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 2022 and Fiscal 2021. For discussion and analysis of our financial condition and results of operations for Fiscal 2021 and Fiscal 2020, 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 2021, 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 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 Fiscal 2022, 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 2022, 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.

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During Fiscal 2022, we continued to experience challenges from raw material, energy, and freight inflation, which have moderated in certain areas, but are expected to continue to a lesser degree in the near term. For Fiscal 2022, we were able to end the year price/cost positive on a dollar basis relative to these inflation impacts and nearly neutral on a gross margin basis. In addition, we experienced production disruptions and input shortages on labor, certain raw materials and freight in 2021 and through Fiscal 2022. These supply chain challenges have moderated in late 2022, resulting in modest improvements in our productivity and ended the year in a more balanced position with supply meeting the underlying demand.

Russia-Ukraine conflict

The conflict between Russia and Ukraine, and the sanctions and counter-sanctions imposed in response to it, have created increased economic uncertainty and operational complexity both in the region and globally, the impacts of which we cannot fully predict. Gates had a single distribution center in Russia that sold primarily to customers based in Russia. In early July 2022, we suspended our operations in Russia, resulting in restructuring and other charges totaling $3.5 million in Fiscal 2022. Should the conflict continue or escalate, it could have a significant negative effect on our business and results in the future including continued inflationary pressures on raw materials, energy and transportation, supply chain and logistics disruptions, volatility in foreign exchange rates and interest rates, and heightened cybersecurity threats. This conflict directly resulted in a decrease of approximately 2% to our 2022 global revenues.

Impact of COVID-19 Pandemic

In the third year of the COVID-19 pandemic, we continue to contend with the ongoing implications of the pandemic and prioritizing 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 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 operational disruptions to date, we have incurred meaningful operational inefficiencies. In addition, certain Gates suppliers have, or may in the future, temporarily close operations, delay order fulfillment or limit production due to the pandemic, including as a result of insufficient raw materials necessary to support their production. 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 addition to the handful of plants that were temporarily closed by government mandates at various times, 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. As shelter-in-place requirements eased in various jurisdictions, we saw sequential quarterly improvements in the second half of 2020 which continued during the first half of 2021, and then began to slow during the second half of 2021 as the global economy continued to normalize. During March 2022, an increase in COVID-19 related cases in certain parts of China resulted in the re-imposition of widespread shutdowns and restrictions in China through most of April and May 2022, and resulted in a modest loss of production, sales and profitability. As the COVID-19 lockdowns began to ease in June 2022, our business in China began to slowly recover, before a rapid rise in infections in China late in 2022 adversely affected customer demand, labor availability, and our profitability. We continue to expect it will take time through the first half of 2023 for our customers and the local supply base in China to operate at more normalized levels. We may experience future production disruptions where plants are temporarily closed or productivity is reduced by government mandates or as a result of supply chain or labor disruptions, which could place further constraints on our ability to produce or deliver our products and meet customer demand or increase our costs. We may also continue to experience periods of inconsistency in customer demand as customers address their own supply chain constraints. During this crisis, we have maintained our ability to respond to changes in demand and we continue to fund key initiatives, which we believe will serve us well as our end markets continue to evolve.

We have strength and flexibility in our liquidity position, which includes committed borrowing headroom of $438.9 million under our lines of credit, in addition to cash balances of $578.4 million as of December 31, 2022. In addition, our business has a demonstrated ability to generate free cash flow even in challenging environments.

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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.

Results for the year ended December 31, 2022 compared to the results for the year ended January 1, 2022

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 2022 were $3,554.2 million, compared to $3,474.4 million during the prior year, an increase of 2.3%, or $79.8 million. Our net sales for Fiscal 2022 were adversely impacted by movements in average currency exchange rates of $185.1 million compared to the prior year, principally due to the strengthening of the U.S. dollar against a number of currencies, in particular the Euro, Japanese Yen and Turkish Lira. Excluding this impact, core sales increased by $264.9 million, or 7.6%, during Fiscal 2022 compared to the prior year, driven primarily by a $363.1 million benefit from favorable pricing, partially offset by the impact of lower volumes.

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Core sales in our Power Transmission and Fluid Power businesses increased by 4.8% and 12.6%, respectively, during Fiscal 2022 compared to the prior year. These improvements were primarily driven by increases in sales to customers in our industrial channels, with industrial replacement sales up by 9.6% and industrial first-fit sales up by 8.4%. The majority of this growth was focused in North America and EMEA, where industrial sales grew by 11.5% and 17.3%, respectively, during Fiscal 2022 compared to the prior year. The off-highway, diversified industrial, and personal mobility end markets drove most of the industrial channel growth during Fiscal 2022, increasing by 10.6%, 7.7% and 22.6%, respectively, compared to the prior year, particularly in North America and EMEA. Sales growth in the automotive channel extended to 6.0% during Fiscal 2022 compared to the prior year, primarily due to the automotive market rebounding from supply-chain issues and the global semiconductor chip shortage, particularly in North America. The growth in core sales was partially offset by decline in both industrial and automotive sales in Greater China, which declined by 17.4% and 7.3%, respectively, compared to the prior year. The Greater China region experienced declines across all end markets primarily due to the continued challenges in Chinese economy exacerbated by the pandemic-inflicted lockdowns during the second quarter with continued impact throughout the year. Our business was also negatively impacted by the abrupt change in COVID-related policies in China in December 2022, which led to a rapid rise in COVID infections in China and resulted in a decline in customer demand and limited labor availability, with continuing impact into early 2023.

Cost of sales

Cost of sales for Fiscal 2022 was $2,303.6 million, compared to $2,135.2 million for the prior year, an increase of 7.9%, or $168.4 million. This increase is primarily attributable to higher inflation-related costs, including higher materials, utilities and inbound freight costs, of $242.4 million, in addition to a $10.1 million adjustment to remeasure certain inventories on a last in, first out (“LIFO”) basis. Cost of sales also increased by $117.2 million as a result of lower absorption of fixed costs, which was partially offset by lower volumes. These increases were further offset by $136.8 million as a result of favorable movements in average currency exchange rates.

Gross profit

As a result of the factors described above, gross profit for Fiscal 2022 was $1,250.6 million, compared to $1,339.2 million for the prior year period, a decrease of 6.6% or $88.6 million. Our gross profit margin dropped by 330 basis points to 35.2% for Fiscal 2022.

Selling, general and administrative expenses

SG&A expenses for Fiscal 2022 were $853.7 million compared to $852.7 million for the prior year. This increase of $1.0 million was driven primarily by higher share-based compensation costs of $19.7 million, largely due to the March 2022 vesting of certain pre-IPO options as discussed further in Note 19 to the condensed consolidated financial statements included elsewhere in this report. Other increases are due to higher travel, marketing, and IT and other administrative expenditures. These increases were largely offset by favorable movements in average currency exchange rates compared to the prior year period.

Transaction-related expenses

Transaction-related expenses of $2.1 million were incurred during Fiscal 2022, related primarily to the secondary offering completed in March 2022 and certain other corporate transactions. Transaction-related expenses of $3.7 million were incurred during the prior year, 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.

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.

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Restructuring and other strategic initiatives during Fiscal 2022 related primarily to our ongoing European reorganization, including $2.5 million of labor, severance and other costs related to relocating certain production activities within Europe during Fiscal 2022, in addition to severance costs of $2.4 million during the year related to relocation and integration of certain support functions into our regional shared service center. We also incurred $3.5 million of costs during Fiscal 2022 in relation to the suspension of our operations in Russia, which included severance costs of $0.7 million, an impairment of inventories of $1.1 million (recognized in cost of sales), and an impairment of fixed and other assets of $1.1 million (recognized in asset impairments). Other restructuring costs incurred during the period related to facility relocations and other legal and consulting costs.

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 (recognized in asset impairments). 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.

Other operating expense (income)

Other operating expense of $0.2 million was recognized during Fiscal 2022, as compared to the other operating income of $9.3 million recognized in the prior year, which related primarily to a net gain on the sale of a purchase option on a building that we lease in Europe.

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 2022 increased by $2.1 million when compared to the prior year primarily due to higher interest rates on the Existing Dollar Term Loans and the issuance of the New Dollar Term Loans in November 2022, partially offset by the impact of derivatives. In addition, interest expense on other loans increased by $1.0 million during Fiscal 2022 due to drawings on the Asset-backed revolver in March 2022, which was paid off during the year. These increases were largely offset by the decrease from interest expense on the Euro Term Loan, due to a combination of the Euro debt payoff on November 16, 2022 and favorable movements in average currency exchange rates.

Amortization of deferred issuance costs increased during Fiscal 2022 primarily due to the accelerated amortization of $2.2 million incurred in Fiscal 2022 due to the repayment of Euro Term Loan on November 16, 2022.

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Other (income) expense

Other income for Fiscal 2022 was $13.2 million, compared to an expense of $0.9 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, partially offset by higher fees incurred in relation to our trade accounts receivable factoring program due to a higher discount rate.

Income tax expense (benefit)

For Fiscal 2022, we had an income tax expense of $14.9 million on pre-tax income of $257.8 million, which resulted in an effective tax rate of 5.8% compared to 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% for Fiscal 2021.

The effective tax rate for Fiscal 2022 was driven primarily by tax benefits of $26.4 million for unrecognized tax benefits due to lapsed statute of limitations, and $15.3 million for the partial release of valuation allowance on deferred tax assets for U.S. foreign tax credits. In addition, we had net $7.6 million of tax expense primarily on earnings from international operations.

The effective tax rate for Fiscal 2021 was driven primarily by tax benefits of $26.4 million related to the partial release of valuation allowance 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 on deferred tax rate changes.

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 2022 that it was more likely than not that deferred income tax assets in the U.S. related to foreign tax credits totaling $15.3 million are realizable as a result of changes in estimates of taxable profits against which these credits can be utilized. In Fiscal 2021 we determined 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.

Adjusted EBITDA

Adjusted EBITDA for Fiscal 2022 was $680.6 million, compared to $735.8 million in the prior year, a decrease of 7.5% or $55.2 million. The Adjusted EBITDA margin was 19.1% for Fiscal 2022, a 210 basis point decline from the prior year. The decrease in Adjusted EBITDA was driven primarily by the decrease in gross profit of $88.6 million, which was largely the result of higher inflation and lower absorption of fixed costs as described above.

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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 (61.2% of Gates’ net sales for the year ended December 31, 2022)

Net sales in Power Transmission for Fiscal 2022 decreased by 1.9%, or $42.6 million, compared to the prior year. Excluding the adverse impact of movements in average currency exchange rates of $149.2 million, core sales increased by 4.8%, or $106.6 million, compared to the prior year, driven primarily by a $208.4 million benefit from favorable pricing, partially offset by the impact of lower volumes.

Power Transmission’s core sales to industrial customers grew by 6.3% during Fiscal 2022, compared to the prior year periods. Industrial growth during Fiscal 2022 was focused in the diversified industrial, personal mobility, and off-highway end markets, which together grew by 11.2%, compared to the prior year period, primarily in North America and EMEA. Sales to the on-highway end market declined by 2.7% during Fiscal 2022, compared to the prior year period, primarily from Greater China, partially offset by slight growth in all other regions. Automotive sales grew by 3.8% during Fiscal 2022, compared to the prior year periods, driven by strong growth in automotive first-fit sales in North America and East Asia during Fiscal 2022. Sales to the industrial replacement channel also increased by 7.3% during Fiscal 2022, primarily from EMEA, South America and Greater China.

Power Transmission Adjusted EBITDA for Fiscal 2022 decreased by 19.3% or $96.6 million compared to the prior year, driven primarily by a combination of higher inflation, operating inefficiencies related to raw material challenges, and lower volumes, partially offset by the benefit from favorable pricing of $208.4 million. As a result, the Adjusted EBITDA margin for Fiscal 2022 was 18.6%, a 400 basis point decline from the prior year.

Fluid Power (38.8% of Gates’ net sales for the year ended December 31, 2022)

Net sales in Fluid Power for Fiscal 2022 increased by 9.7%, or $122.4 million, compared to the prior year. Excluding the adverse impact of movements in average currency exchange rates of $35.9 million, core sales increased by 12.6%, or $158.3 million, compared to the prior year, driven primarily by a $154.7 million benefit from favorable pricing.

Fluid Power’s core sales growth in Fiscal 2022 was driven by increased sales to both industrial and automotive customers. Sales to industrial channels increased by 11.5%, while automotive channels grew by 16.7%, respectively, compared to the prior year period. Industrial sales to all end markets increased, but was primarily driven by sales to the off-highway and energy and resources end markets, particularly in North America and EMEA, partially offset by declines in Greater China and East Asia & India. Automotive replacement sales also grew by 16.8% during Fiscal 2022, primarily in North America.

Fluid Power Adjusted EBITDA for Fiscal 2022 increased by 17.6%, or $41.4 million compared to the prior year, driven primarily by the benefit from favorable pricing. As a result, the Adjusted EBITDA margin was 20.0%, a 130 basis point improvement from the prior year.

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Liquidity and Capital Resources

Treasury Responsibilities and Philosophy

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

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

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

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

Cash Flow

Year ended December 31, 2022 compared to the year ended January 1, 2022

Cash provided by operating activities was $265.8 million during Fiscal 2022 compared to cash provided by operating activities of $382.4 million during the prior year period, driven primarily by lower operating performance during the current year, an increase of $34.8 million in taxes paid, an increase of $27.2 million in trade working capital movement, and higher bonus payments. These decreases in operating cash flows are partially offset by higher value-added tax recoveries than in the prior year.

Net cash used in investing activities during Fiscal 2022 was $90.7 million, compared to $86.0 million in the prior year period.

Net cash used in financing activities was $253.1 million during Fiscal 2022, compared to $148.6 million in the prior year period. This higher cash outflow was driven primarily by the $175.9 million paid to acquire shares under our share repurchase program, including shares repurchased through an intermediary from Blackstone as further described in Note 19 to the consolidated financial statements included elsewhere in this report, and higher debt issuance cost paid as a result of refinancing the Euro Term loan in November 2022. This higher cash outflow was partially offset by lower net payments on debt of $31.9 million, compared to $91.0 million in the prior year period, which included a $69.5 million repayment against our Euro Term Loan.

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Indebtedness

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

We refer to the term loans denominated in U.S. dollars as the “Dollar Term Loans” and the term loan denominated in Euros as the “Euro Term Loan”. Details of our long-term debt are presented in Note 15 to the consolidated financial statements included elsewhere in this annual report.

Debt drawings and redemptions

On November 16, 2022, we issued a new tranche of $575.0 million of dollar-denominated term loans (“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 plus €1.0 million accrued interest. The New Dollar Term Loans have substantially similar terms as the then-outstanding Dollar Term Loans (the “Existing Dollar Term Loans”), except bearing interest at the borrower’s option at either Term SOFR (as defined in the credit agreement) plus 3.50% margin per annum, subject to a 0.50% per annum Term SOFR floor, or at the base rate plus 2.50% per annum, subject to a 1.50% per annum base rate floor. The New Dollar Term Loans require 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 Loan 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 19 to the consolidated financial statements included elsewhere in this annual report. As of December 31, 2022, we have paid down the borrowings on the asset-backed revolver and have no remaining outstanding balance.

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 financing costs (recognized in interest expense).

Dollar Term Loan credit agreement amendments

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.

During the third quarter of 2021, as a consequence of the amendments described above, the margin on the Existing Dollar Term Loans was reduced by 0.25% as the consolidated total net leverage ratio (as defined in the credit agreement) dropped below 3.75 times.

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On February 24, 2021, we made amendments to the credit agreement governing the our term loan facilities, including extending its maturity date from March 31, 2024 to March 31, 2027, reducing the interest rate floor applicable to the Existing Dollar Term Loans from 1.00% to 0.75% and modifying the applicable interest rate margin for the Existing Dollar Term Loans 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 are being amortized to interest expense over the new remaining term of the Existing Dollar Term Loans using the effective interest method.

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 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 December 31, 2022, before intercompany eliminations, our non-guarantor subsidiaries represented approximately 72% of our net sales and 69% of our EBITDA as defined in the financial covenants attaching to the senior secured credit facilities. As of December 31, 2022, before intercompany eliminations, our non-guarantor subsidiaries represented approximately 62% of our total assets and approximately 25% of our total liabilities.

Net Debt

Net Debt is a non-GAAP measure representing the principal amount of our debt less the carrying amount of cash and cash equivalents. During Fiscal 2022, our Net Debt decreased by $8.0 million from $1,921.0 million as of January 1, 2022 to $1,913.0 million as of December 31, 2022. Net Debt was impacted favorably by $54.3 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. The favorable movement in currency exchange rate resulted in a lower U.S. dollar equivalent balance of our Euro Term Loan facility refinanced and replaced by the New Dollar Term Loan in November 2022. Excluding this impact, Net Debt increased by $46.3 million, which was driven primarily by $175.9 million paid to acquire shares under our share repurchase program, plus capital expenditures of $87.0 million, dividends paid to non-controlling interests of $28.7 million, and $23.3 million debt origination and issuance costs of incurred in respect of the New Dollar Term loans drawn in November 2022, partially offset by cash provided by operating activities of $265.8 million.

Borrowing Headroom

As of December 31, 2022, our asset-backed revolving credit facility had a borrowing base of $214.7 million, being the maximum amount we can draw down based on the current value of the secured assets. As of December 31, 2022, there were letters of credit outstanding against the facility amounting to $25.8 million. We also have a secured revolving credit facility that provides for multi-currency revolving loans up to an aggregate principal amount of $250.0 million, with no amounts drawn as of December 31, 2022.

In total, our committed borrowing headroom was $438.9 million, in addition to cash balances of $578.4 million.

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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 December 31, 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 $79.5 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 December 31, 2022.

(2)    Post-retirement benefit obligations represent our expected cash contributions to defined benefit pension and other post-retirement benefit plans in 2023. 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.

(3)    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.

Cash Balances

As of December 31, 2022, our total cash and cash equivalents were $578.4 million, compared to $658.2 million as of January 1, 2022.

Restricted cash was $3.0 million as of December 31, 2022, compared to $2.7 million as of January 1, 2022, including $0.6 million as of December 31, 2022 and $1.0 million as of January 1, 2022, which was held in escrow for insurance purposes. Cash held in our non-wholly owned Asian subsidiaries was $161.3 million and $168.4 million as of December 31, 2022 and January 1, 2022, respectively.

Non-GAAP Measures

EBITDA and Adjusted EBITDA

“EBITDA” is a non-GAAP measure that represents net income or loss from continuing operations 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).

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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 certain of our peer companies. 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;

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

•inventory adjustments related to certain inventories accounted for on the 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. 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, 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.

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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)    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.

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 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 $6.6 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 $117.3 million due to Gates Global LLC and its subsidiaries from indirect parent entities of Gates Global LLC as of December 31, 2022, compared to a payable of $0.9 million as of January 1, 2022, and additional cash and cash equivalents held by the Company and other indirect parents of Gates Global LLC of $6.4 million and $12.7 million as of December 31, 2022 and January 1, 2022, 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 future years were based on region-specific growth or decline assumptions determined by management, taking into account market trends and strategic initiatives. 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 2022 were 10.5% for both reporting units.

For both reporting units, the fair values exceeded the carrying values and no goodwill impairments were therefore recognized during Fiscal 2022.

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 2022 impairment test was 11.5%. As a result of the impairment testing, no impairment was recognized during Fiscal 2022.

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 2022, we determined that it was more likely than not that certain deferred income tax assets in the U.S. totaling $15.3 million were realizable. 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.

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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.