimer, Analyst
Great. Thank you.
Operator, Operator
We have a question from Stephen Volkmann. Your line is open.
Stephen Volkmann, Analyst
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 and CEO
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 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, Analyst
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 and CEO
Absolutely.
Vik Kini, Chief Financial Officer
I agree. I want to add that we are encouraged that price cost has remained positive since last year and through the first half of this year. We expect it to improve further in the second half. Additionally, if commodity prices decrease next year and considering how we adjust our pricing, we see that as a potential benefit for 2023. It’s also important to note, as reflected in the financials, that our inventory levels remain high due to the ongoing supply chain issues. Once our supply chain stabilizes, we have a significant opportunity to utilize that inventory effectively. The good news is that we have the backlog to support this in the latter part of this year. It really comes down to our ability to execute and a return to more normal conditions in the supply chain.
Stephen Volkmann, Analyst
Super. Thank you.
Vik Kini, Chief Financial Officer
Yes. Thanks Steve.
Operator, Operator
Our next question comes from Nicole DeBlase. Your line is open.
Unidentified analyst, Analyst
Yeah. Thanks. Good morning guys.
Vik Kini, Chief Financial Officer
Good morning Nicole.
Unidentified analyst, 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 and CEO
Yes, hi Nicole. I believe we will definitely follow up. To be honest, it was quite broad-based. We are beginning to see some releases for a number of long-cycle projects. Many of these large projects that have been discussed are now moving forward, which is generating positive momentum. Some of these are related to energy transition, capacity expansion, and in some cases, onshore developments as well. From a global standpoint, we are seeing good activity across all regions, with particularly exciting developments in the U.S., China, and even Europe. Overall, it was a broad-based improvement.
Unidentified analyst, 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 believe the second half will be more significant. Last year is a good comparison, as we typically see stronger performance in the second half. This trend seems to stem from two factors: the company's profitability and the usual fluctuations in working capital. For this year, you can expect a relatively stronger fourth quarter. However, this depends on the ongoing adjustments in working capital, particularly with inventory being the largest factor. In the first half, we accumulated around $200 million in inventory, which has impacted our cash flow. Nevertheless, we are satisfied with generating $165 million in free cash flow in the second quarter. Overall, we are pleased with our team's performance despite the working capital challenges, and we have a solid backlog and a clear strategy to free up that cash.
Unidentified analyst, Analyst
Thanks Vik. I'll pass it along.
Operator, Operator
Our next question comes from Vlad Bystricky. Your line is open.
Unidentified analyst, Analyst
Good morning guys. Thanks for taking my question.
Vicente Reynal, Chairman and CEO
Good morning Vlad.
Unidentified analyst, 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 and CEO
Certainly. When we examine our pipeline, the characteristics suggest that we're still primarily focused on smaller, bolt-on acquisitions. Currently, we're not looking at deals exceeding one billion dollars. This isn't because such opportunities aren't available, but rather because we are concentrating on smaller transactions that can significantly enhance our value.
Unidentified analyst, 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 and CEO
We're seeing better price acceleration and realization. From Q1 to Q2, we improved prices by nearly 200 basis points, whether it's ITS or PST. These actions are already accounted for in our backlog, allowing us to ship products at higher prices, which contributes to organic growth. Additionally, as Vik mentioned, the price-cost margin is expected to improve in the second half. Regarding volume, the easing of supply chain constraints will help us accelerate shipments, meeting customer demands. This results in better price realization and an enhanced supply chain, leading to improved production capabilities.
Unidentified analyst, Analyst
Great. That’s helpful Vicente. Thanks.
Vicente Reynal, Chairman and CEO
Thank you. Thank you, Vlad.
Operator, Operator
We have a question from Nathan Jones. Your line is open.
Nathan Jones, Analyst
Good morning, everyone.
Vicente Reynal, Chairman and CEO
Hi, Nathan.
Nathan Jones, Analyst
I wanted to start off with a question about the long-cycle projects, Vicente. You mentioned that some of those are being released and contributing to the order book. By the time those projects are ready to place orders with Ingersoll Rand, they will likely proceed regardless of the economic conditions. Can you provide any insights on some of the larger, longer-cycle projects that may have been in the planning stages, and if customers are reconsidering them due to higher interest rates or economic uncertainty? Have you heard anything about customers delaying or reassessing earlier-stage projects?
Vicente Reynal, Chairman and CEO
I'll say Nathan to be honest, it's an interesting question, but I would say that nothing that we see dramatically customers just putting 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, Analyst
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
Certainly. To summarize our actions in the second quarter, we executed several steps to implement our capital structure strategy. Our goal is to maintain a path toward an investment-grade credit rating while managing interest rate exposure by balancing our fixed and floating rate debt. In this quarter, we accomplished a few key actions. First, we paid off the full euro-denominated term loan, which amounted to $621 million in US dollars. We also completed €1 billion in cross-currency swaps with a three-year term, with half fixed and half floating. Lastly, we executed $1 billion of US dollar interest rate caps at 4% on the base interest rate. These measures have significantly adjusted our fixed to floating ratio compared to the end of Q1. This is part of our ongoing effort to evolve our capital structure, and we remain optimistic about achieving an investment-grade rating, at which point we would likely shift more toward a fixed rate structure. Fortunately, the maturities of our debt are extended until 2027, providing us ample time to assess and adjust our structure. We also have considerable flexibility due to strong free cash flow and liquidity at the end of Q2, enabling us to execute our capital allocation strategy, which includes a focus on M&A opportunities.
Nathan Jones, Analyst
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, Analyst
Good.
Vik Kini, Chief Financial Officer
Thanks Nathan.
Operator, Operator
Our next question comes from Joe O'Dea. Your line is open.
Joe O'Dea, Analyst
Hi. Good morning.
Vicente Reynal, Chairman and CEO
Good morning, Joe.
Joe O'Dea, Analyst
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 it's best to break this down into two parts. First, we are reaffirming our commitment to achieve 400 to 500 basis points of annualized inorganic growth. In our guidance, we're still targeting an impact of about $225 million this year, which primarily comes from deals already announced last year and one small acquisition called Jorc made in the first quarter. The three deals announced earlier this week are not included in our guidance yet since they haven't closed, but we anticipate their closure in the second half of the year. Based on what Vicente indicated regarding the letters of intent and what's in the pipeline, we expect the annualized impact from these deals, along with the one we just announced, to help us reach that 400 to 500 basis points target. So, whether we look at the in-year revenue impact or the annualized potential, all of it points toward achieving our goal. Additionally, I want to clarify that the three deals announced this week are not yet reflected in our guidance until they are finalized.
Joe O'Dea, Analyst
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 and CEO
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, Analyst
Got it. Thanks very much.
Vicente Reynal, Chairman and CEO
Thank you.
Operator, 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 and CEO
Thank you, Paul. I'd like to share a few thoughts as we wrap up. I want to express how proud I am, and how proud we all are, of the work our teams accomplished during the second quarter and the first half of 2022. In terms of performance and navigating this challenging macro environment, Ingersoll Rand remains financially strong, operationally sound, and our business is resilient. Our culture of agility and ownership, alongside our IRX platform, is crucial to maintaining our momentum. We are also focused on strengthening our team for long-term success. I am thrilled to announce the addition of Mark Stevenson and Michael Stubblefield to the Board. I believe both will bring significant value as we continue to transform our company. Thank you for your ongoing support, and I look forward to connecting with many of you soon. Thank you.
Operator, Operator
This concludes today's conference call. Thank you for attending.