Earnings Call Transcript - RRX Q2 2021

Operator, Operator

Good day. And welcome to the Regal Second 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 Mr. Robert Barry, Vice President of Investor Relations. Please go ahead.

Robert Barry, Vice President of Investor Relations

Great. Thanks, Ian. Good morning, everyone. Welcome to Regal Beloit’s second quarter 2021 earnings 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’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 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 three, 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. On slide four, we provided some additional disclosures related to the planned merger with Rexnord PMC business. And on slide five, let me briefly review the agenda for today’s call. Louis will lead off with his opening comments and an overview of our 2Q results. Rob Rehard will then provide our second quarter financial results in more detail and discuss our 2021 guidance. Louis will then come back to provide an update on our planned merger with Rexnord PMC. We will then move to Q&A. After which, Louis will have some closing remarks. And with that, I will turn the call over to Louis.

Louis Pinkham, CEO

Great. Thanks, Rob, and good morning, everyone. Thanks for joining us to discuss our second quarter earnings and to get an update on our business and thank you for your interest in Regal. Building on the solid momentum we had in the first quarter, Regal delivered accelerating topline growth, significant margin gains and strong free cash flow in the second quarter. Organic growth was 37% and adjusted operating margin rose nearly 500 basis points, resulting in 140% adjusted EPS growth, which is the second quarter in a row that we achieved record results. I am also incredibly pleased to report that based on our second quarter performance and the margins implied in the 2021 guidance we shared last night, that we are hitting our operating margin expansion target under our 300-in-3 plan well ahead of schedule. As a reminder, at our March 2020 Investor Day, we outlined a plan to raise our adjusted operating margin by 300 basis points over three years using 2019 as a baseline. Many factors allowed us to outperform our 300-in-3 goal, but I believe Regal’s focus on 80/20 principles is chief among them. Underlining the strength of this performance is that it was achieved while confronting steep inflationary headwinds, scattered supply chain disruptions and lingering COVID-19 impacts. I believe this demonstrates very strong execution by our global Regal team. So before getting into more detail on our second quarter results, I want to thank all my Regal colleagues around the world for their hard work and resourcefulness, as they remain focused on serving our customers, executing on our restructuring plans and cultivating new growth opportunities. I am also pleased to report that Regal continues to mature its various growth initiatives and while recovering end markets boosted our growth rate, Regal also continued to achieve share gains in all of our segments during the second quarter. I want to emphasize that we are definitely gaining momentum and share through our focused approach in the Industrial Powertrain, which I have an example of in the next slide. Turning to our results, I think, a standout positive in the second quarter was Regal delivering 37% organic topline growth with all four segments contributing. Essentially, all our markets supported this positive performance. Because COVID distorts the comparisons with 2020, it’s notable that our sales in the second quarter were up almost 4% versus 2019. A few highlights by vertical include our unit material handling business, which was up nearly 30%, our alternative energy business within PTS posted revenue that was a multiple of the levels seen in the prior year, and our North America Residential HVAC business was up over 40% in the quarter. Notably, we started to see better momentum in our Commercial HVAC business and expect the non-residential end market, which represents about 12% of Regal sales, to be a nice source of growth for us in 2022. Regionally, our China business was also a very strong contributor, up more than 60% in the quarter. Our China team continues to execute at a high level, capitalizing on recovering end market demand while also driving nice share gain. While 37% organic sales growth will be hard to beat, I am confident we’ll continue to see strong momentum in the back half, given strong order rates in the second quarter and as we entered the third quarter. Orders in the second quarter were up 57% on a daily basis and our tracking up at a mid-2020’s pace in July. Our orders were up 22% versus the second quarter 2019. Notably, we think strength in our Residential HVAC and pool pump businesses is set to continue through the second half, which is an improvement versus our more cautious stance on these markets when we spoke last quarter. This strength is driven by robust orders and a sizable backlog, as our sense that underlying demand remains healthy, a regulatory change in our pool business and the HVAC channel in particular remaining understocked. In fact, the restock in residential HVAC we had anticipated in the first half of this year may be deferred to the first half of 2022, as we and the market balance accelerated demand and supply. We also see momentum building in our later cycle general industrial business and in the food and beverage and hospitality market, among others, as we move into the back half and look ahead into 2022. Rob will share more thoughts on the cadence of recovery in our end markets later in the call. Turning to margins, Regal posted a record 14% adjusted operating margin in the quarter. The addition of sizable volume gains, a steady cadence of progress in our 80/20 productivity initiatives, executing our multiyear restructuring program, and gains from our efforts around Lean resulted in significant second quarter margin expansion. Regal’s adjusted operating margin rose 460 basis points versus the prior year second quarter and is up 300 basis points versus the second quarter in 2019. As I noted earlier, the strong margin performance is happening despite facing supply chain challenges, mainly in certain electronic components and significant inflationary pressures. This is where 80/20 is really helping us make better strategic pricing decisions and allocate resources to our highest value opportunities. And along with our hedge programs and buy-a-hedge strategies and our teams executing a wide range of mitigating strategies with urgency and discipline, I am pleased that Regal was able to achieve price-cost neutrality in the quarter. Before turning it over to Rob, I would like to share more detail about a significant order we received in the quarter in our PTS business which highlights the power of offering an integrated powertrain solution and how Regal is leveraging its technology leadership and application expertise to create value-added solutions for our customers. In this example, our customer is a leading player in the resource recovery market, which essentially turns waste into energy as a replacement for coal. The customer was designing a next-generation product and was looking for shorter lead times, improved ease of installation, and real-time monitoring and support functionality. Our Regal solution integrates our motor, a series of critical components along the Industrial Powertrain and our Perceptiv remote monitoring sensor technology to create a solution that meets all the customer’s needs while also lowering net material content and is expected to save the customer up to $1 million annually. This custom solution is an example of how Regal’s ability to sell an integrated solution of powertrain and IoT-enabled sensing components created superior value for our customer. Regal’s capabilities in this regard are strong and will be enhanced materially with the addition of Rexnord PMC and reinforces our confidence in the cross-marketing synergies that underpin our strategic rationale for doing the merger with PMC in the first place. With the addition of Rexnord PMC, we’ll be able to do this in a wider array of applications and in an expanded set of end markets. And now, I’ll turn the call over to Rob, who will take you through the financials in more detail and discuss our guidance before I come back to update you on the Rexnord merger.

Rob Rehard, CFO

Thanks, Louis, and good morning, everyone. As you can see, Regal had very strong results in Q2. Now, let’s discuss our results by segment and then I’ll walk through our latest guidance, including some high-level thoughts on end market outlooks for this year and for 2022. Starting with Power Transmission Solutions or PTS, organic sales in the second quarter were up 33.1% from the prior year on broad-based strength, but with particularly strong performance in the alternative energy and U.S. general industrial markets and in our conveying business. Pruning actions were approximately 280 basis points of topline headwind in the quarter. Operating margin in the quarter for PTS was 19.4%, up 580 basis points compared to the prior year, a record level for this segment for the second quarter in a row and above our expectations. Orders in PTS for the quarter were up nearly 40% and are tracking up mid-30s in July both on a daily basis. Order strength in the second quarter and in July was broad-based. Turning to Climate Solutions, organic sales in the second quarter were up 43.4% from the prior year, which was slightly above our expectations. The increase was primarily driven by our North America Residential HVAC business, further demand recovery in Europe, and continued strength in the general industrial and commercial refrigeration markets. Pruning actions were approximately 350 basis points of topline headwind in the quarter. The adjusted operating margin in the quarter for Climate was 18.4%, up 600 basis points versus the prior year period. Strong volumes, favorable mix and continued cost reductions were all margin tailwinds. While our two-way material price formulas continue to lag material inflation in the quarter, we saw non-contracted price increases help bridge the gap, so that we ended in a neutral price-cost position for the quarter. We continue to anticipate that price actions under our two-way material price formulas will catch up during the third quarter. Orders in Climate for the second quarter were up 80% on a daily basis on broad-based strength. Orders in July are pacing up high teens. For Residential HVAC in particular, orders in the second quarter were up over 60% on a daily basis and while that pace has moderated slightly in July, based on our current backlog and what we’re hearing from our OEM customers, our assessment is that end-user demand remains healthy. Our view that the channel is still largely in an understocked position and we anticipate healthy growth rates in our Residential HVAC business for the remainder of this year despite the tougher back half comps. Note that this is a positive revision versus our prior view. Turning to Commercial Systems, organic sales in the second quarter were up 49.6% from the prior year. Strength in the quarter was broad-based but was particularly good in the North America general industrial end market, in our pool pump business, and in China. Notably, sales in pool pumps were up almost 50% in the second quarter benefiting from strong consumer demand, healthy sales of new products that are supporting share gains, and some restock activity. We think the outlook for pool remains healthy aided by these same drivers and we now expect healthy growth in this business for the remainder of this year, even as comps toughen. 80/20 pruning was 140-basis point headwind in the quarter. The adjusted operating margin in the quarter for Commercial Systems was 11.6%, up 560 basis points compared to the prior year. This margin was up primarily due to favorable volume and mix. Our teams have done a great job managing through the ongoing freight and logistics challenges to minimize the impact on the business. Orders in Commercial for the quarter were up nearly 70% on a daily basis, reflecting broad-base strength. For July, orders are tracking up high 20s, also on broad-base strength. In Industrial Systems, organic sales in the second quarter were up 15.2% versus the prior year. The segment saw strength in the data center market and improving demand in the North America general industrial market. Pruning actions during the quarter were approximately 190 basis points of topline headwind. The adjusted operating margin in the quarter for Industrial was 2.3%. While volume, cost reductions, and mix were all tailwinds for Industrial in the quarter, the business encountered larger than anticipated disruptions in its Mexico supply chain and also faced COVID-related headwinds in India that resulted in a six-week closure of the facility. We are happy to report that this site is once again fully operational. While these temporary unexpected setbacks may have delayed some of the efficiency gains we expected from transitioning to our new TerraMAX platform, we firmly believe that the structural changes we have put in place at Industrial and are continuing to implement will enable this business to achieve meaningful profit improvement within the next 12 months to 18 months. As we look ahead to the remaining quarters of 2021, we believe Industrial can deleverage margin progress versus the first half and we would expect performance at a mid single-digit level for the back half of 2021. Orders in Industrial for the quarter were up approximately 45% on a daily basis, with order rates in July tracking in the mid- to high-single digits on broad-based strength. On the following slide, we highlight some key financial metrics for your review. A couple of notable highlights. First, our free cash flow of $74 million, or 90% of adjusted net income is a strong result that reflects some incremental pressure on working capital given the higher volumes. Even so, we continue to expect cash conversion above 100% for the year. Second, we further delevered the balance sheet and ended the quarter with net debt to adjusted EBITDA of 0.7 times. Moving to the outlook, with two quarters behind us and COVID-related impacts significantly diminished, we are in a position to provide annual guidance. We expect 2021 adjusted diluted earnings per share in a range of $8.70 to $9, which would represent growth of 53% year-over-year at the midpoint. This implies revenue growth in the high teens. At the bottom of this page, we’ve included some additional assumptions that can be used when modeling 2021. Furthermore, and consistent with what we previously communicated, we expect to take actions in 2021 that will result in annualized cost savings of $25 million, of which we achieved roughly $6 million in Q2, and for modeling purposes, I would assume the remainder of roughly $13 million occurs ratably during the year. On the next slide, and as Louis highlighted in his opening remarks, we wanted to provide an update on our 300-in-3 initiative we laid out at our Investor Day in March of last year. The many changes we’ve implemented over the past couple of years have resulted in hitting that goal in less than two years. While improved volume has certainly contributed to hitting these goals this year, if you compare our sales results to 2019 levels, you’ll find growth largely aligned with the assumptions we included in our Investor Day projections. The key drivers of our margin improvement include the decentralization of the business, driving increased accountability and P&L ownership at every level of the organization, a focus on 80/20, utilizing policy deployment to affect strategic initiatives and drive above planned performance. The Regal business system and executing and exceeding our cost-out opportunities in the areas of footprint consolidation, product rationalization, and best value country sourcing, while we are not planning to update our Investor Day targets at this time, we still have sight to continued margin improvement through the cycle. We see this as a great momentum as we move closer to the successful merger with Rexnord PMC. Before turning it back over to Louis, I want to spend a few minutes sharing some details on our end market exposures. We thought this would be helpful as you start to develop estimates for post-2021 growth rates. A few things I think are worth highlighting on this slide. One, roughly half of our sales are into the consumer, general industrial and non-residential construction end markets, which represent approximately 21%, 19%, and 12% of our sales, respectively. Second, the other 50% of our sales are made into a diverse array of end markets. Third, while our Residential HVAC and residential pool markets tend to garner outsized attention from the investment community, these markets represent only about 25% of our sales, with residential pool being 4%. We classify these sales mostly in the consumer end market with modest exposure to residential new construction, consistent with demand for these products being mostly replacement driven. Lastly, as we think about where we are in the cycle for our principal end markets, we expect that roughly 30% have not started to recover or are only in the earliest stages of recovery and so are unlikely to see a material uptick in demand until 2022. These include our sales into the non-residential end market, hospitality, much of food and beverage, oil and gas, and the more capital spending-driven parts of general industrial. We also believe our exposures in alternative energy and data centers, while posting strong growth in 2020 and 2021, have ample runway to continue growing at very healthy rates in 2022 as well. To be clear, we expect all of our markets to be strong in 2022, but we are highlighting markets we expect to accelerate since they will still be rebounding. For reference, I’ll add that Rexnord PMC business has roughly 15% of its sales into the aerospace end market, plus 6% into non-res and 20% into food and beverage, and so we also see significant opportunities for accelerating end market demand to benefit that business in 2022. Beyond end market tailwinds, as you know, we have spent a lot of time over the last two years making investments and structural changes in the business that will enable more robust outgrowth and we expect to see increasing benefits from these efforts in the coming years including in 2022. And now, I will turn the call back over to Louis.

Louis Pinkham, CEO

Thanks, Rob. I’d like to spend a few minutes updating you on our planned merger with Rexnord’s PMC business. First, as I mentioned earlier, we now have all required regulatory approvals needed to close. One key remaining step is shareholder approval of both Regal and Rexnord, and we announced last week that our special shareholder meeting is scheduled for September 1. In light of this information, we now expect the transaction to close sometime in the second half of 2021. The precise timing will depend on the IRS letter ruling, but late in the third quarter or early in the fourth quarter seems most likely. Second, our dedicated integration planning team is working diligently to ensure we hit the ground running on synergy realization when we close and I feel very good about the team’s efforts on this front and remain highly confident we’ll meet or exceed our estimates for synergies. Third, while we are not providing an update regarding the private letter ruling from the IRS that is being sought in connection with this transaction, I’ll note, as more fully described in the proxy statement we filed with the SEC on July 21, we believe that based on recent share ownership information and assuming receipt of the IRS private letter ruling, we are still on track to be within the dividend range provided when we announced the transaction in February with a midpoint of roughly $300 million. Lastly, with the strength of Regal’s 2021 anticipated performance and the strength of the Rexnord PMC performance as communicated by Rexnord last week, we are feeling even more confident in the timing of this merger and the opportunity for shareholder value creation. As a result, we are raising our estimated pro forma adjusted sales and EBITDA estimates for 2022. We now expect approximately $5 billion in pro forma revenue versus $4.5 billion when we announced the transaction and we now expect adjusted EBITDA in excess of $1 billion, up from approximately $940 million communicated in February. In addition, while we’re not raising our estimated synergies or quantifying the cross-marketing synergies we’ve identified, wins like the one we shared earlier with the resource recovery OEM make us more confident about the enhanced value proposition we will have post-closing. Being able to sell customers a complete, integrated Industrial Powertrain solution across a wider array of applications and end market will meaningfully help new Regal grow above market and was a central strategic consideration for us pursuing the merger in the first place. And with that, I’ll turn it back over to the Operator. Operator, we are now ready to take questions.

Operator, Operator

It looks like your first question comes from Michael Halloran of Baird. Please proceed.

Michael Halloran, Analyst

Hey. Good morning, everyone.

Louis Pinkham, CEO

Good morning, Mike.

Michael Halloran, Analyst

Let's start with margins. We've done well this quarter and over the past couple of years. Can we discuss the PTS margins? There was a significant increase. I'd like to hear more about the key factors driving that increase and, more importantly, how we should consider the sustainability of that margin going forward. Is that an appropriate run rate to expect, or are there considerations we need to be aware of for the future?

Louis Pinkham, CEO

Yeah. Let me start with that, Mike. First of all, I think our PTS business is performing incredibly well, firing on all cylinders. It’s really driven. They’ve embraced 80/20 incredibly well, not only from the standpoint of SKU reduction, footprint rationalization, but also then leveraging the Industrial Powertrain and focusing our efforts on gaining share and growing. And so, I would tell you, although we are seeing in the second half that we’ll see a little bit of balance, these margins are sustainable and will actually improve further. And so we’ve got a high 30s gross margin business that especially then with the combination with Rexnord PMC we’ll be taking them over 40.

Rob Rehard, CFO

Yeah. And I would just add, Mike, for a second on that one. Certainly, some mix impacted the quarter in terms of some of the key drivers that we highlighted during the call that were in my remarks, in terms of solar and material handling, in particular that were nice margin drivers for us. As you look out for the remainder of the year, while we do see that these are largely sustained margin rates, we don’t expect them to continue quite at the rate that we saw as we exited the second quarter, but certainly above historical levels and so still very nice improvement.

Michael Halloran, Analyst

Okay. Thanks for that. Appreciate it. A follow-up here then just more broadly as we think about the margins, pretty impressive that price cost neutral in the quarter considering all the headwinds out there and considering the timing of when the material price formulas kind of normalized. So as you’re looking towards the back half of the year here, maybe just a little deeper discussion on how you think that price cost equation starts layering out through the years, maybe some of this catch up materializes and depending on inflation factors?

Rob Rehard, CFO

It’s great to see that we achieved price-cost neutrality in the first half and we expect to maintain that in the second half. In our Climate and Commercial businesses, we're still working on our two-way material price formulas, which we anticipate will catch up in the third quarter. We also expect additional inflation to impact the business as we progress through the second half. However, we are confident in our team's ability and the new strategies we've implemented to capture prices, allowing us to offset these inflationary pressures and remain neutral in the second half. It’s not an easy task, but it becomes more manageable when our customers expect it, know about the inflation, and when competitors are generally keeping pace. Our 80/20 strategy is significantly aiding us in making these strategic pricing decisions. Sometimes, we need to approach our customers multiple times to secure the necessary price adjustments, which is what our teams are focusing on. We’re handling this effectively, which is why we reached our goals in the second quarter, and I expect this trend to continue for the rest of the year.

Michael Halloran, Analyst

Appreciate it, gentlemen. Thank you.

Louis Pinkham, CEO

Thanks, Mike.

Rob Rehard, CFO

Thanks.

Operator, Operator

Our next question comes from Jeff Hammond of KeyBanc Markets. Please proceed.

Jeff Hammond, Analyst

Can you hear me?

Louis Pinkham, CEO

Yeah. Good morning, Jeff.

Jeff Hammond, Analyst

I noticed in the presentation you mentioned buyback, and my understanding is that you previously suggested it's not something you're prioritizing. However, it seems the market isn't fully recognizing the progress you're making internally and with the portfolio changes. I'm curious about your thoughts on buyback and how quickly you can initiate it once the deal is finalized.

Rob Rehard, CFO

Sure. As you’re right, we have been somewhat limited on what we can do between now and the merger close. But, big picture, we’re not averse to stock purchases and we do plan to maintain a balanced approach to capital deployment once we get past the close. So that’s the way we’re thinking about it and we’re not coming off that position. So we can get back into buying back stocks we decide to do so afterwards. We can be more precise on timing, of course, after the close.

Louis Pinkham, CEO

I appreciate you recognizing the stock performance, as we certainly see it too. However, our team is focused on driving stronger, more profitable growth and enhancing our overall performance. That is our primary focus. We believe we are doing well, and with the merger with Rexnord, we will become even stronger as a company, and that performance will be acknowledged.

Jeff Hammond, Analyst

Okay. Great. And then so you gave the guidance on the high-teens growth. Are there any segments that are going to be notably above that or below that? You gave a lot of good detail on the order trends? But just trying to get a sense of any outliers within that growth rate?

Rob Rehard, CFO

Sure, Jeff. The way I think about it is in this order, from highest to lowest and this from a segment perspective as we work through the back half of the year. I would say the highest growth that we would expect would be coming through on the Commercial segment followed by Climate, then PTS, and lastly, Industrial in that order is the way I look at the back half.

Jeff Hammond, Analyst

I am:

I am:, I am:

I am:

Louis Pinkham, CEO

We have been undergoing a transition and have introduced a new product, TerraMAX, which is being expanded in Mexico. Additionally, due to the tariffs, we moved significant production from China to Mexico. Consequently, our supply chain has stronger ties to China, and we are focusing on localizing more operations in the North American market. Compared to our other businesses, Regal's main advantage remains its global supply chain and manufacturing presence. However, this was not the case for the industrial sector, which relied heavily on production from China and India. Therefore, establishing operations in Mexico is putting more pressure on the industrial business compared to our other sectors.

Jeff Hammond, Analyst

Okay. That’s very helpful. Thanks.

Rob Rehard, CFO

Yeah. Thanks, Jeff.

Operator, Operator

Our next question comes from Christopher Glynn of Oppenheimer. Please proceed.