Gates Industrial Corporation plc — Q1 2019 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. The report covers the 91-day quarter ended March 30, 2019, compared with the 91-day period ended March 31, 2018. Sales were approximately 61% replacement-channel and 39% first-fit. Reportable segments were Power Transmission and Fluid Power.
Financial Performance and Position
| Metric | Q1 2019 | Q1 2018 | Change |
|---|---|---|---|
| Net sales | $804.9 million | $852.0 million | Down 5.5% |
| Gross profit | $307.3 million | $335.9 million | Down 8.5% |
| Gross margin | 38.2% | 39.4% | Down 120 basis points |
| Operating income | $100.2 million | $118.3 million | Down 15.3% |
| Net income from continuing operations | $605.1 million | $29.4 million | Significantly higher due primarily to tax benefit |
| Net income attributable to shareholders | $613.7 million | $24.2 million | Significantly higher |
| Diluted EPS | $2.08 | $0.09 | Higher, substantially tax-driven |
| Adjusted EBITDA | $165.5 million | $183.9 million | Down 10.0% |
| Adjusted EBITDA margin | 20.6% | 21.6% | Down 100 basis points |
Power Transmission sales declined 8.5% to $499.5 million, with Adjusted EBITDA down 12.3% to $109.9 million and margin declining to 22.0%. Fluid Power sales were broadly flat at $305.4 million, while Adjusted EBITDA declined 5.1% to $55.6 million and margin declined to 18.2%.
Cash and cash equivalents were $333.6 million at March 30, 2019, compared with $423.4 million at December 29, 2018. Cash used in operating activities was $47.7 million, compared with $26.5 million used in the prior-year quarter. Investing cash use was $31.7 million, including $22.9 million of capital expenditures. Financing cash use was $13.1 million, primarily for term-loan amortization. Net debt increased to $2.67 billion from $2.60 billion.
Total debt had a carrying value of $2.96 billion and principal value of $3.00 billion at quarter-end. The company had no cash drawings under its $185.0 million secured revolving facility or its $325.0 million asset-backed revolver; $51.1 million of letters of credit was outstanding under the asset-backed revolver. Management reported $458.9 million of committed borrowing headroom plus cash balances.
Material Changes Versus the Prior Comparable Period
- Core sales declined 2.1%, excluding currency and first-year acquisition effects. Currency movements reduced reported sales by $34.6 million, while the Rapro acquisition contributed $5.6 million.
- Lower volumes, distributor destocking, automotive first-fit weakness in Europe and China, wage and material inflation, lower manufacturing absorption, facility start-up costs and tariffs pressured margins.
- Inflation-mitigating pricing partially offset inflation and volume pressure.
- Interest expense fell to $38.1 million from $59.8 million, primarily because the company had redeemed $913.7 million of debt in Q1 2018 and had lower deferred financing-cost amortization.
- Restructuring expense was $3.3 million, versus restructuring income of $0.3 million in the prior-year quarter, relating to a facility closure in France and an Asian business restructuring.
- The company adopted the new lease standard, recognizing right-of-use assets of $126.0 million and lease liabilities of $132.9 million at transition. At March 30, 2019, reported right-of-use assets were $120.9 million and lease liabilities were $129.9 million.
- The company implemented a European reorganization that centralized regional operations in Luxembourg and changed the assessment of deferred tax asset realizability.
Guidance, Outlook, Commentary, Risks and Unusual Items
No specific quantitative full-year revenue or earnings guidance is provided in the filing. Management stated that available liquidity was sufficient for present requirements and did not anticipate material long-term deterioration in the overall liquidity position.
Management described industrial activity as a key sales driver and noted growth in construction and energy, exploration and extraction, but also cited automotive first-fit weakness, distributor destocking and declining agriculture demand in North America. The company expects restructuring accruals to be used primarily during 2019 and 2020.
The quarter’s reported tax benefit was highly unusual: a $539.7 million benefit on $65.4 million of pretax income, producing an effective tax rate of negative 825.2%. The benefit included a $617.3 million discrete release of valuation allowances, primarily related to Luxembourg deferred tax assets. This benefit was partially offset by a $66.1 million discrete expense for unrecognized tax benefits, principally associated with the European reorganization. The reported net income and EPS therefore are not representative of underlying operating performance.
Key risks include substantial leverage, floating-rate debt and interest-rate exposure, foreign-exchange volatility, raw-material availability and inflation, global economic and industrial conditions, distributor and customer inventory levels, competition and pricing pressure, manufacturing disruptions, acquisitions and integration, product liability and warranty claims, environmental and regulatory matters, labor issues, pension funding requirements, litigation, information technology disruptions and the significant influence of Blackstone. Management reported no material changes to the risk factors in the 2018 Form 10-K.
Management stated that the company was in compliance with applicable debt covenants. The term loans mature in 2024, subject to a potential springing maturity in 2022 if more than $500 million of Dollar Senior Notes remain outstanding. The remaining $568.0 million of Dollar Senior Notes mature in July 2022.
Important Facts for Investors to Verify
- Whether core sales stabilize after the reported 2.1% decline and distributor destocking reverses.
- The sustainability and cash-tax implications of the deferred tax asset valuation-allowance release, including the $615.6 million Luxembourg component.
- Underlying earnings and cash generation excluding the $617.3 million discrete tax benefit.
- Progress in restoring gross and Adjusted EBITDA margins amid inflation, tariffs, start-up costs and restructuring.
- Net debt reduction capacity, operating working-capital requirements and continued availability of revolver borrowing headroom.
- Exposure to floating interest rates, foreign exchange and the 2022 to 2024 debt maturities.
- Results of the European reorganization and the associated $66.1 million unrecognized-tax-benefit expense.
- Execution and costs of the France and Asia restructuring initiatives and the integration of the Rapro acquisition.
- Potential effects of automotive weakness in Europe and China, agriculture weakness in North America and future distributor inventory adjustments.