Johnson Controls International plc

Welcome to the Johnson Controls fourth quarter 2022 earnings call. Your lines have been placed on listen only until the question and answer session. To ask a question, please press star one on your telephone keypad. This conference is being recorded. If you have any objections, you may disconnect at this time. I will now turn the call over to Michael Gates, Senior Director, Investor Relations. Thank you.

Good morning and thank you for joining our conference call to discuss Johnson Control's fourth quarter fiscal 2022 results. The press release and all related tables issued earlier this morning, as well as the conference call slide presentation, can be found on the investor relations portion of our website at johnsoncontrols.com. Joining me on the call today are Johnson Control's Chairman and Chief Executive Officer, George Oliver, and our Chief Financial Officer, Olivier Leonetti. As a reminder, before we begin, during the course of today's call, we'll be providing certain forward-looking information. We ask that you review today's press release and read through the forward-looking cautionary informational statements that we've included there. In addition, we'll use certain non-GAAP measures in our discussions, and we ask that you read through the sections of our press release that address the use of these items. In discussing our results during the call, references are made to adjusted earnings per share, EBIT A and EBIT, excluding restructuring as well as other special items. These metrics together with organic sales, free cash flow, and other measures specified in the slide presentation are non-GAAP measures and are reconciled in the schedules attached to our press release and in the appendix to the presentation posted on our website. Additionally, all comparisons to the prior year are on a continuing OPS basis. With that, I will turn the call over to George.

Thanks, Mike, and good morning, everyone. Thank you for joining us on the call today. I will start out with a quick look back at fiscal year 2022 and update you on our progress across our strategic priorities. Olivier will provide a detailed review of our fourth quarter results in our fiscal 2023 guidance. As always, we will leave the remainder of the call to take your questions. Let's begin with slide three. As we rounded out fiscal year 2022, we delivered another quarter of solid results that had us meeting or exceeding our updated outlook for the full year. Despite a challenging macroeconomic environment that saw unprecedented inflation levels, foreign exchange headwinds, and continued supply chain disruptions, we achieved robust top-line growth and maintained margin strength as we closed out the fiscal year. Compared to the prior year, reported sales for the year increased approximately 7% to $25 billion and grew 9% organically, in line with the high end of our guide. The strong demand is also shown in total field orders, up approximately 10% organically year over year, in our record backlog, which grew significantly, up 13% year over year. This strong demand backdrop further highlights our unique value proposition for mission-critical products and services supported by secular trends that continue to drive the industry. We've made significant progress over the year, working closely with our suppliers to mitigate the impact of supply chain disruptions. We have also continued to execute our productivity savings plan, exceeding our $230 million cost savings target throughout the fiscal year. Lastly, our disciplined approach to pricing has helped drive sequential margin improvement, offsetting material foreign exchange impacts as we continue to cycle through our higher margin backlog during the second half of the fiscal year. With our focus on fundamentals and execution, our team's work this year positions Johnson Controls to capitalize on our strong momentum heading into fiscal year 2023. Overall, 2022 was a significant year in improving our operations and increasing our competitive edge as we continue to deliver on enhancing our digital capabilities leading the way for smart and connected building solutions. Across the organization, we have continued to invest in key technologies and foster partnerships, allowing us to capitalize on the vectors of growth we serve. We have also continued to gain market share across our global products and services, driven by commercial HVAC, industrial refrigeration, and fire detection. We are in a great position to realize the benefits of our transformative service offerings through our differentiated digital platforms. And as the trends for healthy and sustainable buildings continue to expand, I am confident in the strength of our capabilities, which continues to serve the needs of our customers. Lastly, while the market is faced with macro uncertainties, we are seeing tailwinds within our business. Favorable government incentives across the world, global heat pump demand, and continued backlog strength will provide us with additional momentum heading into fiscal year 2023. Now turning to slide four. OpenBlue's suite of connected solutions continues to play a vital role in meeting our customers' needs, laying the blueprint for the future of smart buildings. In fiscal year 2022, we have significantly expanded our suite of digital services and offerings, spanning across a breadth of devices from connected chillers, industrial refrigeration equipment, to connected controls and BAS systems. To date, we have enhanced the existing connectivity of almost 11,000 chillers through OpenBlue, representing a 106% increase year over year. This provides customers with added levels of connectivity to monitor and improve performance with actionable insights. We've also made significant progress in advancing the latest edition of our OpenBlue Bridge. With this solution, we can seamlessly reduce the complexity of integrating devices and expand the range of building solutions and devices that interface with the OpenBlue stack. This provides our customers with the added benefits of AI at the edge and gives them the peace of mind that comes with zero-trust cybersecurity explicitly tailored for operational equipment. Our enterprise software as a solution offerings continue to expand, spanning from comprehensive enterprise management to specific customer use cases covering decarbonization, occupant health, and safety. Along with these added capabilities, our footprint is also expanding. During the fourth quarter, we are proud to announce our recently launched OpenBlue enterprise management solution for AliCloud, supporting our expansion of smart building solutions into China. The future lies with OpenBlue, and we are excited to continue disrupting the building environment as we look ahead to the upcoming year. Moving on to slide five. While our digital growth strategies continue to mature, we have accelerated our core service growth through our field business and the strength of our OpenBlue service offerings. In fiscal year 2022, core service orders increased during the fourth quarter, with orders and revenues up over 7% and 8% year over year. By 2024, we anticipate additional service revenue opportunities of more than $2 billion. On to slide six. Turning to our growth factors, we are successfully growing our sustainability initiatives. Johnson Controls is uniquely positioned to take full advantage of recent favorable market tailwinds, including credits for renewable offerings from the Inflation Reduction Act to an actionable shift towards heat pump usage as Europe continues to push for energy independence and low emission alternatives. Heat pump demand continues to be a momentum driver, and we have gained market share realizing $800 million in the quarter, representing 48% of total HVAC sales. Our partnership with Microsoft is driving results in their Beijing's West Campus, helping reduce emissions and improve uptime. In addition, our work with Colorado State University has helped transform the campus and reach net zero electricity throughout our 20-year relationship. We help customers design, digitize, and deploy solutions to achieve net zero. We are continuously expanding our open blue net zero buildings offerings. Decarbonization is a priority among our customers, and as climate change poses an impending risk, we continue to build out energy efficient and secure solutions. During Q4, we had our largest historical quarter of about $420 million in orders, which led to secured orders of over $1 billion for the full year, growing 12% year over year. Turning to slide seven, the healthy buildings market opportunity remains strong as our customers invest in unlocking employee health, wellness, and productivity benefits associated with well-managed indoor environments. We are positioned to capture this trend and help customers manage challenges through our open blue indoor air quality as a service with some exciting wins coming in Q4. Additionally, we're leading the way in advancing new solutions and research into the linkage between healthy buildings and decarbonization, helping our customers achieve both outcomes simultaneously. Notably, during the quarter, we delivered promising results. In fiscal year 22, orders increased 45% year over year. Our healthy buildings pipeline represents over $1.3 billion in revenue, And we expect continued order growth as more customers leverage the value of improved indoor environmental quality. And now we turn to slide eight. We consistently demonstrate our commitment to sustainability. During the quarter, Fortune's 2022 Change the World list recognized Johnson Controls for our service offerings of open blue solutions and open blue net zero buildings. I'm also very proud that we have been named one of Forbes World's Best Employers in 2022. I am now going to turn the call over to Olivier to go through the financial details of the quarter.

Thanks, George, and good morning, everyone. Let me start with the summary on slide 9. Sales in the quarter were up 10% organically at the end of our guidance of 9 to 10% growth, with price contributing nearly 9 points, in line with what we originally anticipated. We saw strong performance across our shorter cycle global products portfolio up 11%. Our longer cycle field businesses also performed well, up 10% with solid growth in both service and install. Segment EBITDA increased 9% with margins expanding 55 basis points to 16.5%. better leverage on higher volumes, favorable mix, and the incremental benefits of our ongoing SG&A and COGS programs, more than offset continued supply chain constraints, and dilutive but improving price costs. EPS of $0.99 was at the midpoint of our guidance and increased 13% year-over-year, benefiting from higher profitability as well as lower share count. During the quarter, we absorbed an additional $0.03 of FX headwinds versus the prior guide. Four-year free cash flow conversion was 67%. As a result of the disruptions of the supply chain over the last two years, we have built up our inventory to meet customer demand. Turning to our EPS bridge on slide 10, overall operations contributed $0.16 versus the prior year, including a $0.07 benefit from our COGS and SG&A productivity program, helping to exceed our targeted savings for the year. In the quarter, FX was a $0.05 headwind. In addition, higher net financing charges and non-controlling interest impacts were offset by a lower share count. Please turn to slide 11. Orders for our field businesses increased 9% in aggregate. Install orders increased low double-digits in the quarter with continued demand for applied HVAC and controls systems. We are also seeing continued strength in our service business with orders up 7% driven by double-digit growth in both eMILA and APAC. Build backlog remains at record levels, growing 13% to $11.1 billion, a $1.2 billion increase versus the prior year while remaining flat quarter over quarter. Lastly, our global products third-party backlog grew more than 25% to $2.3 billion and continues to show strength. Let's discuss our segment results in more details on slides 12 and 13. Sales in North America were up 9% organically with broad-based growth across the portfolio. Our installed business grew low double digits with increased retrofit and upgrade projects and new construction growth. Overall, HVAC and controls grew low double digits and fire and security increased high single digits. Orders were up 13% with strong growth of more than 50% in our sustainability infrastructure business as our decarbonization solutions continue to resonate with our customers. Applied HVAC orders grew nearly 20%, with another 30 quarters for equipment orders up over 30%. Fine security orders declined low single digits. Total backlog ended the quarter at $7.5 billion, up 18% year-over-year. Segment margins in the quarter were 14.7%, a sequential improvement of 400 basis points driven by increased volume leverage and the execution of projects with an improved book margin profile, a direct result of the pricing discipline implemented earlier in the year. In the quarter, North America continued to be impacted by Super 8 chain disruptions. Overall, Super 8 chain was a $50 million headwind, contributing to a 50 basis points decrease in the quarter year over year. Cells and Imila were up 9% organically, with continued strength in fire and security business, which grew at a low double-digit rate. In Q4, while industrial refrigeration, HVAC and controls grew high single digits and mid single digits, respectively. By geography, revenue growth was broad-based, with strength in Europe partially offset by low single-digit decline in both Latin America and the Middle East. Orders were up 3% led by high single digits growth in our fire and security platform. Backlog was up 7% to $2 billion. Segment EBITDA margin declined 160 basis points to 9.4% as a result of unfavorable region and project mix along with continued FX headwinds, which offset favorable volume leverage and the benefit of cost savings during the quarter. Sales in Asia-Pacific increased 12% driven by ITIN's growth in our HVAC and controls platform. Service performed well in the quarter, growing low double digits in aggregate, benefiting from our shorter-term transactional business in China. Overhaul, China grew 16%. Orders increased 3% driven by low double-digit growth in services. Install orders, remain flat year-over-year, backlog of $1.6 billion, decline 2 percent year-over-year. Segment EBITDA margins decline 140 basis points to 14 percent, driven by FX headwinds, lower volumes, and unfavorable mix due to high HVAC shipments, offsetting positive price cost and the benefit of cost savings. Sales in our shorter cycle global products business increased 11% in Q4, benefiting from strong price realization of 12%. Commercial HVAC product sales were up mid-teens in aggregate, with strength in light commercial driven by 25% growth in North America and Imila, respectively. Applied HVAC sales were up 9%, with continued chiller demand within our data center and markets. Outside of North America, our global residential HVAC sales were up 8% in aggregate. North America RISI HVAC was up mid-single digits, benefiting from both high growth in our equipment and parts business and strong price realization. Our HVAC business grew low double digits, led by strong double digits growth in Europe, driven by continued demand for our Hitachi residential heat pumps. APAC RISI HVAC cells grew high single digits, led by strong growth in Japan. Fire and security products grew low double digits in aggregate, led by our access, control, and video solutions business, and strong demand in North America and Emila for our fire detection products. EBITDA margin expanded 300 basis points to 21.9%. driven by the benefit of our productivity actions, higher volume leverage, and favorable mix. Turning to our balance sheet and cash flow on Site 14, we ended Q4 with $2 billion in available cash and net debt at 1.9 times, which is lower than our target range of 2 to 2.5 times. As previously mentioned, free cash flow was impacted by temporarily building up inventory to meet customer demand. In Q4, capex spend declined 29%. However, for the year, it increased 7% as we continue to make selective investments to improve efficiency and expand capabilities. Before we get into next year's guidance, I wanted to provide some commentary on a special item recorded in the quarter. We recorded a $255 million charge to increase our environmental remediation and related reserves, primarily related to our facility in Marinette, Wisconsin, where contamination exists for the use of firefighting foam containing PFAS compounds. Over the last three years, our team has made significant progress in our investigation and remediation activities, including completing construction of a groundwater extraction and treatment system. As a result of that work, we were able to perform a refresh analysis based on currently available information known to us to date. This resulted in a reasonable estimate of the cost associated with the long-term remediation actions we expect to perform over an estimated period of up to 20 years. Now let's discuss our fiscal year 23 guidance on slide 15. Currently, we are seeing continuous strength in demand heading into the first quarter of fiscal year 2023. Our backlog, which is at historical levels, continue to build along with our continued momentum across end markets. Orders remain strong ending into Q1 with low double-digit organic growth expected as our value proposition continues to resonate with our customers. we anticipate low double-digit organic revenue growth with price contributing 10%. Segment EBITDA margin is expected to expand 120 to 130 basis points and adjusted EPS is expected in the range of 65 to 67 cents, which represents year-over-year growth of 20 to 24%. On a full-year basis, we're taking a prudent approach and providing a wide range to reflect the macroeconomic uncertainty that could potentially impact the balance of the fiscal year. Our full-year adjusted EPS guidance range of $3.20 to $3.60 represents a 7% to 20% growth rate, respectively. The top quartile of our range signifies our base case scenario. This accounts for normalized GDP growth, continued growth, vector acceleration, and conversion of our existing backlog. The low end of this range, $3.20, provide a bookend reflecting a potential downside scenario. This scenario accounts for potential degradation of global GDP, which we believe would be offset by our resilient services and commercial market presence, along with additional cost mitigation actions. On the top line, we anticipate high single-digit to low double-digit organic growth, with price representing about 10% as our offering continues to resonate with our customers. We anticipate segment EBITDA margin expansion of 80 to 120 basis points as we continue to execute our higher book margin backlog throughout the fiscal year. Full-year cash flow is expected to be between 80% and 90%. Operationally, we continue to improve our working capital management and expect further improvements from the gradual reduction of inventories as supply chain normalizes. As we close our fiscal year, we look forward to accelerating our strategic initiatives. We have aligned our business to minimize potential headwinds to enhance operational improvements, improve cost structure, and productivity enhancements. We are optimistic given the strong fundamentals across our businesses. The resiliency of our products and services continue to resonate with our customers as our order velocity and backlog remain strong. Heading into fiscal year 2023, we look to continue our growth momentum and invest in advancing our digital service offering while capitalizing on secular trends. With that, operator, please open up the lines for questions.

Thank you. As we begin the question and answer session, if you would like to ask a question over the phone, please dial star 1. If you need to withdraw your question, please press star 2. In respect of time, we ask that you limit yourself to one question and one follow-up question. Our first question comes from Andrew Obin, Bank of America. Your line is now open.

I guess good morning. Good morning, Andrew. Yeah, so just a question in terms of very nice pricing outlook into next year. I was just wondering if you could give us some color you know, as to what the backlog looks in terms of pricing and what gives you confidence that this kind of pricing will be achievable next year.

So if you look at next year, indeed, we are modeling in our guide 10% of price and about 1% of volume growth. In Q1, the volume would be much higher, about 3%, with the price being about 10%. If you look at today, our order velocity today, which includes this kind of pricing, is still growing. As we said in our prepared remarks, Q1 order is actually being very healthy and actually accelerating in Q1 relative to Q4. So we believe that the value proposition of our offering is resonating, the backlog is strong, and we believe we can command this kind of pricing, Andrew.

Thank you. And the next question, we've actually got a couple of questions from investors just regarding your guide for next year. You know, top line, pretty good. Margin, pretty good. I think the low end of the guide, just, you know, if you sort of try to look versus consensus, just trying to see if there are any below the line items that are sort of impacting the EPS guide. As I said, because the top line and margin look very much in line or better than the street, but, you know, sort of the midpoint ends up being below. Thank you.

So, what we indicated in our prepared remarks is that the wider range add two scenarios from a macro standpoint. A base scenario, which is what we believe is going to be the most likely case, which will be the top quartile scenario. of the guide that would equate to an EPS range of 360 to 350. Why do we believe it's the base scenario? Few reasons for that. One, at the macro level, the economy we are facing is still growing. Dodge, if you take the U.S., 51 percent. ABI is still strong. PMI at about 50. So, no indication today that we have a slowdown. That's point number one. Point number two, our order velocity is still very strong. And we mentioned what those numbers were for Q1. We have various incentive programs around the world, in the U.S., Europe. We have a strong backlog. We have a very resilient service business and a strong commercial exposure. So we believe that the base case is a top quartile guide. Now, we're also listening to what is happening out there. And you have some economists, some CEO mentioning that we could have a slowdown next year. We believe that the worst case scenario from a slowdown standpoint would translate into a GDP based upon economist estimates of zero to 1% in term of growth. And we wanted to give you a bookend of how we would perform in the case we would have a major slowdown of GDP. But today, that's not what we are facing, Andrew, and the top quartile reference.

That makes perfect sense. Thanks so much for the great explanation. Thank you.

Our next question comes from Steve Tusa. Your line is now open.

Hi. Good morning, guys. How are you?

Good morning, Steve.

Can you just give a little more color on the guidance by the various segments? And then anything on the bridge that stands out, I guess, you know, just from a residual cost savings or recovery of inefficiencies, you know, from this year and anything that you guys can detail on the EPS bridge? Thanks. Of course.

So if you look at the elements of the guide, today we see the business for services to be strong. We expect the service business to grow in the 11%, give or take. Install business to be low double-digits. and global products to be in the mid-teens. Price-cost would be positive, of course. It was already, Steve, in the year. The price-cost equation is still going to be dilutive, though, next year, as we are not fully realizing covering the inflation we have been facing. That would be the main points regarding the guide, Steve.

Thank you. Our next question comes from Jeff Sprague with Vertical Research Partners. Your line is now open.

Thanks. Good morning, everyone. Hey, just one more on the guide. And it doesn't look like you're including much, if any, capital deployment in the guide. What are your thoughts around that? And is there an active M&A pipeline?

So, you're right, we're going to have a modest increase in capex. That was embedded in our free cash flow guide. Regarding M&A, we have a very active pipeline. We are looking at touching M&A. We're going to be careful about how we deploy cash, particularly in the current climate. And we will invest mainly in our digital and IP acquisitions for our global products, Jeff.

Great. And just on PFAS, always fun to talk about, right, but topical today, just pivoting more to, you know, the MDL and the like, I just wonder if you could give us an update on what your strategy is if this recent ruling kind of against the idea of the government contractor defense in any way kind of changes your posture or how you kind of approach trying to work through a settlement here.

No change. The reserve does not include litigation recovery. The litigation is ongoing, and we believe we have a strong defense, including our government contractor defense, Jeff. We also have, as you know, insurance coverage. And at this point, we believe that any financial impact on our company is not probable. and or estimable. So we have not reserved for this particular item.

Great. Thank you.

Our next question comes from Nicole DeBlade with Deutsche Bank. Your line is now open.

Yeah, thanks. Good morning, guys. Hi, Nicole. I just want to ask a three-part question, kind of clarifying a few items in the guidance. Number one, is there any supply chain constraint embedded in the outlook versus the $50 million you realized in 4Q? Number two, SG&A cost savings. You guys mentioned that you over-executed in fiscal 22. Just curious how much you're getting in fiscal 23. And number three, does the guidance, could you just confirm that it does not include any buybacks? Thank you.

On the supply chain, we expect the supply chain to normalize after fiscal year 23. It's still improving sequentially, but we believe we're not going to be back to our normal state until mid-year. That's point number one. Point number two on USG&A, and that is embedded in our guide. we actually expect to deliver more productivity savings, and that is included in the guide we gave you, Nicole. And in terms of buyback, as we have said now for a number of quarters, we want to deploy 100 percent of free cash flow through dividend and buyback. We expect dividend to grow with earnings and the balance to be in buyback. That would be about a billion. invite back Nicole embedded in our guide. Thank you.

Our next question comes from John Walsh with Credit Suisse. Your line is now open.

Hi, good morning.

Hey, John.

I wanted to ask you, I guess this is a little bit about the recent CapEx increase, but obviously you've took up your capability in U.S. residential. Just curious if you're done expanding the production there and kind of how the reception has been in the market with the new product.

Yeah, I'll take that, John. As it relates to the DOE 2023 and the cutover, you know, we are going, everything's going well and unplanned. And when you look at more than half of our residential portfolio is meeting the DOE 2023 requirements, which have been launched and we're on target to launch the remaining pieces of the portfolio before the required conversion dates. What we've seen is that customers can order place orders for the products that are already launched. And we're providing customers the opportunity to pre-buy products before they're actually formally launched. Now we've been working through the existing backlog and inventory to ensure a seamless transition. We are about 100% cutover is complete in the south, and we're working on the cutover in the north by year end. Commercial products are on schedule and set to launch through the balance of the calendar year. And so, overall, we're on track, and I think a lot of the investment that was required to be able to meet those requirements has been put into place, and we feel very good about the way that we're executing on that. I think as this transitions, that will provide a tailwind for us. As you know, we've had a large backlog in residential this year. We've been converting that backlog. We've been timing this transition appropriately with the launch of the new products. And we feel as we go forward, not only do we get higher price on the new products, but as we now get our run rates better improved now with the launch, we see significant pickup in our ability to be able to not only reduce the backlog, but be able to then take on new orders with our capacity expansion and residential.

Great. And then maybe just looking at the forward guidance, you know, can you provide any color on how much of the current backlog will ship next year or just how we should think about the backlog conversion into next year?

So our backlog is about $13 billion. We believe that a large proportion of that should convert next year. And again, going back to the conversation we have had about the guide, that's why also our base case would be a top quartile in terms of EPS range, the backlog would give us a nice coverage. An additional comment on the backlog, this backlog is very resilient. It's associated with very bespoke projects which have capital tied for our customers. So they want that to be delivered to them.

John, let me add some color on that. When you look at our global product businesses and how that played out through the year, You know, certainly we had a low first half, and then we had a pretty significant step up here with our seasonality in Q3. And we've continued to improve our supply chain to maintain that pace as we get into the first half of 2023. And so we've seen a nice recovery in our units, you know, as far as our supply chain recovery. It's been across our applied and building management system products. We've had a little bit of constraint within our residential, but as I said earlier, that is being addressed with our capacity expansion and through the conversion now to the DOE 2023. We've got all of our suppliers now on a recovery rate that supports a run rate through the first half that gets us positioned to recover a lot of the backlog in the first half as we ramp up for the seasonality in 2023 in third quarter. So we've made a lot of progress. Our supply chain teams have done a heck of a job. working through this and feel confident that we'll get back to normal lead times and normal backlogs by the end of 2023.

Great. Thank you. I'll pass it along.

Our next question comes from Julian Mitchell with Barclays. Your line is now open.

Hi. Good morning. I just wanted to circle back to the guidance. I think you'd said that you're assuming only 1% volume growth in fiscal 23, but I just wondered if you've got this big backlog and supply chain is easing, why wouldn't the volume growth be several points higher? And maybe tied to that, your guide embeds faster margin expansion early in the year, than the balance, even though price cost and supply chain get easier as the year goes on. So just trying to understand that, is there something assumed in the volume guide for the back half or something on mix, which is kind of pulling down the margin and offsetting the supply chain and price cost tailwind?

You're right. This is a prudent assumption. If you look at Q1, where we have more visibility, volume is actually three points of the growth, which will be back to historical average. We are planning for the year a lower level of volume based upon us being prudent. And that prudence is also reflected in the guide in the second half as well, in the base case.

So, Julian, let me comment on that also. In the first half, we're trying to take the backlog here in the first and second quarter. Typically, we do go down seasonally, and then we're, given the progress we made in third and fourth quarter, we're trying to pick up some of that backlog in the first part of the year. Certainly, we get the leverage on that. We're, on a year-on-year compare, we get much better leverage on that. And so I think, you know, and then the turns in our field-based business, we're working to get back to our normal turn rate in our projects where with this supply chain disruption over the last, you know, 18 months, we've, you know, anywhere from a month to two in our ability to turn projects. So we see that improving during the course of the year. So you'll see some acceleration of that in the first half, as well as our units with our recovery of our product-based businesses. And so I think that's some of those, Those are some of the fundamentals that are playing out in the numbers.

That's very helpful. Thank you. And then maybe a more sort of fiddly financial question. I think going back to a question earlier about below the line items, I think one thing that maybe people underestimated was the financing charges in 23. So you're guiding those at about $300 million. Q4 was about 60. So is that step up? more just kind of variable interest rates flowing through, you know, is anything assumed around the gross debt? And just wondered if there's any kind of pension impact in the P&L in 2023, year on year.

You're right about all of those. So in terms of interest, that's the byproduct of the interest rate rising. We are not factoring any significant increase in the level of debt. and pension income is indeed going to decline. That's the assumption.

Great. Thank you. Thank you very much, Julien.

Our next question comes from Chris Snyder with UBS. Your line is now open.

Thank you. So, order momentum, you know, clearly pretty strong through the fiscal fourth quarter. What's the outlook here on orders into 23? You know, at what point should we expect this to moderate, just given the backlog and stabilizing, I think even potentially shortening lead times?

Well, I'd say I'll take that. You know, I'd say the pipelines that we're currently working on, both in direct and indirect, continue to be strong. We continue to convert at the rates that we've been here in the second half of this year. We're actually projecting a very strong Q1 with orders. And so we're watching this closely. You know, the one area that we'll watch is in the residential space, you know, given that we think we're at the peak of the market now and what is going to play out there. Now, for us, it's because we've been constrained with our capacity and with the supply chain disruptions. We have, you know, have not been able to convert at the rate that we could if we had had the capacity. And so now on a go-forward basis with our recovery, We'll be able to take on more orders there with the new product that we're launching. And so net-net, you know, obviously we're watching it closely, but I think, you know, we still see good momentum across the businesses.

Thank you for that. And then for my follow-up, I wanted to ask on service. And just to see if there's anything you could provide around pricing on the service side, just so we can kind of get a feel for what type of market share, you know, benefits we're seeing from the digital initiatives. Thank you.

Yeah, we have been very disciplined with pricing on services and not only with the traditional, you know, more of the mechanical services. But as you know, we've been enhancing our services with OpenBlue and with connectivity and new software applications. And so that's where you start to get a higher mix of service as we add on those capabilities. Overall, we've been able to more than offset the cost as we have across now all of the segments. And so I think on a go-forward basis, as we get a higher mix of connectivity, higher mix of software services, we'll start to see a real accretion on service margin rate. But we've obviously... While we've been expanding, we've been very disciplined on the pricing that we're getting for the value proposition that we're providing to our customers.

Thank you. Appreciate that.

Our next question comes from Scott Davis with Milius Research. Your line is now open.

Hey, good morning, guys. Hey, Scott. A couple small nips here. Is the margin structure on heat pumps kind of at scale, kind of comparable to the average of the other product lines, or is it a tad better?

Yeah, so when you look, you've got to look at the mix of heat pumps, Scott. Of our HVAC portfolio, we're about 50% heat pumps, and that spans, you know, pretty much all of the platforms. Now, as we're creating these new value propositions around decarbonization and electrification of these units, certainly there's a pickup in margin because there's a higher demand as we're launching these new products. And so that mix will continue to improve with the new products that are being launched. You know, we've seen good strength in our industrial refrigeration business. You know, even our Hitachi business has a high mix of heat pumps, and we're putting those heat pumps, you know, we're seeing good growth in Europe. as well as across the globe, actually, but a big pickup in Europe. And so as we're making the investments and the demand, you know, signals are increasing because of decarbonization sustainability and the value proposition that these bring, we're getting incremental margins as a result.

Okay. Helpful. And then just follow up on the prior question on price, because you weren't explicit, and perhaps that's on purpose. But if the if the average company average is 9% price or the guide is 10, will the service and install side be close to that average, you think, in 2023?

You know, when you look at our pricing across the segments, we've been, obviously, our book and bill business and global products, we've been very aggressive, Scott, in making sure that we're recovering. You know, with shorter cycles, we've recovered all of the costs through price, and we're going to get back to to the margins where we were previous to the, you know, ramp-up of inflation. On the field-based businesses within install and services, we have, with the project-based business, as you know, we, when we, you go back two years ago and when we were projecting cost, we were under-costing projects because we didn't factor in the level of inflation that was experienced. Now, that all was fixed a year ago, and that's been, as you see now, the mix coming through the field project-based business. is very strong, right, with the pricing that was put in place as a result of now taking into account all of the costs and even some of the disruption costs that we're experiencing. So the project-based businesses are very high, recovering the margin that previously we were short on. On the service-based businesses, lower, because we maintain the value proposition and we haven't seen the amount of inflation that comes through the mix of our services that we provide. And so, but again, we're offsetting cost. And then with the value proposition that we bring with OpenBlue, with the digital, you know, offerings, we then accrete margin in addition to that with those value propositions. So it's lower than the 9% just pure price cost. But now we're going to get a higher mix because of the additive services.

Okay, yeah, that colors are super helpful. Thank you, guys. Best of luck in 23. I'll pass it on. Thank you, Scott.

Thank you. Our next question comes from Joe Ritchie with Goldman Sachs. Your line is now open.

Thanks. Good morning, guys. Good morning. So I'd like to start on the supply chain once again. I think, Olivia, you mentioned that the supply chain destructions were roughly 50 million this quarter. I think they were roughly 65 million last quarter. So on the margin, things got a little bit better. But I'm just curious, are you seeing this? Is this still a labor issue? Is this a component issue? What have you seen yet better, and where are you still seeing constraints?

Yeah, Joe, I'll take that. You know, we've done incredible work over the last 18 months when this all got turned upside down because of lead times and all of the critical components, you know, being extended more than double the lead times is really what started the disruption. And as a result of that, we've done a lot of good work around how do we commonize all of our components and ultimately then get aligned with our strategic suppliers in getting the volumes that we need, not only short-term, but supporting the growth going forward. And we've done that pretty much across all of our commodities. And obviously the one that initially impacted us was the microchips and semiconductor materials. And we're fully lined out on that now in a good recovery position as we go forward. And so we are seeing, on a run rate basis, good improvement as we're heading into Q1. And so as we've been, we've been very proactive. We've been, you know, I would say now as we look at our run rates, of being able to reduce our backlog, we're now getting suppliers aligned and getting firm commitments that we can meet these run rates to ultimately bring this backlog down and achieve the growth that we're positioned to achieve in 2023. Our supply chain team has done a great job. Our manufacturing sites have been keeping production going while we're continuing this recovery on materials. And, you know, we went from 65 million in the third quarter to 50 million in the fourth quarter. We expect that to be reduced again in first quarter. But we do, this is, we've got everyone lined out to a recovery rate here first, second quarter, so that as we position for third and fourth, which is our seasonal high quarters, we're going to be well positioned not only to have recovered our backlog, but now to be positioned with lead times that are very competitive in our ability to be able to take on additional volume in the second half of the year. And that's what we're positioned to do. So even though we have a little bit of headwind still with disruption, we've been pricing that disruption in our go-forward pricing. And then with the offsetting some of our headwinds is the additional COGS and SG&A work that we're doing to lean out the company and offset any additional headwinds that we might achieve. But overall, I would tell you from where we are, you know, from six months ago to where we are today, we're in a much different much different, uh, spot.

Got it, George. That's a, that's super helpful. And then I guess maybe just one other question on the margin, uh, or maybe not the margin, but the 23 bridge. And so as you kind of think through it, I think we were originally expecting 260 million in cost out. It sounds like price cost, uh, from a dollar perspective should be positive. Are there any other key items to really think through as we're thinking through, like, you know, what the incrementals should look like in 2023 versus 2022? I recognize that you guys have a low volume expectation, but are those the kind of key items, or is there anything else that you would like to call out as we try to look at just, like, the adjusted EBITDA segments?

No, you're right. If you look at the impact of the disruption on next year, we are modeling about 40 basis points, 4-0. And if you look at the incremental before, including the disruptions, the incrementals are expected next year to be at about 33% net of disruptions, excluding them. In other words, we should be at over 40%. Joel.

Got it. Okay. Helpful. Thank you. Welcome.

Our next question comes from Josh Pogowinski with Morgan Stanley. Your line is now open.

Hey, good morning, guys. Just want to follow up on that supply chain. Good morning. Just on that kind of supply chain easing and backlog conversion. You know, during the seasonally slower period, George, like you mentioned, you know, first quarter, second quarter, how much do you think you were able to sort of pull in as a function of, hey, maybe demand normally in these quarters wouldn't be this high, but we have extra backlog and they'll take it whenever they can get it. There's some sort of buffer, you know, in first quarter, especially that we should be aware of that is maybe kind of backlog driven or supply chain normalization driven.

Yeah, so when we look at backlog and we look at our run rates, we're pretty well positioned here through the first quarter, you know, because of our backlog and the run rates that we're achieving across each one of these product businesses. We're actually trying to, on these markets that are unconstrained, meaning that there's even more growth that we can go after if we can commit cycle times that are lower, we're actually doing that to fill in additional volume later in the year. And so what we're doing is in the first quarter, you do have less days, but we're, you know, we're targeting to try to maintain our run rates across all of our sites at the same level that we had in the fourth quarter. And so to your point, does that give us an ability to be able to not only achieve the, that gives us good ability to achieve the forecast we've made, and then as we track that in Q2, we believe that that will continue. So at this stage, we feel good about where we are and we do see continued improvement as we get through the first half of the year.

Okay, got it. And then on the price in revenue versus price in orders, I know that was sort of a big talking point last quarter, Olivier, just getting that sequential price or higher uptick. What was that phenomenon like this quarter, i.e., are you still getting more price in the order book than is coming out of the backlog in shipping and revenue today?

In the order book, the level of pricing has increased in Q4 relative to Q3 for our field business. The level of orders and price into it is about one and a half points higher than it was in in Q3. So we're in the more than the mid-teens pricing in order. So strong pricing based upon the strength of our value proposition, I would say, Josh. Got it. That's helpful. Appreciate it. Best of luck. Take care.

Our next question comes from Dean Dre with RBC. Your line is now open.

Thank you. Good morning, everyone. Good morning. I was hoping to get some more context on the free cash flow guide for 23, the 80% to 90%. Are you assuming any drawdown on working capital as the supply chain normalizes, or is that a potential upside to the free cash flow target?

So our guide is 80% to 90%. There are two elements into this.