Martinrea International, Inc. (OTCPK:MRETF) Q3 2022 Earnings Conference Call November 1, 2022 5:30 PM ET
Company Participants
Robert Wildeboer – Executive Chairman
Pat D’Eramo – President and Chief Executive Officer
Fred Di Tosto – Chief Financial Officer
Conference Call Participants
David Ocampo – Cormark Securities
Mark Neville – Scotiabank
Brian Morrison – TD Securities
Michael Glen – Raymond James
Peter Sklar – BMO Capital Markets
Krista Friesen – CIBC
Ben Jekic – PI Financial
Operator
Good evening, ladies and gentlemen, and welcome to the Martinrea International Third Quarter Results Conference call. Instructions for submitting questions will be provided to you later on. I would now like to turn the call over to Mr. Rob Wildeboer. Please go ahead, sir.
Robert Wildeboer
Good evening, everyone. Thank you for joining us today. We always look forward to talking with our shareholders, and we hope to inform you well and answer questions. We also note that we have many other stakeholders, including many employees on the call, and our remarks are addressed to them as well as we disseminate our results and commentary through our network. With me are Pat D’Eramo, Martinrea’s CEO and President; and our CFO, Fred Di Tosto. Today, we will be discussing Martinrea’s results for the quarter ended September 30, 2022. I refer you to our usual disclaimer in our press release and filed documents I will speak, Pat will speak, then Fred and then we’ll do some Q&A.
I want to touch on three things for you. And then turn it over to Pat and Fred for their comments. Many of them more detailed than mine, and perhaps more interesting. First, I want to thank our people in our leadership team for their hard work. Despite tough times, our results are the fruits of their hard work and dedication, and a lot of great performance. We say often it’s all about your people. And ain’t that the truth. Our leadership group recently got together for a Global Leadership Conference, twice postponed by the pandemic and lockdown measures, 150 or so people. It was a fantastic event, Pat will get into more detail about a few things. But the culture we drive at Martinrea every day and everything we do is evident in our team.
A focus on Lean thinking, taking waste out of every process, a focus also on entrepreneurial thinking, which means taking ownership of what you do. And at the core, a golden rule culture, meaning treat people the way you want to be treated. I talked about these things a lot. But so to all the other leaders in our team, we walk to talk and take care of our people. The theme of the conference was living our vision. And that’s what we do consistently making people’s lives better by being the best we can.
Second, related to our culture, are our results. I believe, as Peter Drucker has said, culture eats strategy for breakfast. Here’s an example of good culture breeding good results. As Pat and Fred will elaborate on in some detail. Our Q3 was outstanding, especially in the context of the challenging world in which we live. Record quarterly revenues, record quarterly EBITDA adjusted, excellent free cash flow, and one of our highest EPS numbers ever.
These results should not come as too much of a surprise to you or to us as they reflect what we have been saying for quite some time. If you recall very early last year, we said the chip and other supply chain shortages were a real problem. Some said chip shortages were a blip. We said they were a blip. If you recall, check the tape. We said that we would struggle as customers production schedules are massively disrupted. And a year ago, we lost money in Q3 and Q4 as predicted. At the time, we said the first half of 2022 would be better and it was.
We showed decent profitability. We also said that the second half of the year would be better than the first half. And this is proving out. By the way, we’ve also said and still say next year will be better than this one, as we expect production volumes to improve significantly. We also expect higher revenues, free cash flow and operating margins. The trend line is up to the right, as they say is proving out.
Please recall our position in 2019. That was a record year of profitability and profits. We also won over a $1 billion in annual sales based on projected volumes of new work if as and when launched. Even with the pandemic, lockdowns, trade disputes, inventory shortages, a Russian war effort, inflation and higher interest rates, we have continued to invest in our business in launching that record level of new work. And so now that much as launch is launching our revenues are now significantly higher driving higher profits in cash flow. Not unexpected, this is what we plan for.
Frankly, and this is not an arrogant statement, but it is a true one. We believe we understand the auto parts market, the auto market, and most of the geopolitical issues we face as well as anyone in the business or looking into the business. We have now over 18,000 employees in 57 plants in 10 countries on five continents, and it is our business to know our business. As we say at the start of our calls, we want you to see how we see the world. And we’ve been pretty accurate on the fundamentals, we’re happy to share our thoughts.
Long term, which should be the time horizon for the investor, our future looks bright, and we have never been stronger. The third area, I would like to touch on are some of the key challenges we see over the next several months, noting that the overall trend line for auto parts suppliers in general and us also is positive over time, not negative. The Russian Ukraine situation is not going away anytime soon, and still impacts energy prices supply chains, including many minerals and so forth. This will be a headwind, we believe.
Related to that is the issue of energy prices in Europe, where we do about 20% of our business. We think it’s going to be a cold, expensive winter. And frankly, we see a strain on energy prices over the winter and probably next also, this will have an effect on profits and margins and probably volumes. But as predicted, we’re seeing moves to provide energy price relief to industry.
Our industry has been involved in many discussions. In Germany, the auto industry is the largest and the country is going to ensure the industry does not shut down. Programs are being developed to alleviate energy costs. This after Europe has worked hard to build up gas reserves for the winter. Germany is talking about a subsea program that is massive, and could cost them €200 billion. But this should keep production going. A very, very expensive lesson, perhaps in sustainability and renewable energy policy. It could cost Germany $0.5 trillion to remove reliance on Russian gas. Inflation pressures do exist. And it’s front page news, especially as they give rise to higher interest rates as the Fed, the Bank of Canada and others raise rates to lower inflation. I’m not a fan of the higher interest rate policy as I think it’s somewhat misguided.
In industry, including our own, we’re seeing much inflationary pressure easing off, including in many input products, materials and shipping costs. Inflation has been caused to a large extent, not by the war in the Ukraine, but by governments printing money, by supply chain issues caused by lock down policies and so forth. We’re getting a handle on some of these things. At the same time, consumers are going to spend on Travel, Leisure, entertainment, people have been locked up for two years, they’re going to spend. So not sure higher rates are necessary. And many in our industry have given that advice to governments.
Maybe our industry input had some influence on the lower than expected rate hike last week. The time to stop interest rate hikes in North America was yesterday, especially in Canada, I digress. But suffice it to say I do believe rate increases will end sooner rather than later. And rates will stabilize, at least at a sustainable level. I also believe people will adjust and continue to buy vehicles as they are financed by rates that still historically are not too high, often provided by OEMs that have strong balance sheets.
And as I said, industry production next year, and a number of years after that should be higher than this year or last. And that is good for us auto parts suppliers. We’d like to thank all our shareholders, lenders, suppliers, customers, governments and employees for your support. We cannot grow and thrive without it.
With that, I’d like to turn it over to Pat.
Pat D’Eramo
Thanks, Rob. Hello, everyone. As noted in our press release, we generated an adjusted earnings per share of $0.56 and an adjusted operating income of $70 million in Q3, up from a loss of $16 million in Q3 of last year. Production sales came in at $1.1 billion, up 41% year-over-year. Adjusted EBITDA of $140 million was a record for the company as Rob mentioned.
Adjusted operating income margin came in at 5.8%, 170 basis points sequential improvement over Q2 on production sales that were 7% higher, a solid result, which was mainly driven by higher sales volume and an improved mix compared to last quarter. A reduction in launch cost as volumes on some key programs are smoothing, although others are still sporadic, and continued improvements in our Martinrea Operating System or Lean activity.
We also continue to make good progress on recovering inflationary costs through commercial negotiations with our customers. I’m proud of the work that team has done on this front. These discussions have a lot of layers, and are never simple. But our team has faced the challenge head-on and concluded several agreements on favorable terms. We’ve made good progress commercially and we expect to see further progress as the year comes to a close. Commercial negotiations will not completely subside. But we do see them normalizing latter in the latter part of 2023 depending on inflation.
On our last call, we said that we expected our Q3 results to be better than Q2. As supply chain bottlenecks improved, our launch activities moves, and we drive cost recoveries, this is exactly what happened. We are right where we expected to be during the quarter. And we expect a strong finish to the year with good momentum into 2023. Having said that, we continue to face a challenging environment on several fronts. But we’ve seen steady improvement in the production environment since last year, we continue to deal with supply related disruptions from several of our customers. So while our production environment is stabilizing, it’s not as stable as we expected it to be at this point.
Margin percentages remain below potential despite the improvement in the past few quarters. We made progress and offsetting significant costs through inflationary pressures are proving to be more persistent than we envisioned. While inputs such as steel and aluminum have seen some pricing relief. We have passthrough mechanisms on these commodities, or other commodities where we don’t have pricing passthrough we have not seen as much relief.
As you know, energy prices have been a significant headwind in our European business. Though natural gas prices in Europe have been declining since September. They remain a headwind and continue to sit well above year ago levels. The good news is, we continue to expect a strong 2023, which I will elaborate on in a moment.
Turning to our global operations. In North America, we saw notable increase on our adjusted operating income margin in Q3 compared to Q2 on an 8% increase in production sales. As mentioned earlier, lower launch costs and a positive mix along with improvements in operations resulted in better margins during the quarter. As you are aware, we have been launching a lot of business over the last couple of years. On our last call, we indicated that we had not seen much benefit from lower launch costs, and that this would become more evident in the back half of the year. This proved to be the case in Q3 as programs ramped up and we made operational progress and launch costs declined.
As discussed, we are making progress on recovering inflationary costs with more to come. Along with inflationary recovery, we are also making steady progress operationally and we continue to see opportunity here. There is a lot we can do in the moment, and even more that we could achieve in a more stable labor environment. Labor remains challenging all over, but especially in the United States.
Turning to Europe, adjusted operating income declined slightly in the third quarter compared to Q2. We continue to make progress in our operations. Unfortunately, this has been masked by a significant cost challenge most notably energy, and we are devoting a lot of time on recovering a fair portion of these costs.
In our Rest of World segment, adjusted operating income improved over last quarter on better volume and mix as the strict COVID lockdown measures in China that impacted us through the first half of the year began to ease. Looking forward, we continue to expect 2023 to be a strong year for us with better production volumes, sales, margins, and free cash flow compared to 2022. And what we expect will be the beginning of a strong cycle with the majority of our plants running at full capacity.
But that said we are revising our 2023 outlook. Based on what is in front of us at the moment we now expect 2023 total sales to be between $4.8 billion and $5 billion. Adjusted operating income margin to be between 6% and 7%, and free cash flow to be between $150 million and $200 million. Although short of what we originally were expecting, still a very solid year, in particular, the free cash flow outlook.
The updated margin and free cash flow outlook reflects the slower normalization in the supply chain and production environment, tight labor conditions. And the fact that we are not recovering 100% of inflationary costs increases, although I would say that we’re doing quite well in this area. The free cash flow outlook is also being impacted by higher interest costs due to overall increased borrowing rates.
Operating margins are also being impacted by material passthrough, which is largely the reason for our sales outlook range being up along with the expected higher tooling sales. Excluding these two items, our sales outlook for next year would actually be lower than our original outlook generally reflective of the current IHS volume projections. Material passthrough impacts our sales with no corresponding incremental margin benefit. This has a detrimental impact on our margin percentages is it essentially represents sales without profits. Tooling sales are also essentially passthrough to our customers and carry little to no margin.
So overall, we’re expecting 2023 to be a solid year and a nice increase in 2022 levels. And we’re very focused on free cash flow, and it is reflected in our outlook for next year. Of course, there’s still a lot of uncertainty as Rob mentioned, be it from supply chains challenges that impact production, or macroeconomic risks from high inflation and interest rates, or the potential for an economic slowdown. The energy crisis in Europe in particular is a material risk when that we are monitoring closely. We don’t have a crystal ball, but we are confident that we will navigate our way through these challenges as we have in the past.
Now I’m going to take a moment and talk about our Global Leadership Conference or GLC that we held last month in Blue Mountain a couple hours north of Toronto. The GLC brought together a 150 of our top leaders across the organization for three days to discuss the company’s strategic direction and priorities for the future. It was a great event. We had people in attendance from every region that we have our presence in, including Canada, the U.S., Mexico, Brazil, Germany, Spain, Slovakia, China and Japan. Leaders left the conference energized and excited about our future with a clear direction on priorities for 2023 and 2024.
There are some key takeaways from the conference. The overarching theme is that we are doubling down on our four pillars strategy which encompasses our high performance culture, operational excellence, discipline financial management, and customer focus. This is the same basic strategy that enabled us to expand our business both organically and through acquisition, double our adjusted operating income margin from 4% to 8% in less than five years and introduce new and innovative products to the market, or what we call breakthrough products, securing the next leg of our growth. Simply put, strategy has served us well in the past that we are accelerating it.
I want to expand on what discipline financial management means. To us, it means prudent profitable growth and in the focus on free cash flow. Sales growth is to be selective, targeted, and guided by our return on invested capital and free cash flow targets. We had several presenters speak on the importance of free cash flow, and we held an interactive workshop on the topic that all attendees participated in. We are committed to these objectives, and have a high level of buy in across the organization.
I also want to touch on operational excellence. We spent a lot of time talking about program management, and our Martinrea Operating System or MOS, what we sometimes refer to as Lean. Through presentations and panel discussions, business unit leaders and other executives reflected on our challenges and key learnings for the future. Of course, strong program management is also a key part of the customer focus. It has a big impact on how we are perceived by our customers. How they view our capabilities, on time delivery, quality, and the ability to adjust to demands that had had tremendous fluctuation due to supply chain challenges.
For MOS we held multiple workshops using interactive tools that demonstrated how implementing Lean practices and having Lean mindset have positively impacted the business and how we must accelerate this thinking to continue to improve efficiency, productivity and profits, as well as employee engagement and morale. Another key takeaway is that we’ve had a lot of opportunities within our core automotive parts business, but not limited to it. We are an innovative company and our R&D capability is strong, we see a lot of opportunity to develop new innovative products for our customers. These include breakthrough products, some of which I outlined in detail on our last call, we expect to introduce more of these products to the market in the coming months and years ahead.
Our Martinrea Innovation Development or MiND initiative is also central to our innovation focus, MiND has already delivered tremendous value to us. We have a 21% ownership stake in NanoXplore and together we introduced the brake line product coated with graphene that is unique to the market and has recently been named a 2022 Automotive News PACE Award winner. And we continue to explore the potential supply graphene enhanced lithium ion batteries for electric vehicles through our VoltaXplore joint venture.
We see MiND as an incubator for new technologies that can augment our product offering and capabilities. And there are a number of exciting opportunities that we continue to explore through this initiative. We covered a lot of ground in three days. And as I alluded to, people left with a clear vision of where we are heading as an organization, and what leadership’s role is to deliver on the plan. Many thanks to the Martinrea team for their hard work that has provided strong results thus far.
With that, I’ll pass it to Fred.
Fred Di Tosto
Thanks, Pat, and good evening, everyone. As Pat noted, our third quarter financial results were much improved over last quarter on better margins and higher production sales with a record quarterly adjusted EBITDA. Though we continue to deal with challenges on multiple fronts, including supply-related production disruptions, inflationary cost headwinds, tight labor market conditions and an energy crisis in Europe, our results continue to trend higher, as we said they would. We’re making great progress in recovering inflationary costs through favorable commercial settlements with our customers, and we continue to drive operating improvements across the organization.
We have also started to see the benefits of lower launch costs in our margins. We expect our results to improve further as supply chain disruptions abate, and our launch activity continues to normalize. As Pat outlined, we anticipate higher production volumes, sales, margins and free cash flow in 2023.
Taking a closer look at our performance quarter-over-quarter. Production sales were 7% higher on better volume and mix. The production environment continues to improve, but we’re still dealing with supply-related production disruptions with a number of our customers. Adjusted operating income margin came in at 5.8%, a nice increase from the 4.1% we generated last quarter. Margins benefited from improved volume and mix, lower launch costs as key programs ramp up towards mature volumes and operating improvements from our Lean activity.
As such, adjusted operating income was up 53% sequentially in Q3, and adjusted EBITDA was a record $140.2 million, up 23% over Q2. Free cash flow came in at $64.1 million, a solid result, reflecting strong EBITDA growth and positive working capital flows. Free cash flow was $35.4 million for the first nine months of the year. We expect free cash to be positive for the full-year 2022.
Looking at our performance on a year-over-year basis. Third quarter adjusted operating income of $69.7 million was up sharply from a loss of $16.2 million in Q3 of last year. And adjusted EBITDA more than tripled on production sales that were 41% higher. Recall that Q3 2021 was a quarter that supply-related production disruptions were at their worst, marking a low point in our financial performance before results began to improve in subsequent quarters. While higher year-over-year operating results are nice to see, margins are still below what we know we can achieve. It takes time, but ultimately, we do expect to get there.
Moving on to our balance sheet. Net debt was about flat quarter-over-quarter at $928 million at the end of Q3. As we announced earlier this year, we have an amended covenant structure with our lenders, our adjusted EBITDA in Q3 and Q4 of last year is ignored. The remaining quarters in the trailing 12-month period are prorated when calculating net debt-to-EBITDA for covenant purposes. Our leverage ratio is also subject to higher limits to the third quarter of this year.
On this basis, our calculated net debt-to-EBITDA under the revised terms was 2.17x in Q3, down from 2.3x in Q2, a comfortable level and well below the covenant maximum of 3.75x for the quarter. Based on the standard or unadjusted calculation, net debt-to-EBITDA was 2.43x at the end of the quarter, well below our typical 3x covenant threshold. As such, we are below 3x even without the amended formula. We expect to end the year lower than this as we lap Q4 of 2021.
Our leverage ratio should naturally continue to improve in the coming quarters as we generate an increasing amount of EBITDA and free cash flow, a portion of which we will use to pay down debt. We have strong relationships with our lenders, and we thank them for their continued support.
And with that, I’ll now turn it back over to Rob.
Robert Wildeboer
Thanks guys. Now it’s time for questions. We see we have shareholders, analysts and competitors on the phone, also some employees. So we may have to be a little careful with our answers, but we will answer what we can. Thank you all for calling.
Question-and-Answer Session
Operator
Thank you. We will now take questions from the telephone lines. [Operator Instructions] The first question is from David Ocampo from Cormark Securities. Please go ahead.
David Ocampo
Thank you. Good evening everyone.
Pat D’Eramo
Hello.
David Ocampo
Pat, I really appreciate the margin commentary on 2023 and it does make a lot of sense. But when I’m thinking about the inflation pass-through provisions and the revenue basically has zero margins, do you believe that the 6% to 7% is the new normal going forward? Or is that 8% still possible in the current inflationary environment like thinking beyond 2023?
Pat D’Eramo
Until we know what inflation does, it would be hard to answer. I mean if things normalized or go back to what you call a normal level at least, certainly, we could get back on board with where we were in the past. But the energy costs in Europe and the erratic supply chain situation, those things would have to get back to what we would consider normal before I would commit to that.
Fred Di Tosto
Yes and I think the pass throughs are going to be downward pressure on margin. The higher the pass throughs, the greater the downward pressure, and that has a lot to do with our updated forecast.
Pat D’Eramo
But I would say this, all things being equal, if you go back to 2019, when we were in the 8% range, certainly, those things are in our graphs in the future, I believe.
David Ocampo
So Pat, is it better to look at or evaluate Martinrea based on kind of return on invested capital as opposed to margins just because of the way that the revenue portion of the inflationary pressure is zero margin?
Pat D’Eramo
Yes. I think at the moment, certainly, our returns, our free cash flow generation and just our improved profit could be probably a better thing to look at, though I think margins again in the future would be something to discuss. At least to a higher valuation, we’d support that.
David Ocampo
And is there like a return on invested capital target that we should be thinking for you guys?
Fred Di Tosto
Yes. We have strict total rates. We have disclosed that in the past. We typically target an IRR of 15%. Just given the higher interest rates, we’ve actually increased that slightly. So it’s somewhat higher than that at the moment. And it kind of fits in with our strategy of being somewhat more selective in terms of what business we go after going forward.
Pat D’Eramo
With our plans, for the most part, being full, it gives us the ability to step back and make better decisions than you might if you had a bunch of empty facilities.
David Ocampo
Yes, that makes sense guys. That’s it for me.
Pat D’Eramo
Thank you.
Operator
Thank you. Our next question is from Mark Neville from Scotiabank. Please go ahead.
Mark Neville
Hi, good afternoon guys. Great results. Hi, maybe just first on the recoveries. Can you just give us sort of a rough sense of how big the impact was in Q3? And maybe just how it flowed through the P&L? I assume it’s just come through in the sales of 100% margin. Is that correct?
Fred Di Tosto
I’m not going to get too specific in that area. In the past, we talked about the $100-plus million headwind. We’re recovering a fair share of that. We’re not recovering 100%. And with the higher energy costs, more recently, that number is a little bit higher. But I want to kind of stay away from that, just given the fact that some of these negotiations and results are somewhat confidential and I don’t want to necessarily discuss and elaborate any further.
Pat D’Eramo
I would add, we’re happy with our progress.
Mark Neville
Okay. Yes. I guess I had sort of a follow-up. I was just curious on how far along the way are you? And I think — I’m not sure if it was sort of Pat or Rob that said this might continue the negotiations in the second half of 2023. Is that right?
Pat D’Eramo
Yes. So it was me. And basically, you’re doing commercial negotiations all the time. It’s just the significant increase due to the inflationary cost this past year. And those will spill over into next year, at least the early part of the year. And then as that normalizes normal, what I would call normal commercial negotiations will continue as they always have. But the level of intensity and the amount of time spent on it is much higher this past year.
Fred Di Tosto
And maybe I’ll just said, so as we close out ’22, we’re closing out some of these final negotiations with some customers, and a lot of them — all of them are dealing with ’22. Some of those deals will set precedent for next year and clearing to next year and others, we’ll have to renegotiate essentially. So this activity will continue for a period of time until we get to a new normal of cost level.
Robert Wildeboer
A lot of the higher financial results or higher financial results have been driven obviously by the record revenues, and some of that’s passthrough, but some of that is just the fact that we’re producing a lot more product. As you recall, we won a lot of work in 2019. Over the last several years, we’ve continued to invest lots of capital in order to launch those programs and put capital in place to support the higher revenue level and with that comes higher EBITDA and all that type of stuff.
Mark Neville
Yes, I’ll for sure these are good numbers for the Q3 this year. Maybe on the 2023 guide. Again, maybe if we’re talking EBIT dollars versus EBIT percent, I think if my math is correct, the EBIT dollar midpoint will be down sort of 10%, 15%. Again, I appreciate all the details and to put sort of the puts and takes. But I guess if we were to so — if you were to rank the top two, three things that are impacting what — how would you rank those, I guess?
Fred Di Tosto
You going to do your job.
Pat D’Eramo
As far as the improvements, I guess, is what you’re asking — what are the tops of the reduction. Okay.
Mark Neville
The reduction, yes.
Fred Di Tosto
I mean I think we hit all the main points. I mean, I’ll maybe just repeat them. I mean in the past does have an impact on our margin percentage. So that’s quite substantial in terms of higher sales with essentially no profitability associated with it. We’re not recovering 100% on the inflationary cost increases as I noted.
And in addition to that, the production environment continues to be lumpy. We expect that to continue into next year. And then our sales guidance range is up. But if you back out the material passthrough as well as we are going to be — we’re expecting higher tooling sales next year. Our outlook actually is resulting lower volume outlook for next year. So the lower volume has some of an impact as well.
Mark Neville
Great. Understood. Thanks guys.
Operator
Thank you. Our next question is from Brian Morrison, TD Securities. Please go ahead.
Brian Morrison
Yes, good evening. First question. Fred, maybe just going through the Q3 results, the operating margin. When I look at it on a sequential basis, the production sales are up nominally, maybe 1%, 2%. I realize there’s some mix benefit from being weighted in the U.S. But if I just look at the increments, you’re probably up 25 to 30 basis points in terms of the operating margin relative to Q2, but you’re up 170 basis points sequentially. So what are the — I mean, when I take a look at launch costs or Lean activity, commercial negotiations, maybe just break down an additional 140 basis points or the additional $20 million of EBIT?
Fred Di Tosto
Yes. So the volume and mix — volume has an impact, but also we saw an improved mix in the quarter. I think a bigger impact, and we talked about this earlier in the year, in the back half of the year, we’re expecting our launch activity and launch costs to start normalizing, and we saw that in Q3. And that’s just a byproduct of operational improvements as well as some of the production on some of these programs smoothing out. So we saw some of that in Q3, and we continue to expect the back half of the year in terms of launches to normalize compared to the front half of last year. So eventually, everything is kind of falling into place.
Brian Morrison
Excellent. And were those launch costs, is that the biggest contributor to that delta then?
Pat D’Eramo
I’d say that one of the problems with the launch cost was the increased ramp of the customers in some cases. I mentioned this before that if you’re supposed to launch to full volume in a month and it’s taking 12, 14 months in some cases, you’re not generating the revenue or the smoothness in your operations in order to run like you would normally plan to run. So the volumes in a lot of the cases, not all, I’ll emphasize that, but a lot of the cases has improved and those improved volumes translate into our plants and to smoother running, and that’s had quite an impact.
So the better the customer runs, the better we can improve our operation and run with them, and we’re starting to see that this quarter. But again, I don’t want to celebrate yet because there’s still a lot of disruption. They don’t tend to be a week at a time anymore, but it will be a day here, a day there, a couple of days, and it’s very disruptive to the workforce because you can’t adjust or flex your workforce for two or three days. So you end up with inherent inefficiencies in people because you can’t run.
Brian Morrison
Pat, just — I’m not sure it was clear on the call, but are you still insinuating that Q4 is going to be better than Q3 in terms of financial performance?
Fred Di Tosto
We said the second half of ’23 or of ’22 would be better than the first half. So we’ve got to go and look at some of the releases and so forth and see how people adjust their inventories at Christmas time.
Pat D’Eramo
Yes, we get a lot of erratic. And this isn’t even in normal times a lot of erratic releases that get canceled, a couple of weeks out from Christmas. And then how the products running, they look at their supply chain issues, and a lot of times unexpectedly will end up — the customer will end up shutting down a week or two before they say they are and so sales tend to drop a lot of times in December. But we do expect our performance, given whatever sales we have to be good.
Fred Di Tosto
Yes.
Brian Morrison
Okay. And then Pat, last question, if I can. Just in terms of the guidance, I understand the inputs while you’re taking the forecast operating margin down. It makes complete sense. The question I have though is, what is factored in for European risk, whether it be elevated energy costs or potential for production curtailments? Do you have anything factored into that?
Pat D’Eramo
In terms of energy, so that essentially layers into our commercial discussions in negotiating with our customers. So we have managed to offset some of the increased costs with these recoveries, and we’re assuming we’ll be able to do that next year as well as it relates to our ’23 guidance.
Brian Morrison
And in terms of production volumes?
Pat D’Eramo
Well, we essentially budget and forecast on IHS. So their current projections would be pretty close to what we are expecting next year and baked into our outlook.
Brian Morrison
All right. Great result. Thanks very much.
Operator
Thank you. Our next question is from Michael Glen from Raymond James. Please go ahead.
Michael Glen
Hey, thanks for getting me in. Can you just talk about what’s coming up in 2023 for Martinrea in terms of new launch activity?
Pat D’Eramo
We don’t have nearly the launch schedule we had the previous couple of years, but we still have a number of launches like we would in the other year in our aluminum group. There’s a couple of good size ones. There’s some volume ups throughout our organization where customers have come and asked us to increase the level of capacity because they foresee their sales going up in the near future. So we wouldn’t consider that a full launch, but you are usually adding equipment and changing your lines and things like that. We do see a lot of that right now. I’m trying to think.
Robert Wildeboer
Yes, we don’t have any big launches starting next year. We have EVA2, the Mercedes program that’s just launching now, and we’ll ramp up next year. In addition to that, there will be some preparation for some upcoming launches in ’24, in particular with GM, their BEV3 EV platform as well as BT1XX, which is their HUMMER EV and their electric pickup truck.
Michael Glen
And then…
Robert Wildeboer
Go ahead Pat.
Pat D’Eramo
We just going to…
Michael Glen
I’ll let you talk, Pat.
Pat D’Eramo
No, no. Go ahead, please.
Michael Glen
So the margin for North America this quarter, like when we’re thinking of the programs that factored into that margin, are there many of those programs that are still operating below what the target margins are? Is there a wide delta there?
Pat D’Eramo
There are a few programs that are not meeting the ramp schedule as planned. A couple of good sized ones. They’ve improved. One of the two in particular has improved, but the other is still struggling. But even the one that’s improved is off schedule. So I foresee those programs getting better next year, especially, and I think we’ll see better performance from ourselves because, again, the more you can smooth production, the more we can stabilize our operation.
We’ve done a lot despite the fact we get a lot of this erratic production schedule, but nothing is better than even flow through the system. And I expect that will continue to improve. But we still get surprises. Just today, we had one of our customers shut down an operation for the next week totally unexpectedly. And those things happen still more often than we like. And more often than they like too, I’m sure.
Robert Wildeboer
It’s not necessarily chip related. It could be other components. This example was actually stereo.
Pat D’Eramo
Yes, it wasn’t chips. But I think some of those other supply chain issues that have been hiding behind chips, we’re going to see more of, the ones we haven’t known about that will start to appear.
Michael Glen
And just to try to understand this European energy dynamic. So we saw just a huge run in energy prices through the period, through the quarter. And when you reported, though, it looked like it was — overall, it was a pretty — it wasn’t a notable impact in the period, especially when you look to Q3 versus Q2 over in Europe. So when we see those big runs happen, if we see those big runs take place in energy prices over in Europe through the winter, if that happens, should we anticipate that you’re passing that through then to customers? Do you have that negotiated now?
Fred Di Tosto
Well, we’re still negotiating. So that would be the intention. And we’ve had some success, but we still have some work to do there. The other thing to note is this year in ’22, we did have some hedges in place to kind of temper the impact, not 100%, but we had some. And those are going to start expiring as well, and the premises is to be able to offset it with customer recoveries and so forth. A lot of that work should be done by the end of the year, and we should be going into next year with those frameworks in place.
Robert Wildeboer
Don’t think that the energy price hasn’t had a significant impact. They have had an impact on costs and also on production schedules from customers and so forth. You can see our European results aren’t nearly as good as our North American results. There’s a lot of stress in the system there. We’re dealing with it pretty well. But as we said in our remarks, it’s going to be a tough winter in Europe as they deal with what happens when the weather turns cold.
Fred Di Tosto
Still, a large percentage of our energy spend was on spot this year as well.
Michael Glen
Would you be okay indicating just how much of an overhang excess energy cost was in the quarter?
Robert Wildeboer
No.
Michael Glen
Okay, and then for 2023 guidance, it looks like you’re forecasting somewhere over $300 million in CapEx. Is that sort of the assumption embedded into the free cash flow guide?
Fred Di Tosto
Our guidance on that hasn’t changed. We’re expecting our CapEx next year to be in and around depreciation and amortization as a percentage of sales, and that should be just under $300 million in that range.
Michael Glen
Okay. And is there any sort of working capital assumption in there as well to think about?
Fred Di Tosto
I mean our production related working capital will flow with sales at typical rates. The one that continues to be volatile, will always be volatile is tooling related working capital. And I think the last couple of years, we’ve proven that we can manage that quite well. So expect them to do the same next year.
Michael Glen
Okay, thank you for taking the questions.
Fred Di Tosto
Thank you.
Operator
Thank you. The next question is from Peter Sklar from BMO Capital Markets. Please go ahead.
Peter Sklar
Good evening. So this very elevated level of earnings you have, particularly in North America, like can some of it be attributed to the outcome of your commercial negotiations and that you had some retroactive recoveries during the quarter? Or is this kind of the earnings level of the company now in the context of all the pluses and minuses that you talked about?
Fred Di Tosto
The commercial activity definitely helps. I mean those deals are quite complex. There’s a lot of puts and takes. I think if you look at our historical North America margin, we’ve been higher than that. So I still think there’s upside to that outlook. And if you think about our outlook for next year, our margin expectation, we’re expecting each of our segments to contribute to that.
Peter Sklar
So it’s not like you got a big whack of recovery that inflated the margin just for this quarter. Is that what you’re saying?
Fred Di Tosto
The relative improvement, we were at 5% in Q2, 7%. It was volume mix as well as the launch activity that I referred to earlier.
Pat D’Eramo
We had a lot of good improvements in our operations or I should say, leveling from improved volumes. I would attribute a big piece of it to that.
Robert Wildeboer
Yes. I think as we said, second half of last year, we lost in part because customer schedules were going haywire. The first half of the year, we said would be better, and they are. The second half is better than the first half and they are and next year should be better. So that shows a progression in margin overall. So the fact that this quarter was higher than last quarter in the first half is what we were predicting before we were doing the commercial negotiations.
Peter Sklar
Great, okay. And then as I listened to management talk on the call, I just want to make sure I’m interpreting this right, but I’m getting the impression that the biggest item for this big jump in operating earnings that you’ve experienced is launch, the fact that launch costs are going down and new programs are ramping up, so you’re getting contributions. That’s the biggest item on the list in terms of contribution. Do you agree with that?
Fred Di Tosto
It’s a big part of it. And also sales mix. Obviously, in any given quarter, depending on what products we’re selling in this volatile environment, we see these pretty large mix swings. We end up coming on the right end of that in Q3.
Robert Wildeboer
Peter, that’s a really good question. But one of the things, and Fred has a wonderful chart that just shows the downtime from different customers. And so in the second half of last year, there was a lot of rent. And then in the first quarter, there was less rent, second quarter less rent, third quarter, less rent. That really has a huge impact on the profitability of any operation. When you go stop and start and you can’t plan, it’s very, very difficult. And third quarter was a lot better than previous quarters. Certainly, a lot better than it was nine months ago.
Fred Di Tosto
I’ll say General Motors is our largest customer, and I’m saying this year, in particular, they’ve actually done quite well in managing their production schedules. Still up and down to an extent, but they’ve been the best of the bunch.
Peter Sklar
Okay.
Pat D’Eramo
How do I say this because I said it last year. When we’re shutting down for weeks at a time, we’re laying off people and they’re not coming back and that creates instability. And then as it’s just a day here and a day there, you’re holding on to the people and you’re paying for them and they’re not doing any work. No fault of theirs, there’s just nothing to do, but you can’t let them go because they won’t come back.
And so the less of those random down days, the more efficiency we’re gaining in what we’re paying our people to do the work that they do. So it really does have a pretty significant impact when the customers run. And some customers have lowered their volumes on a daily basis in order to continue to run smooth. And that makes a huge impact as well because we can lower the level of workers we need but keep them all working all the time. So the efficiency gains there as well. And a lot of that is hidden as we’ve gone through this the last year or so, and that’s certainly helping a lot.
Peter Sklar
Okay. I understand. Rob, I wanted to ask you, you said some on a different topic now. You said something very interesting that — well, you say a lot of interesting things, but there was one and many interesting things I want to ask about. In terms of the situation in Germany, if we have a cold winter and there’s energy rationing, you felt confident that the German government would not ration energy to the automotive industry and the industry would not go down. Is that just kind of you thinking through common sense? Or are there people in government you’re talking to? I’m just wondering how you’ve come to that viewpoint.
Robert Wildeboer
I’d — I always appreciate when governments act with common sense. It’s not always the case. But in this particular thing, there have been several sources. First of all, part of a pretty big automotive industry, and we know that the OEMs have been having discussions and our people in Germany have been having some discussions as well.
But if you recall, about six weeks ago, the German chancellor was in town in Toronto and meeting with our Prime Minister and a number of other folks, and I was invitee to that. But we actually spent a lot of time talking about, well, what do you do about energy? And so there were two aspects to that. The first one was them ensuring that they had it. So that basically means securing supply. And they were making good progress then. And since then, they still have.
So basically if you look at some headlines that say we’re going to have enough gas. The second thing, though, is once you have the gas, you say, well, what’s the pricing of it, right? And France, at that time had already pledged something like €20 billion to help out their industry. And there were discussions at that time about what Germany is going to do with respect to their industry.
And you can talk about rationing and so forth, but the German OEMs are quite clear that they’re not going to be making vehicles if they’re going to lose thousands of euros per vehicle because of the energy costs, and we’re right behind them as a supplier saying the same thing. So the number that I’ve heard at that time was perhaps as high as 200 million.
Pat D’Eramo
Since billion.
Robert Wildeboer
Billion, sorry, 200 million wouldn’t do much, but 200 billion, and those discussions are still moving forward, and we’ve heard that as recent as the last 48 hours that they’re working on a package. At the same time, and we’ll see how this goes. But what happens with gas prices, they’ve been all over the place, and we’ll see what happens there.
So I think there’s going to be a solution in that context, but we’ll have to see how it plays out. The reality is that it’s been made very clear in Germany and some other jurisdictions that while it may be a tough winter, the checkbooks are going to be open in order to ensure that you don’t shut down the economy. And in Germany, of course, auto is the largest part of that economy, very big players and it makes — the economic cost to Germany is actually higher if their industry goes down than if they subsidize energy prices. So that’s [indiscernible].
Peter Sklar
And Rob, I did understand that these meetings with the Chancellor, did you attend some of these meetings as industry representative or you’re hearing from people?
Robert Wildeboer
No, no, I was there face-to-face, and they’ve said, don’t worry, we got it covered. And then that’s when I had — I was the guy who said — or I was one of the guys who said, it’s great that you got the gas, but what’s the price?
Peter Sklar
Okay. Got it. And then, Fred, just one last question. I don’t know if you have it at your fingertips or not. If not, it’s okay. But I think your total tooling revenues were $67 million. Can you give it — can you break that down by the three geographies?
Fred Di Tosto
Yes, I don’t have that in front of me. I can get that to you. So maybe Neil and I can sit back with you after the call.
Peter Sklar
Okay. Thank you.
Operator
Thank you. Our next question is from Krista Friesen from CIBC. Please go ahead.
Krista Friesen
Hi, thanks for taking my question here. Just a follow-up on European Energy. So for your 2023 guidance, are you assuming that there will be some subsidies that kick in? Or are you just assuming that you’ll be compensated from the OEMs kind of at the same level that you’re being compensated at the moment? How are you thinking about the energy price for next year?
Fred Di Tosto
We are assuming essentially that we’ll be able to offset at a particular percentage, not consistent with what we’re kind of seeing this year either in the form of the customer recoveries or it could be in the form of government relief as well. So it depends on what this package that’s being proposed look like and how we can get access to it. And our customers plan that.
Robert Wildeboer
And this is November 1. We have to see how a lot of things play out with the war and the gas price and that type of stuff. So in that sense, we’ll play it the same as other folks, but there is a resolve amongst the government and the industry and other industries to try and minimize the impact to industry so that industry can stay open and employ people.
Krista Friesen
Okay. Perfect. And then just looking at production. We’re a month into Q4 here. Has that — if you were to compare to, let’s say, the first month of Q3, is there a notable difference in the smoothness of production schedules? Or is it relatively similar to what you saw at the beginning of Q3?
Pat D’Eramo
I would call it similar. Would you agree?
Robert Wildeboer
Yes, I would agree with that. I think we alluded to it earlier. As we kind of enter into the holiday season, that’s really where the question marks on what the volume will look like as we go into the end of the year and into the holidays.
Fred Di Tosto
That’s where the customers often adjust.
Pat D’Eramo
And those adjustments might be a little more erratic due to the supply chain issues they’re having. They may — one of our customers last year ended up taking a lot of their lines down so they could come out of the chute in January and run smooth. And in that particular case, it worked really well, and they’ve run probably one of the best this year. I mean they’ve done very well comparatively. So we don’t know what we’re going to see until we see it, unfortunately.
Krista Friesen
Okay. Great. And just one last one. Can you remind us what leverage ratio you’re targeting here given how much free cash flow you’re generating and will be generating? What you’re kind of looking to get to?
Fred Di Tosto
So our strategy hasn’t changed longer term. We target to be in and around 1.5 turns of EBITDA. That would be something we’d be targeting and not necessarily looking to change it at this point.
Robert Wildeboer
We’re making great progress.
Krista Friesen
Okay. Perfect. Thank you. And congrats on a good quarter.
Pat D’Eramo
Thanks.
Operator
Thank you. [Operator Instructions] The next question is from Ben Jekic from PI Financial. Please go ahead.
Ben Jekic
Great quarter guys. And all my questions have been answered. Thank you.
Operator
Thank you. So there are no further questions registered at this time. So Mr. Wildeboer, I will transfer the meeting back to you.
Robert Wildeboer
Okay. Thanks very much, everyone for calling in this evening. If you have any further questions, just contact us, either Neil or Fred or Pat or I, and we’ll try and take your call and help you out. Have a great evening.
Operator
Thank you. Your conference has now ended. Please disconnect your lines at this time and we thank you for your participation.
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