Gates Industrial Corp Ltd. (GTES) FY 2022 MD&A

Item 7: Management’s Discussion and Analysis

of Financial Condition and Results of Operations

The following discussion should be read in conjunction with our audited consolidated financial statements and related notes thereto included elsewhere in this annual report. This discussion and analysis addresses Fiscal 2021 and Fiscal 2020. For discussion and analysis of our financial condition and results of operations for Fiscal 2020 and Fiscal 2019, see Management's Discussion and Analysis of Financial Condition and Results of Operations, in Part II, Item 7 of our Annual Report on Form 10-K for Fiscal 2020, which is incorporated herein by reference. 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” and “Risk Factors” above.

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 mobility and recreation. 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 Fiscal 2021, 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 Fiscal 2021, 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. Among our automotive first-fit customers, a majority of our net sales are to emerging market customers, where we believe our first-fit presence provides us with a strategic advantage in developing those markets and ultimately increasing our higher margin replacement channel sales.

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We continue to make progress on our restructuring program, which is primarily intended to optimize our manufacturing and distribution footprint over the mid-term by removing structural fixed costs and, to a lesser degree, streamlining our selling, general and administrative (“SG&A”) back-office functions. We anticipate that most of the remaining costs associated with these actions will be incurred during 2022. Some of these costs will, in accordance with U.S. GAAP, be classified in cost of sales, negatively impacting gross margin, but due to their nature and impact of hindering comparison of the performance of our businesses on a period-over-period basis or with other businesses, they will be excluded from Adjusted EBITDA, consistent with the treatment of similar costs in prior periods.

During 2021, we experienced challenges from raw material and freight inflation, which we expect to continue in the near term. We have remained price/cost neutral on a dollar basis relative to these impacts in Fiscal 2021 and expect this to continue in 2022. In addition, we have experienced production disruptions and input shortages on labor, raw materials and freight. We continue to prioritize supporting our customers and anticipate that the margin impact of incremental costs incurred as a result of doing so will be temporary. While we believe we can continue to manage through these challenges, this may impact our ability to deliver products to our customers.

Impact of COVID-19 Pandemic

The first quarter of 2020 marked the beginning of an unprecedented environment for the global economy, which has continued throughout 2021, though impacting our business in different ways at different times. We continue to prioritize the health and safety of our employees and the communities in which we operate around the world, taking additional protective measures in our plants to safely maintain operational continuity in support of our global customer base.

We are adhering to local government mandates and guidance provided by health authorities and, where necessary, continue to implement quarantine protocols, social distancing policies, working from home arrangements, travel limitations, frequent and extensive disinfecting of our workspaces, provision of personal protective equipment, and mandatory temperature monitoring at our facilities. Where possible, we have made COVID-19 vaccines available to our employees, holding on-site vaccination clinics at a number of facilities. We may take further actions if required or recommended by government authorities or if we determine them to be in the best interests of our employees, customers, and suppliers.

Our operations are supported largely by local supply chains. Where necessary, we have taken steps to qualify additional suppliers to ensure we are able to maintain continuity of supply. Although we have not experienced any significant disruptions to date, certain Gates suppliers have, or may in the future, temporarily close operations, delay order fulfillment or limit production due to the pandemic. Continued disruptions, shipping delays or insolvency of key vendors in our supply chain could make it difficult or more costly for us to obtain the raw materials or other inputs we need for our operations, or to deliver products to our customers.

Gates employs an in-region, for-region manufacturing strategy, under which local operations primarily support local demand. In those cases where local production supports demand in other regions, contingency plans have been activated as appropriate. In addition to the handful of plants that were temporarily closed by government mandates, we have proactively managed our output to expected demand levels and occasionally suspended production at other plants for short periods of time, predominantly in the first half of 2020. 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 constraints on our ability to produce or deliver our products and meet customer demand or increase our costs.

As shelter-in-place requirements eased in various jurisdictions, we saw sequential quarterly improvements in the second half of 2020 and this continued during the first half of 2021. We expect the pace of these improvements to slow as the global economy continues to normalize, which we began to experience during the second half of 2021. During this crisis, we have maintained our ability to respond to demand improvements and we continue to fund key initiatives, which we believe will serve us well as our end markets continue to recover.

We have strength and flexibility in our liquidity position, which includes committed borrowing headroom of $445.1 million under our lines of credit, in addition to cash balances of $658.2 million as of January 1, 2022. In addition, our business has a demonstrated ability to generate free cash flow even in challenging environments.

While we have generally seen a rebound in demand from the pandemic-induced declines of 2020, the evolving impact of the pandemic, including the emergence of variants, and continuing measures being taken around the world to combat its spread, may have ongoing implications for our business which may vary from time to time. Some of these impacts may be material but cannot be reasonably estimated at this time.

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Results for the year ended January 1, 2022 compared to the results for the year ended January 2, 2021

Summary Gates Performance

(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 Fiscal 2021 were $3,474.4 million, compared to $2,793.0 million during the prior year, an increase of 24.4%, or $681.4 million. Our net sales for Fiscal 2021 were favorably impacted by movements in average currency exchange rates of $76.3 million compared to the prior year, due principally to the weakening of the U.S. dollar against a number of currencies, in particular the Euro, Chinese Renminbi and the Canadian Dollar. Excluding this impact, core sales increased by $605.1 million, or 21.7%, during Fiscal 2021 compared to the prior year, driven primarily by higher volumes, but with a $103.7 million benefit from favorable pricing.

Core sales in our Power Transmission and Fluid Power businesses increased by 20.4% and 24.0%, respectively, during Fiscal 2021 compared to the prior year. These improvements, predominantly a function of the significant economic impact from the COVID-19 pandemic in the prior year, were driven primarily by increases in sales to customers in our industrial channels, with industrial first-fit sales up by 34.1% and industrial replacement sales up by 30.7%. The majority of this growth was focused in North America and EMEA, where industrial sales grew by 27.1% and 42.7%, respectively, during Fiscal 2021 compared to the prior year. The diversified industrial end markets, which grew strongly in all regions, but particularly in North America and EMEA, drove most of the industrial channel growth during Fiscal 2021, compared to the prior year, increasing by 35.8% globally. Sales to industrial off-highway end markets grew by 26.7% during Fiscal 2021 compared to the prior year, primarily in North America. Sales to automotive replacement customers increased across all regions, growing globally by 15.0% during Fiscal 2021 compared to the prior year, with over half of this growth coming from EMEA. Sales growth in the automotive first-fit channel was more muted at 2.4% during Fiscal 2021 compared to the prior year, due primarily to a stronger prior year performance in Greater China due to the earlier start to the recovery in this region in 2020, and 2021 impacts from softening customer demand resulting from the global semiconductor chip shortage, and the impact of government-mandated power outages in Greater China.

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Cost of sales

Cost of sales for Fiscal 2021 was $2,135.2 million, compared to $1,758.3 million for the prior year, an increase of 21.4%, or $376.9 million. Higher volumes contributed $308.5 million of this increase, with higher inflation-related costs, including higher inbound freight costs, driving an additional $100.9 million of the increase. Unfavorable movements in average currency exchange rates added a further $41.6 million to cost of sales during Fiscal 2021 compared to the prior year. These increases were offset partially by the improved manufacturing performance due to the higher absorption of fixed costs on higher volumes.

Gross profit

Gross profit for Fiscal 2021 was $1,339.2 million, up by $304.5 million or 29.4% from $1,034.7 million for the prior year. As described above, this change was driven primarily by higher volumes, improved manufacturing performance, and a benefit from favorable pricing, offset by higher inflation-related costs.

Our gross profit margin for Fiscal 2021 improved by 150 basis points from prior year to 38.5%.

Selling, general and administrative expenses

SG&A expenses for Fiscal 2021 were $852.7 million compared to $776.9 million for the prior year. This increase of $75.8 million was driven primarily by higher labor costs of $30.4 million and unfavorable movements in average currency exchange rates of $13.7 million. The remainder of the increase resulted largely from various volume-related increases driven by the rebound in demand during the current period compared to the prior year.

Transaction-related expenses

Transaction-related expenses of $3.7 million were incurred during Fiscal 2021, related primarily to the amendment to our Dollar Term Loan credit facility completed in February 2021, as well as certain other corporate transactions during the year. Transaction-related expenses of $5.2 million were incurred during the prior year, related primarily to payments made on resolution of certain contingencies that affected the purchase price paid by Blackstone upon acquiring Gates in July 2014.

Restructuring expenses

As described further under the “Business Trends” section above, we continue to make progress on our previously announced restructuring program, which is primarily intended to optimize our manufacturing and distribution footprint over the mid-term by removing structural fixed costs, and to streamline our SG&A back-office functions.

Restructuring and other strategic initiative costs, including asset impairments, of $9.4 million were recognized during Fiscal 2021, including $3.4 million of primarily severance and other labor-related expenses related to our European reorganization involving office and distribution center closures or downsizings and the implementation of a regional shared service center, and $3.7 million of additional costs related to the closure in 2020 of a manufacturing facility in Korea, including impairment of fixed assets of $0.6 million. Also during Fiscal 2021, we incurred $1.4 million of inventory impairments (recognized in cost of sales), predominantly in North America as part of a strategic product line shift, and we recognized $1.0 million of expenses related to the consolidation of certain of our Middle East businesses. Partially offsetting these costs were gains of $3.1 million on the disposal of buildings in Korea and France that were no longer needed following the completion of certain restructuring initiatives.

Restructuring and other strategic initiative costs, including asset impairments, of $43.9 million were recognized during the prior year, related primarily to the closure of a manufacturing facility in Korea, our European reorganization involving office and distribution center closures or downsizings and implementation of a regional shared service center, the closure of two North American manufacturing facilities, and reductions in workforce, primarily in EMEA and North America. The closure of the Korean facility resulted in an accrual for severance and other labor costs of $13.2 million, an impairment of inventory of $1.4 million (recognized in cost of sales) and an impairment of fixed assets of $4.8 million (included in asset impairments). Restructuring costs related to our European reorganization were $12.6 million, of which $11.4 million related to estimated severance.

Other operating income

Other operating income of $9.3 million was recognized during Fiscal 2021, related primarily to a net gain on the sale of a purchase option on a building that we lease in Europe.

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Interest expense

Details of our long-term debt are presented in note 15 to the consolidated financial statements included elsewhere in this report.

Interest on debt for Fiscal 2021 decreased by $12.9 million when compared to the prior year due primarily to interest savings on debt repayments and the benefit from lower interest rates on the Dollar Term Loan, offset partially by the impact of derivatives. The benefit from the repayment of €58.7 million ($69.5 million) of our Euro Term Loan during June 2021 was offset by a combination of the impact of derivatives and an increase in interest caused by unfavorable movements in average currency exchange rates.

Amortization of deferred issuance costs has decreased during Fiscal 2021 due primarily to the extension of the maturity of the Dollar Term Loan completed in February 2021, in addition to the accelerated amortization of $3.7 million incurred in Fiscal 2020 due to the repayment of $300.0 million of our Dollar Term Loan facility on December 31, 2020.

Other expense (income)

Other expense for Fiscal 2021 was $0.9 million, compared to an income of $14.2 million in the prior year. This change was driven primarily by the impact of net movements in foreign currency exchange rates on net debt and hedging instruments in addition to lower interest income on cash balances, and fees incurred in relation to our trade accounts receivable factoring program.

Income tax expense (benefit)

For Fiscal 2021, we had an income tax expense of $18.4 million on pre-tax income of $349.7 million, which resulted in an effective tax rate of 5.3% compared to an income tax benefit of $19.3 million on pre-tax income of $71.0 million, which resulted in an effective tax rate of (27.2)% for Fiscal 2020.

The effective tax rate for Fiscal 2021 was driven primarily by tax benefits of $26.4 million related to the partial valuation allowance release on deferred tax assets for U.S. foreign tax credits, $16.1 million for deferred taxes on unremitted earnings of our subsidiaries, and $14.0 million from deferred tax rate changes.

The effective tax rate for Fiscal 2020 was driven primarily by tax benefits of $32.3 million related to audit settlements, changes in valuation allowance and tax law changes.

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Deferred Income 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 in Fiscal 2021 that it was more likely than not that deferred income tax assets in the U.S. related to foreign tax credits totaling $53.4 million are realizable as a result of changes in estimates of taxable profits against which these credits can be utilized. Similarly, we determined that it was more likely than not that deferred income tax assets in Fiscal 2020 primarily related to disallowed interest carryforwards in the U.K., Luxembourg, and Belgium totaling $29.5 million were realizable.

In Fiscal 2020, the deferred tax assets above include $26.0 million of assets which have no expiration in these jurisdictions. As a result of changes in estimates of future taxable profits in the third quarter of Fiscal 2020, due primarily to anticipated changes to the composition of our intercompany financing arrangements related to proposed international tax law changes, our judgment changed regarding valuation allowances on these deferred tax assets.

Significant Events

On March 27, 2020, the Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”) was enacted and signed into law in the U.S. in response to the COVID-19 pandemic. One of the provisions of this law is an increase to the allowable business interest deduction from 30% of adjusted taxable income to 50% of adjusted taxable income for the 2019 and 2020 tax years. This modification significantly increased the current deductible interest expense of the Company for both years, which resulted in a cash benefit while increasing our effective tax rate through requirements to allocate and apportion interest expense for certain other tax purposes, including in determining our global intangible low-taxed income inclusion, deduction for foreign derived intangible income, and the utilization of foreign tax credits.

Adjusted EBITDA

Adjusted EBITDA for Fiscal 2021 was $735.8 million, compared to $506.6 million in the prior year, an increase of 45.2% or $229.2 million. The Adjusted EBITDA margin was 21.2% for Fiscal 2021, a 310 basis point increase from the prior year. The increase in Adjusted EBITDA was driven primarily by the increase in volumes, pricing benefits and improvement in manufacturing performance, as described above, together driving an increase in gross profit of $359.4 million, which was offset partially by higher inflation-related costs, including inbound freight, and higher SG&A expenses, as noted above.

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.”

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Analysis by Operating Segment

Power Transmission (63.8% of Gates’ net sales for the year ended January 1, 2022)

Net sales in Power Transmission for Fiscal 2021 increased by 23.1%, or $416.1 million, compared to the prior year. Excluding the favorable impact of movements in average currency exchange rates of $49.2 million, core sales increased by 20.4%, or $366.9 million, compared to the prior year, driven primarily by higher volumes, but with a $57.5 million benefit from favorable pricing.

Power Transmission’s core sales to industrial customers grew by 33.8% during Fiscal 2021, compared to the prior year, driven by growth in industrial first-fit sales, particularly in North America and EMEA, and strong industrial replacement growth in East Asia & India. This industrial growth was predominantly focused in the diversified industrial end market, which grew by 35.9% during Fiscal 2021 compared to the prior year, primarily in North America, EMEA and Greater China. Industrial on-highway end market sales increased globally by 19.7% compared to the prior year, driven by growth in North America and EMEA, while industrial off-highway end market sales were more mixed, with strong growth in North America offset partially by moderate declines in Greater China, due primarily to the stronger prior year performance in Greater China due to the earlier start to the recovery in this region in 2020. Automotive replacement sales also drove growth during Fiscal 2021, increasing by 18.4% globally, compared to the prior year, with strong growth in all regions, but primarily in EMEA, which grew by 24.7% in Fiscal 2021 compared to the prior year. Sales to automotive first-fit customers grew more modestly at 2.8% compared to the prior year, with strong growth in East Asia & India largely offset by declines in Greater China, due to softening customer demand resulting from the global semiconductor chip shortage, and the impact of government-mandated power outages.

Power Transmission Adjusted EBITDA for Fiscal 2021 increased by 41.8% or $147.6 million compared to the prior year, driven primarily by a combination of higher volumes, improved manufacturing performance and pricing benefits. These increases were offset partially by higher inflation-related costs and increased SG&A spending, related primarily to labor. As a result, the Adjusted EBITDA margin for Fiscal 2021 was 22.6%, a 300 basis point improvement from the prior year.

Fluid Power (36.2% of Gates’ net sales for the year ended January 1, 2022)

Net sales in Fluid Power for Fiscal 2021 increased by 26.7%, or $265.3 million, compared to the prior year. Excluding the favorable impact of movements in average currency exchange rates of $27.1 million, core sales increased by 24.0%, or $238.2 million, compared to the prior year, driven primarily by higher volumes, but with a $46.2 million benefit from favorable pricing.

Fluid Power’s core sales growth in Fiscal 2021 was driven almost entirely by increased sales to industrial customers, which grew by 30.8% compared to the prior year, with industrial replacement sales outperforming sales to industrial first-fit customers. This growth was driven primarily by sales to the industrial off-highway end market, which grew across most regions, but predominantly in EMEA and North America, and in the construction end market in particular, which grew by 62.8% and 25.3%, respectively, in these two regions. Growth in sales to the diversified industrial end market, which grew by 35.6% globally, primarily in North America, also contributed to the overall industrial sales growth in Fiscal 2021 compared to the prior year. Growth in automotive replacement sales was more modest during Fiscal 2021 at 4.7% compared to the prior year, driven primarily by EMEA.

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Fluid Power Adjusted EBITDA for Fiscal 2021 increased by 53.1%, or $81.6 million compared to the prior year, driven primarily by a combination of higher volumes, improved manufacturing performance and pricing benefits. These increases were offset partially by higher inflation-related costs and increased SG&A spending, related primarily to labor. As a result, the Adjusted EBITDA margin for Fiscal 2021 was 18.7%, a 320 basis point improvement from the prior year.

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 2024; 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

Year ended January 1, 2022 compared to the year ended January 2, 2021

Cash provided by operating activities was $382.4 million during Fiscal 2021 compared to cash provided by operating activities of $309.0 million during the prior year. This increase was driven primarily by higher operating performance during the current year, offset partially by an increase in trade working capital of $131.3 million more than in the prior year, driven by the increase in production and sales, and an increase of $22.6 million in cash taxes paid.

Net cash used in investing activities during Fiscal 2021 was $86.0 million, compared to $77.5 million in the prior year. This increase was driven primarily by higher capital expenditures, which increased by $19.6 million from $67.4 million in the prior year to $87.0 million in Fiscal 2021, offset partially by proceeds of $8.4 million on disposal of fixed assets.

Net cash used in financing activities was $148.6 million during Fiscal 2021, compared to $353.8 million in the prior year. This lower cash outflow was driven primarily by the $300.0 million repayment of our Dollar Term Loan facility in December 2020, offset partially by the $69.5 million repayment made in June 2021 against our Euro Term Loan facility, $11.4 million of higher debt issuance costs, related primarily to the amendments made to the credit agreement during February 2021, and $10.6 million paid to acquire shares under our share repurchase program.

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Indebtedness

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

Details of our long-term debt are presented in note 15 to the consolidated financial statements included elsewhere in this annual report.

Debt redemptions

During June 2021, we made a principal debt repayment of €58.7 million ($69.5 million) against our Euro Term Loan facility. As a result of this repayment, we accelerated the recognition of $0.4 million of deferred issuance costs (recognized in interest expense).

Dollar Term Loan credit agreement amendments

On February 24, 2021, we made amendments to the Dollar Term Loan credit agreement, including extending its maturity date from March 31, 2024 to March 31, 2027, reducing the floor applicable to the Dollar Term Loan from 1.00% to 0.75% and modifying the applicable interest rate margin for the Dollar Term Loan to include a 0.25% reduction if our consolidated total net leverage ratio (as defined in the credit agreement) is less than or equal to 3.75 times. In connection with these amendments, we paid accrued interest up to the date of the amendments of $3.7 million, in addition to fees of approximately $8.6 million, of which $6.9 million qualified for deferral and will be amortized to interest expense over the new remaining term of the Dollar Term Loan using the effective interest method.

During the third quarter, as a consequence of the amendments described above, the margin on the Dollar Term Loan was reduced by 0.25% as the consolidated total net leverage ratio (as defined in the credit agreement) dropped below 3.75 times.

Revolver extensions

On November 18, 2021, we amended the credit agreements governing both of our revolving credit facilities to, among other things, increase the size of the cash flow revolving credit facility from $185.0 million to $250.0 million, and decrease the maximum commitments available under the asset-backed revolver from $325.0 million to $250.0 million. In addition, the letter of credit sub-facility under the cash flow revolving credit facility was increased from $20.0 million to $75.0 million. The maturity dates of both revolving credit facilities were also extended from January 29, 2023 to November 18, 2026 (subject to certain springing maturities related to our Euro Term Loan and Unsecured Senior Notes if more than $500.0 million is outstanding in respect of either such facility 91 days prior to their respective maturities).

In connection with these amendments, we paid fees of $3.3 million, which have been deferred and will, together with existing deferred issuance costs related to these facilities, be amortized to interest expense over the new term of the facilities on a straight-line basis.

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 January 1, 2022, before intercompany eliminations, our non-guarantor subsidiaries represented approximately 74% of our net sales and 69% of our EBITDA as defined in the financial covenants attaching to the senior secured credit facilities. As of January 1, 2022, before intercompany eliminations, our non-guarantor subsidiaries represented approximately 62% of our total assets and approximately 28% of our total liabilities.

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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 2021, our net debt decreased by $278.4 million from $2,199.4 million as of January 2, 2021 to $1,921.0 million as of January 1, 2022. Net debt was impacted favorably by $39.6 million due to movements in currency exchange rates, related primarily to the impact of the weakening of the Euro against the U.S. dollar on our Euro-denominated debt. Excluding this impact, net debt decreased by $238.8 million, which was driven primarily by cash provided by operating activities of $382.4 million, offset partially by a number of cash outflows, including capital expenditures of $87.0 million, dividends paid to non-controlling shareholders of $26.6 million, debt issuance costs of $11.7 million paid primarily in respect of the amendments to the credit agreement in February 2021, and $10.6 million paid to acquire shares under our share repurchase program.

Borrowing Headroom

As of January 1, 2022, our asset-backed revolving credit facility had a borrowing base of $240.4 million, being the maximum amount we can draw down based on the current value of the secured assets. The facility was undrawn for cash, but there were letters of credit outstanding against the facility amounting to $45.3 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.

In total, our committed borrowing headroom was $445.1 million, in addition to cash balances of $658.2 million.

Tabular Disclosure of Contractual Obligations

Our consolidated contractual obligations and commercial commitments are summarized in the following table which includes aggregate information about our contractual obligations as of January 1, 2022 and the periods in which payments are due, based on the earliest date on which we could be required to settle the liabilities. The table below excludes our gross liability for uncertain tax positions of $103.7 million because the timing of cash settlement, if any, is unknown at this time.

Floating interest payments and payments and receipts on interest rate derivatives are estimated based on market interest rates prevailing at the balance sheet date. Amounts in respect of purchase obligations are items that we are obligated to pay in the future, but they are not required to be included on the consolidated balance sheet.

(1)    Future interest payments include payments on fixed and floating rate debt. Floating rate interest payments are estimated based on forward market interest rates and terms prevailing as of January 1, 2022.

(2)    Net payments on cross currency swaps, interest rate caps, interest rate swaps and currency forward contracts are estimated based on forward market rates prevailing as of January 1, 2022.

(3)    Post-retirement benefit obligations represent our expected cash contributions to defined benefit pension and other post-retirement benefit plans in 2022. It is not practicable to present expected cash contributions for subsequent years because they are determined annually on an actuarial basis to provide for current and future benefits in accordance with federal law and other regulations.

(4)    A purchase obligation is defined as an agreement to purchase goods or services that is enforceable and legally binding on us and that specifies all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction.

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Cash Balances

As of January 1, 2022, our total cash and cash equivalents were $658.2 million, compared to $521.4 million as of January 2, 2021.

Restricted cash was $2.7 million as of January 1, 2022, compared to $2.7 million as of January 2, 2021, including $1.0 million as of January 1, 2022 and $1.0 million as of January 2, 2021, which was held in escrow for insurance purposes. Cash held in our non-wholly owned Asian subsidiaries was $168.4 million and $152.7 million as of January 1, 2022 and January 2, 2021, respectively.

Distributable Reserves

Under the laws of England and Wales, future dividend payments or share repurchases may only be made out of “distributable reserves” on the Company’s statutory balance sheet. During August 2019, the High Court of Justice in London sanctioned a reduction in the Company’s statutory capital for the purpose of creating distributable reserves by approving the cancellation of the deferred shares in issue and the cancellation of the entire amount standing to the credit of the Company’s share premium account, creating $5.5 billion of distributable reserves. These transactions, which have no impact on the consolidated U.S. GAAP financial statements, facilitate the possible future payment of dividends to shareholders of the Company or possible future share repurchases.

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 equity and debt transactions;

•asset impairments;

•restructuring expenses, including severance-related expenses; and

•fees paid to our private equity sponsor for monitoring, advisory and consulting services.

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.

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We exclude from Adjusted EBITDA acquisition-related costs that are required to be expensed in accordance with U.S. GAAP. In particular, we exclude the effect on cost of sales of the uplift to the carrying amount of inventory held by entities acquired by Gates. 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; impairments of intangibles and of other assets, representing the excess of their carrying amounts over the amounts that are expected to be recovered from them in the future; and fees paid to our private equity sponsor.

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:

(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)    During Fiscal 2021, we realized a net gain of $9.3 million related to the sale of a purchase option on a building that we lease in Europe.

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.

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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.

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 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:

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

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 $4.7 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 receivable of $0.9 million due to Gates Global LLC and its subsidiaries from indirect parent entities of Gates Global LLC as of January 1, 2022, compared to a receivable of $0.6 million as of January 2, 2021, and additional cash and cash equivalents held by the Company and other indirect parents of Gates Global LLC of $12.7 million and $4.2 million as of January 1, 2022 and January 2, 2021, respectively.

Critical Accounting Estimates and Judgments

Details of our significant accounting policies are set out in note 2 to our audited consolidated financial statements included elsewhere in this annual report.

When applying our accounting policies, we must make assumptions, judgments and estimates concerning the future that affect reported amounts of assets, liabilities, revenue and expenses. We make these assumptions, estimates and judgments based on factors such as historical experience, the observance of trends in the industries in which we operate and information available from our customers and other outside sources. Due to the inherent uncertainty involved in making assumptions, estimates and judgments, the actual outcomes could be different. The policies discussed below are considered by management to be more critical than other policies because their application involves a significant amount of estimation uncertainty that increases the risk of a material adjustment to the carrying amounts of our assets and liabilities.

Net Sales

We derive our net sales primarily from the sale of a wide range of power transmission and fluid power products and components for a large variety of industrial and automotive applications, both in the aftermarket and first-fit channels, throughout the world.

In most of our agreements with customers, we consider accepted customer purchase orders, which in some cases are governed by master sales agreements, to represent the contracts with our customers. Revenue from the sale of goods under these contracts is measured at the invoiced amount, net of estimated returns, early settlement discounts and rebates. Taxes collected from customers relating to product sales and remitted to government authorities are excluded from revenues. Where a customer has the right to return goods, future returns are estimated based on historical returns profiles. Settlement discounts that may apply to unpaid invoices are estimated based on the settlement histories of the relevant customers.

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Our transaction prices often include variable consideration, usually in the form of discounts and rebates that may apply to issued invoices. The reduction in the transaction price for variable consideration requires that we make estimates of the expected total qualifying sales to the relevant customers. These estimates, including an analysis for potential constraint on variable consideration, take into account factors such as the nature of the rebate program, historical information and expectations of customer and consumer behavior. Overall, the transaction price is reduced to reflect our estimate of the amount of consideration that is not probable of significant reversal.

We allocate the transaction price to each distinct performance obligation based on their relative standalone selling price. The product price as specified on the accepted purchase order or similar binding contract is considered to be the standalone selling price. In substantially all of our contracts with customers, our performance obligations are satisfied at a point in time, rather than over a period of time, when control of the product is transferred to the customer. This occurs typically at shipment. In determining whether control has transferred and the customer is consequently able to control the use of the product for their own benefit, we consider if there is a present right to payment, legal title and physical possession has been transferred, whether the risks and rewards of ownership have transferred to the customer, and if acceptance of the asset by the customer is more than perfunctory.

Impairment of Goodwill and Other Indefinite-Lived Assets

Goodwill and other indefinite-lived intangible assets are subject to an annual impairment test but are also tested for impairment if an event occurs or circumstances change that would more likely than not reduce the fair value below its carrying amount.

Goodwill

Goodwill arising in a business combination is allocated to the reporting unit that is expected to benefit from the synergies of the acquisition. Where goodwill is attributable to more than one reporting unit, the goodwill is determined by allocating the purchase consideration in proportion to their respective business enterprise values and comparing the allocated purchase consideration with the fair value of the identifiable assets and liabilities of the reporting unit.

Goodwill is not amortized but is tested for impairment on the first day of the fourth quarter or more frequently whenever events or changes in circumstances indicate that the carrying value may not be recoverable and is carried at cost less any recognized impairment.

To identify a potential impairment of goodwill, the fair value of the reporting unit to which the goodwill is allocated is compared to its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, the goodwill of the reporting unit is not considered impaired. If the fair value is lower than the carrying amount, an impairment charge is recognized for the amount by which the carrying amount exceeds the reporting unit’s fair value, limited to the amount of goodwill allocated to that reporting unit.

Management based the fair value calculations on a weighted blend of the income and market approaches. The income approach was based on cash flow forecasts derived from the most recent financial plans approved by the board of directors, in which the principal assumptions were those regarding sales growth rates, selling prices and changes in direct costs. Forecasts for the following two years were based on region-specific growth assumptions determined by management, taking into account strategic initiatives.

Cash flows for each of the reporting units for the years beyond this period were projected to grow at compound annual growth rates reflecting annual changes over the next seven years from the 2024 growth rates to the terminal growth rate. For Gates as a whole, this growth rate was calculated to be 1.6%. The terminal growth rate for both reporting units was set at 2.5%, a rate that does not exceed the expected long-term growth rates in the respective principal end markets.

Management applied discount rates to the resulting cash flow projections that reflect current market assessments of the time value of money and the risks specific to each reporting unit. In each case, the discount rate was determined using a capital asset pricing model. The discount rates used in the impairment tests of goodwill during Fiscal 2021 were 9.0% for both reporting units.

For both reporting units, the fair values exceeded the carrying values and no goodwill impairments were therefore recognized during Fiscal 2021.

We base our fair value estimates on assumptions we believe to be reasonable at the time but that are unpredictable and inherently uncertain. In addition, we make certain judgments and assumptions in allocating goodwill between reporting units and in allocating shared assets and liabilities to determine the carrying values for each of our reporting units tested. Changes in assumptions or circumstances could result in an additional impairment in the period in which the change occurs and in future years.

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Indefinite-Lived Assets Other than Goodwill

To identify a potential impairment of indefinite-lived assets other than goodwill, the fair value of the asset is compared to its carrying amount. If the fair value of the indefinite-lived asset exceeds its carrying amount, it is not considered impaired. Fair value is calculated based on the anticipated net cash inflows and outflows related to the indefinite-lived asset.

During the periods covered by this annual report, we held an indefinite-lived brand and trade name intangible asset. We test the intangible for impairment on the first day of the fourth quarter or more frequently whenever events or changes in circumstances indicate that the carrying value may not be recoverable and is carried at cost less any recognized impairment.

The fair value for our indefinite-lived brand and trade name intangible asset was determined using a relief from royalty valuation methodology in which the key assumptions included sales growth rates and an estimated royalty rate. Sales forecasts were determined on the same basis as those used for the annual impairment testing of goodwill (as described above).

Management applied discount rates to the calculated royalty savings that reflect current market assessments of the time value of money and the risks specific to each region in which those royalty savings arose. In each case, the discount rate was determined using a capital asset pricing model adjusted for a premium to reflect the higher risk specific to the nature of the intangible asset. The discount rate used in Fiscal 2021 impairment test was 10.0%. As a result of the impairment testing, no impairment was recognized during Fiscal 2021.

We base our fair value estimates on assumptions we believe to be reasonable at the time but that are unpredictable and inherently uncertain. Changes in assumptions or circumstances could result in an additional impairment in the period in which the change occurs and in future years.

Taxation

We are subject to income tax in most of the jurisdictions in which we operate. Management is required to exercise significant judgment in determining our provision for income taxes. Management’s judgment is required in relation to unrecognized income tax benefits whereby additional current tax may become payable in the future following the audit by tax authorities of previously-filed tax returns. It is possible that the final outcome of these unrecognized income tax benefits may differ from management’s estimates.

Management assesses unrecognized income tax benefits based upon an evaluation of the facts, circumstances and information available at the balance sheet date. Provision is made for unrecognized tax benefits to the extent that the amounts previously taken or expected to be taken in tax returns exceeds the tax benefits that are recognized in the consolidated financial statements in respect of the tax positions. A tax benefit is recognized in the consolidated financial statements only if management considers that it is more likely than not that the tax position will be sustained on examination by the relevant tax authority solely on the technical merits of the position and is measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon settlement assuming that the tax authority has full knowledge of all relevant information. Provisions for unrecognized income tax benefits are reviewed regularly and are adjusted to reflect events such as the expiration of limitation periods for assessing tax, guidance given by the tax authorities and court decisions.

Deferred income tax assets and liabilities are recognized based on the expected future tax consequences of the difference between the financial statement carrying amount and the respective tax basis. Deferred income taxes are measured on the enacted rates expected to apply to taxable income at the time the difference is anticipated to reverse. Deferred income tax assets are reduced through the establishment of a valuation allowance if it is more likely than not that the deferred income tax asset will not be realized taking into account the timing and amount of the reversal of taxable temporary differences, expected future taxable income and tax planning strategies.

Deferred income tax is provided on certain taxable temporary differences arising on investments in foreign subsidiaries, except where we intend, and are able, to reinvest such amounts on a permanent basis or to remit such amounts in a tax-free manner.

We have recorded valuation allowances against certain of our deferred income tax assets and we intend to continue maintaining such valuation allowances until there is sufficient evidence to support the reduction of all or some portion of these allowances. During Fiscal 2021, we determined that it was more likely than not that certain deferred income tax assets in the U.S. totaling $53.4 million were realizable. During Fiscal 2020, we determined that it was more likely than not that certain deferred income tax assets in the U.K., Luxembourg and Belgium totaling $29.5 million were realizable.

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Accounting Pronouncements Not Yet Adopted

Recently issued accounting pronouncements that may be relevant to our operations but have not yet been adopted are outlined in note 3 to our audited consolidated financial statements included elsewhere in this annual report.