Gates Industrial Corp Ltd.: Form 10-Q for the period ended Apr 1, 2023

of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the condensed consolidated financial statements and related notes thereto included elsewhere in this quarterly report. In addition to historical information, this discussion contains forward-looking statements that involve risks, uncertainties and assumptions that could cause actual results to differ materially from management’s expectations. Factors that could cause such differences are discussed in “Forward-Looking Statements” above and Part I, Item 1A. “Risk Factors” in our annual report.

Our Company

We are a global manufacturer of innovative, highly engineered power transmission and fluid power solutions. We offer a broad portfolio of products to diverse replacement channel customers, and to original equipment (“first-fit”) manufacturers as specified components, with the majority of our revenue coming from replacement channels. Our products are used in applications across numerous end markets, including industrial off-highway end markets such as construction and agriculture, industrial on-highway end markets such as transportation, diversified industrial, energy and resources, automotive, and personal mobility. Our net sales have historically been, and remain, highly correlated with industrial activity and utilization, and not with any single end market given the diversification of our business and high exposure to replacement markets. We sell our products globally under the Gates brand, which is recognized by distributors, equipment manufacturers, installers and end users as a premium brand for quality and technological innovation; this reputation has been built over 110 years since Gates’ founding in 1911.

Within the diverse end markets we serve, our highly engineered products are often critical components in applications for which the cost of downtime is high relative to the cost of our products, resulting in the willingness of end users to pay a premium for superior performance and availability. These applications subject our products to normal wear and tear, resulting in natural, and often preventative, replacement cycles that drive high-margin, recurring revenue. Our product portfolio represents one of the broadest ranges of power transmission and fluid power products in the markets we serve, and we maintain long-standing relationships with a diversified group of blue-chip customers throughout the world. As a leading designer, manufacturer and marketer of highly engineered, mission-critical products, we have become an industry leader across most of the regions and end markets in which we operate.

Business Trends

Our net sales have historically been, and remain, highly correlated with industrial activity and utilization and not with any single end market given the diversification of our business and high exposure to replacement channels. This diversification limits our exposure to trends in any given end market. In addition, a majority of our sales are generated from customers in replacement channels, who serve primarily a large base of installed equipment that follows a natural maintenance cycle that is somewhat less susceptible to various trends that affect our end markets. Such trends include infrastructure investment and construction activity, agricultural production and related commodity prices, commercial and passenger vehicle production, miles driven and fleet age, evolving regulatory requirements related to emissions and fuel economy and oil and gas prices and production. Key indicators of our performance include industrial production, industrial sales and manufacturer shipments.

During the three months ended April 1, 2023, sales into replacement channels accounted for approximately 63% of our total net sales. Our replacement sales cover a very broad range of applications and industries and, accordingly, are highly correlated with industrial activity and utilization and not a single end market. Replacement products are principally sold through distribution partners that may carry a very broad line of products or may specialize in products associated with a smaller set of end market applications.

During the three months ended April 1, 2023, sales into first-fit channels accounted for approximately 37% of our total net sales. First-fit sales are to a variety of industrial and automotive customers. Our industrial first-fit customers cover a diverse range of industries and applications and many of our largest first-fit customers manufacture construction and agricultural equipment.

During the three months ended April 1, 2023, challenges related to supply chains, logistics, and inflation continued to ease, which improved our productivity and expanded our profitability and margin. We continue to make progress on improving our inventory position and turnover to meet our customer demands. We expect our inventory-focused initiatives, combined with easing of supply chain headwinds, to continue enhancing our working capital use and cash conversion through Fiscal 2023.

Cybersecurity Incident

As previously disclosed, the Company experienced a malware attack in February 2023. We promptly activated our incident response and business continuity plans and our normal global business operations resumed over the course of ten days following the incident. As part of our incident response, we among other things, initiated an investigation, engaged the services of cyber-security experts and outside advisors, and notified appropriate law enforcement authorities. We are engaged in an ongoing process of notifying regulatory agencies and potentially affected individuals, as appropriate, in the relevant geographic locations. While we were able to quickly restore our operations, the incident resulted in some disruption to sales as well as non-recurring costs of $5.1 million during the quarter, some of which may be partially offset by insurance recoveries. We have made and continue to make investments to enhance the protection of our information technology systems.

Russia-Ukraine conflict

The conflict between Russia and Ukraine, and the sanctions and counter-sanctions imposed in response to it, have created increased economic uncertainty and operational complexity both in the region and globally, the impacts of which we cannot fully predict. Gates had a single distribution center in Russia that sold primarily to customers based in Russia. In early July 2022, we suspended our operations in Russia. Should the conflict continue or escalate, it could have a significant negative effect on our business and results in the future including continued inflationary pressures on raw materials, energy and transportation, supply chain and logistics disruptions, volatility in foreign exchange rates and interest rates, and heightened cybersecurity threats.

Impact of COVID-19 Pandemic

During March 2022, an increase in COVID-19 related cases in certain parts of China resulted in the re-imposition of widespread shutdowns and restrictions in China through most of April and May 2022, and resulted in a modest loss of production, sales and profitability. As the COVID-19 lockdowns began to ease in June 2022, our business in China began to slowly recover, before a rapid rise in infections in China late in 2022 adversely affected customer demand, labor availability, and our profitability. We continue to expect it will take time through the first half of 2023 for our customers and the local supply base in China to operate at more normalized levels. We may experience future production disruptions where plants are temporarily closed or productivity is reduced by government mandates or as a result of supply chain or labor disruptions, which could place further constraints on our ability to produce or deliver our products and meet customer demand or increase our costs. We may also continue to experience periods of inconsistency in customer demand as customers address their own supply chain constraints. Throughout the pandemic, we have maintained our ability to respond to changes in demand and we continue to fund key initiatives, which we believe will serve us well as our end markets continue to evolve.

Results for the three months ended April 1, 2023 compared to the results for the three months ended April 2, 2022

Summary Gates Performance

(dollars in millions)

(1) See “—Non-GAAP Measures” for a reconciliation of Adjusted EBITDA to net income from continuing operations, the closest comparable GAAP measure, for each of the periods presented.

Net sales

Net sales during the three months ended April 1, 2023 were $897.7 million, compared to $893.4 million during the prior year period, an increase of 0.5%, or $4.3 million. Our net sales for the three months ended April 1, 2023 were adversely impacted by movements in average currency exchange rates of $31.1 million compared to the prior year period, principally due to the strengthening of the U.S. dollar against a number of currencies, primarily the Euro and Chinese Renminbi. Excluding this impact, core sales increased by $35.4 million, or 4.0%, during the three months ended April 1, 2023 compared to the prior year period, driven primarily by a $65.9 million benefit from favorable pricing, partially offset by the impact of lower volumes.

Core sales in our Power Transmission and Fluid Power businesses increased by 3.2% and 5.2%, respectively, for the three months ended April 1, 2023 compared to the prior year period. These increases were driven primarily by an increase in sales to customers in our automotive channels, which were 6.6% higher compared with the prior year period. Automotive replacement sales and automotive first-fit sales grew by 6.4% and 7.1%, respectively, during the three months ended April 1, 2023 compared to the prior year period. The majority of this sales growth in the automotive channel was focused in EMEA and North America, which grew by 13.8% and 3.6%, respectively. Sales from industrial channels also increased by 1.9% during the three months ended April 1, 2023 compared to the prior year period, which was primarily driven by the off-highway and energy end markets. The industrial end market growth was primarily from EMEA and partially offset by a 3.2% decline from Greater China compared to the prior year period, as a result of the COVID-related production and supply challenges described previously, for the three months ended April 1, 2023.

Cost of sales

Cost of sales for the three months ended April 1, 2023 was $572.6 million, compared to $588.5 million for the prior year period, a decrease of 2.7%, or $15.9 million. The decrease is primarily attributable to favorable movements in average currency exchange rates of $24.4 million and lower inbound freight costs of $10.6 million for the three months ended April 1, 2023, compared to the prior period. These decreases were partially offset by higher material and utility costs due to inflation, and an increase of in cost of sales as a result of lower absorption of fixed costs, which was partially offset by lower volumes.

Gross profit

As a result of the factors described above, gross profit for the three months ended April 1, 2023 was $325.1 million, compared to $304.9 million for the prior year period, an increase of 6.6% or $20.2 million. Our gross profit margin improved by 210 basis points to 36.2% for the three months ended April 1, 2023, up from 34.1% for the prior year period.

Selling, general and administrative expenses

SG&A expenses for the three months ended April 1, 2023 were $232.1 million compared to $235.2 million for the prior year period. This decrease of $3.1 million was driven primarily by lower stock compensation costs of $14.6 million, largely due to the vesting of certain pre-IPO options in the prior year period as discussed further in Note 14 to the condensed consolidated financial statements included elsewhere in this report, partially offset by a $10.7 million charge to reflect an estimated credit loss due to a recent customer bankruptcy as further described in Note 3 to the condensed consolidated financial statements included elsewhere in this quarterly report.

Transaction-related expenses

Transaction-related expenses for the three months ended April 1, 2023 were $0.2 million compared to $0.8 million for the prior year period. The decrease in expenses for the three months ended April 1, 2023 related primarily to the secondary offering completed in the prior year period.

Restructuring expenses

Restructuring expenses of $5.5 million were incurred during the three months ended April 1, 2023, related primarily to severance and other non-labor costs related to relocating certain production activities in China, Mexico and Europe.

Restructuring expenses of $0.5 million were recognized during the prior year period, related primarily to severance and non-severance labor costs and other costs related to facility closures or relocations in several countries.

Interest expense

Our interest expense was as follows:

(dollars in millions)

Details of our long-term debt are presented in Note 12 to the condensed consolidated financial statements included elsewhere in this report. Interest on debt for the three months ended April 1, 2023 increased when compared to the equivalent prior year period, primarily due to the higher interest rates applicable on the floating rate Dollar Term Loans, including the New Dollar Term Loans bearing interest rate at Term SOFR plus an applicable margin, partially offset by the impact of derivatives.

Other expense

Our other expenses were as follows:

(dollars in millions)

Other expenses for the three months ended April 1, 2023 were $0.3 million, compared to $0.6 million in the prior year period. This change was driven primarily by the impact of higher interest income on bank deposits compared to the prior year period due to higher interest rates, and net movements in foreign currency exchange rates on net debt and hedging instruments. The decrease is partially offset by higher costs incurred in relation to our trade accounts receivable factoring program due to an increase in the discount rate, as well as lower expected returns on post-retirement benefit plan assets based on the most recent actuarial valuations.

Income tax expense (benefit)

We compute the year-to-date income tax provision by applying our estimated annual effective tax rate to our year-to-date pre-tax income and adjust for discrete tax items in the period in which they occur.

For the three months ended April 1, 2023, we had an income tax expense of $15.3 million on pre-tax income of $46.2 million, which resulted in an effective tax rate of 33.1%, compared to an income tax benefit of $2.2 million on pre-tax income of $35.2 million, which resulted in an effective tax rate of (6.3)% for the three months ended April 2, 2022.

For the three months ended April 1, 2023 the effective tax rate was driven primarily by discrete tax benefits of $6.4 million, of which $2.6 million related to the impacts of tax law changes primarily in Turkey and Belgium, $1.9 million related to undistributed foreign earnings, and $2.9 million related to other net discrete expenses, partially offset by $1.0 million of net unrecognized tax benefits. For the three months ended April 2, 2022, the effective tax rate was driven primarily by the partial valuation allowance release on deferred tax assets for U.S. foreign tax credits, offset partially by jurisdictional mix of taxable earnings.

Deferred Tax Assets and Liabilities

We recognize deferred tax assets and liabilities for future tax consequences arising from differences between the carrying amounts of existing assets and liabilities under U.S. GAAP and their respective tax bases, and for net operating loss carryforwards and tax credit carryforwards. We evaluate the recoverability of our deferred tax assets, weighing all positive and negative evidence, and are required to establish or maintain a valuation allowance for these assets if we determine that it is more likely than not that some or all of the deferred tax assets will not be realized.

As of each reporting date, we consider new evidence, both positive and negative, that could impact our view with regard to the future realization of deferred tax assets. We will maintain our positions with regard to future realization of deferred tax assets, including those with respect to which we continue maintaining valuation allowances, until there is sufficient new evidence to support a change in expectations. Such a change in expectations could arise due to many factors, including those impacting our forecasts of future earnings, as well as changes in the international tax laws under which we operate and tax planning. It is not reasonably possible to forecast any such changes at the present time, but it is possible that, should they arise, our view of their effect on the future realization of deferred tax assets may impact materially our financial statements.

After weighing all of the evidence, giving more weight to the evidence that was objectively verifiable, we determined during the three months ended April 1, 2023, that it is more likely than not that deferred tax assets in the U.S. totaling $3.0 million are realizable, which will be recognized during the year through the effective tax rate. As a result of changes in estimates of current year taxable profits against which the foreign tax credits can be utilized, our judgment changed regarding valuation allowances on these deferred tax assets.

Adjusted EBITDA

Adjusted EBITDA for the three months ended April 1, 2023 was $174.5 million, compared to $156.8 million for the prior year period, an increase of 11.3% or $17.7 million. Adjusted EBITDA margin was 19.4% for the three months ended April 1, 2023, a 180 basis point improvement from the prior year period margin of 17.6%. The increase in Adjusted EBITDA was driven primarily by an increase in gross profit of $20.2 million, which was largely the result of favorable pricing, partially offset by higher inflation and lower absorption of fixed costs described above.

For a reconciliation of net income from continuing operations to Adjusted EBITDA for each of the periods presented and the calculation of the Adjusted EBITDA margin, see “—Non-GAAP Measures.”

Analysis by Operating Segment

Power Transmission (61.1% of Gates’ net sales for the three months ended April 1, 2023)

(dollars in millions)

Net sales in Power Transmission for the three months ended April 1, 2023 decreased by 1.3%, or $7.5 million, compared to the prior year period. Excluding the adverse impact of movements in average currency exchange rates of $25.4 million, core sales increased by 3.2%, or $17.9 million, compared to the prior year period, driven primarily by a $37.8 million benefit from favorable pricing, partially offset by the impact of lower volumes.

Power Transmission’s core sales growth was driven primarily by higher sales to customers in our automotive channels, which grew by 7.0% during the three months ended April 1, 2023 compared to the prior year period, particularly in EMEA where automotive replacement and first-fit sales grew by 14.8% and 12.6%, respectively. Industrial channel sales declined by 2.3% globally compared to the prior year period, driven primarily by North America with declines across most industrial end markets. Off-highway and personal mobility end markets continued strong performance during the three months ended April 1, 2023, with core sales growth of 16.2% and 15.1%, respectively, compared to the prior year period.

Power Transmission Adjusted EBITDA for the three months ended April 1, 2023 increased by 10.1%, or $9.9 million, compared to the prior period. This increase was driven primarily by a combination of favorable pricing of $37.8 million, partially offset by lower absorption of fixed costs and higher inflation. As a result, Adjusted EBITDA margin for the three months ended April 1, 2023 was 19.6%, a 200 basis point increase from the prior year period Adjusted EBITDA margin of 17.6%.

Fluid Power (38.9% of Gates’ net sales for the three months ended April 1, 2023)

(dollars in millions)

Net sales in Fluid Power for the three months ended April 1, 2023 increased by 3.5%, or $11.8 million compared to the prior year period. Excluding the adverse impact of movements in average currency exchange rates of $5.7 million, core sales increased by 5.2%, or $17.5 million, compared to the prior year period, driven primarily by a $28.1 million benefit from favorable pricing, partially offset by the impact of lower volumes.

Fluid Power’s core sales increase in the three months ended April 1, 2023 was driven primarily by growth in sales to our industrial customers. Sales to our industrial first-fit and replacement customers grew by 8.3% and 3.0%, respectively, compared to the prior year period, predominately from North America and EMEA. Industrial sales to off-highway and energy end markets drove the majority of this growth, increasing globally by 6.5% and 15.8%, respectively, during the three months ended April 1, 2023 compared to the prior year period. This growth was partially offset by a decrease of 3.4% in sales from diversified industrial end market compared to the prior year period.

Fluid Power Adjusted EBITDA for the three months ended April 1, 2023 increased by 13.2%, or $7.8 million, compared to the prior year period. The increase in Adjusted EBITDA was driven primarily by a combination of favorable pricing of $28.1 million, partially offset by lower absorption of fixed costs and higher inflation. The Adjusted EBITDA margin consequently increased by 160 basis points compared to the prior year period.

Liquidity and Capital Resources

Treasury Responsibilities and Philosophy

Our primary liquidity and capital resource needs are for working capital, debt service requirements, capital expenditures, share repurchases, facility expansions and acquisitions. We expect to finance our future cash requirements with cash on hand, cash flows from operations and, where necessary, borrowings under our revolving credit facilities. We have historically relied on our cash flow from operations and various debt and equity financings for liquidity.

From time to time, we enter into currency derivative contracts to manage currency transaction exposures. Similarly from time to time, we may enter into interest rate derivatives to maintain the desired mix of floating and fixed rate debt.

As market conditions warrant, we and our majority equity holders, Blackstone and its affiliates, may from time to time seek to repurchase securities that we have issued or loans that we have borrowed in privately negotiated or open market transactions, by tender offer or otherwise. Subject to any applicable limitations contained in the agreements governing our indebtedness, any such purchases may be funded by existing cash or by incurring new secured or unsecured debt, including borrowings under our credit facilities. The amounts involved in any such purchase transactions, individually or in the aggregate, may be material. Any such purchases may relate to a substantial amount of a particular tranche of debt, with a corresponding reduction, where relevant, in the trading liquidity of that debt. In addition, any such purchases made at prices below the “adjusted issue price” (as defined for U.S. federal income tax purposes) may result in taxable cancellation of indebtedness income to us, which may be material, and result in related adverse tax consequences to us.

It is our policy to retain sufficient liquidity throughout the capital expenditure cycle to maintain our financial flexibility. We do not have any meaningful debt maturities until 2026; however, we regularly evaluate market conditions, our liquidity profile, and various financing alternatives for opportunities to enhance our capital structure, and may refinance all or a portion of our indebtedness on or before maturity. We do not anticipate any material long-term deterioration in our overall liquidity position in the foreseeable future, and believe that we have adequate liquidity and capital resources for the next twelve months.

Cash Flow

Three months ended April 1, 2023 compared to the three months ended April 2, 2022

Cash provided by operating activities was $52.5 million during the three months ended April 1, 2023 compared to cash used in operating activities of $105.4 million during the prior year period, driven primarily by a decrease of $91.0 million in trade working capital movement, combined with improved operating performance in the current year, an improvement in value-added tax recoveries compared to the prior year period, and a decrease of $2.3 million in income taxes paid, partially offset by $8.3 million in higher cash paid for interest in the current year period.

Net cash used in investing activities during the three months ended April 1, 2023 was $29.9 million, compared to $25.0 million in the prior year period. The increase of cash used in investing activities was primarily driven by an $8.2 million increase of net cash paid under corporate-owned life insurance policies, partially offset by decreased capital expenditures of $3.4 million.

Net cash used in financing activities was $2.1 million during three months ended April 1, 2023, compared to $115.8 million in the prior year period. Current year outflows were primarily related to required payments related to debt facilities and derivatives, partially offset by $11.3 million of proceeds from stock option exercises. The cash outflow in the prior year was driven primarily by the $175.2 million paid to acquire shares under our share repurchase program, including shares repurchased through an intermediary from Blackstone as further described in Note 15 to the condensed consolidated financial statements included elsewhere in this report. The prior year cash outflow was partially offset by proceeds from debt facilities due to the drawing of $70.0 million under our asset-backed revolving credit facility.

Indebtedness

Our long-term debt, consisting principally of two secured term loans and the U.S. dollar denominated unsecured senior notes, was as follows:

(dollars in millions)

We refer to the term loans denominated in U.S. dollars as the “Dollar Term Loans” and the unsecured senior notes denominated in U.S. dollars as the “Dollar Senior Notes”. Details of our long-term debt are presented in Note 12 to the condensed consolidated financial statements included elsewhere in this quarterly report.

Debt drawings and redemptions

On November 16, 2022, we issued a new $575.0 million tranche of dollar denominated term loans (the “New Dollar Term Loans”) pursuant to an amendment to the credit agreement governing our term loan facilities, using the proceeds to extinguish the entire outstanding principal balance of €563.8 million under our Euro Term Loan facility (the “Euro Term Loan”) plus €1.0 million accrued interest. The New Dollar Term Loans have substantially similar terms as the dollar denominated term loans drawn on July 3, 2014 and refinanced on February 24, 2021 (the “Existing Dollar Term Loans”), bearing interest at the borrower’s option at either Term SOFR, subject to a 0.50% per annum Term SOFR floor, plus 3.50% margin per annum, or at the base rate, subject to a 1.50% per annum floor, plus 2.50% per annum. The New Dollar Term Loans require scheduled quarterly amortization payments of 1% per annum based on the initial aggregate principal amount and mature in November 2029. The New Dollar Term Loans require a prepayment premium in connection with certain repricing transactions occurring within six months following the closing of the amendment. Issuance discount and costs totaling approximately $23.2 million related to the issuance of the New Dollar Term Loans have been deferred and will be amortized to interest expense over the remaining term of the related borrowings using the effective interest method. The repayment of Euro Term Loan resulted in the accelerated recognition of $2.2 million deferred financing costs (recognized in interest expense).

During March 2022, we drew $70.0 million under our asset-backed revolving credit facility to partially fund the purchase of shares under our share repurchase program, as discussed further in Note 15 to the condensed consolidated financial statements included elsewhere in this report. During Fiscal 2022, we paid down the borrowings on the asset-backed revolver and have no remaining outstanding balance as of April 1, 2023 and December 31, 2022.

Dollar Term Loan credit agreement amendments

On March 1, 2023, we amended the Existing Dollar Term Loans, revolving credit facility and asset-backed revolver, which bore interests at LIBOR plus an applicable margin. The amendments modified the reference rates for borrowings in dollar from LIBOR to Term SOFR or Adjusted Term SOFR, as applicable. For further information on the facilities, see Note 12 to the condensed consolidated financial statements included elsewhere in this quarterly report.

On November 16, 2022, we amended the credit agreement governing our term loan facilities to pay off and replace our Euro Term Loan with a new class of $575.0 million of New Dollar Term Loans as described above.

Non-guarantor subsidiaries

The majority of the Company’s U.S. subsidiaries are guarantors of the senior secured credit facilities.

For the twelve months ended April 1, 2023, before intercompany eliminations, our non-guarantor subsidiaries represented approximately 72% of our net sales and 69% of our EBITDA as defined in the financial covenants attaching to the senior secured credit facilities. As of April 1, 2023, before intercompany eliminations, our non-guarantor subsidiaries represented approximately 63% of our total assets and approximately 25% of our total liabilities.

Net Debt

Net Debt is a non-GAAP measure representing the principal amount of our debt less the carrying amount of cash and cash equivalents. During Fiscal 2023, our Net Debt decreased by $21.4 million from $1,913.0 million as of December 31, 2022 to $1,891.6 million as of April 1, 2023. Net Debt was impacted adversely by $4.1 million due to movements in currency exchange rates. Excluding this impact, Net Debt decreased by $25.5 million, which was driven primarily by cash provided by operating activities of $52.5 million and partially offset by $14.6 million of capital expenditures during the three months ended April 1, 2023.

Borrowing Headroom

As of April 1, 2023, our asset-backed revolving credit facility had a borrowing base of $247.1 million, being the maximum amount we can draw down based on the current value of the secured assets. As of April 1, 2023, there were letters of credit outstanding against the facility amounting to $26.1 million. We also have a secured revolving credit facility that provides for multi-currency revolving loans up to an aggregate principal amount of $250.0 million, with no amounts drawn as of April 1, 2023.

In total, our committed borrowing headroom was $471.0 million, in addition to cash balances of $594.9 million.

Non-GAAP Measures

EBITDA and Adjusted EBITDA

EBITDA is a non-GAAP measure that represents net income or loss for the period before the impact of income taxes, net interest and other expenses, depreciation and amortization. EBITDA is widely used by securities analysts, investors and other interested parties to evaluate the profitability of companies. EBITDA eliminates potential differences in performance caused by variations in capital structures (affecting net finance costs), tax positions (such as the availability of net operating losses against which to relieve taxable profits), the cost and age of tangible assets (affecting relative depreciation expense) and the extent to which intangible assets are identifiable (affecting relative amortization expense).

Management uses Adjusted EBITDA as its key profitability measure. This is a non-GAAP measure that represents EBITDA before certain items that are considered to hinder comparison of the performance of our businesses on a period-over-period basis or with other businesses. We use Adjusted EBITDA as our measure of segment profitability to assess the performance of our businesses, and it is used for total Gates as well because we believe it is important to consider our profitability on a basis that is consistent with that of our operating segments, as well as that of our peer companies with a similar leveraged, private equity ownership history. We believe that Adjusted EBITDA should, therefore, be made available to securities analysts, investors and other interested parties to assist in their assessment of the performance of our businesses.

During the periods presented, the items excluded from EBITDA in computing Adjusted EBITDA primarily included:

• non-cash charges in relation to share-based compensation;
• transaction-related expenses incurred in relation to major corporate transactions, including the acquisition of businesses and related integration activities, and equity and debt transactions;
• restructuring expenses, including severance-related expenses;
• credit loss related to a customer bankruptcy;
• cybersecurity incident expenses; and
• inventory adjustments related to certain inventories accounted for on a Last-in First-out (“LIFO”) basis.

Differences exist among our businesses and from period to period in the extent to which their respective employees receive share-based compensation or a charge for such compensation is recognized. We therefore exclude from Adjusted EBITDA the non-cash charges in relation to share-based compensation in order to assess the relative performance of our businesses.

We exclude from Adjusted EBITDA acquisition-related costs that are required to be expensed in accordance with U.S. GAAP. We also exclude costs associated with major corporate transactions because we do not believe that they relate to our performance. Other items are excluded from Adjusted EBITDA because they are individually or collectively significant items that are not considered to be representative of the underlying performance of our businesses. During the periods presented, we excluded restructuring expenses and severance-related expenses that reflect specific, strategic actions taken by management to shutdown, downsize, or otherwise fundamentally reorganize areas of Gates’ business; expenses related to a malware attack that occurred in February 2023; and changes in the LIFO inventory reserve recognized in cost of sales for certain inventories that are valued on a LIFO basis. During inflationary or deflationary pricing environments, LIFO adjustments can result in variability of the cost of sales recognized each period as the most recent costs are matched against current sales, while historical, typically lower, costs are retained in inventory. LIFO adjustments are determined based on published pricing indices, which often are not representative of the actual cost changes or timing of those changes as experienced by our business. Excluding the impact from the application of LIFO therefore improves the comparability of our financial performance from period to period and with the Company’s peers, and more closely represents the physical flow of our inventory and how we manage the business.

EBITDA and Adjusted EBITDA exclude items that can have a significant effect on our profit or loss and should, therefore, be used in conjunction with, not as substitutes for, profit or loss for the period. Management compensates for these limitations by separately monitoring net income from continuing operations for the period.

The following table reconciles net income from continuing operations, the most directly comparable GAAP measure, to EBITDA and Adjusted EBITDA:

(dollars in millions)

36

(1) Transaction-related expenses relate primarily to advisory fees and other costs recognized in respect of major corporate transactions, including the acquisition of businesses, and equity and debt transactions.

(2) Inventory impairments and adjustments include the reversal of the adjustment to remeasure certain inventories on a LIFO basis. The recent inflationary environment has caused LIFO values to drop below First-in, First-out (“FIFO”) values because LIFO measurement results in the more recent inflated costs being matched against current sales while historical, lower costs are retained in inventories.

(3) On January 31, 2023, one of our customers filed a voluntary petition for reorganization under Chapter 11 of the U.S. Bankruptcy Code. In connection with the bankruptcy proceedings, we evaluated our potential risk and exposure relating to our outstanding pre-petition accounts receivable balance from the customer and have recorded a $10.7 million pre-tax charge to reflect our estimated recovery. We will continue to monitor the circumstances surrounding the bankruptcy in determining whether adjustments to this recovery estimate are necessary.

(4) On February 11, 2023, Gates determined that it was the target of a malware attack. Cybersecurity incident expenses include legal, consulting, and other costs incurred as a direct result of this incident, some of which may be partially offset by insurance recoveries.

Adjusted EBITDA Margin

Adjusted EBITDA margin is a non-GAAP measure that represents Adjusted EBITDA expressed as a percentage of net sales. We use Adjusted EBITDA margin to measure the success of our businesses in managing our cost base and improving profitability.

(dollars in millions)

Core growth reconciliations

Core revenue growth is a non-GAAP measure that represents net sales for the period excluding the impacts of movements in average currency exchange rates and the first-year impacts of acquisitions and disposals, when applicable. We present core growth because it allows for a meaningful comparison of year-over-year performance without the volatility caused by foreign currency gains or losses or the incomparability that would be caused by impacts of acquisitions or disposals. Management believes that this measure is therefore useful for securities analysts, investors and other interested parties to assist in their assessment of the operating performance of our businesses. The closest GAAP measure is net sales.

(dollars in millions)

Net Debt

Management uses Net Debt, rather than the narrower measure of cash and cash equivalents and restricted cash which forms the basis for the condensed consolidated statement of cash flows, as a measure of our liquidity and in assessing the strength of our balance sheet.

Management analyzes the key cash flow items driving the movement in net debt to better understand and assess Gates’ cash performance and utilization in order to maximize the efficiency with which resources are allocated. The analysis of cash movements in Net Debt also allows management to more clearly identify the level of cash generated from operations that remains available for distribution after servicing our debt and post-employment benefit obligations and after the cash impacts of acquisitions and disposals.

Net Debt represents the net total of:

• the principal amount of our debt; and
• the carrying amount of cash and cash equivalents.

Net Debt was as follows:

(dollars in millions)

The principal amount of debt is reconciled to the carrying amount of debt as follows:

(dollars in millions)

Adjusted EBITDA adjustments for ratio calculation purposes

The financial maintenance ratio in our revolving credit agreement and other ratios related to incurrence-based covenants (measured only upon the taking of certain actions, including the incurrence of additional indebtedness) under our revolving credit facility, our term loan facility and the indenture governing our outstanding notes are calculated in part based on financial measures similar to Adjusted EBITDA as presented elsewhere in this report, which financial measures are determined at the Gates Global LLC level and adjust for certain additional items such as severance costs, the pro forma impacts of acquisitions and the pro forma impacts of cost-saving initiatives. These additional adjustments during the last 12 months, as calculated pursuant to such agreements, resulted in a net benefit to Adjusted EBITDA for ratio calculation purposes of $8.8 million.

Gates Industrial Corporation plc is not an obligor under our revolving credit facility, our term loan facility or the indenture governing our outstanding notes. Gates Global LLC, an indirect subsidiary of Gates Industrial Corporation plc, is the borrower under our revolving credit facility and our term loan facility and the issuer of our outstanding notes. The only significant difference between the results of operations and net assets that would be shown in the consolidated financial statements of Gates Global LLC and those for the Company that are included elsewhere in this report is a payable of $119.3 million due to Gates Global LLC and its subsidiaries from indirect parent entities of Gates Global LLC as of April 1, 2023 (compared to a payable of $117.3 million due to Gates Global LLC and its subsidiaries as of December 31, 2022) and additional cash and cash equivalents held by the Company and other indirect parent entities of Gates Global LLC of $34.9 million and $6.4 million as of April 1, 2023 and December 31, 2022, respectively.

Critical Accounting Estimates and Judgments

Our management’s discussion and analysis of financial condition and results of operations is based on our condensed consolidated financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these condensed consolidated financial statements requires us to make estimates and assumptions concerning the future that affect the reported amounts of assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenue and expenses during the reported period.

Please refer to “Critical Accounting Estimates and Judgments” described in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2022, as filed with the SEC, from which there have been no material changes.

Our market risk includes the potential loss arising from adverse changes in foreign currency exchange rates, interest rates and commodity prices, and the credit risk of our customers and third party depository institutions that hold our cash and short term deposits. From time to time, we use derivative financial instruments, principally foreign currency swaps, forward foreign currency contracts, interest rate caps (options), and interest rate swaps to reduce our exposure to foreign currency risk and interest rate risk. We do not hold or issue derivatives for speculative purposes and monitor closely the credit quality of the institutions with which we transact. Our objective in managing these risks is to reduce fluctuations in earnings and cash flows associated with changes in foreign currency exchange rates and interest rate movements. For a discussion of quantitative and qualitative disclosures about market risk, please refer to our annual report from which our exposure to market risk has not materially changed.

Disclosure Controls and Procedures

The Company maintains a set of disclosure controls and procedures designed to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms. Any controls and procedures, no matter how well designed and operated, can provide only reasonable, not absolute, assurance of achieving the desired control objectives. The Company’s management, with the participation of the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, has evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based upon that evaluation, the Company’s Chief Executive Officer and the Company’s Chief Financial Officer concluded that, as of April 1, 2023, the Company’s disclosure controls and procedures were effective to accomplish their objectives at the reasonable assurance level.

Changes in Internal Control over Financial Reporting

There has been no change in our internal control over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Item 1A. “Risk Factors” in Part I of the Company’s annual report, which could materially affect the Company’s business, financial condition, operating results or liquidity or future results. The risks described in the annual report are not the only risks facing the Company. Additional risks and uncertainties not currently known to the Company or that it currently deems to be immaterial also may materially adversely affect its results of operations, financial condition or liquidity. There have been no material changes to the risk factors disclosed in the annual report.