Westinghouse Air Brake Technologies Corporation

Good day and welcome to the WAB Tech fourth quarter 2022 earnings conference call. All participants will be in a listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on a touch-tone phone. To withdraw your question, please press star then two. Please note, this event is being recorded. I would now like to turn the conference over to Christine Kubacki, Vice President of Investor Relations. Please go ahead.

Thank you, Operator. Good morning, everyone, and welcome to Wabtec's fourth quarter 2022 earnings call. With us today are President and CEO Rafael Santana, CFO John Olin, and Senior Vice President of Finance John Mastelers. Today's slide presentation, along with our earnings release and financial disclosures, were posted on our website earlier today and can be accessed on the Investor Relations tab on wabtexcorp.com. Some statements we're making are forward-looking and based on our best view of the world and our business today. For more detailed risks, uncertainties, and assumptions relating to our forward-looking statements, please see the disclosures in our earnings release and presentations. 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.

Thanks, Christine, and good morning, everyone. Let's move to slide four. I'll start with an update on our business, my perspectives in the quarter, our progress against our long-term value creation framework, and then John will cover the financials. We delivered a strong fourth quarter which is evidenced by strong sales growth and increase in adjusted earnings per share. We achieved this despite significant headwinds, including a volatile macro environment, supply chain disruptions, and negative effects. Sales were roughly $2.3 billion, which was up 11% versus prior year. Revenue was driven by strong performance across the freight segment but partially offset by unfavorable effects. Total cash flow from operations was $410 million, which brings year-to-date cash flow to over $1 billion, achieving a full-year cash conversion rate of over 90%. Overall, our financial position remains strong. We continue to allocate capital to maximize shareholder returns by investing for future growth, executing on a strategic M&A, and returning cash to shareholders. Total multi-year backlog was $22.4 billion, up $272 million year over year, and excluding the headwinds from foreign exchange, backlog was up $680 million, or up 3% from last year. We continued our progress against our long-term growth strategies. Overall, we had a strong finish to the year despite a number of challenges. As a result of this strong performance and our confidence in the future, our board of directors reauthorized a $750 million share buyback and approved a 13% increase in the quarterly dividend. We entered 2023 with strength and momentum across the portfolio and we're well positioned to continue to drive profitable growth even with near-term uncertainty and volatility in the global economy. Shifting our focus to slide five, let's talk about our end market conditions in more details. As we look at key metrics across our freight businesses, we remain encouraged by underlying business momentum and the strong pipeline of opportunities. North America car loads were down slightly in the quarter, but locomotive parkings are down from the same time last year, despite lower freight traffic. We continue to see significant opportunities in demand for modernizations and new locomotives as our customers invest in their aging fleets, and they also place a greater focus on reliability, productivity, and fuel efficiency. Looking at the North American railcar build, demand for railcars continue to show strength with industry backlog about 60,000 cars. Railcars in storage are below pre-COVID levels with about 18% of the North American railcar fleet in storage. As a result, industry orders for new railcars continue to improve and the industry outlook for 2023 is for about 40,000 to 45,000 cars to be delivered. Overall, we believe we have an opportunity to continue building significant long-term momentum with growth in modernizations, in new locomotive sales, in railcar builds, and in rolling stock. Internationally, activity has also continued to show positive signs, and we continue to execute on a strong pipeline of opportunities. Finally, Transitioning to the transit sector, the long-term secular drivers are positive as the globe continues to increase investments in clean, safe, and efficient transportation solutions. Next, let's turn to slide six to discuss a few recent business highlights. We recently secured additional Tier 4 locomotive orders in North America. These orders now total over 100 units to be delivered across 2023 and 2024. We also signed two international deals in Asia and South America to deliver new rolling stock and also won two international long-term service contracts in South America and in Kazakhstan. Finally, WAPTEC's FlexDrive locomotive was recognized for sustainable innovation by the Business Intelligence Group and awarded Commercial Technology of the Year by S&P Global. Looking ahead, all of this demonstrates the strong pipeline of opportunities we continue to execute on. WAPTEC is well-positioned to continue to capture profitable growth with innovative and scalable technologies that address our customers' most pressing needs. Turning to slide seven. I want to briefly touch on why we're strongly positioned to deliver resilient and more predictable earnings in volatile times. We believe our demonstrated execution combined with favorable end markets and our leading technologies and solutions will enable us to remain resilient during times of increasing volatility. This resiliency comes in part from our multi-year backlog and strong base of recurring revenues. Our multi-year backlog of over $22 billion provides visibility and support for both short and long-term growth. Similarly, our base of recurring revenues of 44% of total sales, which grew by three percentage points in 2022, provides high margin and stable earnings. And finally, we have a track record of strong operating margin expansion across the business as evidenced by our ability to realize price, deliver productivity, and aggressively manage costs. Now let's turn to slide eight. To further illustrate the point of our ability to drive consistent, predictable earnings, I wanted to provide more color of our combined new locomotive and modernization deliveries in North America. Over the past six years, North American new locomotive deliveries have been challenged due to weak car load growth, PSR, and COVID. Over that period, the investment in the fleet has come primarily through modernization of locomotives, but this still remains below historical replacement levels. As we have discussed in past calls, the core North American active Mainline fleet of heavy haul locomotives is made up of roughly 16,000 locomotives. With a replacement cycle of roughly 25 years per locomotive, we estimate the annual replacement rate over time to be over 600 new locomotives and or modernizations per year. As you can see, the industry has been operating at roughly half of that level for the past six years. Yet, looking forward, we expect a growing need for refreshment of that fleet. And with record fleet age and growing obsolescence driven by next-gen technologies, along with the expectation of rail share gains versus truck, and the need to reduce greenhouse gases by 2030, that the demand for reliable and efficient power is increasing. This expected demand provides Wabtec the opportunity to fill our existing capacity for delivery of new and modernized locomotive solutions in an effective and efficient fashion over the next several years. Looking forward, we believe our execution combined with strength of our business, leading products, and technologies result in Wabtec being resilient through economic cycles, delivering more predictable earnings, and superior shareholder returns. And with that, I'll turn the call over to John to review the quarter, segment results, and our overall financial performance. John?

Thanks, Rafael, and good morning. Turning to slide nine, I'll review our fourth quarter results in more detail. We finished the year with another good quarter of operational and financial performance despite continued challenges in foreign currency exchange, still elevated input costs, and persistent supply chain disruptions. Sales for the fourth quarter were $2.31 billion, which reflects an 11.2% increase versus the prior year. Freight segment sales were very strong, up 17.1%, partially offset by unfavorable foreign currency exchange impacting sales in our transit segment. Q4 sales were negatively impacted by unfavorable foreign currency exchange, which reduced our revenue growth in the quarter by 4.5 percentage points. For the quarter, GAAP operating income was down $17 million, driven by higher restructuring costs. Adjusted operating margin in Q4 was 15.3%, down 0.8 percentage points versus prior year. We expected our margin to be lower in the quarter on both a sequential and year-over-year basis. The key drivers of the year-over-year margin performance include unfavorable mix within business groups, in particular within equipment and services, due to strong sales of locomotives and modernizations versus last year's performance, some of which pushed from the third quarter to the fourth quarter, and higher technology spend associated with investment in future growth and costs associated with the commercialization of the first battery electric locomotives. Gap earnings per diluted share were 86 cents, which was down 15.7% versus the fourth quarter a year ago, During the quarter, we had pre-tax charges of $32 million for restructuring, largely related to our Integration 2.0 initiative to further integrate Wabtex operations and to drive $75 to $90 million of run rate savings by 2025. I will talk more about our progress on Integration 2.0 in a moment. In the quarter, adjusted earnings per diluted share were $1.30, up 10.2% versus the prior year. Overall, Webtek delivered another solid quarter of results, demonstrating the underlying strength of the business and our ability to navigate through volatile macroeconomic conditions. Turning to slide 10, let's review our product lines in more detail. Fourth quarter consolidated sales were strong, up 11.2%. Excluding foreign currency exchange, sales were up 15.7%. Equipment sales were up 14.1%. from last year due to higher locomotive sales this quarter versus last year. Component sales were up 10.6% year-over-year, largely driven by higher OE railcar build. Digital electronic sales were up a strong 34.7%, which was driven by robust demand for onboard locomotive products and software upgrades, along with revenue contribution from the strategic bolt-on acquisitions of Benavision and EARNC earlier in the year. Our services sales grew 16.6% versus last year. The year-over-year increase was driven by higher sales from a larger active fleet versus last year and increased mod sales. The superior performance, reliability, and availability of our fleet continues to drive increased customer demand for our services and solutions. Across our transit segment, sales decreased 1.7% versus prior year to $637 million. Sales were down versus last year due to the negative impacts of foreign currency exchange. Absent the impacts of foreign currency, transit sales would have been up 9.3%. The momentum in this segment remains positive as megatrends such as urbanization and decarbonization drive increased investments in green infrastructure. Now moving to slide 11. As forecasted, gross profit margin was lower driven by unfavorable mix, adverse foreign currency exchange, and higher input costs, partially offset by increased pricing and productivity. Pricing actions implemented to recover increased costs positively impacted our margins during the quarter. Mix was unfavorable, especially within our equipment and services businesses behind strong sales of locomotives and mods. Raw material costs, while down from recent highs over the last year, were up again year over year. Foreign currency exchange adversely impacted revenues by 4.5 percentage points and adversely impacted fourth quarter gross profits by $21 million. Finally, manufacturing costs were favorable due to productivity gains, which were partially offset by higher transportation 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 12, For the fourth quarter, as expected, operating margin declined on both a GAAP and adjusted basis, driven by lower gross margins and increased investment in future technologies. GAAP SG&A was up $8 million versus prior year due to higher net restructuring costs related to Integration 2.0. Adjusted SG&A was $271 million, which was flat versus prior year, but down 1.3 percentage points as a percentage of sales. 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 our segment results on slide 13, starting with the freight segment. As I already discussed, freight segment sales were strong for the quarter and GAAP segment operating income was $209 million for an operating margin of 12.5%, down 2 percentage points, which was impacted by increased restructuring expenses versus the year-ago quarter. Segment adjusted operating income was $284 million, down 1.7 percentage points versus the prior year. The benefits of higher sales and improved productivity were offset by unfavorable mix within business groups and higher technology investments and costs associated with the commercialization of the first battery electric locomotives. Finally, segment backlog was $18.64 billion, up $139 million or 0.8% from the end of Q4 last year. On a constant currency basis, segment backlog was up $344 million from last year. Turning to slide 14, transit segment sales were down 1.7% driven by the negative effects of foreign currency exchange. Unfavorable foreign currency exchange impacted segment sales by 11 percentage points. Gap operating income was $63 million, down 2.3 percentage points, which was impacted by increased restructuring expenses versus the year-ago quarter, largely related to our Integration 2.0 initiative. Adjusted segment operating income increased by $7 million to $95 million, which resulted in an adjusted operating margin of 14.8%, up 1.2 percentage points versus the prior year driven by strong productivity, benefits from prior restructuring activities, and disciplined cost management. Finally, transit segment backlog for the quarter was $3.8 billion, up 3.6% versus a year ago. On a constant currency basis, backlog would have been up 9.2%. Moving to slide 15, I would like to briefly touch on our progress against our Integration 2.0 initiative. Recall that during our Investor Day last March, we announced a restructuring program comprised of an estimated one-time expenses between $135 and $165 million that would yield an incremental $75 to $90 million of run rate cost savings by 2025. These savings were to be achieved through a combination of actions which simplify, streamline, and consolidate parts of our operations. A great example of the actions we are taking to drive these savings occurred in the fourth quarter, including two consolidation projects across our manufacturing footprint, which will eliminate a total of four facilities, and a third project focused on streamlining and optimizing our North American distribution network. With full-year restructuring expenses of $46 million in 2022, we achieved an initial $5 million of savings during the year. We expect investment to increase more meaningfully in 2023 and are on track to meet our 2025 goals, positioning Wabtec to drive multi-year margin expansion. Now let's turn to our financial position on slide 16. We had strong cash generation in the quarter. Q4 cash flow was $410 million, bringing total cash for the year to $1.04 billion for a cash conversion rate of 93%. Cash flow benefited from higher earnings, but was impacted versus last year by the proactive build of inventories ahead of our 2023 growth expectations and managing supply disruptions of critical parts. Our debt leverage ratio at the end of the fourth quarter declined 2.2 times. and our liquidity is robust at $2.29 billion. And finally, we returned a significant amount of capital back to shareholders in 2022, with $584 million returned through share repurchases and dividends. And as Rafael mentioned, our board of directors approved a $750 million share buyback reauthorization and increased our quarterly dividend to 17 cents per share up 13%. As you can see in these results, our financial position is strong, and we continue to allocate capital and a balanced strategy to maximize shareholder returns. Now, moving to slide 17, quickly recapping the year. Overall, the team delivered a strong year for all our stakeholders. Despite challenging dynamics, we drove revenue growth, expanded our operating margins, and generated robust cash flow. The resiliency of the business and strong execution provides us a solid foundation and good momentum as we enter 2023. And with that, I'd like to turn the call back over to Rafael.

Thanks, John. Let's flip to slide 18 to discuss our 2023 financial guidance. We believe that the underlying customer demand for our products and solutions remains strong across our product lines, and our backlog continues to provide significant visibility into 2023 and beyond. We are committed to driving adjusted margin expansion into 2023, despite Aptax volatility, a still challenging cost environment, and continued investments in technology. The team is committed to driving strong top-line growth while aggressively managing costs. With these factors in mind, we expect 2023 sales of $8.7 billion to $9 billion, which is up nearly 6% at the midpoint, and adjusted EPS to be between $5.15 and $5.55 per share, which is up 10% at the midpoint. We expect cash flow conversion to be greater than 90%. Now, let's wrap up on slide 19. As you heard today, our team delivered a solid quarter to finish out the strong year. We delivered on our full-year commitments despite a challenging and volatile environment, thanks in large part to our resilient install base, world-class team, innovative technologies, and our relentless focus on our customers. These results were in line with our five-year outlook we provided at our investor day last year. With strong momentum across the portfolio, increased visibility through our multi-year backlog, and relentless focus on continuous cost improvement, WAPTEC's well-positioned to drive profitable long-term growth and maximize shareholder returns. With that, I want to thank you for your time this morning. I'll now turn the call over to Christine to begin the Q&A portion of our discussion. Christine?

Thank you, Rafael. We will now move on to questions. But before we do, and out of consideration for others on the call, I ask that you limit yourself 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.

We will now begin the question and answer session. To ask a question, you may press star then 1 on a touch-tone phone. If you are using a speaker phone, please pick up your handset before pressing the keys. If at any time your question has been addressed and you would like to withdraw your question, please press star then 2. At this time, we will pause momentarily to assemble our laughter. The first question today comes from Allison Polanak with Wells Fargo. Please go ahead.

Hi, good morning. Good morning, Alison. I want to turn to the services outlook. You noted an uptick in locomotive. Just wondering if you could give us a little bit more context on how impactful you're thinking about that for 23. Is it sort of a point offset, something bigger? I know there's a lot of moving parts in that business right now. Just any thoughts?

Was the comment specifically with regards to services, Alison?

Yes, yes.

Okay. Elson, I mean, we're certainly, when you think about North America, car loads being down here today. So we're continuing to see demand for both mods and new locomotives. I think a lot of that is really tied to driving productivity, driving efficiency, driving reliability. And I think the other piece is certainly an element, if you think about the capex for class ones in the U.S. We see that up for the year. So Those are potentially some of the have-wins could come with, I think, lower car loads. Right now, we're really planning for flattish in terms of that context. But I think what's most important is really the elements of the backlog coverage that we've got for the year. It's ahead of what we had a year ago. This is probably one of the highest 12-month backlogs we've had since 2019, which really just further strengthens our position to deliver in 23. Last year, we've signed a number of multi-year orders, I think, for both new locomotives but for modernizations as well. So this provides additional visibility, not just into 23, but in the case of mods, all the way to 25 for new locomotives and beyond that. So we have a strong pipeline of deals, and we continue to see good momentum in both the pipeline of deals in North America and internationally.

No, that's great. And then just a point, you mentioned sort of that replacement level for locomotives. I know under the assumption that you probably wouldn't reach that level this year, but how quickly? I mean, there's ESG targets and so forth. Is it sort of a 24-25 that you think you could reach that sort of run rate for a replacement there or above? Just any thoughts there on how you see this walk towards that level? Thanks.

Alison, I wouldn't speculate how that will progress, but I think we're certainly still coming from the trough. And when you look at some of the elements of the age of the fleet, continued investment to make sure you have productivity, but you also drive reliability on that fleet. And the elements of ESG, I think we have a lot of opportunity here to help customers bridge that existing power into cleaner power. So it comes with upgrades. and incorporating technologies like hybrid and things like that. So I think we're well positioned on that regard.

Great. Thank you.

Thanks.

The next question comes from Justin Long with Stevens. Please go ahead.

Thanks. I wanted to ask about freight margins. I know you were expecting negative mix and some sequential weakness there, but the magnitude of the weakness was a bit surprising. especially when you look at the different businesses within freight. You know, digital electronics and services revenue was up pretty significantly on a sequential basis, and equipment revenue was actually down a bit. So I was wondering if you could give a little bit more color on the mix impact you saw maybe within those different businesses. And I know you called out the tech costs as well, so maybe a quantification of the headwind you saw there.

Okay, Justin, this is John. So again, let's step back in the full year guidance. We expected it to be up in 2022, and we talked about margin growth in the first half and margin contraction in the back half, which you had mentioned, Justin. And that's exactly what happened. The first half was up 1.4 percentage points, and the second half was down 0.7 points. And the fourth quarter was right in line with the second half being down that seven-tenths of a point. So overall, fourth quarter was down eight-tenths. A couple things driving that is, first, the unfavorable mix. That was the biggest driver of the reduction. And, Justin, that was mixed within our business groups. You had mentioned between our business groups, right? And some of our higher margin products did grow at a faster rate. but that was offset by unfavorable mix within the groups. And in particular, that was within the equipment and services group behind very strong sales of locomotives and modernizations versus last year. And to put it in perspective, we sold 30% of all combined locos and mods were sold in the fourth quarter. So that put that pressure on it. And if you recall, Justin, in the third quarter, max day margins came in a little bit better than what we had anticipated. And at that time, we talked about some of our international local mod deliveries being pushed from the third quarter to the fourth quarter. So that was why it was a little bit more pronounced maybe than was expected. So that was a big piece of it. The other piece was really our continued investment in the future of our business and decarbonization. So part of that was the technology spend. And as you can see on the face of the P&L, that was up $8 million on a year-over-year basis. And again, that is our investment in hydrogen and battery electric as well as digital. And the other piece with regards to our investment in the future were costs associated with the commercialization of the first battery electric locomotives. So about a year from now, we'll be shipping out the first battery electrics. We couldn't be more thrilled or excited about that. And in the fourth quarter, we had costs. And as you remember, we wouldn't have had those same costs in 2021. So that's what's driving the negative variance on those. But overall, we're right where we expected to be on a full year basis and certainly looking forward to moving into a strong 2023.

That's helpful. And is there a way to quantify the costs related to the battery electric commercialization that you referenced?

Well, I would say generally, overall, half of it was mixed and the other half was a combination of the investment in both technology as well as the commercialization costs.

Got it. Got it. Very helpful. And then on the 2023 guidance, are buybacks assumed within that outlook? And maybe, John, you could give a little bit of color on the expected quarterly cadence of that guidance, because to the point you just made, we can see some fluctuations based on the timing of locomotive deliveries and mods.

Yeah. First, Justin, the first question is, is the use of or the generation of cash that we expect to have in 2023 is included in our guidance. Now, you had mentioned repurchases. Again, that could come in the form of acquisitions. It could come in the form of share repurchases. It all depends on if we have the right M&A, we'll invest it that way. But the cash generation is contemplated in the guidance that we provided this morning. The second question is when we move to revenue and margin cadence. I think the most important part is on a full year basis, we expect our operating margins to be up moderately versus 2022 margins of the 16.2 and to be generally in line with our long-term margin growth framework that we presented at our investor day about a year ago, Justin. So, okay, let's talk about revenue and margin guidance for 2023. I want to start with 2022 because it certainly plays into what we expect in 23. All through 2022, we characterized our revenue and margin cadence as higher margin growth in the first half and higher revenue growth in the back half. And that's exactly the way it played out. In 2023, we expect to see the opposite cadence that we had in 2022. Consequently, we expect higher revenue growth in the first half versus the second half of 2023. And we expect our full year margin growth to come largely in the second half of 2023. And as you can imagine, the drivers of this are the cadence that we continue to see with, I'm sorry, the driver of the cadence is the mixed impact of our international locomotive sales. And, Justin, as we talked about it, they were pretty pronounced in the back half of 2022, and we would expect more mixed headwinds in the front half of 2023 as we execute on some of those international locomotive sales. And then the second reason is that we're comping against higher 22 margins in the first half and stronger 22 revenue growth in the second half.

Great. I appreciate all that detail. Thanks for the time.

Thank you, Justin. Thank you.

The next question comes from Scott Group with Wolf Research. Please go ahead.

Hey, thanks. Good morning, guys. So any color on the new Tier 4 LOCO orders? Is that one rail, multiple rails? Can you say who it's with? And how do you expect that order to be split out over the next couple of years? And then just maybe just separately as I think about like markets, any update here on ECP breaks? It's in the news a little bit. How do you think about that opportunity?

Scott, I think first, I mean, we continue to see a demand for both new locomotives and for modernizations as we had highlighted on previous calls. So we've been able to secure at this point over 100 units. They'll be delivered between 2023 and 2024. And it's really a function of us working through the supply chain here. But that's how we see it playing out. And we continue to look at certainly, I think, expanding some of the penetration of some of the products that we have. I think specifically with brakes, that's something we talked earlier on when we started the integration. So it's something we're certainly looking at incorporating the new products, and it's certainly an opportunity that we'll continue to look at it.

Okay. And then, you know, as I think about last year and now your guidance for this year, right, better revenue growth is sort of coinciding with maybe some margin pressure and when revenue growth slows, some better margin. Is there something we can do to sort of get both at the same time of good revenue growth and margin improvement sort of coinciding with each other? I'm just curious how you think about that over the next few years.

Well, I'll just start with I think we're well positioned to both revenue and margin expansion going to 23. And I think what gives us I'll call greater confidence than maybe before even is the fact that we have the backlog coverage that goes not just into 23. I think you saw some of my comments when it comes down to visibility into 24 and 25. And we believe our guidance here is pretty prudent in the light of all the headwinds. we had in the past couple of years. So we feel pretty really committed to be driving here strong, meet single digits, up on the revenue line and double digits on EPS.

Thank you, guys. Thank you.

The next question comes from Chris Weatherby with Citigroup. Please go ahead.

Hey, good morning. This is Madeline for Chris. Thanks so much for taking the question. You know, if you guys could just touch a little bit more on, you know, how you're evaluating acquisition opportunities and sort of, you know, how we should be, you know, thinking about the year in 2023, you know, and if you think sort of, you know, in 2022, if there's, you know, any, you know, comparable metrics on that front, just, you know, sort of share your puts and takes on how you're thinking about that moving forward into this year.

Hi, Matt. This is John. Matt, just in general, When we look at capital allocation, we are very interested in doing strong strategic bolt-on M&A that is accretive to overall margins. So that being said first, if we don't have that, we're very, very happy to return the cash to our shareholders in the form of share repurchases. And that's exactly what you saw in 2022. We had three acquisitions. totaling about $90 million of investment, and then we return $473 million in share repurchases, and then another $100 plus in dividends. But as we look forward, we have a very robust process that we follow, that we look at all the opportunities that we have. We certainly have areas of focus that we're pressing onto, largely in the digital and some of the new technologies that'll be the future of rail. But we are very focused on garnering, you know, strong acquisitions, and we're working hard at it.

Awesome. Thanks so much for that detail. You know, and just, you know, following up on a little bit of a separate topic, you know, just touching on, you know, rail volumes in general. I know that you said they came in, you know, a little bit softer in the fourth quarter and that, you know, potentially weighed on business in some aspects. Didn't know if you had any sort of, you know, comments regarding, you know, rail volumes, you know, seeing a little bit of a weaker freight economy in the first half of this year. And do you think that that, you know, if there's any risk associated with that 2023 guidance that you guys issued? Thanks.

So I think, I mean, you've got to look at both. And I think we're seeing a pipeline of opportunities, both strong in North America and internationally. I think quarter to date, we've made more progress in some key geographies. Some that I would highlight to you is certainly Kazakhstan and Africa. You'll see us continue to expand on both new locomotives, modernizations and service orders. We have a number of projects under discussion in Asia where the volume dynamics continue to be a positive. In mining, the demand continues. Similar to what I said on the previous quarter, we're seeing services growing faster than equipment. In North America, I think despite of car loads being down, we continue to see interest and demand on both modernizations and new locomotives. In transit, I think the infrastructure spending continues. Governments are continuing to invest. Our OEMs have very strong backlogs. We'll see some of that converting to orders for our transit business. And we're continuing to increase investment into technologies. So when you think of battery electric, I think we're excited about some of the opportunities there. First delivery is happening next year, and we're continuing to make progress on that as well. Thanks so much for the detail. Thank you.

The next question comes from with Jeffrey. Please go ahead.

Good morning. So you highlighted $5 million of savings realized this year as part of Integration 2.0. Could you provide any color on how you're thinking about these savings into 2023?

Yes. So number one, Integration 2.0, we just launched about a year ago. and we couldn't be more pleased. We invested $46 million, a little bit higher than we first anticipated when we put the program together, which is great news in that our teams got the projects off, announced, and set quicker than we thought. And so we would expect the savings to be garnered a little bit ahead of our schedule as well. But the first year, $5 million, we feel great because a lot of those projects didn't start until later in the year. And we would expect a pretty quick ramp on that, because as we exit 2025, we'll be at the run rate of $75 to $90 million of savings. So that's just a couple of years away. So we would expect a pretty sizable increase, both in 23 and 24, leading up to 25.

Thanks. And then one of your competitors recently took a large impairment charge on the lower outlook for logos and mods. Could you maybe talk about the competitive environment and how you're thinking about market share gains?

On that one, we continue to really focus on partnering and creating value for our customers. And that comes with really innovative solutions that drive value for them. and drives value for us as well. As a result, I think we're well-positioned to drive long-term profitable growth for the business. I will not comment on the specifics of any announcements here at this point.

Okay, thanks for taking the questions.

Thank you. Thank you.

The next question comes from Jerry Revich with Goldman Sachs. Please go ahead.

Yes, hi. Good morning, everyone. Good morning, Eric. I was really impressed with the transit performance in the quarter, both from margins and booking standpoint. Can you just talk about your expectations for margins in 23 for that segment in particular? And if you could, just give us color on what drove the bookings and the margin profile of what's coming in the book now.

Jerry, a couple of things. Number one, we do expect both margin expansion across both segments. and revenue expansion on both segments for the year. On transit in specific in the fourth quarter, I think there's benefit from really catch up in the quarter. Some of that was an element of supply chain disruptions, which we've had. There was certainly the cyber incident, which had a significant impact there in the third quarter. But we also have had what I call underlying growth for the business. The fundamentals for the business are good. The book-to-bill is above 1. The 12-month backlog on a constant current basis is above 14%. Our multi-year backlog on a constant currency basis is above 9. And at the same time, while we're pleased with the progress, I think we still have significant work ahead to really simplify the footprint, further improve margins. We will have variation quarter-to-quarter. But we're committed to continue to expand margins here and take action to drive profitable growth in the business.

Great. And separately, Rafael, can I ask about mods? You know, you folks have been growing deliveries by, you know, it looks like mid-teens for a bit here. I'm wondering, in 23, as you ramp up on Union Pacific deliveries, does that growth rate for mod deliveries accelerate? And can you remind us from a capacity standpoint, what's the constraint to ramping up production? How much would you be able to ramp up with your existing footprint versus needing to make significant investments for mods specifically? Thanks.

Chair, mods growing double digits. The good news there is the element of multi-year orders that give us visibility, in this case here, all the way out to 2025. so I feel strong about that. And when you have that visibility, you're actually really able to translate that into what I call efficiencies across the supply chain, which drives both quality in the product, so product performance being up. The other elements, you're able to translate that into also I'll call economies that you're able to pass it on to your customer. And I don't see enough constraints tied to our overall capacity. The one thing I would highlight to you, I mean, we're certainly continuing to operate in a very challenging supply chain environment. There's some areas that have improved, but electronics, I think, is an area that we continue to see bottlenecks there. And some of those will extend throughout the first half of of this year, at least as far as we look at it. So I think that's the element to keep in mind.

I appreciate the discussion. Thank you.

Thank you.

The next question comes from Ken Hoekstra with Bank of America. Please go ahead.

Great. Good morning. Just to get two clarifications, I guess, before I jump in. Is this a legacy contract on international locomotives, or is that just structurally lower margins? and then mix. John, you mentioned, I think, three times already that the mix within category like equipment, is that because you have lower margins on mods versus new equipment, or is there something else that I'm missing, just if I can understand those two?

So, Ken, I think that the first question is just the cadence of the way the orders unravel. So we've got various orders coming, or various international locomotives being built for around the world, and we have a period of of delivery in the back half of 22 and the front half of 23, that's a little bit lower margin, and we're seeing some of that progress through the system. Other than that, the book is typically lower margin for both mods and new locomotives versus the company average. So when we talk about things such as an increase, a strong increase in the volume related to that, it translates into lower margins within the groups that house those. So I called out equipment and services. Equipment is where we book new locomotives, and the services business kind of houses the modernizations. So with those growing very strong in the fourth quarter, that brought those margins down in those groups, and that's what drove the mixed unfavorability.

Okay, I got that, John. I just thought you meant within the group. But if you just mean one group being equipment versus services, then I get that. And then, Rafael, you talk about the 600 kind of run rate per year. I think you got a question on that earlier. Is there any reason you don't give number of mods or new builds in order to track how you're doing versus that historical level? Obviously, we know when it was zero, it becomes irrelevant. But as it scales and gets larger, is there still a competitive – differentiation and giving that number to understand when we're getting back toward a normal run rate, you know, as we get into the few hundred in that mix?

We think there is, especially when it comes down to the number of customers that we have out there. So we do see this as an element of competitive nature that we do not want to necessarily disclose. On the other side, I think we're trying to really make sure we provide greater visibility in terms of what we're seeing in terms of the demand, especially with regards to mod, modernizations, and also new locomotives through that process. So does that answer your question?

Yeah, so you're saying even to break it out, you know, even to put them together, both mods and locos, it's still a – okay.

And the way to think about it today, to a large extent, we're utilizing the same supply chain for that. So a lot of the plants that were originally really taught around just dedicated to new units, I mean, we've got those now and really able to flex between those two. So I think it makes sense to lump those two together. And just I think through that process gives you at least visibility here in terms of how utilization looks like for the company.

And then my just last one on the – John, you had a question before about the progress on the expense costs specifically in 23, right? Obviously, you had $46 million. Are you not talking specifically to a number and kind of what's in that guidance just so we can understand? And then you talked about two plants being shut down, or I think it was four plants you mentioned. Are there big projects coming in 23 that we can kind of look at as far as where you get those synergistic gains?

Yeah, Ken, so the overall program we're expecting, I don't know, one-time spending of $135 or investment of $135 to $165. We saw the $46 million in 2022. We would expect 2023 to be higher than that, and then we start to taper off in 2024 in terms of our investment. And at the same time, we would expect to see those savings escalate. Now, of the $43 million of restructuring investment that we made in 2022, 32 million of it came in the fourth quarter. And again, we talked about the teams have been very good at lining up the projects. And an example of those were three that we were doing. Two would take out four facilities. They were both in Europe. And I'm looking at streamlining some of the network there, manufacturing network. and then the distribution in North America. So that, they were kicked off in the third quarter. That's when a lot of the reserves are set up, and we'll begin to see the savings in 23 and 24 from those.

And are those in SG&A and corporate costs, or is... No, no, no, no.

I'm sorry. Maybe we're not talking about the same thing. The $46 million is integration 2.0 savings, and... They're not in our adjusted numbers. They're in our GAAP numbers. And then we've got a bridge in the financials that show the bridge between adjusted and GAAP. And that's where this investment is recorded. Great. Reflected.

Appreciate the time we found. John, thank you.

Thanks.

The next question comes from Matt Elcott with Callen. Please go ahead.

Good morning. Thank you. First, just a quick follow-up to the competitive landscape question earlier. Historically, how much have you guys done in the line of upgrading non-WAPTEC locomotives, and do you think there are opportunities there going forward?

We do have opportunities there. We have started a process around those, and we're currently upgrading units that are non-WATAC. So that's certainly an opportunity that we look at it, and we look at it not just in North America. We're also doing the same internationally.

That's good to know, Rafael. Speaking of international, I think last month Siemens announced a 1,200 freight locomotive order with Indian Railways. Is that something you guys would have bid on? And just generally any update on the India opportunity for you guys will be helpful. There's a significant infrastructure effort there, and I think they just raised their gap for that for the next fiscal year to 10 trillion rupees or $120 billion.

John and I had the opportunity to be in India end of last year, and, I mean, we certainly see, I think, growing momentum in terms of the opportunities there. As you know, we have – long-term agreements. We have, at this point, delivered over 500 units of that agreement. I think there is good opportunities here to further build on that momentum. I think there's a demand for more. Transit has a very significant footprint, and I think one that we can take advantage within, I think, earlier into the market from that perspective. When it comes down to evaluating other opportunities for the business, that's something we do always. And if we see an opportunity to step into a market with a differentiated product, we'll certainly do that. And that's something that we'll continue to evaluate for the business. There's certainly I think from our customers in various parts of the world, I request that we look at some of those opportunities.

And then the order from Siemens, that was for electric locomotives. We are currently not in the market.

Yeah. And, John, I'm sorry if I missed it. The sequential decrease in the total backlog this quarter and last quarter, did you say anything about that? I know it's not significant, but nonetheless, a decrease.

Yeah, Matt, it's just the technical term is lumpiness of backlogs. You know, when we look at 2022, we had a very strong year in overall backlogs. They were both up. But if you look at it on a quarterly basis, there is a lot of volatility there. So the first quarter in 2022, we're up a half a billion, $600 million in the second quarter, and then down in the third quarter about four to five, and down $500 in the fourth. So it's just a nature of how the backlogs come in and go out and what we're comparing to and lapping. So you're always going to see a fair amount of volatility from quarter to quarter.

Matt, one of the things that I think is very important to keep in mind is the following. When I get orders that cover now three years ahead, you're not going to see those repeat itself every year. And we've got quite a bit of those, which actually provide, I think, a lot of the visibility that I described to you guys. So I'll be careful on looking on, I'm going to call separate quarter spaces. What we have is I'll call stronger coverage orders. than probably we've had since 19, to be very honest, as I look into the next 12 months. And in a specific, when it comes down to modernization, that goes out now to 25. And for new units, I mean, as we have some long-term agreements, I mean, some of those goes way out there, especially in the case of India.

Yeah, makes sense. Thanks, Rafael. Thanks, John. Thanks, Christine. Thank you.

The next question comes from Dylan Cummings with Morgan Stanley. Please go ahead.

Great. Good morning. Thanks for the question. I just wanted to play devil's advocate for a second on the kind of new local outlook. You know, I think a lot of the factors that you mentioned in terms of elevated fleet age, right, desire to kind of increase fuel efficiency, they've been present in the market for a while. So in terms of the visibility that you have to get to that kind of above 600 unit, you know, milestone you laid out, I guess my short kind of question is, why is this time different? Are you having conversations with Class 1s that are giving you visibility to that number, or what's actually driving the confidence in reaching that milestone?

So I'll go back to my early comments. I'm not going to speculate on how the recovery or volume I had looks like. What I can tell you is we've got greater coverage than we've had in the business, especially if I go back, like, to 2019, and that's represented by the backlog we have. I think the other point we wanted to make there is that we're still at trough levels. And if you connect that to the age of the fleet, if you connect that to the elements of how you continue to drive productivity, if you start thinking about the obsolescence of the components into that fleet, together with the component of the ESG, I think you've got a lot of opportunity here to continue to build out on that momentum. That's really the point that we wanted to make.

Gotcha. Thanks, Raphael. And if I can just ask one more on the digital growth in the quarter, it was super strong. I know there was some, you know, M&A tailwind in there as well, but just considering it was one of the last verticals to kind of recover post-COVID and a lot of the class ones had pushed out investment in that area, you know, now it seems to be really materializing in your own revenue profile. If we want to assume a bear case for, you know, class one CapEx and real volume the next year, just how durable could that digital growth be just considering that that, you know, investment had been pushed out to the right for so long on the part of the class ones?

So I'll start with double digits got off last year. We see the opportunity to drive double digits again for this year. We had about a billion dollars in orders for digital electronics in 2022. I think this is, well, number one, a significant increase versus the year before. And book to bill was really above, very positive, in fact, for 21 and 22, one of the highest between our businesses. Some of these are multi-year agreements. So no different than the past couple years. We need to drive convertibility of orders in 23 to cover that. North America continues to improve internationally. The pipeline continues to be very strong. I think some progress made here on recurring revenues. I think we talked about that a little bit into the business. We've got some additional work to be done there. And supply chain has improved a bit into the fourth quarter here. That's, I think, some of the goodness you saw. But as I mentioned, I think we're continuing to see top dynamics in supply chain the first half of the year in terms of chip shortages and semiconductors and some other ones.

Great. Appreciate the time.

Thank you.

The next question comes from Steve Barger with KeyBank Capital Markets. Please go ahead.

Thanks. On the guidance slide, it looks like you expect growth in all the categories you list. Are those rank ordered by growth rate? And do you expect anything in the portfolio will contract in 2023?

They're not listed in rank order. We have talked at Investor Day that we do expect equipment to be the fastest growing over the next several years. We certainly saw that in 2022. But they're not listed in rank order, Steve.

Can you give us any more color around the growth rates that you do expect for those categories?

No, we don't break out that. We've talked about, you know, the $8.7 billion to $9 is growth of 4% to 8%. We expect that to be achieved through both our freight segment as well as transit to both be up in revenue and in margin. But we don't break out the individual pieces of that.

Can you tell us how much of the 6% projected growth is price?

No, no, we don't. We don't have that broken out. We don't typically break that out as well. You know, as we look to next year, we got a lot of uncertainties and we feel very good about the overall margin growth or revenue growth at a midpoint of 6%. But if I was to add color, I mean, of course,

double-digit growth here into the services, mods, really being a key driver of that. On equipment, I mean, we'll continue to see the momentum internationally. I think the question is really more around the speed in which you convert some of these orders, but there's certainly a very robust pipeline there. And digital, I just made some of the comments here. Overall, I think we have the opportunity here to drive both revenue and margin expansion for our businesses, and that's what we're focused on, and that's really across the board.

Thanks, Rafael. And just to make sure we're thinking correctly about the cadence comments, if I assume a first-half freight margin similar to 4Q and transit margin around the average of last year, It looks like first half EPS will be down somewhere mid to high single digit versus 2022. Is that how you're thinking about that first half progression?

Dave, we are not providing quarterly EPS guidance. Suffice to say that, you know, during 2023, we expect higher revenue growth in the first half versus the second half, and we expect full year margin growth to largely come in the second half of the year.

Understood. But given the mixed issues that you're talking about, should we assume that the first half freight margin is similar to 4Q?

We're not providing that look. We expect there to be more mixed pressure in the first half, and that will result in more margin growth coming from the second half of the year.

Got it. Thanks.

Thank you. Thank you, Steve.

This concludes our question and answer session. I would like to turn the conference back over to Christine Kubacki for any closing remarks.

Thank you, Operator. Thank you, everyone, for your participation today. We look forward to speaking with you again next quarter.

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