Gates Industrial Corporation plc — Q3 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 aftermarket replacement and first-fit channels globally. The filing covers the 91-day quarter and 273-day year-to-date period ended September 28, 2019, compared with September 29, 2018. The financial statements are unaudited and prepared under U.S. GAAP.
For the first nine months, approximately 63% of sales came from replacement channels and 37% from first-fit channels. Reportable segments were Power Transmission and Fluid Power.
Key financial metrics
| Metric | Q3 2019 | Q3 2018 | 9M 2019 | 9M 2018 |
|---|---|---|---|---|
| Net sales | $746.6 million | $828.4 million | $2,361.4 million | $2,555.5 million |
| Gross profit | $272.4 million | $327.2 million | $881.1 million | $1,020.6 million |
| Gross margin | 36.5% | 39.5% | 37.3% | 39.9% |
| Operating income | $76.7 million | $117.8 million | $278.8 million | $377.0 million |
| Net income attributable to shareholders | $35.5 million | $59.9 million | $670.7 million | $169.7 million |
| Diluted EPS | $0.12 | $0.20 | $2.30 | $0.58 |
| Adjusted EBITDA | $145.0 million | $181.2 million | $475.9 million | $570.0 million |
| Adjusted EBITDA margin | 19.4% | 21.9% | 20.2% | 22.3% |
Year-to-date net income benefited from a significant discrete tax benefit. Gates recognized a $497.8 million income tax benefit, including a $605.1 million benefit from releasing valuation allowances on deferred tax assets, partly offset by tax charges related to the Luxembourg tax-rate change and European reorganization. The benefit is not representative of recurring operating performance.
Cash provided by operating activities was $145.2 million, compared with $142.3 million in the prior-year period. Capital expenditures were $58.5 million, versus $154.9 million, and net cash used in investing activities was $69.6 million, versus $214.1 million. Cash and cash equivalents totaled $456.1 million at September 28, 2019.
Principal debt was $2,975.9 million and carrying debt was $2,953.3 million. Net debt declined to $2,519.8 million from $2,603.7 million at December 29, 2018. The company reported $444.0 million of committed borrowing headroom, including $309.2 million under the asset-backed revolver and $185.0 million under the secured revolving facility, subject to existing letters of credit and facility terms.
Material changes versus the prior comparable period
- Q3 sales declined 9.9%; nine-month sales declined 7.6%. Excluding currency and the first-year acquisition impact, core sales declined 8.5% in Q3 and 5.1% year to date.
- Volume declines were the primary driver of lower sales, partly offset by inflation-mitigating pricing actions. Q3 volume decreased by $86.1 million, while pricing contributed $15.4 million.
- Industrial demand weakened, particularly in North America, China and East Asia. Construction, agriculture, general industrial and automotive markets were notable areas of weakness.
- Power Transmission Q3 sales declined 7.4% and Fluid Power sales declined 13.8%. Segment Adjusted EBITDA declined 16.2% and 27.2%, respectively.
- Gross margin fell 300 basis points in Q3 and 260 basis points year to date, primarily because lower volumes reduced fixed-cost absorption and manufacturing performance. Wage and material inflation and tariffs also pressured margins.
- Adjusted EBITDA declined 20.0% in Q3 and 16.5% year to date, despite lower SG&A expense and procurement savings.
- Interest expense declined to $114.5 million year to date from $139.8 million, primarily because of prior-year debt repayments and lower deferred financing-cost amortization.
- Restructuring and other strategic-initiative costs increased. Q3 costs totaled $6.3 million and year-to-date costs totaled $11.9 million, including severance and facility-closure-related inventory and fixed-asset impairments.
Guidance, outlook, commentary and risks
Management stated that the lower demand environment exiting the third quarter was expected to persist for the foreseeable future. Gates is accelerating restructuring intended to consolidate manufacturing and distribution facilities, reduce structural fixed costs and streamline back-office functions. Most related costs are expected to occur in 2020 and 2021 and may reduce GAAP gross margin, although management expects to exclude qualifying items from Adjusted EBITDA.
Management believed liquidity and capital resources were adequate for the next twelve months. Debt facilities remained in covenant compliance. The term loans mature in 2024, subject to springing maturity provisions, and the $568.0 million of Dollar Senior Notes mature in July 2022.
Key risks include global industrial and automotive weakness, foreign-exchange volatility, trade tensions and tariffs, raw-material and labor inflation, pricing pressure, substantial leverage and floating-rate exposure, facility and supply-chain disruptions, restructuring execution, pension funding needs, tax-position changes, litigation, product liability, environmental matters, cybersecurity and international regulatory risks. Blackstone and its affiliates remained majority owners and could exert significant influence.
The company adopted the new lease standard in 2019, recognizing $126.0 million of right-of-use assets and $132.9 million of lease liabilities at transition. At quarter end, total lease liabilities were $129.4 million. Management reported no material change to previously disclosed risk factors, and disclosure controls were effective at the quarter end.
Most important facts for investors to verify
- Whether industrial demand, particularly in construction, agriculture and general industrial markets, stabilized after the third quarter.
- Whether restructuring actions improve fixed-cost absorption and restore gross and Adjusted EBITDA margins, and the total cash cost expected in 2020–2021.
- The sustainability of the $497.8 million year-to-date tax benefit and the recoverability of the remaining deferred tax assets.
- Debt maturity and refinancing risk, including the 2022 senior-note maturity, springing-maturity provisions and floating-rate exposure.
- Available revolver capacity after considering the $50.2 million of outstanding letters of credit and applicable borrowing-base limitations.
- Underlying free cash flow after capital expenditures, working-capital requirements, pension contributions and dividends to non-controlling interests.
- Currency, tariff and inflation effects on sales, cost of sales and segment profitability.
- Potential future effects of legal, environmental, product-warranty, tax and other contingencies, notwithstanding management’s assessment that known proceedings were not expected to be material.