Earnings Call Transcript - IR Q1 2022

Operator, Operator

Hello, everyone, and welcome to the Ingersoll Rand First Quarter 2022 Earnings Call. My name is Victoria, and I will be coordinating your call today. I’ll now pass over to your host, Chris Miorin to begin. Please go ahead.

Chris Miorin, Vice President of Investor Relations

Thank you, and welcome to the Ingersoll Rand 2022 First Quarter Earnings Call. I'm Chris Miorin, Vice President of Investor Relations. Joining me this morning are Vicente Reynal, Chairman and CEO, and Vik Kini, Chief Financial Officer. We issued our earnings release and presentation yesterday, which we will reference during the call. Both are available on the Investor Relations section of our website, www.irco.com. Additionally, a replay of this conference call will be accessible later today. Before we start, I want to remind everyone that certain statements on this call are forward-looking and are subject to the risks and uncertainties discussed in our previous SEC filings, which you should read alongside the information provided on this call. Please review the forward-looking statements on Slide 2 for more details. During today's remarks, we will also reference certain non-GAAP financial measures. A reconciliation of these measures to the most comparable measure calculated and presented in accordance with GAAP can be found in our slide presentation and 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 update our 2022 guidance. Now, I'll turn the call over to Vicente.

Vicente Reynal, Chairman and CEO

Thanks, Chris, and good morning to everyone. Starting on Slide 3, Ingersoll Rand's unwavering commitment to our purpose of making life better is evident in the sustainability of our products, which help our customers reduce their energy consumption and water usage. We delivered another strong quarter in the first quarter with our teams leveraging the IRX process to outperform even with ongoing challenges in the supply chain, accelerating inflation, and geopolitical uncertainty. The performance in Q1 is attributed to our highly engaged employee base who think and act like owners because they are. Our latest engagement scores highlight this dynamic where we now rank in the upper part of the top quartile scoring over 500 basis points above the manufacturing benchmark. And for the most critical question of how happy are you working at Ingersoll Rand, we rank in the top 10% of all manufacturing organizations. Not only are we focused internally, but also on the needs of those outside our organization. Last quarter, we made a $1 million commitment to support Ukrainians impacted by the war with humanitarian aid. Demand for our products and services remains strong with our backlog at an all-time high and our leading indicators showing resiliency in our markets. We remain attuned to the dynamic environment around us and are hyper-focused on executing on what we can control. Moving to Slide 4. We've spoken before about how operating sustainably is embedded in our company and is intentionally at the center of our core values as it underpins our very existence. Ingersoll Rand makes life better for customers by making them more sustainable. We'd like to take time today to highlight that even in an uncertain environment, customers have significant opportunities to reduce their emissions and materially reduce their energy costs and water usage. And this is how we think about our sustainability strategy, growing sustainably by providing mission-critical solutions to customers that reduce energy and water usage and operating sustainably in the processes we employ to deliver those solutions. We spoke at our recent Investor Day in November about the sustainability mega trend. And despite the uncertainty in today's market, we strongly believe that this trend will drive customer decision-making to invest in more efficient flow creation devices like air compressors, blowers, and pumps, which has been an underinvested area over the past decade or so. Turning to Slide 5. Our customers are increasingly realizing that air compressors and air treatment optimization is an essential opportunity to reduce their Scope 1 and Scope 2 emissions. Air compressors consume up to 30% of the manufacturing site's electricity. And with the recent significant rise in energy costs, this will continue to increase. Ingersoll Rand's products provide industry-leading efficiency that enables customers to reduce the energy cost from our compressors by up to 50%, and air treatment solutions or dryers by up to an incredible 90%. As we have forecasted the potential impact of our Scope 3 emissions, we have established a goal of helping our customers achieve a combined 15% reduction in greenhouse gas emissions from the use of our products, which equates to more than 40 million megatons of CO2. Our customers are becoming more educated about the impact that compressor optimization can have on their mission. We have shown two examples in this slide of global leaders in both the consumer electronics and paper industries, who clearly identified compressor optimization as a top priority for greenhouse gas emission reduction in their latest sustainability reports. In addition to energy usage, our customers are also faced with water shortage and a need to improve water management and quality. And you can see at the bottom of the page, we're a global paper company and a world leader in consumer packaged goods, have committed to reducing water usage by 25% and 20% per unit, respectively, a significant commitment. And one we're very well positioned to solve with our products. Approximately 30% of our total revenue base is generated from products focused on improving water management, purification, and reducing water consumption. We're committed to helping customers save over 1 billion gallons of water annually through the use of our products. Turning to Slide 6. Not only is our largest customer making buying decisions based upon opportunities to improve energy efficiency, but we believe that almost all of our customers take energy efficiency into account. Additionally, governments are now regulating energy conservation standards for compressors, and we anticipate these trends will continue to accelerate, and we intend to remain at the forefront of these requirements. Last year, just in the U.S., we conducted over 4,000 compressor system audits, which is an increase of 60% from 2019. After the audits, we made upgrade recommendations based upon evaluations of energy efficiency and several other factors, and this led to $100 million in sales directly attributable to these audits. And this is a great example of how we connect and educate our customer base on total cost of ownership and energy efficiency. We estimate that two-thirds of our current global installed base could realize meaningful improvements in efficiency by upgrading their compressor system. And with the midpoint of 15% energy efficiency uplift across that portion of the install base, a customer with a typical compressor system will realize, on average, a payback of less than two years at current energy prices. So you can see the savings here are real and meaningful, and we're highly engaged in educating our entire customer base about this opportunity. Moving to Slide 7. In addition to helping our customers progress on their sustainability journey, we're leveraging IRX to achieve our goal of being recognized as a top quartile ESG company by operating sustainably. Those efforts have delivered significant progress. And within the past six months, we've been materially upgraded by all of our targeted ESG rating agencies, including MSCI, Sustainalytics, S&P Global, and CDP. In fact, Sustainalytics and S&P Global now rank us in the top 15% of companies in our sector, exceeding our goal of becoming top quartile in half the time we had committed to it. But we're not finished with the journey; we're just getting started. We take our role as a sustainability leader very seriously, and we're committed to continuous improvement and progress towards achieving our other sustainability goals. I would now turn the call over to Vik to provide an update on our Q1 financial performance.

Vikram Kini, Chief Financial Officer

Thanks, Vicente. Moving to Slide 8, we continue to be encouraged by the performance of the company in Q1, which saw a strong balance of commercial and operational execution fueled by IRX to overcome persistent inflationary pressures, a challenging supply chain environment, increased geopolitical uncertainty, and lockdowns in Shanghai. Despite these challenges, we continue to remain on track to deliver on our $300 million synergy commitment with $50 million expected to be realized in 2022. Total company orders and revenue increased 25% and 18% year-over-year, respectively, with strong double-digit orders growth in ITS and double-digit organic revenue growth across both segments. Our orders in the quarter were a record for the company and revenue was a first quarter record, setting us up for continued strength in 2022. The company delivered first quarter adjusted EBITDA of $304 million, a 24% year-over-year improvement, and adjusted EBITDA margin of 22.7%, a 110 basis point improvement from the prior year. Incremental margins for the company were 29% despite the aforementioned challenges. Free cash flow for the quarter was $32 million and remained positive despite working capital headwinds, most notably an increase of approximately $100 million in inventory to support the growing backlog and elevated incentive compensation costs coming off a strong 2021 performance. Total liquidity was $3.1 billion at quarter end, and cash was up approximately $400 million from the prior year. This takes our net leverage to 1.2x, a 0.7x improvement from the prior year and a slight increase of 0.1x from the prior quarter. Turning to Slide 9. For the total company, Q1 orders grew 21% and revenue increased 14%, both on an organic basis. Overall, we posted a strong book-to-bill of 1.22x for the quarter. We remain encouraged by the strength of our backlog, which is up approximately 70% from Q1 of 2021. Total company adjusted EBITDA increased 24% from the prior year. ITS segment margin improved 70 basis points while our PST segment margin declined 260 basis points with the largest driver of the decrease coming from M&A. When adjusted to exclude the impact of M&A completed in the 12 months ending March 31, PST margin declined by 130 basis points, driven mainly by the impact of inflation, FX, and product mix. It's important to note that both segments did remain price cost positive in terms of dollars in the first quarter, which speaks to the nimble actions of our team despite ongoing inflationary headwinds. Finally, corporate costs came in at $29 million for the quarter, down year-over-year primarily due to lower incentive compensation costs and general cost savings while continuing to invest in critical growth areas like demand generation and the industrial Internet of Things. We expect corporate costs to normalize back to the low 30s in terms of millions of dollars per quarter for the remainder of the year. Adjusted EPS for the quarter was up 26% to $0.49 per share, and the tax rate for the quarter was 23%. We anticipate the full year being in the low 20s as well. Turning to Slide 10. Free cash flow for the quarter was $32 million on a continuing ops basis, remaining positive despite the aforementioned increases in net working capital. CapEx through the quarter totaled $18 million, which is an approximately 25% increase compared to last year, further demonstrating our continued investment in the business. Free cash flow included $8 million of synergy and standup costs related to the IR merger. Leverage for the quarter was 1.2x, which was a 0.7x improvement versus the prior year. Total company liquidity now stands at $3.1 billion based on approximately $2 billion of cash and $1.1 billion of availability on our revolving credit facility. Liquidity decreased by approximately $100 million in the quarter, which included outflows of $30 million towards strategic M&A, $101 million in share repurchases, and $8 million for our dividend payment. Our M&A funnel remains robust and active with six bolt-on acquisitions currently under exclusive letters of intent. We remain prudent and disciplined to generate strong returns on transactions with highly strategic and synergistic characteristics. But clearly, we have significant firepower to deploy to M&A, which is a strong driver of our compounding growth model. I will now turn the call back to Vicente to discuss our segments.

Vicente Reynal, Chairman and CEO

Thank you, Vik. And turning to Slide 11. Our Industrial Technologies and Services segment delivered strong organic revenue growth of 14%, including approximately 6% in price and 8% volume growth, both of those year-over-year while also demonstrating solid sequential acceleration on both price and volume. Adjusted EBITDA rose 17% year-over-year with an adjusted EBITDA margin of 23.8%, up 70 basis points from the prior year with an incremental margin of 29%. Organic orders were up 25% with a strong book-to-bill of 1.24x. Starting now with compressors, we saw orders up approximately 30%. A further breakdown shows orders for oil-free products growing over 30%, and oil-lubricated products increased approximately 30%. The Americas team delivered strong performance with orders in North America up approximately low 30%, while Latin America was up in the low 40s. In Mainland Europe, orders were up solidly with no material deceleration of note sequentially during the quarter, while India and Middle East were up in the mid-40s. Asia Pacific continued to perform well with orders up mid-20 driven by mid-20s growth in China and high teens growth across the rest of Asia Pacific. In Vacuum and blowers, orders were up low 20s on a global basis. In the power tools and lifting business, orders for the total business were up high teens and saw continued positive momentum. As we discussed during the Investor Day, our demand generation capabilities provide us with the most forward-looking indicators of customer demand through the data-driven approach to developing marketing qualified leads or MQLs, and we gained an additional several months of insight by leveraging this data. We're aware of the uncertainty related to the global economy, but as we review MQLs across our business and across geographies each week, these indicators show double-digit growth year-over-year across all major geographies, including America, Mainland Europe, the Middle East, India, and Asia Pacific. China has clearly been impacted due to the Shanghai lockdown, but even in the most recent weeks, MQLs are very near last year's level. As I mentioned earlier, we're very focused in our approach to delivering sustainable innovative solutions. As such, I want to spend a minute highlighting our LeROI gas compression business, which we acquired in mid-2017. Since then, we have been very focused on repositioning the portfolio of LeROI to further penetrate the biogas market, which has seen strong growth as customers are able to capture gas emitted from sources such as landfills and cattle farms and monetize it as an energy source. As you can see on the page, the growth we have realized from these efforts has been phenomenal and continues to rapidly accelerate. Orders were over $100 million in the past 12 months, and revenue is expected to be more than double in 2022, bringing total organic growth of over five years to over 440%, and creating a post-synergy multiple of the acquisition of around 1x. We have greatly exceeded our mid-teens return on capital target and expect to achieve approximately 70% ROIC by this year. LeROI is just a fantastic example of a highly strategic and synergistic company whose value has been unleashed in the transition from a family-owned business to ownership of Ingersoll Rand. A few weeks ago, I had a chance to visit the LeROI team in Sidney, Ohio. The transformation the team is making is very impressive. You can feel the energy, passion, and engagement of employees as you enter the manufacturing floor. We heard a lot of feedback around how the ownership mentality we have and the equity we granted has positively impacted not only the performance we show here, but more importantly, the lives of many of our employees in a very positive way. Moving to Slide 12. Revenue in the Precision and Science Technologies segment grew 12% organically with approximately 5% price and 10% volume growth. Additionally, the PST team delivered strong adjusted EBITDA of $85 million, which was up 27% year-over-year with incremental margins of 22%. Adjusted EBITDA margin was 28.6%, down 260 basis points year-over-year, primarily driven by the impact of M&A. Again, the segment was down 130 basis points, excluding the impact of acquisitions, with an adjusted EBITDA margin of 29.9% ex M&A. Overall, organic orders were up 6%, which is on top of 13% year-over-year organic growth in Q1 of 2021. In addition, we continue to be excited about our funnel for the hydrogen fuel business, which now stands in excess of $100 million. The integration of Seepex, which we acquired in September of '21 continues to progress very well, with strong growth in new geographies and an acceleration of margin expansion into the low 20s from the mid-teens level inherited at the transaction closed just a couple of quarters ago. I also had a chance to listen to the Seepex team in the U.S., and once again, our unique approach to ownership brand is playing a very crucial role in accelerating engagement and performance. I left very excited about the future potential of Seepex as part of Ingersoll Rand. A further example of our focus on sustainable innovative solutions is the Thomas pump brand, a compression technology primarily targeting the life and science market with a $2.5 billion addressable market. Thomas Pumps serve the patient care end market, both in facilities through applications like ventilators and also at home through oxygen concentrators. Adjacent today is an in-vitro diagnostic end market. We have leveraged our highly translatable technology to grow 40% within this market, with a very strong focus on OEMs and with significant runway ahead. We have recently secured several sizable orders from large pharma customers in the in-vitro space who designed our Thomas pump into their new products, which will generate strong recurring revenue over the customers' product life cycle. Moving to Slide 13. After a strong start to the year, we're raising our 2022 guidance. We're raising organic revenue growth 100 basis points from 8% to 10% driven by a 100 basis point increase in organic growth expectations from both the ITS and PST segments as compared to the original guidance. FX is expected to now contribute a headwind of approximately 2% versus 1% on the prior guidance. This leads to total company revenue up 11% to 13%. We're also increasing the adjusted EBITDA range to $1.385 billion to $1.425 billion. We continue to expect free cash flow conversion to adjusted net income to be greater than or equal to 100%. We anticipate our adjusted tax rate to be in the low 20s, and CapEx to be approximately 2% of revenue. Lastly, we want to provide some color on Mainland Europe and lockdowns in Shanghai. During the quarter and into April, we have not seen any material slowdown in orders. In fact, we monitor our marketing qualified leads or MQLs as we said, fairly closely and as they are really a leading indicator for order activity, and MQLs in Europe have been quite stable throughout 2022. As for the lockdowns in Shanghai, we're starting to see the easing of the lockdowns trending positively. We remain encouraged. But as you know, this is a fluid situation that we continue to monitor closely. And although we don't provide quarterly guidance, the best way to think about it is we are not making significant changes to the first half and second half phasing as compared to our original guidance. Having said this, we still see continued Q1 to Q2 sequential growth in revenue and adjusted EBITDA, both expected to be modest. Turning to Slide 14. As we wrap up today's call, I want to reiterate that Ingersoll Rand is in a very strong position. We delivered record performance in the first quarter, and our backlog provides momentum into the second quarter. 2022 is poised to be a strong year despite known challenges and dynamic market conditions. We will continue to remain agile and leverage IRX across every facet of our business to deliver on our commitments. To our employees, I want to say thank you for your continued engagement and making thoughtful, action-oriented decisions like the owners that you are. This engagement continues to drive the accomplishment of our mission to make life better for our customers, the environment, and the shareholders. Our balance sheet is very strong, and with our disciplined and comprehensive capital allocation strategy, we remain resilient and have the ability to deploy capital to investments with the highest return on capital as we continue our track record of market outperformance. So with that, I'll turn the call back to the operator and open for Q&A.

Operator, Operator

And our first question comes from Michael Halloran from Baird.

Michael Halloran, Analyst

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

Vicente Reynal, Chairman and CEO

Mike, this clearly provides us with greater visibility than we've had in previous years. ITS, as you know, operates on a long cycle. We should consider that around 20% to 25% of that backlog relates to the longer cycle, which offers us a good perspective for potentially 2023. Overall, we're experiencing excellent visibility for the next couple of quarters, even more than what we've seen in the past as we approach 2023.

Michael Halloran, Analyst

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

Vicente Reynal, Chairman and CEO

That's it, Mike. It's a matter of being prudent as we navigate the ramp after the lockdowns in China and any ongoing geopolitical conditions that may obscure short-term visibility. However, I believe it's evident in the orders and our comments that momentum is ongoing. Our marketing qualified leads remain strong and resilient. At this point, it's mainly about being cautious based on what we're observing.

Operator, Operator

Our next question comes from Julian Mitchell from Barclays.

Julian Mitchell, Analyst

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

Vikram Kini, Chief Financial Officer

Yes, Julian, your perspective is quite accurate. Let me begin with the price cost aspect. From a dollar standpoint, price cost was positive in the first quarter. While it wasn't necessarily margin-enhancing, we did manage to address inflation through pricing. We anticipate that the situation in Q2 will be fairly similar. The geopolitical issues and the consequences of the Russian-Ukraine conflict are contributing to the inflationary pressures we expect in Q2. It's important to highlight that we've been adjusting our pricing strategy, and we project that price cost will become more favorable and positively impact margins in the latter half of the year. So that's how to approach it. Additionally, your observation regarding the incrementals being slightly dampened in Q2 due to these factors and the Shanghai lockdowns is correct. This will lead to somewhat subdued incrementals in Q2 specifically.

Julian Mitchell, Analyst

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

Vicente Reynal, Chairman and CEO

So yes, I mean I think orders continue to be actually fairly good. Clearly, as we go more into Q2, Q3, tougher comps, obviously. As you remember, last year, we were seeing that 30% and 40% orders momentum, but we still see very good momentum as we are moving here into the month of April. And from a PST perspective, I think the way I think about it is, again, they're comping against that double-digit orders from Q1 of 2021. But if I look at it from a sequential perspective, actually on an absolute dollar, sequentially Q4 to Q1, we saw about a 10% increase in order momentum on the PST. So again, speaks pretty well as to no concerns on what the team is seeing and the ramp continues in terms of the order momentum, which obviously will lead to a better outcome here.

Operator, Operator

Our next question comes from Rob Wertheimer from Melius Research.

Robert Wertheimer, Analyst

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

Vicente Reynal, Chairman and CEO

I believe our teams have observed an increase in customer requests related to energy efficiency. A relevant data point is the rise in the number of energy efficiency audits we're conducting in the U.S., which is up 60% compared to pre-pandemic levels in 2019. We also perform many audits in Europe, where we are seeing similar growth trends. Customers are increasingly aware of the need for energy efficiency. We are utilizing our demand generation efforts to further educate customers on potential achievements in this area, which is creating a positive momentum for us.

Robert Wertheimer, Analyst

Perfect. Can you provide some comments on the general timeline for your factory upgrade, including when it might be investigated, decided upon, and delivered? I'll stop there.

Vicente Reynal, Chairman and CEO

Sure, yes. Regarding customer audits, the process from the time the customer requests an audit to when we deliver a report can take a couple of months. We aim to gather valuable data points during this time. Generally, the cycle may take about two months for us to have a face-to-face meeting with the customer and agree on their potential purchase.

Robert Wertheimer, Analyst

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

Vicente Reynal, Chairman and CEO

Yes, it goes into the lead time. We currently have an extended backlog, so depending on the product, it will affect the regular lead time. It could take another couple of months or even longer.

Operator, Operator

Our next question comes from Jeff Sprague from Vertical Research.

Jeffrey Sprague, Analyst

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

Vicente Reynal, Chairman and CEO

Yes. Jeff, once we're in exclusive LOI, we don't find anything. I mean I said hit rate is pretty high. I'm going to say maybe 90% plus. So we're confident that we're going exclusive with them, and we have done enough diligence, but it's just a matter of kind of some of the final negotiating points. In terms of deal size, think about these six bolt-ons similar in nature to LeROI by the time that we made that acquisition. So you can see that they're small in size, but not that every deal will be like LeROI. We want it to be always like that. But clearly, it shows that these bolt-ons can become significant good acquisitions for us over the period of time.

Jeffrey Sprague, Analyst

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

Vicente Reynal, Chairman and CEO

Yes, to clarify, when we refer to a marketing qualified lead, we consider it to be a medium to hot lead. These leads have already been prequalified through our internal algorithms and our demand generation, which we like to think of as our artificial intelligence engine. As a result, the close rate for these leads is significantly higher than average. We don't disclose our specific close ratio because we view that information as strategic, but it definitely exceeds the typical sales call. This is why we are very optimistic about continuing to push for marketing qualified leads. With several thousand marketing qualified leads generated each week, we find this to be quite promising.

Operator, Operator

Our next question comes from Joe Ritchie from Goldman Sachs.

Joseph Ritchie, Analyst

So maybe just starting off, going back to the discussion around audits. I thought that was a really interesting discussion. So I know it's not an apples-to-apples comparison because 4,000 audits, your installed base I think, across your portfolio of products is something like 5 million. I'm just trying to think through this opportunity on a longer-term basis because I see $100 million conversion and that's pretty meaningful, like 2 points to your ITS growth. And so I'm just wondering, is this something like a growth multiplier over the coming years, is this something you guys are hoping to kind of bank on going forward? Any thoughts around that would be helpful.

Vicente Reynal, Chairman and CEO

Yes, Joe. The 4,000 audits we mentioned are only in the U.S. We anticipate many more globally. This is part of our self-help growth initiative, which we believe is important for customers to understand their options. We've been working on this for a while and are getting proficient at applying it to both compressors and blowers. For instance, Rontec in the pulp and paper sector is conducting numerous audits focused on energy and water conservation. This approach is strategic for us, and we have a unique method. Our recent acquisitions, such as Lawrence Factor a few quarters ago, enhance our ability to conduct air audits while maintaining air purity and efficiency through remote connectivity testing. This initiative can be a significant growth driver for us, as demonstrated by a 60% increase in audits compared to 2019, pre-pandemic. It will continue to be a key area of investment for us.

Joseph Ritchie, Analyst

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

Vicente Reynal, Chairman and CEO

Yes. China accounts for approximately 15% of our sales. We've stated before that we operate in the country primarily for the local market, with around 90% of the products sold in China also produced there. This means our supply chain is relatively self-contained. We do not have a factory in Shanghai; our facilities are located in Xuzhou, Wuxi, and Busan, which have not been significantly affected by the lockdowns as our workers can continue to access these locations. In Shanghai, we only have a distribution center, and while it has been impacted, especially on the aftermarket side, the government is beginning to permit some companies, including ours, to resume operations. Now, we need the supply chain to start ramping up. The focus is not solely on us, but rather ensuring that our suppliers in the Shanghai area, who have experienced lockdowns, can increase their output as quickly as we have. We are adopting a cautious approach as we enter the second quarter, and as we improve our collaboration with our suppliers to enhance ramp-up efforts, we anticipate potential opportunities to better serve our customers.

Operator, Operator

Our next question comes from Nigel Coe from Wolfe Research.

Nigel Coe, Analyst

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

Operator, Operator

Our next question comes from Josh Pokrzywinski at Morgan Stanley.

Joshua Pokrzywinski, Analyst

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

Vicente Reynal, Chairman and CEO

I think, Josh, maybe the one different variable that is maybe very new here is ESG and the 2030 and 2050 targets that companies are agreeing to. You saw on one of our slides how we actually included quotes from sustainability reports from pretty large companies that basically talk about the compressor and the air treatment systems being their way for getting to their Scope 1 and Scope 2 activity. I think it's a combination of the multiple variables that, yes, energy has spiked in the past, and that kind of may create a little bit of acceleration. But I think now the really fundamental change in the market is the fact that these kind of ESG targets that companies are putting out, and realizing that this underinvested area of compressors, blowers, and pumps that consume energy, there's now time to really upgrade that. The second variable could be around IoT and how the industrial Internet of Things and the remote connectivity is really accelerating that connectivity of the product to really enhance energy consumption and water usage even stronger. So those are the two variables that are very different now that really we think are going to create a better sustainable ongoing momentum.

Joshua Pokrzywinski, Analyst

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

Vicente Reynal, Chairman and CEO

Yes. I'd say, Josh, if I say in terms of things that we can control that we have been working on for the past several years, is how we have moved to better end markets, kind of what we call sustainable, high-growth end markets, whether it is food, beverage, life, and sciences. We called that out in the Investor Day as the quality of life and how we continue to see that as we move more of our product by our own choosing to be able to play in those end markets, that provides a better sustainability. The second one is, again, in terms of what we can control, it will be demand generation. We think that this is a really compelling competitive differentiator that is allowing us to reach this highly fragmented customer base in a much more highly cost-effective way. Very, very efficient, allowing us to create this acceleration in market qualified leads that turn into sales-qualified leads. The way we like to say sometimes internally is that we're getting our sales guys more at-bats and basically hitting more home runs than in the past. And the third piece internally in terms of what we can control is, I'll say, innovation. I mean, you see how new product development for us is essential. Every quarter, we speak about how we've been able to create new technologies, new products, I mean, the Thomas pump in the technology and moving it into in-vitro diagnostics. Or even the LeROI compressor, which was very gas compressor-oriented, and we moved that to a much more sustainable end market. So I think those are three areas that we have in our control that are allowing us to have much more sustainable ongoing growth.

Operator, Operator

Our next question comes from Andrew Kaplowitz from Citi.

Andrew Kaplowitz, Analyst

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

Vikram Kini, Chief Financial Officer

Yes. Andy, this is Vik. Maybe I'll start, and I can let Vicente on as well. You're absolutely right. I think if you followed the journey here for a few years, we made some very concerted efforts, I'd say, to eliminate a lot of the, what I'll call cyclicality that was inherent in the portfolio previously. So you've obviously seen that with the divestitures, particularly with upstream oil and gas obviously being divested away from the business. And then I'd say a couple of other areas now as we think about today and moving forward. One is the aftermarket piece, which you're absolutely right. We see a path to be above 40% from a total enterprise perspective, which is a more stable and recurring base of revenue, obviously, more profitable as well. And I think the other one that Vicente just mentioned, and he gave a number of examples, whether it be the LeROI or the Thomas pumps, is what I'll call higher growth, more sustainable end markets. So you've seen a lot of push for areas, whether it be on the water side, whether it be on the lab life science, whether it be hydrogen, a lot of the applications that our oil-free compression technology goes into. So I would tell you, yes, that's absolutely been a huge push and a very concerted effort. I think if you look at the portfolio today, even versus what the composition was from an end market perspective at the time of the RMT, it's meaningfully different by virtue of both of those areas that we focus on.

Andrew Kaplowitz, Analyst

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

Vikram Kini, Chief Financial Officer

Yes. That's a thought on, Andy. Obviously, clearly, given the backlog and the global supply chain environment, you have seen a build of inventory here in Q1. I would say, obviously, right now, clearly, with the Shanghai situation and still kind of some of that supply chain unrest that's there, we would expect to continue to see working capital at probably slightly elevated levels here, particularly through the first half of the year. So Q2 probably not being much different. And then the second half being, I'd say, about more of the normalization. So I think by the second half, again, assuming everything continues to return to some semblance of normal, you would expect to see that seasonality probably come back in. It’s worth noting here that our cash flow is typically seasonal Q1 is typically the lightest, and it does ramp towards the end of the year. We would expect no different this year, just a little bit more exacerbated in the first half due to the inventory situation.

Operator, Operator

Our next question comes from Nathan Jones at Stifel.

Nathan Jones, Analyst

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

Vicente Reynal, Chairman and CEO

Yes, Nathan, I would say and it actually varies by business and also the product lines within the businesses. So for example, we've now been able to have the small compressors to reduce the lead time dramatically versus what it was in the past. In the aggregate, you can think about lead time maybe about the same to slightly better with some mix within those product lines that we have. So is our team working aggressively to try to reduce and use it as a competitive advantage? You bet they are, yes.

Nathan Jones, Analyst

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

Vicente Reynal, Chairman and CEO

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

Nathan Jones, Analyst

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

Vicente Reynal, Chairman and CEO

Yes, we actually do charge for some of those in certain industries, but it's a minimal amount. We do this mainly to ensure that customers are committed to the audits. Sometimes, if we offer it for free, they might not pay much attention to it. In some cases, we do charge, but it's not aimed at making a profit from these audits. It's primarily to foster conversation about what we can offer the customer.

Operator, Operator

Our next question comes from Stephen Volkmann of Jefferies.

Stephen Volkmann, Analyst

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

Vikram Kini, Chief Financial Officer

Yes, Steve, that's absolutely correct. I would expect the incremental margins to be significantly better in the second half of the year compared to the first half. The main factor driving this change will clearly be price cost, which is the most significant contributor. As we've mentioned, we anticipate that price cost will positively impact dollar amounts in all quarters, although it won't necessarily lead to margin positivity, especially in the first half. The second half should show much better results. Additionally, we still expect to realize $50 million in synergies, which tend to be somewhat seasonal. The synergies we are witnessing now are primarily focused on innovation and volume in specific areas. It's important to note that these will also exhibit seasonality, strengthening more so in the second half of the year. Furthermore, we have synergies from the bolt-on acquisitions completed last year, particularly in the Seepex business. We are currently implementing many actions related to this, and we expect a more noticeable impact on margins in the latter half of the year. Also, for the PST acquisitions, remember that we didn't have those in the first half of last year, creating some differences between the two halves of this year. Once we fully account for the acquisitions, things should stabilize more. Overall, the three main drivers will be price cost, which is the largest factor of the three.

Stephen Volkmann, Analyst

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

Vikram Kini, Chief Financial Officer

Yes. Steve, they are bolt-on in nature and vary in margin profile as well as by segment. We have a good mix across the portfolio. Generally, most of the acquisitions we are making fall within the 20% to 25% margin range. We usually have a solid plan for how these will achieve or exceed the segment margin profile within three years. The return profile for all six of these deals aligns with the targets we've set previously. Even if there is some minor dilution initially, we believe we can address that quickly.

Operator, Operator

Our final question comes from Nigel Coe from Wolfe Research.

Nigel Coe, Analyst

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

Vicente Reynal, Chairman and CEO

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

Nigel Coe, Analyst

I'm curious if there are any specific credits or incentives at the manufacturing level that could help encourage customers to consider replacements.

Vicente Reynal, Chairman and CEO

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

Nigel Coe, Analyst

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

Vicente Reynal, Chairman and CEO

Yes. Great. So this is actually one that very well fits in line with what we said before about moving to the sustainable high-growth end markets. So we're taking that technology of those large centrifugal compressors into air separation for hydrogen or for LNG. So these are the kind of more what we call more sustainable end markets that we're seeing. Also, food and beverage and also a lot of the new semiconductor expansions that you're seeing and the localization of the supply chain. And the last one is electric vehicle production and lithium battery ion production. I mean those are the end markets that we have pivoted away from oil and gas and into these better sustainable growth markets. So this is a great example of taking what we can control, which is taking the products and positioning them very well into end markets that are seeing better growth momentum.

Operator, Operator

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

Vicente Reynal, Chairman and CEO

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

Operator, Operator

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