Data center equipment company Vertiv(NYSE: VRTV) is one of the most intriguing stocks in the industrial sector. The company has made significant progress in recovering from a difficult 2021 when it found itself significantly behind the pricing increases needed to offset surging cost inflation. 2022 marked a year of improvement, and based on management's guidance for 2023, the company is set for a substantial increase in earnings and cash flow. Here's the lowdown.
Vertiv gets its pricing
The following chart shows the improvement in pricing through 2022. As you can see, the benefits of price increases grew throughout the year and contributed significantly to profit improvement and margin expansion. In February 2022, management told investors to expect $360 million of benefit from pricing as "actions have all been implemented and price realization accelerates through 2022 as the proportion of sales at the new higher pricing replaces sales from existing backlog."
The good news is that the pricing benefit came in slightly ahead at $365 million for the full year, and management is addressing the supply chain issues that hurt it in the last couple of years.
Data source: Vertiv presentations. Chart by author.
That said, Vertiv did significantly miss its earnings and cash flow guidance for 2022. For example, initial guidance for 2022 called for an adjusted operating profit of $525 million and a free cash flow (FCF) of $150 million, when the actual numbers came in at $439 million and outflow of $260 million.
What went wrong in 2022
It's clear that price increases went as planned, but cost increases, foreign exchange movements, and working capital requirements did not. As a result, material and freight inflation was $40 million worse than expected, and "foreign exchange, divestitures, and other" was $45 million worse than expected in 2022. That accounts for the bulk of the miss in earnings. Frankly, it's an understandable miss, given the market conditions, and Vertiv certainly wasn't the only company to get caught out by cost inflation in 2022.
What happened to Vertiv's free cash flow
However, the FCF miss deserves more circumspection. It came down to $90 million less than expected in earnings (as outlined above) and a whopping $380 million worse than expected trade working capital requirement.
CFO David Fallon discussed the increased working capital requirements on the recent earnings call, citing "delayed collections in China from the impact of COVID, higher-than-expected inventory as we continue to manage supply chain constraints while managing a record high volume and also delayed receipt of advanced payments for several large orders, which were pushed into and likely spread throughout 2023."
In other words, management used cash to build inventory in response to supply chain issues which might have left Vertiv unable to fulfill orders. That's fair enough, but delayed collections, for whatever reason, are always a concern, as are delayed payments. For reference, management expects $370 million less in working capital usage in 2023, starting with $15 million in the first quarter -- two numbers to follow closely when Vertiv reports its Q1 earnings.
Is Vertiv stock a buy?
The good news is that Vertiv's end markets remain in excellent shape, at least according to its peers. nVent Electric expects strong growth in data centers -- its data solutions business grew 35% in 2022. Schneider Electric grew its data center and networks sales by a double-digit rate in its fourth quarter. Eaton's management said its Q4 "orders were up 11% on a rolling 12-month basis with strength in data center and commercial and institutional markets," and it expects "solid growth" in the data center end market in 2023.
All told, Vertiv's end market remains positive. Management is calling for a $275 million improvement in pricing in 2023, with FCF of $300 million to $400 million and adjusted EPS of $1.17 to $1.27. The midpoint of the earnings guidance, based on the current price, would put Vertiv on a price-to-earnings ratio of just 12.7 times earnings at the end of 2023. That looks cheap, provided Vertiv can meet its working capital expectations this year. If so, the stock could have significant upside potential now that it's pushing price increases through.
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Lee Samaha has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
