Earnings Call Transcript - VRT Q4 2021

Operator, Operator

Good morning. My name is Matt and I will be your conference operator today. At this time, I would like to welcome everyone to Vertiv's Fourth Quarter and Full-Year 2021 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. Please note that this call is being recorded. I would now like to turn the program over to your host for today's conference call, Lynne Maxeiner, Vice President of Investor Relations.

Lynne Maxeiner, Vice President, Investor Relations

Great. Thank you, Matt. And good morning. And welcome to Vertiv’s fourth quarter and full-year 2021 earnings conference call. Joining me today are Vertiv Executive Chairman David Cote, Chief Executive Officer Rob Johnson, Chief Financial Officer David Fallon, and Chief Strategy and Development Officer Gary Niederpruem. Before we begin, I'd point out that during the course of this call, we will make forward-looking statements regarding future events, including the future financial and operating performance of Vertiv. These forward-looking statements are subject to material risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. We refer you to the cautionary language included in today's earnings release, and you can learn more about these risks in our registration statement, our proxy statement, and other filings with the SEC. Any forward-looking statements that we make today are based on assumptions that we believe to be reasonable as of this date; we undertake no obligation to update these statements as a result of new information or future events. During this call, we will also present both GAAP and non-GAAP financial measures. Our GAAP results and GAAP-to-non-GAAP reconciliations can be found in our earnings press release and in the investor slide deck found on our website at investors.vertiv.com. So with that, I'll turn the call over to Executive Chairman Dave Cote.

David Cote, Executive Chairman

I and the Vertiv team are disappointed and embarrassed by our second half of 2021 and projected first-half 2022 financial performance. We got behind on the inflation recovery curve with insufficient price and stayed there all year. The past few months Rob and his team have implemented price increases that we expect will generate $360 million year-over-year price versus $260 million incremental inflation, generating $100 million of favorable price versus cost for the full year 2022. Because much of that price is in the backlog, it takes several months for the increases to show in the financials, and that explains the vast difference between our expected first-half and second-half 2022 performance. Our unimpressive short-term performance, including anticipated first-half 2022 results, is unimpressive. Our expected long-term performance starting in the second half of 2022 will be quite impressive. We are getting ahead finally on price and inflation recovery. Our orders are off the charts, and market-leading. The supply chain should loosen. We have favorably resolved the tax receivable agreement and two lawsuits, and the product ramp-up is just beginning. Some of you may be wondering why I don't get more involved. The answer is, I have. And that's why you see much more aggressive inflation forecasting, price implementation, and other fixes that Rob will talk about. Management has readily accepted and implemented the suggestions and will deliver as presented. I apologize for putting all our investors through this. That being said, if we restructure this year we should turn around in the second half; the long-term thesis is very intact, especially as performance begins in the second half. If you take the second half run rate into 2023, you can see how intact that thesis is. We know we have to prove it to you, and we will. So with that, I will turn the call over to Rob.

Robert Johnson, Chief Executive Officer

Thank you, Dave. The management team and I share the same sentiment about our Q4 results and the outlook for the first half of 2022. But before diving into the key messages on the first slide, let me comment on two topics. First, while Dave has been a good mentor to me over the last two years, our relationship has certainly evolved over the past 60 to 90 days. As his opening comments suggest, he has become much more actively involved in the day-to-day aspects of the business, both on the cost and price side. He is helping me on an almost daily basis to conduct reviews with our teams and host other business topics, and it is my full expectation that this level of involvement will continue through 2022. Secondly, let me address our guidance miss in the fourth quarter for which I take full responsibility. In short, we screwed up, and some of you undoubtedly are wondering how we could get so surprised. We significantly underestimated the magnitude of the material and freight inflation in the fourth-quarter forecast, mostly in the Americas, by approximately $36 million. This underestimation of cost also contributed to our underpricing in the market in 2021. So it was a huge deal not only for costs, but also price. Half of the inflation miss was related to unforeseen supplier de-commits on critical components and our need to execute spot buys and premium freight to meet customer commitments. The other half is related to forecasting issues within the Americas region, heavily influenced by our ERP implementation, but also due to forecasting process issues within the region. These regional cost and forecasting issues have been fixed, and we feel very confident with our cost projections for 2022 as evidenced by our January costs being lower than what we were planning. And that is why we're comfortable with what we have. In addition, based upon a better understanding of our underlying cost, we have been extremely aggressive with pricing over the last 90 days or so, as you will see in today's presentation, to more than offset the higher costs. With this better understanding of cost and higher pricing, which we're seeing in our year-to-date orders, we're confident that we will deliver strong financial results in the second half of 2022 and beyond. Now, turning to the key messages on the first slide: One, demand for Vertiv products and services is very strong. Our organic sales were up 4% from Q4 of 2020. The strength of our position in the market can be validated by our order rate, which was up over 50% in Q4 over last year and has pushed Vertiv's total backlog to over $3.2 billion. Two, the profitability challenge is primarily driven because of inflationary headwinds, not because of a flawed strategy or decreasing demand for our products and services, but due specifically to inflation that companies everywhere are battling. Our fourth-quarter adjusted operating profit was $94 million, which unfortunately was $58 million lower than last year's fourth quarter. We felt inflationary pressures most severely in the Americas, but also across our other regions. Our pricing actions increased as the year went on, but they were exceeded by inflationary costs and created a $135 million net headwind. We continue to raise price at an aggressive rate even as recently as last month, and we will continue to do so to make sure we get ahead of inflation. As you know, and fortunately, we are carrying a large backlog and it takes quarters for that pricing to be fully realized. Fourth, we don't see the full impact of our pricing actions in the first half of 2022 but those actions will kick in during the second half and we expect the second-half adjusted operating profit to be approximately $455 million, $230 million over the second half of 2021. Supply chain issues are real and challenging, delaying product completion. The Vertiv team is battling parts on a daily basis. Our biggest challenge is with electromechanical parts and fans—critical components of many of our Vertiv products. Internally, we have launched countermeasures to address the shortages. However, we expect and have been prepared for supply chain pressures to continue for the majority of 2022. Final and most important key message: although 2021 did not produce the results we expected for reasons I just shared, Vertiv is now well-positioned for strong performance in the second half of 2022 and into 2023 due to our aggressive pricing actions in Q4 and early 2022. Turning to Slide 4, recapping our 2021 performance, and then I'll provide some additional detail on what's playing out for 2022. With regard to 2021, we continue to have strong demand for our products. Some of this demand is because we are in a strong growing market, some is because we are winning with our go-to-market strategies, and some is a result of our Vertiv product development efforts. These three reasons are giving us an order rate that's almost up 30% year-over-year and over 50% in the fourth quarter. Admittedly, we believe the significant order growth rate in quarter four is an indicator that we could have priced even more aggressively, and adds further confidence that our pricing actions over the next several months are appropriate and will be received in the market. But a good portion of our $3.2 billion backlog will ship in 2022. Right now, we're getting visibility into customer plans for 2023 and beyond. This visibility is being provided in the form of forecasts and purchase orders, providing us greater visibility to our revenue profile not only over the next several quarters, but into the future. On the 2021 supply side, we fully expect to be challenged for most of the year. Critical parts availability is spotty and despite all the efforts to qualify second and third sources and redesign products where possible, we know part shortages are something our industry will grapple with throughout the year. In addition, 2021 inflation got ahead of our pricing just when we thought we had budgeted enough price—inflation got worse. This happened several times. We have corrected it now and are being very conservative in our expectation that inflation will not go away in 2022. The acquisition of E&I closed in November. Integration efforts are in full swing. We remain more confident than ever in our purchase decision. Vertiv will reap the benefits from the complementary nature of E&I's processes and products and its ability to be an accretive platform for Vertiv into the future. In 2021, we invested significantly in R&D just as we planned; we launched several new and innovative products as evidenced by their order rates. These products have exceeded expectations for market acceptance, allowing us to take share in certain categories. In 2021 we invested in R&D as a fundamental part of our long-term growth strategy. Now as we turn to the 2022 outlook: Our demand environment remained strong, but deliveries remain constrained by part shortages, especially in semiconductors and electromechanical parts that I discussed earlier. We don't plan to see meaningful improvement in the supply chain this year. We have new production capacity coming online in the Americas to support our growing thermal business. We are anticipating material and freight costs will continue to increase, but our incremental pricing actions are expected to materially offset 2021 and 2022 inflation by the end of 2022. Pricing realization accelerates throughout 2022 and provides a net price-cost tailwind by Q3. We expect profit in the first half of 2022 will remain challenged, but will materially improve in the second half of the year as price-cost turns positive. Due to the pricing actions already initiated, we expect to exit 2022 in a good position. Turning to Slide 5, this is the chart we used to illustrate what we're seeing in the market in each of our regions and each of our end markets. In the cloud and hyperscale markets, they remained strong, represented by green in the Americas and EMEA. In APAC however, we see some slowdown as China is pushing cloud and hyperscale companies to maximize their existing facilities. We expect this to be a short-term phenomenon. When looking at our colocation customers, we're not only seeing strength across the regions, but increasing strength in the Americas and EMEA. Tier-1, Tier-2, and Tier-3 customers are building out data centers to serve their customers, and we are participating in a very healthy way with those build-out efforts. Our enterprise, small and medium business markets remained constant from Q4 to Q1. We're experiencing good performance in each region; the pipeline is growing and the Americas is leading the way. The communications network market remains consistently strong with an uptick in the Americas as 5G deployment continues to accelerate. The commercial industrial market remains consistent in EMEA and APAC, and we did see an uptick in the Americas allowing us to upgrade Americas from yellow to green. While the commercial and industrial market is a smaller slice of our business, the variety of products and services we sell in this market continues to grow. Moving to Slide 6, we closed the E&I acquisition on November 1st, and the integration team has been hard at work ever since. E&I has also faced, and is facing, supply constraints and inflation, which has temporarily affected the top and bottom line. E&I has a very healthy backlog. We believe the pricing actions that we've taken in Q4 and will continue to take as needed will be realized in the back half of 2022 with E&I as well. We anticipate 2022 revenue from E&I alone to come in around $470 million with an adjusted operating profit of $80 million. Customer reactions to the deal have been nothing short of fantastic, and this acquisition has increased our relevancy with our customers. We expect as 2022 progresses, the synergistic leverage we will get from E&I will enhance our performance in 2023 and beyond. So I might summarize E&I in 2022 as a tough year, but still a great deal. Now I will turn it over to David to walk through the financials.

David Fallon, Chief Financial Officer

Thanks, Rob. First turning to Slide 7. This slide summarizes our fourth-quarter financial results, which certainly fell short of our external guidance across most of these financial metrics versus last year. Sales were up $105 million or 8%, 4% organic when adjusted for the $67 million of sales from E&I, and we also had about a $13 million foreign exchange headwind. Our fourth-quarter top-line, as Rob mentioned, continued to be negatively affected by challenges with procuring parts, while underlying market demand was certainly much stronger than implied by this year-over-year sales growth, with orders up over 50% compared to last year's fourth quarter. This is evident with our record-high backlog at year-end. Without the supply chain constraints—and this is a little bit hypothetical—our sales growth percentage would have easily been in the double digits for the fourth quarter. Adjusted operating profit of $94 million fell significantly short of our external guide and was primarily driven by contribution margin, which I'll summarize in a separate slide in a bit. On this slide, we captured the drivers of the $58 million reduction in adjusted operating profit from last year's fourth quarter, including $80 million lower contribution margin, which was primarily driven by a $60 million headwind from price-cost: approximately $90 million of material and freight inflation only partially offset by $30 million of incremental pricing. And of note, our pricing was actually relatively consistent with our external guide. As we will discuss with 2022 guidance, we've addressed the $60 million fourth-quarter and $135 million full-year 2021 price-cost imbalance with aggressive price actions taken in the fourth quarter and early 2022. Returning to the fourth quarter, adjusted operating margin and adjusted EPS dropped consistent with the adjusted operating profit decline, with adjusted operating margin about 500 basis points lower and adjusted EPS about $0.25 lower than last year's fourth quarter. And finally on this page, fourth-quarter free cash flow was significantly lower than prior year, primarily driven by the lower adjusted operating profit, but also timing of working capital and about $30 million of cash M&A expenses. Turning to Page 8, this slide summarizes our fourth-quarter segment results. The Americas region continues to be more impacted by supply chain challenges than the other two regions. The supply chain challenges negatively affected both Americas' top and bottom line, with organic net sales up just $7 million or around 1% against a very strong regional market demand backdrop where orders were more than two times last year's fourth quarter. The left-hand chart at the bottom of the page shows the $69 million year-over-year decline in adjusted operating profit in the Americas, heavily influenced by price-cost—approximately 70% to 75% of the overall net price-cost headwind for 2021, and in the fourth quarter, concentrated in the Americas despite the Americas representing less than 45% of total sales. Freight inflation was particularly acute in the fourth quarter and accelerated significantly in the U.S. as we progressed through the end of the year. In response to disproportionate net inflation in the Americas, our fourth-quarter and 2022 pricing responses have also been much stronger in that region. All things considered, APAC posted relatively good results in the fourth quarter with organic sales up almost 3% and adjusted operating profit and margin relatively flat with last year, although not completely immune from the current supply chain challenges; relatively little of our 2021 net price-cost headwind came from APAC. And finally on this slide, moving to the right, EMEA showed strong fourth-quarter top-line growth with organic sales up 11%; however, margins were down about 130 basis points from last year as the leverage benefit from these higher sales was more than offset by a price-cost headwind. Next, turning to Slide 9. This chart bridges fourth-quarter adjusted operating profit from our $176 million guidance to the $94 million actual and the $82 million negative variance. $46 million of this variance was due to higher-than-expected material, freight and labor inflation, primarily in the Americas and especially concentrated on freight, including premium freight for both inbound and outbound shipments to protect customer deliveries, but also due to an increase in standard over-the-road rates, which were up over 30% from last year's fourth quarter. As we will discuss shortly, our 2022 guidance assumes that these fourth-quarter inflationary headwinds continue and trend even higher in 2022. Moving to the right, we incurred approximately $10 million more than expected sales commission expense in the fourth quarter, primarily due to strong fourth-quarter orders up over 50% from last year's fourth quarter. E&I, as Rob mentioned, came in short of expectations in the fourth quarter and volume for overall Vertiv was lower than expected due to the parts availability that we discussed. And finally, on this page, pricing was materially in line with our fourth-quarter expectations, off about $2 million, but approximately $53 million of pricing we realized in 2021 has been sticky. As we will review in a few moments, it is expected to accelerate significantly as we progress through 2022. Next, turning to Slide 10, this page summarizes our full-year 2021 results versus prior year. We won't spend a lot of time on this slide as I'm sure everyone is anxious to understand what we see going forward in 2022, but to summarize 2021: despite the supply chain constraints, we grew our top line organically by about 11%, which likely would've been over 15% without the supply challenges. Our adjusted operating profit and margin were significantly affected by negative net price-costs with almost $190 million of material and freight inflation, only partially offset by $53 million of pricing. Although more aggressive pricing actions were taken at the end of 2021 than implied by the $53 million full-year number, realization in our income statement was influenced by our significant backlog, which drives the timing lag between inflation and offsetting price hitting our P&L. We certainly expect pricing to catch up with costs in 2022. And finally on this page, full-year 2021 free cash flow was about $27 million lower than last year with a $92 million cash interest benefit from debt restructuring more than offset by an inventory build, cash M&A expenses, higher capex and cash taxes. Now, flipping a couple of slides, we transition from 2021 actuals to 2022 guidance beginning with Slide 12. But before we dive in, you will see that we supply a lot of detail within our 2022 guidance, including first-half, second-half, and quarterly breakouts for expected sales, adjusted operating profit, and also pricing and inflation. We are providing this detail because we absolutely realized we have likely damaged some of our credibility in 2021, notably with the quality of our external guidance, and we want to be fully transparent with you on how we see the year unfolding. It is impossible to understand the dynamics within 2022 without looking at only full-year figures. And as you will see, our anticipated second half of 2022 is much different and much improved from the first half. And each quarter improves sequentially from the previous quarter. This expected improvement both in the second half and with each successive quarter is driven by accelerating price-cost benefit versus 2021. Of course, we understand that providing this level of detail likely creates the expectation for us to supply the same level of detail as we progress through the year. And we are absolutely prepared to do that and we will update our assumptions and projections for all inputs as appropriate. And we know that you'll track with us every step of the way. So with that said, finally, getting to the content on Slide 12, this page summarizes our broad expectations for 2022 by splitting our guidance between first and second half. We expect the first half to continue to be challenged by parts availability with underlying organic volume when you remove price to be down 5% year-over-year despite the record year-end backlog, as we do not see significant supply chain constraints lessening at all in the first half of 2022 versus what we saw at the end of 2021. In addition, although price-cost recovers as we exit the second quarter, it is still projected to be upside-down by approximately $70 million for the full first half. The second half is a much different story as we expect financial performance to improve significantly from the first half. We assume 6% higher organic volume, once again excluding price, and part of that is based on greater visibility to allocation of parts in the second half. This 6% higher organic volume could be conservative based upon our backlog and the end-market demand. But once again, the underlying driver of improved sales performance in the second half is pricing. Based upon pricing actions that we have already taken, we expect $250 million of incremental year-over-year pricing in the second half alone, and as a result, price-cost is expected to be a positive $170 million in the second half, significantly improving adjusted operating profit, with adjusted operating margin increasing to 14%. Our expectations for a strong second half pertain to a strong 2023 as we capture additional year-over-year pricing from actions already taken, as virtually all sales in 2023 will be at the higher pricing. While we have significant sales in 2022 from our existing backlog at lower historical pricing levels, and we'll further explain this dynamic in a couple of slides, let's move on to Slide 13. This is another slice of our guidance going from a first-half, second-half perspective to a quarterly perspective. Net sales, adjusted operating profit, and adjusted operating margins are all projected to sequentially increase as we progress through the year. And as we mentioned on the prior slide, the primary driver of this sequentially improving financial performance is the timing of price realization. The chart at the bottom left illustrates the quarterly profitability trend for both 2021 and 2022. Our price-cost issues began in the third quarter of 2021 and we anticipate them to be addressed after the second quarter of this year, so we're almost three quarters of our way through what we see is a four-quarter issue, and price-cost turns positive for each of the last two quarters of 2022. Finally, on this page, the chart at the upper right shows the relatively conservative volume assumptions inherent in the plan. With full-year organic volume, once again excluding pricing, assumed to increase just 1% as we do not assume significantly improving parts availability as we progress through the year. We will continuously assess that assumption as we go forward. Next, turning to Slide 14, this page details our year-over-year quarterly price-cost or net inflation assumptions for 2022. For the full year, we expect to generate $100 million favorable year-over-year price-cost, including the assumption of $360 million of price offset by $260 million of incremental inflation. As discussed in the prior slides, our quarterly pricing increases sequentially as the proportion of sales from existing backlog declines as you can see in the chart at the bottom of the page. Also very important, we should have significant carryover price benefit into 2023 as we expect 95% of next year sales to be at the higher pricing levels. While in 2022 only 50% were, and this drives an expectation for about $200 million of carryover pricing impact for 2023. From an inflation perspective, we assume that what we experienced exiting 2021 will continue through full-year 2022. That's approximately a $160 million year-over-year carryover negative impact. But in addition, we have assumed $100 million of new inflation in 2022. As I mentioned, 2021 actual inflation outpaced our expectations at each step of the way and we believe it prudent to assume that inflation will continue to worsen in 2022, which drives the $100 million incremental assumption. We will definitely reevaluate this new inflation assumption as we progress through 2022. Based on the foregoing assumptions, we expect price-cost to be neutral in the second quarter and, as mentioned, significantly favorable for the second half beginning in the third quarter. Next, turning to Slide 15, this page supplies some color on our confidence that the $360 million pricing number for 2022 is achievable and will stick. First, as we saw on the previous page, the first $125 million of the $360 is actually included in our year-end backlog, so we consider that highly probable to certain. The second $235 million is based on pricing projections in new 2022 orders that will book and ship within the year. Based upon the market acceptance of our fourth-quarter price increase, evidenced by the 51% increase in orders, we certainly saw the opportunity to be much more aggressive with 2022 pricing. In late 2021 and early 2022, we initiated multiple waves of list price increases across all product lines and all regions. Although we certainly were a bit more aggressive in both the Americas and EMEA where inflation has been more pronounced, based upon our order rates so far in January and February, which are in line or even a little bit higher than last year's order rates for that same period, it appears that our higher pricing is sticking in this high-demand, short-supply market environment. Of course, we will continue to reevaluate this assumption and reassess our pricing as we progress through the year. As we have mentioned many times, we believe we operate in a great position in a good industry. Data center demand for our equipment and more importantly our technology is not abating anytime soon and it should continue to accelerate going forward. With the backdrop of rising global costs and long-term market demand, we believe our price increases are justifiable, reasonable and achievable. In fact, one lesson learned as we managed price increases over the last nine months or so is that we have historically underestimated our ability to get price. And based upon the success of our recent price actions, we have absolute confidence that we will be able to drive consistent price increases going forward. Turning to Slide 16, this page summarizes our full-year 2022 financial guidance. We provide added detail in the appendix to aid analysts and investors with modeling. Overall, we expect 13% top-line growth, 8% organic. Components of this organic growth are 7% price and 1% volume, as our assumption is that the supply chain constraints do not significantly ease in 2022 and only in the fourth quarter if at all. We will continue to reassess this possibly conservative assumption as we go through the year. Full-year adjusted operating profit is expected to increase $54 million or 11%, with base Vertiv relatively flat and most of the increase coming from net acquisitions and divestitures. There is an $85 million year-over-year increase in fixed costs and we provide some additional color on that increase in the appendix. As we showed in prior slides, quarterly adjusted operating profit and margin increase sequentially with higher pricing, with fourth-quarter operating profit projected to be $255 million. Fourth-quarter adjusted operating margin expected to be 15% and fourth-quarter adjusted EPS to exceed $0.40 a share. So even though full-year financial metrics are not overly impressive, we should be exiting 2022 in a very good position. Finally, on this page, we summarize both adjusted EPS and free cash flow for 2022, and once again we supply underlying assumptions for each in the appendix. Now turning to Slide 17, this page summarizes our first-quarter financial guidance. As we previewed in prior slides, our performance in the first quarter will continue to be challenged by negative price-cost, about $70 million in the quarter, and supply chain constraints will unfavorably affect year-over-year organic volume. We estimate by about $45 million. The net impact is not great as shown by the expected $20 million adjusted operating loss. But these first-quarter results should be the nadir for our quarterly financial performance, as we project consistent quarterly improvement as we go through 2022 based on actions we have already initiated, including delivering $360 million of higher pricing for full-year 2022 and pricing actions that should deliver an additional carryover impact of $200 million into 2023. Now with that said, I turn it back over to Rob.

Robert Johnson, Chief Executive Officer

Thanks, David. Now let's turn to Slide 18. I know this quarter's earnings report is not what you expected from us and is not what we expected from ourselves. We got caught up in supply chain challenges that reflect most of the world and we did not appropriately anticipate the inflationary pressures we would experience as we tried to obtain parts we needed to manufacture our products. We have a great position in a good industry. We have world-class products and service offerings. We have a talented team. We are relevant to our customers. We are cultivating our relationships, and we are investing in our future. And we have a clear line of sight to our margin expansion goals. While I'm extremely disappointed in our performance in Q4, I'm confident in our ability to deliver on our 2022 commitments and how the new actions we have taken have set us up to deliver a very impressive 2023. In the end, our success for 2022 and beyond is highly dependent on our ability to deliver the pricing commitments that we have communicated today, and I have the confidence that we'll be able to deliver that. I take personal responsibility for this as well. To Vertiv employees around the world: thank you for the work you've done and continue to do, and the support you provide to each other and to our customers. With that said, I want to thank all of you for listening today, and I will now turn the call over to the operator who will open up the line for questions.

Operator, Operator

We will begin the question-and-answer session. We'll pause briefly to compile the Q&A. Our first question will come from Scott Davis with Melius Research, please go ahead.

Scott Davis, Analyst, Melius Research

Hey, good morning, everybody. Rough day for everyone. I want to get a sense of whether you need to change your sales commission structure—looks like your sales force is getting paid to book unprofitable contracts. How do you need to change that or am I misreading it? I'm just trying to get a sense of the incentive system internally and how it might need to change in 2022?

Robert Johnson, Chief Executive Officer

No, to be clear, they are not paid to book unprofitable business. We actually instituted, over the last 60 to 90 days, even tighter controls so they don't have the ability to just discount to grow the backlog and grow the business. We have a very tight, rigorous process that goes all the way up to certain levels and including myself, depending on what discounts are being requested. We hold that tight from that perspective so that they don't have the freedom to just discount to build backlog or to go book orders. In different parts of the world, we have profitability as part of the overall sales compensation. So again, the answer would be no, they're not paid to book unprofitable business.

Scott Davis, Analyst, Melius Research

Rob, from a cultural perspective, it seems like Vertiv is a place where maybe bad news doesn't travel up as fast as it should. You guys reported on October 27th, you already had one of the three months of the quarter in your back pocket—how did you guys miss it from a rate-of-change perspective? What was the breakdown between financial controls and cultural challenges? Are you learning from this, because we cover a lot of companies and you guys are an outlier at the extreme end of really getting hit here?

Robert Johnson, Chief Executive Officer

Yes. So a couple of things. As I said in my opening comments, we did have some issues upfront with our ERP in the Americas. To be clear, we didn't see the rate of inflation that we actually experienced until later in the quarter and the later month. We did, however, see an increase in spot buys and expedited freight in order to counter supplier de-commits. When we came out in our last earnings call, supply for us with certain suppliers actually got worse and de-commits happened and accelerated throughout the quarter. So it really wasn't necessarily a cultural issue as much as a systems issue and our ability to see that as we changed over ERP. And secondly, we consciously made decisions to pay expedited freight and drive spot buys in order to counter the de-commits from our suppliers.

Scott Davis, Analyst, Melius Research

Okay, that's helpful.

David Cote, Executive Chairman

If you don’t mind Scott, this is David Cote and I will probably ask David Fallon to interject also. About 75% of our issue is approximately in the Americas. In the Americas there was a cultural issue between the sales folks and operations folks truly understanding what was going on. When the October results were actually okay, November looked a little bit worse, but not distressingly so, and we got the report that December was going to recover. When we got the December results, that's where all of a sudden everything seemed to crash. We didn't really know all the details of it until we got to the latter part of January and spent a good part of February trying to figure out what the heck was going on and what we had to do. Rob and I got significantly more involved with what we had to do to resolve the cultural issues that did exist in the Americas, and that's been addressed. When it came to inflation, it was clear we had been underforecasting what was going to happen with inflation. I would argue some of that was a cultural issue also, which we have addressed. That's why we've been so aggressive on the pricing side. If you take a look at our Americas orders, they were up 115% in the fourth quarter, which is an indication that we could've been pricing a lot better than we did and we have adjusted that. That's why we're pleased to see that as we go into January, at least from what we can see in February so far, orders in the Americas are continuing to grow even over what was a good first quarter of 2021. We've had to get much more heavily involved in resolving these issues. I'm confident they have been resolved and they will continue to work with the new process. I'm encouraged by what I see for the second half, which gives us a very good lead into the future and gets us back where we should have been all along. One of our learnings from all this is how we've underestimated our ability to get price, historically, not just currently. That's another dynamic that's going to change. So yes, there has been a significant amount of change over the last 60 days. Rob, do you want to add anything?

David Fallon, Chief Financial Officer

When we got the December results, that's where it really deteriorated. We didn't know all the details until late January. We spent a lot of time in February trying to figure out what was happening and what we had to do. Rob and I got significantly more involved with what needed to be done to resolve the cultural and process issues in the Americas, and that's been addressed. We had been underforecasting inflation. I would say some of that was a cultural issue, and we have addressed that as well.

Operator, Operator

Our next question will come from Nicole DeBlase with Deutsche Bank. Please go ahead.

Nicole DeBlase, Analyst, Deutsche Bank

Yeah, thanks. Good morning. Where I'm struggling a little bit is understanding how you'd make such big cultural changes in the scope of two months. Maybe you could give some examples to help us and what has changed about the planning process in 2022 to give investors confidence that this isn't going to happen again?

Robert Johnson, Chief Executive Officer

I'll address some of the culture issues upfront. Dave can talk a little bit about it and I'll talk a bit about the planning process. As it relates to cultural issues, the organization wasn't set up to drive a lot of price in previous years—we've shown $20 to $25 million in price. What we had to do from the top down—Dave, myself, and others in the management team—was really drive all the way down to the salespeople what it means to get price, how to get price, and not to be afraid to lose orders. That's something culturally we had to overcome, and it has proven out that we were able to get price. The other cultural issue is the FIOP process for the Americas and having that tighter pull together so that demand, supply, and constraints are working closely together, which was exacerbated by the new ERP system that caused a lack of visibility for a period of time but has since been fixed. On the process side, we are well beyond the ERP implementation in terms of visibility, as evidenced by January's results where we have better visibility into our PPV and purchase variances and have a good handle on inflation. We were behind throughout the quarter, as Dave mentioned, and got into December, recognized what was going on and have implemented both process changes—pricing levels of approval—and process changes with the integration of Americas operations, supply and sales. David Fallon, Dave, any other comments?

David Fallon, Chief Financial Officer

I agree with Rob. Often when it comes to forecasting, it's a lot of blocking and tackling. We have instituted a lot of rigor in the last 60 days, specifically around the Americas forecasting process. Last Thursday Rob and I were effectively in and out of a meeting that lasted from 9:00 AM to 10:00 PM. We're putting a lot of diligence into this, and we understand our credibility was harmed as it related to forecasting. We will not let that happen again and we're confident with the steps and processes we've put together for that specific issue.

David Cote, Executive Chairman

Just to add a little more color, Nicole, the Americas cultural issue was always there; it wasn't visible in a stable cost and supply chain environment. It became extraordinarily visible as we started to run into those two problems. Rob pulled together a come-to-Jesus meeting with the Americas operations and sales folks to say this is not happening anymore. You're going to sort this out just like we were able to in EMEA and APAC, and we want to figure out exactly where we are now and have a better process going forward. It was a long day and Rob and Dave came in at the conclusion and we adjusted what we thought was going to happen for '22 as a result, negatively, but it allowed us to better understand where the bottom was than we had in the past. They've changed the process they will use going forward, both culturally and mechanically, and Rob and Dave are going to be very involved in understanding that reconciliation every month to make sure we truly understand what's going on. I'm confident we've addressed that at this point, but it will take ongoing attention and Rob and Dave are doing that.

Nicole DeBlase, Analyst, Deutsche Bank

Thanks. That's really helpful color. Just a quick follow-up to give someone else a chance: the order activity was obviously really strong this quarter. What did it look like excluding E&I, and maybe you could comment on organic backlog as well? I put out the E&I contribution from the underlying part of the business.

David Fallon, Chief Financial Officer

Nicole, the order rate percentages are all without E&I because we haven't tried to approximate what orders would've been in fourth quarter 2020 with E&I. So that order rate is all excluding E&I. But if you look at the backlog, the $3.2 billion of backlog does include E&I, which was just a little bit short of $300 million at year-end. So the base Vertiv backlog is somewhere between $2.9 and $3 billion.

Nicole DeBlase, Analyst, Deutsche Bank

Very helpful. I'll pass it on. Thank you.

Operator, Operator

Our next question will come from Jeff Sprague with Vertical Research. Please go ahead.

Jeff Sprague, Analyst, Vertical Research

Thanks. Good morning. Not to beat a dead horse on that last thread, but I wanted to come back to the ERP system. Have all the kinks been worked out? Also, I was concerned to hear the comment that teams are left to figure things out; it sounds like it requires more direct marching orders. Can you give some assurance that you've righted the ship and everybody's aligned?

Robert Johnson, Chief Executive Officer

Hi Jeff. A couple of things. The teams aren't left to just go figure it out on their own. The combination of Dave, myself and David have given strict marching orders on what needs to happen and they need to make it happen. So they don't just go figure it out and come report back; we've given specific instructions on what needs to be done. On the ERP system, as you know, all ERP systems are difficult. In this particular one, while the cutover occurred, we were able to continue to ship and do basic business functions. We didn't have a problem in that regard; it was more about understanding price variances and other detailed items that we didn't get to right away after the launch. We've since fixed those issues. Post-launch you always have things to fix, and that's where we got caught up, lacked some visibility, and then began to better understand that in December and toward the end of January. It took a little longer to assess where we were and now we understand our PPV.

David Fallon, Chief Financial Officer

Monitor is perhaps not a strong enough word. Rob and Dave will be much more involved in understanding that the reconciliation works the way it was supposed to. Our approach is not to have the CEO always tell people to just work together. The teams have to recognize the problem, fix the processes themselves and come up with how they're going to operate going forward. They have recognized the problem and developed fixes not only for the current forecast but to prevent recurrence. Rob and Dave are committed to making sure that happens.

Operator, Operator

Our next question will come from Mark Delaney with Goldman Sachs. Please go ahead.

Mark Delaney, Analyst, Goldman Sachs

Thanks very much for taking the questions. First, about the assumption of $100 million of incremental inflationary cost off the December run rate—maybe you can elaborate on how you're coming up with that number, how much of that is based on what suppliers are saying, and how much is conservatism?

David Fallon, Chief Financial Officer

Mark, it's a combination of things. There is an element of conservatism included in that number based on our lessons from last year. Every time we put a forecast in the ground, inflation got worse. We saw that especially in the Americas as we progressed through the year. So there's a provision of conservatism, but certainly part of the $100 million is based on what we're seeing currently. It's hard to handicap a specific split between conservatism and observed cost increases, but we'll reassess as we go through the year and provide an update at the end of the first quarter.

Mark Delaney, Analyst, Goldman Sachs

Are any input costs stabilizing that give you confidence that $100 million is conservative, or why wouldn't they just keep going up at the same rate as last year?

David Fallon, Chief Financial Officer

There is some good news: notably some commodity prices, particularly steel in the U.S., have come down. Our pricing for steel—which is our most prevalent commodity—is indexed based on an average price of the prior quarter, and steel prices have come down fairly nicely since mid-fourth quarter. We've seen some of that benefit in our Q1 pricing. If lower steel prices hold through the end of Q1, we should see a benefit in Q2. We have not built into any of our forecasts a specific commodity improvement this year, so that would be an example of conservatism built into our forecasting.

Mark Delaney, Analyst, Goldman Sachs

On procurement strategy for 2022, to what extent is Vertiv locking in contracts and pricing to give you visibility into expenses, and have you changed procurement to get better certainty of supply?

Robert Johnson, Chief Executive Officer

A couple of things: regarding price and contracts, we've been putting escalators in contracts if commodities change outside a certain boundary, which wasn't in all contracts before. That's a backstop to get additional price if necessary. Regarding supply, we've qualified additional suppliers, redesigned certain parts where possible, and broadened the supplier base. We've qualified additional fan vendors and changed some designs to uncouple constraints. We've qualified additional IGBT suppliers for power conversion products, and we've continued to look to diversify suppliers across regions. A lot of this work started as COVID hit and taught us to qualify and drive additional suppliers, and we'll continue to avoid single-source dependencies.

Mark Delaney, Analyst, Goldman Sachs

Thank you.

Operator, Operator

Our next question will come from Lance Vitanza with Cowen. Please go ahead.

Lance Vitanza, Analyst, Cowen

Thanks for taking the questions. On Slide 13, looking at the adjusted operating profit guide for 2022 I see $200 million in Q3 and $255 million in Q4. Is there seasonality in that trajectory? Should we think of Q4 annualized as a starting run rate for 2023?

David Fallon, Chief Financial Officer

There's likely some seasonality in the Q4 projections for 2022, but not nearly what we normally would have. Q4 is certainly a better run-rate projection for 2023, although Q1 2023 is probably going to be lower than Q4 2022. It's a lot easier to annualize the Q4 2022 number than in other years because we are assuming continued supply constraints in that number, and of course we're hopeful some of that gets rectified in the second half.

Lance Vitanza, Analyst, Cowen

On the stock at this price, can we expect to see management buying shares or the company considering buybacks given liquidity and covenants?

David Fallon, Chief Financial Officer

We continuously look at alternative uses for cash. Based on the stock reaction, a stock buyback is more attractive than it was yesterday. I'm not making any commitments, but it is something we would strategically evaluate.

Lance Vitanza, Analyst, Cowen

On the balance sheet, could you talk about plans to de-lever and when cash plus available borrowings might bottom out? Are there any maintenance covenants in the revolver that could crimp liquidity?

David Fallon, Chief Financial Officer

There are no covenant issues. We have one covenant in the ABL—fixed charge coverage ratio—and we have ample room; it won't be an issue this year. As it relates to cash use, 2021 was an exception, but generally our lowest free cash flow is in Q1. This year we will use cash in Q1, but free cash flow should progressively improve through the year. I would say early third quarter is probably the bottom point for liquidity. We resolved the tax receivable agreement, and there is a $50 million payment at the end of June and another in September. Soon after the $50 million payment at the end of June would likely be the bottom of our liquidity, and it should improve thereafter.

Operator, Operator

Our next question will come from Nigel Coe with Wolfe Research. Please go ahead.

Nigel Coe, Analyst, Wolfe Research

Thanks. I just want to go back to pricing: how did you change incentive structures around price to hardwire the behavior changes into compensation? Also, the order strength in the Americas in Q4—how confident are you that it wasn't primarily pre-buying ahead of price increases? And could you comment on the pricing embedded in the current ordered backlog relative to the price increases in your guide?

Robert Johnson, Chief Executive Officer

Nigel, thanks. On incentives, we changed approval authority and tightened discounting thresholds. One of the quickest ways to drive change is stop unnecessary discounting. We've raised list prices and changed the levels at which discount decisions can be made, up to myself and David as needed, so we don't give away pricing through lower-level approvals. That's both a cultural change and a process change we've implemented over the last 60 to 90 days. Regarding the Americas dynamic, the market is capacity-constrained and lead times have extended for many components. What we're seeing is customers putting in orders to secure slots; in some cases they're ordering 12 to 18 months out. The demand is extremely strong globally. This wasn't simply a rush to buy ahead of price—many of the pricing actions were taken in November and earlier—it's broader demand from colocation, cloud and the channel where our products are preferred. We're seeing continued growth even with higher pricing.

Gary Niederpruem, Chief Strategy and Development Officer

Nigel, on the backlog pricing: as we entered January 1st, pricing embedded in the backlog was around $125 million, roughly 4% to 4.5%. Momentum for pricing strengthened each quarter in 2021 with Q4 being the high point. The step-up we saw in Q4 and what we've seen in January and early February suggests the price increases we've put out have not materially changed order input, which gives us confidence in building pricing further as the year goes on.

Nigel Coe, Analyst, Wolfe Research

Okay. Thanks. I'll leave it there.

Robert Johnson, Chief Executive Officer

Thanks Nigel.

Operator, Operator

Our next question will come from Steve Tusa with JPMorgan. Please go ahead.

Steve Tusa, Analyst, JPMorgan

Hi, guys. On pricing, how will this change next year and the year after that when historically equipment pricing has been pressured? Do you see this pricing stickiness as structural because of your innovation and differentiation, or is it more temporary due to current supply-demand dynamics? How confident are you that you can maintain the spread in an industry that typically has challenging equipment pricing?

Robert Johnson, Chief Executive Officer

Steve, traditionally the industry hasn't always had the innovation to justify price. What we're seeing is that when we differentiate—with innovative products and solutions, notably in thermal management and other areas—pricing sticks. We've been increasing R&D investment for that reason. Where we can demonstrate differentiated value, customers will pay higher prices. We also compete with many local players who are experiencing the same cost pressures, so we're seeing the market accept pricing for differentiated products. The organization has reset its mindset that we can get price when we deserve it through innovation and differentiation, and we'll continue to focus on those areas.

Steve Tusa, Analyst, JPMorgan

Thank you. You mentioned thermal, that's the HVAC side?

Robert Johnson, Chief Executive Officer

Yes, thermal management products and other areas where we've innovated. Historically we underestimated the value of existing differentiation in our product line, and this process has shown us that existing innovation was underpriced. That realization will allow us to price more appropriately going forward.

Steve Tusa, Analyst, JPMorgan

Got it, thanks. Good luck through the beginning of the year.

Operator, Operator

Our next question will come from Amit Daryanani with Evercore ISI. Please go ahead.

Amit Daryanani, Analyst, Evercore ISI

Thank you. Two questions on incentives: how does incentive compensation get aligned to fix these challenges on the sales side and at the management level? Has incentive comp changed to rectify some of the challenges you had?

Robert Johnson, Chief Executive Officer

As it relates to management, we are completely aligned with shareholders on earnings and profitability going forward. Pricing is absolutely part of management objectives for 2022—not just for my team but for teams below me. On the sales side, depending on the region, sales compensation is tied to pricing and quota attainment at higher price points. Higher prices mean higher quota attainment and therefore higher commissions. We've also put in approvals to prevent price leakage on big deals. The areas we needed to shore up were where price leakage could happen on large deals, and we've pushed back and implemented higher levels of approval so pricing is protected. We feel confident sales and management globally understand the importance of getting price and the impact to their compensation.

David Cote, Executive Chairman

To add: what Rob is recommending to the Board is significantly lower payouts than would be normal, and Rob is also recommending that he and his team take a zero bonus this year. Their compensation is heavily focused on equity and stock performance, so they're incentivized to drive the stock price higher and fix these issues.

Amit Daryanani, Analyst, Evercore ISI

Perfect. That's really helpful. Thank you.

Operator, Operator

Our next question will come from Andrew Obin with Bank of America. Please go ahead.

Andrew Obin, Analyst, Bank of America

Good afternoon. The medium-term goal for adjusted operating margin was 15% plus. How do you think about the bridge from the 2022 midpoint of 9.3% up to 15%? How much is structural versus tactical fixes to put out fires?

David Fallon, Chief Financial Officer

Andrew, much of the improvement is driven by pricing, which we feel good is sticking. Look at the adjusted operating margin in the fourth quarter, which was around 15%; that's a useful datapoint to consider. We would say as we exit 2022, we should be back on track to our margin goals and potentially even accelerated because of the pricing carryover into 2023. So our plans to reach the 15% plus level are consistent with where we were, and the pricing actions and operational leverage should get us there.

Andrew Obin, Analyst, Bank of America

Thanks. A clarification on Slide 13: why is pricing realization only 110% in the first half versus higher in Q3 and Q4? Is that driven by backlog composition?

David Fallon, Chief Financial Officer

Great question. The biggest dynamic is that pricing realization is driven by what we sell out of backlog. The pricing for book-and-ship new orders is higher than what's embedded in backlog from year-end 2021. The lower first-half proportion reflects the fact that a higher share of sales in the first half will come from older backlog with lower pricing; as we progress through the year, a greater share of sales will be new orders at higher pricing, which is why pricing realization accelerates into the second half.

Andrew Obin, Analyst, Bank of America

Got you, thanks.

David Fallon, Chief Financial Officer

Thanks, Andrew.

Operator, Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Rob Johnson for any closing remarks.

Robert Johnson, Chief Executive Officer

Sure. Again, I want to apologize to all of you for our Q4 performance. We're not happy with it, and you're not happy with it. We have a handle on the issues and I hope you saw that through our presentation today. We need to prove it to you throughout this year and we will earn your trust back. Thank you and have a good day.

Operator, Operator

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