Gates Industrial Corporation plc — Q2 2022 Form 10-Q Summary
Business context and reporting period
Gates manufactures engineered power transmission and fluid power products for industrial and automotive applications, serving replacement and first-fit channels globally. Reported segments are Power Transmission and Fluid Power. The filing covers the 91-day quarter ended July 2, 2022 and the six months ended July 2, 2022, compared with July 3, 2021. Financial statements are unaudited and prepared under U.S. GAAP.
Approximately 63% of first-half sales came from replacement channels and 37% from first-fit channels. Power Transmission represented 61% of first-half sales and Fluid Power represented 39%.
Key financial metrics
| Metric | Q2 2022 | Q2 2021 | Six months 2022 | Six months 2021 |
|---|---|---|---|---|
| Net sales | $906.8 million | $915.1 million | $1,800.2 million | $1,796.4 million |
| Gross profit | $326.2 million | $366.7 million | $631.1 million | $712.2 million |
| Gross margin | 36.0% | 40.1% | 35.1% | 39.6% |
| Operating income | $112.7 million | $149.1 million | $181.1 million | $277.7 million |
| Net income attributable to shareholders | $53.1 million | $96.9 million | $84.0 million | $164.2 million |
| Diluted EPS | $0.19 | $0.33 | $0.29 | $0.55 |
| Adjusted EBITDA | $180.1 million | $216.0 million | $336.9 million | $412.3 million |
| Adjusted EBITDA margin | 19.9% | 23.6% | 18.7% | 23.0% |
Q2 core sales increased 3.6% excluding currency effects, but reported sales declined 0.9% because of a $41.1 million foreign-exchange headwind. First-half core sales increased 3.9%, while reported sales increased 0.2%.
- Power Transmission Q2 sales declined 7.7% and Adjusted EBITDA declined 31.6%; the segment margin fell to 18.9% from 25.4%.
- Fluid Power Q2 sales increased 11.4% and Adjusted EBITDA increased 17.0%; the segment margin improved to 21.4% from 20.3%.
- Cost of sales increased 5.9% in Q2 and 7.8% year to date, primarily from materials and inbound freight inflation. Management identified $66.1 million of Q2 inflation-related costs.
- Q2 operating income included $0.6 million of asset impairments and $3.2 million of restructuring expense. Adjusted EBITDA also excluded $3.6 million of inventory impairments and adjustments.
Cash flow, debt and liquidity
- Cash used in operating activities was $81.8 million in the first six months, compared with $111.8 million of cash provided in the prior-year period. The decline reflected lower operating performance, higher taxes paid, bonus payments and working-capital investment.
- Capital expenditures and intangible-asset purchases totaled $38.1 million. Net cash used in investing activities was $42.6 million.
- Net cash used in financing activities was $127.3 million, including $175.8 million for share repurchases and $70.0 million borrowed under the asset-backed revolver.
- Cash and cash equivalents were $393.2 million at July 2, 2022, down from $658.2 million at January 1, 2022.
- Principal debt was $2.5825 billion and carrying debt was $2.5717 billion. Net Debt increased to $2.1893 billion from $1.9210 billion at year-end 2021.
- Debt consisted primarily of a $1.3568 billion Dollar Term Loan, a $587.7 million Euro Term Loan, $70.0 million under the asset-backed revolver and $568.0 million of 6.25% senior notes due 2026. The Euro Term Loan matures in 2024 and the Dollar Term Loan in 2027.
- Committed borrowing headroom was $404.3 million, in addition to cash balances. The company stated that it had adequate liquidity and capital resources for the next twelve months and no meaningful debt maturities until 2024.
- The company was in compliance with applicable financial covenants as of the reporting period.
Material changes versus the prior comparable period
- Reported sales were broadly flat, but pricing benefits of $97.5 million in Q2 and $146.3 million year to date were offset by lower volumes and currency translation.
- Gross margin declined 410 basis points in Q2 and 450 basis points year to date, while Adjusted EBITDA margin declined 370 and 430 basis points, respectively.
- Net income attributable to shareholders declined 45.2% in Q2 and 48.8% year to date. The decline reflected inflation, lower volumes, lower fixed-cost absorption, foreign-exchange-related expenses and higher share-based compensation year to date.
- Other expenses changed to $8.1 million in Q2 from $1.2 million of other income in the prior-year quarter, principally because of foreign-currency movements on net debt and hedging instruments.
- Share-based compensation increased to $27.6 million year to date from $12.8 million, including a $16.1 million charge from vesting of certain pre-IPO options following a March 2022 liquidity event.
- Gates repurchased 11.5 million shares for approximately $174.7 million, reducing outstanding shares to 282.3 million from 291.3 million at January 1, 2022.
- Comprehensive loss was $77.8 million in Q2, primarily due to a $142.4 million foreign-currency translation loss.
Guidance, outlook, commentary and risks
- Management expected raw-material and freight inflation, labor and input shortages, and logistics disruptions to continue through the remainder of 2022.
- The company stated that it remained price/cost positive in the first half and expected additional pricing across regions and channels, with a goal of Adjusted EBITDA margin neutrality to inflation by year-end 2022. The filing does not provide full-year revenue or earnings guidance.
- Management estimated that the Russia-Ukraine conflict would reduce 2022 global revenue by approximately 2%. Gates stopped shipping product into Russia in late February and suspended Russian operations in early July, recording $1.3 million of related restructuring and impairment costs in Q2.
- COVID-19 shutdowns in China during March through May caused modest losses of production, sales and profitability. Management expected recovery to continue but at a slower pace than after the initial 2020 lockdowns.
- Key risks include supply-chain and raw-material availability, inflation, freight costs, customer pricing pressure, foreign-exchange and interest-rate volatility, COVID-19 disruptions, the Russia-Ukraine conflict, cybersecurity, litigation, product liability, pension funding, tax changes and substantial leverage.
- The company factors receivables under a voluntary program; $98.4 million of receivables had been accelerated as of July 2, 2022, with $1.4 million of related costs recorded year to date.
- Management reported no material accrued legal contingencies and did not expect known proceedings to materially affect financial position, results or cash flows. Warranty liability was $17.9 million at quarter-end.
Important facts for investors to verify
- Whether pricing actions can offset persistent inflation, freight, labor and supply-chain costs and restore Adjusted EBITDA margins.
- The pace of recovery in China and the ultimate revenue impact of the Russia-Ukraine conflict.
- Operating cash-flow conversion and working-capital trends, particularly receivables and inventories.
- Leverage, floating-rate exposure and upcoming 2024 Euro Term Loan maturity, including the effect of higher interest rates.
- The sustainability and funding source of share repurchases given negative first-half operating cash flow and increased Net Debt.
- The extent to which reported earnings benefited from discrete tax benefits, including the $11.7 million year-to-date benefit from releasing valuation allowances on U.S. foreign tax credits.
- The impact of foreign-exchange movements on reported sales, comprehensive income, goodwill, intangible assets and debt balances.