Timken Co Q1 FY2022 Earnings Call

Good morning. My name is Christina, and I will be your conference operator today. As a reminder, this call is being recorded. At this time, I would like to welcome everyone to Timken's First Quarter Earnings Release Conference Call. Thank you, Mr. Frohnapple, you may begin your conference.

Thanks, Christina. And welcome, everyone, to our first quarter 2022 earnings conference call. This is Neil Frohnapple, Director of Investor Relations for The Timken Company. We appreciate you joining us today. Before we begin our remarks this morning, I want to point out that we have posted presentation materials on the company's website that we will reference as part of today's review of the quarterly results. You can also access this material through the download feature on the earnings call webcast link. With me today are The Timken Company's President and CEO, Rich Kyle; and Phil Fracassa, our Chief Financial Officer. We will have opening comments this morning from both Rich and Phil, before we open up the call for your questions. During the Q&A, I would ask that you please limit your questions to one question and one follow-up at a time to allow everyone a chance to participate. 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 on today's press release and in our reports filed with the SEC, which are available on the timken.com website. We have included reconciliations between non-GAAP financial information and its GAAP equivalent in the press release and presentation materials. Today's call is copyrighted by The Timken Company, and without expressed written consent, we prohibit any use, recording or transmission of any portion of the call. Finally, I would like to announce that we are planning to host an Investor Day on Wednesday, September 28, in New York City. So, please stay tuned for more details. With that, I would like to thank you for your interest in The Timken Company, and I will now turn the call over to Rich.

Thanks, Neil. Good morning and thank you for joining us today. Timken delivered an excellent first quarter, with record revenue, record earnings per share and 20% EBITDA margins. We delivered these results in the face of continued inflationary pressures, supply chain challenges, and lingering COVID issues. Our performance demonstrates the resiliency of the company and builds on our track record of delivering strong financial results through industrial cycles and dynamic market conditions. In the quarter, demand continued to be very strong across almost all markets and geographies. Despite persistent supply chain and COVID challenges, we increased revenue by 10% over last year's first quarter and by almost 12% compared to the fourth quarter. Even with the strong revenue, incoming orders continued to outpace shipments and backlog grew sequentially. We achieved neutral price cost in the quarter, which was the primary driver of the improved EBITDA margins. We re-priced many of the annual contracts at the start of the year and we continued to adjust spot and aftermarket pricing throughout the quarter. We are on track to achieve greater than 4% price this year. Earlier in the year, we forecasted that costs would hold at fourth quarter levels, and that is largely what happened until late in the quarter when we saw our costs tick higher after the Russia-Ukraine war began. As a result, price realization in the quarter completely offset the significant year-on-year increases in material, logistics, and manufacturing costs, which were essentially flat from the prior year. Sequentially, performance strengthened each month through the quarter, both operationally and financially. COVID and supply chain issues persisted, but improved as the quarter progressed. However, the Russia-Ukraine war and the COVID disruptions in China did not become issues until late in the quarter, and we are assuming they will both have a bigger impact on the second quarter results. More on that in a moment. In terms of capital allocation, we repurchased 1.5 million shares in the quarter, or approximately 2% of the outstanding shares. We also paid our 399th consecutive dividend. On Friday, we announced the acquisition of Spinea. Spinea is a technology leader in serving robotics and automation OEMs, particularly in the factory automation sector. This business is an excellent complement to Cone Drive. Together, these businesses will provide customers a package of leading technology solutions for their factory automation systems. Spinea comes to Timken as a solid financial performer with pre-synergy EBITDA margins of around 20%. We are excited to welcome Spinea employees to Timken. Overall, it was an excellent start to the year. Timken has established its ability to deliver results in varying economic and geopolitical conditions, including inflation and, unfortunately, a war in Europe. Timken will perform well in an inflationary environment. While rising commodity prices and input costs may pinch our margins in the short term, as they did at the end of last year, we will recover those costs in the market over time. And while the inflation we've experienced in the last year is significantly more pronounced than anything we have seen in the last couple of decades, we remain confident that we can recover input costs in the market through pricing, and the first quarter demonstrated that ability. Turning to the outlook, uncertainty remains elevated, and the range of possibilities for the rest of the year remains wider than normal. We lowered our revenue outlook slightly for the full year due to the potential headwinds from the Russia-Ukraine war, currency fluctuations, and the continuation of supply chain issues. We suspended our operations in Russia near the end of Q1, and we are assuming in our guidance that there will be no revenue from Russia for the remainder of the year. Last year, Russia accounted for about 1% of our sales. The change in revenue outlook is not a reflection of current demand for our products or our ability to supply. Demand for our products continued to grow through the first quarter and remains very strong. The pricing environment for Timken is also very positive. Pricing took a step up in Q1 from the fourth quarter, and we expect it to continue to increase modestly through the remainder of the year. We have continued to increase production levels through capacity additions, increases in staffing, and through productivity gains. We are in a good position to deliver 10% organic revenue growth for the full year. This assumes that our customers and suppliers all continue to deal with various supply chain issues at an elevated level throughout the year. Across the company, April shipments continued at roughly March's pace, despite a slowdown in China due to COVID restrictions and no revenue from Russia. Overall, the demand situation is stronger than our revenue outlook as we continue to assume in our forecast that there will not be any significant improvement in supply chain performance throughout the year. As I mentioned, our China revenue was impacted in April due to COVID restrictions. Our plants are running and have not been significantly impacted, but customer shipments, as well as exports, are both down as customers and logistics networks have been affected. We have assumed that this will improve by the end of the second quarter and will not be an issue in the second half, but that remains uncertain. From an earnings perspective, we are holding onto the prior guidance range of $5 to $5.40, which reflects the higher level of uncertainty we are facing. We are assuming our costs to be higher in the second quarter than they were in the first and to hold at these higher levels for the rest of the year. We saw energy, steel, and commodity prices increase with the start of the war, and other costs, including logistics, have not eased. We don't know if the recent uptick in costs will hold or be transitory, but I would say that we are being significantly more cautious on our cost outlook than we were at the same point last year. Last year at this time, we assumed that much of the inflation would be transitory. This year, we are assuming that it will be permanent. We are, of course, working tirelessly to mitigate both the inflation and supply chain costs and there's also the possibility that costs ease through the balance of the year, but we are also preparing that we will need to realize more pricing both this year and in 2023 to offset the net impact of these higher costs. We expect cash flow to seasonally improve the rest of the year but to remain well below 100% conversion. This is due to an increase in working capital to serve the growth and to mitigate supply chain challenges. Our balance sheet remains strong. We remain active in the M&A market and we expect to continue to allocate capital through the remainder of 2022. In closing, I want to reiterate that our performance over the last several years, including our first quarter results, demonstrates the enduring strength of our product portfolio, the diversity of our market mix, and the capabilities of the Timken team. Timken has been a mid-to-high teen EBITDA margin business every year for over a decade. This has been achieved through the highs and lows of industrial cycles, falling and rising commodity prices, special tariffs, currency swings, the pandemic, and now, most recently, through inflation, unprecedented supply chain challenges, and a war. Through all of those conditions, whether positive or negative, demand for Timken products and technology remained strong, and we continue to grow and deliver for our customers, investors, and employees. In 2022, Timken is on track to deliver record revenue and earnings per share for the fourth year out of the last five, while at the same time continuing to advance our strategy to grow the Company's industrial leadership position.

Okay. Thanks, Rich, and good morning, everyone. For the financial review, I'm going to start on Slide 14 of the presentation materials. Timken delivered a great start to the year, with strong performance across the board in the first quarter, and you can see a summary of our financial results on this slide. Revenue in the quarter was over $1.1 billion, up about 10% from last year and a new record for the company. We delivered an adjusted EBITDA margin of 20% and we achieved all-time record adjusted earnings per share of $1.61. Turning to Slide 15, let's take a closer look at our first quarter sales performance. Organically, sales were up 11% from last year, which reflects broad growth across most markets and sectors as well as higher pricing. On the right-hand side of the slide, you can see organic growth by region, excluding both currency and acquisitions. All regions were up in the quarter versus the year-ago period, led by the Americas. Let me add a little color on each region. We were up 22% in Latin America, as most sectors were up year-on-year, with industrial distribution and rail posting the strongest gains. In North America, our largest region, we were up 14%, with most sectors up there as well, led by distribution, off-highway, and marine. In Europe, we were up 11%, with strong growth in distribution, off-highway, and general industrial. This was partially offset by lower renewable energy and Russia rail shipments. And finally, in Asia, we were up 3% as sales were down in China from the very strong first quarter of last year, but solidly up across the rest of the region. From a market standpoint, rail was notably up, while automotive was lower. Turning to Slide 16, adjusted EBITDA was $225 million or 20% of sales in the first quarter compared to $204 million or 19.9% of sales last year. Adjusted EBITDA was up $21 million or 10%, with margins up 10 basis points from last year's strong first quarter. We delivered a sizable step-up in margins from the fourth quarter. Looking at the change in adjusted EBITDA, the biggest thing that jumps out is that price mix and material and logistics costs fully offset each other in the first quarter. This allowed us to capture the benefits of our strong organic volume growth, which more than offset the impact of higher SG&A expense. Let me comment a little further on a few of these items. As I mentioned, price mix was positive in the quarter, with pricing being meaningfully higher in both mobile and process industries, reflecting our recent pricing actions. Mix was also positive, driven by strong distribution sales. Moving to material and logistics, as expected, we saw a significantly higher cost in the first quarter compared to last year, driven by inflationary pressures and supply chain challenges, but I would point out that these costs were largely in line with fourth quarter levels. On the SG&A line, costs in the first quarter were up in dollars, supporting the higher revenue and reflecting annual compensation increases, but SG&A was down as a percentage of sales, as we continue to leverage our cost structure very well coming out of COVID. And finally, I want to touch on manufacturing performance. In the quarter, we benefited from higher production volume and achieved productivity improvements, but this was fully offset by the impact of higher energy, labor, and other costs, as well as continued supply chain-related inefficiencies. On Slide 17, you'll see that we posted net income of $118 million or $1.56 per diluted share for the quarter on a GAAP basis. This includes $0.05 of net expense from special items, driven largely by Russia-related charges. On an adjusted basis, we earned $1.61 per share, up 17% from last year and a new Timken record for any quarter. You'll note that we had fewer shares outstanding on average in the first quarter compared to last year, reflecting our buyback activity. Our first quarter adjusted tax rate was 25.5%, in line with last year. Now, let's move to our business segment results, starting with Process Industries on Slide 18. For the first quarter, Process Industries' sales were $584 million, up more than 12% from last year. Organically, sales were up 13%, driven by growth across most sectors with distribution and general industrial posting the strongest gains. Heavy industries, marine, and industrial services were also up, while renewable energy was down modestly as expected. Pricing was also positive in the quarter. Process Industries' adjusted EBITDA in the first quarter was $158 million or 27.1% of sales compared to $136 million or 26% of sales last year. The increase in segment margins was mainly attributable to the impact of higher volume and positive price mix, which more than offset higher operating costs in the quarter. Now let's turn to Mobile Industries on Slide 19. In the first quarter, Mobile Industries' sales were $540 million, up roughly 7% from last year. Organically, sales increased nearly 9%, with off-highway and rail posting the strongest gains. We were also slightly up in aerospace and heavy truck, while automotive was down modestly against a challenging comp last year. Pricing was also positive in the quarter. Mobile Industries' adjusted EBITDA for the first quarter was $79 million or 14.7% of sales, compared to $80 million or 15.9% of sales last year. So, EBITDA dollars were roughly flat year-on-year. The decline in segment margins was driven by the impact of higher operating costs, which more than offset the benefits of higher volume and positive price mix. While Mobile continued to be more negatively impacted by cost headwinds than Process Industries, I would point out that margins in Mobile were up over 600 basis points from the fourth quarter, driven by a significant improvement in price cost. Turning to Slide 20, you'll see that operating cash flow was just slightly negative in the first quarter, reflecting higher working capital to support our sales growth and customer service. After CapEx of $34 million, our free cash flow was negative $35 million. The first quarter is normally the lowest quarter for cash flow given seasonal working capital needs and our annual incentive compensation payouts in March. We expect a significant step-up in cash flow over the course of the rest of the year, but it will be more back half-weighted. Taking a closer look at our capital structure, we ended the quarter with net debt to adjusted EBITDA at 1.8 times, well within our targeted range. Note that gross debt includes the $350 million 10-year bond issuance we completed in March. This provides us with additional financial flexibility at an attractive fixed rate of 4.125%. It will also enable us to fund the Spinea acquisition with cash that's already on hand. From a capital allocation standpoint, during the first quarter, Timken returned $124 million to shareholders through the repurchase of 1.5 million shares of company stock and the payment of our quarterly dividend. The step-up in share buybacks during the quarter demonstrates our confidence in the long-term outlook for the business and our commitment to consistent and accretive capital allocation. Now let's turn to the outlook with a summary on Slide 21. Our first quarter performance was a terrific start relative to the full-year earnings outlook we provided three months ago. However, the level of uncertainty has risen over the past couple of months with the Russia-Ukraine conflict and ongoing COVID lockdowns in China. Given this uncertainty, we have decided to hold our full year earnings outlook and continue to evaluate it as we move through the rest of the year. Though our full year earnings guidance is unchanged with adjusted earnings per share in the range of $5 to $5.40 per share, which would be up 10% from last year at the midpoint and a new record for Timken. The mid-point of our earnings outlook implies that 2022 adjusted EBITDA margins will be roughly flat with last year, which is modestly better than our prior outlook. Our outlook assumes a step-up in inflationary pressures and supply chain inefficiencies over the remainder of the year compared to our prior guidance. To the extent these headwinds don't materialize as assumed or are transitory, or to the extent we can otherwise mitigate them, it would provide upside to the guidance. Turning to the revenue outlook, we're now planning for revenue to be up around 8% in total at the midpoint versus 2021 compared to 10% in our prior outlook. The 2% reduction is comprised of 1% organic and 1% currency. Organically, we now expect revenue to be up 10%, compared to 11% in our prior outlook. This change reflects the impact from suspending operations in Russia, and the expectation for continued supply chain disruptions. We continue to see solid demand across most markets and sectors, and we also expect to benefit from growth initiatives and positive pricing. Our demand outlook is supported by our strong backlog as well as incoming order rates and customer sentiments. With respect to currency, we now expect a 2% headwind on the top line for the full year, up from 1% in our prior outlook. This is based on April spot rates, which reflect the strengthening of the US dollar versus key currencies since the beginning of the year. Please note that our outlook does not include any revenue from Spinea, which is expected to close in the June timeframe. Moving to free cash flow, for the full year, we estimate conversion at around 65% of net income. We expect CapEx in the range of 4% to 4.5% of sales, which includes several growth-related projects and other initiatives to improve productivity and margins. For 2022, we anticipate net interest expense to be roughly $65 million, reflecting the recent bond issuance and our expectation for higher variable interest rates, and we estimate that our adjusted tax rate will be around 25.5%, in line with the first quarter, but up slightly from our prior guidance. To summarize, Timken delivered an excellent start to the year and we remain well-positioned to achieve record results for 2022. Our team remains focused on driving our profitable growth strategy, winning in the marketplace and performing well through this ever-changing environment.

This concludes our formal remarks and we'll now open the line for questions, operator?

We'll take our first question from Rob Wertheimer with Melius Research.

So, actually, my first question—and my question is really just going to be a strategic one with the Spinea acquisition, which looks pretty interesting. I wonder if you could compare the technology of Spinea to what you do currently. You mentioned highly engineered. I don't know if it's a bit more advanced. I wonder if you could describe. I understand it fits well into kind of automation end markets, which are growing nicely, but does it also represent a branch into more highly engineered products? Does it expand your total addressable market (TAM) on acquisitions? And, does it open up new avenues for future growth? Thanks.

Yes. Thanks, Rob. So, Cone Drive has organically developed what we call the harmonic drive for robotic applications and Spinea's specialty is cycloidal drive. The differences lie in the torque and weight—it’s a very complicated subject, simplifying it, generally bigger, heavier applications would lean towards the Spinea solution while smaller joints or lighter duty would lean towards Cone. Now, we'll have a full complement of products. I would say the precision level and complexity is similar for both. But two things: one, we want to fill this out, and two, since we're organic, we're working our way into that market in Cone's case, and it's taken us some time. But now, we just acquired a significant position. So, customer access for Spinea has been cultivated for 20 or 30 years while Cone's has been at it for just a few. In terms of your follow-up question, there are actually some other similar adjacent products that we still don't have in this, and also opportunities moving beyond factory automation into a bigger presence in guided vehicles and other precision drive applications. Spinea, specifically, has a strong European history, and an enormous Asian market where their presence is quite small. So, we believe being part of the Timken family can significantly enhance their growth there. So, while it's not a huge acquisition, it’s a very exciting one for us in a remarkable growth market.

Okay. Thanks, Rich. And then, for my last question regarding your general feeling on the acquisition pipeline, is it active right now in periods of uncertainty?

I think our activity level is good. I would say it's fully back to where it was pre-pandemic. And then, also, as we discussed in either the last call or the one before that, we spent some time on larger possibilities, but I would say we're now back to focusing 100% on cultivating and actively pursuing small to mid-size deals, which you've seen us do, say, at the size of Spinea, up to two to three times that size. That's where we're focused. We've got a lot in the pipeline and I would be hopeful that Spinea would not be our only acquisition closed in 2022, but obviously, a lot of factors are at play.

Go to our next question from Bryan Blair with Oppenheimer.

I apologize if I missed this detail, but could you break out the volume and price contribution that's now factored into your 10% organic sales outlook? I think it was 7% and 4% last quarter or thereabout. And I'm assuming that we now have a few more balances or perhaps some price weighting to revise that.

Yes, Bryan. Thanks for the question, and welcome to the call. On the sales outlook, I think you heard Rich talk about pricing coming in as we thought. We expect to achieve greater than 4% pricing for the full year, and the rest of that would come from volume. We're not getting more specific on the pricing breakdown than that. You heard from Rich that the Q1 pricing came in as expected. We continue to adjust spot pricing through the quarter and look at aftermarket pricing, feeling confident that we'll exceed our 4% target for the year. So, you can think about the rest being in volume, as we discussed strong growth across sectors. The only sector that will be flat for the year, as we anticipated, is renewable energy, which should stay flattish for the year, but the rest of the markets are strong across the board.

And just to be clear, it's 10% organic. We start with a little bit of a headwind from FX.

Yes. Understood. I appreciate the color. And no surprise that your cost profile steps up sequentially. I was wondering if you could offer a little more detail on that front, how we should think about the impacts on a segment basis. You had mentioned that Mobile is understandably facing a little more pressure there and how that influences segment margin outlook and cadence for the year?

I would say, first, our operational performance on supply chain challenges improved as the quarter progressed. Going back to January, we were dealing with significant Omicron cases, high absenteeism in our plants, and delays in the supply chain. These issues persisted, so I wouldn’t say they completely disappeared, but we did see some positive momentum on that front. However, when the Russia-Ukraine war broke out, energy costs primarily in Europe surged, and global steel prices went up, particularly scrap prices in the US increased significantly almost immediately. We had expected logistics costs to ease, but they have instead held steady. So, we’ve been cautiously assuming that these costs will remain elevated for the rest of the year.

Go to our next question from David Raso with Evercore ISI.

Maybe I missed it, but could you provide the margin cadence for the year? Just given the fourth quarter, you would think there would be a relatively easy year-over-year comp, but it looks like you're implying the rest of the year maintains margins that are only flat year-over-year. Can you help us with that, particularly for Q2?

Yes. Thanks, David. The guidance assumes we still would expect some second-half improvement in the margins year-over-year. We think we’re being conservative relative to the guide; that's why we held our earnings guidance. We do expect costs to tick up a bit, particularly in Q2, and then sustain those levels for the rest of the year. So, we expect second-half margins to improve year-over-year.

Just so we level set, on the second quarter, year-ago EBITDA margins were 18.8%. Just to give us some framework here a little bit. I mean, is it 150 bps lower year-over-year? I think we're all just trying to square up the price costs for 1Q. How much does it go negative again in 2Q to drive that margin down? And then...

Yes. David, I don't think we want to go into second quarter specifics and outlook. But, to add more color to what Phil said, our EPS has ranged from 51% in the first half to 58% in the second half over the last four years. We do have some seasonal parts of our business that are consistent. Both in '19 and '21, it was in the higher '50s. Last year, this was impacted by rising costs, and '19 saw a little easing in volume. So, the mid-point of the guide implies a slightly heavier weighting in the first half relative to the second half.

That's very helpful. And when it comes to raising prices compared to your original thoughts based on your cost outlook, have you already seen these cost increases, or are you preparing to revisit the market since your original increases?

We did see a step-up in pricing from Q4 to Q1. Some of our global distribution prices went up mid-quarter. Not all that was in the run rate. We have contracts opening mid-year. So, I think what we're assuming in the guide is a similar progression of modest price increases for the remainder of the year. That being said, as we've gone through contracts this last year, we are increasingly structuring our commercial negotiations to incorporate more flexibility. We have a lot of pricing mechanisms, a lot of indexes, contract spot pricing, and quotes, etc. We've been trying to obtain better coverage.

And just to summarize that, you have more flexibility for the next 9 months than if we had the same conversation 12 months ago.

Yes, it's flexibility with more coverage or better terms that cover our indexes.

And we'll take our next question from Stephen Volkmann with Jefferies.

A couple of demand questions, if I could. I know you said Russia was somewhere around 1% of your sales. I think it was actually more for some of your large competitors. I’m just curious if there's any type of an opportunity there to backfill some of the other shortfalls based on that?

Yes. I think we can look at historical business in Russia as being divided into two parts. The rail business produced in Russia, sold in Russia, is probably gone. The non-rail business produced outside of Russia, sold into Russia has a potential to redirect that capacity and revenue to other locations since market share itself is gone. We believe that market is currently being served by others.

And perhaps the other point to highlight is that some of our competitors may have larger market footprints. Our footprint in Russia is mainly in rail; and while the rest of the business is served from outside Russia, taking into account that those with larger regional footprints will be impacted more significantly.

Right. That's what I was...

We're really clear that historically, we were only in the rail market and in metals and commodities markets—not in automotive or truck segments. But I realize some of our competitors have market positions in those industries as well.

Okay. And then, on the flipside, everybody is watching for signs of demand destruction, because obviously, you're not the only one seeing cost increases. So I'm curious if there is any— does it look like it based on your end market chart, but is there anything that you’re worried about relative to demand and demand destruction on price?

No. We haven't seen anything you could point to. I think the war certainly makes people a little more nervous, ourselves included, but there's been nothing significant. The one factor we can point to today is China with the lockdowns. However, there's a general sentiment that this won't adversely affect demand, and when the lockdowns ease, things will return to normal. This was reminiscent of what happened back in early '20. So, we think that possibility is quite plausible. Still, we've seen no negative impact on demand from pricing or from the war, and the demand situation remains very strong.

Moreover, when inspecting markets like Process, heavy industries tend to move slower, but we've seen significant year-on-year improvements, primarily driven by OEM demand coming from industries like metals, aggregates, pulp and paper, and even oil and gas. The momentum is robust across the Process portfolio, except for renewable energy, which we anticipated to be stable this year. On the Mobile side, we noted a sequential increase in railway traction despite the Russia impacts. So, overall, we see solid momentum in off-highway and other sectors, reinforcing a favorable outlook.

Go to next question from Chris Dankert with Loop Capital.

I guess, first off, thinking about the automation portfolio now, is that principally serving machine builders, more end users? Is it a healthy mix of both? And then, just any comments you can give us on growth rates in that business during the first quarter here?

Yes. The largest portion of that market for us is automatic lubrication systems, which serve various markets, replacing manual lubrication processes. That's the solution itself. Moving into end markets, our second biggest market before Spinea would be automated warehouse systems. Rollon has a solid position there along with a couple of other product lines. So, it's a mix. But I think going back five or six years ago would have been sub-1% of the company, because we weren't in automatic lubrication systems in these other markets. I won’t disclose the specific growth rate for the first quarter, but I think the trend has overall been positive, high single-digit type growth. What we’re seeing emerging from the pandemic only increases the demand for automation because of labor shortages, the tendency to reduce labor intensity while boosting output, and development in emerging markets, such as China and India are also promising. In that context, we remain very optimistic about the future prospects.

Got you. And that's really, really helpful, thank you. And then, you have mentioned renewable energy. I think everyone understands that you have some pretty massive comps to deal with in that business, and that's why it's flattish this year. But again, in order rates and interest in that business, do you feel like—for 2023, we should be able to get back to growth in that market specifically?

Yes. So, to backtrack on your specific question, I really think when reviewing our revenue trends over recent years, it exhibits the benefits of having a diverse market base. Renewable energy drove our business in 2020 during the pandemic while China kept us afloat during other periods. This year, however, other end markets and global regions are expected to carry us. Regarding renewable energy specifically, we ended last year on a lower note, resulting in expected declines this quarter. Crucially, we needed strong order flow to support the second-half growth, which has indeed materialized. Given recent developments around energy independence and geopolitical circumstances influencing investment in these markets, we are more confident than ever that this sector will facilitate growth. However, like with other forecasts, we started slow this year and are currently hopeful that China resolves its situation swiftly, especially as backlogs increase and orders build. Customer sentiment for the latter half of the year appears to be very promising.

We'll take our next question from Joe Ritchie with Goldman Sachs.

Could you elaborate a little bit more on what's happening on the ground in China? I know it's about mid-teen percentage of sales for you guys? The environment has been very fluid, especially since the end of the quarter. So, any color on end markets and specifically what you guys are observing?

Yes. Our observations depend heavily on the location of our factories and those of our clients. Our factories have been minimally impacted; we’re not positioned in Shanghai or Beijing, where lockdowns are more severe. However, many of our employees in Shanghai have been unable to leave their homes or access the office for some time, yet we still manage operations. However, ports and trucking have been greatly affected, and certain customers are facing difficulties depending on their geographic locations. We've noticed a decline in China revenue, with a double-digit drop in April compared to March. We anticipate a continued decline in May; however, our internal sentiment is that this situation will resolve relatively quickly. The optimistic view is that by the end of this month, operations will return to normal. For now, though, the outlook is still uncertain. I would say we do not see a scenario where there’s a 40% to 50% drop, and the industry continues to operate.

Got it. That's helpful. And then is it impacting your Mobile market more than your Process market at this point?

No. I would suggest that there's little correlation. It tends to be more of a Process Industries’ market for us, particularly due to renewable energy. So, I’d say there’s probably an even impact between the markets, but in dollar terms, it primarily affects Process.

Okay. Got it. And then, for my last follow-up, I noted you break out on the dollar basis for materials and logistics impact year-over-year that seemed to decline in the first quarter versus the fourth quarter. So, I was just curious if you’re seeing any easing for either, and where you’re seeing a little less pressure?

I'm not certain about the decline from the fourth quarter to the first you're referencing, in dollars. I think it was mostly flat. I would have said material costs were somewhat flat to down slightly on a unit cost basis. However, we did see an uptick in April after the war began, causing commodity prices and alloy costs to rise. Logistics are a bit off their peak, which saw a dramatic rise from a year ago. So, while there are some positive signs, we are cautious about any assumptions regarding easing, especially given the current exposed situation.

We'll go to our next question from Steve Barger with KeyBanc Capital Markets.

Rich, going back to your comments on how strong demand is in most end markets. We’re aware that orders for many of your customers have been robust in Q1, and backlogs are sizable across the board. What are the actual pinch points in production that could affect your ability to supply at higher rates?

Well, I think the conservatism comes from us, as well as our customers. They may say they need a thousand of a product over the next months, but their labor issues could hinder that. While demand is strong, it’s often not as smooth as we would typically like. Starting upstream, we’re certainly up from where we were a year ago, but we still have occasional challenges regarding materials where supply is either short or variable. We are actively hiring to strengthen our production capacity globally, but we're facing some setbacks with specific components like electrical parts impacting our automatic lubrication systems. It should also be noted that during January and February, we had a significant level of absenteeism in our facilities, though this started improving in March. But now we have magnified complications occurring due to the situation in China. All of these factors contribute to keeping some inefficiencies and throughput levels in supply chains.

Would you say it's more your customers' inability to take that next step, or is it more internal in terms of your ability to secure electronic components or other materials?

I'd argue it's both. There are challenges on both ends.

Okay. And then on industrial automation, we’ve heard from some public OEMs and integrators noting growth in certain areas from high teens to above 30% across portfolios. Is there anything you can do to position for these higher-growth verticals in automation, or what’s your strategy to accelerate market share in this area?

I think there are both organic and inorganic strategies at play. The answer is definitely yes. Our move into lubrication systems fits into that aim and I think that’s a business we expect to see grow substantially faster than our overall portfolio tied to industrial GDP growth. It specifically targets labor shortages and focuses on improving equipment uptime and maintenance, which can defer capital cycles. We were initially doing quite well with the BEKA acquisition until the pandemic hit; we are now regaining traction here. We anticipate it will have substantial growth. Additionally, regarding factory automation, the Spinea acquisition is expected to follow a similar trajectory, allowing us to scale our position and benefiting from the consistent global demand driven by labor shortages and other factors.

Yes, and the pictures you have on slides 8 and 9 are of the bigger industrial robots. Are you also selling into the cobot space?

Yes. The harmonic drive that we have in our portfolio would tend to be on the smaller side while the cycloidal, which we just acquired from Spinea, would tend to serve the larger side, and often depending on which joint, segments and their characteristics could host both products. Our goal is to establish a presence in both categories.

And we'll take our next question from Courtney Yakavonis with Morgan Stanley.

Appreciated some of the color on the quarterly EPS distribution. Could you also just comment a bit on the revenue cadence for the year? Typically, Q2 is pretty similar to Q1, but given the COVID disruptions in North America in January and February, as well as the disruptions in China in Q2. Any thoughts on revenue cadence moving through the year?

Certainly. Typically, the first and second quarter generating peaks in both revenue and EPS tend to hover from 1% to 3% in growth. This year, however, we project a bit more caution given the loss of direct Russian revenue alongside the initial losses from China in April. Traditionally, we experience a 2% to 3% decline from Q2 to both Q3 and Q4. So, we expect that baseline to hold true again this year, but remain cautious.

Great. That’s helpful. And then just on some of the changes that you've called out on end markets, can you remind us what percentage of rail revenue comes from Russia? I think that was really the only end market you took out of the higher growth bucket and lowered expectations, assuming that all of that is related to Russia. The ex-Russia business is actually performing quite well, so if you could provide a bit more color on that too.

Yes. I would say globally, rail sales excluding Russia are performing well. It was a market that lagged last year. However, I believe the US rail market is set for a strong run-through and well into likely 2023. So globally, the rail market excluding Russia is pacing positively. As for Russian rail sales, it contributes call it 0.5% or slightly less of company revenue. Although this reduction lowers our estimates for the corporation as a whole, it is inconsequential in the grand scheme.

Speaking of industrial services, it showed solid year-over-year growth in the first quarter. This business primarily aligns with the industrial activity in North America, though it does operate globally. For the entire year, we noted notable improvement in backlog and bookings, suggesting stronger growth within this sector compared to our earlier expectations. Several sectors our services division targets are thriving, such as oil and gas. We're observing increased activity tied to global developments, with more robust industrial activity seen in the Americas and some positive trends across Europe to a lesser degree. Thus, seeing positive developments in bookings and activity in Q1 gives us confidence it will maintain through the year.

Go to our next question from Michael Feniger with Bank of America.

Filling in for Ross here. I appreciate that you have more flexibility on pricing than a year ago. If pricing is 4% in Q1 and your costs are rising, why is that 4% number not moving higher on a full year basis? Is it because of annual contracts, or are your competitors not raising pricing as aggressively? Please expand on that for us.

Yes. Our pricing metric is a year-over-year comparison based on the exact mix of parts sold. Last year around this time, our pricing was likely close to zero. By late in the second quarter pricing began to increase. To achieve 4% in the second half, we need to generate more pricing than we have today because the pricing comp becomes more challenging as the year advances. Although we foresee more pricing coming in, we’re not diving deeper into specific thresholds of how much more pricing to expect.

Fair enough, Rich. I’m curious, you made a comment about how inflation is not only transitory—does that permanence extend beyond just pricing? What changes might you consider in your operations from raising prices alone? Are you taking steps toward reshoring supply chains with critical suppliers? If you could comment on that portion, that would be great.

Yes. Certainly, on the labor side, we’re looking at how it could impact our CapEx and automation, and I expect a meaningful percentage of our annual CapEx spend will target either pure automation, or assets and equipment technology to enhance labor productivity and improve material conversion efficiency. We are also considering our operational footprint. Labor challenges vary globally, influencing our investment attractiveness. Historically, we may have held back on some facility investments due to fears about attracting labor, but now these concerns are much more valid, especially in smaller communities.

Yes, thanks, Christina, and thank you everyone for joining us today. If you have any further questions after today's call, please contact me. Thank you, and this concludes our call.

This concludes today's call. Thank you for your participation. You may now disconnect.