Business Context and Reporting Period
Gates Industrial Corporation plc is a global manufacturer of engineered power transmission and fluid power products serving industrial and automotive applications through replacement and first-fit channels. Reported segments are Power Transmission and Fluid Power. The unaudited Form 10-Q covers the 91-day quarter and 273-day year-to-date periods ended September 26, 2020, compared with September 28, 2019.
Approximately 65% of year-to-date sales came from replacement channels and 35% from first-fit channels. Results continued to be affected by the COVID-19 pandemic, although management reported sequential improvement in the third quarter.
Financial Performance and Liquidity
| Metric | Q3 2020 | Q3 2019 | 9M 2020 | 9M 2019 |
|---|---|---|---|---|
| Net sales | $712.2 million | $746.6 million | $1,998.8 million | $2,361.4 million |
| Gross profit | $273.6 million | $272.4 million | $732.9 million | $881.1 million |
| Gross margin | 38.4% | 36.5% | 36.7% | 37.3% |
| Operating income | $63.9 million | $76.7 million | $125.7 million | $278.8 million |
| Net income attributable to shareholders | $41.9 million | $35.5 million | $55.1 million | $670.7 million |
| Diluted EPS | $0.14 | $0.12 | $0.19 | $2.30 |
| Adjusted EBITDA | $140.0 million | $145.0 million | $344.0 million | $475.9 million |
| Adjusted EBITDA margin | 19.7% | 19.4% | 17.2% | 20.2% |
Q3 sales declined 4.6% year over year, including a $7.3 million unfavorable currency effect; core sales declined 3.6%, primarily from lower volumes. Year-to-date sales declined 15.4%, including a $40.8 million currency headwind; core sales declined 13.6%.
Q3 gross profit increased modestly despite lower sales, supported by improved manufacturing performance, lower tariffs and raw-material deflation. Year-to-date gross profit and operating income fell substantially because of lower volumes and reduced fixed-cost absorption. Q3 Adjusted EBITDA declined 3.4%, while year-to-date Adjusted EBITDA declined 27.7%.
Cash provided by operations was $127.5 million for the nine months, compared with $145.2 million in the prior-year period. Capital expenditures and intangible-asset purchases totaled $45.6 million, and net cash used in investing activities was $53.6 million. Cash and cash equivalents were $672.3 million at September 26, 2020.
Total debt had a carrying value of $2,978.1 million and principal value of $2,994.6 million. Net debt was $2,322.3 million, down from $2,349.7 million at December 28, 2019. The company reported $432.3 million of committed borrowing headroom, no cash drawings under its revolving facilities, and $32.0 million of letters of credit outstanding under the asset-backed revolver. Management stated that debt covenants were satisfied and that liquidity was adequate for the next twelve months.
Material Changes Versus the Prior Comparable Period
- COVID-19-related demand weakness reduced sales across most regions and channels, particularly industrial markets, construction and energy.
- Q3 automotive replacement sales grew 3.6%, while industrial replacement sales declined 9.4% and automotive first-fit sales declined 8.3%.
- Greater China sales increased 9.1% in Q3, while North America declined 5.9% and EMEA was broadly stable.
- Power Transmission Q3 sales declined 1.1% and Fluid Power sales declined 10.7%. Year-to-date declines were 13.2% and 18.9%, respectively.
- Restructuring and asset-impairment charges increased to $8.7 million in Q3 and $32.9 million year to date, compared with $2.0 million and $5.9 million, respectively, in the prior-year periods.
- Year-to-date income was not comparable with 2019 because the prior year included a $605.1 million discrete tax benefit, primarily from releasing valuation allowances on Luxembourg net operating losses.
- Q3 included a $16.0 million income-tax benefit on $29.7 million of pretax income, producing a negative 53.9% effective tax rate. Year-to-date tax benefit was $31.5 million on $26.3 million of pretax income.
- Accumulated other comprehensive loss attributable to shareholders increased to $982.3 million, mainly reflecting foreign-currency translation and cash-flow-hedge losses.
Guidance, Outlook, Commentary and Risks
Management expected fourth-quarter performance to improve sequentially from Q3 but expected full-year revenue to decline versus 2019. Management also expected the full-year decremental margin to improve from 2019 as a result of cost restructuring and tighter cost management. No specific numerical revenue or earnings guidance was provided.
The restructuring program includes manufacturing and distribution footprint optimization, facility closures or downsizings, shared-service implementation and workforce reductions. Most related costs are expected in 2020 and 2021. The company expects restructuring reserves of $11.4 million at quarter-end to be used during the remainder of 2020 and in 2021.
COVID-19 remains the principal near-term uncertainty. Risks include renewed shutdowns, supply-chain interruptions, supplier insolvencies, production constraints, uneven end-market recovery and customer credit deterioration. Other material risks include substantial leverage, floating-rate debt and LIBOR transition, foreign-exchange exposure, raw-material availability and pricing, litigation and product liability, pension contributions, international operations, and the significant influence of Blackstone-affiliated shareholders.
The company used interest-rate and foreign-currency derivatives for risk management and did not hold derivatives for speculative purposes. Its term loans mature in March 2024, the revolving facilities mature in January 2023, and the $568.0 million of 6.25% senior notes mature in January 2026.
Management stated that known legal proceedings were not expected to materially affect financial position, results of operations or cash flows. Warranty liability was $19.8 million at September 26, 2020, compared with $16.0 million at the prior-year quarter-end.
Facts Investors Should Verify
- Whether the anticipated Q4 sequential recovery and full-year revenue decline assumptions were realized in subsequent filings.
- The sustainability of Q3 gross-margin improvement and whether fixed-cost absorption improves as volumes recover.
- Progress, cash costs and savings from the Korean, European and North American facility restructuring actions.
- Debt maturities, covenant headroom, floating-rate exposure and the effect of LIBOR replacement on borrowing costs.
- The quality and sustainability of reported earnings given substantial discrete tax benefits and the use of Adjusted EBITDA.
- COVID-19 effects on industrial, construction, energy and automotive demand, supply continuity and customer credit losses.
- Recoverability of deferred tax assets, goodwill and intangible assets, particularly if the recovery is weaker than expected.