Earnings Call Transcript - VRT Q2 2023

Operator, Operator

Good morning. My name is Lauren, and I will be your conference operator today. At this time, I would like to welcome everyone to Vertiv's Second Quarter 2023 Earnings Conference Call. Please note that this call is being recorded.

Lynne Maxeiner, Vice President of Investor Relations

Great. Thank you, Lauren. Good morning, and welcome to Vertiv's Second Quarter 2023 Earnings Conference Call. Joining me today are Vertiv's Executive Chairman, Dave Cote; Chief Executive Officer, Giordano Albertazzi; and Chief Financial Officer, David Fallon. Before we begin, I would like to 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 annual and quarterly reports and other filings made 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 rapid 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. With that, I'll turn the call over to Executive Chairman, Dave Cote.

David Cote, Executive Chairman

Well, these last few quarters have been a lot more enjoyable to report. We had another strong quarter of performance in Vertiv, which positions us very well to achieve our significantly increased 2023 outlook. Adjusted free cash flow, adjusted operating profit, sales, and margins all performed very well, and operational execution continues to improve. We've raised our full year guidance because of our strong first half performance. We also have the very pleasant effect of a strengthening balance sheet. The data center end market continues to look very healthy, and there is an incremental tailwind from AI coming. That tailwind should provide additional opportunities for many years for Vertiv because our technology will matter. A great market position, a great industry where we can differentiate with technology, these attributes are what attracted me to Vertiv over four years ago, and they are truer today than ever. We're obviously pleased with the results, but there is so much more to come. There's a lot of upside, not just in the market and our technology, but also just continuing to fix legacy process issues and building a high-performance culture which didn't exist. Gio and his team are off to a great start, and there is a lot of work left to be done, but it also supports more consistent execution over the long term.

Giordano Albertazzi, CEO

Well, thank you very much, Dave. We saw the positive momentum continuing into the second quarter across all key financial metrics. Second quarter sales were up 25% organically, led again by a 48% increase in the Americas. We continue to see supply chain improvements and increased resiliency. We saw healthy market demand, which supported the shipment of substantial volumes in the Americas region. Orders excluding FX were down just 3% from last year's second quarter, better than anticipated, and book-to-bill remained at 1. Despite ongoing order normalization as well as difficult comparisons, the market remains healthy. We have also seen encouraging AI-related activity, and I'll elaborate on this when we cover Slide 6. Our adjusted operating profit was $251 million, and we saw benefits from our increased volume as well as price costs. Our adjusted operating profit margin improved 860 basis points to 14.5% as we continue to strengthen operational execution. I am particularly pleased to report the strong adjusted free cash flow of $227 million in the second quarter. We also continue to see the leverage profile of the business improve at 3.1x at the end of Q2 as the balance sheet continues to strengthen. These are early successes and still much more opportunity ahead. We are raising our full year guidance and are now expecting sales for the full year to be up 20% organically, AOP at $950 million at the midpoint, and adjusted free cash flow of $550 million at the midpoint. We are executing our plan to deliver the full year one quarter at a time, and our transformation continues. We are making meaningful steps forward in our operational execution. We are demonstrating clear traction and there is tremendous value creation ahead. We're not relenting our focus on operational execution; that is what we intend to continue to demonstrate each and every quarter. So let's now turn to Page 4. A few changes on the market environment slide. First, we moved cloud hyperscale to green in EMEA. Globally, we have seen an acceleration in the cloud hyperscale and colocation market segment in the last 90 days, substantiated by the large amount of incremental capacity being planned as well as by the amount of leasing capacity signed in this past quarter. Our pipelines have clearly strengthened. It is hard to delineate what is AI and what is not. But we know the industry is certainly getting ready for AI, and we have orders in our books and opportunities in our pipeline that are unequivocally for AI infrastructure. Conversations with cloud and colocation players are now about making sure there is available capacity to support a healthy outlook, and we are in discussions with several large and relevant customers on what this commercial arrangement can look like. This is very encouraging. As we move to telecom, this area has further weakened in the last 90 days, with some further carving of spend by the major telco carriers. We anticipate the telecom markets to remain quiet for the balance of 2023, which is not particularly worrisome. These patterns are not atypical for this market. We have left the APAC market yellow across the segments. The China market specifically experienced a slower-than-expected start to the year, not just for us but for most companies. In our current view, we are not anticipating much recovery in the China market in 2023, but there are some encouraging signs as we see orders turn positive in Q2 and pipelines are healthy. There are no changes in view on enterprise, SMB or commercial and industrial. Overall, I'm more encouraged today than 90 days ago, given the clear demand signals from the cloud hyperscale colocation markets that support our view for the second half of '23 and shape our thinking around 2024. Let's move to Slide 5. Orders performed better than anticipated, although down 3%, they are coming together stronger than expected, and they were 13% sequentially up from Q1. The book-to-bill ratio of 1 preserves a healthy backlog. We anticipate orders to be flat more or less in Q3 and turning positive in Q4. I know everyone is interested in what AI orders look like in the quarter. And candidly, that would be almost impossible to answer with precision. We have seen AI-related orders, I would say, in the tens of millions of dollars. Our customers are focused on AI retrofit rate infrastructure, and we see evidence of this in our pipelines. Many of our products today can be used for either regular density or high-density applications, and we won't be able to report out a discrete AI number. For example, most AI today is still being air cooled, which is perfectly served by the traditional vertical portfolio. Over time, a part of these loads will transition to liquid. We are uniquely positioned to provide liquid cooling to remove heat from the server and the rack. But removal of the heat doesn't stop outside the rack. You need to remove the heat from the data center as well, and we have a portfolio of solutions to do just that. As I mentioned, we are seeing clear demand acceleration signals from the market, and we are having conversations with very relevant market players around securing capacity, and not just over the next few quarters, but well into '24 and beyond. Let us transition to supply chain. We see the environment improving, but there are two parts to this story. First, supply chain continues to incrementally improve. No doubt, lead times are gradually reducing, and there is more certainty in supply. The second part is the self-health aspect. We have been vocal about our multi-sourcing programs. One of the most important architects of this ongoing supply chain resilience program, Paul Ryan, is now our leader of global procurement. He is not new to me or to Vertiv. He has been with us for over a decade and has more than 25 years of experience and a strong track record in operational execution combined with a very clear strategic vision. Supply chain resilience is key considering the demand waves that may be ahead. Let's now talk capacity. We have been investing in capacity for a few years in a balanced approach across the globe. The focus is on utilizing and coordinating capacity globally. We have recently announced a new role in the organization, Executive Vice President of Manufacturing, Logistics and Operational Excellence, with Anders Carberry leading the effort. Over the last five years, Anders has led Vertiv's operations in Asia, then EMEA and finally the Americas. In the Americas operations over the past year, specifically, we have seen significant improvements. He's the right person to take the organization to the next level on process and operations improvement as well as company-wide deployment of the Vertiv operating system. Our ability to navigate strong periods of growth in a complex environment continues to improve. Let's talk about inflation. While inflation is trending a bit more favorably than anticipated, a couple of dynamics influence the second half of 2023. First, metal prices were at lower levels in Q3 and Q4 over the last year. So as we compare that, we are experiencing year-on-year inflation, a bit higher in the second half. We also anticipate that when the Chinese economy accelerates, that increased demand could cause additional inflationary pressure on commodities. We have seen a favorable tailwind from price costs with good processes in place that better prepare us for volatility related to our input costs. Let's go to Slide 6. We believe AI will increase our overall TAM. AI is a reinforcement of demand trend, and AI workloads are incremental to new applications. They aren't in general, replacing other applications in our digital economy. We expect growth in both high-density and general compute. This benefits all Vertiv technologies. We believe liquid cooling is not a displacement risk and, in fact, is additive to growth for Vertiv. Before liquid cooling, we would take the heat from the building. With liquid cooling, it's additive. We reach out into the rack and get one step closer to the heat generation point while still controlling all parts of the heat rejection. The infrastructure transition to AI, high-density environments will be complicated and likely involve hybrid approaches to technology deployment. It is very likely a data center will need both liquid and air cooling orchestrated closely together to optimize the data center environment. We do very well with that approach with the widest portfolio of thermal technology available, alongside the deepest domain expertise on how to orchestrate these technologies using our advanced control systems. We also have over 3,500 field service engineers across the world to support the deployment and maintenance of the infrastructure. We have the scale and the ability to increase capacity. I believe you can sense my excitement. Much more to come on high-density AI at our Investor conference in November, but we feel very well positioned for this opportunity.

David Fallon, CFO

Perfect. Thanks, Gio. Turning to Page 7. This slide summarizes our second quarter financial results. As you can see, strong financial performance across the board, starting with our results from last year. 9% of that was from pricing and 16% from volume, with most of that volume benefit in the Americas, highlighting the continued supply chain and operational improvements in that region, which has been a pillar of our turnaround over the last 18 months or so. Adjusted operating profit was $61 million higher than our prior guidance, $45 million from higher pricing, $25 million from incremental volume, and $15 million from lower-than-expected inflation. These tailwinds were partially offset by headwinds from foreign exchange and investment in fixed costs, primarily from restructuring and incentive compensation. Higher-than-expected pricing was driven by higher volume, favorable regional mix, and some conservatism for potential pricing headwinds that did not materialize. Inflation was not as bad as we expected, as commodity costs, including metals, declined from the end of the first quarter, likely influenced by a slower-than-expected rebound in the Chinese economy. Next, on this slide, and very proudly, we generated $227 million of adjusted free cash flow in the quarter, an impressive $460 million higher than last year's second quarter. While there's still a lot of work to do to optimize working capital, our second quarter is reflective of our focus on cash and indicative of the cash generation potential of this business when we do control working capital, which increased just $5 million in the second quarter despite a $213 million increase in sales from the first quarter. Now the second quarter number was aided by some favorable timing tailwinds, and we should not expect free cash flow to be 130% of adjusted net income each quarter, but it shows we have made significant strides towards unlocking the cash generation potential of this business while funding organic growth. Last on this slide, net leverage declined to 3.1x at the end of the quarter and is expected to be approximately 2.3x by year-end, well within our previously communicated target leverage range of 2 to 3x. It was only a few months ago that we were being labeled by some and likely discounted from a multiple perspective as highly levered. We argued at the time that it was pursuant to a mechanical calculation and just a matter of timing. Well, I think we were proven correct as our year-to-date performance has now driven that mechanical calculation towards what we believe to be the practical reality. Turning to Page 8. This slide summarizes our second quarter segment results. The Americas region continues to show strong year-over-year performance with organic net sales growth of 48%, including 35% from volume and 13% from pricing. Adjusted operating margin improved 12.3 percentage points on the strength of price cost, fixed cost leverage, and notably improved operating results from E&I. APAC top line continues to be influenced by slower-than-expected recovery in China. Volume was relatively flat, so our organic growth was driven by incremental pricing. Adjusted operating margin declined about 100 basis points from last year, primarily driven by approximately $6 million of restructuring costs in the quarter. We do anticipate sequential quarterly sales growth in APAC in the third quarter but we have reduced our full year projection from our prior guidance, now expecting full year low single-digit growth. EMEA grew organically 9% in the second quarter almost entirely driven by pricing. We expect third quarter sales in EMEA to be down slightly from the second quarter, with a significant increase in the fourth quarter and full year growth expected to be in the upper single digits. EMEA continues to impress from an adjusted operating margin perspective, posting 26.6% for the second quarter, 870 basis points higher than last year, driven primarily by price cost and fixed cost leverage. Finally, on this page, corporate costs were $21 million higher than last year, driven by higher restructuring and incentive compensation costs and an incremental $5 million loss on foreign exchange. Based on the current guidance, we anticipate these incremental costs at our corporate entity to flow through for the full year, and we expect second half corporate costs to be consistent with the first half. Next, turning to Page 9. This slide summarizes our third quarter guidance. As a reminder, we have anticipated a more stable quarterly sequential sales cadence as we proceed through 2023. For this reason, our third quarter guidance looks largely consistent with our second quarter in absolute terms. We have included provision for sequential increases in both pricing and inflation in the third quarter and sequential headwinds from foreign exchange, including $15 million on sales and $5 million on adjusted operating profit. Moving to Slide 10, our full year guidance. We are raising our projected top line by $285 million, primarily driven by higher expected sales in the Americas, partially offset by lower expected sales in APAC with EMEA consistent with prior guidance. We are raising our 2023 adjusted operating profit guidance by $150 million, $60 million from the second quarter beat and $90 million in the second half. This increase translates into a 170 basis point increase in our expected adjusted operating margin to 14%. While we have not explicitly provided fourth quarter guidance, math suggests we exit the year at 15%, edging closer to our intermediate-term target of 16%, which should provide good momentum transitioning into 2024. And finally, on this page, we are increasing our full year adjusted free cash flow guidance by $200 million at the midpoint to $550 million. This is an $810 million improvement over last year and demonstrates momentum not only with our drive for profitability but also with our management of working capital. Before I hand it back over to Gio, let me address some potential questions on our adjusted free cash flow guidance, which implies approximately $300 million of free cash flow in the second half, which is $150 million lower than our second quarter number multiplied by 2. The primary driver of this variance is timing, both for CapEx and cash taxes, which are normally back half loaded, and this year is no exception. These two items explain approximately $130 million of the $150 million variance. The remainder is driven by higher use of cash from trade working capital as we prepare for strong anticipated demand in 2024, partially offset by higher projected EBITDA and lower cash interest. So with that said, I turn it back over to Gio.

Giordano Albertazzi, CEO

Well, thanks a lot. As Dave said earlier, great quarter. There's still a lot to do. In our February call, I went through the focus areas for 2023, creating a high-performance culture where ownership is clear, and we hold ourselves accountable for the results, constant focus on things that matter, and executing a relentless focus on execution. At the halfway mark of 2023, we have made progress. Innovation and technology continue to be a key differentiator for Vertiv. With our ongoing investment in this area, I am very encouraged by our road maps for R&D and technology development. I believe you will see this momentum building and differentiation further distinguish Vertiv as the partner of choice in critical infrastructure. I continue to travel around the globe visiting customers in Vertiv locations, and key industry players are more excited today than I have been in the last 25 years with this great organization. I can feel the energy and momentum building in our business and our industry. It is tangible. This traction is not easy to translate into words, but you are starting to see the transformation taking hold, deepening, and becoming Vertiv's DNA. So the takeaways: strong first half, supported by continued improvements in operational execution, a healthy market, and momentum continuing, in fact increasing with AI tailwinds. We are raising our guidance across all financial metrics and especially pleased to be raising our adjusted operating profit guidance to $950 million at the midpoint. This indicates a healthy second half and a great foundation for 2024. An important reminder, Vertiv's Investors Conference on November 29th at the New York Stock Exchange. So I truly hope you can join us and make sure you mark that in your calendars. With that, over to the operator.

Operator, Operator

Our first question comes from Nigel Coe from Wolfe Research.

Nigel Coe, Analyst

So November conference is in the calendar. No problem with that. Great. So obviously, a lot to go through. One thing you mentioned, Gio, was the AI, so GPU retrofit opportunity. And we don't often think of retrofit activity in the data centers. So maybe just run through sort of what you're seeing today and sort of how impactful do you think this could be for Vertiv? And maybe just talk about how important your service organization can be if we do start seeing material retrofits?

Giordano Albertazzi, CEO

Yes, there are two aspects to this, Nigel. Thank you for the question. There is certainly a kind of a non-retrofit new market, new data center, and it's a place where our service organization becomes absolutely critical in our ability to partner with customers everywhere in the world. Not all the players in specifically the liquid part of the thermal spectrum have this ability to reach out everywhere as we are. We have demonstrated that, and our numbers prove that. As I was saying, 3,500 service engineers globally. But the other is we see it today and we talk with our customers today, and they say, not only do we have to think about liquid cooling. But the thing that we have to think about is a hybrid environment probably in an initial build that has more traditional server cooling. So there needs to be an ability to retrofit over time because the sites will hybridize, and we enable that. Then being there with our customers to execute on that retrofit is again fundamental. That retrofit is not just the rack itself or the row, but it's the ability to interconnect and balance it with the rest of the existing thermal system. But think about the stock of data centers that exist in the industry today. It's really hard to believe that that part will not be hybrid in and of itself. Today, we hear people saying, hey, we are already having AI-enabling high-density racks, and we air cool them. But that sounds easier said than done; then you have to balance, of course, the cooling. At the same time, that very same retrofit can be a liquid retrofit eventually. Again, the same problem exists, even more complicated, than with infrastructure thought for future retrofit. Hope I answered that, it could be very long. I will avoid.

Nigel Coe, Analyst

Yes, there's a lot there. I mean, it sounds like it could be quite a material opportunity. On the pricing, so I think it's 9% in the quarter. I think, 7% in the third quarter. Maybe, David, what's in your fourth quarter for pricing? And then what would be a reasonable outlook for pricing in 2024? I'm assuming we're going to be down to a more normal range. But I'm just curious if you're still continuing to push price real time.

David Fallon, CFO

Yes. From a quarterly cadence perspective, pricing is 9% in the first quarter, 9% in the second quarter, 7% in the third quarter, and 5% in the fourth quarter. So for the full year, that's $420 million, up about $120 million from our prior guidance. It's probably too early at this point to comment on 2024 pricing, but we should have a nice tailwind heading into next year.

Operator, Operator

Our next question comes from Andy Kaplowitz with Citigroup.

Andrew Kaplowitz, Analyst

Gio, you said it's difficult to discern AI versus not AI in your markets. But as you said, your pipeline of opportunities seems to have increased in the last 90 days, and you turned EMEA's cloud hyperscale to green. So is there a way to quantify how much bigger your pipeline is that is feeding into the expectation of flat bookings in Q3 and up modestly in Q4? And then just stepping back, would you say AI contribution in orders is coming earlier than you expected in 2023?

Giordano Albertazzi, CEO

Well, the acceleration of the pipeline that I referred to during the presentation is specific to industry and to region and customer, really. So it varies, but the acceleration is real. How big? It is part of a wave of demand, as I explained. This is additional demand that will probably drive also the more traditional type of loads and compute further up. Specifically, the comment about EMEA is that we start to see this effect hit EMEA as well. We wanted to send the message that we see acceleration across colocation and cloud because of AI. How big exactly? Again, it's premature to say. The market is moving. I would say it's hard to distinguish what is AI and what is not. We know that some technologies, specifically for high density, specifically for GPU. And that is a little bit earlier to track. But we know that there are many traditional technologies that are there to enable AI as well. That's true for the power part of our portfolio and for the thermal part.

Operator, Operator

Our next question comes from Amit Daryanani from Evercore.

Amit Daryanani, Analyst

Congrats on a nice print. Gio, I was hoping you could just talk a little bit more about when it comes to cooling AI clusters, liquid cooling clearly becomes more important, especially in higher densities. But there seem to be multiple ways that you can use liquid cooling. Direct-to-chip is something you folks do, but I think there's immersion and other forms of it. So from your perspective, do you think Vertiv's strategy would be to have a broader liquid cooling solution across different formats? Or would you want to focus more on direct-to-chip? And then as it relates to these AI clusters, can you just touch on what do you think your economics look like versus the corporate average?

Giordano Albertazzi, CEO

So I want to reiterate the message that I had when I was going through the slides; when we talk about liquid cooling here, we really talk about how we extract heat from the heat generation point, i.e., the chip, to outside the server, outside the rack, and into the data center. This is the novelty. As I was saying, there are three ways to make that extraction: A, continue to do it through air. We have seen air-cooled racks going all the way to north of 40 kilowatts per rack density. But clearly, at a certain stage, liquid cooling will kick in, in the form of immersion or direct-to-chip. We have both in our portfolio. We're partnering with people that handle both. We believe that the main technology going forward for liquid is really direct-to-chip. But again, it is certainly a portfolio approach that we're taking.

Amit Daryanani, Analyst

Got it. And then, I guess, how do you think about the economics with these clusters versus corporate average? I imagine it’s more complex with higher ASPs. But I would love to know if you think that's fair, and then how does it flow out for operating margins and so on as well?

Giordano Albertazzi, CEO

Well, it's a bit a lot of detail and also premature for those details. But I go back to the point I made at the beginning: we see this as additive. So it is another technology. We did not participate in the heat sink or extraction from the server. Now we are starting to participate in that part of the equation. So it's a bit premature, but I want to ensure we understand that this is an addition for us. But that absolutely dovetails in what you're asking for.

Operator, Operator

Our next question comes from Lance Vitanza with TD Cowen.

Lance Vitanza, Analyst

My question is, with leverage down to around 2x at the end of the year, you're about a year ahead of where we thought you'd be. It seems to me that 2x is low enough and that free cash flow in 2024 should be directed back to shareholders. Can you discuss your thoughts on that idea? Would you favor increasing the recurring dividend, a share buyback, or perhaps other vehicles? How are you thinking about the return of capital?

David Fallon, CFO

Yes. First, let me say it's very nice to have this conversation because we couldn't have asked this a year ago. At this point, we're going to get through this year. We will share in our investor conference our further thoughts on capital allocation. We certainly are participating in an industry where there should be plenty of growth and plenty of opportunity to continue to reinvest in the business. We do recognize that we will have to make some strategic decisions with what to do with some excess cash. As we said previously, we believe there are some accretive strategic acquisitions out there. That is probably something we would look at first, but we'll be able to give a lot more detail in November.

Operator, Operator

Our next question comes from Jeff Sprague from Vertical Research.

Jeffrey Sprague, Analyst

It was a good quarter, and it's great to see. I wanted to discuss the exit rate regarding the margin. Thank you for calculating that for us. We had done the math, but I'm glad you highlighted it. My question pertains to whether we can return to the original algorithm we had before the setbacks 18 months ago, where we focused on operational improvements and price execution among other things. Could you provide an update on those areas, especially the internal operational opportunities you see? I would imagine that given the current strong demand, you expect to maintain a positive price-cost balance for the foreseeable future. Do you agree?

Giordano Albertazzi, CEO

Maybe I can start with a little bit on the three points: price, cost, and execution. We've been vocal about the price efforts and successful execution, as David explained with our outlook. However, what is most important is our price cost. When we discussed price, I was vocal about the fact that we now have a muscle that we did not have before, and that has helped us a lot to rebalance against the pretty big inflation position. We have a lot of focus on efficiency, particularly in manufacturing execution and procurement. There is still potential in general. Execution, in particular, is true across the organization. I can point to the execution that we have started to drive in procurement and manufacturing and our ability to ship. This has characterized and accelerated our ability to deliver on a strong backlog we entered 2023 with. We will have time in November to go into more details about the exact axes of this acceleration.

Jeffrey Sprague, Analyst

Yes, it is. I wonder if you could give us some perspective on incremental margins, trying to kind of pull all that together. If we say we're not done in '23 but we're in a strong position now, what would be a reasonable incremental margin construct for us to have in our head?

David Fallon, CFO

Yes. The easy answer is higher. If you look at where we were last year, we were probably in the low 30s from a variable contribution margin perspective. We're in the upper 30s at this point in time. Call it mid- to upper 30s. Out of the projected 600-plus basis point increase in operating margin this year versus last year, about 400 of that is related to the variable contribution margin and 200 is from fixed cost leverage. I don't want to discount the power of the fixed cost constant methodology and culture. That should continue to provide upward momentum on operating profit. As we've consistently said, our intermediate-term goal is 16%. We have high confidence of getting there for sure, but we're not celebrating. Our long-term goal is 20% and higher, but to get there, we need to continue to improve the contribution margin while incorporating that fixed cost leverage philosophy.

Operator, Operator

Our next question comes from Nicole DeBlase from Deutsche Bank.

Nicole DeBlase, Analyst

Can we just start with enterprise demand? I know you didn't change the bubbles in the market outlook, but what are you seeing on that front? I know this has been kind of like a watched item year-to-date.

Giordano Albertazzi, CEO

Nicole, not much really to add to what we were saying. We continue to see that demand fairly stable. The technology continues to evolve for everyone in the industry, and that's not just for colocation or hyperscale. Again, not a lot to elaborate upon here. We see stability in that space.

Nicole DeBlase, Analyst

Okay. And then the EMEA margins, obviously, saw a big step-up this quarter. How are you thinking about the sustainability of that level of margins into the second half of the year?

Giordano Albertazzi, CEO

I would say that we have done a very, very good job operationally in terms of positioning ourselves in the market with our technology and with our total cost of ownership story. We are strongly positioned in EMEA altogether.

Operator, Operator

Our next question comes from Steve Tusa from JPMorgan.

C. Stephen Tusa, Analyst

Congrats on the free cash flow. Just a nitpicky one, then I have a follow-up. But why do you guys have inflation, the material freight and labor inflation, ticking up quarter-to-quarter from 2Q to 3Q? Is that something to do with the comp from last year?

David Fallon, CFO

Yes. There are three components to the inflation story. You have material inflation, which is a $110 million headwind for the full year. You have an actual benefit in freight of about $40 million, and labor is about $100 million. The benefit from freight is definitely front-end loaded. So of that $40 million, probably $30 million is in the first half, which provides a tailwind as you look at the second half versus the first half. In addition, we do see an uptick in labor inflation, partly because of the timing of pay raises, but also related to a foreign exchange dynamic in Mexico where we have some of our labor. I would say those are probably the two most significant dynamics. It's primarily a front half, back half dynamic for both freight and labor.

C. Stephen Tusa, Analyst

And then can you just help reconcile it? It just seems like the other guys, the other peers you compete against, their orders are trending better than you guys on a year-over-year basis. I know there's some difference in portfolio, there's some lumpiness. Do you feel like you're being selective, or are you holding your own in these bids for now?

Giordano Albertazzi, CEO

There are two elements here. One is the normalization that we've been vocal about in the last two calls, and this will continue. That's a very normal, very healthy situation we’re in. We have very strong comparisons, and we see pipelines growing. I am positive about the trajectory we're on. I can't speak for other players.

David Cote, Executive Chairman

Base period of comparison.

Giordano Albertazzi, CEO

Exactly. If we revert to the beginning of the year, we were at a $4.8 billion backlog, and we were likely going to shrink that. We were to probably consume this backlog. So here we are halfway through the year, and that has not been the case. We have a book-to-bill of 1. But only if we look at our book-to-bill on the trailing 12 months, we are at 1.1. There are multiple ways to look at this. I recommend we don't take things at face value, but instead double-click on what's really behind the numbers.

C. Stephen Tusa, Analyst

Yes, great. And then just one last one. On this new technology around cooling and the proliferation of AI-related data centers. Do you feel like you're going to need to invest more, whether it's through acquisitions or through technology, at some stage to kind of bring more in-house? Or is it more steady as she goes as far as partnerships and developing internally? Is there a certain degree of acquisition you feel like you'll end up doing when you get better visibility on what the format is?

Giordano Albertazzi, CEO

This technology is still at a very early stage. Like every technology at this stage, you're looking at opportunities through multiple lenses. One is the organic lens, and we're certainly investing a lot, but we have partnerships as well. There are multiple opportunities out there. With a stronger balance sheet, we'll focus on understanding exactly what's the best path going forward as the market matures.

Operator, Operator

Our next question comes from Andrew Obin from Bank of America.

Andrew Obin, Analyst

Just a question. What are typical lead times for thermal management products at this point? If data center owners are planning to buy these GPU chips, what lead times are you quoting for the related thermal products?

Giordano Albertazzi, CEO

Well, that really depends on the customer request, of course. But at this moment, we have changed significantly from the situation we were in 2022, as we explained during the last earnings call, where we were facing lead times of 50 to 60 weeks, now down to much lower levels around 30 to 40 weeks, and continuing to reduce. What the requested lead times we get depends on the strategy of the various players. Do not think, if I may suggest, that it's an exact concatenation of when do I get the chip or GPU and when I need the infrastructure because the two things go in parallel. Very often, the infrastructure comes first. You may see some earlier infrastructure demand ahead of the bulk of chips available for AI. Our lead times have improved considerably, and we're now able to serve the market with much shorter lead times than we did a year ago and indeed even three months ago.

Andrew Obin, Analyst

And maybe just a follow-up. Could you give us some color on internal changes that you're making to improve cash? Changes on how you bill, payment terms, down payments, just any color about sort of nuts and bolts of moving the needle there?

David Fallon, CFO

Yes. I think your words, nuts and bolts, probably is a pretty good description. Similar to what we did from an operational perspective, notably in the Americas, we are getting into the basics and focusing on day-to-day execution. We have a lot stronger visibility and transparency regarding payment terms with every customer. We get daily updates about inventory levels. Most importantly, we have a plan that we are executing against. I would say there's been some early successes, but there is still a ton of opportunity out there. This has been a focus as we exited last year—probably starting in force mid last year—but it's also a huge cultural aspect. When we talk about metrics, we generally start with cash at this point in time. We are encouraged with where we are but not satisfied; there's still a lot of work to do.

Operator, Operator

Our final question comes from Mark Delaney from Goldman Sachs.

Mark Delaney, Analyst

Congratulations on the strong results. The company had been expecting backlog to get worked down a bit this year as lead times normalize. But with the book-to-bill, as you mentioned, at 1.0 for both Q1 and Q2, can you share your latest views on how you expect backlog to trend? Do you still think that comes down a bit this year? Given the better-than-expected demand, do you think you need to put any more manufacturing capacity in place to support that?

Giordano Albertazzi, CEO

Yes. Well, thanks for the question. When it comes to the backlog, we have planned for orders that see our orders in Q3 and Q4 indexed sequentially. We will see what the backlog does exactly. We are still in an unusually big backlog situation, given our historical trends and the industry's historical trends. We were north of 70% coverage. We believe that anything above 50% is a good place to be. Let's see how things unfold in that respect. The pipeline strength is encouraging. In terms of capacity, we do have capacity. We have increased our investment in capacity over the last 12 to 18 months. We are certainly extracting more capacity from what we have. We have talked many times about our Vertiv operating system, which is a significant enabler for increasing capacity from our current footprint. However, we are focused on building scenarios as to what will happen. We will move early if needed when we see an imbalance between the potential demand and our available capacity.

Operator, Operator

Thank you. This concludes our question-and-answer session. I would like to turn the conference back over to Giordano Albertazzi for closing remarks.

Giordano Albertazzi, CEO

Well, thanks a lot. Again, a good first half, looking forward to our second half, and looking forward to meeting you all in November.

Operator, Operator

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