Earnings Call Transcript
REGAL REXNORD CORP (RRX)
Earnings Call Transcript - RRX Q3 2025
Operator, Operator
Good morning, and welcome to the Regal Rexnord Third Quarter 2025 Earnings Conference Call. Please note, this event is being recorded. I would now like to turn the conference over to Robert Barry, Vice President, Investor Relations. Please go ahead.
Robert Barry, Vice President, Investor Relations
Great. Thank you, operator. Good morning, and welcome to Regal Rexnord's Third Quarter 2025 Earnings Conference Call. Joining me today are Louis Pinkham, our Chief Executive Officer; Robert Rehard, our Chief Financial Officer; and Rakesh Sachdev, Chairman of our Board of Directors. I would like to remind you that during today's call, you may hear forward-looking statements related to our future financial results, plans and business operations. Our actual results may differ materially from these projected or implied due to a variety of factors, which we described in greater detail in today's press release and in our reports filed with the SEC, which are available on the regalrexnord.com website. Also on this slide, we state that we are presenting certain non-GAAP financial measures that we believe are useful to our investors, and we have included reconciliations between the non-GAAP financial information and the GAAP equivalent in the press release and in these presentation materials. Turning to Slide 3. Let me briefly review the agenda for today's call. Louis will lead off with opening comments and an overview of our 3Q performance and an update on our data center business. Rob Rehard will then present our third quarter financial results in more detail, review our 2025 guidance, provide an update on tariffs and offer some initial thoughts on 2026. 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, CEO
Great. Thanks, Rob, and good morning, everyone. Thanks for joining us to discuss our third quarter results and to get an update on our business. We appreciate your continued interest in Regal Rexnord. Before discussing our third quarter results, I would like to make some brief comments about the news regarding my succession, which we announced last night concurrently with our third quarter earnings release. It has been an immense honor to lead the company for the past 6-plus years. We have achieved a lot, inclusive of two major acquisitions and the divestiture of the Industrial segment, transformation of our portfolio, significant revenue growth, gross margin expansion and free cash flow acceleration and have positioned Regal Rexnord as a valued partner serving our customers' most critical needs. We have assembled a strong team of leaders who have built great teams that are focused on leveraging the 80/20, expanding secular growth opportunities and driving continuous improvement. Our portfolio is well positioned to grow, especially when the ISM returns to an expansionary period for industrial production. With third quarter sales up about 2% and orders up about 10%, along with our improving top line momentum, there is a lot to be excited about. So with that, and in light of some personal decisions that I recently made, the Board and I have agreed that this is a good time to initiate a transition plan to pass the baton to a new leader who will guide Regal Rexnord through the next phase of our growth journey over the coming several years. I look forward to continuing to lead the company until the Board identifies my successor. Rest assured, we have a strong team, and we'll continue to execute on our profitable growth initiatives for the benefit of our customers, our associates and our shareholders. In short, it is business as usual. And now on to the quarter. Our team delivered solid third quarter performance, nicely ahead of our expectations on orders, and roughly in line on sales and adjusted EBITDA, driven by over execution in PES and strong execution in IPS and AMC. Performance would have tracked even stronger if it were not for larger-than-expected pressures from two items out of our control: additional tariffs announced in August just after our Q2 earnings call and incremental challenges in sourcing rare earth magnets. Looking forward, our growth potential took a significant step higher in the quarter, driven by strong orders. These results, plus our expectation for further order strength in fourth quarter are setting us up for solid growth in 2026. In short, good results, great momentum. So before continuing, I want to take a moment to thank our 30,000 Regal Rexnord associates for their hard work and disciplined execution. Our associates continue to manage the impacts of tariffs and rare earth magnet constraints and are doing a great job working our commercial funnels to drive improved orders and performance. Now let me provide some specifics on our third quarter. Orders in the quarter on a daily basis were up 9.8% versus prior year, and book-to-bill was 1.05. We ended the quarter with our backlog up 6% versus the prior year. As I will elaborate on shortly, in the quarter, we booked $135 million of data center orders and then an additional $16 million order in October. This is a market where we are clearly gaining traction, and we are investing to support further growth. We also saw strong order growth in discrete automation and in our air moving business in PES for the data center and semiconductor markets, while IPS posted its fifth quarter in a row of positive orders growth against the backdrop of generally sluggish end markets. Our sales in the quarter were up 70 basis points versus the prior year on an organic basis, in line with our expectations for an inflection to growth. In the quarter, we saw particular strength in energy markets, discrete automation and aerospace, net of headwinds in medical as well as some project timing in data center. The latter is clearly temporary as recent orders show we are building tremendous momentum in our data center business. For reference, on a year-to-date basis, enterprise organic sales are up slightly and are expected to be up low single digits for the year. Turning to margins. Our third quarter adjusted gross margin was 37.6%, down 80 basis points versus the prior year period on mix and impacts related to rare earth magnet availability and tariffs. Adjusted EBITDA margin was 22.7%, roughly flat versus prior year and reflects an $11 million synergy benefit, mostly offset by mix, tariffs and rare earth magnet pressure. Adjusted earnings per share for the quarter was $2.51, up versus the prior year. And lastly, we generated $174 million of free cash flow in the third quarter, which was used primarily to pay down debt. We ended the quarter with no variable rate debt. In summary, a solid third quarter, during which we delivered strong orders and a rising backlog, which keeps us optimistic about accelerating top line and earnings growth in fourth quarter and into 2026. Next, I'd like to elaborate on the significant momentum we are gaining in the data center market, which we believe can be needle moving to our enterprise sales growth. On the left side of this slide, we provide an overview of our diverse capabilities in the data center market. You can see that all three segments play, but our largest presence today is in our Thomson Power Systems business in AMC, where we are providing switchgear and transfer switches to support standby and backup power in data centers. This was a $30 million business 5 years ago and is on track to hit $130 million this year. The traction we are seeing in this fast-growing secular market is being driven by the success factors listed on the lower left of this slide. It starts with the quality of our products, demonstrated over 5 decades of service. What differentiates us is our ability and willingness to customize the system designed to best meet the needs of our customer. Our lead times are competitive, and in a market being fueled by remarkable levels of AI investment, lead times matter a lot. Our enterprise scale has been critical to getting us in the door with new and larger customers because it helps them get comfortable that we can deliver on our service and delivery commitments. Aftermarket service capabilities are a growing part of our value proposition as we invest in our service footprint. Lastly, and highly relevant in today's market, we are willing and able to make investments to flex our manufacturing capacity, which supports future growth and bolsters our service levels. On the right side of the slide, we describe our recent wins in the data center market worth $195 million. We have been very focused on building our commercial organization, which combined with our enterprise scale has allowed us to grow our bid pipeline to what today is approaching $1 billion. We are also seeing good data center growth in PES, which won a $20 million order in the quarter to provide HVAC chiller subsystems to cool hyperscale data centers. For perspective, PES' commercial HVAC business has been benefiting from data center growth for some time, especially in North America. What is different with this order is its scale. In short, our value proposition of technology differentiated subsystems to achieve the high levels of energy efficiency required by data center operators is resonating. You may remember that part of our growth strategy for PES is leveraging proven technologies in new secular markets. While not mentioned on this slide, the PES team also won a $7 million project in the quarter for a semiconductor clean room customer that included multiple fan solutions, including fan filter units. Our PES team is gaining traction, growing its business in new secular markets. As you can see on the slide, it is currently working a $100 million data center-related bid pipeline. As you know, we have been directing the majority of our growth investment to secular markets. In data center, that has included funding portfolio expansion into modular electrical pods or e-Pods. These turnkey power management solutions can help expedite data center construction by making the installation of critical power management content more plug-and-play. These e-Pods would typically contain our switchgear, transfer switches, power distribution units as well as air moving content. Regal is also project managing the assembly of these e-Pods, including content from third parties. So part of our value proposition is providing a single source of contact for the customer and allowing the customer to procure power management content with a single SKU. We estimate the market size for e-Pods is roughly $10 billion. There are two particularly compelling attributes of this opportunity. One, it helps customers expedite their installation of new hyperscale data centers today. And two, it positions us to serve a market that many expect will evolve towards a network of smaller data centers that sit closer to the applications they are supporting. These edge data centers are forecast to number in the thousands and will likely be constructed using a few modular building blocks that contain all the requisite data center content. Our commercial team has been actively engaged with potential e-Pods customers, and our bid pipeline currently exceeds $400 million. So nearly half of AMC's total $1 billion data center bid pipeline I referenced earlier. In short, a tremendous new product opportunity for our customers and for Regal. To support the growth we have secured in our bidding on, we are investing to expand our capacity, both in our legacy power management systems and to support e-Pods. As you can see on this slide, the current footprint for our data center business in AMC includes two locations, one in British Columbia and one in Mexico. We recently started developing new capacity by expanding our British Columbia footprint and also developing a new site near Dallas, Texas, which will grow our footprint by over 50%. The Dallas facility is scheduled to begin shipping product by mid-2026. As a reminder, this business is relatively CapEx light, and so our investment is centered on light manufacturing, assembly and test equipment as well as adding the talent to support our expanding operations. This is a good example of how our significant enterprise resources allow us to respond quickly to attractive market opportunities. While our data center business today represents a small percentage of our enterprise sales, it is growing quickly, and we are investing across the spectrum of resources needed to support and fuel further growth. Starting in the coming quarters, we believe our data center business can contribute a point or more of growth to our enterprise growth rate at company accretive margins. In short, a huge opportunity for Regal that we are extremely excited about. And with that, I'll turn the call over to Rob.
Robert Rehard, CFO
Thanks, Louis, and good morning, everyone. Now let's review our operating performance by segment. Starting with Automation & Motion Control, or AMC. Sales in the third quarter were down 1% versus the prior year period on an organic basis, which was just shy of our expectations. The performance primarily reflects project timing in data center, weakness in the medical end market, and further challenges sourcing rare earth magnets, which continued to limit our ability to ship certain high-margin products in the medical and defense markets. These headwinds were largely offset by strength in discrete automation and in aerospace. Regarding the challenges around rare earths, last quarter, we expected these were diminishing, especially for non-defense products, where we were making good progress with license approvals for exports from China and with our efforts to find alternative sources of supply. However, the situation worsened in the quarter as the rate of China license approvals slowed considerably. And it became clear that even in the absence of an official policy change, China was not approving export license applications for India, where we have a large facility making product for surgical applications. At this point, we are continuing to work on securing alternative sources of supply and making strategic production moves that facilitate exports from China. Given our experience navigating rare earth magnet approvals, which is worse than we anticipated coming out of the second quarter, we now believe these headwinds will impact us through the end of the year and into early 2026. After which, we expect to see net benefits in the P&L from working down our past due backlog associated with these impacted products. I'll share more on this in the guidance section. Turning to margins. AMC's adjusted EBITDA margin in the quarter was 20.5%, which was on the lower end of our guidance range. The primary pressure was related to securing rare earth magnets. Orders in AMC in the third quarter were up a strong 31.7% versus the prior year on a daily basis for a book-to-bill of 1.23. As discussed earlier, this performance is largely tied to winning two large orders in the data center market, worth a combined $115 million. Excluding these orders, orders in AMC would have been up 1%, reflecting strength in discrete automation with orders up 17%, net of weakness in medical and order lumpiness in the aerospace business. As Louis indicated earlier, this strong momentum in data center continued in October when we booked an additional order worth $60 million for a total of $175 million of recent data center orders in AMC. Of further note in the quarter, we received our first electromechanical actuator production order for eVTOL, and we booked $8 million of humanoid-related orders, adding to our momentum in both of these spaces. As a reminder, to the extent humanoid or eVTOL adoption grows, we are very well positioned to address this demand. Turning to Industrial Powertrain Solutions or IPS. Sales in the third quarter were up 1.6% versus the prior year on an organic basis, which was modestly above our expectations. The growth largely reflects strength in energy and metals and mining, with the segment's other markets relatively flat. Adjusted EBITDA margin for IPS in the quarter was 26.4%, about 50 basis points below our expectation and down slightly versus the prior year. Performance reflects synergy gains, offset by weaker-than-expected mix, including product and channel mix, along with the impact of tariffs. Orders in IPS on a daily basis were up 2.3% in the third quarter. This marks the fifth quarter in a row of positive orders growth for the segment and has contributed to the backlog growing 5% year-over-year. Book-to-bill in the third quarter for IPS was 0.96. Turning to Power Efficiency Solutions or PES. Sales in the third quarter were up just under 1% versus the prior year on an organic basis, which was in line with our expectations. The result primarily reflects strong growth in pool and in commercial HVAC. Within the residential HVAC portion of this business, which represents roughly one-third of the segment, sales of air conditioning units were down over 20%, which was offset by strength in furnace, resulting in residential HVAC overall being flat in the quarter. We would attribute the relative outperformance to our continued strong position in this market. Turning to margins. Adjusted EBITDA margin in the quarter for PES was 19%, which was above our expectations and up 120 basis points versus the prior year period, aided by favorable mix and strong cost management. Orders in PES for the third quarter were up 1.7% on a daily basis. As Louis highlighted in his remarks, this team is accelerating its growth in new secular markets such as semiconductor and data center. Book-to-bill in the quarter for PES was 1.02.
Louis Pinkham, CEO
Turning to the outlook on Slide 13. We are narrowing and lowering our adjusted EPS guidance to the range of $9.50 to $9.80 or $9.65 at the midpoint. Our revised assumptions are outlined in the table on this slide. Notably, our sales guidance is rising modestly, primarily to reflect initial revenue from our recent data center project wins and some additional tariff pricing net of incremental impacts from delayed shipments of products with rare earth magnets. Our adjusted EBITDA margin is now expected to be 22% versus our prior assumption of 22.5%, factoring what we now forecast to be net unfavorable tariff impacts in the year on a dollar basis and the mixed impacts of rare earth magnet-related shipment delays. We have also made some adjustments to certain below-the-line items, which are outlined in the table. With all of this said, the majority of our guidance changes are due to margin headwinds caused by newly introduced and increased tariffs, along with additional rare earth magnet supply chain constraints. Regarding free cash flow, we are now expecting to generate $625 million this year. The decline versus our prior guidance largely reflects the impact of the following three items: one, higher tariff costs associated with the expanded scope of Section 232 tariffs, coupled with the significantly increased India tariffs; two, the impact of strategic working capital investments, particularly those tied to the large data center orders we announced, along with supply assurance inventory for rare earth magnets; and three, higher cash interest costs given the timing and amount of cash flows relative to prior expectations. We see both the tariffs and the working capital investments as timing-related as we expect the impact of pricing on tariffs to flow through once that inventory is sold in the first half of 2026. On Slide 14, we are updating our expectations regarding tariff impacts. The gross annual unmitigated cost impact from tariffs as of our last update was $125 million. Based on tariffs in place today, that value has risen to $175 million, largely reflecting the rise in India tariffs to 50% and the expanded scope of Section 232 tariffs on steel, aluminum, and copper. Given the extent of the tariff increases and the limited time left in the year to implement mitigation actions and price changes, we now expect to have a net tariff impact on a dollar cost basis of approximately $17 million this year. Furthermore, we now expect to be dollar cost neutral on tariffs by the middle of next year and to be margin-neutral on tariffs by the end of next year. We see an opportunity for this to accelerate, especially if the India tariff is meaningfully reduced. On the right-hand side of the slide, we lay out our principal mitigation actions, which we shared last quarter and which our teams continue to manage on a daily basis.
Robert Rehard, CFO
On Slide 15, we provide more specific expectations for our performance by segment on revenue and adjusted EBITDA margin for fourth quarter and for the full year. Let me outline the primary changes to our full year outlook since our last update by segment. For AMC, we are now expecting sales to be up low single digits versus flat to up single previously, reflecting stronger shipments in data center and discrete automation, net of impacts from rare earth availability on shipments to the medical and defense markets. Our adjusted EBITDA margin outlook for AMC is now 50 basis points lower at the midpoint, mainly reflecting incremental rare earth volume and mix impacts worth approximately $8 million, of which we recognized about $3 million in the third quarter. We expect the recovery of rare earth magnet supply to continue into early 2026 versus by the end of this year, as discussed in our last earnings call, through resourcing efforts aimed at eliminating the need for China to approve export licenses for shipments to India. For IPS, our outlook for the segment's adjusted EBITDA margin is now 50 basis points lower at the midpoint, mainly factoring in an unfavorable net tariff impact, primarily associated with the expanded scope of the Section 232 tariffs. Lastly, for PES, our outlook for the segment's adjusted EBITDA margin is now 50 basis points lower at the midpoint, also factoring an unfavorable net tariff impact primarily associated with the increase in tariff rates on India to 50%, including a 25% penalty tariff added in August. While we are experiencing some margin pressures from tariffs and rare earths, we remain confident in our midterm ability to achieve our 40% gross margin and 25% adjusted EBITDA margin targets. Our teams continue to execute well on what is in our control.
Louis Pinkham, CEO
Finally, as I wrap up my prepared remarks, I would like to share a few high-level thoughts on our outlook for 2026. From a sales perspective, we are clearly building momentum as we enter next year, given our strong orders in third quarter, the order strength we're already seeing in fourth quarter, sizable 2026 shippable backlogs in our IPS and AMC segments and growing tailwinds from our cross-sell synergies. Tariff pricing should also be a tailwind, as with any recovery in our end markets, which, for the most part, we believe are at or near trough levels of demand. Given ongoing macro and tariff-related uncertainties, we are going to remain measured in our approach to framing out the year. And for now, we think sales in 2026 should grow at a low to mid-single-digit rate. From a margin perspective, we have an additional $40 million of cost synergies anticipated in 2026 and would expect upside from achieving price/cost and then margin neutrality on tariff headwinds. But again, the margin neutrality is not expected until the end of 2026. We would expect organic growth to leverage at roughly 35% overall, higher in AMC and IPS and lower in PES, consistent with the gross margin differences between these businesses. Finally, from a balance sheet perspective, we expect meaningful further progress in 2026 on deleveraging and for our net debt leverage to end the year at roughly 2.5x. This assumes we generate almost $900 million of free cash flow in the year, which would represent free cash flow margins in the low teens. In short, we are increasingly enthusiastic about our prospects in 2026, especially the potential for improved top line performance, but also more broadly about our ability to drive improvements throughout the P&L, on the balance sheet and in our cash flow performance. And with that, operator, we are now ready to take questions.
Operator, Operator
The first question today is from Michael Halloran with Baird.
Michael Halloran, Analyst
First off, Louis, thanks for everything. Sad to hear you leaving, but you're absolutely leaving the company in a better spot, and I wish you nothing but the best moving forward.
Louis Pinkham, CEO
Really appreciate that. Thanks, Mike.
Michael Halloran, Analyst
So first, I certainly appreciate Rob's comments on the puts and takes in the fourth quarter. Could you reframe that a little bit and talk more about what that looks like sequentially? What is accelerating from 3Q? How are you framing the furnace versus the air cooling piece within PES? How do the data center pieces roll in? And just maybe talk about what's getting better, what's getting worse and some of the assumptions around the sequentials.
Louis Pinkham, CEO
Yes, I’m happy to do that, Mike. When you first look at PES, it was a solid third quarter. For the fourth quarter, we're anticipating residential HVAC to decline by low double digits. Air conditioning is expected to decrease by nearly 30%, while furnaces should increase by high teens. Additionally, we're projecting commercial HVAC to rise by mid-single digits, pools to be down by low single digits, and general commercial to see a slight increase as well. The main factor influencing the sequential change and our revised guidance for PES down about 1% is that residential HVAC was flat in the third quarter but will drop by low double digits in the fourth quarter. Regarding AMC, a significant part of our discussion revolves around data centers. Data center performance was down 40% for us in the third quarter, but it’s projected to increase by more than 50% in the fourth quarter. We have it accounted for in our backlog; it’s primarily a matter of timing and scheduled shipments. This is a key driver for the fourth quarter, along with some positive developments we’re seeing in discrete automation within aerospace. However, we will continue to face challenges in the medical sector, and we're beginning to ramp up production for items that utilize rare earth magnets. We noticed slight improvements in Q3 and expect stronger results in Q4, as Rob mentioned in his prepared remarks. Lastly, concerning IPS and its sequential performance, the focus is on project orders that are part of our backlog. Distribution for us was down in Q3, with the aftermarket defined as down about 1%. We don’t expect that to improve in Q4. Our expectation is to execute on our project backlog. That's how we're approaching our guidance for Q4.
Michael Halloran, Analyst
Yes, that's very helpful. I have a follow-up regarding the data center content you shared. Those numbers you presented suggest a significant opportunity. You mentioned that this year is projected to be around $130 million, with over $190 million in orders. How do you foresee that ramping up next year based on your current insights? More importantly, regarding the $1.1 billion across the various segments, how is that expected to impact the Regal portfolio over the next few years? What ramp-up are we anticipating? What are the win rates and entitlements? Any multi-year framing you could provide would be appreciated.
Louis Pinkham, CEO
We are truly excited about our progress. Over the past five years, our Thomson data center business has experienced a significant compound annual growth rate and currently stands at approximately $130 million. We anticipate that this could potentially double over the next two years. This gives you an idea of our optimistic outlook. Our backlog remains strong, and we are achieving success due to our scale, dedication to service, and our ability to tailor solutions to meet our customers' specific requirements, something some of our competitors are less inclined to do. Additionally, we are investing in expanding our capacity in Texas and British Columbia. The primary challenge we face is the supply chain issues with components, but overall, we are confident about our potential. As I mentioned earlier, we expect this development to significantly impact our growth, possibly adding 1 to 1.5 percentage points next year. We will continue to invest and grow in this area, which we believe could become a significant aspect of Regal Rexnord's business moving forward.
Operator, Operator
The next question is from Julian Mitchell with Barclays.
Julian Mitchell, Analyst
Louis, sorry to see you go, but I wish you well and thanks for all the efforts down the years.
Louis Pinkham, CEO
Thanks, Julian.
Julian Mitchell, Analyst
Just wanted to start off with the commentary sort of into next year. You've spoken to that low to mid-single-digit organic sales growth firm-wide. It seems like 1 to 1.5 points of that is coming from data center, so a couple of points from the rest of the company. So maybe a couple of things. One is, help us understand the sort of data center overall percent of revenue or dollar revenue this year, so we can understand the jumping off point into 2026. And then should we expect the operating leverage on that volume growth is very limited in the first half because of tariffs and rare earths and so forth?
Louis Pinkham, CEO
Specific to data centers, the tariff on rare earths will not have an impact. Currently, our data center business, including the Thomson segment, accounts for about $130 million. Overall, data centers represent roughly 3% of Regal's total revenue, which translates to an additional $50 million. We anticipate that this segment will become more significant in 2026 as we progress. I believe that addresses most of your questions.
Robert Rehard, CFO
I think the only other part would be that the margins on the data center business will be roughly segment average. We see that as margin accretive for the enterprise.
Julian Mitchell, Analyst
That's helpful. I have a follow-up question regarding the operating leverage for the total enterprise. It seems there is an additional challenge affecting the 2025 guidance from rare earth materials and tariffs on a firm-wide basis. Could you clarify how this headwind will impact profits over the next few quarters compared to what you experienced in Q3? I'm trying to understand if we can expect significant margin expansion in the upcoming quarters due to volume leverage, or if those gains will be negated by the effects of the tariffs and rare earth challenges?
Robert Rehard, CFO
Overall, we expect leverage to be around 35% for the business. There are two parts to this answer. The overall business is expected to be roughly 35%, while AMC and IPS are projected to be around 40% to 45%, and PES will be lower. The benefits will phase in, with greater advantages in the latter half of the year as we approach margin neutrality. Therefore, the weight of expectations will lean more towards the second half. For the year, we anticipate about 30% to 35%. However, we expect the first couple of quarters to face margin challenges, as we aim for dollar cost neutrality by the end of the first half of next year, with full margin neutrality not expected until the second half. This outlines the phasing from one half of the year to the other.
Operator, Operator
The next question is from Jeff Hammond with KeyBanc.
Jeffrey Hammond, Analyst
Louis, best of luck, and I'll echo Julian and Mike's comments.
Louis Pinkham, CEO
Thanks, Jeff.
Jeffrey Hammond, Analyst
I would like to discuss the margin situation. You mentioned $40 million in integration savings. Rob, you indicated that the tariff impact might be a positive factor for our pricing structure going into 2026. How should we approach the pricing and tariff situation as it potentially improves, and what are your thoughts on the rare earth issue stabilizing from 2025 to 2026?
Robert Rehard, CFO
I think it's a bit early to be too specific at this moment. We do expect to overcome the rare earth challenges by early '26, and that shouldn't pose an issue. Currently, we are facing about $13 million in rare earth headwinds as we end this year, which represents an additional $8 million from what we reported after the second quarter. We believe we will be able to navigate through most of that relatively quickly, potentially by the first half of next year, and then progress will improve in the latter half compared to the first half. However, we are not prepared to provide more detailed information until we release our fourth-quarter results and offer official guidance.
Jeffrey Hammond, Analyst
Okay. Great. As your tariff pressure has increased, are you finding it more challenging to secure pricing, particularly in PES due to customer concentration? Also, could you elaborate on what is driving the growth in furnaces? Are there market share gains or is there no destocking occurring?
Louis Pinkham, CEO
Yes. Let me address tariffs first, excluding PES. We aim to remain tariff neutral and maintain our margins. The 232 derivative tariff was implemented right after our last earnings call, which has caused delays for IPS and AMC. As Rob mentioned, we expect this to ramp up in the first half of next year, similar for PES, though there’s a bit more pressure from India. We're confident in our global presence and its unique advantages. If tariffs for India remain at 50%, we will have to relocate production, although we haven't made that decision yet. I'm not concerned about our ability to manage this, and as Rob noted, we plan to achieve margin neutrality by the end of next year and cost neutrality by mid-next year, giving us some time to navigate this. Now, regarding your furnace question, furnaces account for about 40% of our residential HVAC business. It’s important to note that furnace sales declined significantly in 2023 but are expected to improve in 2024. We believe there's potential for further recovery to normal levels. Our ability to outperform in this market stems from gaining market share through our differentiated and IP-protected technology. Therefore, we feel optimistic about our standing in the furnace segment. I hope that answers your questions, Jeff.
Operator, Operator
The next question is from Kyle Menges with Citigroup.
Kyle Menges, Analyst
And Louis, sad to see you go. It was great working with you and best of luck.
Louis Pinkham, CEO
Yes, thank you.
Kyle Menges, Analyst
Yes, I would like to delve into the approximately $1 billion data center pipeline you mentioned. How did you come up with that figure? Additionally, what do you perceive as a reasonable win rate for you?
Louis Pinkham, CEO
Yes, Kyle, that's a great question, but it's challenging to provide a precise answer. I can tell you that our pipeline consists of several large projects involving multiple customers. We have been making significant investments in our commercial team, so this isn't a narrow focus. There are several large projects related to hyperscale. We have also invested substantially in expanding our portfolio to include e-Pods and delivering that solution. It would be difficult to give you a specific win rate. Recently, we received two large orders that we were optimistic about during negotiations, and that was a significant win for us. For now, I want to assure you that we are investing in our commercial teams and capacity, and we will continue to drive growth in this area. We believe it will play a significant role for Regal in the future, and we’ll provide more clarity on win rates after some time.
Operator, Operator
Makes sense. And then maybe turning to free cash flow. I can appreciate some of the reasons why free cash flow guide was lowered for this year. But I am just curious, your confidence level in free cash flow being better next year and then ability to execute on further deleveraging. And I guess, it would be helpful to hear a ballpark of how much lower interest expense could potentially be next year as well.
Robert Rehard, CFO
Yes. Looking ahead to next year, we anticipate the free cash flow to reach nearly $900 million, building off this year's projected $625 million. This increase is expected to come from some growth and EBITDA expansion, along with an additional $60 million to $70 million from working capital improvements, which will help close the gap, in addition to reduced cash restructuring expenses. We also expect a decrease in cash interest expenses by around $40 million next year. While there will be some offsets related to cash taxes and capital expenditures, these are the main factors contributing to the target of $900 million. This year, our free cash flow was impacted by inventory challenges, but we expect improvement in working capital as the year concludes. We're optimistic about managing our inventory better next year. From a leverage perspective, we project to end next year at approximately 2.5 times, supported by the free cash flow of $900 million used to reduce our debt. We are currently finalizing our strategy for the bond that is coming due, which should be completed in the next month. Additionally, we have a prepayable term loan of about $900 million, which we aim to address in the first quarter. Overall, we are confident in our ability to get down to a leverage ratio of 2.5 times and believe we can generate this cash flow with clear visibility on how to achieve it.
Operator, Operator
The next question is from Tomo Sano with JPMorgan.
Tomohiko Sano, Analyst
This is Tomo. Louis, although we have only just recently met, I wanted to say thank you for your leadership and wish you continued success.
Louis Pinkham, CEO
Thank you, Tomo. Thank you so much.
Tomohiko Sano, Analyst
My question is, could you share more details on the CEO succession process, including timeline, criteria for the new leader, and how you are ensuring continuity in strategies and execution, please?
Louis Pinkham, CEO
Yes. Tom, thank you. And I'm actually going to pass it initially to Rakesh Sachdev, our Chairman of the Board, who has some prepared remarks that he'd like to share. So Rakesh?
Rakesh Sachdev, Chairman of the Board
Thank you, Louis. I believe that when you look at the company's progress and the efforts that Louis and the team have put in over the last six years, the transformation is truly impressive. The company is now very decentralized, and we have a strong group of leaders in place. As Louis mentioned, we are generating significant cash flow in a high gross margin business, and we are positioned for notable growth. Therefore, we are in a very strong position. Louis and the Board have been discussing the next phase of growth for the upcoming years, and we feel this is an appropriate time to move forward. We have begun the search process and engaged a top executive search firm. We are starting this process now and will approach the selection of a successor to Louis thoughtfully and carefully. Louis will stay on during this period, and as mentioned, it will be business as usual until we appoint the new CEO. I anticipate it will take about four to six months to appoint someone, but we are not in a hurry. It’s important for us to find the best possible leader. The search committee on the Board consists of four members: three CEOs, including one currently active and two former CEOs, so we have experienced perspectives to guide this decision. You can be assured that we will identify a strong candidate for this role. With that, Louis, I'll hand it back to you.
Louis Pinkham, CEO
Thank you, Rakesh. Tomo, I want to reinforce Rakesh's point and reiterate that we will ensure a smooth and orderly transition. Our team has never been stronger at all levels, and our focus will remain on maintaining business as usual. We will concentrate on what we can control and continue to execute as we have in the past. I hope that clarifies things, Tomo.
Operator, Operator
The next question is from Nigel Coe with Wolfe Research.
Nigel Coe, Analyst
Maybe a question for the Chairman again. Are you fully committed to an external candidate? Or are there other internal options as well? And when you think about the profile of the person you're seeking, would it be with a very similar background to Louis in terms of operational chops? Or are you looking for maybe slightly different attributes?
Rakesh Sachdev, Chairman of the Board
Thank you for the question. Yes, we are conducting a thorough search. We are considering external candidates and will not dismiss internal options, but this will be an extensive and careful process. We are specifically looking for a candidate who possesses strong leadership skills similar to those of Louis, who has successfully managed complex global operations. Our focus will be on growth. Regal Rexnord has always aligned with operational excellence, and we have excellent leaders in that area. However, we also need someone who can drive commercial growth, which will be crucial for the next leader of our company. Additionally, maintaining our positive company culture is very important. We have developed a great culture here, and it is essential that the new leader continues to nurture that as we move forward.
Nigel Coe, Analyst
That's great. And Louis, look, I've covered the stock for 20 years. And the last 7 years have easily been the best. So you've done an incredible job of really changing the game for this company. So it will be sad to see you go.
Louis Pinkham, CEO
Thank you, Nigel.
Nigel Coe, Analyst
But no question, the data center. I mean I know we've discussed how should we think about the contribution margins on the backlog you're building? And can you maybe just be a little bit more precise on when you expect to have this new facility up and running?
Louis Pinkham, CEO
Yes. I'm going to go backwards. Nigel, you're cutting out a bit, but I think I understand your intent. We are currently starting the process of establishing the new facility. We will be hiring staff throughout this quarter and into the next, beginning training soon. We expect to have product moving through the facility in the first quarter, but it won't ship until the second quarter and likely later in that quarter. That's our initial project plan. In terms of contribution margin, all our evaluations so far indicate that this will meet the fleet average margins for AMC, which is beneficial for Regal. This will positively impact Regal's overall business. Keep in mind that a significant portion of the bill of materials for these pods includes our Regal products like parallel switchgear, automatic transfer switches, and PDUs. Additionally, we will include our air moving products in these systems as well. We are confident about their positioning and the margins we expect to achieve.
Robert Rehard, CFO
And I would just add that the investments we're making today that we mentioned earlier are very CapEx light. This is more of assembly and test. And so that's important to note. This should not weigh on margins as we move forward.
Operator, Operator
The next question is from Christopher Glynn with Oppenheimer.
Christopher Glynn, Analyst
Louis, it's been a pleasure working with you and best of luck there.
Louis Pinkham, CEO
Thanks, Chris.
Christopher Glynn, Analyst
It seems we'll continue to work together for a couple more quarters. I have a question regarding the discrete automation orders, which you mentioned are up 17%. I'm interested in how you would describe that growth – is it associated with large projects, unpredictable, or more consistent? Is it a dramatic increase, or are we simply comparing to an easier period? I can't remember the third quarter from last year. Is this a notable sequential change?
Louis Pinkham, CEO
We mentioned at our Investor Day that we did experience some order losses, but we are starting to receive new orders. This serves as another indication that we are investing more in technology and working to expand our market reach. We feel confident in our position within discrete automation. It's important to highlight that our defense sector performed quite strongly this quarter.
Christopher Glynn, Analyst
And then a quick follow-up on the eVTOL initial order there. Is that going to be kind of very sporadic? Or is that starting to ramp?
Louis Pinkham, CEO
It's sporadic for now. It's not ramping. The point of emphasizing it, though, and I know you all know this, but in the aerospace industry, when you start a production order, that means you're moving forward. And if you listened to some of the announcements, for example, the LA Olympics has a contract out for 50 eVTOLs for taxis. We'll see if that comes to true fruition. But this is a market that if it accelerates, Regal Rexnord is well positioned. So that's why we shared it in the prepared remarks.
Operator, Operator
This concludes our question-and-answer session. I would like to turn the conference back over to Louis Pinkham for any closing remarks.
Louis Pinkham, CEO
Thank you, operator, and thanks to our investors and analysts for joining us today. Our team delivered strong performance in third quarter in all segments for what was in our control. Most importantly, strong orders in the quarter and order strength in fourth quarter should set us up for solid growth in 2026. Stronger growth, anticipated additional margin gains, including improved tariff and rare earth mitigation, expectations for further cash flow growth and plans to reduce net leverage ratios below 3x means we are poised to create increasingly significant value for our shareholders and other key stakeholders in 2026 and beyond. 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.