Good morning. My name is Nadia, and I'll be your conference operator today. At this time, I would like to welcome everyone to Vertiv's second quarter 2022 earnings conference call. All lines have been placed on mute to prevent any background noise. Please note that this call is being recorded. I would now like to turn the program over to your host for today's conference call, Lynne Maxeiner, Vice President of Investor Relations.
Great. Thank you, Nadia. Good morning and welcome to Vertiv's second quarter 2022 earnings conference call. Joining me today are Vertiv's Executive Chairman, Dave Cote, Chief Executive Officer, Rob Johnson, Chief Financial Officer, David Fallon, and Chief Strategy and Development Officer, Gary Niederpruem. Before we begin, I point out that during the course of this call, we will make forward-looking statements regarding future events, including the future financial and operating performance of Vertiv. These forward-looking statements are subject to material risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. We refer you to the cautionary language included in today's earnings release, and you can learn more about these risks in our annual and quarterly reports and other filings with the SEC.
Any forward-looking statements that we make today are based on assumptions that we believe to be reasonable as of this date. We undertake no obligation to update these statements as a result of new information or future events. During this call, we will also present both GAAP and non-GAAP financial measures. Our GAAP results and GAAP to non-GAAP reconciliations can be found in our earnings press release in the investor slide deck found on our website at investors.vertiv.com. With that, I'll turn the call over to Executive Chairman, Dave Cote.
As I mentioned on our previous calls, we're taking 2022 a quarter at a time with an escalating performance profile as price increase is realized. It has taken time to work our way through the backlog, but as we do, performance escalates. The profile won't look exactly the same as we outlined in February, but in substance, the story and performance are in line with that profile. End market demand remains robust. Our order rates reflect this strength. As market leaders in these spaces, we are furthering the gap by accelerating our new product introductions. We also continue addressing the operational areas, particularly in the Americas, that have caused shortfalls historically. Well, while there are still some improvements to work through, the SIOP process in Americas under the leadership of Giordano Albertazzi is better aligned than ever.
There is still work to do, but certainly it is in a much better place and continuing to improve. There are other process improvements also being addressed by the new management team in the Americas. They are getting after challenging areas that have really become apparent during these recent periods of high volatility. The new management team is doing exactly what we need them to do, cleaning these up and resetting the base for a great runway ahead in the fourth quarter and 2023 in a very profitable part of the business, the Americas. Third quarter is expected to be a sequential step-up in performance, followed by another expected large step up for Q4. I know some of you may question our ability to deliver the second half as presented in our guidance, especially a significant fourth quarter.
The team will walk you through why and how we believe that will happen as price realization improves and supply improves with newly qualified suppliers. We remain on pace to achieve a significant step-up in financial performance that supports the earnings profile we presented back in February. End markets remain strong. Inflation is starting to moderate. We are navigating supply chain challenges and bringing additional suppliers online, and price is sticking. For the anticipated performance profile, we expect that 2023 can be a very good year for Vertiv and our shareholders. With that, I turn the call over to Rob.
Thank you, Dave. Q2 was another step forward in delivering on our commitments for 2022. Starting with some of the key messages on slide three, demand continues at a pace I've not seen in the 30 years of my career in this market. Orders were up 17% in second quarter, 11% from volume, and 10% from higher prices, with a 4% deduct for foreign exchange. Our customers are focused on securing supply in a tight market, and we see that both in our orders and backlog, which firms up the demand outlook well into 2023. Our adjusted operating profit exceeded the midpoint of our guidance. We continue to work through a number of key actions for improvement, but where we have fully implemented change, we are seeing the benefits take hold. Key among them is our pricing performance.
We have proved to ourselves, and now hopefully to you, our investors, that we are a business that can get price. Our pricing plan remains at $360 million for the full year. Supply chain continues to be challenging, but we've made very good progress in securing qualified second and third sources of supply for key components, and we'll start seeing the benefit from that activity in Q3 and more fully in Q4. Our new thermal facility in Monterrey, Mexico, has started production, and we have a new fan supplier coming online that has committed to help us meet the significant demand we're seeing across the thermal management market. Our work qualifying new suppliers is not only limited to fans. We have also qualified new breaker manufacturers, semiconductor suppliers, and other suppliers. Well, there's still more work to do.
We have been very aggressive in our actions to manage the challenging supply chain environment, most notably in the electronic components. In light of the supply chain conditions and in conjunction with the expected significant sales increase in the second half of the year, we have not been able to reduce inventory as quickly or as significantly as we anticipated and communicated to you earlier in this year. While we're expected to use cash in the second quarter, it was larger than we anticipated. Although there should be an improvement in the next six months, we are reducing our full year expectations for free cash flow to a range of $25 million of use to $25 million of cash generation.
As Dave mentioned, we've made significant progress in our SIOP process globally, but we are especially happy with the progress that we've made in Americas and believe, based on these improved processes, inventory reduction should be a significant source of cash flow in 2023. While there are many moving pieces, we provided updated guidance for our adjusted operating profit, reducing the midpoint by $25 million. We have provided a detailed bridge on the changes on these slides on slide 12 that David Fallon will cover shortly. There is some rebalancing between third and fourth quarter, but in aggregate, we are still on pace to deliver a very strong second half with a noticeable step-up across key financial metrics. Turning to slide four. This slide summarizes what we see in the market by region.
No change in our view across our end markets versus what we saw in April. They are still quite healthy and very strong. Cloud and colocation remain robust. You've seen this in the cloud growth rates reported by all major cloud providers. AWS reported last week that their cloud business increased 33% in the second quarter and believes that we are still in the early stages of enterprise and public sector cloud adoption. Certainly, the growth in cloud market supports this view. Data growth is not slowing down. Our view on the enterprise and small to medium business remain consistent from Q1, and we believe edge applications will continue to provide growth and lift for these markets. The communication market continues to see 5G investment, and we're aligned with all the relevant players in this space.
In the commercial and industrial market, vital applications continue to drive growth and opportunities for Vertiv. The market outlook remains very healthy. It is likely our year-over-year order growth rate will moderate in the second half as the comparisons to prior year will be difficult. I want to reiterate, the end markets we play in continue to be very, very good shape. Moving on to slide five. Customer demand remains strong. Our order rate and backlog are a clear demonstration of this strength. We are delivering on our price plan and have implemented price actions needed to deliver the second half pricing plans, including that on our book and ship business. As I said earlier, supply chain continues to be challenging, especially in electronics.
We do not expect this to abate in 2022, and we anticipate that we will see pressure at least through the first half of 2023. We have incurred higher costs for electronic components since we had to go to the spot market to secure some of that supply. In addition, material and freight inflation was higher as absolute dollars for the second quarter, but generally in line with the adjusted for the higher volume. We have started to see some relief in commodity and freight markets. We typically see a benefit on this on a quarter lag, but expected to provide a nice tailwind for us as we go into 2023. We've made good progress in qualifying additional suppliers on key components and should start seeing additional supply hit our factories in late Q3 and further into Q4.
This provides support to our volume assumptions for the ramp in Q3 and Q4. We have to add some fixed costs sooner than anticipated to support the volume lift in areas such as our new thermal plant in Monterrey, Mexico. In summary, the market remains strong. Supply chain is still complex, but we are getting to the implementation phase for the new suppliers that should help alleviate sourcing pressures on the most critical components. With that, I'll now turn it over to David to walk us through the financials. David?
Thanks, Rob. Turning to page six, this slide summarizes our second quarter financial results. As you can see, net sales increased 11% from last year's second quarter, and we're up 8% organically, including 2% from volume and 6% from price. The E&I acquisition added $114 million in net sales and was partially offset by a $60 million FX headwind, more than 70% of that headwind in EMEA. We also had a headwind related to the divestiture of our industrial UPS business in EMEA, and that was a $17 million headwind.
Pricing added $80 million in the quarter, which was in line with guidance and double what we saw in the first quarter, as we continue to burn through the lower price backlog and recognize more sales booked after we implemented substantial price increases late last year and earlier this year.
Adjusted operating profit of $82 million exceeded the midpoint of guidance, but was $52 million lower than last year's second quarter. We list some of the components of this reduction at the bottom of the page, but in summary, there was $11 million, or $10 million unfavorable price costs and $45 million headwind from FX and other, including a $10 million foreign exchange headwind, $10 million from direct labor, inflation, and inefficiency, in part driven by the supply chain challenges, and approximately $20 million from cost headwinds in the Americas, primarily related to customer support costs, our sales incentive compensation program, and several other drivers.
We expect to see continued year-over-year cost headwinds in the Americas in the third quarter, but we believe we have identified and addressed most of these issues as we will enter the fourth quarter and transition into 2023. Adjusted diluted EPS was $0.10 For the quarter, which was in line with guidance. Second quarter free cash flow was negative $232 million. While we expected a net use of cash, it was certainly higher than we anticipated. As Rob mentioned, we have not reduced inventory consistent with our expectations at the beginning of the year, in part due to continued supply chain challenges, but also in preparation for the significant volume ramp in the second half of the year.
We are improving our SIOP processes globally, and as Dave mentioned, notably in the Americas, and we expect to receive an inventory-free cash flow dividend at some point in 2023. Turning to page seven, this slide summarizes our second quarter segment results. We saw sequential quarterly improvement in organic sales growth, adjusted operating profit, and adjusted operating margin across all three regions. The Americas region grew organically 6.6% or $37 million with most of that growth coming from price. We do anticipate more balance between price and volume in the Americas in the second half of 2022, including mid-teen year-over-year volume growth as we continue to qualify new suppliers and launch the Monterrey facility.
Americas adjusted operating profit of $82 million was negatively impacted year-over-year by price cost, higher fixed cost, including to support the volume ramp up in the second half and additional cost headwinds we referenced on the previous slide. In APAC, organic sales increased 5.9% despite the China COVID lockdowns, which we estimate lowered second quarter sales by approximately $30 million. Notwithstanding the impact of the lockdowns, adjusted operating profit for APAC was actually higher than our expectations as we were able to drive higher sales in other APAC subregions while managing fixed costs. Finally, we continue to see strong growth in EMEA with organic sales up 13.3% with a good balance between volume and price. While inflation accelerated in the second quarter from the first quarter, so did our pricing.
Our second quarter net price cost in EMEA, while still a headwind, was less of a headwind than what we saw in Q1, and we expect price cost to be a significant tailwind in the second half of the year. Moving to slide eight, we summarize our updated third quarter guidance, which is about $50 million lower at the midpoint than our previous guidance. This slide summarizes third quarter versus last year, but likely more pertinent is an analysis of the changes from our previous guidance, which we provide in a couple slides.
Despite the reduction, third quarter guidance still reflects a material sequential step-up from the second quarter across all of our key financial metrics, with organic sales expected to be up approximately $100 million, 70% of that volume, and adjusted operating profit expected to be up almost $60 million at the midpoint. Despite the reduction from our prior guidance, our third quarter expectations return us to an adjusted operating profit level from last year's third quarter and will serve as a strong bridge to a substantial improvement in the fourth quarter and transition us into a very strong 2023. Next, turning to page nine, this slide summarizes our revised full year financial guidance, which reflects the $37.5 million lower adjusted operating profit at the midpoint, versus our prior guidance.
Once again, we provide detail of this reduction on slide 10, the next page. From a macro perspective, it is driven by a $25 million foreign exchange headwind and an additional $12.5 million net from additional cost wins in various categories, partially offset by the benefit from incremental sales volume. More on this on the next slide. As Rob mentioned at the outset, as it relates to free cash flow, we are reducing our full year guidance to a range of $25 million to -$25 million, in part due to lower expected adjusted operating profit, but probably more significantly from changed expectations with our expected inventory reduction.
We continue to improve our SIOP processes in what is a very challenging supply chain environment, and we're encouraged that these improved processes will result in much improved inventory management, but the timing of the inventory reduction benefits will likely be pushed into 2023. Nonetheless, we are still anticipating significant improvements in free cash flow in the second half of the year, and notably in the fourth quarter. Now, turning to slide 10, we provide additional detail underlying changes from our previous guidance. As you can see on the slide, foreign currency translation certainly driven by the strengthening U.S. dollar negatively impacted net sales by approximately $160 million for the full year, and adjusted operating profit by approximately $25 million. We include some additional information on our foreign currency exposure on page 27 in the appendix in this package.
Just as a broad overview, over 50% of our sales are denominated in a currency other than the U.S. dollar. Changes in the euro and British pound have been more acute than other currencies, and as a result, over 70% of our negative FX impact is in EMEA. Moving on, incremental volume is expected to generate an additional $230 million of sales. $100 million of that was in the second quarter. These sales translate into $82 million of adjusted operating profit for the full year. There is a pronounced increase in volume in the fourth quarter as we've increased sales expectations primarily in the Americas based upon our success in qualifying new suppliers and of course, the launch of the Monterrey facility.
Material inflation is up $20 million from our previous guidance, $10 million in each Q2 and Q3, primarily driven by continued higher costs for electronic components and spot buys. We anticipate this pressure to ease somewhat heading into the fourth quarter as we continue to bring additional suppliers into our supply chain. We have reduced profit expectations for E&I for the full year by about $12 million. This is mostly driven by timing as shipments have shifted to the right and into 2023. That business continues to improve and the demand environment continues to be strong with backlog at E&I up over 60% from year-end 2021, which portends significant sales and profitability improvement heading into 2023. We have increased our fixed cost estimates for the year by approximately $30 million.
Most of this driven by timing as we anticipated adding some of these fixed costs in early 2023, but we accelerated the timing to support the higher volume in the second half and for early 2023. Some of these higher fixed costs are also related to IT spending as we continue to optimize our ERP system in the Americas. Last, on this chart, our other cost headwinds, primarily in the Americas, and as we mentioned, associated with any number of underlying factors, most of which we believe are transitory and addressable and should be mitigated as we enter the fourth quarter and pivot into 2023. In summary on this slide, current full year guidance is about $37 million lower than prior guidance at the midpoint, $25 million of that related to FX.
With $50 million of the $37 million reduction in the third quarter, offset by an $11 million increase in the fourth quarter, and of course, the $2 million beat in the second quarter. Next, turning to slide 11, we provide a sequential bridge from third quarter to fourth quarter for both net sales and adjusted operating profit, a $220 million increase in net sales, and a $113 million increase in adjusted operating profit. We understand that based upon our fourth quarter last year, there may be some concerns with our ability to deliver a robust fourth quarter this year. To help allay these potential concerns, we provide this bridge which quantifies the sources of the uplift.
First, the higher volume is certainly supported by improved visibility in the sourcing, and as we've mentioned, the launch of the Monterrey facility. In addition, it's very important to understand we normally have a seasonal volume ramp from third quarter to fourth quarter. The $35 million sequential pricing benefit is driven by the continued burn of lower priced backlog in previous quarters, with a vast majority of our fourth quarter shipments from higher priced orders from late 2021 and early 2022. We anticipate approximately $10 million additional adjusted operating profit from E&I in the fourth quarter, primarily from incremental volume, which should flow through at higher margins pursuant to improved pricing, similar dynamic to the base Vertiv business.
Finally, as we discussed on the prior slide, other is driven by the ramp down in the Americas cost headwinds, partially offset by additional fixed costs. In summary, the fourth quarter adjusted operating profit guidance of $253 million at the midpoint certainly represents a substantial quarter for us, especially considering the $13 million adjusted operating profit in the first quarter and the $82 million in the second quarter. However, we believe we are addressing two of the most pressing issues that drove lower first half performance, pricing and support and supply chain constraints. We have visibility and confidence in our ability to deliver these fourth quarter projections.
On the following slide, slides 12 through 14, we will continue to be transparent with our communications around our plan and provide additional details for the second half. In February, we laid out an aggressive but achievable plan through the first six months. Our high level scorecard reflects $91 million higher sales, $25 million higher adjusted operating profit, $10 million higher pricing, and $5 million lower inflation. Likely more important, our expectations for the fourth quarter have not significantly changed from the beginning of the year. On page 12, this illustrates our current quarterly sales guidance at the top of the slide and our prior April guidance at the bottom. There's certainly a lot of numbers on this slide.
I won't go through each and every one of them, but of note on the right is the increased volume growth from our previous guidance, higher across all three regions, but most certainly most significant in the Americas as we have referenced. Turning to page 13. This slide summarizes our updated quarterly adjusted operating profit and margin guidance, a similar construct to the previous slide with current guidance at the top and the April guidance at the bottom. We've already discussed changes in guidance and the step up from the third quarter to a fourth quarter that would be a record high and by a wide margin for sales, adjusted operating profit in an adjusted operating margin between 14%-15%.
Finally, for me, for prepared remarks on slide 14, we show the expected quarterly 2022 progression of our regional adjusted operating margins. We have primarily focused externally on the recovery plan for the Americas, but as reflected on this slide, there is expected sequential quarterly adjusted operating margin improvement across all three regions. Even though not depicted on this slide, the same is true for E&I. The scale of the improvement is more significant in the Americas and EMEA as they were more impacted by inflation than APAC. These charts illustrate that the entire Vertiv global team is driving improved execution. Clearly, we are focused on unlocking value on a global basis, and we know you are watching closely, and we'll continue to be very transparent with the status of our progress.
With that said, I turn it back over to Rob.
Thanks, David. Turning to slide 15, where we provide our expectations for market conditions over the next 18 months or so. We share many of the drivers of optimism for 2023 that portends to be a very strong year. First, you've heard us comment on several times on the strength of the market we serve. All major cloud companies are growing strongly and continue to invest. Colocation utilization rates continue to be high. Edge demand and 5G rollouts will continue, and we are very well-positioned to win on both of those fronts. While we are certainly mindful of the possibilities of a recession, we don't think that blunts the growth of data, certainly not in the near term or intermediate term.
In fact, business could likely utilize more data in ways to enrich their business models and gain productivity across their operations in the face of recessionary conditions. In summary, our demand remains strong. We are currently filling our backlog for the second half of next year, and we expect these favorable conditions to continue. On the right-hand side of this slide, we provide a quick list of reasons to be optimistic about 2023. Our fourth quarter is shaping up consistent with our beginning of the year expectations with pricing actions not only returning profitability to where we were prior to the challenging supply chain and inflationary environment, but to a higher level. In fact, we believe we are a much stronger company today and will be much stronger company tomorrow.
Because of these events over the last 12 months and the results we are very encouraged with that we see for 2023. Although we are not prepared to provide a lot of detail into 2023 expectations, we still need to execute and deliver Q3 and Q4, and there is plenty of uncertainty with supply chain and inflation. To give everyone something to work with for next year, we do expect that our adjusted operating profit to be 50% higher in 2023 than in 2022. Of course, there are still a lot of moving pieces, and we will know more, and we will update this expectation after our third and fourth quarters. Please view this as a preliminary guidepost as we look forward to a strong 2023. Finally, on slide 16, and again, the summary of our key messages for today.
Sitting here one quarter further into 2022, I feel more strongly than ever that the process improvements we've made and implementing throughout the year give us the ability and the consistency to get price. Coupled with the corrective actions we've taken in the Americas are going to result in a very, very successful future for Vertiv. Without a doubt, the proof will be in the back half of 2022. I pledge to you that we are committed to executing well and transparently communicating our progress. With that said, I want to thank our employees, our board members for your continued support in our organization as we continue to make significant strides forward. I will now turn the call over to the operator, who will open up the lines for questions.
Thank you. We will now begin the question and answer session. In order to ask a question, please press star followed by the number one on your telephone keypad. We'll pause for just a moment to compile the Q&A. Our first question today comes from Nigel Coe of Wolfe Research. Nigel, please go ahead. Your line is open.
Thanks. Good morning. Thanks for all the detail. There's a lot to chew through here, that's for sure. Just wanted to run through you mentioned some of the cost headwinds in Q2 you know linking through to Q3 and then improving into Q4. I thought maybe we could just like dive a little bit deeper on that. You mentioned some of the cost headwinds in Americas. We've got the Monterrey facility, et cetera. Maybe if you can just run through that quickly, that'd be awesome.
Yeah. Thanks. Thanks, Nigel. This is David. There's really two categories. And we try to break those out on slide 10. You know, first category is related to fixed costs. These are certainly tied, although not completely, tied to additional costs to support the second half ramp up in volume. Some of these costs we anticipated to add at the beginning of 2023, but we brought them forward. Most of these are plant related costs, but also includes you know, some engineering costs, you know, related to the qualifying of new vendors and parts. But I think there's probably a question if these would create a tail or a headwind for 2023.
I think that $15 million we're expecting in Q4, you annualize that, to $60 million versus the $30 million for this year would imply a $30 million headwind. Some of these costs, you know, certainly are one-time related to support either a hard ramp in a plant like Monterrey or a soft ramp in many of the other plants that are seeing high volume. I would not anticipate to see a significant year-over-year headwind related to fixed costs in 2023. The other cost headwinds bucket, which we estimate at about $18 million Q2, $15 million in Q3, we truly believe these are transitory. These are very specific issues. We mentioned a couple of them in the slide deck.
Customer support costs, also higher costs related to sales incentive plan. These are, and there's a host of other issues that Gio and his team have been identifying and addressing over the last two quarters or so, and we believe we have them identified. They'll continue to present a headwind in Q3, but we believe these should be fully resolved in Q4, and from a year-over-year basis, actually provide a nice year-over-year tailwind for 2023.
Okay, great. Just curious on the material inflation. We've got a $10 million clip to both Q2, Q3, and then that's neutral in Q4. Is that just, you know, kind of a more normalized purchasing pattern combined with, you know, some of these new suppliers onshore? I mean, any color there?
You know, you're absolutely right. I think we've seen a little bit of stability, although there continues to be variability as it relates to electronic components. Inflation there certainly is higher than we anticipated heading into the quarter. You know, I think the light at the end of the tunnel is related to the new supplier qualifications that we're seeing that should come online in the fourth quarter. I think if you look at the ramp up of new inflation, I think we saw $15 million in Q1. That ramped to $40 million in Q2, and we anticipate that $40 million of new inflation will remain consistent in Q3.
We actually have implied in our guidance a $5 million dip in Q4. Still subject to change. There's still a lot of uncertainty and challenges with the electronic components. We're still relying to a certain extent on spot buys, but we believe we've taken some really proactive steps and initiatives to address those higher costs we're paying, and primarily through qualifying new suppliers.
Thanks, David. My follow-on is the free cash flow in the second half of the year. You mentioned the SIOPs improving in 2022. Wondering, you know, the degree of confidence.
In executing on the second half free cash plan. Perhaps more importantly, going into 2023, you know, you mentioned an inventory-free dividend in 2023. Does that suggest that you're confident in, you know, converting over 100% in 2023?
Probably not prepared to commit on a free cash flow conversion for next year, but we certainly are optimistic. You know, our beginning of the year guidance for inventory actually assumed a $50 million reduction from end of year 2021. That's a 2021 year-end number that was actually up fairly significantly from the end of 2020. Yeah, in reality, we'll probably build inventory by about $100 million again in 2022. That's a $150 million delta, and there's other moving pieces, but that effectively explains the takedown in the full year number from 150 to about zero at a midpoint. There is definitely opportunity as it relates to optimizing our inventory levels.
We are very confident that we are executing towards that opportunity through our SIOP processes. I would be very optimistic that we should have a reduction, a real reduction in inventory or certainly from a DIO perspective, in 2023. We refer to that, you know, internally as a dividend, and it should not only create a very nice one-time benefit from that reduction in 2023, but certainly on an ongoing basis as we look at our reduced.
Thanks, David. That helps. Cheers.
Yep. Yep.
Thank you. Our next question comes from Scott Davis of Melius Research. Scott, please go ahead. Your line is open.
Thank you, operator. Good morning, everybody.
Good morning, Scott.
Guys, I wanted to talk a little bit about the Monterrey facility, if you will, because this is a new thing, perhaps. Is the Monterrey facility replacing some higher cost capacity in addition to creating new capacity and, you know, can you just give us a little bit of color on why it's needed?
Yeah, Scott, sure. We've seen a large uptick in our thermal business, especially with some of the innovative solutions that we've delivered. It's really complementing. We're not shutting down any other capacity. It's really additional capacity for the additional volume that we're seeing. This is something we've been planning for a while, and we think Monterrey is a great place to be from a cost perspective, but it is really to help the ramp and the demand that we see and the backlog that we have in our thermal business.
Okay. Just to back up a little bit, the Vertiv story was always pitched as if, you know, holding fixed cost steady, you know, which is, you know, the Dave Cote playbook. He wrote a book on it. I think we've had multiple quarters in a row of not holding fixed costs. Are we gonna be back on that in 2023? I mean, where do you guys stand? Not trying to be rude.
Yeah. Thanks, Scott. It's just.
It's a great question. No, Scott, I can assure you that's not the first time that question was asked. It's certainly been a focus here internally. You know, we are still absolutely committed to holding fixed cost constant on a year-over-year basis going forward. The added fixed cost that we're seeing here in 2022, that is, you know, more from a timing perspective. These are fixed costs that we had anticipated adding in the first half of 2023. You know, just to put these fixed costs in perspective and the need for the timing, our second quarter sales at an annual run rate were about $5.6 billion. That's ramping up to $6.8 billion in the fourth quarter.
We continue to focus on fixed costs. I think we have seen increases over the last couple years, but most of those increases are pursuant to operations in higher capacity and also R&D. I can tell you our administrative functions are absolutely constant from a fixed cost basis in 2023 versus or in 2022 versus 2021, and will continue to be. We are selective with fixed costs and to the extent that it creates a future return, including you know, R&D and you know, from an operational perspective you know, we'll choose from a timing perspective to sometimes accelerate those.
Okay. That's helpful. Thank you, and good luck, guys. Pass it on.
Yep. Thanks, Scott.
Thanks, Scott.
Thank you. Our next question comes from Jeff Sprague of Vertical Research. Jeff, please go ahead. Your line is open.
Thank you. Good morning, everyone.
Morning.
Yeah, I also wanted to touch on Monterrey-
Congratulations on getting the name right.
Yeah, it's amazing, Mr. Cote. Really crushing it now.
You're doing well. Just wondering on Monterrey, how critical this capacity is to meeting the top line forecast here for the year. Is the plant actually up and running and delivering commercial product yet? Kind of a second part to the first question is, you know, are we on a ramp where we've got visibility of getting the revenues we need out of that plant in the back half?
Yeah. Hey, Jeff. Hi, this is Rob. Monterrey, first of all, is up and operating. It delivered even in Q2 some products to our customers. We are shipping, and we are in the middle of a ramp with that going into Q3, and then a steeper ramp going into Q4. As long as we get the supply, we feel confident with the way that plant's operating. It is needed to provide the necessary volume increase, more so in Q4 for us. We feel confident with the team. They've spent a lot of time down there, and so far so good with the product coming out of the plant right now.
Great. Also just on the cost side, what exactly is this customer support cost that you're talking about? Is this expedited freight? Is it allowances? You know, what actually is going on there? And what's the visibility of that moderating?
Yeah, Jeff, this is David. It's a combination of things. You know, in one example, we had to rent a crane to facilitate the installation of product into a customer site. We continue to focus on our customers and in some cases we'll actually you know foot the bill as it relates to hitting timing. Some of those customer support costs are also pursuant to late deliveries and in some cases our contracts include penalties if we don't deliver product in the you know agreed amount of time. You know, a lot of these things are certainly tied into the supply chain.
We're still, you know, kind of, day to day as it relates to supply, which creates a lot of uncertainty with delivery. Some points we just have to catch up and you know, spend some of our own money to hit some promised customer delivery dates. The reason this is tied into the new supply is a lot of those pressures should go away as we continue to qualify new vendors. When you can you know, spread that risk over you know, three or four vendors as opposed to one or two, it really helps planning out a plan and a delivery schedule, and we think a significant amount of these costs should go away.
Sort of on that front, one last one from me, and I'll pass it. Just also kind of the internal, you know, operations of the company as it relates to systems and ERP. You mentioned still working on that. Maybe just an update on what needs to be accomplished and to what degree, if any, is it, you know, still somewhat of a restraint on orders, delivery, operations, what have you?
Yeah. I would say we are over the significant launch hurdle that you get with a lot of ERPs. You know, that certainly created noise in the fourth quarter, early first quarter. We have a fully functioning system. It's not perfect. Not many ERPs are, you know, a year after launch. But you know, in conjunction with some of the issues that we have identified in the Americas over the first six months, and you know, we're still identifying, we've actually seen the system as a very useful tool versus the system we previously had to actually address those issues. We continue to you know identify ways the system can help.
I would say we have a fully functioning system, but we'll continue to invest in that system to optimize the usage and to address issues as they come forward.
Great. Thanks for the color. Thanks, Dave Cote. Nice hearing you.
Here to serve, Jeff. Here to serve.
Thank you. Our next question comes from Andy Kaplowitz of Citigroup. Andy, please go ahead. Your line is open.
Good morning, everyone.
Good morning, Andy.
Morning, Andy.
Good morning. Could you talk about the progress you've made in getting the company more focused on pricing? You know, why pricing hasn't gone up at least a little with volume and inflation? With the understanding that a lot of pricing was locked into backlog, you know, at the beginning of the year, you obviously are seeing significantly more volume than you previously expected. You did raise your inflation forecast a little bit. So why can't you get a little bit more price as revenue and inflation goes up?
Yeah, Andy, I'll address the first part just on our pricing. You know, we feel from where we've been in the past, as you know, we feel really good about the 360 we've talked about this year. That being said, pricing is now built into our DNA, how we go get it, our process on a global basis, the approvals when we raise price, and we continue to look at that. Pricing was not just a one and done for us. We'll continue to evaluate where we have innovative solutions, making sure that, you know, we're getting the appropriate price we have for the market. So as we go through this year into next year, we don't expect this to be something we responded to an inflationary thing, and we're done.
We'll continue to refine the way we go about driving price. I would expect. You know, part of our thesis has been create, you know, great products that solve real customer problems that are innovative and get paid for that. We'll continue to work that as we go through it. David can speak a little bit to, you know, why, you know, some of the inflationary stuff as the price, as we drive it. You know, we are getting there right now as we talked about into Q4, a lot of that old backlog falling away and a new price we'll begin to see in that. It gives us a nice uplift in Q4. David?
Yeah. Thanks, Rob. Andy, we were fully anticipating that question from someone. You're absolutely right. As volume assumptions go up, so should the pricing. We've made the decision because a lot of that additional volume is in the Q4. We made the decision just to keep the pricing target at the $360, maybe so as to not overcomplicate things. It's absolutely fair to look at this as an opportunity for additional pricing based on that volume, over and above the $360. We also have not added into this external model of potential additional inflation that would also be associated with that higher volume. On a net-net basis, it's probably an opportunity.
There would be an offset with additional pricing and additional inflation just mathematically from that higher volume. When we looked at it, we felt like we just wanted to kind of keep the messaging simple quarter to quarter. We've included that as a net opportunity, you know, in our bucket of, you know, net risks and opportunities that we see for the second half of the year.
Sure, that's helpful. Maybe if I could take that conversation into 2023. You obviously stated that you expect a 50% improvement in adjusted operating profit. Could you talk about, as we sit here today or maybe, you know, forecast forward, how much backlog coverage you have, you know, on that improvement? I think you said you expect supply chain and/or electronic component headwinds to last well into 2023. What kind of price versus cost or supply chain assumptions are you baking into, in that initial 2023 expectation?
Yeah, I can address that, Andy. And I'll probably answer with a non-answer. We're not really prepared to provide a whole lot of color at this point. It's still very early. As Rob mentioned on the call, we still have to deliver on Q3, Q4. I certainly would include on the list of potential opportunity for next year, pricing. You can look at that just from the increased sequential pricing that we're seeing here in on a quarterly basis in 2022. There's gonna be probably a $150 million-$200 million carryover pricing benefit just by doing the calculus, right? As it relates to some of the other elements, you know, notably, backlog coverage, we're certainly.
We certainly have a robust backlog today. To a certain extent, we're filling backlog for the second half of next year with some of our products. We're feeling really good from a demand perspective. There's certainly we would place more uncertainty as it relates to inflation and the supply chain. As we have seen, you know, those are, you know, somewhat mercurial as it relates to month-to-month, quarter-to-quarter. We believe we're doing everything we can within our power and being proactive to address it. It's hard at this point to give any type of quantitative detail on what we expect for next year.
Appreciate the color, though.
Yep.
Thank you. Now our next question comes from Mark Delaney of Goldman Sachs. Mark, please go ahead. Your line is open.
Yes. Good morning. Thank you very much for taking the questions, and appreciate all the detail and the presentation. First question is on the implied 4Q outlook. Maybe you can better contextualize how much turns or book and ship business you're anticipating in that guide and how that compares to typical fourth quarters.
I would say we have really good visibility certainly into Q3. If you look at you know, backlog versus book and ship for Q4, it's likely higher than what we would see in other quarters. Including for a fourth quarter. You know, fairly significant ramp in Q4, at least from prior guide, was not related to filling out a backlog. It was very directly related to have the capacity and the supply of components to ship that backlog. You know, every quarter and even in every month, there's a certain amount of book and ship business. I would say we have really good confidence in fourth quarter as it relates to
You know, the backlog coverage. You know, for us, as Rob mentioned, you know, a bigger risk would be the execution of the ramp of the Monterrey facility, and also the additional fan supply. We don't think demand, you know, will be an issue certainly for Q3 or Q4.
That's helpful. For our second question was on pricing and, in particular pricing for 2023. Maybe you can remind us how much of your negotiations are done, you know, toward, you know, the end of the calendar year, you know, setting up for the following year. You know, kind of related to that, you know, to the extent input costs stay, kind of where they are, do you think you'll be able to hold on to all the pricing you've been able to achieve as you do go into 2023 or, you know, or some of the customers are gonna say, "Oh, well, input costs are still going up, so, you know, I'm looking for a reduction next year." Thanks.
Hey, Mark, this is Rob. No, all the pricing actions have been done and been implemented for what we need to do. As I mentioned earlier, we continue to look at additional opportunities for price where we have innovative products and solutions. I feel confident that we've executed on those. Those have been put in place a while ago, from that perspective. As it relates to, you know, customers, you know, asking or looking to take the price down, it's kind of a similar phenomenon. We didn't get a lot of pricing on the backlog that we had. That was part of our problem. We had to burn through that.
Expecting kind of the same thing to happen, that the hard purchase orders that we have today, that people want are the price that we set forth in those as we go forward. I don't expect that to deteriorate either as we go into 2023 if inflationary, you know, conditions go. We've bought inventory at higher prices. They understand that. It's something that, you know, wouldn't keep me up at night that we're gonna see that activity. We will continue, even in a deflation, inflation goes away environment, as I mentioned earlier, we'll continue with this pricing muscle that we have now to get price where it makes sense and where we're providing more value to the market.
That was a valuable lesson learned from us as we went through this whole activity, is that, you know, people do value the services and the products that Vertiv make.
Thank you.
Thanks, Mark.
Thank you. Our next question comes from Lance Vitanza of Cowen. Lance, please go ahead. Your line is open.
Thanks, guys, and congratulations on the strong quarter. I wanted to ask you about E&I. It looked a little bit weaker than expected and the guidance as well. You mentioned during the prepared remarks some timing related issues, and I think you said that the asset continues to improve, but maybe you could clarify if I'm getting that right. In any case, if you could elaborate a bit on exactly what the issues are there at E&I.
Yeah, sure. Hi, Lance. Thanks for the question. Appreciate the comments as well. Yeah, with E&I, what we've seen, what I think David kind of talked about and when he was speaking is we're seeing some of the, some of their stuff push out of this year, push into next year, with some of the projects that they have. You know, E&I had experienced kind of a little bit later than Vertiv did the inflationary impacts, and then lack of supply on breakers and then were not just like us, slower to get price. We feel that's corrected. We really are excited. David mentioned the backlog for E&I is up over 60%, I believe, since we bought them. So the activity's good.
We've got the price now being built in the back, in the backlog and in the orders that are coming forth. I'm really still very excited, probably more excited about the asset now than when I was when we acquired it. Yeah, we had a dip and unfortunately, you know, we'll go through this year with that. We see E&I pulling out of this next year with the additional pricing. We have seen some projects shift, which happens in their business because they're heavily on the construction side of it. We have seen some of that shift, and some of that will shift into next year. I don't know, Gary, any other thoughts?
Yeah, I think that's exactly right, Rob. I mean, yeah, Lance, the amount of quote activity pipeline, the joint development between the Vertiv sellers, the E&I sellers, the embrace that the customer base has had has been phenomenal. The only thing, to Rob's point is really some of that switchgear and some of the modular skidded power units that they sell shifted out to the right, some of it because of supply, some of it because of customer site readiness. Overall, it's actually coming up on plan just like we had planned earlier in the year.
You're not seeing, just to be clear, you're not seeing any issues with how the integration has gone or anything that would make you feel less excited about what you acquired?
No, absolutely the opposite. I think, integration has gone really well. They had the couple stumbles that they had was really pricing and getting components, and they were kind of later on both of those. A lot of people are talking about breaker availability. Breakers drive a lot of the content in our products, and we still see that as something that's not readily available. We have looked at additional breaker sources and have been qualifying them. Overall, integration has gone well, and what I could tell you, as Gary mentioned, on the back, on the actual funnel, the activity and the synergy with Vertiv, as we thought it would be, is really there.
You know, we never baked in any kind of sales synergy upside to our model, but just what we thought would happen is our sellers would pick this up, we would take it out to a wider audience, to the enterprise, and to a broader base of customers that we reach and touch. Very happy with the asset, happy with the management team there. What they've done, and I think this is going as smooth as it possibly could, except for the getting prices quicker than we did, and getting supply turned around. Overall, this fits in our portfolio very well.
Okay. Thanks very much, guys.
Thank you. Our next question comes from Steve Tusa of JP Morgan. Steve, please go ahead. Your line is open.
Hey, guys. How's it going?
Good. Hey, Steve. Thank you.
Good. Hey, Steve.
Good. Just on the backlog, I guess trying to read the tea leaves a little bit here with the big revenue ramp in the fourth quarter, do you expect book-to-bill in the second half to be above one in total? Obviously, it'll kind of modulate 'cause of the big fourth quarter, but in total, do you think book-to-bill can be above one?
Yeah. We're still putting together our projections for you know orders for the fourth quarter. You know, you can look at the you know the second half you know sales number. I would say we would expect continued orders growth in Q3. Q4 poses a pretty good year-over-year tailwind. I would say it would be plus or minus close to that you know one-time book-to-bill.
Okay. Then just more philosophically, maybe a question for Dave. How are we defining success at this stage? Is it kind of a hard line on this fourth quarter and the 50% increase for 2023? Or is it, you know, if we continue to have these costs that pop up, you know, like they have in the third quarter, where the guidance is below it, kind of things keep getting pushed forward. You know, if you come to the fourth quarter and things, quote-unquote, "slip into 2023," is that an acceptable outcome for you at this stage? Or is there more of kind of like a hard line here now, given what we've seen the last few quarters? Acknowledging the sequential improvement is steady.
Steve, I assume that.
That's a question for Dave Cote. Yeah, Dave Cote.
Yeah.
Yes, that's right.
Right.
Yeah. Yeah. I would say it's not so much the number itself for the fourth quarter as it is the lead-in to 2023. As you know, this whole year has been one of having to transition through a backlog, be a hell of a lot more aggressive on price than we were, and be a lot more aggressive on where to put it in the first place. Okay. This was a transition year for us. The whole point was to get price, to get Americas fixed enough so that it was in a position where it could perform and to lead us into what I think is gonna be a very good 2023.
That's the game that we're playing here, is to work our way into a position where for 2023 onward, we're in the kind of position to perform that we thought we were before. This has been a tactical year that we've had to run into. The strategy of the company is still right, still good. It's a great position in a good industry. Technology's good. We're still doing all the new product intros, still increasing R&D spending. The trick here has been to get Americas fixed and to get price running ahead of total inflation, not just inflation for 2022. That's the way it looks like it's coming together at this point. As I said, I feel good about the profile and feeling good about 2023. That's the game for us.
Anything lumpy seasonally about 2023? Like, if you do push out a 4Q into 1Q, I would assume that, you know, price costs, that kind of stuff shouldn't be that lumpy, so that you should start 2023 on a pretty strong footing. If that's the case, it would, you know, kind of reinforce what you see for 2023, or is 2023 a more back-end load, you know, just as back-end loaded because of seasonality?
No. With the kind of lead-in that we should get from 4Q, we would expect 1Q to be markedly different from what it was this year. Dave, I assume you agree with that.
Totally agree. You know, the key there is the additional fan supply we're getting in the fourth quarter will you know certainly lead into Q1, Q2. There's always seasonality, but probably a little bit less pronounced next year.
Okay. Great. Thanks for the color, guys. I appreciate it.
Sure.
Thanks, Steve.
Thank you. Our next question comes from Andrew Obin of Bank of America. Andrew, please go ahead. Your line is open.
Thank you. This is David Ridley-Lane in for Andrew Obin. Hyperscale and colocation CapEx may be more secular than cyclical. Historically, enterprise and S&P CapEx has been tied to the broader economy. Wondering what you're hearing from the field, from sales about enterprise pipelines. Have you heard anything about, you know, 2023 CapEx plans?
David, this is Rob. I'll start with that.
Yeah.
Gary, you can kind of chime in there. What I'd say is, you know, the activity in enterprise has been kind of stifled by the COVID and people still not fully going back to the office. What we are seeing is a phenomenon as people go back to the office to refresh their edge, their closets, that type of thing. That activity has been fairly strong. The projects in that space are fairly strong, from what we're seeing from the field on the enterprise side of things. Some of our larger enterprise data center customers continue to build and continue to have demand on us. We, you know, I'm pretty bullish on what we're seeing, just what's necessary to update the enterprises and then expand the enterprises.
As we mentioned, you know, data is not slowing down by any stretch, and people are using data to drive more efficiency in there. In order to do that, they're gonna have to have the compute and/or, you know, the infrastructure to make that happen. I know, Gary, you were gonna say something.
I think that's exactly right, Rob. David, you're right. The cloud and colo, that CapEx, it's always hard to peg it in any given quarter, so we look at more the trajectory and the run rate of that. That all looks very healthy. The enterprise, there would not be a like CapEx number that gets published anywhere, so we take a lot of that from voice of customer and from our pipeline and what we're hearing directly from the individuals. To Rob's point, we have not heard any conversations picked up anywhere around, "Hey, we're gonna slow down. Hey, we're doing this. Hey, we're planning for, you know, this in 2023." Well, that looks any different than what we thought over the last couple of quarters.
We still think the enterprise edge IT channel, all that market is pretty healthy. The only one exception was China had a little bit of a setback in enterprise just because of the COVID lockdowns that occurred in late Q1 and Q2, but they're coming out of that now, so we've seen that pipeline start to ramp up in enterprise. Everything we see in that area in channel, edge, enterprise, sort of lump it all together, still looks pretty good and robust to us.
Got it. That's helpful. You know, in the Americas region, that's really the key for you to have a meaningful margin recovery. Can you just give a little bit more color on the internal initiatives that you have beyond sort of the Monterrey facility that would drive margin expansion go forward?
David, this is David. You know, certainly if you look at the second quarter and some of the headwinds versus last year, to kind of compare it prior to this higher inflation supply chain challenged environment. You know, price cost certainly played a role. The Americas was actually still negative price cost in Q2. I think it was about $10 million. You know, we certainly feel like we'll address that with the additional pricing we expect to get in the second half of the year. Pricing will continue to be a lever, and we've never been super aggressive with pricing, and what we've realized is that we've left a lot of money on the table.
We could have been pricing much more aggressively, you know, for a long while here. Based on the strength of our products and notably our thermal products, we'll continue to be aggressive with pricing. That will continue to be a lever next year, even beyond offsetting inflation, whether from a dollar perspective or a percentage perspective. It, you know, a lot of the other things, I don't wanna discount them by calling them blocking and tackling, but there are a lot of elements of, you know, operations that we have identified over the last six months or so that can be significantly improved. We talked a lot about the SIOP process. That's not only gonna improve our ability to manage inventory, it will improve our ability to drive margin.
You know, capacity planning is another. You know, the organizational structure continues to get benefits from ERP and driving process and putting additional tools in place. You know, going back to maybe the very beginning, this Americas region was built through a series of acquisitions that never were really integrated. We've done some of that over the last four or five years. There's still a ton of benefit out there just by putting in place some improved processes. I think we're already starting to see that benefit. You know, we would expect an acceleration of those things in 2023 and beyond.
Thank you very much.
Thank you. There are no further questions at this time. This concludes our question and answer session. I would like to turn the conference back over to Rob Johnson for any closing remarks.
Okay. Thank you. Thank you to everybody, participating today and for your support. Our second quarter is another step forward in delivering on our plan that we detailed out, last February. It continues to be a dynamic time in a macro, environment, but we remain firmly focused on executing a strong second half, which will provide a strong setup for 2023. Again, appreciate everyone's support, and I'd like to thank everyone for joining the call today.
Thank you. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines.