Gates Industrial Corporation plc — 2018 Q2 Form 10-Q Summary
Business context and reporting period
Gates is a global manufacturer of engineered power transmission and fluid power products used in industrial and automotive applications. Products are sold through replacement and first-fit channels in more than 100 countries. The filing covers the three and six months ended June 30, 2018, compared with July 1, 2017. Results are unaudited and include the historical operations of Omaha Topco before the January 2018 reorganization and initial public offering.
For the six months, approximately 61% of sales came from replacement channels and 39% from first-fit channels. Reportable segments are Power Transmission and Fluid Power.
Financial performance and key metrics
| Metric | Q2 2018 | Q2 2017 | Six months 2018 | Six months 2017 |
|---|---|---|---|---|
| Net sales | $875.1 million | $769.1 million | $1,727.1 million | $1,499.3 million |
| Gross profit | $357.5 million | $318.4 million | $693.4 million | $605.2 million |
| Gross margin | 40.9% | 41.4% | 40.1% | 40.4% |
| Operating income | $140.9 million | $116.7 million | $259.2 million | $211.1 million |
| Net income from continuing operations | $92.9 million | $8.3 million | $122.3 million | $34.3 million |
| Net income attributable to shareholders | $85.6 million | $0.5 million | $109.8 million | $19.3 million |
| Diluted earnings per share | $0.29 | Less than $0.01 | $0.38 | $0.08 |
| Adjusted EBITDA | $204.9 million | $179.0 million | $388.8 million | $332.0 million |
| Adjusted EBITDA margin | 23.4% | 23.3% | 22.5% | 22.1% |
Q2 sales increased 13.8%, while six-month sales increased 15.2%. Reported growth included favorable foreign exchange effects of $16.4 million in Q2 and $58.6 million year to date, and acquisition contributions of $38.0 million in Q2 and $72.1 million year to date. Core sales growth, excluding currency and first-year acquisition effects, was 6.7% in Q2 and 6.5% year to date.
Operating performance benefited from higher volumes, pricing actions intended to offset inflation, and productivity improvements. Gross margin declined because recent acquisitions were dilutive, including an approximately 100-basis-point impact in Q2 and 120-basis-point impact year to date. Adjusted EBITDA margin nevertheless improved modestly.
- Power Transmission Q2 sales were $549.6 million, up 7.6%, with Adjusted EBITDA of $133.3 million and a 24.3% margin.
- Fluid Power Q2 sales were $325.5 million, up 26.0%, with Adjusted EBITDA of $71.6 million and a 22.0% margin. The margin declined 70 basis points, primarily because of acquisitions.
- Income tax expense was $11.5 million in Q2 and $23.2 million year to date. Effective tax rates were 11.0% and 15.9%, respectively, compared with 35.2% and 33.1% in the prior-year periods.
Cash flow, liquidity, debt and balance sheet
- Cash provided by operating activities was $93.9 million for the six months, compared with $87.0 million in the prior-year period. Working-capital investment reduced cash flow, including increases of $108.6 million in receivables and $53.0 million in inventories.
- Cash used in investing activities was $173.7 million, including $114.2 million of capital expenditures and $50.9 million for the Rapro acquisition. Capital spending supported facility expansion and new Fluid Power production capacity.
- Cash used in financing activities was $173.0 million. The company received $799.1 million of net IPO proceeds and used those proceeds and excess cash to redeem $913.7 million of debt principal and pay $27.0 million of redemption premiums.
- Cash and cash equivalents were $305.2 million at June 30, 2018, compared with $564.4 million at December 30, 2017.
- Carrying value of debt was $3.012 billion, compared with $3.956 billion at year-end. Net debt declined to $2.707 billion from $3.391 billion.
- Debt consisted principally of a $1.721 billion Dollar Term Loan, a $759.4 million Euro Term Loan and $568.0 million of Dollar Senior Notes. The Euro Senior Notes were fully redeemed in January 2018, and $622.0 million of Dollar Senior Notes were redeemed in February 2018.
- The Dollar Term Loan bore interest at 5.08% at June 30, 2018. The term loans mature in 2024, subject to a springing 2022 maturity under specified conditions. The Dollar Senior Notes mature in 2022 and carry a 6.00% fixed rate.
- Revolving facilities were undrawn for cash. Total committed borrowing headroom was $452.2 million, in addition to cash balances, although $54.5 million of letters of credit was outstanding under the asset-backed revolver.
- Management reported compliance with applicable debt covenants and stated that current working capital was sufficient for present requirements.
Material changes versus the prior comparable period
- Sales growth was broad-based, led by Fluid Power, industrial markets, construction, agriculture and emerging markets. North America was the primary contributor to industrial growth.
- Pricing actions and volume growth largely offset wage, material and freight inflation. Higher inbound freight costs increased Q2 cost of sales by approximately $7.8 million.
- Interest expense declined by $29.0 million in Q2 and $24.4 million year to date, primarily because of lower debt balances, lower loan margins and the absence of certain prior-year debt refinancing charges.
- Other income and expense improved materially because foreign-currency gains on net debt and hedging instruments replaced prior-year losses. This benefit was partly offset year to date by $27.0 million of debt redemption premiums.
- The company acquired Rapro, a Turkey-based molded and branched hose business, on April 26, 2018, for $50.9 million net of cash acquired. The acquisition generated $43.0 million of provisional goodwill, and purchase accounting remained incomplete at quarter-end.
- Restructuring expense was $2.3 million in Q2 and $2.0 million year to date, compared with $4.1 million and $5.9 million in the respective prior-year periods.
- Shares outstanding increased to 289.8 million from 245.5 million at year-end, primarily because of the January IPO and related share issuances.
Outlook, management commentary, risks and unusual items
Management described industrial demand as strong across regions and expects replacement-channel diversification to reduce dependence on any single end market. It is investing in additional Fluid Power capacity and pursuing restructuring and cost-reduction initiatives. Management stated that it does not anticipate a material long-term deterioration in liquidity in the foreseeable future.
The filing provides no formal revenue or earnings guidance. Management expects approximately $5.5 million of 2018 defined-benefit pension contributions and $6.1 million of other post-retirement benefit contributions.
- Key risks include substantial leverage, floating-rate debt, foreign exchange exposure, raw-material availability and inflation, pricing pressure, industrial and regional economic conditions, supply-chain or facility disruptions, labor matters, litigation, product liability, environmental requirements, cybersecurity and information-technology interruptions, and acquisition integration.
- Blackstone remains the majority shareholder and has significant influence. Sponsor monitoring fees were $2.1 million in Q2 and $4.0 million year to date.
- Valuation allowances remain against certain deferred tax assets. Management believes a portion could be released within the next 12 months if sufficient positive evidence develops; the resulting tax benefit could be material but timing and amount are uncertain.
- The company expects adoption of the new lease standard to have a material effect on recognition, measurement and presentation, although the impact had not been quantified.
- Rapro goodwill and other acquisition accounting remained provisional. Legal proceedings, warranties and other contingencies were not expected by management to materially affect financial position, results or cash flows, although outcomes cannot be predicted with certainty.
- Foreign-currency movements produced substantial period-to-period volatility in other income and comprehensive income. Q2 other comprehensive loss was $136.3 million, primarily from currency translation.
Important facts for investors to verify
- Reconcile reported sales growth with the effects of currency, acquisitions, pricing and underlying volume growth.
- Assess whether Fluid Power acquisition growth and new capacity can offset acquisition-related margin dilution.
- Review debt maturities, floating-rate exposure, refinancing requirements and the springing maturity provisions.
- Monitor working-capital consumption, capital expenditures and conversion of Adjusted EBITDA into operating cash flow.
- Evaluate the sustainability of the unusually low effective tax rate and any potential deferred-tax-asset valuation allowance release.
- Confirm final purchase accounting for Rapro, including goodwill, intangible assets and deferred taxes.
- Consider the effect of sponsor fees, non-GAAP adjustments, restructuring costs and other unusual items when comparing profitability.
- Review the annual-report risk factors and the company’s continuing exposure to foreign currency, inflation, industrial cycles, supply-chain disruption and leverage.