Earnings Call Transcript - RRX Q4 2021

Operator, Operator

Good day, and welcome to the Regal Rexnord Corporation Fourth Quarter 2021 Earnings Conference Call. All participants will be in listen-only mode. After today’s presentation, there’ll be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Robert Barry, Vice President of Investor Relations. Please go ahead.

Robert Barry, Vice President of Investor Relations

Great. Thank you operator. Good morning and welcome to Regal Rexnord's fourth quarter 2021 earnings conference call. Joining me today are Louis Pinkham, our Chief Executive Officer; and Rob Rehard, our Vice President and Chief Financial Officer. Before turning the call over to Louis, I would like to remind you that the statements made in this conference call that are not historical in nature are forward-looking statements. Forward-looking statements are not guarantees since there are inherent difficulties in predicting future results and actual results could differ materially from those expressed or implied in the forward-looking statements. For a list of factors that could cause actual results to differ materially from projected results, please refer to today’s earnings release and our SEC files. On slide 3, we stated we are presenting certain non-GAAP financial measures in this presentation. We believe that these are useful financial measures to provide you with additional insight into our operating performance and for helping investors understand and compare our operating results across accounting periods and in the same manner as management. Please read the slide for information regarding these non-GAAP financial measures and please see the appendix for reconciliations of these measures to the most comparable measures in accordance with GAAP. Turning to slide 4. Let me briefly review the agenda for today's call. Louis will lead off with his opening comments. Rob Rehard will then provide our fourth quarter financial results in detail and discuss updates to our 2022 guidance. We will then move to Q&A, after which Louis will have some closing remarks. And with that, I'll turn the call over to Louis.

Louis Pinkham, Chief Executive Officer

Great. Thanks Rob and good morning, everyone. Thanks for joining us to discuss our fourth quarter earnings and to get an update on our business, and thank you for your interest in Regal Rexnord. While the fourth quarter continued to present many challenges, in particular around inflation and supply chain disruptions, our Regal Rexnord team met these challenges head on and delivered solid results. In the quarter, Regal Rexnord posted robust 11% organic top-line growth, achieved positive price/cost for the enterprise, exceeded the midpoint of our earnings per share target range and delivered strong free cash flow. We closed the year with a balance sheet that is 1.3 times levered on a pro forma basis, which gives us lots of optionality around capital deployment. Furthermore, with our fourth quarter orders up about 30% and up mid-20s in January, we ended 2021 with a record backlog and, as a result, have a very healthy top-line potential in 2022. These strong results are the product of disciplined execution, strong adherence to 80/20 principles, price discipline, and targeted management of our toughest challenges, in particular supply chain consistency, logistics, and inflationary pressures. In one sign of our team's success navigating these challenges, I am extremely proud to share that Regal Rexnord was recently named Supplier of the Year by one of our large OEM customers. I believe the award reflects our strong service during a challenging time, which is fantastic. But what made me even more excited was our customers citing alignment on our values and in particular, on our value of diversity, engagement, and inclusion, and on our value of innovation with purpose, creating products and solutions that are purposeful for our customers and, through a consistent focus on improving energy efficiency, products and solutions that are purposeful for our planet. This news and our fourth quarter performance marked a consistent close to a year characterized by tremendous progress transforming our business into a stronger performing, higher margin, faster growing, more cash-generative, and higher return global enterprise. So before going any further, I want to thank all of our Regal Rexnord associates around the world. Our strong performance, at its core, is about our nearly 30,000 talented associates, their disciplined execution, leveraging their individual skills and diverse perspectives, always guided by our Regal Rexnord values to act with urgency to serve our customers and meet our financial commitments. Let's also not forget that during the fourth quarter, we closed a transformational merger with Rexnord's Process & Motion Control business and completed the acquisition of Arrowhead Systems. While we are only one quarter in working jointly with PMC, now the Motion Control Solutions segment, and have owned Arrowhead for only a couple of months, I'm extremely pleased with the positive momentum we're already seeing behind our integration and synergy activities. In fact, as we've conducted monthly operating reviews with our new associates from PMC and Arrowhead, many have remarked that it feels like we've been operating as one Regal Rexnord team for many years. This great cultural fit is the main reason I remain confident that synergies from these transactions can add materially to our future margin, free cash flow, and organic growth profile. As we have discussed before, the cornerstone of our MCS sales synergies are the significant benefits we see from being able to offer our customers an integrated industrial powertrain solution, that is our motors plus the critical power transmission components that connect the motor to whatever it is powering. We believe this value proposition will become even more compelling as we leverage data collected from all the key powertrain components and use that data to optimize the system's performance through perceptive intelligence. So, I'd like to provide a brief update on our continued progress pursuing powertrain opportunities. Our engineering teams have been hard at work on how to optimize performance of the greatly expanded scope of powertrain solutions we are now able to provide, by leveraging the legacy PTS and PMC portfolios in conjunction with our motors. This clearly will be a multiyear journey, but even so we have already seen some accelerated advances. In parallel, our sales teams have been actively speaking with our customers about the benefits of procuring integrated powertrain solutions, and I'm excited about the number and quality of these conversations. To shed some light on what I'm referring to, this slide provides examples of powertrain solutions we are working on. All of these are active projects with actual customers and are in the development or quoting phase. In each example, we have noted the principal components included in this solution, as well as some of the key benefits each can provide to our customers. You'll notice a diverse array of benefits including energy efficiency, greater reliability, and optimized performance. As our powertrain efforts continue to advance, we'll keep you updated on our progress, including quantifying the revenue impact we expect to see from selling these solutions. Now, where we have been seeing more immediate merger-related benefits on the top line is in cross-selling activity, which are just getting started and are expected to ramp meaningfully as 2022 unfolds. We'll look to quantify these benefits as our efforts mature, but I think it's fair to say that from cross-selling alone we'd expect sales of at least $10 million in the first year and that gross margins that are accretive to the enterprise. Before I share some thoughts on our 2022 outlook, I'd like to make a couple high-level comments about the operating environment. As you know, we and many others have been confronting a host of inflation and supply chain challenges through most of 2021. On the whole, I believe we've been navigating through them as well as, and in some cases, a little better than our peers, which has helped us gain some share and likely also boosted our ability to manage price. However, as we close 2021, I would say these challenges intensified. Freight congestion at the ports was particularly acute in the fourth quarter. Freight inflation has stepped up meaningfully as well and labor availability has become more of a challenge for some of our businesses, especially in the United States. We believe a resurgence in COVID cases with the highly transmissible Omicron variant has been a factor intensifying all of these headwinds. Now the good news is an incredibly healthy demand environment, which you can see in our order rates and a healthy backlog. So we feel good about top line prospects, very good actually. But in the last couple of months our visibility has diminished around how quickly we'll be able to work down the backlog and around certain costs associated with serving this demand, most notably freight and labor, although we believe these peaked in the fourth quarter of 2021. As a result, we decided to take a slightly more conservative approach when updating our 2022 guidance. At a high level, we're adjusting the top line to reflect our strong orders and record backlog, while retaining some caution around supply chain constraints. From a margin perspective, we're factoring some incremental pressure related to non-commodity inflation, in particular, labor and freight.

Rob Rehard, Vice President and Chief Financial Officer

Thanks, Louis, and good morning, everyone. As you heard, Regal Rexnord had very strong results in Q4, but the team is also navigating headwinds on a number of fronts, so I'd also like to send my congratulations to our global team for executing so well in this challenging environment. Now, let's discuss our results by segment and then I'll discuss our guidance. As a reminder, having closed the merger with Rexnord PMC, we are now discussing segment operating performance on an adjusted EBITDA basis. We'll start with our Motion Control Solutions segment, or MCS, which beginning in the fourth quarter of 2021 reflects the combination of our legacy Power Transmission Solutions segment, or PTS, our newly acquired Arrowhead business, plus Rexnord PMC. Organic sales for MCS in the fourth quarter were up 4.9% from the prior year on strength across most of our end markets, but with particularly healthy demand in the food and beverage, general industrial, and agriculture markets. In addition, the business had nice tailwinds from share gains. Partially offsetting these tailwinds was pressure from lapping large prior year project activity in the China wind energy market. Furthermore, and this can be said for all of our businesses, supply chain disruptions continue to impact our ability to deliver resulting in increased backlog, but posing an additional headwind to the top line. Lastly, our 80/20 related pruning actions were approximately 130 basis points of top line headwind in the quarter. Adjusted EBITDA margin in the quarter for MCS was 24.5%, up 10 basis points compared to the prior year with benefits from volume, price, and permanent restructuring actions largely offset by impacts from supply chain disruptions and inflation, including freight, labor, and materials. Orders in MCS for the quarter were up approximately 30% and were up at a mid-40s rate in January both on a daily basis. Turning now to Climate Solutions. Organic sales in the fourth quarter were up 18.4% from the prior year. The increase was driven by broad-based strength in almost all markets and with particular strength in North America residential HVAC markets, North America general industrial markets, and in EMEA. The business also continued to achieve nice market share gains. In addition, price was a meaningful contributor to Climate's top line performance in the quarter, reflecting what is generally heightened price discipline for all of Regal Rexnord, but also more specific segment-specific tailwinds related to catching up on price under our two-way material price formulas, or MPFs. As you may remember, dynamics related to MPFs are most significant in our Climate segment. Finally, pruning actions were approximately 70 basis points of top line headwind in the quarter. The adjusted EBITDA margin in the quarter for Climate was 19.8%, down 130 basis points versus the prior year period. Factors impacting this margin include higher inflation, including freight, supply chain-related frictions, and negative mix. While price/cost was favorable in the quarter and helped to offset the continued impact of inflation, this dynamic was a drag on margins in Q4, similar to what we've seen throughout the year. Orders in Climate for the fourth quarter were up high 20s and up roughly 7% in January both on a daily basis. We continue to have healthy backlog in Climate, and messaging from our HVAC OEM customers remains very positive, with tailwinds from residential restock activity likely still mostly ahead of us. Turning to Commercial Systems, organic sales in the fourth quarter were up 13% from the prior year. Growth in the quarter reflects strong performance in large commercial HVAC and North America general industrial markets. We're also confident that our Commercial business is achieving share gains in the North America general industrial market aided by some of our digital investments. Notably, pricing was a meaningful contributor to top line performance in the quarter, while volumes were impacted by supply chain disruptions, specifically logistics challenges that intensified as the quarter progressed and ended up being worse than we expected. These pressures have bled into the first quarter, but we're continuing to work with urgency to identify and implement countermeasures. To close out our top line discussion for Commercial, 80/20-related pruning was a 180 basis point sales headwind in the quarter. The adjusted EBITDA margin in the fourth quarter for Commercial Systems was 11.1%, down 320 basis points compared to the prior year. Despite a healthy top line, headwinds from inflation, mix, and supply chain disruptions drove a net year-over-year margin decline. When assessing Commercial's margin performance this quarter, it's important to understand that our Commercial segment has experienced a disproportionate negative impact from supply chain and logistics headwinds. This is due partly to the segment's above-average exposure to seaborne freight compared to our other segments. Not only has seaborne container inflation become particularly acute, but mounting disruptions across our Commercial segment supply chain have led us to book containers with shorter lead times at elevated spot rates, which has further raised our costs. If there's a silver lining here, it's that much of this margin pressure is timing-related and we believe this dynamic should become less severe as supply chain frictions ease, enabling backlog reduction and shorter lead times between when products are shipped and when they are delivered, which will likely occur over the next couple of quarters. Actually, we're already seeing some improvement in January. Shifting to orders, the demand environment for commercial remains very healthy, with segment orders for the fourth quarter up mid-20s, and January orders up approximately 8% both on a daily basis. In Industrial Systems, organic sales in the fourth quarter were up 4.5% versus the prior year. Pruning actions during the quarter were approximately 320 basis points of top line headwind. The adjusted EBITDA margin in the quarter for Industrial was 8.9%, up 230 basis points versus the prior year period. Although we feel good about improved performance in Industrial Systems, especially due to the supply chain and logistics challenges, it is important to note that this business will see some quarter-over-quarter lumpiness. Orders in Industrial for the quarter were up mid-20s and were up at a low-teens rate in January, both on a daily basis. On the following slide, we highlight some key financial metrics for your review. A couple of notable highlights. First, on the right side of this page, you'll see we ended the year with a net debt-to-EBITDA ratio of 1.8 times or 1.3 times on a pro forma basis, and consistent with our prior expectations. Second, our free cash flow of $82.6 million, which resulted in a cash flow conversion rate of 289% or 118.1% for the full year 2021. Lastly, we purchased $25 million of our shares in the fourth quarter. We have $434 million remaining on our $500 million share purchase authorization. Now moving to the outlook. We are raising our expectations for adjusted earnings per share to a range of $10 to $10.60 from our prior range of $9.95 to $10.35. The range assumes a mid-to-high single-digit revenue growth rate, including a headwind from roughly two points of pruning. Currency is expected to be a very modest headwind to sales. In thinking about where to set our top line growth forecast, we tried to balance the competing dynamics of a very strong demand environment evident in our strong order rates and a record backlog, with supply chain frictions that remain severe and, in some cases, have worsened, plus labor availability challenges at some of our US locations. In addition, some of our plants and certain facilities at our suppliers have seen significant spikes in absenteeism that we believe are related to the latest COVID-19 variant, which has weighed on our output. While we are cautiously optimistic that conditions related to COVID in the supply chain will improve as the year unfolds, current conditions make us believe it is prudent to err on the side of conservatism as we start the year. As a result, our outlook assumes we make only limited progress in 2022 towards working down our backlog. From a margin perspective, our revised outlook factors some incremental pressure on margins compared to our prior expectations. The principal drivers of this heightened pressure are significant non-commodity inflation, in particular, in labor and freight, in addition to weaker absorption related to supply chain frictions. We model these dynamics being particularly challenging in the first quarter with moderate improvements assumed in subsequent quarters. Regarding commodity inflation, we have started to see some leveling in the prices of our principal commodities, steel, copper, and aluminum. While this is encouraging, we are not yet seeing prices decline and our outlook assumes only modest tailwinds from lower commodities in 2022. At the bottom of this page, we are providing modeling items that should help investors bridge from EBITDA down to net income and our adjusted earnings per share. While we are choosing to err on the side of caution here as we start the year, our confidence in this business remains extremely strong. We have line of sight to additional margin upside through our synergy efforts, disciplined cost-saving initiatives, and continued focus on 80/20 and lean. We're gaining traction with our growth initiatives, especially our Industrial Powertrain cross-segment initiative and our clean balance sheet, plus strong cash flows create material upside from capital deployment. The future is certainly bright. And with that operator, we are now ready to take questions.

Operator, Operator

We will now begin the question-and-answer session. The first question comes from Mike Halloran with Baird. Please go ahead.

Mike Halloran, Analyst

Hey good morning gentlemen.

Louis Pinkham, Chief Executive Officer

Hey good morning, Mike.

Mike Halloran, Analyst

So let's talk about the guidance a little bit just to make sure I understand the moving pieces here. Obviously, the components of what are creating some sloping in the trajectory to the year make a lot of sense. But could you help frame, how much pressure we're seeing in the first quarter or give some sort of sense for what the earnings cadence should look like this year versus a normal year? And then also maybe give some context for how you're thinking about sequential revenue trends through the year versus a normal year?

Rob Rehard, Vice President and Chief Financial Officer

Sure, Mike. This is Rob. Let me – first of all, we should see improving revenues EBITDA and margins in the first quarter absolutely. But to provide some more directional guidance, it might be best to look at how we see Q1 shaping up relative to the way we ended Q4 or maybe more of a sequential view. So from a top line perspective, we would expect some slight improvement in Q1 relative to Q4 and this applies to all of our segments. From an EBITDA margin perspective, I think it's best to actually talk to that by segment. So first in Commercial, we'd expect margins to return to rates that we saw in the first three quarters of 2021 or just north of 15%. And this is partially tied to some slight improvement a little bit in supply chain logistics, especially at the ports as well as the timing we discussed during the call. Now moving to Industrial, we'd expect margins to approximate those that we saw in Q4 but possibly a little closer to our full year exit rate for Industrial. In Climate, we would expect margins to move up slightly relative to Q4, as we address some of the electronic supply chain constraints that we talked about. And then finally in MCS, we'd expect margins to improve also a bit from Q4, as we start to realize more of the synergy savings anticipated as the year progresses. And so when it comes to the sequential on the revenue side certainly we'll see revenues progress as we move through the year. Normally, we're fairly flat in terms of revenues and that cadence as we go through the year. But in this year in particular, the first quarter as those – some of those logistics and supply chain challenges start to ease, it'll be a little lower in the first than we may have seen historically and then start to move up as we move through the subsequent quarters. So hopefully that helps.

Mike Halloran, Analyst

No. No that does help. And on the HVAC side in the pool side a couple of areas, where you maybe have some tougher comps as you work through the year maybe just some thoughts on how you think about the stability or sustainability of the underlying demand there. It sounds like backlog orders are good. It sounds like the customer conversations are good. But how do you think about sustainability of that? And when you get to the back half of the year, are there volume pressures that could potentially materialize or are the indications consistent positive growth there?

Louis Pinkham, Chief Executive Officer

Yes. Hey, Mike, this is Louis. I'm going to break that into two pieces. And first HVAC and realizing that residential HVAC makes up about 15% of Regal Rexnord and Commercial about 10%, so let's talk about residential. All the near-term growth drivers are positive and you certainly probably track the OEMs as well that have come out and felt that end-market demand is strong. We see it as well. Pricing is certainly going to help also especially as our material price formulas have caught up. And then lastly, I would say, as we think about the restocking, we absolutely have felt some challenges in fourth quarter and even third quarter, especially with the electronic supply chain. And so some of the pressure we saw due to mix in Q4 should relieve itself over the next few quarters as that electronic supply chain balances out. But I'll tell you electronics is going to continue to be a headwind all year long. With that said, longer term for residential, you talked about the back half. We believe that there will continue to be strength. Strength in residential new construction will help here as well as just the reality that with COVID there's still significant work-from-home activity. And then lastly, I remind you that 2023 we'll see a new SEER rating uplift which will be a benefit for Regal Rexnord especially as we're the leader in variable frequency and variable speed drive motor technology. So that's how I think about HVAC. And so we think HVAC 2022 is going to be pretty solid. Pool same for the most part. End-user demand remains quite strong. However, we did see in the fourth quarter and we absolutely expected it as well, a bit of a slowdown mostly because of supply chain disruptions and contractor availability. And in the fourth quarter of 2021 there was tough compares. Now longer term for 2022, we believe the demand profile is strong. And as you know, the July 2021 regulation that requires all 1.1-horsepower and above motors to be variable speed is a benefit to Regal Rexnord if for no other reason than our pricing levels on those products are quite a bit higher than our standard motor offering. So all-in-all, we feel good about both HVAC and Pool. I will make one other point on Pool though. Pool is only 3% of our sales. So it doesn't have as much influence. Clearly, HVAC is the big part of our business.

Mike Halloran, Analyst

And Louis, could you just also touch on the commercial piece in there and...

Louis Pinkham, Chief Executive Officer

Yeah. Sorry, I missed that. Thanks. Yeah. No, we see the commercial HVAC market strong this year, gaining momentum through the year. It definitely will be a tailwind for us. And we've seen it in the order rates as well, Mike. So it should be a strong commercial HVAC year for us.

Mike Halloran, Analyst

Really helpful. Thanks for the color.

Louis Pinkham, Chief Executive Officer

Sure.

Jeff Hammond, Analyst

Hey. Good morning guys.

Louis Pinkham, Chief Executive Officer

Good morning.

Rob Rehard, Vice President and Chief Financial Officer

Good morning, Jeff.

Jeff Hammond, Analyst

So you talked about the revenue — some of the early revenue synergies. That's good to hear. I think your comment seemed to suggest that the synergies were on track or ahead. I'm just trying to get a better sense. Is the part about it being ahead really just around the sales synergies coming faster, or is there anything from a cost standpoint that's different or better?

Louis Pinkham, Chief Executive Officer

Yes, Jeff, this is Louis. I'll address that. From a cost synergy perspective, I am quite confident that we are on track. We expect to finish the first year with a run rate of about $70 million. The team is performing well in all areas. Regarding cross-selling synergies, we haven’t provided guidance yet and are not quite ready to do so. We plan to offer more specific objectives later in the year. What I'm noticing is two main points. First, I'm very enthusiastic about our industrial Powertrain and the initial discussions with OEMs in identifying opportunities. I genuinely believe we are the only North American provider of a complete solution, which allows us to optimize the operating capabilities of individual components together. In some cases, we understand the applications better than our customers, and we definitely know our products well. Combining these elements leads to better optimization, reliability, and energy efficiency, which is significant. The potential for us lies in the cross-selling opportunities, which have been more promising than we initially expected, especially at this early stage. The reality is that there is considerable overlap in distribution between the legacy businesses, PTS and PMC, although not on the OEM side, which was a key reason for this merger. We are now able to identify pull-through opportunities between the components of the individual legacy businesses to the customer bases of one another. That's where I'm seeing some positive developments that I'm excited about.

Jeff Hammond, Analyst

Okay, that's great. And then I just wanted — the order rates be helpful by segment. I thought what stood out is the MCS kind of acceleration into January where the other ones may be normalized. I didn't know if that's — has to do with comps or what's different about kind of that acceleration and the huge really order rates in January for MCS?

Louis Pinkham, Chief Executive Officer

Yes. I mean this one's a pretty simple one. It's all around aerospace. And so, we are seeing that market start to return. We're certainly getting orders. It's highly influencing the overall numbers which we feel good about. We like the aerospace market. We think long term, it's a growth market. It's certainly been challenged with COVID over the last few years, but we think it's a good market to be in.

Jeff Hammond, Analyst

Okay. Thanks so much guys.

Louis Pinkham, Chief Executive Officer

Got it.

Nigel Coe, Analyst

Thanks. Good morning everyone.

Louis Pinkham, Chief Executive Officer

Good morning, Nigel.

Nigel Coe, Analyst

Good morning. So just as an FYI dropped by your booth at HRI earlier this week and the system kind of emphasis really came through the integration of the motors and powertrain really came through so we're seeing that.

Louis Pinkham, Chief Executive Officer

Awesome.

Nigel Coe, Analyst

What are the current price and cost dynamics, particularly regarding the NPS in the Climate business? Are we still experiencing challenges with those NPS, and do we expect to see significant improvement in the first half of the year? Additionally, could you provide more insights on the anticipated improvement in Commercial from the fourth quarter to the first quarter? That's quite a substantial increase.

Louis Pinkham, Chief Executive Officer

Yes. So, Nigel let me take that. From a Climate perspective the NPS had basically caught up. Where we've had opportunities though is we did see some mix pressure in the fourth quarter and that's strictly from the standpoint of the electronic supply chain being fairly constrained. We absolutely left business on the - in the production lines that we could have shipped if the semiconductor supply chain was a bit more robust. We're feeling good going into Q1 that margins will improve slightly because of the supply chain kind of working itself out and bluntly shouldn't take many quarters to work itself out, but better than fourth quarter. From a commercial side, it's really as simple as saying that the log jam in the ports and the freight constraints had an impact on the margins. The inflation in freight was significant. If you pull out that inflation from freight out of Q4 we would have leveraged as we would have expected in Q4 in our Commercial business in the mid-20s. This is what we're expecting going into Q1 of 2022.

Nigel Coe, Analyst

Okay, that's great. And then my follow-on is you alluded to the mix benefits from the SEER change at the end of this year. So as we go to 15 SEER in the southern states, can you maybe just like give us a bit more color in terms of what that does for your opportunity sets in the residential markets? Is there a significant uplift in mix from that one SEER change?

Louis Pinkham, Chief Executive Officer

Nigel, I apologize. My hearing clearly. I'm not quite sure I understood your question. Could you please repeat it? Apologies.

Nigel Coe, Analyst

Yes. You mentioned the SEER change in residential HVAC is good news for Regal. Just looking for a bit more color there. What does this kind of offer you in terms of mix price points, et cetera?

Louis Pinkham, Chief Executive Officer

Okay. Sorry, I didn't hear SEER. That was the issue. We're already starting working with the OEMs. Clearly that development starts significantly in advance. We actually have a new product that's going to be launched with one OEM in particular that will provide a nice margin step-up to that 35% gross margin level that we'd like to see. The SEER requirements one SEER level step-up is expected in 2023 that drives more variable speed motor requirements. From a margin mix perspective that's a benefit for us. We aren't quite ready to quantify what all of that means for us yet, Nigel, but all in all it should be a positive tailwind.

Christopher Glynn, Analyst

Thanks. Good morning.

Louis Pinkham, Chief Executive Officer

Good morning, Chris.

Christopher Glynn, Analyst

Wanted a clarification on backlog. I think your guidance said just partial backlog reduction expected this year. So to what extent does that assume trend line orders are pretty sticky versus some correction against maybe some early loading of orders in recent quarters?

Louis Pinkham, Chief Executive Officer

It's a great question Chris actually. We expect the trend line of orders to be pretty consistent through the year. Why? Because the supply chain will continue to be stressed and the demand continues to be strong. So do I think the backlog is elevated a bit because our lead times have extended and therefore MRP is just driving more order rates? I do, but we also believe that our lead times will and have started to see some decline in our lead time and yet our order rates continue to be strong. So our expectation is order rates are strong throughout the year.

Christopher Glynn, Analyst

Okay. Thanks. And then on the mid-40s January orders boosted MCS is that pure pro forma organic orders period-over-period or is there some acquired backlog aspect to that?

Louis Pinkham, Chief Executive Officer

No, we tried to do an apples-to-apples comparison on that so it is strength in orders and demand. And as I commented earlier, it's highly influenced by aerospace. Overall we feel the demand profile in MCS continues to be strong. In addition, although restocking did occur through 2021 we're still in the process of restocking in that market space. So, the January orders are solid for MCS.

Operator, Operator

The next question comes from Walter Liptak with Seaport Research. Please go ahead.

Walter Liptak, Analyst

Hi, guys. Thanks, good morning.

Louis Pinkham, Chief Executive Officer

Good morning.

Walter Liptak, Analyst

Wanted to ask about the synergies and if you can just refresh us on the $70 million and what you still have to go get this year to get to that $70 million. And then in 2023 the synergies?

Louis Pinkham, Chief Executive Officer

Yeah. So $70 million run rate for coming out of 2022. What do we have to go get to achieve that? At this point, when we talked about this broken down into three categories. The first category is the organizational changes. And coming out of 2021, we had executed on most of those. That's got going into Q1 starting a nice run rate. Indirect material savings are on track and we feel good about that negotiating with suppliers feel good there. Direct material, yes, there's some customer approvals, and supply chain negotiations still ongoing, but on track. The footprint rationalization is more weighted towards the end of next year in 2023, but all the planning is as we expected at this point. So we feel good at that $70 million coming out of 2022. Coming out of 2023, we're expecting $100 million, much more weighted to the supply chain — excuse me — much more weighted to the footprint rationalization activities. That's where those really start to accelerate in 2023. Planning feels really good though, Walt, so we're pretty confident on the cost side.

Walter Liptak, Analyst

All right. Yeah, that sounds great. Thank you. And then I guess as you're working on these synergies, the cash flow is going to be coming through. I wonder if you could talk a little bit about the Arrowhead acquisition and how that integration is going. And how is your appetite for doing other deals in 2022?

Louis Pinkham, Chief Executive Officer

Sure. So Arrowhead is going well. We've owned the business for a couple of months now. This was an opportunity for us to acquire into a space that's growing probably at quite an accelerated rate, 18% CAGR over the last three years. We're forecasting 10% plus for us over the next few years in that business. It also gives us quite a few vectors for us to look at additional acceleration of growth. And as we've talked about historically, our ModSort offering, which is well-suited for the e-commerce space, which has grown significantly under our ownership over the last three years, will accelerate because of Arrowhead's competency in providing a subsystem in their control engineering competency, and so synergistically really just a nice fit for us. From a disciplined capital allocation perspective, I can tell you our funnel is strong. I like what I see. I think there's opportunity. I'll tell you though we will be disciplined as we talked about in the past. We will not overpay. It needs to be in a market that's growing above GDP that has good gross margins, 35% plus or a path to get there, accretive in the first year, ROIC of 10% year three, year five is highly strategic. So we'll be disciplined financially but it needs to strengthen our position. Like I said, I think the funnel is strong. We're actively talking about a number of opportunities. We won't shy away from an acquisition in 2022. But what I'll tell you is it won't be — my guess is you won't see anything in the short run but perhaps later in the year into 2023.

Chris Dankert, Analyst

Hey good morning guys. Thanks for taking the questions.

Louis Pinkham, Chief Executive Officer

Good morning.

Chris Dankert, Analyst

Fully appreciate taking a somewhat conservative hack at the guide here. I'm just trying to think out loud if input and freight costs don't ease up as expected here, how quickly can we course correct and readjust and pass that pricing through? Is there a way to get ahead of it a little bit more quickly than in the past? Any comments on just the speed there?

Louis Pinkham, Chief Executive Officer

Yes. So we are using in some instances Chris, surcharges. Surcharges allow us to move faster than a normal price list, price increase, and so that has helped. I would tell you that the pressure we saw in the fourth quarter, the inflation for sure was partially due to our supply chain constraints and the need to go to the spot market to confirm containers. The inflation in the spot market was up 125% in the fourth quarter, a lot of which was driven by the big retail components of the end of the year and even the Chinese New Year holiday. We are better able to manage through that because of the reduction in supply chain constraints we are seeing coming into Q1. So we feel better around the cost profile, but it's still inflated over 2021. And then like I said, to be able to go for price, we definitely have used surcharges to help us address this accelerated inflation.

Chris Dankert, Analyst

Got it, got it. That's helpful. And then again very excited to hear more about the cross-selling synergies over time here. But is there also kind of a margin opportunity tied to that cross-selling sense? By definition, a lot of these are going to be more system-based sales. Or is that too optimistic a way to frame it?

Louis Pinkham, Chief Executive Officer

The industrial powertrain, I would say, absolutely. There's going to be some margin opportunities especially with the OEMs, right? We typically have a little bit lower margins with OEMs and then have a little bit higher margins in the aftermarket. But because we're able to provide an optimal solution, it should be a mix-up. From a cross-selling perspective, I would tell you, it's not about the optimization piece. It's just simply about selling legacy Regal components into the PMC channel, and legacy PMC components into the Regal OEM channel. So I don't believe there's a margin uplift there. There is for overall Regal Rexnord though, because of course the MCS segment margins are about 500 to 600 basis points above our fleet average. So from a mix perspective, that's a benefit for sure.

Joe Ritchie, Analyst

Thanks. Good morning, everyone.

Louis Pinkham, Chief Executive Officer

Good morning, Joe.

Joe Ritchie, Analyst

So, I guess my first question. You guys touched on the M&A piece of the capital allocation bucket for this year. I'm just curious, it doesn't seem like you have much dialed in for buyback. I know you raised your authorization last quarter. How are you thinking about that toggle for 2022?

Rob Rehard, Vice President and Chief Financial Officer

Yes, Joe. This is Rob. Absolutely. We intend to remain balanced in our capital allocation, and that does absolutely include the optionality around buying back our shares, which we've done in the fourth quarter and is an option for us going forward. However, it isn't in any way embedded in our guidance at this time but it's absolutely an option for us and that's the way we're thinking about it.

Joe Ritchie, Analyst

Got it. Okay. That's clear. And then, I guess, the question I know that you guys historically have been reticent to give, your pricing that's going to come through this year. But I'm curious when you think about all the puts and takes on price/cost and the margins that you've given us for the first quarter and through the year, how do you see that relationship trending throughout most of 2022?

Rob Rehard, Vice President and Chief Financial Officer

Yes, Joe, this is Rob again. We expect the price versus cost situation to be positive as we head into 2022, which will carry over and contribute a couple of points into the new year. We have been improving our ability to achieve better price leverage as we progress through the year and have maintained a neutral price/cost relationship over the last 17 quarters. We're enhancing our capability to capture more price to offset the margin pressure we’ve experienced in several of our businesses. The ease of this varies by business. However, we are seeing improvement, and we anticipate further enhancements throughout the year. Thus, we expect this progress to positively affect our margins each quarter moving forward. While we see price/cost as a positive factor, we must acknowledge that other types of inflation, such as labor and freight, are also impacting our business. Additionally, surcharges, as Louis mentioned earlier, are helping to mitigate some of this impact. Nonetheless, these factors can still limit some of the improvements you might normally expect from the carryover and the added price we expect next year.

Louis Pinkham, Chief Executive Officer

Hey, Joe, I'm going to add one other comment and clearly, I agree with everything Rob just said. The other piece to keep in mind, we are getting more mature every day around how we drive 80/20. And 80/20 helps us know where we should be driving price versus where we should be driving more customers to a product to drive efficiency in our manufacturing facilities. So on top of all of what Rob shared, 80/20 should continue to give us momentum through 2022. Thank you, operator, and thanks to our investors and analysts for joining us today. As I consider 2022, there's a lot to be excited about, even with a challenging operating environment. We're starting the year with a record backlog. Our team is executing at a very high level and we see growing revenue and margin tailwinds from our M&A synergies, further capitalizing on the benefits of 80/20, and as our lean initiatives keep maturing, all of which in the coming years are expected to drive significantly higher gross margins. This operating performance supports strong free cash flow and along with our clean balance sheet means sizable value creation upside from capital deployment. Frankly, as much progress as we've already made, I believe we're still in the early innings of transforming our business. So I look forward to sharing further updates in the future. Thank you again for joining us today and thank you for your interest in Regal Rexnord.

Operator, Operator

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