Gates Industrial Corp Ltd.: Form 10-Q for the period ended Sep 30, 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 “Cautionary Note Regarding 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 nine months ended September 30, 2023, sales into replacement channels accounted for approximately 64% 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 nine months ended September 30, 2023, sales into first-fit channels accounted for approximately 36% 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 nine months ended September 30, 2023, challenges related to supply chains, logistics, and inflation continued to ease, which improved our productivity and expanded our profitability. We continue to make progress on improving our inventory position and turnover to meet our customer demands. We expect our inventory-focused initiatives to continue enhancing our working capital use and cash conversion through Fiscal 2023.

Global conflicts, such as the conflict between Russia and Ukraine and the sanctions and counter-sanctions imposed in response to it, created increased economic uncertainty and operational complexity both in Europe, Middle East and Africa (“EMEA”) 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. The Russia-Ukraine and other global conflicts did not have a significant adverse impact on our operating results during the three months ended September 30, 2023. We will continue to monitor if the Russia-Ukraine and other conflicts impact global economic conditions or our business.

During 2022, our operations in China were impacted by the COVID-19 pandemic and related government actions, resulting in a modest loss of production, sales and profitability as well as decreased customer demand and labor availability. Although these conditions improved in 2023, we may experience future production or distribution disruptions associated with public health crises where individual locations 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 were able to maintain 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 and nine months ended September 30, 2023 compared to the results for the three and nine months ended October 1, 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 September 30, 2023 were $872.9 million, compared to $860.7 million during the prior year period, an increase of 1.4%, or $12.2 million. Our net sales for the three months ended September 30, 2023 were favorably impacted by movements in average currency exchange rates of $16.2 million compared to the prior year period, principally due to the weakening of the U.S. dollar against a number of currencies, in particular the Euro and Mexican Peso. Excluding this impact, core sales decreased by $4.0 million, or 0.5%, during the three months ended September 30, 2023 compared to the prior year period, driven primarily by the impact of lower sales volume, partially offset by a $39.1 million benefit from pricing.

Core sales in our Power Transmission business increased by 1.2% while core sales in our Fluid Power business decreased by 3.0% for the three months ended September 30, 2023 compared to the prior year period. The overall decline in core sales was primarily driven by a 9.7% and 2.8% decline in sales to our industrial first fit and industrial replacement channels, respectively, for the three months ended September 30, 2023, primarily in North America, Greater China, and EMEA. Personal mobility, off-highway and diversified industrial end markets drove most of this decline from industrial sales for the three months ended September 30, 2023. These decreases were largely offset by increases in sales to our automotive replacement and automotive first-fit channels by 6.4% and 5.4%, respectively. The growth of the automotive replacement sales primarily came from EMEA and South America, while the increase of automotive first-fit sales was mostly driven by North America and East Asia & India.

Net sales during the nine months ended September 30, 2023 were $2,706.9 million, compared to $2,660.9 million during the prior year period, an increase of 1.7%, or $46.0 million. Our net sales for the nine months ended September 30, 2023 were adversely impacted by movements in average currency exchange rates of $20.4 million compared to the prior year period, principally due to the strengthening of the U.S. dollar against a number of currencies, in particular the Chinese Renminbi, Turkish Lira, and Canadian Dollar. Excluding these impacts, core sales increased by $66.4 million, or 2.5%, during the nine months ended September 30, 2023 compared to the prior year period, driven primarily by a $166.0 million benefit from pricing, partially offset by the impact of lower volumes.

Core sales in our Power Transmission and Fluid Power businesses increased by 3.8% and 0.4%, respectively, for the nine months ended September 30, 2023 compared to the prior year period. These improvements were primarily driven by sales to customers in our automotive channel with an overall growth of 8.6%, primarily due to EMEA and North America with a year-over-year increase in core sales of 18.0% and 2.4%, respectively.

Cost of sales

Cost of sales for the three months ended September 30, 2023 was $529.5 million, compared to $551.2 million for the prior year period, a decrease of 3.9%, or $21.7 million. This decrease was primarily attributable to lower volume and improved fixed cost absorption of $27.2 million. The decreases were partially offset by unfavorable movements in average currency exchange rates.

Cost of sales for the nine months ended September 30, 2023 was $1,685.7 million, compared to $1,720.3 million for the prior year period, a decrease of 2.0%, or $34.6 million. The decrease was primarily driven by favorable movements in average currency exchange rates of $22.0 million and lower volume net of lower fixed cost absorption of $13.9 million. This decrease was partially offset by higher inflation-related costs.

Gross profit

As a result of the factors described above, gross profit for the three months ended September 30, 2023 was $343.4 million, compared to $309.5 million for the prior year period, an increase of 11.0% or $33.9 million. Our gross profit margin improved by 330 basis points to 39.3% for the three months ended September 30, 2023.

As a result of the factors described above, gross profit for the nine months ended September 30, 2023 was $1,021.2 million, compared to $940.6 million for the prior year period, an increase of 8.6% or $80.6 million. Our gross profit margin improved by 240 basis points to 37.7% for the nine months ended September 30, 2023.

Selling, general and administrative expenses

Selling, general and administrative (“SG&A”) expenses for the three months ended September 30, 2023 were $213.4 million compared to $199.7 million for the prior year period. This increase of $13.7 million was driven primarily by an increase in labor and benefits expense of $17.5 million and unfavorable movements in average currency exchange rates of $7.5 million. The increases were partially offset by lower share-based compensation costs and decreased warranty expenditures.

SG&A expenses for the nine months ended September 30, 2023 were $666.2 million compared to $644.0 million for the prior year period. This increase of $22.2 million was driven primarily by an increase of labor and benefits expense of $34.4 million and an $11.4 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. This increase was partially offset by lower share-based compensation costs of $15.2 million, largely due to the March 2022 vesting of certain pre-IPO options as discussed further in Note 14 to the condensed consolidated financial statements included elsewhere in this report. Additional offsets were primarily due to decreased outbound freight and warranty expenditures.

Transaction-related expenses

Transaction-related expenses of $1.3 million and $2.1 million were incurred during the three and nine months ended September 30, 2023, respectively, related primarily to the accrued fees for amending the New Dollar Term Loans in October 2023 and certain other corporate transactions. Transaction-related expenses of $0.7 million and $2.0 million were incurred during the prior year three and nine months ended October 1, 2022, respectively, related primarily to the secondary offering completed in March 2022 and other corporate transactions.

Restructuring expenses

Restructuring and other strategic initiatives during the three and nine months ended September 30, 2023 related primarily to severance and other non-labor costs related to relocating certain production activities in China, Mexico and Europe. During the three months ended September 30, 2023, we also incurred additional non-severance labor and benefit costs of $0.3 million related to relocation and integration of certain support functions into our regional shared service center in Europe. Other restructuring costs incurred during the three months ended September 30, 2023 related to legal and consulting expenses, as well as costs associated with prior period facility closures or relocations in several countries.

Restructuring and other strategic initiatives during the three and nine months ended October 1, 2022 related primarily to our ongoing European reorganization, including $2.2 million of labor and severance costs related to relocating certain production activities within Europe during the three months ended October 1, 2022, in addition to severance costs of $2.3 million during the nine months ended October 1, 2022 related to relocation and integration of certain support functions into our regional shared service center. We also incurred $1.4 million and $2.7 million of costs, respectively, during the three and nine months ended October 1, 2022 in relation to the suspension of our operations in Russia, which included severance costs of $0.7 million, an impairment of inventories of $0.3 million (recognized in cost of sales), and an impairment of fixed and other assets of $1.1 million (recognized in asset impairments) for the nine months ended October 1, 2022. Other restructuring costs incurred during the period related to non-severance and other labor and benefit costs, prior period 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 increased by $5.5 million for the three months ended September 30, 2023 and increased by $25.0 million for the nine months ended September 30, 2023, when compared to the respective prior year periods. The increase during both the three and nine months ended September 30, 2023 was primarily driven by a higher interest rate on the Dollar Term Loans, partially offset by the impact of derivatives. Interest expense during both the three and nine months ended September 30, 2023 also increased due to higher interest rates and higher borrowing amounts under the asset-backed revolver. Amortization of deferred issuance costs increased during the three and nine months ended September 30, 2023 primarily due to the additional costs incurred from issuing the New Dollar Term Loans in November 2022.

Other (income) expense

Our other (income) expense was as follows:

(dollars in millions)

Other (income) expenses for the three and nine months ended September 30, 2023 were income of $0.2 million and expense of $3.8 million, respectively, compared to expenses of $3.1 million and $11.8 million, respectively, in the prior year periods. These changes were driven primarily by the impact of net movements in foreign currency exchange rates on net debt and hedging instruments and increased interest income on our bank deposits, partially offset by higher interest costs on post-retirement obligations based on the most recent actuarial valuations. In addition, the economies of Türkiye and Argentina are both designated as a highly inflationary economy under U.S. GAAP. The functional currency for a portion of our Türkiye operations and our Argentina operations were previously changed from their local currency to the U.S. dollar as a result of applying highly-inflationary accounting treatment. During the three and nine months ended September 30, 2023, we incurred a foreign currency remeasurement loss of $3.7 million and $8.5 million, respectively, due to translation adjustments for these entities that operate in highly inflationary economies, compared to a remeasurement loss of $0.2 million and $1.6 million during the three and nine months ended October 1, 2022, respectively.

Income tax expense

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 September 30, 2023, we had income tax expense of $1.0 million on pre-tax income of $86.6 million, which resulted in an effective tax rate of 1.2%, compared to an income tax expense of $11.4 million on pre-tax income of $67.4 million, which resulted in an effective tax rate of 16.9% for the three months ended October 1, 2022.

For the three months ended September 30, 2023, the effective tax rate was driven primarily by discrete tax benefits of $11.0 million, of which $12.9 million related to unrecognized tax benefits due to audit closures offset by $1.9 million of other discrete expenses. For the three months ended October 1, 2022, the effective tax rate was driven primarily by a discrete tax benefit of $3.5 million related to the partial release of valuation allowance on deferred tax assets for U.S. foreign tax credits, partially offset by $2.6 million of other discrete expenses.

For the nine months ended September 30, 2023, we had an income tax expense of $25.9 million on pre-tax income of $213.7 million, which resulted in an effective tax rate of 12.1%, compared to an income tax expense of $21.5 million on pre-tax income of $174.2 million, which resulted in an effective tax rate of 12.3% for the nine months ended October 1, 2022.

For the nine months ended September 30, 2023 the effective tax rate was driven primarily by discrete benefits of $12.9 million related to unrecognized tax benefits due to audit closures. For the nine months ended October 1, 2022, the effective tax rate was driven primarily by discrete benefits of $15.2 million related to the partial release of valuation allowance on deferred tax assets for U.S. foreign tax credits.

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 September 30, 2023, that it is more likely than not that deferred tax assets in the U.S. totaling $2.4 million are realizable, none of which was discrete. As a result of changes in estimates of future 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 September 30, 2023 was $189.4 million, compared to $177.7 million in the prior year period, an increase of 6.6% or $11.7 million. Adjusted EBITDA margin was 21.7% for the three months ended September 30, 2023, a 110 basis point increase from the prior year period margin of 20.6%. The increase in Adjusted EBITDA was driven primarily by the increase in gross profit of $33.9 million, which was largely the result of favorable pricing, partially offset by lower volumes. The increase in Adjusted EBITDA was also partially offset by higher labor and benefit expenses during the three months ended September 30, 2023.

Adjusted EBITDA for the nine months ended September 30, 2023 was $561.2 million, compared to $514.6 million in the prior year period, an increase of 9.1% or $46.6 million. Adjusted EBITDA margin was 20.7% for the nine months ended September 30, 2023, a 140 basis point improvement from the prior year period Adjusted EBITDA margin of 19.3%. The drivers of the increase in Adjusted EBITDA were similar to those described above for the three-month period, further offset by lower absorption of fixed costs and higher inflation costs during the nine months ended September 30, 2023 compared to the prior year period.

For a reconciliation of net income 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 (61.5% and 61.3%, respectively, of Gates’ net sales for the three and nine months ended September 30, 2023)

(dollars in millions)

(dollars in millions)

Net sales in Power Transmission for the three months ended September 30, 2023 increased by 2.7%, or $13.9 million, compared to the prior year period. Excluding the favorable impact of movements in average currency exchange rates of $7.8 million, core sales increased by 1.2%, or $6.1 million, compared to the prior year period, driven primarily by a $23.5 million benefit from pricing.

Net sales in Power Transmission for the nine months ended September 30, 2023 increased by 2.3%, or $37.3 million, compared to the prior year period. Excluding the adverse impact of movements in average currency exchange rates of $24.7 million, core sales increased by 3.8%, or $62.0 million, compared to the prior year period, driven primarily by a $96.1 million benefit from pricing, partially offset by the impact of lower volumes.

Power Transmission’s core sales to automotive customers grew by 6.4% and 10.1% during the three and nine months ended September 30, 2023, respectively, compared to the prior year periods. EMEA contributed most of this growth particularly in automotive replacement sales, which grew by 12.8% and 20.2%, respectively, during the three and nine months ended September 30, 2023 compared to the prior year period. The growth of sales to our automotive customers was partially offset by a decline in industrial sales of 6.7% and 5.2% for the three and nine months ended September 30, 2023, respectively. The industrial sales decline was mostly driven by personal mobility and diversified industrial end market during both the three and nine months ended September 30, 2023, primarily from North America, EMEA, and East Asia & India.

Power Transmission Adjusted EBITDA for the three months ended September 30, 2023 increased by 14.3%, or $14.6 million, compared to the prior year period, driven primarily by pricing, partially offset by lower volumes. As a result, Adjusted EBITDA margin was 21.7%, a 220 basis point improvement from the prior year period.

Power Transmission Adjusted EBITDA for the nine months ended September 30, 2023 increased by 13.6%, or $41.1 million, compared to the prior year period. This increase was driven primarily by pricing, partially offset by lower volumes, lower absorption of fixed costs and higher inflation-related costs. The increase resulted in an Adjusted EBITDA margin of 20.7%, a 210 basis point improvement compared to the prior year period.

Fluid Power (38.5% and 38.7%, respectively, of Gates’ net sales for the three and nine months ended September 30, 2023)

(dollars in millions)

(dollars in millions)

Net sales in Fluid Power for the three months ended September 30, 2023 decreased by 0.5%, or $1.7 million, compared to the prior year period. Excluding the favorable impact of movements in average currency exchange rates of $8.4 million, core sales decreased by 3.0%, or $10.1 million, compared to the prior year period, driven primarily by a decrease in volume, partially offset by a $15.6 million benefit from pricing.

Net sales in Fluid Power for the nine months ended September 30, 2023 increased by 0.8%, or $8.7 million, compared to the prior year period. Excluding the favorable impact of movements in average currency exchange rates of $4.3 million, core sales increased by 0.4%, or $4.4 million, compared to the prior year period, driven primarily by a $69.9 million benefit from pricing, partially offset by lower volumes.

Fluid Power’s core sales to our industrial channel declined by 5.3%, while sales to our automotive channel increased by 5.1% during the three months ended September 30, 2023. The decline in the industrial channel was primarily driven by North America, while automotive growth arose from EMEA and North America. The off-highway end market drove most of the sales decline of 7.9% during the three months ended September 30, 2023 compared to prior year period. Fluid Power’s core sales growth of 0.4% during the nine months ended September 30, 2023 was primarily attributable to a 2.2% increase in the automotive channel sales compared to the prior year period, primarily driven by EMEA and North America. Sales to our energy end market grew 9.2% for the nine months ended September 30, 2023, primarily driven by EMEA. This was partially offset by a decline in diversified industrial sales of 5.2% during the nine months ended September 30, 2023 compared to prior year period, primarily driven by EMEA and North America.

Fluid Power Adjusted EBITDA for the three months ended September 30, 2023 decreased by 3.8%, or $2.9 million, compared to the prior year period, driven primarily by lower volumes and increased labor and benefits costs, partially offset by pricing. As a result, the Adjusted EBITDA margin was 21.7%, a 70 basis point decline from the prior year period.

Fluid Power Adjusted EBITDA for the nine months ended September 30, 2023 increased by 2.6%, or $5.5 million, compared to the prior year period. This increase was driven primarily by pricing, partially offset by lower volume and absorption of fixed costs, increased labor and benefits costs, and higher inflation costs, resulting in an Adjusted EBITDA margin of 20.8%, a 40 basis points improvement 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 Sponsor 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

Nine months ended September 30, 2023 compared to the nine months ended October 1, 2022

Cash provided by operating activities was $291.7 million during the nine months ended September 30, 2023 compared to cash provided by operating activities of $18.8 million during the prior year period, driven primarily by an improvement of $180.0 million in trade working capital movement compared to the prior year period, 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 $26.8 million in income taxes paid compared to the prior year period, partially offset by $30.6 million higher cash paid for interest in the current year period.

Net cash used in investing activities during the nine months ended September 30, 2023 was $58.0 million, compared to $71.5 million in the prior year period. The decrease of cash used in investing activities was primarily driven by decreased capital expenditures of $18.5 million, partially offset by a $4.6 million increase in net cash paid under corporate-owned life insurance policies.

Net cash used in financing activities was $241.7 million during the nine months ended September 30, 2023, compared to $177.0 million in the prior year period. Current year outflows were primarily related to the $251.7 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 increase of cash outflow was partially offset by $28.2 million in lower dividends paid to non-controlling interest shareholders in 2023.

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

During May 2023, we drew $100.0 million under our asset-backed revolving credit facility to partially fund the purchase of shares under our share repurchase program. The balance on the asset-backed revolving credit facility was fully paid off during the three months ended September 30, 2023, as discussed further in Note 12 to the condensed consolidated financial statements included elsewhere in this quarterly report.

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 (as defined in the credit agreement), 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. 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 had no remaining outstanding balance as of December 31, 2022.

Dollar Term Loan credit agreement amendments

On October 10, 2023, we amended the New Dollar Term Loans’ interest rate to be, at our option, either Term SOFR, subject to a floor of 0.50%, plus a margin of 3.00% per annum, or the base rate, subject to a 1.50% per annum floor, plus 2.00% per annum.

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 September 30, 2023, before intercompany eliminations, our non-guarantor subsidiaries represented approximately 73% of our net sales and 72% of our EBITDA as defined in the financial covenants attaching to the senior secured credit facilities. As of September 30, 2023, before intercompany eliminations, our non-guarantor subsidiaries represented approximately 65% of our total assets and approximately 23% 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 increased by $7.0 million from $1,913.0 million as of December 31, 2022 to $1,920.0 million as of September 30, 2023. Net Debt was impacted adversely by $13.3 million due to movements in currency exchange rates. Excluding this impact, Net Debt decreased by $6.3 million, which was driven primarily by $251.7 million paid to acquire shares under our share repurchase program and $47.2 million of capital expenditures, partially offset by cash provided by operating activities of $291.7 million during the nine months ended September 30, 2023.

Borrowing Headroom

As of September 30, 2023, our asset-backed revolving credit facility had a borrowing base of $250.0 million, being the maximum amount we can draw down based on the current value of the secured assets. During May 2023, we drew $100.0 million under this facility to partially fund the purchase of shares under our share repurchase program, all of which was repaid during the three months ended September 30, 2023, as discussed further in Note 15 to the condensed consolidated financial statements included elsewhere in this report. In addition, there were letters of credit outstanding against the facility amounting to $31.6 million as of September 30, 2023. 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 September 30, 2023.

In total, our committed borrowing headroom was $468.4 million, in addition to cash balances of $556.8 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 interest and other expenses), 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;
• asset impairments;
• 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 the 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; credit loss related to a customer bankruptcy; 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)

(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 recorded a $11.4 million pre-tax charge during the nine months ended September 30, 2023 to reflect our estimated recovery. We 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)

41

Core revenue 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 revenue 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)

(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 $5.6 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 $342.3 million due to Gates Global LLC and its subsidiaries from indirect parent entities of Gates Global LLC as of September 30, 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 $11.3 million and $6.4 million as of September 30, 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 September 30, 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.