Earnings Call Transcript - RRX Q3 2022

Operator, Operator

Good morning, and welcome to the Regal Rexnord Third Quarter 2022 Earnings Conference Call. 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 Third Quarter 2022 Earnings Conference Call. Joining me this morning 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'd 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 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 filings. On Slide 3, we state that 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 this 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 third quarter financial results in more detail and discuss updates to our 2022 guidance. Louis will then share some brief comments about our recently announced acquisition of Altra. 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 earnings and begin an update on our business, and thank you for your interest in Regal Rexnord. As you saw in our announcement last week regarding our planned acquisition of Altra, it is clear that our team is working on a number of fronts to continue advancing Regal Rexnord's transformation into our faster-growing, higher-margin, more cash generative and higher-return enterprise. I am excited to report that the product of those efforts is also apparent in our strong third quarter results. Even in the face of persistent inflationary and supply chain headwinds and some incremental macro-related caution at our customers, our Regal Rexnord team delivered strong third quarter performance. That includes 8% organic top line growth, 120 basis points of adjusted EBITDA margin expansion and further evidence of share gains, supported by our digital and e-commerce investments, new products and competitive service levels. The margin gains we achieved were enabled by a host of factors. Chief among them, continued strong performance, realizing merger synergies, where we remain ahead of plan and continuing to achieve a positive price/cost position. Also notable, the team's disciplined approach to managing working capital improved our free cash flow performance in the quarter. And so as we forge ahead into the fourth quarter, we are firmly on track to meeting our earnings guidance commitment which we have revised to reflect a modestly higher midpoint in our targeted range for earnings per share. For this strong execution, pursued with a sense of urgency as well as continued adherence to our Regal Rexnord's values, I want to say a sincere thank you to our approximately 29,000 Regal Rexnord associates around the world. Turning to orders. We did see some moderation as expected. Daily organic orders were down 3.6% for the quarter on an FX neutral basis in line with what we shared at our September Investor Day. Even so, we remain cautiously optimistic about our top line prospects, especially given our strong backlog position, up roughly 70% from the beginning of 2021, plus commentary from many of our customers across a range of end markets that remains fairly positive. In addition, for certain of our end markets, including aerospace, mining, agriculture and non-residential construction, which makes up over 25% of Regal Rexnord, there are signs of growing momentum. And beyond what markets give us, we have many outgrowth initiatives underway, including a healthy pipeline of new mix positive products and high-impact digital and e-commerce investments, which brings me to controllable execution. It's our mantra at Regal Rexnord. Regardless of what the macro does, we will manage it by focusing on what is under our control. And we have a lot under our control on the growth, margin and free cash flow fronts. Controllable execution is evident in our third quarter segment performance. Commercial is a great example. The segment turned in another quarter of double-digit organic top line growth as the benefits of 80/20 initiatives, new products and digital and e-commerce investments are driving our growth. Industrial also continued to demonstrate strong execution. Adjusted EBITDA margin up 370 basis points and mid-teens organic order growth are quantifiable signs that the turnaround at Industrial is continuing and even gaining momentum. Climate performed just slightly below what we had communicated in our last earnings call, with incremental temporary margin pressure largely tied to nonmetals inflation and mix. However, the Climate team has a plan for improvement back to the segment's more normal high teens to low 20s margin levels with a step-up in Q4 and improvement throughout 2023, and we remain very excited about Climate's prospects as we head into 2023. Given regulatory changes, we are well-positioned to address government incentives around heat pumps and meaningful new product tailwinds, which brings me to MCS, solid growth and very strong margin performance in large part related to that team continuing to realize merger synergies, but also strong operational performance. Our powertrain team is also gaining momentum in the market, and I'll share an example of one of its recent powertrain wins on the next slide. As we discussed at our September Investor Day, we assembled a cross-functional team dedicated to selling integrated industrial powertrain solutions, leveraging end market application and product expertise spanning our motors and power transmission businesses. The team has accelerated our traction selling powertrains and our opportunity funnel is growing nicely. Pictured on this slide is a recent powertrain win, the product of the team's collaborative efforts. This win was with a grain processing customer involved in the production of ethanol, renewable diesel and biodiesel fuels. The customer was looking for an integrated solution that improved efficiency and reliability and lowered install time. What our team came back with was a subsystem that integrates our Marathon Motors, our fault gearbox and couplings and Rexnord bearings. What makes the solution differentiated is a design that leveraged our powertrain team's relevant application expertise, in this example, a bucket elevator for the agriculture end market. The result was lower complexity, reduced install time and greater efficiency and reliability. We made it easier for our customer and gave them a superior product. Having deep application expertise is part of the secret sauce to selling powertrains and one of the reasons we're excited about adding Altra is because it enhances our capabilities in relevant powertrain components and extends our application expertise into new markets. We will share more on this front post-closing. And with that, I'll turn the call over to Rob to take you through our third quarter performance in more detail.

Robert Rehard, CFO

Thanks, Louis, and good morning, everyone. I'd also like to send my thanks to our global team for their strong execution in what continues to be a challenging operating environment. Now let's turn to our third quarter segment financial performance. Starting with our Motion Control Solutions segment, or MCS, Organic sales in the third quarter were up 3.6% from the prior year. The result reflects broad-based growth, but with particular strength in the general industrial and aerospace end markets, partially offset by weakness in alternative energy, in particular, the China wind market. Adjusted EBITDA margin in the quarter for MCS was 27.2%, up 30 basis points compared to the prior year, factoring favorable price realization, merger synergies and volume, partially offset by mix, higher freight costs and FX headwinds. As expected, the segment posted a nice, sequential improvement in margin in the quarter. Orders in MCS for the quarter were flat on an organic FX-neutral basis. In October, book-to-bill tracked at roughly 1.0. Turning to Climate Solutions. Organic sales in the third quarter were up 4.9% from the prior year. The increase was driven by healthy price realization and modest volume gains in our North America residential HVAC OEM business, partially offset by modest volume declines elsewhere, particularly in Europe. We attribute our volume gains in HVAC to outgrowth since we believe in-market volumes moderated against a challenging prior year compare. The adjusted EBITDA margin in the quarter for Climate was 16.4%. Factors impacting margins in the quarter include commodity inflation, including plastics, unfavorable mix and higher freight costs, partially offset by strong price realization. We also had some carryover impacts from second quarter related to intentional decisions the business made to overserve certain high-value customers, which resulted in lower past dues, but also higher freight and component costs. While Climate margins were a bit slower to improve relative to our expectations, we continue to see this margin performance as temporary. The Climate team has a path to modestly higher margins in the fourth quarter and plans for a more significant recovery in 2023, when we expect the segment's adjusted EBITDA margin to move back into the high teens or low 20s. Turning to orders. Orders in Climate for the third quarter were down 10% on an FX-neutral basis, adjusted to exclude the impact from an OEM customer pushing out orders tied to several key platform changes. Book-to-bill in October is tracking at roughly 0.95. While the orders reflect a deceleration from recent periods, this performance is broadly in line with our expectations as our lead times continue to shrink, given a moderate improvement in the supply chain environment along with the fact that a number of our customers decided to take a more conservative stance on inventories into the end of the year. More broadly, we remain very enthusiastic about Climate's prospects in 2023, when we expect several tailwinds to support growth and margin gains, including higher U.S. minimum efficiency standards in residential HVAC, rebates on heat pumps in the Inflation Reduction Act and significant new products that we are launching. You may recall that we discussed all these tailwinds in more detail at our September Investor Day. Turning to Commercial Systems. Organic sales in the third quarter were up 11.5% from the prior year. Growth in the quarter reflects strong performance in large commercial HVAC, North America general industrial and our air-moving business. The strength we are seeing in general industrial continues to reflect meaningful share gains tied to investments we are making in digital, e-commerce, and new products. The adjusted EBITDA margin in the third quarter for Commercial Systems was 16.7%, up 20 basis points compared to the prior year, reflecting favorable price realization, partially offset by commodity and other non-material product cost inflation, weaker mix and higher freight costs. Shifting to orders. Segment orders for the third quarter were down just over 9% on an FX-neutral basis or flat after adjusting for orders from pool pump OEMs, which have been actively rightsizing their inventories as we move into the off-peak season for pools. Looking to October, book-to-bill tracked at roughly 0.9. In Industrial Systems, Organic sales in the third quarter were up 14.7% versus the prior year. Principal drivers include strong price realization and volume. The latter tied mostly to share gains as greatly improved operating performance is allowing the industrial team to win in the market. The business has, however, seen some modest weakening in China, which we expect to become slightly more pronounced in the fourth quarter and temper the segment's growth. The adjusted EBITDA margin in the quarter for Industrial was 13.2%, an increase of 370 basis points versus the prior year period. While the margin did fall a bit shy of where we anticipated in the quarter, we continue to be extremely pleased with the performance at Industrial, which we feel remains on a sustainable path to stronger performance. Orders in Industrial for the quarter were up approximately 16% on an FX-neutral basis, very strong performance that we think provides further evidence that Industrial's operational recovery is gaining momentum. In October, book-to-bill was 1.0. 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 quarter with a net debt to adjusted EBITDA ratio of 1.4x. Second, our free cash flow in the quarter was $111.1 million, which equates to a conversion rate of roughly 93%. Our team did a great job improving free cash flow performance in the quarter, and we expect to see further improvement in the fourth quarter. That said, as much progress as we are making on free cash flow, based on what we know today, while we will continue to push for a 100% free cash flow conversion rate in 2022, we believe we may end closer to 95% mainly due to persistent supply chain challenges and our focus on maintaining high service levels with our highly valued customers. We expect the fourth quarter to demonstrate very strong cash flow performance as we close out the year. As we've previously stated, our focus will continue to be on paying down our debt with the improving cash generation. Moving to the outlook. We are raising our guidance at the midpoint by revising our expectation for adjusted earnings per share to a narrowed range of $10.35 to $10.75 from our prior range of $10.20 to $10.80, which is a $0.05 increase at the midpoint. Considering the revised range, it now contemplates a sizable increase in net interest expense. Our updated outlook embeds core operating performance that is tracking nicely above our prior expectations. Now let me provide a bit more color by segment for the fourth quarter. From a top-line perspective, we would expect the revenues for the Commercial, Climate and Industrial segments to moderate slightly lower from the third quarter levels due mostly to seasonality. We would expect the revenues for the MCS segment to come in relatively flat to third quarter levels. Moving to margins. We would expect Commercial margins to move to low to mid-teens, Industrial to low double digits, and then both Climate and MCS to improve modestly from third quarter levels. I'll wrap up this section by saying that on the whole, we are very pleased with the Q3 results, and our team's ability to execute in an extremely challenging environment. We are meeting nearly all of our expectations. And while the macro outlook has certainly become less certain, our outlook remains very positive, considering the tremendous amount of self-help we have in front of us on the growth, margin, and cash flow fronts. And now before we open the line for questions, I will turn the call back to Louis for a few comments highlighting last week's announcement to acquire Altra Industrial Motion.

Louis Pinkham, CEO

Thanks, Rob. I am sure you are aware, last week, we announced our decision to acquire Altra Industrial Motion. The industrial logic for adding Altra to Regal Rexnord is crystal clear. It transforms our automation capabilities and enhances our industrial powertrain offering, creating clear benefits for our customers and a host of new opportunities for profitable growth. Expected financial returns are incredibly strong. Accretion in year 1, double-digit accretion thereafter. ROIC above 10% by year 5 and a path to a 40% enterprise gross margin supported by $160 million in cost synergies plus upside from substantial expected cross-marketing synergies. Notably, our expected 2025 free cash flow rises from about $1 billion as shared at our Investor Day to about $1.1 billion in 2025. And then to nearly $1.4 billion in 2026 as our interest cost and cash tax rate both decline significantly in '26 and beyond. We believe the valuation is compelling and reflects the quality of the Altra business, its synergies with our business and the transaction's timing. The acquisition is unique because it will deliver significant synergies and catalyze our growth while further enhancing our scale and diversification which improves our already strong credit profile. We have always managed Regal Rexnord in a manner consistent with an investment-grade credit profile, low leverage, abundant liquidity, consistently strong free cash flow conversion, and manageable debt maturities. We are larger, more diversified, and lower-levered than our investment-grade rated peers today, and the acquisition of Altra further enhances our scale, diversification, and exposure to resilient end markets. We are adding leverage to fund the transaction, and we believe it will be manageable. We expect our enhanced credit profile will give us broad access to financing in both the bank loan and bond markets. We've designed a permanent debt structure that will give us the flexibility to acquire and integrate Altra while repaying debt expeditiously to achieve our leverage target which is consistent with an investment-grade profile. We recognize the macro uncertainty on the horizon, but are encouraged by the quality of the record backlogs at Regal Rexnord and Altra. We have run extensive sensitivity scenarios for interest rates and our forecasted EBITDA, and we expect the combined Regal Rexnord and Altra to be resilient, aided by strong pro forma cash flows and our under-levered balance sheet ahead of the transaction. We closed out the third quarter with net debt to adjusted EBITDA of 1.4x, and we expect further stand-alone delevering in advance of the transaction closing next year. We're putting our balance sheet to work to acquire a highly strategic asset and create meaningful value for our shareholders. We've already begun the process of putting our new permanent debt structure in place. Yesterday, we hosted a meeting with our relationship lenders, which was very well attended and received. We'll have more details on the outcome shortly, but we are moving quickly to amend our existing debt structure to facilitate the acquisition and put in place flexible, attractively priced, and prepayable debt to facilitate our delevering targets. The motion control and the automation industries are undergoing significant change, and we are operating from a position of strength. We are ready to do this transaction. We've made significant progress on Regal Rexnord's operational transformation and PMC's merger integration and have a clean balance sheet. We expect the heaviest lifting on integrating PMC to be complete before starting footprint moves at Altra. The playbook and team that worked so well with PMC will be deployed at Altra. For all these reasons, we are excited about Altra associates joining our Regal Rexnord team and confident in our team's ability to create meaningful value for all of our stakeholders with this transaction for our customers, our associates, and our shareholders. And with that, operator, we are now ready to take questions.

Operator, Operator

And our first question will come from Michael Halloran of Baird.

Michael Halloran, Analyst

So can we talk a little bit about order trajectory as you said here and kind of end market thoughts into next year? Obviously, at the Analyst Day, you threw out a low single-digit kind of growth number. We're seeing some weakening in some of the markets, obviously, some nice offsets with what you're doing internally. SEER coming on some other things. So just maybe some commentary on that side and how we should be thinking about things as we track into next year.

Louis Pinkham, CEO

Yes, sure, Mike. As a reminder, at Investor Day, we did say 3% to 4% growth, assuming no recession and end markets that are flat to up modestly. That paradigm is still relatively intact, but more uncertain around the market. It reflects a 2% to 3% outgrowth tied to many of our growth initiatives and of course, our strong backlog. If investors have a different view on end markets, they can adjust the framework, but we feel very good about what's in our control especially around our digital and e-commerce initiatives, our new products, and our superior service levels. We're going to provide more clarity on 2023 when we report the fourth quarter. So for now, I think that's about where I want to end my commentary.

Michael Halloran, Analyst

That was helpful. What can you tell us about channel inventory? There are some targeted areas where it seems there is some destocking happening at the customer level. Could you share your thoughts more broadly across the enterprise?

Louis Pinkham, CEO

Yes. Some of the metrics are still strong, Mike, I'd say ISM remains above 50. But as of September, new orders and employment contracts were coming down a bit. I'll tell you in the industrial distribution channel, they're still sounding quite positive. And as you know, we have clear visibility to their sales out and they're still strong. So given that, they are looking at some inventory adjustments, but we're feeling that the industrial channel is still really solid. Now pool is a very small part of Regal Rexnord, it's only about 2% to 3%, but that had a big reset, if you will, during Q3. The HVAC OEMs in their normal pattern will take down their inventories going to the end of the year. So overall, a little bit more mixed. But I'll tell you, with 50% of our business being in more of that industrial space, we feel pretty good around the industrial distribution and continuing into next year. Now one other comment that I would make is when I look at our business and what we've done to change the portfolio over the last few years, we're about 1/3 early cycle, a third mid-cycle and about 1/3 late cycle. And we're seeing some momentum in that late cycle, non-residential construction, aerospace, these are markets that are gaining some momentum, and we feel good about. So a little bit mixed bag. But hopefully, that helped.

Operator, Operator

Our next question comes from Julian Mitchell of Barclays.

Julian Mitchell, Analyst

Just wanted to talk back to the fourth quarter guide on a sort of firm-wide levels. So Rob, you laid out some segment-moving pieces. I just wanted to clarify, if we're thinking kind of enterprise-wide at Regal Rexnord, is the guide midpoint based on kind of mid-single-digit organic sales growth, sort of 21.5% EBITDA margins? Are those the right sort of rough ballpark figures for Q4? And then from your book-to-bill comments, do we assume that orders are probably down sort of high single digits in Q4?

Robert Rehard, CFO

So Julian, thank you for the question. First answer is yes. I assume about low to mid-single-digit growth in Q4, and your EBITDA comment on the margin side is tracking very closely to where our expectations are, maybe slightly below, but pretty close to that based on some of the comments that I made. The second part of your question was related to order expectations as we move into the fourth quarter. And again, we would expect orders to be down a bit in the fourth quarter, maybe low single digits in the fourth quarter.

Louis Pinkham, CEO

Yes. And that would be on an FX-neutral perspective, Julian, just to be clear. And so that would probably translate more to down mid- to high single digit, but we do expect orders to be down in the fourth quarter.

Operator, Operator

Next question comes from Jeff Hammond of KeyBanc.

Jeff Hammond, Analyst

So just on Climate margin, I thought that that was going to get better, and it stepped down again and I think the trajectory is maybe a little bit less into 4Q than you thought. Maybe just what's changed there and maybe speak to the mix dynamic?

Louis Pinkham, CEO

I'll address this, Jeff. Margins were slightly below our expectations, primarily due to factors we couldn't control, including a weaker mix, as well as additional supply chain and inflation challenges, particularly concerning plastics, which is a significant part of our supply. We believe that these climate-related pressures are temporary and anticipate a return to normal levels, especially as we move into 2023. In the fourth quarter, we expect some improvement in the mix and overall performance. Our climate business is strong and has significant growth potential for 2023, particularly with the SEER regulation and our new product launches. We are confident that we will return to margins in the high teens to low 20s in 2023.

Jeff Hammond, Analyst

Okay. And then as we look at the Altra deal and the combined businesses, just if we go back, clearly some concerns over the leverage. If you kind of run the stress test on recession for both businesses, where does that take you from a leverage at a high watermark? And just if you were to get into that situation, anything you can really do to kind of accelerate the debt pay down, whether it be noncore business, divestitures, et cetera?

Robert Rehard, CFO

Sure. This is Rob. So Jeff, I'd tell you that the stress testing that we did with those dramatic shifts in EBITDA that we might stress test for '23 and even '24 still provided - it never provided a scenario where we couldn't service the debt, the leverage did get above 4%, but still always were able to service the debt. And if there was, and to your second part of the question, which was, would we look to accelerate anything? Hey, as we've commented previously, we are always evaluating our portfolio, but we have no plans at this time to do anything like that. And if we did make that determination, we'll certainly communicate that at the appropriate time.

Operator, Operator

The next question comes from Joe Ritchie of Goldman Sachs.

Joe Ritchie, Analyst

Louis, there is some concern around the timing of this Altra acquisition, trying to integrate 2 assets and the resourcing you have in place to do it successfully. Can you maybe just talk a little bit about the timing and then also your confidence in getting after the synergies associated with the Altra deal once it closes?

Louis Pinkham, CEO

Yes, happy to. Yes. And I've thought about this a lot and got a pretty thoughtful response here that I'm going to take you through. And it really starts with certainty and actionability. So we maintain a short list of transformative targets that we see as providing a unique combination of an accretive margin growth and synergy that can provide a step change on our continued transformation journey. Altra was the crown jewel on that list for us. And put simply, we did not believe this deal would be available in the future. It wouldn't have been available for us a year ago, and we felt we needed to act. The biggest challenge is finding the opportunity where one of these targets is actionable and acquirable under highly attractive terms while we also have the readiness from an integration perspective and the balance sheet to transact. All of those elements lined up here, which we believe is very rare. The deal metrics are best in class as compared to our Rexnord PMC deal, as well as other recent deals in the PT and automation landscape. We are also ready with a proven integration team on this deal that will quickly synergize and have high visibility into taking out public costs quickly and then dovetailing once we are finished with the PMC footprint moves to be able to move quickly into the Altra moves. The one element of question is leverage, I would say. We did extensive sensitivity analyses on both EBITDA downside, as well as further interest rate increases, looking at past recessions, including multiyear downside scenarios. In all cases, we feel highly confident in our ability to navigate. We also worked with JPMorgan and met with the rating agencies prior to signing to ensure we felt confident in our path to securing the debt we need to close this transaction and maintain our commitment to an accelerated reduction in our leverage. Ultimately, we sat down and outlined pros and cons. We made a disciplined decision based on the facts and data. We debated this extensively, and there are external factors that we cannot yet get into, but we strongly believe this deal as it stands now would not be available in the future. I'm highly optimistic, as is our team, and there's a lot to process here. As more of our investors have time to better get their arms around what we're doing, I'm confident that they will be compelled and as excited as we are about this transaction. So hopefully, that helps.

Joe Ritchie, Analyst

Yes, that was comprehensive. I appreciate that. Maybe my one follow-up is, once you've got this debt lined up, and I know that you've turned out a lot of your current debt, I'm just curious, how are you thinking about the structure of both variable versus fixed debt going forward? And then secondly, is the #1 priority for you at this point once the deal gets executed to pay down debt?

Robert Rehard, CFO

There are two parts to this. First, we are currently in the process of upsizing our revolver and term loan, which is happening over the next few weeks. Once that is completed, we plan to approach the bond market to consider issuing 3, 5, 7, or 10-year bonds. This will help us stagger the repayment to avoid having too much due in any single year, allowing us to pay down our debt quickly. We have a clear path to reducing our leverage to 2.5x or 3x by the end of 2024, and below 2.5x in 2025, thanks to our strong cash flow generation. Our priority has always been to maintain an investment-grade profile, and we intend to use our available cash to continue paying down debt until we reach a comfortable leverage range of 2 to 2.5x.

Operator, Operator

The next question comes from Christopher Glynn of Oppenheimer.

Christopher Glynn, Analyst

I just wanted to go back to the comment on Climate margins, getting back to the high teens, low 20s in 2023. Was that comment meant to capture the full year or kind of a target rate by later in the year?

Robert Rehard, CFO

Yes. It really was to capture the full year. And honestly, when we get into the first quarter, we would expect to be very close to, if not right on that target and then progress through the year in that range. So hopefully, that helps.

Christopher Glynn, Analyst

Great. And then for industrial, just curious, margins kind of broke out last quarter with some onetime, but held in new target range here. Just curious how that overall pivot to Mexico, relocating the supply chain and staffing there. If anything interesting is going on there, if it's all going according to plan.

Louis Pinkham, CEO

Yes, everything is progressing as planned, Chris. I want to emphasize that due to the size of the industrial business and the breakdown we provided for better visibility, a $1 million shift in performance can significantly impact margins. The transition to Mexico is in a very stable state, and I feel confident about the supply chain. The Industrial business is facing some challenges related to China. Our business profile shows that Industrial has a larger presence in China compared to our other sectors. China accounts for about 8% of Regal Rexnord, while for Industrial, it's 25%, and APAC is 35%. So the situation there is a bit more complex, with some headwinds affecting us, which is the main factor driving this.

Operator, Operator

The next question comes from Nigel Coe of Wolfe Research.

Nigel Coe, Analyst

Thanks for the question. I wouldn't normally lead off with interest, but it's a big swing in the guide, and there's a big step-up from 3Q to 4Q; 2Q to 3Q to 4Q. Are you baking in future rate increases into that number? Or are you marking-to-market current rates? And given the swing, obviously, in interest, I think the big swing, you previously expressed confidence, Louis, in the high end. Are we now sort of more at the midpoint?

Robert Rehard, CFO

No, first of all, regarding the increase in interest. There are two components to this. One relates to the rate increases we've observed. We're using the yield curves to determine what our interest rate should be now and in the future, which we're incorporating into our projections to assess where that interest should end up. The second aspect is related to our free cash flow cadence; we haven't generated as much cash in the first three quarters of the year as we typically do. This is mainly due to our inventory levels and our efforts to prioritize our highly valued customers. We made significant progress in the third quarter, and we're now over 90% and expect to finish the year at around 95%, which suggests substantial cash flow in Q4. However, in Q3, we didn't pay down as much debt as we had anticipated, which contributed to some of the interest expense you're referring to. These are the two factors that influenced the numbers and the adjustments. Nonetheless, the positive takeaway is that despite these challenges, we're outperforming operationally and still able to raise our guidance at the midpoint. We feel confident that we're managing to compensate for these issues and other foreign exchange headwinds that our business, like many others, has been facing, while still performing very well.

Louis Pinkham, CEO

Yes. And so I would just add on to that, Nigel, exactly what Rob said. We did state the upper end, we reset the midpoint up $0.05. Operationally, we're performing at that upper end. But the 2 items of the interest rate and FX should not be missed here, bring us to, we feel confident at 10.55.

Robert Rehard, CFO

It really wasn't anything that impacted the profit and loss statement. It's related to purchase accounting and how we account for allowances when we merged with Rexnord. So there wasn't an increase in the allowance that would affect the profit and loss statement; it is more related to the balance sheet and reestablishing that allowance in the third quarter.

Operator, Operator

And our next question will come from Chris Dankert of Loop Capital.

Chris Dankert, Analyst

I guess, looking at the PMC business, organic growth, I understand there's some pretty hefty comp issues there, a lot of noise with the PMC deal. But 3.6% organic, a little bit light versus some of your major distributors and some of your peers here, I guess. Maybe I underappreciated it just the China wind component, but any comment on kind of the organic growth in MCS this quarter and kind of how we're going to trend forward a bit.

Louis Pinkham, CEO

Yes. It was a really hard compare bluntly. And it was a hard compare on 2 fronts, winning projects in China, as well as solar projects in the U.S. If you would eliminate those, we would be at high single digits growth. We felt really good about the performance.

Chris Dankert, Analyst

Got you. Thanks so much for breaking that out a bit. And then forgive if I missed it, on the PMC synergies, both the sales and the cost synergies, any update kind of on what was realized in the quarter here?

Robert Rehard, CFO

Yes, Chris. We did see about $14 million come through in the third quarter related to the synergies on the PMC deal. That brings us after the third quarter up to about $33 million on a realized year-to-date. And to be clear, we do expect that we should see fourth quarter about $17 million, right, which would get you about over $50 million for the full year and really just a bit ahead of our $70 million targeted exit rate from 2022.

Louis Pinkham, CEO

And yes, sorry, go ahead.

Chris Dankert, Analyst

That's good. I was going to circle back on with the sales side.

Louis Pinkham, CEO

Yes. So Chris, we aren't in a position to give you a specific number here. We're still on our track to get $30 million of incremental sales synergies for this year, but we're not prepared to report on Q3.

Operator, Operator

The next question is a follow-up from Nigel Coe of Wolfe Research.

Nigel Coe, Analyst

I couldn't resist one more. So thanks for the opportunity. Obviously, the leverage is sort of like, Joe, has already made that question. No doubt you'll take down leverage really quickly post the Altra deal. But I'm just wondering, could noncore asset sales accelerate that process? Is that on the menu opportunities?

Louis Pinkham, CEO

I apologize, Nigel, I didn't hear your question. Could you repeat what you said about sales?

Nigel Coe, Analyst

Yes. Noncore asset sales, so to the extent that there are...

Louis Pinkham, CEO

I'm sorry for the misunderstanding. It is possible, but we aren't in a position to comment on that right now. We conducted a complete portfolio review and will continue to do so regularly. However, we don't have a clear plan at this time.

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. In summary, the Regal Rexnord team is continuing to deliver very strong performance. That gives me confidence that even if we head into a period of heightened macro uncertainty, our Regal Rexnord team can create value for our customers and shareholders and new opportunities for our associates by focusing on controllable execution, and we have so many value-creating opportunities to pursue. As we outlined at our September Investor Day, we have a path to accelerated organic growth and material margin and free cash flow upside. With the addition of Altra, our targets move even higher. 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, and you may now disconnect.