Gates Industrial Corporation plc (NYSE:GTES) Q2 2023 Earnings Call Transcript

Gates Industrial Corporation plc (NYSE:GTES) Q2 2023 Earnings Call Transcript August 4, 2023

Gates Industrial Corporation plc beats earnings expectations. Reported EPS is $0.36, expectations were $0.32.

Operator: Hello, and welcome to the Gates Industrial Corporation Q2 2023 Earnings Call. All lines have been placed on mute to prevent any background noise. [Operator Instructions] I will now turn the conference over to Rich Kwas, Vice President of Investor Relations. Go ahead.

Rich Kwas: Good morning, and thank you for joining our second quarter 2023 earnings call. I’ll briefly cover our non-GAAP and forward-looking language before passing the call over to our CEO, Ivo Jurek, who will be followed by Brooks Mallard, our CFO. Before the market opened today, we published our second quarter 2023 results. A copy of the release is available on our website at investors.gates.com. Our call this morning is being webcast and is accompanied by a slide presentation. On this call, we will refer to certain non-GAAP financial measures that we believe are useful in evaluating our performance. Reconciliations of historical non-GAAP financial measures are included in our earnings release and slide presentation, each of which is available in the Investor Relations section of our website.

Please refer now to Slide 2 of the presentation, which provides a reminder that our remarks will include forward-looking statements within the meaning of the Private Securities Litigation Reform Act. Forward-looking statements are subject to risks that could cause actual results to be materially different from those expressed in or implied by such forward-looking statements. These risks include, among others, matters that we have described in our most recent annual report on Form 10-K and in other filings we make with the SEC. We disclaim any obligation to update these forward-looking statements. We’ll be attending investor conferences later in the third quarter, including the RBC Global Industrials Conference and the Morgan Stanley Laguna Conference.

We look forward to meeting with many of you. With that out of the way, I’ll turn the call over to Ivo.

Ivo Jurek: Thank you, Rich. Good morning, everyone, and thank you for joining us today. Let’s begin on Slide 3 of the presentation. Our global teams achieved solid results. We delivered Q2 revenue and profitability above the midpoint of our guidance as well as strong free cash flow. Our nearly 4% core revenue growth was fueled by strength in our automotive vertical across both the first-fit and replacement channels. The EMEA region led growth geographically with organic growth of high single digits year-over-year. Our China business experienced a nice rebound year-over-year with core growth in the high 20s of a COVID impacted prior year period, however, fell a little short of our expectations. We continue to see solid demand for our products and our book-to-bill remains above one exiting the quarter.

We see constructive demand trends globally from the automotive end market and somewhat more mixed picture across the industrial end markets. We realized strong margin expansion in the second quarter compared to last year. Adjusted EBITDA margin expanded 120 basis points year-over-year and exceeded 21%. We delivered a high 50% EBITDA flow-through on incremental revenues compared to the prior year period. The EBITDA margin expansion was fueled by a 170 basis points increase in our gross margin. We experienced greater operating stability and benefited from a more normalized supply chain environment relative to the prior three quarters. Our free cash flow generation and conversion were also nice highlights for the quarter. We generated $116 million of free cash flow for the quarter, which represented 114% conversion versus adjusted net income, a substantial increase versus the prior year period.

Working capital levels have stabilized and contributed to improved earnings as our operations have continued to normalize. For the first half of the year, we delivered almost 90% of our adjusted net income to free cash flow. Seasonally strong performance as the bulk of our free cash flow is usually generated in the second half of the calendar year. Our net leverage ratio finished at 2.8 times, a substantial decrease from the year ago period while also returning $250 million to shareholders via our share buyback in May. Based on our second quarter outperformance, we are increasing our adjusted EPS range to $1.18 to $1.24 from a range of $1.13 to $1.23. The updated range includes the benefit from a lower share count following our successful share repurchase in May.

Moving to Slide 4. Second quarter total revenue was $936 million, which translated to core growth of approximately 4% versus the prior year. Changes in foreign currency were a nominal headwind year-over-year. Our automotive growth was healthy across both the first-fit and replacement channels. Of channels realized double-digit core revenue growth compared to Q2 2022. The industrial end markets remain a bit choppy. Energy, construction and on-highway produced solid growth year-over-year, which was offset by softness in agriculture, diversified industrial and personal mobility. Adjusted EBITDA was $197 million and adjusted EBITDA margin was 21.1%, representing an expansion of 120 basis points compared with the prior-year period. Our margin improved compared to the prior-year period, driven by favorable price realization and less operational headwinds due to greater stability in supply chain.

A trend that is consistent with our expectations at the onset of the year. As previously mentioned, the year-over-year adjusted EBITDA margin improvement was driven by gross margin expansion. We expect gross margin to show year-over-year improvement in the second half of 2023 as well. Adjusted earnings per share was $0.36. Higher operating income contributed to the EPS growth year-over-year partially offset by increased net interest expense. The share repurchase was executed in May, provided approximately $0.01 of EPS accretion in the quarter. On Slide 5, let’s review our segment performance. In the Power Transmission segment, we posted $574 million of revenue and core growth of 7% compared to Q2 2022. Currency was slightly more than a 100 basis points of headwind.

Automotive was the highest growth end market for the segment with core growth increasing at a high teens rate year-over-year. The automotive replacement and first fit channels grew at similar rates year-over-year. Construction and on-highway generated double-digit core growth, partially mitigated by softer demand in our diversified industrial and personal mobility end markets. Power transmission’s adjusted EBITDA margin increased 180 basis points year-over-year, and incremental EBITDA margin exceeded 50%, compared to Q2 2022. Our team executed well and benefited from a less volatile operating environment. Our Fluid Power segment generated revenues of $362 million. Revenues declined slightly year-over-year on a core basis. Our industrial end markets were mixed and core growth in our replacement and first fit channels both, and it’s slightly down versus the prior year period.

The construction vertical was a relative outperformer posting solid core growth year-over-year. We are benefiting from growing infrastructure investments occurring in the U.S. and elsewhere with core revenue performance largely unchanged. Operating leverage was limited, which resulted in only modest segment margin expansion compared to the prior year period. With that, I will now pass the call over to Brooks for additional details on our results.

Brooks Mallard: Thank you, Ivo. Please turn to Slide 6 and I’ll review our core revenue performance by region. Core growth in the second quarter was led by China and EMEA. China core growth was 28% year-over-year as our business comped to the COVID induced shutdowns that occurred in last year’s second quarter. The on-highway and automotive end markets realized the strongest growth rates year-over-year with the first fit and replacement channels both delivering significant growth. EMEA revenues expanded 9% organically versus last year. Automotive was the primary growth driver with core growth exceeding 20%. Both auto replacement core growth and first fit core growth increased double digits compared to the prior year. Industrial market performance was varied with growth in certain markets and declines in others.

In aggregate, our EMEA industrial business core revenues declined low single digits compared to last year. In North America, we experienced a modest revenue decline on a core basis compared to a record revenue performance last year. The replacement and first fit channels saw similar levels of decline compared to the prior year. End markets were mixed with positive core growth in automotive, energy and construction and softness in diversified industrial, agriculture and personal mobility. East Asia and South America core growth rates were consistent with the company’s overall top line performance. In aggregate, we delivered good organic growth in a variable demand backdrop, underscoring our end market and channel diversity and the resilience of our business model.

On Slide 7, we provide an adjusted earnings per share walk from the second quarter of 2022. Improvement in operating income contributed approximately $0.06 per share of earnings growth. Higher net interest expense was a 3% per share headwind. Other items, including the weighted average share count reduction, contributed a positive benefit of about $0.01 per share. Moving to Slide 8, we show a summary of our cash flow performance and balance sheet metrics. Our free cash flow for the second quarter was $116 million or 114% conversion of our adjusted net income. We benefited from margin expansion and more normalized trade working capital. On a trailing 12-month basis, our free cash flow conversion is well above 100%. Our net leverage ratio declined by 0.5 turn versus one year ago to 2.8 times.

We ended the quarter with the lowest net leverage ratio for a second quarter in our history as a publicly traded company. Our consistent strong cash flow generation allows us to continue to strengthen our balance sheet as we execute a balanced capital allocation strategy of investing in the business, paying down debt and returning capital to shareholders. Our trailing 12-month return on invested capital increased 250 basis points year-over-year driven by margin expansion and disciplined capital management. Now please turn to Slide 9 to cover our updated 2023 guidance. We have trimmed our core revenue growth expectation to a range of 0% to 2% year-over-year from 1% to 5% previously. At the midpoint, we expect 1% core growth for the full year compared to 3% in our prior guidance.

The adjustment largely stems from slower industrial demand trends in China and OEM stocking realignment in the personal mobility space. We have maintained the midpoint of our 2023 adjusted EBITDA guidance at $725 million and narrowed the full year range modestly to $710 million at the low end and $740 million at the upper end. We expect greater gross margin expansion driven by operational productivity and a more stabilized cost structure to offset lower expected revenues from industrial markets in the second half. We continue to expect variable incentive compensation will be an EBITDA margin headwind in the second half of 2023, predominantly in the third quarter. We have raised our adjusted earnings per share guidance to a range of $1.18 per share to $1.24 per share, which incorporates the benefits of May’s [ph] share repurchase partially offset by higher net interest expense.

Further, we have adjusted our free cash flow conversion forecast to exceed 100% for the year above our prior guidance of approximately 100% conversion. For the third quarter, we expect revenues to be in the range of $860 million to $890 million. Adjusted EBITDA margin is estimated to be flat compared to Q3 2022 as improvements in gross margin are offset by higher SG&A expenses related to variable compensation. With that, I will turn it back over to Ivo.

Ivo Jurek: Thank you, Brooks. On Slide 10, I’ll wrap up with closing comments before taking your questions. First, we are pleased with our results and the margin progress obtained in the first half of the year. Our EBITDA margin expanded approximately 160 basis points year-over-year in the first half of 2023, led by improved gross margins. We anticipate our throughput and productivity rates will improve as the operating environment continues to normalize. We expect the benefits to build in the second half. As such, we maintained our 2023 adjusted EBITDA guidance at the midpoint and expect better margin performance for the year versus our prior expectation while encountering a slightly less favorable demand environment in the second half.

Furthermore, we are in process of consolidating a facility in China into our existing footprint. We anticipate completing this project by the end of this calendar year. We have a number of actions and initiatives underway now that will enhance the long-term profitability of the company. Second, we generated a significant amount of cash in the first half and are on track to exceed 100% conversion of our adjusted net income for the year. On a trailing four quarter basis, our free cash flow conversion stands at 135%. Third, our substantial free cash flow generation is driving net leverage reduction. We expect to end the year with a net leverage ratio of approximately 2.5 times, which would represent a decline from the year-end 2022. Notably, we intend to accomplish that while having returned $250 million of cash to shareholders via May’s share repurchase.

We plan to stay opportunistic utilizing our excess cash and firmly believe that consistent balance sheet improvement can be accompanied by diligently returning capital to shareholders. Before moving to your questions, I want to thank the 15,000 Global Gates associates for their commitment and dedication especially our North America team, who executed a major ERP upgrade during the quarter without any disruptions to the business. With that, I’ll now turn the call back over to the operator to begin the Q&A.

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Q&A Session

Operator: [Operator Instructions] Your first question comes from the line of Mike Halloran of Baird. Please go ahead.

Mike Halloran: Hey, morning everyone.

Ivo Jurek: Morning.

Brooks Mallard: Morning.

Mike Halloran: Just want to walk through kind of the markets we’re seeing a little bit more stress at this point. Maybe just talk about inventory, inventory in the channel and how you think about the recovery curve as we get to the back half of the year?

Ivo Jurek: Yes. Good morning, Mike. Look, the data I would point out that it’s – that the demand is still quite balanced out there. I’m taking first the inventory question, and I’ll come back to the demand. So the inventories are fairly balanced, and the point-of-sale data still indicates that the situation is actually in a reasonably good shape with a reasonably solid underlying demand. So we are fairly constructive on what’s happening with the channel. Of course, we have anticipated in the second half, some industrial destocking, and we certainly believe that, that’s what’s going to happen, particularly associated with the choppiness that we have been seeing in the Industrial segment. I would say that for the channel destocking, we see some destocking and in applications associated logistics and distribution and some Fluid Power applications like ag as an example.

We also feel that as the supply chain is stabilizing and the lead times are shortening, there is going to be a resulting movements in a channel to have our customers to normalize their inventories as well, just as we have been doing in our business. So right now, we are not seeing – in a nutshell, we are not really seeing any imbalances with sales of us – our business, our products to the channel and channel partners sells out. So maybe a little bit long winded, but a little more color in here. And vis-à-vis what is happening with some of the end markets and some of the weakness that we have been seeing. Look, I’d say that most prominently, we are seeing lower activity in Ag OEMs, particularly on a smaller horsepower equipment. And I think that that’s been reasonably well documented out there.

There’s an OEM stocking realignment in the personal mobility space. So we are seeing some of that. And again, as I said, some of the warehouse automation space, that has slowed down over the last kind of two to three quarters. So that’s kind of how I would represent it. And obviously, our biggest business with industrial is in North America, and we’re seeing some of that there.

Mike Halloran: Appreciate that. And on the margin side of things, good performance in the quarter relative to what you – where the revenue came in. I certainly understand the cadence you laid out in the prepared remarks, more static sequentially for the puts and takes. A twofold question. You might have add one. Could you help with the mix by segment and how you think that progresses? And then secondarily, how do you think the margins will track as we exit this year? What do you think – how are you thinking about that exit rate? I know you’re very positive about the ability to drive margin gains regardless of the demand environment. So maybe just a little bit of level setting and how you think that exit rate looks and the implications for next year.

Brooks Mallard: Let me start with the second part of the question first. We expect gross margins to continue to improve in the back half of the year. We called out that variable comp; especially in Q3 is going to be a headwind. So when you think about what our Q3 looks like, gross margin improvement, 70 bps to 125 bps with that being offset by the variable comp in SG&A. And then in the back half of the year, gross margins up about 150 to 200 basis points with SG&A up again on variable comp, about $100 million to $125 million. And so that’s really in line with what we thought was going to happen maybe a little bit ahead on the gross margin improvement. And remember, Q4 was our toughest quarter last year in terms of gross margin where we saw some of the highest priced inventory flow through relative to some of the supply chain disruptions as in the second half of last year.

So we expect to see gross margin to continue to improve, and then we expect to have gross margin opportunity as we move into next year. On your mix question, let me see if I can – let me see if my answer is what you’re looking for. So the softness we’re seeing in the second half is going to be a little bit of a headwind on mix. When you look at some of the industrial softness in some of our higher-margin stuff, some of the personal mobility stuff is our higher-margin business. But overall, our operating performance continues to improve. So we’re able to offset that and still maintain our EBITDA guidance and even get a little flow through to earnings per share. So net-net, a little bit of headwind on mix in the second half, offset by better gross margin performance from an operating perspective.

So we feel pretty good about where we are from a gross margin perspective. Does that answer your question?

Mike Halloran: I, it was poorly worded on my side. I was – by mix, I mean when you look at the margin progression you’ve laid out for 3Q and then by – 4Q, how does that break down by segment? Your answer is super helpful, but I was looking for some…