Earnings Call Transcript - WAB Q3 2022

Operator, Operator

Hello. And welcome to Wabtec's Third Quarter 2022 Earnings Conference Call. Please note, today's event is being recorded. I now like to turn the conference over to your host today, Kristine Kubacki, Vice President of Investor Relations. Kris Kubacki, please go ahead.

Kristine Kubacki, Vice President of Investor Relations

Thank you, operator. Good morning, everyone, and welcome to Wabtec's third quarter 2022 earnings call. With us today are President and CEO, Rafael Santana; CFO, John Olin; and Senior Vice President of Finance, John Mastalerz. Today's slide presentation, along with our earnings release and financial disclosures were posted to our website earlier today and can be accessed on the Investor Relations tab on wabteccorp.com. Some statements we're making are forward-looking and based on our best view of the world and business today. For more detailed risks, uncertainties, and assumptions relating to our forward-looking statements, please see the disclosures in our earnings release and presentation. We will also discuss non-GAAP financial metrics and encourage you to read our disclosures and reconciliation tables carefully as you consider these metrics. I will now turn the call over to Rafael.

Rafael Santana, President and CEO

Thanks, Kristine, and good morning, everyone. Let's move to Slide 4. I'll start with an update on our business, my perspectives on the third quarter, and progress on our long-term value framework. John will then cover the financials. We delivered a strong third quarter, which is evidenced by strong sales growth and an increase in adjusted earnings per share. We achieved this despite significant headwinds including the loss of business in Russia, supply chain disruptions, and negative FX. Sales were roughly $2 billion which was up 9% versus the prior year. Revenue was driven by strong performance across the freight segment but was partially offset by unfavorable FX. Strong cash flow from operations was $204 million which ranks year-to-date cash flow to $628 million. Overall, our financial position remains strong. We continue to invest in our future growth, return cash to shareholders, and maintain a total multi-year backlog of $22.6 billion, up $767 million year-over-year. Excluding the headwinds from foreign exchange, backlog was up $1.5 billion or up 7% from last year. We continued our progress against our long-term strategies as evidenced by continued expansion in the total backlog versus last year. Overall, we had a strong quarter which was very much in line with our plan for the year. We continue to invest for the future as we execute commercially and operationally with discipline and vigor and we're well-positioned to continue to drive long-term growth even with near-term uncertainty and volatility in the global economy. Shifting our focus to Slide 5. Let's talk about our end-market conditions in more detail. As we look at key metrics across our freight businesses, we are encouraged by the underlying business momentum and strong pipeline of opportunities. North America carloads were up slightly in the quarter after being down for the four previous quarters, and locomotive parkings are down from the same time last year despite lower year-to-date freight traffic. We continue to see significant opportunities and demand for new locomotives and modernizations as our customers invest in their aging fleets and place a greater focus on reliability, productivity and fuel efficiency. When it comes to the North American railcar build, demand for railcars is increasing from what we believe were trough levels in 2021. Railcars in storage are below pre-COVID levels with about 17% of the North American railcar fleet in storage. As a result, industry orders for new railcars continue to improve, and the industry outlook for 2022 is for about 40,000 cars to be delivered. Overall, we believe we have an opportunity to continue building significant long-term momentum with growth in modernizations, new locomotive sales, railcar builds, and rolling stock. Internationally, freight activity also continues to show positive signs. We have been growing our international fleet in the mid-single digits on average over the last five years, and we continue to execute on a strong pipeline of order opportunities. This strength is reflected in this quarter's equipment sales growth of 32%. Finally, transitioning to the transit sector, the long-term secular drivers are positive as the industry continues to trend towards clean, safe, and efficient transportation solutions. Next, let's turn to Slide 6 to discuss a few recent business highlights. During the quarter, we signed a strategic $600 million MOU with KTZ, the national railway company in Kazakhstan. This agreement will bring state-of-the-art technologies to both their yards and mainline operations that will significantly reduce greenhouse gas emissions and operating costs. This historic framework includes 150 flex drive battery electric shunters along with kits to convert traditional diesel locomotives to LNG. We will also collaborate on digital solutions for the fleet beginning with Trip Optimizer. We also recently signed two key deals in Australia to deliver additional locomotive kits. These locomotives will be built in Australia and sold to various Eastern Australian railroad customers. We also closed an order for new locomotives in Africa during the quarter. Finally, in transit, we secured the key order to supply platform doors for Panama's monorail station which marks Wabtec's first transit project in Central America. We also signed a strategic five-year services contract with Akiem, a leading European rolling stock leasing company which provides critical maintenance for hundreds of locomotives in France and Germany. Turning to Slide 7. Before turning it over to John, I want to briefly discuss our ability to deliver predictable earnings to the economic cycle. During our Investor Day earlier this year, we talked about our track record of managing through challenging markets and significant disruptions. As a company, we are uniquely positioned to deliver resilience and predictable earnings given our favorable end-market, a robust backlog of high-level recurring revenues, and disciplined execution. All of which drives profitable growth and value for our shareholders. We believe our favorable end-markets combined with our leading technologies and solutions will enable us to remain resilient during times of increased volatility. In freight, the demand is to accelerate, the need to grow and refresh our expansive global install base, accelerate the adoption of next-gen technologies, and expand our international footprint. In transit, the investment in green infrastructure continues with structurally high energy prices and climate change making the need more urgent. Our multiyear backlog of over $22 billion provides significant visibility and support for long-term growth. The backlog has consistently grown over the past two years despite the challenging economic backdrop. In addition, we have a strong level of recurring revenues which historically contributed approximately 60% to our profits. And finally, we have consistently demonstrated our ability to execute our strategies and deliver growth. Our track record of strong operating margin expansion across the business is evidence of our ability to realize pricing, deliver productivity, and aggressively manage costs. Our execution, combined with the strength of our business, leading products, and technologies, result in Wabtec being resilient to economic cycles, delivering predictable earnings and superior shareholder returns. With that, I'll turn the call over to John to review the quarter's segment results and our overall financial performance.

John Olin, CFO

Thanks, Rafael, and good morning. Turning to Slide 8. I will review our third quarter results in more detail. We had another good quarter of operational and financial performance despite continued challenges in foreign currency exchange, supply chain disruptions, and still elevated input costs. Sales for the third quarter were $2.08 billion, which reflects a 9.1% increase versus the prior year. Freight segment sales were very strong, up 18.2%, partially offset by lower year-over-year sales in our transit segment. Q3 sales were negatively impacted by unfavorable currency exchange, which reduced our revenue growth in the quarter by 5.2 percentage points. For the quarter, adjusted operating income was $343 million, which was up 5.5% versus the prior year. Adjusted operating margin in Q3 was 16.4%, down 0.6 percentage points. While we expected our margin to be down in the quarter behind unfavorable mix, margins came in modestly higher than we had expected. We now anticipate Q4 operating margins to be slightly lower than our Q3 operating margins. In the third quarter, adjusted earnings per diluted share were $1.22, up 7% versus the prior year. GAAP earnings per diluted share were $0.88 which was up 27.5% versus the third quarter a year ago. During the quarter, we had pre-tax charges of $9 million for restructuring and other one-time charges largely related to our integration initiative to further integrate Wabtec operations and to drive $75 million to $90 million of run rate savings by 2025. We are pleased with our Q3 results especially in the face of significant foreign currency exchange headwinds, continued supply disruptions, and strong mix headwinds which were expected in the quarter. We remain diligent and proactive as we focus on execution and work to minimize these challenges. Turning to Slide 9. Let's review our product lines in more detail. Third quarter consolidated sales were strong, up 9.1%. Excluding foreign currency exchange, sales were up 14.3%. Equipment sales were up a strong 32.2% from last year due to higher locomotive deliveries this quarter versus last year. Component sales were up 4.5% year-over-year largely driven by the higher original equipment railcar build. Digital electronic sales were up 20.6%, driven by robust demand for onboard locomotive products and software upgrades along with revenue contributions from the strategic bolt-on acquisitions of Beena Vision and ARINC last quarter. We are particularly pleased with our organic growth in Q3 as it was delivered in the face of continuing chip shortages. Our services sales grew by 14.8% versus last year. A year-over-year increase was driven by higher sales from a larger fleet versus last year and increased MOD deliveries. The superior performance, reliability, and availability of our fleet continue to drive increased customer demand for our services and solutions as railroads increasingly see predictable outcomes across their fleets. Towards our transit segment, sales decreased 10.1% versus the prior year to $550 million. Sales were down versus last year due to the negative impacts of foreign currency exchange. Adjusting for the impact of foreign currency, transit sales would have been up 2.6%. We believe the medium and long-term outlook of this segment remains positive as megatrends such as urbanization and decarbonization drive increased investments in green infrastructure. Now, moving to Slide 10. Our adjusted gross margin declined as expected by 1.4 percentage points to 31.4%. Gross profit margin was lower, driven by unfavorable mix, adverse foreign currency exchange, and higher input costs, partially offset by increased pricing and strong productivity. Pricing positively impacted our margins. Higher pricing was realized from price escalations incorporated into many of our long-term contracts along with other price actions that were implemented to recover increased costs. Mix was unfavorable in the quarter as we significantly increased our sales of locomotives, which have a lower margin than average. While material costs were still up year-over-year, led by dramatically higher energy costs and increased metal costs, foreign currency exchange adversely impacted revenues by 5.2 percentage points and adversely impacted third quarter gross profits by $20 million. Finally, manufacturing costs were favorable due to productivity gains, which were largely offset by higher transportation and logistics costs. Our team continues to execute well to mitigate the impact of these cost pressures by driving operational productivity and lean initiatives. Turning to Slide 11. For the third quarter, adjusted operating margin declined 0.6 percentage points versus last year. As expected, our margins were lower due to mix and increased investment in future technologies but were partially offset by lower adjusted SG&A as a percent of sales. Adjusted SG&A was $256 million, which was largely flat versus the prior year but down 1.2 percentage points as a percent of sales to 12.3%. Engineering expense increased from last year according to plan. We continue to invest engineering resources in current business opportunities but more importantly, we are investing in our future as the industry leader in decarbonization and digital technologies that improve our customers' productivity, capacity utilization, and safety. Now let's take a look at the segment sales results on Slide 12 starting with the freight segment. As I already discussed, freight segment sales were strong for the quarter, and segment adjusted operating income was $307 million for an adjusted margin of 19.9% down 0.7 percentage points versus the prior year. The benefits of higher sales and improved productivity were offset by unfavorable mix and higher engineering investment. Finally, segment backlog was $19.17 billion, up $961 million or 5.3% from the end of Q3 last year. On a constant currency basis, segment backlog was up $1.26 billion from last year. Now turning to Slide 13. Transit segment sales were down 10.1% driven by the negative FX of foreign currency exchange and the cyber incident that occurred late in the second quarter. Unfavorable foreign currency exchange impacted segment sales by 12.7 percentage points and we estimate an additional 5 percentage points due to the cyber incident. Adjusted segment operating income decreased by $17 million to $16 million, which resulted in an adjusted operating margin of 11.0% down 1.5 percentage points versus the prior year. We estimate that the temporary labor inefficiencies driven by the cyber incident were roughly $8 million during the quarter. Excluding these temporary inefficiencies, adjusted operating margin would have been largely flat to the prior year. We do not expect an adverse impact on our transit sales or earnings due to the cyber incident in the fourth quarter. Transit continues to focus on driving down costs, implementing lean practices, and improving operational efficiencies despite the volatile environment. Finally, transit segment backlog for the quarter was $3.44 billion, down 5.4% versus a year ago. However, on a constant currency basis, backlog would have been up 7.2%. Now, let's turn to our financial position on Slide 14. During the quarter, we generated $204 million in operating cash flow resulting in a cash conversion rate of 72%. This brings our year-to-date operating cash flow to $628 million. Cash flow benefited from higher earnings but was impacted by the proactive build of inventories ahead of our strong second half growth expectations and managing supply disruption of critical parts. Our adjusted net leverage ratio at the end of the third quarter declined to 2.3 times and our liquidity is robust at $2.14 billion. During the quarter, we amended and extended our existing credit facility, increasing liquidity by $300 million and extending the facility through 2027. In addition, we established an 18-month delayed draw term loan of $250 million. As you can see in these results, our financial position is strong and we are confident that we can continue to drive solid cash generation, giving us liquidity and flexibility to allocate capital toward the highest return opportunities and to grow shareholder value. With that, I would like to turn the call back to Rafael.

Rafael Santana, President and CEO

Thanks, John. Let's flip to Slide 15 to discuss our 2022 financial guidance. We continue to feel strong about our portfolio businesses and we have delivered against our regional plan financials despite the loss of business in Russia, high input costs, ongoing supply chain disruptions, unfavorable FX, and a cyber incident. We are adjusting our sales range to $8.15 billion to $8.35 billion which reflects the expected impact from unfavorable FX in the second half. We're also narrowing our adjusted earnings per share range to $4.75 to $4.95 while keeping our full-year cash conversion guidance of greater than 90%. Now, let's wrap up on Slide 16. As you've heard today, our team delivered a strong quarter despite a challenging and evolving environment, thanks in large part to our resilient install base, best-in-class technologies, and our team's focus on our customers. For these reasons and more, we are confident Wabtec is well-positioned for long-term profitable growth. Looking forward, we will lean further into the strong fundamentals of the industry and our company to extend our leadership position in rail, delivering innovative and scalable technologies for our customers and harnessing the power of our continuous improvement culture. With that, I want to thank you for your time this morning, and I'll turn the call over to Kristine to begin the Q&A portion of our discussion.

Kristine Kubacki, Vice President of Investor Relations

Thank you, Rafael. We will now move on to questions. Before we do, and out of consideration for others on the call, I ask you to limit yourselves to one question and one follow-up question. If you have additional questions, please rejoin the queue. Operator, we are now ready for our first question.

Operator, Operator

Thank you. And our first question today comes from Justin Long with Stephens.

Justin Long, Analyst

Thanks and good morning.

Rafael Santana, President and CEO

Good morning, Justin.

Justin Long, Analyst

John, I wanted to start with a comment you made about fourth quarter operating margin stepping down from the third quarter slightly. I would think with mix supposed to improve, I believe MOD should be up, and the cyber security incident seems like it's behind us. I would think that margin should be getting better sequentially. So, can you just help us understand what might be offsetting some of those tailwinds I mentioned sequentially? And then, I know you're not giving guidance on 2023 today, but any directional thoughts on margins next year versus this exit rate in 2022?

John Olin, CFO

Thanks, Justin. Nothing has really changed since we've come out on the year. The back half is going to be lower than prior year and certainly in the first half largely driven by mix. As for the fourth quarter, we do expect mix to still be the largest driver of the lower margin. What we said last quarter though was that we expected the third quarter to be the lowest margin of the year. And given where we ended up at 16.4%, that came in exceeding our expectations and really what that does, Justin, is just puts us in a position for the fourth quarter to be slightly lower than the third quarter.

Rafael Santana, President and CEO

Justin, I would add a couple of things there. Just keeping in mind we have over 60% of the new locomotives been shipped in the second half of the year. So, with that we've got some give and some takes between the third and fourth quarters. I think most importantly is we expect margin expansions in '22 and that our teams are executing well and that we're in a strong position to continue our margin expansion into '23 and beyond.

Justin Long, Analyst

Okay, great. That's helpful. And thinking about next year there's a little bit more concern around rail volumes and where we shake out. We're in an environment where rail volumes are down low-single digits maybe even mid-single digits. Is that still an environment where you feel like you can grow freight segment revenue given your backlog for MODs and international locomotives and digital?

Rafael Santana, President and CEO

Yes. It's early certainly to provide guidance in '23, but we continue to see strong demand across the business. When we think about the pipeline of deals, we have relevant opportunities across geographies. We have progressed with the pipeline of opportunities both in North America and then internationally. We expect to finish the year with a book to bill, Justin, about one for all the businesses as we did in '21. I say we're very much on track to finish '22 with a double-digit increase in orders versus the previous year despite FX. That just provides us strong coverage for '23 and beyond. I would like to extend a little bit on what we're seeing across various geographies. We certainly saw some of the winds we had in Australia and Africa. Volume dynamics continue to be positive in Kazakhstan. We have a number of projects under discussion in Asia. Even mining demand continues to hold with that at this point services are actually growing faster than equipment sales as we go into '23. In North America, I think despite the carloads being down here today, we continue to see demands for both MODs and new locomotives with a number of discussions going on. And there’s certainly a significant opportunity for some of the class ones to further improve their operating ratios while also bringing a significant impact to their ESG targets. So, transit I think infrastructure spending continues to be a positive for us. Overall, going into ‘23, we're well-positioned with our backlog coverage.

Justin Long, Analyst

Got it. Thanks for the time.

Operator, Operator

Thank you. And the next question comes from Jerry Revich with Goldman Sachs.

Jerry Revich, Analyst

Yes, hi. Good morning, everyone.

Rafael Santana, President and CEO

Hi, Jerry.

John Olin, CFO

Good morning, Jerry.

Jerry Revich, Analyst

Hi, thanks. I'm wondering if you can talk about the pricing cadence that you folks have seen in the freight segment over the course of the year. Really strong organic growth in the quarter. What proportion of that is pricing? What we're seeing from other industrials is actually pricing accelerating into early '23. I'm wondering if you can comment on whether that cadence supplies your business as well, please.

John Olin, CFO

Yes, Jerry. I think the year is unfolding very much the way we expected with regards to the costs that we're seeing, and they are continuing to rise. We saw them rise quite a bit in the second quarter into the third quarter. Additionally, we are seeing a pricing rise. As we talked about as we exited the second quarter, we reached price-cost equilibrium at that point. We continue to remain there. On to your point, Jerry, we did see a significant jump in the pricing recovery that we got during the quarter, as well as on the higher costs that we hedged up well with the higher costs that we realized.

Rafael Santana, President and CEO

Jerry, I'd say in the near term, we expect inflation to persist, and as an organization, we'll remain diligent on both cost management and pricing.

Jerry Revich, Analyst

Okay. And as you look forward to hopefully the supply chain loosening at some point over the next 12 to 18 months, how should we think about the efficiency gains in that environment? Should we think of the company getting to keep that spread as we have less rework, less waiting for parts, et cetera? Do we keep that as a margin at some point using the lower cost structure that you folks have established to improve margins versus the three supply chain environment? Is that an opportunity?

Rafael Santana, President and CEO

Jerry, we would expect the same thing as we saw going up as coming down. Hopefully the costs will come down. We're seeing a lot of mixed signals. Some are moving in the lower direction and others are actually still rising. But if they do come down, they'll be very similar and the fact that remember that about 60% of our revenue is tied up in long-term contracts that have price escalators. And so, they will adjust as we see those prices adjust. The additional 40% of costs are going up, will go up and get more pricing and as they come down, we may see a little bit of a benefit there.

Jerry Revich, Analyst

Okay, super. Thanks.

Rafael Santana, President and CEO

Good.

Operator, Operator

Thank you. And the next question comes from Matt Elkott with Cowen.

Matt Elkott, Analyst

Good morning. Thank you, Rafael. I think before the GE acquisition you guys did two to three bolt-on acquisitions per year. Do you think you'll ease back into that phase next year or the year after? And any update on the acquisition opportunities would be helpful.

Rafael Santana, President and CEO

Well, we're continuing to explore bolt-on acquisitions. I think we're going to be again opportunistic here. We'll need to be strategic with stronger returns and helping us drive ROIC higher and driving faster growth as well. We're continuing to evaluate opportunities there. We think there's an opportunity for prices to still come down on those. And with that, I mean, we're committed to ultimately really by our cash flow and return of capital to shareholders. So, share repurchase will also be something we're looking at.

Matt Elkott, Analyst

Got it. And then, just my second question is you're on pace for '22 revenue that's about 37% of the year-end backlog in '20, again the 2021. Yes, I know that's not necessarily a perfect metric to gauge future revenues. But, is there any reason why that percentage should be vastly different next year?

Rafael Santana, President and CEO

Well, as I mentioned before, I think going to 2023, we're well-positioned from a backlog, certainly ahead of what we were a year ago. I think even the underlying performance of the business we're really very well-positioned to deliver on the five-year guidance that we provided during the Investor Day last March. Our 12-month backlog, adjusted for currency is up approximately 15% at this point in the year versus the prior year.

Matt Elkott, Analyst

Thanks, Rafael. Thanks, John.

Rafael Santana, President and CEO

Thank you.

Operator, Operator

Thank you. And the next question comes from Scott Group of Wolf Research.

Scott Group, Analyst

Hey, thanks. Good morning, guys. Wanted to ask, the one-year freight backlog was down about 5% from last quarter. I don't know if there's any FX impact there. But any color? And then you talked about mix as a headwind for Q4. Any early thoughts about the mix headwind or tailwind for next year?

John Olin, CFO

Scott. With regards to the backlog, we certainly saw it come down sequentially by 4.7%. However, on a year-to-date basis, we're up 9.8% prior to currency. When you adjust for currency, we're seeing it up about 15%. We've talked about backlogs; sometimes they can be a little bit lumpy. So sequentially, we're down a little bit, but I think the right way to look at it is over time. We certainly feel good about the fact that, excluding currency, we are up 15% for the 12-month backlog. The second question was with regards to mix as a headwind.

Scott Group, Analyst

Mix you talked about the headwind for Q4, if you have any thoughts on next year?

John Olin, CFO

Yes. I think overall, Scott, over the next several years, mix is going to be a headwind. This is what we talked about at Investor Day, as we look to the railroads starting to renew their fleets. We saw some of that activity this year with the UPE and CN as well as the NS module deals that we're going to have to face some lower or headwind or mix headwinds over the next several years. But having said that, we've got a lot of growth and a lot of fixed costs to absorb. We would expect to see our margins grow by 250 to 300 basis points over the next five years, so call it an average of about a 0.5% over that period of time. That's inclusive of mix headwinds.

Scott Group, Analyst

Okay. And then just last thing, is there anything in this IRA bill that benefits you guys for next year?

Rafael Santana, President and CEO

No, no, there's not. Scott. With regards to the Inflation Reduction Act, there's a couple of things. One is there's a tax on, I'm sure, repurchases that everyone's aware of. Secondly, there is a minimum tax that could have an impact on our cash next year. At this point, we don't know enough because not enough of the regulations are out. But they should be out in the first half, and we'll know a little bit more of the overall impact on the company then.

Scott Group, Analyst

I was thinking like maybe along the lines of the investment in battery or hydrogen that you guys are doing, if there's something that could help?

Rafael Santana, President and CEO

We're seeing some specific opportunities tied to the railroads and some of the operators there, Scott. We're following up with those opportunities as we work along. My only comments would be just in battery electric overall. I think the interest continues to be strong in that portfolio that we continue to build. We certainly saw that with the order or the MOU we've signed with Kazakhstan and the level of interest continues across various geographies. So to your point, we could see some benefit coming from specific projects customers will look at driving in North America.

Scott Group, Analyst

Thank you, guys.

Rafael Santana, President and CEO

Thank you.

Operator, Operator

Thank you. And the next question comes from Allison Poliniak from Wells Fargo.

Allison Poliniak, Analyst

Hi, good morning. Can we talk on transit a little bit? I know you talked about infrastructure funds benefiting. But as we think of that flow through over the next few years, does it become more impactful in 2023 or 2024? Is it more even? Just trying to understand how it's shaping into our model?

Rafael Santana, President and CEO

Let me start, Allison, on transit just overall. I think, if you think about the underlying drivers for the business, they are positive. If you look at the backlog coverage for the year, at the end of the third quarter, we're five points ahead of the same time last year. Our 12-month backlog, if you look at constant currency, is about 16.5%. Our total backlog is up 7.2% on the same basis, and we'll finish 2022 with a book-to-bill above one. So with that being said, I think we're continuing to take action to drive profitable growth in the business, and we're continuing to see investment in that regard.

John Olin, CFO

Allison, when we look in the near term, we are certainly seeing some headwinds in our transit business. Currency being the most notable. And again, when you look at the quarter with revenues being down 10.1%, you reverse out currency, you'd be up 2.6%. And then again, we had the other headwind of the year, which is the cyber event that largely hit our transit group. That held back about 5% of revenue in the third quarter. So we'd be up over 7% in the underlying business. That's the best we've been in numerous quarters. So we feel good about that. From a margin standpoint, while margins were down in the quarter by 1.5 points, that's explained again, by the cyber incident. We had about $8 million of temporary variable labor inefficiencies. So this is on labor that was idled or more severely underutilized as we work through the cyber incident. With those behind us, we would expect no impact to our transit sales or earnings due to the cyber incident in the fourth quarter. Transit continues to focus on driving down costs, implementing lean practices, and improving operational efficiencies despite the volatile environment.

Allison Poliniak, Analyst

Great. Thanks. And then just I made a misstep at the cutbacks, there's a slight reduction there. Just anything notable driving the change in that number?

John Olin, CFO

No. I think it's just the fact that the team is very focused on doing more with less, and of the overall lean principles that are being deployed throughout the company as it's coming through in our capital budgets as well. So as you noted, from 2% of revenue estimate, we're down to 1.75%. And also to note that we didn't talk about in the prepared remarks is our effective tax rate is down from an expectation of 26% to 25%.

Allison Poliniak, Analyst

Great. Thank you.

Operator, Operator

Thank you. And the next question comes from Chris Wetherbee with Citi.

Unidentified Analyst, Analyst

Hey, good morning. This is Matt on for Chris. We wanted to touch a little bit more on just broader demand topics. We were wondering what you guys are seeing in terms of the trends in 4Q and more specifically how the inflationary environment and supply chain dislocations have impacted ordering? And where do you see those trends moving forward? I know you touched a little bit on 4Q. But also, if you could give any additional color on 2023 that would be fantastic as well? Thanks.

Rafael Santana, President and CEO

Let me start; I'll pass it on down to John. But with transit in specific, at this point, we’re not seeing any operational disruptions with regards to cyber, as John described. In fact, when we think about the fourth quarter, we would actually expect some level of both manufacturing production and revenue to catch up during the fourth quarter. In terms of overall dynamics, we're continuing to see a strong pipeline of opportunities out there. I did mention here that strength really playing out across various geographies and in many ways across the business. It's all about really driving convertibility into that. We're certainly proud of what we've seen in the digital electronics business, which is continuing to show very positive dynamics, year to date being one of the highest businesses from the book-to-bill perspective. So it's all about converting that pipeline of opportunities. We are certainly in a stronger position to be driving profitable growth into 2023 than we were a year ago. We feel certainly strong about the five-year outlook we're providing the business during Investor Day.

Unidentified Analyst, Analyst

Great. Thanks so much.

Rafael Santana, President and CEO

Thank you.

Operator, Operator

Thank you. And the next question comes from Dillon Cumming with Morgan Stanley.

Dillon Cumming, Analyst

Good morning. Thanks for the question. I just wanted to go back to the discussion on freight margins for a second. I think there wasn't as much margin dilution in the quarter that I would have expected just given a step up in loco deliveries. Can you just talk about whether that was more a function of maybe better than expected buying leverage on those deliveries, or that there was kind of a mix element to it? John, you mentioned that you thought mix would be a kind of quarter-on-quarter headwind going into 4Q. I think historically you've had some maintenance activity and aftermarket activity, the possible number being pulled forward in 3Q. You're not sure that was a driver in the quarter as well. But I'm just wondering if you can speak to those dynamics of the quarter?

John Olin, CFO

Yes. When we look at the freight margin coming in a little bit higher than expected, I think there's two things to look at, Dillon. Number one is mix was a little bit less unfavorable. Secondly, foreign currency exchange actually was a benefit to the margins during the quarter, and it came in a little bit more than we had expected in terms of the overall impact on our business. But again, it hurts profitability but helps out margins a little bit.

Dillon Cumming, Analyst

Got it. Thanks, John. And then maybe just that last one. In terms of the progression of locomotive and parkings, just given that carload volumes kind of moved positive year on year in the quarter. I know last year was really a story of network disruption and network congestion kind of driving higher active fleets. But now that carload trends seem to be stabilizing a bit. Is the message in the Class 1 that they actually need more fleet to service more carloads? Do they feel like fleets are relatively right-sized at the level of volume growth that we've been seeing in 3Q, maybe at the end of the year?

Rafael Santana, President and CEO

I think it’s certainly difficult to describe what we'll see in 2023 from a volume perspective, but certainly I think with some of the elements you described in terms of network velocity improving and dwell time reducing could be a headwind for parkings. I think, on the other side, we've got enough tailwinds to offset that with both the demand for MODs and demand for services overall. I think, at the end of the day it is positive for us.

Dillon Cumming, Analyst

Great. Thanks for the time.

Rafael Santana, President and CEO

Thank you.

Operator, Operator

Thank you. And the next question comes around Ross Kowski with Bank of America.

Unidentified Analyst, Analyst

Hi, Adam on for Ken Hoexter. Thanks for taking my question. Maybe just to drill down on one of the last questions. I believe you mentioned about you expected a third of the locomotive deliveries in 2022 to happen in the third quarter. So is that relatively in line? Maybe just give me a sense of that and where you expect in 4Q? And maybe also if that was part of the mixed benefit in 3Q?

Rafael Santana, President and CEO

So my comment was with regards to the second half of the year, and I said over 60% of the new locomotive deliveries would have happened in the second half. With that, there is again, some give and some takes between third quarter and fourth quarter. As you'd expect, we could see some variation here as we progress through that.

Unidentified Analyst, Analyst

Got it. And then maybe just clarify. So, velocities improving, volumes improving, and also dwell time coming down a little bit. So net-net, as we think about 2023, should we still be thinking about growth in the freight services business with the MODs built into that? And maybe just any thoughts on mixing margins as well?

Rafael Santana, President and CEO

So yes, we do expect growth in the service business, despite the dynamics you described. I think I’ll go back to - we continue to drive towards margin expansion. We feel we're in a strong position here to do so as we look at the coverage we've got going into next year. So that's a positive. We have strong digital growth, as you see it in the numbers as well. Overall, yes, we do expect margin expansion going through 2023 and beyond.

Unidentified Analyst, Analyst

All right. Thank you.

Rafael Santana, President and CEO

Thank you.

Operator, Operator

Thank you. And the next question comes from Felix Boeschen with Raymond James.

Felix Boeschen, Analyst

Hey, good morning, everybody.

Rafael Santana, President and CEO

Good morning.

Felix Boeschen, Analyst

Hey, John, I was hoping we could hone in on the cost side of things real quick. I think you mentioned your price-cost equilibrium in the quarter. Just want to understand if that was a common inclusive of the higher energy costs. And if you have any more directional color around how operations are tracking in Europe in light of all of that?

John Olin, CFO

Yes. The comment was inclusive of all of our costs, rising cost of goods sold, basically. Yes, we're at price-cost equilibrium as we exit the third quarter. With regards to your question specifically on energy, we're managing the best we can. We've got a lot of alternative energy sources in our facilities in Europe, but costs are rising quite a bit. We're certainly happy to see some of the cost controls coming out. But we're in the same boat as all of our competitors are, and probably from a locational standpoint, maybe a little bit better positioned in some of the countries that we're in. We're managing through it the best we can.

Rafael Santana, President and CEO

I'll just add. Our teams continue to work through contingency plans. So we're certainly looking at dual supplier sourcing, that's something they've been looking at as we really prepare ourselves for an outcome that remains uncertain in a lot of ways. But we have invested in moving some of our sites into lower energy and tasked to use, and continue to invest in alternative energy sources there. And also, the cost side of that is like any other rising costs, we will look to price to cover it and manage our margins regardless of whether it's an energy spike, a metal spike, or a labor spike. We're very focused on continuing to build those margins.

Felix Boeschen, Analyst

Okay. That's super helpful. And then just secondly, for me. I think Nordco has been the model for just over a year at this point. And I'm just curious if you could maybe touch on how Nordco's performing against the original estimates, maybe both from a top-line and synergy perspective, if that's possible.

Rafael Santana, President and CEO

So we're happy with the acquisition of Nordco. We're ahead of the performer. The team continues to progress very well. We're certainly excited about the opportunities here to drive growth beyond what we have planned for, especially in the international markets. That's something the team is very focused on, utilizing the footprint that we already have established in other countries to be able to drive down product line. There are a couple of geographies that are really keen for us here, and you'll hear more on some of the progress in the following quarters.

Felix Boeschen, Analyst

Thank you.

Rafael Santana, President and CEO

Thank you.

Operator, Operator

And this concludes the question and answer session. I would like to turn the call to Kristine Kubacki, the Vice President of Investor Relations for closing comments.

Kristine Kubacki, Vice President of Investor Relations

Thank you, operator. And thank you, everyone, for participating today. We look forward to speaking with you next quarter. Thank you. Goodbye.

Operator, Operator

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