Earnings Call Transcript - VRT Q1 2020

Operator, Operator

Good morning. My name is Nick, and I will be your conference operator today. At this time, I'd like to welcome everyone to Vertiv's First Quarter 2020 Earnings Conference Call. Please note that this event is being recorded. I'd now like to turn the program over to your host for today's conference call, Ms. Lynne Maxeiner, Vice President of Investor Relations. Please go ahead.

Lynne Maxeiner, Vice President of Investor Relations

Thank you, Nick. Good morning, and welcome to Vertiv's First Quarter 2020 Earnings Conference Call. Joining me today are Vertiv's 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 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 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 decks found on our website at investors.vertiv.com. With that, I'll turn the call over to Executive Chairman, David Cote.

David Cote, Executive Chairman

Thanks, and good morning, everyone. I want to welcome you to the Vertiv investor call to announce our Q1 2020 results. Before I turn it over to Rob Johnson, I want to begin with a few opening remarks. As we spoke last time, and as many of you know, I was fortunate to be able to work for Honeywell for about 16 years. Those who invested with us made a great return. That performance was marked by consistent annual improvements in the people, processes and portfolio of the businesses that made up Honeywell. We did all the seed planting for new products, services, process improvement and other growth initiatives needed to perform well for a long time. The world is in a very different place than when we spoke a couple of months ago. But those opening remarks stay true, whether we are in a period of economic expansion or economic contraction. If you look at our success at Honeywell, it really took off after the Great Recession. And I attribute that success largely to the fact that we continue to implement an operating system, we drove technology investments, and we planted seeds even during that difficult time. Why do I bring it up? Because we're doing that same kind of seed planting at Vertiv. Now some of you may conflate our withdrawal of guidance even in the face of good orders growth, with the liquidity scenarios we've included, and conclude we see a serious problem looming. That would be an error. They are two entirely separate points. We've withdrawn guidance because we can't be sure we can ship given the government shutdown of facilities for us and suppliers at various times. Additionally, our service people sometimes aren't allowed access to facilities. Our credibility matters greatly to us. And we don't want to guide to numbers we may not be able to deliver even in the face of strong orders. Totally separately, we have included a couple of liquidity scenarios to demonstrate that even if sales fell to $4 billion or even in a 25% sales decline, we will be just fine. It's not a forecast, it's an attempt to make you feel comfortable that we're just fine. Combining these two separate points into the erroneous conclusion that we are forecasting disaster is, well, erroneous. This time has been difficult for everyone. But it also has demonstrated how important data centers and the edge are to our society. It is clearly critical infrastructure and reaffirmation this is a good industry. We have a great position in that good industry. And even at this difficult time, we are investing in the future. Based on how we're running the business during extraordinarily difficult times, including our own customer focus while still seed planting, I am just as excited today as I was three months ago about our future. Now I'll turn over the call to Rob who can take you through the business in a little more detail. Rob?

Rob Johnson, Chief Executive Officer

Thank you, Dave, and welcome, everyone, today. As I said on the last call, I really value the advice that Dave has provided to the team since he's been engaged with Vertiv. And I especially appreciate his counsel now as we navigate through these pandemic times. Before I walk you through the slide, it goes without saying that we have been proactive in protecting the safety of our employees and our customers. We've implemented precautionary measures from temperature screening to increased cleaning and disinfecting of facilities to social distancing at work, just to name a few. Additionally, our service technicians have followed Vertiv's safety protocols and adhered to additional safety measures adopted at customer sites. Safety of our Vertiv employees and our customers has been and will continue to be at the forefront of everything we do. I want to thank the Vertiv employees for their hard work during Q1 and give a shout out to the manufacturing workers and the service technicians who continue to provide products and services to our customers and conduct day-to-day business with the utmost of caution amidst COVID-19. I appreciate their steadfast commitment to Vertiv. It's their unwavering dedication that has allowed us to serve our customers, enable those customers to provide technology and vital applications to the world that they rely on more than ever. To all of our employees on the front line, I say thank you. Let's take a look at the slides, starting with Slide 4. Overall, the demand side of our business was very robust in Q1 as orders were up 13% compared to the first quarter of 2019. We exited Q1 with a record high backlog of $1.6 billion, which can be attributed to cloud, colocation and telecom customers around the world who are delivering vital applications so students could be educated online, hospitals and health care facilities could function, workers could work from home and businesses experiencing a surge in demand during the stay-at-home mandate could deliver. On the revenue side, despite almost all of our manufacturing facilities being up and running, we have been deemed essential. We were still adversely impacted by COVID as many of our facilities are still dealing with some level of disruption. Additionally, Q1 of 2019 had a few large projects complete, which made a difficult comparison. In Q1, we proactively implemented cost actions to protect the business having seen and felt the impact of COVID in China before things spread to other parts of the world. These cost actions are expected to generate $60 million of benefit by the end of the year. David will address liquidity later, but we feel good about our position today and know that even under a variety of downside scenarios that Dave spoke to, we will be able to maintain our strong liquidity base. We stay close to our customers and continually monitor and comply with directives of governments around the world as they relate to pandemic actions. This pandemic has put us and others in a position where things will remain dynamic and unpredictable over the next several months. Because of this, we are withdrawing our previous guidance. I can tell you this, however, Vertiv has been designated as an essential business. We see strong demand for our products and services. We are taking short-term and long-term actions to make sure we continue to serve our customers. We are nimble, flexible and responsive. We are ready to adapt, react and serve in ways that will be needed for today and tomorrow and in the future. Turning to Slide 5. There's a lot of content on this slide, so I won't hit every bullet. But we wanted to provide you with additional knowledge and deeper insight about our business. The first quarter COVID impact of $80 million was roughly 60% supply-based and 40% demand-based. On the supply side, I'm proud to tell you that all of our facilities, with the exception of a small plant in China, are back up and running. Now not all of our facilities are running at 100% because there are still many things they are struggling with: parts issues, logistics constraints, but nonetheless, we are able to operate at some level in every region. The supply side is aggressively being monitored on a daily basis as issues arise. Whether it's government health inspections, supplier output, logistics and many more, there's just a myriad of obstacles that our team has to continue to overcome on a daily basis. The Vertiv team has done an outstanding job to carefully and methodically resolve these issues as they arise in places all over the globe, so we continue to supply products to our customers and assist them with their services needs. Moving on to the demand side. Certainly, the headline number of orders being up 13% is a great accomplishment of the sales and marketing team. Each region grew orders substantially with EMEA leading the way at 26% year-over-year growth in Q1. The orders were largely driven by cloud, large colocation and telecommunication companies. The area where we saw softness was within the small- and medium-sized business that is served by our IT channel partners who have been adversely affected by the pandemic. As this segment of the business starts to come back, we expect to see demand continue. Turning to Slide 6. As I mentioned previously, we were in early identifying, addressing and implementing a number of different cost actions for Q1. The entire leadership team and Board of Directors took a 10% base pay cut. While this may not be new news to most of you, what you didn't know is that they volunteered to do this. Additionally, merit increases for employees were halted for 2020. The 401(k) match in the U.S. has been stopped, and every department has been tasked with a discretionary 15% cut. Furthermore, Dave mentioned in his opening remarks about the use of furloughs, and we have implemented those across every function and every jurisdiction where it's allowed. Employees have been understanding and supportive of our efforts to utilize these measures to make sure Vertiv stays strong and financially healthy. These actions and a few others will contribute to $60 million of P&L benefit during the rest of 2020. We are also being aggressive on the revenue side. Our sales and service teams are strengthening ties with the customer, providing updates and reassurances to them regularly. We have enhanced our marketing message and increased our social media presence as we look for additional ways to reach those in need of the products and services that we provide. The selfless nature of our 19,000-plus employees is a testament to the culture of the organization. Our desire to be present and helpful to those who need us, and our willingness to work while we battle COVID-19, I am proud of the way Vertiv and its team have acted and reacted to all the unknowns we faced in Q1. With that, I'll turn it over to David Fallon to give a deeper dive into the financials.

David Fallon, Chief Financial Officer

Thanks, Rob. Turning to Slide 7. This page provides a summary of our debt structure and our current and expected future liquidity. Starting on the left-hand side, we remind investors that we were able to time the SPAC transaction and debt refinancing quite well with neither likely available to us in this current market environment. However, as a result, we possess a rather simple long-term debt structure with a $2.2 billion term loan maturing in 2027, with $1 billion at a variable rate, currently at 3.4% and $1.2 billion swapped to a fixed rate of 4.1%, resulting in a relatively modest annual cash interest run rate of less than $90 million, which is inclusive of interest on our $455 million asset-based lending facility or our ABL. Now counterparties to our ABL are all large, well-known, reputable banks. Hence, we believe there is little counterparty risk related to credit in our ABL. Our term loan contains no financial maintenance covenants, and our ABL contains only one springing financial maintenance covenant if our availability falls below $45.5 million or 10% of the total facility. The springing financial maintenance covenant is a fixed charge coverage ratio that must be greater than 1 and which was at 3.7 at the end of March. Hence, we believe there is minimal risk of violating this covenant even under significant downside scenarios. The right-hand side of this page summarizes our liquidity, a strong $446 million at the end of the first quarter including $289 million of nonrestricted cash and $157 million available on our ABL. We will review the components of negative free cash flow in the first quarter in a few slides. But $100 million of that use of cash was pursuant to discrete payments related to the SPAC transaction and cash interest, which will not recur going forward. We continue to expect positive free cash flow for the full year including slightly negative in the second quarter and significantly positive in the third and fourth quarters. This projected quarterly cash flow cadence is consistent with prior years, as we generally use cash in the first quarter and second quarter free cash flow is generally somewhat modest due to lower collections from lighter seasonal first quarter sales. Normally, a large percentage of our full year free cash flow is generated in the second half of the year. We feel quite good about our liquidity projections, even under unlikely significant downside scenarios. For example, even if sales are modeled to decline an improbable 25% from last year. And as Dave mentioned at the outset and just for avoidance of doubt, we provide this illustrative downside scenario simply to demonstrate confidence in our liquidity and not as any form of directional guidance. But even under this extreme scenario, our projected liquidity low point in 2020, still does not drop below $300 million, as lower adjusted EBITDA is partially offset by a recovery of working capital, which runs at about 22.5% of sales. And for further clarity, this $300 million low point is not a year-end liquidity figure, but this would be projected to occur at some point intra-month in the fourth quarter, as our liquidity ebbs and flows intra-quarter, but is generally highest at each quarter and year-end. In addition, under this and any significant downside sales scenario, our liquidity is also negatively impacted by lower collateral on the ABL as lower sales reduce eligible accounts receivable supporting the borrowing base. Of course, this modeling scenario also assumes that customers continue to pay amounts owed to us in a timely manner, and we pay suppliers similarly. As of today, we have not experienced any significant collection issues. In addition, our modeling does not assume the benefit of any additional cost actions, which certainly would be likely in a significant sales downturn nor does this scenario include the benefit of any potential additional liquidity actions, including contractually extending supplier payment terms, establishing local lines of credit or even though we do not foresee a dire need at this point, opportunistically accessing debt financing markets. Next slide, turning to Slide 8. This page summarizes our first quarter financial results versus last year's first quarter. Net sales were down $158 million or 15%, including approximately $80 million due to COVID-19 and $19 million from unfavorable changes in foreign exchange rates, as most global currencies weakened versus the U.S. dollar in the first quarter. The remaining $59 million reduction was anticipated heading into the quarter, primarily driven by large projects in last year's first quarter, predominantly in Americas and EMEA. Adjusted EBITDA declined $40 million from last year due to the lower top line, and partially offset by lower fixed costs from prior year restructuring activity. Adjusted EBITDA margin declined 260 basis points primarily due to the lower leverage of fixed costs. And to the far right, free cash flow declined $158 million from last year's first quarter, including $100 million combined due to discrete payments pursuant to the SPAC transaction and cash interest that will not recur going forward. We will provide a more fulsome explanation of changes in free cash flow in just a couple of slides. Finally, on this slide, we include a note at the bottom explaining that pursuant to our debt refinancing at the beginning of March, where we raised the new term loan and concurrently paid off several high-interest rate notes, we recognized $174 million loss on extinguishment of debt. $99 million of this loss was a noncash write-off of deferred financing fees and $75 million was a cash payment for the early redemption of the notes. Neither of these items is included in adjusted EBITDA and the cash payment for early redemption or the $75 million is included in financing activities in the statement of cash flow. Next, turning to Slide 9. This page summarizes our first quarter segment results. I won't delve into the details, but COVID-19 certainly negatively influenced each of the three regions. We disclosed the top line impact for each region on Page 5 of this presentation, including $50 million of the $80 million in APAC, as China was virtually shut down in February. However, excluding the impact of COVID-19 and adjusted for $8 million of foreign exchange, APAC sales actually increased $23 million from last year's first quarter primarily on the strength of telecom and larger colocation and hyperscale customers. Net sales in the other two regions were down from the prior year, even excluding COVID-19 and foreign exchange, primarily driven by several larger projects that shipped in the first quarter of 2019. Lower adjusted EBITDA and adjusted EBITDA margin in each region was primarily driven by lower year-over-year net sales. Next, turning to Slide 10. This chart bridges first quarter free cash flow from last year. While we have historically used cash in the first quarter, free cash flow this year was further negatively impacted by lower sales from COVID-19, which significantly contributed to the $41 million increase in inventory and a $40 million reduction in adjusted EBITDA. In addition, cash interest in this year's first quarter was actually $33 million higher than last year, as we accelerated accrued interest payments on the notes we paid off pursuant to the debt refinancing. And we were also negatively impacted by the timing of interest payments on the former term loan. Of course, on a go-forward basis, our quarterly cash interest will be significantly reduced as reflected by the $79 million run rate adjustment in the green bar farthest to the right. First quarter free cash flow was also negatively impacted by $21 million of discrete costs pursuant to the SPAC transaction. So in summary, on a pro forma run rate basis, we used about $103 million of free cash flow in the first quarter with approximately $80 million directly or indirectly attributable to COVID-19. And despite this negative free cash flow in the first quarter, we still expect significantly positive free cash flow for the full year.

Rob Johnson, Chief Executive Officer

And with that said, I turn it back over to Rob. Thanks, David. As we turn to Slide 11, it's important to communicate the fact that our critical digital infrastructure is more necessary now than ever before because of the world's growing need and dependency on vital applications. While we remain cautiously optimistic on the balance of the year, the dynamic nature of the situation makes it extremely difficult to provide guidance at this time. We do feel good about the demand side, and we believe the volatility of this supply chain will moderate over time. But it's not possible at this time to be able to peg a number for 2020. What I can share, however, is internally, we have run multiple scenarios, as discussed earlier, and sensitivity analysis. And even in the most aggressive downside case, with sales at $4 billion, we would still be in a position to deliver approximately $500 million in adjusted EBITDA. Clearly, additional cost actions would be taken, which we have, but those actions have been identified and are realistic from a timing and savings standpoint. I provide these numbers as a reference point, but have no reason at this time to believe we will see sales fall this far. We are always preparing for every ever-changing scenario. Now turning to Slide 12 and in closing. I want to thank you for your support over the past quarter and in the quarters to come. We participate in a great industry, as Dave said. We have the leadership and position, and never has critical digital infrastructure to support the vital applications of the world been so important as it is now. Our order rate, our cost actions we've implemented, our liquidity position are all in great shape as we continue operating during this dynamic time. We will continue to invest, as Dave said, for the future while managing for today. This strategic approach will prepare us to be even more successful when we emerge from this pandemic and the world adapts to a new normal. Thank you again for your support. Stay healthy. I now turn the call over to the operator who will open the line up for questions.

Operator, Operator

The first question comes from Nicole DeBlase of Deutsche Bank.

Nicole DeBlase, Analyst

Maybe we could start with the cost savings. So the $60 million that you guys are targeting, it seems to me that these are kind of all incremental actions relative to the medium-term margin expansion plan that you've laid out. So maybe you could talk about the temporary versus structural nature of the cost savings. It seems to me like these are all temporary, and they will come back when demand resumes. And maybe the ability to pull some of the medium-term cost items that you guys are working through into 2020 as demand is weak.

Rob Johnson, Chief Executive Officer

Yes, Nicole, this is Rob. I want to clarify that the costs we are discussing are not expected to return to the business when we go back to work. These are costs that we will benefit from, such as furloughs, merit increases, and reductions in discretionary expenses. We fully anticipate realizing these savings and seeing a positive impact on our bottom line throughout the quarter. As you noted, we continue to focus on our previously discussed strategies for margin expansion, including the Vertiv operating system to improve our margin profile and manage fixed costs. What we've covered is in addition to the $60 million target. As Dave Fallon mentioned, we also have additional measures we can implement if needed, depending on demand and changes in the environment. David Fallon, do you have any additional thoughts?

David Fallon, Chief Financial Officer

If I could interject a bit. You are a bit right there, though, Nicole. I mean once volume comes back, yes, people will expect merit increases, we'll return the 401(k), that sort of thing. But as Rob points out, these are very real cost savings this year. So we will get those. And some of those costs only come back if the volume really comes back. And independent of that, I guess, somewhat complementary to it, to Rob's point, we're still working all our plans to keep fixed costs constant as we go forward. So I put all that together and say, this is a smart thing for us to be doing right now and helps us to achieve everything that we've talked about. But at the same time, we want to be prepared for the future. And as volume comes back, which we suspect it's going to, given everything we see in our industry, and we think it's actually going to be pretty darn good, yes, some of that may come back, but it's only going to come back with volume that's in that 45% contribution margin range.

Nicole DeBlase, Analyst

Got it. That's really helpful. And then can we also maybe dig in a little bit to what you guys are seeing in April? Most companies have been willing to comment on that a little bit just because we don't really have a ton of visibility sitting here with what you guys are seeing in the early stages of this in North America and Europe. Is that something that you're willing to give some color on?

Rob Johnson, Chief Executive Officer

Yes. This is Rob. Just at a high level, what I would tell you, we expect throughout Q1, April, to see orders continue in a growth trajectory. And then we expect to see some impact from the COVID and from our ability to deliver. We don't have exact numbers, we really don't know. And again, as we mentioned, we're battling every day all around the world to make sure we can supply, keep our factories open, sub-suppliers. So I would just say that we expect orders to continue to be favorable, and we expect to have some COVID impact as we go through Q2, like most other companies have suggested.

Nicole DeBlase, Analyst

When you say favorable, are you referring to orders still being up year-on-year compared to the first quarter order growth?

Rob Johnson, Chief Executive Officer

Yes.

Operator, Operator

Your next question comes from Mark Delaney of Goldman Sachs.

Mark Delaney, Analyst

Was just hoping the company could discuss the demand environment, both in terms of how the first quarter closed and if any business slipped out compared to what the company had been expecting when it held its last earnings call in March. But maybe more importantly, given the record backlog and based on what management knows today, is Vertiv still expecting a pickup in 2H '20 sales compared to 1H '20 on a qualitative basis?

Rob Johnson, Chief Executive Officer

Mark, Rob here again. To address your first question, we did observe some delays in accessing sites, which affected our ability to fulfill orders due to site closures, as seen in Singapore today. We maintain our expectation that the second half will offer positive growth, consistent with what we've stated from the beginning. However, with COVID, it remains uncertain how long the situation will last and when all countries will return to normal operations. Still, we believe the second half will show an upward trend, as we mentioned previously.

Mark Delaney, Analyst

Got it. That's helpful. And then my second question, I just wanted to better understand one of the comments in the press release. I think the company talked about a stable demand environment, but also orders were up 13% year-over-year. So I'm just trying to better reconcile some of the commentary, some of the puts and takes in orders that the company is seeing and just kind of better understand stable relative to the order growth that was reported.

Rob Johnson, Chief Executive Officer

Yes, Mark, at a high level, we discussed the ongoing adjustment in the U.S. market. We expect to see an uptick in orders in Q1, particularly in the colo and hyperscale sectors. We experienced significant demand in the colo, hyperscale, and telecommunications areas, which aligns with our expectations. Some customers placed orders early to secure their products. However, we anticipate that small to medium businesses and enterprise sectors are not currently on a growth trajectory. Nevertheless, with our new product releases and our focus on these markets, we're confident that once people return to work, we will see a recovery.

Mark Delaney, Analyst

Okay. Lastly, I wanted to follow up on the questions regarding costs and SG&A expenses, which were significantly lower than I anticipated. I'm curious about the incremental savings mentioned and how to view SG&A expenses in the second quarter and throughout the year. Will these expenses trend lower than the figures reported in the first quarter? Additionally, will some of the temporary measures that have been implemented lead to an increase in operational expenses compared to the first quarter?

Rob Johnson, Chief Executive Officer

Yes, I have a few comments. This is Rob again, and then I'll hand it over to Dave or David. I believe the world is going to change in ways we can’t fully predict. However, we have learned to work differently, which may impact some of our discretionary expenses, like travel and T&E. I fully expect our team is exploring new, more efficient and effective ways to conduct work. For instance, training our service personnel, which traditionally involved bringing them in for in-person classes at a high cost, is now being conducted online with tools for online testing and classes. We will continue to leverage the efficiencies and insights gained during this pandemic to enhance our operations moving forward. David Fallon?

David Fallon, Chief Financial Officer

Sure. And just some further detail on that $60 million, probably about 70% of that will impact SG&A. So a good portion of the cost actions that we put in place will benefit SG&A going forward. And I think some of the drivers of the lower year-over-year SG&A in 1Q versus the first quarter last year will continue going forward. We were able to put in place some restructuring activity last year, which we will benefit from in each quarter going forward. So we certainly have some tailwinds behind us as it relates to SG&A. But also reminding folks that we are continuing to invest in innovation and technology and specifically R&D, even through some of the top line issues. And that R&D will be rolling through SG&A. So even though if you look year-over-year, we do not anticipate a significant increase in SG&A because we believe we can offset some of the higher cost of R&D with some of these favorable SG&A trends. We wouldn't necessarily expect significant reductions going forward.

Operator, Operator

Next question comes from Lance Vitanza of Cowen.

Lance Vitanza, Analyst

I wanted to actually focus on Slide 5. I found that very helpful. And I'll start. I was surprised to see the demand impact so significant. I mean 40% of the $80 million of revenues, so roughly $30 million. And I'm just trying to figure out how does that square with the commentary around orders being up year-over-year across the board. And specifically, does demand in this context, does this here include the inability to access customer locations? Or when you refer to demand, are you really specifically referring to just customers saying, we no longer want what we thought we wanted?

Rob Johnson, Chief Executive Officer

This is Rob again. Few comments on that, and then I'll hand it over to David. What I'd say is what we haven't seen is, customer demand, someone place an order and then cancel that. We have not seen canceled orders. So what we have seen, as you mentioned, and you're direct on is that the access to the site are people actually pushing it out just because they're shut down, and we can't access that site. So the combination of not being able to manufacture the goods because of the things that are happening in our manufacturing facilities and the access to sites really drove that revenue, that $80 million COVID impact.

Lance Vitanza, Analyst

Okay. That's super helpful and kind of what I expected, but wasn't clear. So then to the extent that this revenue is deferred rather than lost. Obviously, nobody knows when the lockdown ends. But once the lockdown does end, how quickly would you think, all else equal, we expect to see that deferred revenue return? I mean I would think it would be pretty quick, meaning in within a couple of months from whenever the lockdowns are over. Is that a fair estimation?

Rob Johnson, Chief Executive Officer

I wouldn't say it will happen within a couple of months because I don't know when our factories and supply chain will be fully operational. That will depend on various factors, but site access will improve, and we definitely have a substantial backlog to address. I expect, as we've mentioned before, that the second half of the year will see a significant increase. Based on what we've observed in the backlog and overall customer demand, we are not noticing cancellations or delays. I did mention the situation with small to medium businesses, which is uncertain. Different sectors, such as entertainment and travel, have been heavily affected. I can't predict how they will recover, but we do see growth in other areas like health care. I'm particularly excited about the work-from-home trend, which is increasing the demand for more edge devices. Latency has become a significant issue, something many of you have likely experienced at home. In summary, we see the world recovering, and our products becoming even more essential than they were before COVID.

Lance Vitanza, Analyst

Understood. I have two quick follow-up questions. First, can you remind us what percentage of your revenue currently comes from the channel? Secondly, the EBITDA impact from the COVID situation in the first quarter was about 35% to 40% flow-through. We don’t know what the revenue impact will be in the second quarter, but should we expect a similar flow-through to EBITDA as we saw in the first quarter?

Rob Johnson, Chief Executive Officer

Sure. I'll handle that. Yes, I'll handle the first part and then turn it over to David. On the channel side, that represents about 15% of our overall global revenue, so it's around $600 million, $700 million. David Fallon, on the margin side or flow through?

David Fallon, Chief Financial Officer

Yes. So we applied a 40% contribution margin to the $80 million COVID sales impact. And the reason we use a number that is probably a little bit lower than what we have been broadcasting as our contribution margin is because $50 million of that $80 million was in APAC. And in general, our contribution margins in APAC are lower than the other two regions. For the sake of modeling, going forward, we would anticipate any lost sales impact, whether it's related to COVID or otherwise, to be somewhere between the 40% and 45%. So probably a little bit higher than what we used in the first quarter.

Operator, Operator

Your next question comes from Scott Davis of Melius Research.

Scott Davis, Analyst

Is there any impact on price in the quarter? Is price generally pretty flattish at this point? Or are you able to get any positive price, particularly with new products?

Rob Johnson, Chief Executive Officer

Yes, that's a great question. During the quarter, we were able to achieve some price increases. We have ongoing initiatives from last year that will continue into this year to enhance pricing in certain areas. The introduction of new products with unique features provides us with a bit of pricing power as well. Our focused approach on pricing globally, along with new product launches that have innovative features, allows us to set prices above those of our competitors. For instance, our new DSE air conditioner models provide higher margins for us. Overall, we've managed to implement price increases in various areas during this time, and we are very committed to that.

Scott Davis, Analyst

Okay. That's helpful. And then I probably should have asked this question a while ago, but how much of your backlog has a down payment? What's kind of the standard in putting something into backlog, which, obviously, the confidence in that backlog? Love to get your opinion on that as well. But first question really relating to how much of that requires a down payment?

Rob Johnson, Chief Executive Officer

Yes. Scott, not much at all. Very little do we have prepayment cash upfront on that. Now the backlog is supported by very healthy companies. Those orders that are coming in, whether it's colo, hyperscale, telecom, although all companies are affected by this pandemic, we have a really solid base of very financially stable companies that have placed these orders, and we feel real confident that we won't be seeing canceled orders. The demand is high as you can imagine.

Scott Davis, Analyst

Okay. And just on...

David Cote, Executive Chairman

The other thing that...

Scott Davis, Analyst

Please go right ahead, sorry.

David Cote, Executive Chairman

Yes, Scott, I would like to emphasize that this situation clearly demonstrates the significance of data centers, not only currently but also in the future. It's difficult to believe that these orders will stop, and as Rob mentioned, we typically have a strong backlog.

Scott Davis, Analyst

Anyways, to get back to brass tacks here. A couple of just cleanups, and hopefully, you don't have a lot of other questions, just cut me off if you do. But am I to assume that if 70% of that $60 million is SG&A, then the other 30% is kind of at the factory level and perhaps some of that could be structural/permanent? Is that possible or...

David Fallon, Chief Financial Officer

Scott, this is David Fallon. Absolutely. If you examine the major parts of the $60 million, approximately one-third of that is discretionary spending. This is likely the area of costs we will be aiming to reduce permanently moving forward. A portion of this relates to D&E as an example. We are all discovering new ways to operate without needing to travel. Therefore, I would say some of that $60 million will definitely carry over into next year and beyond. Additionally, one philosophy we’ve adopted is that a fixed cost remains a fixed cost, regardless of whether it’s in the factories or the office. We apply the same treatment to all fixed costs, and a substantial portion of this will be advantageous to the factories as well.

Scott Davis, Analyst

I have one last question. Was the inventory buildup due to the shutdown in mid-March catching you off guard? That seemed like a significant increase, and I imagine there were issues in China earlier in the quarter, which surprised me given the inventory levels.

David Fallon, Chief Financial Officer

Yes. The negative impact from COVID was significant. As we progressed through the first quarter, our top-line performance aligned with our internal projections. However, things deteriorated rapidly in China, which essentially shut down for all of February. The situation in other regions worsened in March as well. When we devised our inventory build plans in early February, we didn't fully foresee the extent of the negative impact that ultimately occurred. Therefore, I would attribute a substantial portion, if not all, of that $40 million to our sales planning projections based on our situation at the end of January.

Operator, Operator

Your next question comes from Nigel Coe of Wolfe Research.

Nigel Coe, Analyst

So I thought one of the highlights of the quarter was services growth remained in place. And I'm just curious how the short-term placed restrictions have impacted services. And then on top of that, maybe just characterize the service book in terms of transactional or discretionary services versus contractual?

Rob Johnson, Chief Executive Officer

Yes. Nigel, thanks for the question and your time here. Yes, the services, one of the areas of growth is if you look at and recall when we kind of on the road and going through is services and the channel IT. So service has been a real focus for us to expand that, get higher capture rates and so forth. So we expected to see growth there. Where we were able to get access, we do have about 55%, 60% of our services are under contract and whether the preventive maintenance and so on. And we've seen some pushback on preventive maintenance and people going to more critical services necessary during this time or what we call start-up services. So we did see an uptick in the actual services, but we did see a downtick a little bit in the spare parts side of things. So the combination of the two kind of led us to a little bit of growth there. We expect coming out of this, especially, Dave mentioned, things are so vital now, customers really want to make sure they get their health checks on their systems and so on. So I would expect and we'll continue to invest in service people, service personnel to make sure that these networks remain vital and robust.

Nigel Coe, Analyst

Right. Yes, that makes sense. I found the free cash flow scenario analysis to be very helpful. Since the 25% decline isn't your base case scenario, are you assuming that working capital can decrease at the same rate as sales, allowing the 20% to remain fairly constant by year-end? Also, David, you mentioned that the second quarter's free cash flow could be negative. Is that typical seasonality for free cash flow?

David Fallon, Chief Financial Officer

Yes. To respond to your second question, absolutely. Traditionally, our free cash flow in the first quarter has been negative, while the second quarter tends to fluctuate between slightly positive and slightly negative. This year, we expect the free cash flow in Q2 to be affected by the lower sales in Q1, leading to a slight cash outflow in Q2. Regarding working capital recovery, our modeling aligns with historical trends, and we are projecting a 22.5% recovery in working capital for every dollar of sales, regardless of fluctuations. In contrast, the contribution margin on sales is approximately 42.5%. Therefore, for each dollar decrease in sales, we estimate a loss of about $0.20 in free cash flow, which represents the difference between the contribution margin and the working capital recovery percentage.

Operator, Operator

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

Rob Johnson, Chief Executive Officer

Thank you, operator, and thank you all of you for those questions. As Dave stated in the beginning, we are investing for the future during this COVID period in R&D and in sales, people and services. We'll continue to do that, so we come out much stronger. We're taking the appropriate actions on cost, and we have additional levers, if necessary, if this pandemic gets worse. We're continuing to drive the long-term margin expansion that we've talked about, and we'll continue to pull those four or five levers. And I want everyone to be clear, as we've mentioned many times, we feel we have solid liquidity. I want to thank all 19,000-plus employees around the world for working hard every day to take care of our customers. We appreciate all your time. Please stay safe. We look forward to speaking to you again soon. Thank you very much. This concludes the call.

Operator, Operator

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