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…

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…

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.