Gates Industrial Corporation plc (GTES) Q1 2019 Earnings Report, Transcript and Summary

Good afternoon. My name is Chris and I will be your conference operator today. At this time, I would like to welcome everyone to the Gates Industrial Q1 2019 Earnings Call. [Operator Instructions] Thank you. Bill Waelke, Head of Investor Relations, you may begin the conference.

Thanks, Chris and thanks everyone for joining us on our first quarter 2019 earnings call. I will briefly cover our non-GAAP and forward-looking language before passing the call over to Ivo who is here today along with our CFO, David Naemura. After the market closed today, we published our first quarter results. A copy of the release is available on our website at investors.gates.com. Today’s call is being webcast and is accompanied by a slide presentation. On this call, we will refer to certain non-GAAP financial measures that we believe are useful in evaluating our performance. A reconciliation of these non-GAAP financial measures is included in our earnings release and the slide presentation, each of which is available on the Investor Relations section of our website. Please refer now to Slide 2 of the presentation, which provides a reminder that our remarks and answers will include forward-looking statements within the meaning of the Private Securities Litigation Reform Act. These forward-looking statements are subject to risks that could cause actual results to be materially different from those expressed or implied by such forward-looking statements. These risks include among others, matters that we have described in our most recent annual report on Form 10-K and in other filings we make with the SEC. We disclaim any obligation to update these forward-looking statements, which may not be updated until our next quarterly earnings call if at all. With that, I will turn the call over to Ivo.

Thank you, Bill. Good afternoon, everyone and thank you for joining us today. Let me start with a high level summary of the first quarter beginning on Slide 3 of our presentation. Our start to the New Year saw a more challenging environment from a market backdrop and operational perspective than we had expected. We will outline a number of actions we are undertaking to accelerate productivity, reduce cost and improve cash flows as we manage through these challenges in the first half of this year. In the first quarter, we generated total revenue of $805 million, which represents a core growth decline of 2.1% compared to the prior year. Total revenue was down 5.1 – 5.5% over the prior year, which includes unfavorable foreign currency translation of 4.1%, partially offset by 70 basis points contribution from acquisitions. Our revenue performance reflected the continued headwinds in a number of our end markets, which we noted on our fourth quarter earnings call where we also indicated that the first quarter would generate the weakest core growth of the year. Most notably, we saw challenging environment in Europe and China, particularly in automotive first fit with China being slightly better and Europe somewhat worse than we had expected. What we did not anticipate as we entered the new year was the significant replacement channel destocking that we experienced mostly in North America and to a lesser degree in Europe. This represented a shift from a period of constrained supply to replacement channel destocking. We will talk more about the environment by region, but overall, I would say the environment is a bit more mixed. We did see modest industrial core revenue growth in the quarter led by our performance in EMEA and South America, primarily driven by the heavy-duty truck and construction end markets. We also had a solid performance in emerging market replacement channels where we are seeing the benefit of our initiatives to expand our channel presence, and we remain positive on our ability to continue to outperform well into the future as we scale up in these markets. Looking at the regional results in more detail, Europe, as we noted, was softer than expected, while we largely anticipated the significant deceleration affecting our automotive first-fit business in Europe, the planned ramp-down of programs, slower market and lingering WLTP related weakness. Our automotive replacement business also experienced the decline in revenue in the quarter driven primarily by destocking. We believe the challenges facing our business in Europe will persist until late in the second half of this year. In China, our Q1 performance was in line with what we expected. We saw another quarter of double-digit growth in our replacement business, which was primarily driven by the fast-growing automotive replacement channel where we continue to build on our leading product portfolio and are executing our focused commercial initiatives. Our revenue in the industrial end markets declined slightly on a core basis, impacted by the continuing trade uncertainty which affected us most significantly at the export focused manufacturers in the first-fit channel. The challenging automotive first-fit conditions in China continued to negatively impact our business, but less so than what we experienced in Q4 of last year. We believe with our business improving as the quarter progressed that the most difficult conditions in China are likely behind us. Based on the currently improving trends, we expect core revenue growth in mid-single digit for the full year in China, primarily driven by growth in the automotive replacement market and market share gain in industrial applications. This view is not reflective of any potential trade war escalation between the U.S. and China. In North America, our overall performance in the quarter was roughly flat on a core revenue basis. We saw growth in a number of our industrial end markets, which was the result of new products and share gains, but this was offset by a decline in our total replacement business. Although we believe this year’s harsher first quarter weather may have been a modest headwind, our replacement business was meaningfully impacted by channel inventory destocking, negatively affecting our total company core revenue growth by approximately 200 basis points. The visibility we presently have into the replacement channels, particularly in North America, indicates that end user demand for our products remains stable and we expect most of the destocking activities to work through our business in the first half of this year. In response to the market environment, we have taken significant operational actions to realign our production output and our inventory levels with the prevailing business conditions. Turning to earnings, our first quarter adjusted EBITDA of $166 million was below our expectations. At 20.6% of sales, our adjusted EBITDA margin reflects a decline of 100 basis points compared to the prior year Q1. We maintained our positive price cost position in the quarter, but adjusted EBITDA was negatively impacted by significant FX headwind and lower than anticipated volume, which primarily impacted our most profitable region of North America. We anticipate margins will remain temporarily compressed in the second quarter as destocking continues and as we reduce production output to work down inventory levels before we expect to see margins recover in the second half of this year. Based on a slower than anticipated start of the year, we are adjusting our full year guidance. We believe that our second quarter will remain under pressure but we anticipate returning to more typical performance in the second half of the year. We expect the issues we have been facing in Europe and China, in addition to the destocking we have experienced in our largest replacement channels, to abate in the second half. We are also currently lapping an exceptionally strong performance in the first half of 2018 and we will begin to face an easier compare in the second half of the year. Additionally, over the last several quarters, we have introduced a number of new innovations and expect to begin recognizing revenues from these new product introductions later in the year and into the future. All of these factors, we believe, support the second half core revenue growth of roughly 3% to 4% implied in our updated guidance. During our fourth quarter earnings call, we highlighted our organizational readiness to begin implementation of certain business optimization actions. This will be covered in additional detail later in the presentation, but as outlined then, we are beginning the implementation of the structural realignment activities. These actions are anticipated to result in savings of approximately $25 million annually with a total cost to achieve of approximately $40 million primarily incurred over the next 18 months. Implementation will begin this year and reach full run-rate savings in 2021. Despite managing through a more challenging environment overall, we remain fully committed to innovation to refresh our product portfolio and accelerate future growth of our business. Within the quarter, we introduced multiple new products. We introduced a new high-performance synchronous belt for industrial applications, which has the ability to handle high levels of torque in smaller spaces and narrower drives, something directly applicable to our belt-to-belt as well as chain-to-belt growth initiatives. We released a new Choke and Kill hose for the oil and gas market, the design of which allows us to offer customer bespoke lengths and connection types as well as shorter lead times. We also further expanded our PRO series hydraulics portfolio with new lines of hoses and couplings, addressing specific performance requirements across multiple end markets. These products offer customers compelling value and provide us with additional opportunities for growth and richer margins. We anticipate these new product introductions contributing to our second half growth rate. Moving now to segments, beginning with Power Transmission on Slide 4, our Power Transmission segment core revenue declined 3.7% in the quarter while total revenue declined 8.5% as a result of significant FX headwinds. Revenue from industrial end-markets grew high single-digits in the quarter on a core basis led by construction and agriculture end markets, particularly in North America where we had our highest regional growth rate. This growth was offset by a mid single-digit decline in our automotive business associated with the previously highlighted weakness in Europe and China as well as destocking we experienced in replacement channels. With respect to core revenue on channel basis, in the quarter, we experienced a low single-digit decline of our replacement business and mid single-digit decline of our first-fit business. Emerging markets underperformed developed markets due largely to the decline in automotive first-fit business in China. Outside of our automotive first-fit business, our Power Transmission revenue was roughly flat on a core basis compared to the prior year first quarter. Our focused chain-to-belt initiative continues to accelerate and our design wins are growing across a number of end markets with notable wins in personal mobility and light industrial automation. We anticipate this initiative will deliver double-digit revenue growth in 2019 over the prior year revenue base. Our Power Transmission adjusted EBITDA declined by $15 million in the first quarter compared to the prior year period, driven primarily by lower volumes and FX. The resulting adjusted EBITDA margin contracted by 90 basis points compared to the prior year period, also driven by lower volumes and FX headwinds. Going to Slide 5, our Fluid Power segment had modest core revenue growth of 80 basis points, with total revenue declining slightly by 20 basis points compared to the prior year quarter. Solid growth in our oil and gas and general industrial end markets was offset by a decline in our agriculture end market and destocking actions by our channel partners. Core revenue growth in emerging markets significantly outperformed that in developed markets for the segment as a whole. On a regional basis, our strongest core revenue growth was in China, where sales into the construction end market were the main driver. In South America, we saw double-digit core revenue growth in most end markets. China and South America, both, also saw particular strength in the total replacement channel business led by sales into industrial end markets. Our largest region of North America experienced a low single-digit core revenue decline. Growth in General Industrial and oil and gas end markets was offset by a decline in agriculture end market, which was impacted by both destocking and program attrition related to the recent capacity-constrained hydraulics environment. Outside of the agriculture end market, our Fluid Power core revenue in North America increased low single digits. Our Fluid Power adjusted EBITDA declined by $3 million prior to Q1 2018. This decline was primarily associated with the ramp up of our new hydraulic facilities, lower volumes to channel partners and increased investment in commercial and new product development capability. While remain focused on managing our business in this more uncertain environment, we are optimistic about the significant opportunities we see with our current and new customers and the new products we launched over the last several quarters. In addition to our recent customer wins, we have a large pipeline of opportunities that we are pursuing globally. This gives us confidence in our growth potential for the second half of this year and beyond. With that, I’ll now turn it over to David for some additional details on the financials. David?

Thanks, Ivo. I will now cover our financial performance beginning on Slide 6. As Ivo said, revenue in total declined 5.5 points with a negative 4.1 point impact from FX and a positive 70 basis point impact from acquisitions. Excluding these two items, we had a core revenue decline of 2.1% in the quarter. We noted on our last quarter earnings call that we expected Q1 would be our most difficult quarter for core growth and we carried in a tough environment from Q4 against difficult comps. We did experience the headwinds we had anticipated, particularly related to Europe and China, with automotive first-fit being the biggest challenge. As Ivo mentioned, we did, however, also see a more mixed environment with some increased softness in some areas as well as inventory destocking in our replacement channels, particularly in North America and Europe. As a result, revenue for the quarter came in lower than we had anticipated. It is not unprecedented for Q1 to get off to a slow start and we had anticipated the demand rates would accelerate as we progressed through the quarter. We did eventually see some improvement, but this was not until the second half of March and was not as significant as we had anticipated. Our adjusted EBITDA of $166 million was a decrease of $18 million from the prior year quarter. Our adjusted EBITDA margin was 20.6%, a 100 basis point decrease from the prior year Q1, largely due to gross margin pressure from lower volumes and some inefficiencies in the quarter including adjusting our production and inventory levels. As a result, we did not decrement at the levels we would have expected. We anticipate these challenges persisting through Q2 as we complete the adjustments to our production levels and reduce inventory to align with the customer activity that we are now anticipating for the first half and rest of the year. I will cover this in greater detail in the outlook in a moment. We did maintain positive price cost with our pricing exceeding raw material inflation and direct tariff impacts. This was dollar positive and about gross margin neutral. We anticipate this dynamic to continue through 2019. We grew adjusted net income to $0.28 per share on a diluted basis compared to $0.25 per share in the prior quarter, which was the result of reduced interest expense and a lower effective tax rate more than offsetting the impact of lower adjusted EBITDA and a higher diluted weighted average share count of approximately 295 million. As you see in the results, we had a sizable, favorable onetime tax item in the quarter that we have removed in reporting our adjusted net income and EPS. This item is primarily the result of reversing the valuation allowance of significant net operating loss carry-forwards in Europe that currently have an unlimited life, but that we previously did not have adequate line of sight to utilizing. In Q1, we have completed the implementation of certain operational actions that have the additional benefit of allowing us to begin utilizing these NOLs. Therefore, in accordance with GAAP, we reversed the associated valuation allowance, which is obviously a non-cash item, in the quarter. Slide 7 provides detail on key cash flow items and our focus on continued deleveraging of the business. Trade net working capital as a percentage of revenue grew by 130 basis points due to increases to inventory in the quarter. This inventory increase was primarily the result of the destocking that we experienced in replacement channels, particularly in North America and Europe. We anticipate normalizing our inventory levels during Q2 as we also align our production with current demand levels as previously discussed. Our free cash flow is presented on a last 12 months basis and therefore, reflects the higher CapEx spend on the Fluid Power capacity as well as the increase in working capital associated with our growth. We will talk about our outlook in a moment but we would anticipate these items improving in the second half of 2019 and our conversion percentage moving back towards historical levels as we have discussed previously. On leverage, we ended the quarter with a net leverage ratio of 3.6x, a decline from 3.9x at the end of Q1 of last year. This slight increase in net leverage from Q4 reflects some normal seasonal build in working capital as well as some higher inventory as we discussed. Despite the more challenging start to the year, the cash profile of the business is such that we believe we will still meaningfully de-leverage the business in 2019. Moving to Slide 8, we are providing additional data on the further business optimization actions introduced in the prior quarter’s call. These actions include some rooftop consolidations within our operations footprint, streamlining of some activities as we drive globalization of certain functions and the establishment of certain shared service back office functions. These actions are consistent with how we have discussed our intent to continue to drive efficiency in the company. The increase in plant productivity over the past few years enables us to now consolidate certain parts of the manufacturing footprint. We have also previously discussed driving further productivity through streamlining G&A, and these other actions are aligned with doing that. These actions will begin this year, with the majority occurring in 2020, achieving the full run rate savings in 2021. It will have a total cost of approximately $40 million over 3 years, with savings expected to reach a run rate of $25 million annually in year 3. Further, we anticipate that from a cash flow perspective, we will break even on this investment in right around 2 years. These actions will be in addition to the restructuring spend levels that we have incurred in recent years. Now moving to our outlook on Slide 9, the slower start to the year that we discussed today has resulted in us reducing our annual guidance. Our updated guidance range for 2019 is core revenue growth of 0% to 2% and an adjusted EBITDA range of $740 million to $760 million. We do not provide quarterly guidance, but we’ll say that currently, we see core growth improving a bit in Q2 from what we saw in Q1, but still slightly negative year-over-year. For gross margin, we expect Q2 to be slightly better than what we saw in Q1 on seasonally higher volumes, but well below the prior year as we work through reducing inventory levels to the current business environment and customer activity. We expect both core growth and gross margins to improve in the second half of the year. The revenue compare will get easier from what is a very difficult compare in the first half of the year. Also, revenue will benefit from continued progress on our organic growth initiatives with the impact from the increase in the second half of the year reflecting about 100 basis points of growth in the full year or about 200 basis points in the second half. As for gross margin, we anticipate working through the realignment of our output around the end of Q2. We also anticipate that certain other cost headwinds will ease, enabling sequential gross margin improvements in the second half, more indicative of what we expect from the business. Capital expenditures are expected to be approximately $140 million for the year, and we are maintaining our free cash flow conversion guide of over 80% for 2019. We continue to see our net leverage reaching approximately 3x by the end of 2019 barring any larger M&A, which is not foreseen at this time. With that, I will now turn it back to Ivo. Ivo?

Thanks, David. The first quarter was a more challenging start to the year than previously envisioned and we have adjusted our full year view to reflect this. Our strategy and priorities remain unchanged and we remain fully confident in our ability to achieve our long-term targets. Focused execution continues to be the key priority for 2019. We are taking appropriate short-term and mid-term steps to manage those items under our control in this more challenging environment. Absent additional unfavorable macro developments, our business is set to return to more typical organic growth in second half of the year based on expectation of China returning to growth, Europe stabilizing and the majority of destocking activities taking place in the first half of the year. Our significant focus on new product development to refresh our portfolio with competitive and differentiated products is showing good promise. We have a significant and growing pipeline of opportunities related to these new products we have recently introduced and believe the traction that we are seeing so far will contribute to growth this year and well into the future across all markets we participate in. We will continue to invest in our business in order to position ourselves for long-term growth and expanded profitability while being mindful of the near-term environment. We are also committed to the successful execution of our footprint optimization and other initiatives to make Gates the preferred partner for our customers. Finally, there is an omnipresent focus across our team on cash generation and the progress towards continued de-leveraging and the enhanced strategic optionality it provides for our business. With that, I will now turn the call back over to the operator for Q&A.

[Operator Instructions] Your first question is from Deane Dray with RBC Capital Markets. Your line is open.

Hey, thanks. Good afternoon, everyone.

Hi, Deane.

Hi, Deane.

I just want to make sure I understand how the destocking issue manifests itself in the quarter. Maybe give us too in the context of sell-in and sell-through because I think I heard you say that the end user demand was stable, so the sell-through sounds like that wasn’t the issue. I am not sure if that was a comment specific to Power Transmission or Fluid Power or total, but maybe you can to start there?

Sure. Look first of all, we were a little bit surprised with the de-stocking to be completely honest about what we have experienced. We look at our POS activities with our largest channel partners, particularly in North America, where we have a reasonably good visibility, a better visibility than in other places. And we have been seen frankly maybe even a stronger performance of sales out than we have anticipated entering the year. So when we look at the products selling into the channel, we couldn’t quite reconcile the divergence between the performance at the end customer demand and the sales into those channels. And if you look at it most pronouncedly maybe to the second part of your question, the most pronounced declines in the inventory at the de-stocking was impacting our Power Transmission business and to a degree, Fluid Power business in North America as well.

And then maybe you can share with us the thinking on how the de-stocking runs through and all that has worked through by the second half. And maybe in your answer you can share with us the cadence in the quarter by month and it sounded as though April was still negative, but had trended better. So just how do you extrapolate and say that has all worked through by the second half?

Yes. So again, our assumption, Deane, primarily is focused on the sales out and we continue to see robust activity with sales out of our products from the channel. That would give us an indication that we are probably closer to seeing the end of the channel destocking sometimes in Q2. At some point in time, a normal replenishment cycle needs to start occurring, because the sales are reasonably robust with our products. We have started the year, I would say the first 2 months of the year are all this kind of – they can go either way. January and February don’t necessarily indicate how the quarter may go. We can have a softer January and February and March can be very, very robust. This year, we really didn’t see the robustness to start coming until the third and fourth week of March and it was a little bit too late to see a rebound in our results. And then I would say that April was probably more or less in line with what we have seen in March, the environment we have exited Q1 with. So I think that that’s when Dave indicated that we see a little better performance in Q2 – or we anticipate a little better performance in Q2 in terms of core growth, but we’re still trying to be realistic and we expect that there’s still destocking that’s going to continue throughout the Q2 before we start seeing a more positive sales in, sales out balance.

Thanks for the color.

Thanks, Deane.

Your next question is from Jamie Cook with Credit Suisse. Your line is open.

Hi, good morning. Just a follow-up on the prior question in terms of when you are seeing things improved a little in March, can you comment with that specific to a certain geography or market and was one more pronounced than the other? And then is there any way if you can help us with sort of the amount of excess inventory that you think is in the channel, whether you want to define it by months or however you can define it? And then my last question is I think you commented on price cost in the quarter, but what is your expectation for the remaining part of the year and is price sticking given sort of a softer start to the year? Thank you.

Thanks, Jamie. So, I would say that China got reasonably better in April over March and March was nicely better than January and February. It will be probably the best regional activity. North America got slightly better, but I would say the environment is more in line with March than anything. In terms of how much inventories in the channel, from my vantage point, where I sit, Jamie, to be completely honest with you is I don’t believe that there is a massive amount of inventory in the channel. I can’t really quite speak to why there is such a significant destocking. That’s probably a better question to some of the channel partners out there, but again, I would reiterate that our sales out activity remains reasonably robust and when we kind of consider what level of destocking has been occurring, we felt that we wanted to rebalance our inventory as well just in case that we are not seeing something in there. But I just would not, from where I sit today, Jamie, I would not expect destocking.

Okay. Thank you. And then just, sorry, your expectations on price cost in the remaining part of the year?

Yes, Jamie, it’s Dave. We were – I know that we were positive on a dollar basis in Q1 and we would expect maintaining that for the full-year as we did – similar to what we did last year. We carried in a reasonable amount of price that we’ll continue to anniversary over the course of the year and there’ll be some level of new price. So, as the environment change, that dynamic might change a little bit, but I think we’re pretty well positioned to be generally flat from a price cost perspective. Last year, we were positive and we said that would narrow, and this year we’d be closer to flat and I think that’s what we see today.

Okay. Thank you. I’ll get back into queue.

Thanks.

Your next question is from Andrew Kaplowitz with Citi. Your line is open.

Hi, this is Eitan Buchbinder on for Andy.

Hi.

Good afternoon.

Hi, you previously mentioned the closing of a sub-scale plant in Turkey and you mentioned additional productivity actions that seem to be bigger and faster than expected with adjusted EBITDA decremental of about 40%. Understanding there’s a higher sense of urgency, given the weaker market, what is the decremental you think you could do in the business moving forward?

Well, I think from a – our goal is going to be around 25%. I think it’s hard to do. I don’t think we’re going to be – necessarily be able respond to 25% decrementals kind of quarter in, quarter out. The decrementals kind of that you’re referring to of 40% here reflects some of the inefficiencies of taking out of the destocking and taking out some of our inventory as well. The restructuring actions we’ve referred to are over a 3-year period and really, frankly, aren’t in response to the current environment, but more we’ve been talking about for a period of time and announced last quarter. But having said that, we always have some level of underlying activities relating to adjusting to current business levels and we’ll be doing that as we take out some production shifts to normalize our production output, as well as our inventory levels in light of the environment we see.

Thank you. And as a follow-up, cash flow guidance remained greater than 80% free cash flow conversion. Can you discuss what it needs to get better for cash flow to – for you to meet your target for the year?

Yes, so, we maintain a reasonably high percentage of sales – of working capital as a reasonably high percentage of sales. So, that is a bit of a tailwind as the top-line normalizes a little bit. Having said that it will be about inventory and our focus on getting out inventory is what will help enable us hitting our cash flow objectives for the year.

Thank you.

Your next question is from Jeff Hammond with KeyBanc Capital Markets. Your line is open.

Hey guys.

Hi, Jeff.

Good afternoon. Hey, so just back to destock, I think you maybe quantify, you said sales would have been flat with the destock some maybe $18 million to $20 million. What do you think that number looks like in 2Q?

We think for the full-year, it’s about a point, Jeff. So, call it similar to what we saw in Q1 and we’d see it running its course through the first half.

And how do you think that will split between PT and Fluid Power? It sounded more on the PT side?

I think probably a little more on the PT side. There was some on the Fluid Power side as well.

Okay. And then talking about sell-out, I guess you were surprised by the inventory destock, but as you look at the sell-out run rates, whether it be by geographic basis or an end-market basis, anything surprised you positively or negatively as you went through the quarter?

Look, I mean, my sense, if I just kind of rewind back as we were entering 2019, I would say that the North America sales out remains at very nice level of activity. And I would have anticipated when the destocking starts rolling in that you would have seen some market decay and we haven’t really seen that. So, that was probably more surprising. China is in a reasonably good shape. Europe was doing okay on FP, but we have seen destocking on PT side. I think that you probably have heard some others to comment on that in terms of channel partner performance. So, my sense is that I’m just a little bit surprised at the level of destocking that took place, but we just – we were surprised and we don’t want to be surprised not reacting and entering second half of the year with a little larger inventory position that’s probably prudent. So, we are taking actions to align ourselves to ensure that we can rebound our performance in the second half.

Okay. And then just last one. The new core growth, 0 to 2, I mean, clearly, PT seems a little softer in 1Q, but any biases on the 2 segments around that core growth number? Thanks.

I mean, I would say that we expect FP to remain slightly up. We have a very significant amount of new opportunities, very large pipeline, due to the new products that we have introduced. And we remain very positive about the opportunities that are in the marketplace for us to capitalize on due to these new product introductions. And then we are more neutral on PT.

The one thing I’d add, Jeff, is the compare for PT against the prior year downturn in first-fit in the second half will get quite a bit easier. But other than that, typically, we would expect our FP business to grow at a little faster rate than PT given what we’re seeing in the year.

Thanks a lot, guys.

Thank you.

Your next question is from Jerry Revich with Goldman Sachs. Your line is open.

Yes, hi, good afternoon, everyone. Ivo, I am wondering if you could just say a little bit more about the Power Transmission aftermarket performance? You had an excellent 2018 on an aftermarket basis globally. Looking back at it now, do we think some of that was inventory stocking and so we are just comping up against that now that availabilities are better and global supply chains are better? And so, I guess, how much visibility do we have on comps turning positive in PT aftermarket considering what looked to be some pretty tough comps in ‘18?

A great question, Jerry. Thank you for joining us today. Look, on the PT side, when I take a look at, particularly, North America, let me start with North America and break it down regionally a little bit. North America, the inventory levels have compressed reasonably well to the tune of north of $10 million in Q1 alone, yet our sales outperformance in Q1 was stronger than last year Q1. So, I really don’t exactly comprehend why there was an inventory take-out. Perhaps it might have been related to an inventory positioning by the distribution channel partners in Q4, but I don’t know that for certain. I can tell you that our service levels have also improved in North America nicely in the second half of ‘18. So, maybe our distribution channel partners are more confident that we can fill much faster than we were filling in ‘18 and that gave them a level of confidence that they can take some further inventory positions out. But that’s to a degree, a speculation on my part. When I take a look at the data in North America, where the business is the biggest, I was a little bit surprised, to be honest with you. In Europe, I think in Europe, we’re facing probably a little different set of issues. I generally feel that the environment – the macro-economic environment is a little more negative. In my sense in talking with some of the customers that I’ve talked to is that they are more negative than they were even in Q4, and my sense is that, that probably is driving some of their decision-making. So, that would be probably around the two biggest pieces of our aftermarket business. China was terrific. We have continued to grow north of 20% automotive replacement business so that the thesis there remains intact and we also had a very good performance in AR in Latin America. So, it’s primarily the destocking in North America, which I’m scratching my head about a little bit, and Europe, where I can understand because of the macro-economic environment there.

Okay. Thank you. And then can you just say more about the assumption that Fluid Power organic growth accelerates over the course of the year, because when we look at those markets, supplier availability is now improving, so what’s the risk of destock in those markets, especially, as production rates should be slowing at some point in truck and construction markets in particular?

Yes. I mean, I would say that you’re right, Jerry. But my expectation is that, I think I have said that to the question from Jeff, we have a very significant pipeline to the tune of $150 million to $200 million of new opportunities that we are working on. We are winning a good amount of these opportunities. And my expectation is that in second half, we’re going to start seeing a nice contribution of filling some of these opportunities and ramping those opportunities up with MXT in particular, with our PRO series hydraulics. Customers love the product. It’s highly differentiated. It’s got a great value proposition. So, we are reasonably positive about our opportunity to start contributing through the NPI to the growth in the second half in FP.

And sorry, Ivo, just a clarification. How much of that tailwind from new products back half of ‘19 versus first half of ‘19? Can you just give us a rough sense?

Jerry, we had said in my remarks I believe that we expected 1 full point of growth for the year of core growth from new products, second half over first half. And we would expect the biggest piece of that to be our hydraulics in PRO series MXT.

Okay, thank you.

Thank you.

Your next question is from Julian Mitchell with Barclays. Your line is open.

Hi, good afternoon. This is Jason Makishi on for Julian.

Hi, Jason, how are you?

Doing alright. Thanks for taking my question. Just a small question on how you’re managing the extra capacity given that so much of investment last year was on building out this capacity and how you’re going to sort of manage these costs moving into Q2 in what appears to be sort of a slowing – still a slow volume environment and maybe even in the back half of the year should any of these headwinds persist?

Okay. So, I just want to make sure I understand your question, in my mind, there are kind of 2 questions there. The short-term question about what we are doing short-term to manage some of the headwinds, and the answer to that question to get it out of the way is that, hey, look, we are looking at reducing our output. The destocking has happened across predominantly PT, some with FP in the first quarter and we are realigning our shift patterns and the number of shifts that we work each week to what we have a present visibility on demand while taking into account that the inventory reduction that we have targeted ourselves with. That’s kind of the short-term activity. On the extra capacity that we have brought onstream last year, I want to remind you that, look, we didn’t bring this capacity onstream, because we thought that we’re going to see a significant market rebound in 2018. When we started this project, we were still at the tail-end of the industrial recession. And we strategically decided to put additional capacity in order to be able to have an opportunity to deliver growth, and two, we have targeted ourselves with completely revitalizing our Fluid Power product portfolio, which we have started to do as our most recent announcement demonstrates. And we felt that with these new products that we will bring online, we will require that incremental capacity well into the future. We also didn’t anticipate that we’re going to fill that capacity in year 1 after we bring it online and that’s how this is playing out. And we anticipate that we’ll fill that capacity over a longer period of time. So, I hope that I answer those 2 components of your question and I’m very happy to add anything else that I miss.

No, thank you. Thanks for the detail.

Your next question is from Josh Pokrzywinski with Morgan Stanley. Your line is open.

Hi, good evening. You’ve actually got Sawyer Rice on for Josh.

Hi, Sawyer.

Hi, Sawyer.

Maybe just a couple here from me. First maybe continuing in that vein, just thinking about the potential downside scenario here. How do you guys think about your ability to accelerate some of those potential restructuring if things to do inflect more negative here?

Well, I think we’ll take – you’ll see us take some typical restructuring actions that are a little more short-term and more responsive to the environment. The broader program that we outlined is more structural in nature and that it’s just going to take time. Of course, we’ll try to do it a little bit faster, but I think what you rather see, Sawyer, is us augmenting that with more typical restructuring actions that can be executed in a much shorter timeframe.

Now I would add on that, Sawyer, that make no mistake, we are going to be very pragmatic about what we see in the marketplace. And frankly, we have decided to take more aggressive reduction in output in Q1 to ensure that we position ourselves well for second half of the year.

Got it. And then maybe just moving to more current events here. Obviously, some fluid situation is developing this week around trade, but maybe just help us size potential impact to Gates if we do get tariff escalation in line with what’s been discussed here?

Yes, I’ll go back to what we said last year relative to the tariffs that are in place today. We have talked about kind of $10 million to $15 million direct tariff impact, Sawyer, and that’s what we’re experiencing through Q1. I think you could extrapolate that to a different environment. The bigger issue, frankly, for us would be the business environment in China, which is a very large market for us. And frankly, we’re also seeing that spill over into some of the countries that also sell into China. So, I think – we talked about seeing a little bit of softness with machine builders and exporters and that’s where I think we’d see the broadest impact, but from a direct tariff impact, we’re kind of in that $10 million range now, that can step up. We would take the same approach of trying to price forward. We’d get a partial year impact of that. But because of our – in region, for region, it hasn’t been the bigger number for us versus the few product categories that we import from China.

Got it. And then maybe if I could just squeeze one more in, Europe sounds maybe a bit weaker than expected, it sounds like some pressure in auto that was unforeseen and obviously, some of the destocking. But anything in the non-auto businesses there that have you more cautious heading into the rest of the year? Thanks.

I think that the industrial performance was actually pretty good for us in Europe in Q1. Again, similarly, Sawyer, to what I said about the broader set of opportunities in FP, we see very significant set of opportunities ahead of us with FP in Europe in particular, where we have now put a large-scale Fluid Power plant and we believe that we are very well positioned to be able to execute on the longer-term vision and fulfill the promise of putting that plant in there to take more market share with our highly competitive products in Europe.

Great, thanks.

Thank you.

And this does conclude the Q&A portion of today’s call. I’ll now turn things back over to Bill Waelke for any closing remarks.

Thank you, everyone, for joining the call and for your interest in Gates. We look forward to updating you on our first half progress in August. Have a good evening.

Thank you.

This concludes today’s conference call. You may now disconnect.