Earnings Call Transcript - RRX Q2 2025

Operator, Operator

Good morning, and welcome to the Regal Rexnord Second Quarter 2025 Earnings Conference Call. Please note this event is being recorded. I would now like to turn the conference over to Rob Barry, Vice President, Investor Relations. Please go ahead.

Robert Douglas Barry, Vice President, Investor Relations

Great. Thank you, operator. Good morning, and welcome to Regal Rexnord's Second Quarter 2025 Earnings Conference Call. Joining me today are Louis Pinkham, our Chief Executive Officer; and Rob Rehard, our Chief Financial Officer. I'd 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 those projected or implied due to a variety of factors, which we describe in greater detail in today's press release and in our reports filed with the SEC, which are available on the regalrexnor.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 his opening comments and overview of our second quarter performance and an update on our cross-sell initiatives. Rob Rehard will then present our second quarter financial results in more detail, review our 2025 guidance and provide an update on tariffs. 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 Vernon Pinkham, CEO

Great. Thanks, Rob, and good morning, everyone. Thanks for joining us to discuss our second quarter results and to get an update on our business. We appreciate your continued interest in Regal Rexnord. In short, our team delivered solid second quarter performance in line with our expectations on sales and modestly ahead on adjusted earnings per share. So before continuing, I want to take a moment to thank our 30,000 Regal Rexnord associates for their hard work and disciplined execution. I am also especially proud of the job our associates have been doing to manage the impacts of tariffs and rare earth magnet constraints. Their efforts keep us confident that we can fully neutralize current tariff impacts on our adjusted 2025 EBITDA and earnings and the adjusted EBITDA margin neutral in the first half of 2026. Now let me provide some specifics on our second quarter performance, starting with sales. Our sales in the quarter were down 1.2% versus the prior year on an organic basis, in line with our expectations. We faced a couple notable headwinds in the quarter related to project timing in metals and mining in our IPS segment and to temporary rare earth magnet availability, which delayed certain higher-margin shipments into the medical and defense markets, specifically in the AMC segment. These headwinds were largely offset by particular strength in residential and commercial HVAC and in aerospace. For reference, our sales in the first half were roughly flat on an organic basis. Regarding tariffs in the demand environment, we have been seeing limited customer spending and project timing impacts, which, in aggregate, are having only a modest impact on our business. Bigger picture, we continue to believe that demand in most of our key end markets is at or near trough levels and were it not for various macro uncertainties, the industrial cycle would be gaining momentum at a firmer pace. Even so, we remain optimistic that our sales will improve and grow at a low single-digit rate in the back half of 2025 and into next year, given multiple quarters of positive orders that have grown our backlog, particularly in our IPS and AMC segments. Orders in the quarter on a daily basis were down 2.5% and book to bill was 0.98. Orders in the quarter were weighed down by AMC, which saw an orders decline of 7.5%. This decline was driven by the timing of a sizable data center order expected in the quarter and a tough compare as orders in AMC were up 12% in the second quarter of last year. Specifically, a $35 million data center order that was expected in the quarter ended up booking early in July. It would have improved AMC's second quarter orders growth by roughly 8 points had it come a week earlier, and Regal's overall orders for the quarter would have been flat. I would like to take a minute to acknowledge the significant achievement this data center order represents for our power management team within AMC and for Regal Rexnord broadly. The order is for switchgear that will be used in a hyperscale data center in North America. We believe this July data center order will be the first of 5 similarly sized orders that the customer plans to award on this particular project and feel that we are well positioned to win some or all of this additional content. And while any additional wins associated with this project would likely hit our P&L only at the end of 2025 and in '26 and '27, this project alone could provide a meaningful boost to our enterprise growth rate next year. In July, daily organic orders for Regal Rexnord were up 4.4%, driven primarily by strength in data centers. Turning to margins. Our second quarter adjusted gross margin was 38.2%, up 10 basis points versus the prior year, excluding Industrial Systems. Our progress on gross margin was aided by achieving $17 million of cost synergies in the quarter. Temporary impacts related to rare earth magnet availability were a modest headwind. Adjusted EBITDA margin was 22%, down 20 basis points versus the prior year, excluding Industrial Systems. Adjusted earnings per share in the quarter was $2.48, up 8.3% versus the prior year. Lastly, we generated $493 million of free cash flow in the second quarter, of which $368.5 million relates to an accounts receivable securitization program we completed in the quarter. This program, which Rob will elaborate on, is net accretive to our earnings by allowing us to accelerate paying down higher cost debt, which remains a top priority. In summary, a strong second quarter, which along with healthy recent orders in backlog growth makes us optimistic about improving top line and earnings momentum in the back half of this year and into 2026. Next, I'd like to spend a few minutes updating you on our cross-sell synergies where we are seeing positive momentum and expect a growing contribution to our sales performance. Bottom line, we are on track to deliver at least the $250 million of cross-sell synergies we announced following the Rexnord and Altra transactions. As you can see on the chart on this slide, we achieved $120 million of cross-sell synergies through the end of last year and are on track to add incremental $50 million this year. As a reminder, principal cross-sell synergies include addressing the broader customer base of the combined business and taking advantage of the unrivaled scale and scope of our product portfolio and go-to-market approach to gain wallet share and to sell more solutions, including powertrain. This value proposition is resonating, which is evident from our growing funnel of cross-sell opportunities, which stood at nearly $300 million at the end of Q2. Notably, the win rate on our cross-sell opportunities has been tracking about 10 points above the enterprise average. On the right-hand side of this slide, we provide a few recent examples of cross-sell wins. The first is a powertrain sold to a cement manufacturer valued at approximately $3 million. The harsh operating conditions in the cement industry translate to significant estimated lifetime aftermarket sales worth about $12 million, which come with nicely accretive margins. We won by making it easier for the customer to build out a new plant by receiving an engineered solution optimized for efficiency and durability versus individual power transmission components that the customer would have to assemble. The next two examples are of wallet share gains. As we discussed at our Investor Day in September of last year, only 15% of our power transmission customers buy more than one product category from us. Even though in most cases, they use most, if not all of the categories we sell. This creates tremendous opportunities for spend consolidation. The scale and scope of our product portfolio, plus significant digital investments that are making it easier to do business with us, position Regal Rexnord as a natural destination for spend consolidation. We expect the initial spend in new categories to ramp considerably as the customers validate our quality and production volume capabilities for the newly added products. Margins on the new categories are at least at our OEM fleet average. In short, we believe the value of our unrivaled scale and scope in power transmission is gaining momentum, evident in the orders and backlog growth we have been experiencing in IPS and AMC. And with that, I will turn the call over to Rob.

Robert J. Rehard, CFO

Thanks, Louis, and good morning, everyone. Now let's review our operating performance by segment. Starting with Automation and Motion Control, or AMC, sales in the second quarter were down 3.4% compared to the same period last year on an organic basis, which aligned with our expectations. This performance mainly reflects weakness in the medical end market, project timing in data centers, and temporary challenges with rare earth magnet availability that affected shipments of certain high-margin products in medical and defense markets. These challenges were largely balanced by strength in aerospace, which exceeded our expectations. AMC's adjusted EBITDA margin for the quarter was 19.5%, falling short of our expectations. This shortfall was primarily driven by delayed shipments of high-margin products that use rare earth magnets due to difficulties in securing these materials. We also faced increased costs, such as expedited freight for magnets. Another contributing factor, though less impactful, was the ongoing destocking of mix-rich products in the medical market. We believe both of these impacts are temporary. Our ability to secure magnets has improved, and we feel that inventory levels in the medical channel are stabilizing, although most anticipated mix improvements will be seen in the fourth quarter. Orders in AMC for the second quarter were down 7.5% from the previous year on a daily basis, resulting in a book-to-bill ratio of 1.0. The decrease in AMC's orders, combined with challenging year-over-year comparisons, mainly reflects destocking in the medical market and the timing of a significant data center project order that, as Louis mentioned earlier, was pushed into early July. Importantly, if we had received the large data center order during the second quarter, AMC's orders would have seen a slight increase. AMC's orders in July were up about 21.5%, driven by several data center wins. As I conclude this segment, we anticipate continued momentum in AMC thanks to a higher mix of shippable backlog for the second half of the year, which has increased mid-single digits compared to last year and is weighted towards the fourth quarter. Additionally, the momentum we are observing in data centers and further order traction in humanoids during the second quarter indicates a higher shippable backlog entering 2026 relative to 2025. Moving to Industrial Powertrain Solutions, or IPS, sales in the second quarter were down 4.4% compared to the same period last year on an organic basis, which was slightly below our expectations. The decline primarily reflects project timing impacts in metals and mining. As a reminder, we noted last quarter that we were seeing strong orders in metals and mining, which continued this quarter. Therefore, the sales weakness in this sector is entirely timing-related. Adjusted EBITDA margin for IPS in the quarter was 26.9%, about 1 point above our expectations and up 110 basis points compared to last year. The better-than-expected margin was largely due to a stronger mix and disciplined cost management, with year-over-year gains primarily driven by synergies. Orders in IPS on a daily basis increased by 3% in the second quarter. Approximately half of this growth was related to large project wins contributing to the expanding backlog. Bookings in our IPS segment are increasingly focused on longer-cycle projects, in line with our strategic goal of selling Industrial Powertrain Systems. IPS's backlog has increased by 15% year-to-date and is expected to start converting at a higher rate in the latter half of this year and into 2026, enhancing our confidence in this segment's sales growth outlook. The book-to-bill ratio in the second quarter for IPS was 1.01. In July, orders on a daily basis remained roughly flat. Now turning to Power Efficiency Solutions, or PES, sales in the second quarter rose by 6.5% compared to last year on an organic basis, which exceeded our expectations. This growth primarily stemmed from strong performance in residential HVAC, which rose nearly 20% during the quarter, as well as strong commercial HVAC results, both trending above our expectations. Overall, we were very satisfied with the growth in this segment during the quarter. As a reminder, we expect residential HVAC end-user volume to remain flat or slightly increase this year, implying significant declines in the latter half, especially in the fourth quarter, due to challenging comparisons from regulatory pre-buy activities. The adjusted EBITDA margin for PES in the quarter was 17.1%, exceeding our expectations and up 1 point from the previous year, supported by higher volumes and effective cost management. Orders in PES for the second quarter were down 5.4% on a daily basis, which met our expectations considering the anticipated challenges in residential HVAC. The book-to-bill ratio in the quarter for PES was 0.9. Daily orders for PES in July fell by 3.6%, which is also consistent with our expectations regarding residential HVAC destocking. As we progress to Slide 10, we are sharing an update on our balance sheet and net leverage ratios following an accounts receivable securitization program we completed in the second quarter that enabled us to expedite debt repayment. This facility, which closed on June 30, totals $400 million. The initial proceeds realized in the quarter were $368.5 million, all directed towards substantially reducing our variable bank debt. Initiating the securitization facility aligns with our approach of consistently seeking new opportunities to improve performance. The facility offers various advantages, as detailed on this slide. Primarily, it enhances adjusted earnings and free cash flow by providing around $4 million in annualized interest savings. We expect nearly $2 million in net interest savings in the second half of this year. Furthermore, the facility allows quicker access to cash from outstanding receivables, improving our working capital profile, as well as enhancing our debt-to-equity and other leverage ratios. Looking ahead, we remain dedicated to strengthening our balance sheet with a focus on reducing leverage to our long-term target range of 1.5 to 2x. Additional information on the securitization facility can be found in our 10-Q. Turning to the outlook. Today, we are reaffirming the midpoint of our 2025 adjusted earnings per share guidance and narrowing our adjusted EPS range by $0.10 on each end to a range of $9.70 to $10.30. Our principal assumptions are outlined in the table on the left-hand side of this slide. Notably, our sales guidance is rising modestly, primarily to reflect improved translational FX rates and to incorporate the impact of tariff-related pricing. Our adjusted EBITDA margin is now expected to be 22.5% versus our prior assumption of 23%, reflecting the impact of transactional FX, tariffs and our latest view on margins in AMC, which I will elaborate on shortly. The tariff impact reflects neutralizing tariffs on a dollar basis, which has a slightly dilutive impact on margin. We still expect to be margin neutral by the middle of next year. Now as it relates to the low versus the high end of our range, let me share a few thoughts on how we are assessing the risks and opportunities. Aside from market performance, one factor impacting the low end of our range is a slower pace of recovery associated with rare earth magnet availability from China. At the high end of the range, we see revenue upside from the recent data center wins and other potential data center opportunities in our funnel, along with further upside if the ISM turns positive. We have also made small adjustments to certain below-the-line items as detailed in the table. Regarding interest expense, please note that there are specific accounting rules for recording the interest expense associated with the accounts receivable securitization facility, which we have summarized on a slide in the appendix of this presentation to help with financial modeling. Overall, we are continuing to take a measured approach to guidance for the year, considering the ongoing macroeconomic and geopolitical uncertainties. On Slide 12, we are updating our expectations regarding tariff impacts. The gross annual unmitigated cost impact from tariffs in place at the time of our first quarter earnings release on May 5 was $130 million. Today, we estimate that value has fallen to approximately $125 million, broken down as outlined on the table. We still expect our mitigation actions to result in tariffs having a neutral P&L impact this year and a neutral EBITDA margin impact by mid-2026. 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 execute with a sense of urgency. Before I leave this slide, I would also like to note that to date, we have not seen clear signs of tariff-related demand deterioration in our business. While there have been scattered examples of customers slowing their decision-making or delaying projects due to tariffs or other macro uncertainties, in aggregate, these actions have only had a modest impact on our business today. Even so, this is something we are continuing to monitor closely, and we intend to provide an update if and when material new information becomes available. On Slide 13, we provide more specific expectations for our performance by segment on revenue and adjusted EBITDA margin for the third quarter and for the full year. The primary change since our last update is that we now expect AMC's 2025 adjusted EBITDA margin to be in a range of 20.5% to 22.5%, which is down roughly 150 basis points versus prior expectations. This change largely reflects higher costs incurred to procure rare earth magnets, a footprint optimization project that we pushed into 2026 due to ongoing tariff uncertainty, as well as a weaker mix. The negative mix impacts are related to softer sales in medical and the latest margin profile of our backlog scheduled to ship in the second half. However, once we move past these temporary headwinds, we continue to see a path to AMC adjusted EBITDA margins in the 24% to 26% range, consistent with the midterm guidance provided at our 2024 Investor Day. While not as impactful, but worth noting, IPS revenue is expected to be up low single digits in Q3 and low to mid-single digits in the second half. This implies the fourth quarter will be the strongest growth quarter for this segment, largely due to the longer cycle engineered-to-order content in the backlog. Also worth noting, we expect PES to be up low single digits in the third quarter, but down low single digits in the back half, implying fourth quarter will be down low to mid-single digits. Embedded in these assumptions, the resi HVAC business is expected to be down over 20% in the second half and down over 25% in the fourth quarter. Finally, as I wrap up my prepared remarks, I'd like to share a few high-level thoughts on our performance and outlook. In short, we believe the underlying momentum in our business is positive and improving, given our growing backlog. We also still have many opportunities to create shareholder value, which include ample levers to accelerate growth, including cross-sell synergies and a clear shift to selling a richer mix of subsystem solutions, a greater emphasis on new product launches and related vitality, over $70 million of remaining cost synergies and further progress shifting our capital structure to equity as we generate cash and pay down our debt. In summary, we are confident we can create value for our shareholders in 2025 and many years to come. And with that, operator, we are now ready to take questions.

Operator, Operator

The first question is from Mike Halloran with Baird.

Michael Patrick Halloran, Analyst

Can you give some context on what you're expecting in the back half of the year from an end market recovery perspective at the midpoint? I know Rob gave the highs and the lows, but also what you're expecting from an order perspective and any variability you're seeing across the segments?

Louis Vernon Pinkham, CEO

Yes, Mike, this is Louis, and thank you for the question. We believe the market situation hasn't changed much. It's a bit weaker in the medical sector, but we anticipate a recovery by the end of the year. The strong markets, like energy, aerospace and defense, and data centers, continue to perform well and should remain solid. Regarding the general industrial sector linked to ISM, we expect it to improve by 2026, though we haven't factored in any enhancements for general industrial just yet. As for HVAC, particularly residential and commercial, we expect a relatively flat performance. When it comes to orders, we anticipate an increase of mid-single digits in the second half, with mid-single digits in IPS and low double digits in AMC, driven particularly by the accelerating markets like data centers. PES is expected to remain flat or slightly increase. Our outlook, based on momentum from Q2, customer discussions, and business performance, suggests revenue growth in the low single digits for Regal in the second half and moving into 2026. Hopefully, that provides clarity, Mike.

Michael Patrick Halloran, Analyst

No, that does. That does. And then I guess twofold question and admittedly unrelated. Can you just give some context on the exposure to the rare earth magnets? It seems like a bigger component than I was expecting in the portfolio. And then also give some context to the data center wins and why those are starting to roll through now, all else equal and what the differentiation has been sort of why you're getting those wins?

Louis Vernon Pinkham, CEO

Yes. Happy to provide a little bit more color there. So rare earth magnets, from an enterprise perspective, actually, rare earth magnets are in products that represent only about 1% of our sales. However, in the quarter, we certainly experienced challenges. And actually, we had to shut down the facility for a couple of weeks in the quarter because we did not have inventory. And this is completely due to the challenges of procuring magnets given the volatile trade policy situation with China. We have largely addressed these challenges at this point and expect to catch up on these shipments in the back half, especially in the fourth quarter. And so even with the 1% of sales exposure, we expect to close this to a neutral impact in the year, but did have an impact on us in Q2, will ramp in Q3 and then will accelerate for Q4. So that's rare earth, Mike. Moving to data center. Honestly, we're well positioned in the data center market. And this is a market that you win large projects. And bluntly, in the first half of the year, we've been down on orders in the data center market as we've been working on these large projects and winning these projects. The funnel is significant. Our differentiation is around our ability to customize the solution of controls in switchgear, in parallel and switchgear. This specific project was a nice win for us in our AMC segment, particularly in our power management business. And we expect it to be a momentum in the space for us to grow further. So a nice win for us. It was the first of what we expect to be maybe 4 or 5 additional orders over the next 6 to 12 months. And I want to clarify also that it's one order, but we actually won 2 other orders in July, which gave us the 21% orders growth, and we expect some strength in, at this point, orders to be up low double digits in the second half, a lot of that driven by data centers. So hopefully that was helpful, Mike, and happy to answer any other questions.

Operator, Operator

The next question is from Kyle Menges with Citigroup.

Kyle David Menges, Analyst

It seems like gaining momentum in IPS with the backlog up year-to-date and expecting, I think, to be exiting the year, it sounds like, just in the fourth quarter for IPS organic growth in that kind of mid-single-digit range. So I'm curious just what's the expectation for first half '26? Should we be extrapolating that 4Q run rate into the first half of next year? And then it seems like July orders, I think you said were flattish in IPS, but you said to expect orders up mid-single digits in IPS. So I guess just what's giving confidence in the reacceleration, I suppose, from July?

Louis Vernon Pinkham, CEO

Thank you for your question, Kyle. Regarding next year, it's a bit premature for us to provide a forecast. However, I mentioned earlier that we hope to begin next year with low single-digit growth, which I believe is a reasonable expectation at this time. About IPS, I emphasize to my team that one month does not establish a trend, but it is crucial to meet the quarterly goals. Therefore, our discussion around IPS for July doesn't raise any concerns regarding flat order growth, especially after seeing approximately 3% growth in Q2 and 8% growth in Q1; we anticipate July to be just an outlier. For the quarter overall, we still aim for mid-single-digit growth, and we have no concerns on that front. Our pipeline in IPS remains robust, as highlighted in our call with a cross-sell pipeline of $300 million, most of which is in IPS. This gives us confidence in our order outlook. Moreover, if ISM improves further, we can expect additional order growth. To wrap up, our backlog in IPS has grown by 15% year-to-date, which contributes to our optimism. I hope that clarifies things, Kyle.

Kyle David Menges, Analyst

Yes. That's helpful. And then, I mean, it seems like really 2 trends emerging in IPS and in AMC. So you have an IPS sounds like delivering more systems versus components. And then AMC, really the data center strength, and it sounds like it could actually be a pretty meaningful contributor to revenues. And I'm just curious on both of those trends you're seeing in IPS delivering more systems, data center and AMC. How should we think about that impacting margins? Is that a positive or negative mix impact for your margins in those segments?

Louis Vernon Pinkham, CEO

Thanks for the question. There are a couple of points to consider. Our systems generally achieve average margins, possibly slightly above, as we offer comprehensive solutions that solve problems with higher reliability. Additionally, there's a significant technical advantage in our offerings. For instance, we recently announced a partnership with ABB to provide a seventh-axis automated solution, which exemplifies the value our systems bring. I believe the best approach to model this would align with peer margins, specifically the average margins of our broader portfolio, as we certainly add considerable value here. Furthermore, the long-term advantage for us lies in the aftermarket, where any component breakdown can lead to even more favorable margins. I hope that clarifies things, Kyle.

Kyle David Menges, Analyst

Yes. And then sorry, the data center positive or negative to mix in AMC?

Louis Vernon Pinkham, CEO

I apologize. No, it's positive. It's positive to mix. It's a benefit for that business.

Operator, Operator

The next question is from Jeff Hammond with KeyBanc Capital Markets.

Jeffrey David Hammond, Analyst

Just was hoping you could quantify the rare earth impact on 2Q both revenue and profit. And then it sounds like you're getting the revenue back, but there's some added maybe shipping or more purchase costs. How should we think about that impact into the second half as well?

Robert J. Rehard, CFO

Yes. Thanks, Jeff. First of all, in the second quarter, there's about $6 million of impact, which is really about 2/3 of the margin miss that we saw in AMC within that quarter. Now we do expect to mostly catch up for the year. However, there will continue to be some costs with some of our mitigation actions that will remain. So roughly about $5 million in the full year is what we're talking about.

Louis Vernon Pinkham, CEO

And it had about a $10 million sales impact in the quarter, Jeff.

Jeffrey David Hammond, Analyst

Okay. That's helpful. I want to understand the doubling of the rest of world tariff a little better. Additionally, regarding the tax law changes, I believe you reiterated your free cash flow outlook. We've observed several companies benefiting from the tax bill on cash. Can you provide any insights on potential changes in the near term or long term?

Louis Vernon Pinkham, CEO

Yes. So from a rest of world perspective, it's really just where our manufacturing aligns with where the tariffs are now falling out. So a couple of comments there. India, Thailand, those are manufacturing locations for us. Now I'll also comment that, again, rest of world is relatively low, and it shows you that our strategy around in region, for region has really paid off. Secondly, both of those plants happen to be plants where we produce product in other locations as well. And so what we're framing up for you is the impact, given our current supply chain. But what we're trying to do, of course, is mitigate and mitigate around where we produce, where we supply from before we go and look just for price. And so those 2 in particular, we're going to be able to work through fairly easily, I'd say.

Robert J. Rehard, CFO

On the tax side, in relation to the One Big Beautiful Bill Act, we are still assessing the impact. Our initial assessment suggests that we could see a small, insignificant cash tax benefit this year with no change to the tax rate. This is included in our guidance. We expect a slight benefit in cash taxes, but we also anticipate some challenges due to the timing of tariffs and their potential effect on cash flow this year. These factors seem to balance each other out, but we are still maintaining our forecast of $700 million in free cash flow, excluding the ARS we discussed today.

Operator, Operator

The next question is from Julian Mitchell with Barclays.

Julian C.H. Mitchell, Analyst

Maybe start with the AMC division. So sort of 3 bits of it. I wondered if you could just give any brief comments on, one, on the rare earth issue. So is that plant that was shut now back to close to full production? And then on medical, I think it's 10% of AMC revenue. Sort of do you have a good line of sight as to customer inventories sort of real-time? Or is it opaque? And then the automation part, which is 1/3 of AMC, I'm not sure you've talked too much about that so far. I know that the recovery there was a big part of the sort of Q4 EBITDA ramp in AMC. So maybe just how are you seeing sort of demand and project conversion into revenue there?

Robert J. Rehard, CFO

Great. Thanks, Julian. Let me take the first part of your question, which was related to the plant shift that I believe you're questioning. What that was? It was a footprint-related shift that we had. Isn't it?

Louis Vernon Pinkham, CEO

Actually, let me jump in. This is around the plant that we shut down in Q2 because of rare earth.

Robert J. Rehard, CFO

Got it.

Louis Vernon Pinkham, CEO

The plant is currently operational, though not at full capacity. We are receiving a consistent supply of rare earths, which is reflected in our guidance indicating a recovery starting in Q3. We feel optimistic about this, but we still need to address the $10 million shortfall we mentioned earlier, which we expect to recover by Q4. Regarding the medical market, while it may seem unclear at times due to OEMs underestimating their inventory, we have strong partnerships with them. We're confident that demand will align with our supply as we move towards the end of this year and into next year. As for automation, it's a key area of growth for us. Our automation segment saw a 4.5% increase in our 12-month order rolling rate in discrete automation, with our backlog rising in low double digits for shipments in the second half and up 12% year-over-year. This influx gives us confidence in our margins for the second half. I hope that clarifies your questions.

Julian C.H. Mitchell, Analyst

That's very helpful, Louis. And then one quick follow-up, maybe for you, Louis, again, on the sort of environment, I guess, of conversion of orders to revenue because you and many of your sort of short-cycle industrial brethren have seen good orders or better orders for the best part of the year, but the revenues seem stuck in the mud still. So I suppose maybe flesh out why you think that's happening? And is there maybe less visibility than in the past on the conversion rate of orders into revenue?

Louis Vernon Pinkham, CEO

Yes. Julian, we can improve how we analyze the data to provide better insights. However, I want to emphasize that we are not entirely a short-cycle industrial business anymore. Certain segments, such as PES, remain short cycle, but IPS and AMC are shifting towards a longer cycle. The main challenge in converting orders into sales lies within our larger projects and system solutions, which operate on longer cycles. We believe that in the second half of the year, both IPS and AMC will show mid-single-digit growth, indicating a positive trend. This improvement is closely tied to the strength of our orders in AMC and IPS, which have primarily come from longer-cycle projects and applications. I hope this explanation helps.

Operator, Operator

The next question is from Saree Boroditsky with Jefferies.

Saree Emily Boroditsky, Analyst

Could you elaborate on your competitive position regarding the data centers? Are you experiencing demand from a wide range of customers, or are you heavily dependent on a single customer, considering you mentioned several significant orders from the same client?

Louis Vernon Pinkham, CEO

Thank you for the question. Let me address the second part first. We received a few orders in July that we are pleased with from various customers, so we are not reliant on just one. We highlighted the $35 million specifically because we have been working on that project for some time and anticipated it would close in the second quarter, but it actually closed in July. I can confidently say that our pipeline has never been stronger in the data center sector. With the growth of hyperscale data centers, we are well-positioned. Our competitive advantage lies in our ability to offer customized solutions and controls. Many of our larger competitors tend to focus more on standard offerings, but we excel in collaborating with data center designers to create tailored solutions, which is highly valued. Therefore, we feel optimistic about our position and foresee it contributing positively to our growth into 2026.

Saree Emily Boroditsky, Analyst

Yes, I appreciate the color. And then again, like thanks for all the detail on the orders. The data center obviously helped in July. So could you just provide some color on what you saw excluding this large order? And just anything on underlying demand trends within July because I think you provided the quarter, but not just July without it.

Robert J. Rehard, CFO

I believe that the orders would be up slightly, excluding that large data center order in July.

Operator, Operator

The next question is from Nigel Coe with Wolfe Research.

Nigel Edward Coe, Analyst

Can we discuss the margin outlook for the second half regarding AMC? You've expanded the margin range for AMC, which now shows a spread of four percentage points, estimated between 21% and 25%. Considering the current backlog visibility and the recovery of rare earth metals, could you explain what factors are influencing the high and low ends of this range? Additionally, regarding rare earths, it appears that the situation isn't fully resolved for U.S. manufacturers based on our information. Could you elaborate on what progress has been made and whether it involves a multiyear sourcing agreement? Any insights would be appreciated.

Robert J. Rehard, CFO

Sure. Let me start by discussing the AMC margin and the guidance we provided. We slightly adjusted the range to better align with our comments regarding rare earth exposure within AMC. The latter half of the year, particularly the fourth quarter, is expected to show a significant increase in shippable backlog, up by low double digits, an improved mix within that backlog, and continued progress in catching up on deliveries of products incorporating rare earth magnets, which we anticipate will be resolved by year-end. A lot of this will be concentrated in the fourth quarter, and these products generally have higher margins. We also expect that conditions in the medical market will start to stabilize as we move through the second half of the year, which has been a major challenge for volume and margins. Additionally, cost pressures related to rare earth materials should ease. Currently, we are paying higher premiums, but we expect these costs to decrease as the year progresses.

Louis Vernon Pinkham, CEO

Let me address your question about rare earth in summary. For the past four months, I have participated in one or two calls each week with our teams to manage this situation. There is no doubt this could be a better use of time, but our strength lies in our disciplined approach. We have been dual sourcing and collaborating with other suppliers to increase supply. However, it is important to note that 90% of the supply comes from China, which limits our options. We have also shifted production to increase assembly in China, where it is easier to obtain approvals for applications when products are manufactured there. Currently, we are confident that we have met all commercial application and product demand needs for this year. The situation with defense is more complicated, primarily due to trade agreements and our relationship with China. This will also need to be dual sourced, and we are actively working on it. We believe we have a clear path forward for this year, but it is definitely a dual sourcing effort. Overall, I hope it is clear that we are disciplined in our operations and management. I cannot thank our team enough for their efforts, and we feel good about resolving these issues throughout the year. I hope this instills confidence.

Nigel Edward Coe, Analyst

No, it does help, and great job on resolving that issue. It sounds quite challenging. Regarding the accounts receivable facility, I understand the reasoning behind it. It certainly improves your leverage ratios. Could you please discuss the boundaries regarding the capacity? Currently, it's about $4 million. What will the capacity be going forward? I want to ensure that the costs related to the program fall under interest. I believe they do, but I'd like to confirm that.

Robert J. Rehard, CFO

The program is renewable on an annual basis, and it is priced at about 150 basis points below the current rates for the revolver and term loans, resulting in approximately $4 million in annual savings. We have the option to continue with the renewal of the program or reduce it as needed, with a maximum limit of $400 million. However, we can adjust it to any level we deem appropriate. More details regarding the representation of these costs in our financial statements can be found in the slide appendix. Under the accounting rules, interest expense on the ARS facility is recorded in selling, general, and administrative expenses. We plan to exclude this expense from our adjusted EBITDA calculation since it is considered interest expense but will keep it in adjusted EPS. All these specifics are included in the appendix of the presentation.

Operator, Operator

The next question is from Tim Thein with Raymond James.

Timothy W. Thein, Analyst

The first question I have is for you, Louis. I'm interested in your thoughts on the AMC business and the idea that we could see a domestic manufacturing recovery in the future. This has been a topic of discussion for a while now, and given the incentives from the recent tax reform, it could lead to increased domestic manufacturing activity. I'm aware that this wouldn't immediately reflect in project quoting or pipelines, but I'm curious about your long-term perspective on this possibility and any discussions you've had with customers regarding it.

Louis Vernon Pinkham, CEO

Yes, I believe we are seeing more dependence on the rebound of industrial production markets. The ISM index has been below 50% for over two years, and any improvement in this area will positively impact both our IPS and AMC segments. The reason we pursued the acquisition of Altra is our desire to enter the automation sector, as we strongly believe that automation will increase, especially given macro trends like labor inflation and low unemployment rates. Regarding reshoring, there are certainly specific areas like semiconductors and some acceleration in data centers, but I wouldn’t categorize that as reshoring. All these trends will benefit Regal. However, we have not yet seen a notable acceleration nor are we hearing many opportunities related to reshoring at this time. That’s my viewpoint based on our discussions with customers.

Timothy W. Thein, Analyst

Okay, understood. Can you provide insights on the pickup in activity for IPS and how that aligns with the feedback from your distributor customers, particularly in the domestic market? I'm just curious if you can elaborate on that.

Louis Vernon Pinkham, CEO

Yes, that's a great question. It connects to a previous inquiry about our expectations for growth in the second half of the year, which we anticipate will be driven by longer cycle projects ramping up. You're correct that some public companies reported low single-digit declines in volume sales within the distribution sector. However, we believe this is related to the ISM index remaining below 50% for over two years. We are optimistic that industrial production will show improvement, albeit modestly, by 2026 when we expect the ISM index to rise above 50%. As we look ahead to August, I'm providing our forecast for 2026. We do not anticipate any significant increase in our distribution sales for the latter half of 2025. I hope that clarifies things, Tim.

Operator, Operator

The next question is from Joe Ritchie with Goldman Sachs.

Joseph Alfred Ritchie, Analyst

So I know we've talked about the rare earth topic maybe at nauseam at this point, but I do have another question. We haven't really heard much issues with rare earth from some of your peers or really across the sector. I'm just wondering, Louis, you provided some commentary around being dual-sourced for portions of it. Like is it something about the way you're sourcing supply chain that it was a bigger issue for you guys this quarter than maybe some of your peers? And then the follow-on to that is, are you at all concerned about any share loss associated with those programs?

Louis Vernon Pinkham, CEO

Well, first of all, our peers in this space tend to be more private companies than public companies. You're not going to see a direct peer here in providing ultra-high precision motors for comparison, certainly not in the public company space. We actually think we're in a better overall supply chain situation because of the global nature and our ability to shift production to China to support this challenge. So we do not feel we're losing market share. If anything, a couple of the private peers are in countries facing significant tariffs, and as long as those tariffs remain, we believe there may be opportunities as we are quoting on some projects that could allow us to gain some share. It has been relatively challenging, but the team has done a great job managing through it, and we see this could actually present potential upside for us.

Joseph Alfred Ritchie, Analyst

That's interesting. That's helpful color, Louis. And then just real quickly on the near term. Also for AMC, just given that the guide is the widest there, both from a sales and EBITDA margin standpoint. And my guess is that it is related to like how quickly you get availability of the rare earth magnets that you're using. But maybe just provide some level of confidence in that range? And what are kind of the biggest swing factors for the third quarter?

Louis Vernon Pinkham, CEO

Yes. So you're spot on around why we opened up the range a little bit more in Q3. Right now, the flow of magnets is pretty strong. And I would say the reason why there's potential upside is some of these data center orders and being able to move a little bit faster in execution towards the end of Q3 if that's possible. So you're right, we opened it up for that reason, but we feel pretty good on the 6th of August that the flow of rare earth is what we expected based on the guide, and our opportunities are to hit the midpoint is pretty confident.

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 Vernon Pinkham, CEO

Thank you, operator. And thanks to our investors and analysts for joining us today. Our team delivered strong performance in the second quarter, and we look ahead to the back half of the year and into 2026. We are optimistic about the positive momentum we are building, given our last 12-month order trends, growing backlog, ample remaining cost synergies, growing cross-sell synergies, a healthy new product pipeline and tailwinds to earnings and cash flow from further balance sheet deleveraging. We believe this momentum, coupled with our valuation makes Regal Rexnord a unique value creation opportunity for our investors. Thank you again for joining us today, and thank you for your interest in Regal.

Operator, Operator

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