Thank you for standing by. My name is Cheryl, and I will be your conference operator today. At this time, I would like to welcome everyone to the Gates Industrial Corporation Q2 2022 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be question-and-answer session. Thank you. Bill Waelke, Head of Investor Relations. You may begin your conference.

Thank you for joining us this morning on our Second Quarter 2022 Earnings Call. I'll briefly cover our non-GAAP and forward-looking language, before passing the call over to our CEO, Ivo Jurek, who will be followed by Brooks Mallard, our CFO. Before the market opened today, we published our second quarter results. A copy of the release is available on our website at investors.gates.com. Our call this morning 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. Reconciliations of historical non-GAAP financial measures are included in our earnings release and the slide presentation, each of which is available in the Investor Relations section of our website. Please refer now to slide 2 of the presentation, which provides a reminder that our remarks 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 in 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. With that, I'll turn things over to Ivo.

Thank you, Bill. Good morning, everyone, and thank you for joining our call today. I'll begin on slide 3 of the presentation. I'm pleased with our team's performance, which represents solid improvement from the first quarter in a very inconsistent operating environment. Underlying demand trends for our products are constructive across most of our markets, and our backlog continues to grow with our book-to-bill remaining above one. We generated near record quarterly revenue despite the COVID lockdowns in China, the suspension of our business in Russia, and incremental FX headwinds. These results are compared against the best quarter in the company's history in Q2 of last year. Our profitability continued its trajectory of improvement as anticipated. While we have not seen inflation meaningfully abate, the significant pricing actions we have taken are gaining momentum and allowing us to be in a positive price/cost position. We continue to successfully navigate ever-changing operational dynamics. Raw material availability has improved. However, we continue to face inconsistent supply of certain petrochemicals we use across key product lines. Although, we have seen some easing in container prices and port congestion, the reliability of intra-region freight and logistics is still spotty. We are comfortable with managing through these external challenges, and have a number of initiatives underway to mitigate the impact of these issues as the year progresses. With respect to our business in China, exiting June, we began to see a recovery from the significant impact of the COVID lockdowns. However, we expect it will take additional time for our customers and the local supply base to ramp up their operations towards more normal levels. We anticipate this recovery will steadily continue but at somewhat slower pace than what we experienced coming out of the initial COVID lockdowns in 2020. Outside of the specific headwinds in China and Russia, we have not seen a degradation of business activity. We are experiencing more significant FX headwinds and anticipate the operating challenges outside of our direct control will persist through the balance of the year beyond our prior expectations. This updated view is reflected in our revised full year outlook. Our business is sound, and our team's solid execution is focused on managing through the present operating environment to meet the end market demand and support our customers' critical needs while delivering the continued sequential revenue growth and margin expansion we expect in the second half of the year. Moving now to slide 4. Our total revenue was $907 million with core growth of 3.6%, offset by a 4.5% FX headwind. Core growth was led by the industrial end markets where our initiatives are focused on capitalizing on secular tailwinds. Our Mobility business delivered another quarter of solid growth as did our Diversified Industrial end markets, where our products that drive efficiency improvements in fixed industrial applications are captured. Rounding out our top-performing end markets were Off-Highway, which benefited from strong growth in agricultural applications; and Energy, driven by increased activity in North America and Middle East. Second quarter adjusted EBITDA was $180 million or a margin of 19.9%, representing sequential improvement of 230 basis points. This improvement was driven primarily by more favorable pricing, offsetting the negative impact from China and Russia as well as operational inefficiencies from challenges associated with raw material availability. Adjusted earnings per share were $0.32 in the quarter, representing sequential growth of 23%, primarily driven by higher operating income. Moving to slide 5, and our segment level results, our Power Transmission segment had revenue of $543 million in the quarter, including a core revenue decline of 2% and negative FX impact of 5%. The segment was impacted disproportionately by its much higher exposure to China and Russia as well as a limited availability of the certain engineered compounds used in products of this segment. Looking at the segment in total, our Mobility business saw the strongest growth, followed by the Diversified Industrial end market. As a result of the strong progress we have made with our growth initiatives over the past several years, we are bumping up against some capacity limitations in certain product lines. The targeted investments, we are making to address these limitations are ramping up. And we expect them to come online in the second half of this year. Our Fluid Power segment, had revenue of $364 million in the quarter, including core growth of 14% and negative FX impact of 3%. We saw a solid performance across the board with double-digit core growth in all end markets. Our strongest performance came in, in our Automotive Replacement business, which posted core growth in the low-20s. All of our industrial end markets saw similar growth rates in the low-teens to mid-teens, benefiting from supportive demand across the industrial complex. Our new products also continued to perform well with core growth of over 40%, not all of which is incremental, and includes the replacement of legacy products, but at a more favorable margin. With respect to profitability, our Power Transmission segment was impacted primarily by its exposure to China, Russia and raw material shortages. Despite the difficult operating environment and inefficiencies associated with the ramp up of targeted capacity in support of our growth, the segment saw sequential margin expansion of 130 basis points. Our Fluid Power segment generated strong margins in the quarter with much less exposure to China and Russia as well as fewer material availability challenges. It converted its higher revenue growth into sequential and year-over-year margin expansion of 390 and 110 basis points, respectively. In both segments, we manage pricing actions across all regions and channels in response to the significant inflation we experience. We expect the pricing momentum to continue and contribute to further sequential margin expansion in the second half. I'll now turn the call over to Brooks, for additional color on our results. Brooks?

Thank you, Ivo. Moving now to slide 6 and the regional breakdown of our core revenue performance, overall core growth was 3.6%, despite the headwinds from China COVID lockdowns, Russia and continued material supply challenges. Improved pricing performance in every region and execution on our growth initiatives in the Americas and EMEA were the primary drivers of our revenue growth. In North America, core revenue growth represented substantial acceleration from Q1. The growth was broad-based, with double-digit growth in all end markets compared to the prior year. Our Mobility, Energy and Off-Highway end markets had the highest growth rates, all in the mid-teens to 20% range. From a channel perspective, we saw the largest growth in sales to OEM customers. Though order rates remain strong, supply chain headwinds did prevent backlog reduction and additional sales volume in Q2. Our core growth in EMEA was 0.4% with a strong pricing performance offset by significant revenue headwinds from Russia and specific petroleum-based material shortages. We had double-digit core growth in nearly all industrial end markets, led by Diversified Industrial, Mobility and Off-Highway, which more than offset a modest decline in automotive first-fit. Excluding Russia, growth was also balanced across the first-fit and replacement channels. As we communicated on our last earnings call, it was a difficult operating environment in the second quarter for our business in China as a result of the strict COVID lockdowns. The lockdowns which overall created dislocation in both demand and the supply chain resulted in a core revenue decline of 31%. One of our production facilities in Shanghai was completely shut down for approximately six weeks, while others in the surrounding areas were impacted by the severely reduced movement of materials and finished goods. As the COVID lockdowns began to ease in June, our business slowly started to recover. The recovery continued in July. And while we expect it to steadily improve, it will likely happen at a rate below what we previously anticipated. Finally, our businesses in South America and East Asia and India had varied performance in the quarter. South America had another strong quarter with core growth of 18%. We saw good performance across all end markets, led by On-Highway, Off-Highway and Diversified Industrial. In East Asia and India, demand remains steady, and we saw solid growth in our Auto Replacement business and in the On-Highway end market. Given the specific regional challenges, we're pleased with our performance overall. The regional dynamics remain fluid, and we were focused on maximizing our operational flexibility to meet the end market demand. Moving now to slide 7 and some details on key balance sheet and cash flow items. Our LTM free cash flow of $108 million was impacted by higher investment in working capital, primarily inventory, to mitigate the impact of supply chain and logistics reliability challenges. We're also being negatively impacted by higher cash taxes and temporary delays in collecting certain VAT receivables, partially due to changes in the regulatory environment. We expect all of these items to normalize and improve cash flow in the second half of 2022. Our net leverage at the end of the quarter was 3.3 times, compared to 3.2 times at the end of Q1. The slight increase was driven primarily by lower LTM free cash flow and adjusted EBITDA. We had a solid 18.1% return on invested capital with a year-over-year decrease driven primarily by lower LTM operating income. Moving now to slide 8 and our full year guidance. We are increasing the bottom end of the range of our core revenue outlook. The demand environment continues to be constructive, and we have additional capacity coming online to support growth in key end markets. We are updating our outlook to reflect the impact of FX and a slower rate of improvement in China, as well as material availability and logistics challenges that we now expect to continue for the remainder of the year. A lower overall tax rate and minority interest are expected to partially offset these impacts. We are reducing our 2022 full year adjusted EBITDA guidance range to $705 million to $755 million, and our full year adjusted earnings per share range to $1.15 to $1.25 per share. For the second half, we expect more muted seasonality between Q3 and Q4, with the quarters looking similar in terms of overall sales and margins. We expect margins to continue to improve sequentially in the back half of the year as additional pricing and sales volumes materialize, resulting in a second half adjusted EBITDA margin in the range of 100 to 175 basis points higher than Q2. With respect to free cash flow, we expect improved profitability and reduced investment in inventory to drive good cash flow generation in the second half. However, we anticipate exiting the year with elevated levels of inventory to minimize further disruptions from material availability and supply chain challenges. As a result, we have updated our guidance accordingly. We are pleased with the progress we made with pricing to address the impact of inflation and although mindful of the potential for higher energy costs, believe we are still on track to achieve price cost, margin neutrality by the end of the year. With that, I will turn it back over to Ivo for some final thoughts.

Thanks, Brooks. Moving now to the summary on slide 9 and a few key takeaways. I would like to wrap up by recognizing the determination and perseverance of our Gates associates around the world whose efforts drove our solid performance under highly challenging macro conditions. While we expect the operating environment to remain volatile in the near-term due to geopolitical events, inflation and poor reliability of supply chain globally, we have a strong management team in place to navigate in an uncertain market. Our business model is resilient and focused on delivering mission critical, highly engineered solutions to our customers. Throughout the past several years, we stayed committed to investing in innovation and our growth initiatives, which are contributing to the strong order flow we are seeing. We expect our pricing momentum to continue and anticipate benefiting from the targeted capacity we are in process of ramping up. Whatever volatility we experience in the coming quarters, we are confident we are well-positioned to take advantage of fast-growing market opportunities for our advanced products and solutions and deliver on our mid-term growth strategy. With that, I will now turn the call back over to the operator to begin the Q&A.

The first question is from Jerry Revich of Goldman Sachs. Please go ahead. Your line is open.

Yes, hi. Good morning, everyone.

Good morning, Jerry.

Good morning, Jerry.

I'm wondering if you could just put a finer point on how the year-over-year cadence is tracking for your business in China. I know you mentioned it's below your prior expectations, and it's rising sequentially. What about year-over-year? And what does your guidance assumes the fourth quarter exit rate for the lines of business in China? Thanks.

Yes. So, Jerry as we have indicated, China was pretty tough right down mid-30s, a little worse than what we anticipated. When we entered the quarter, we anticipate that we'll see maybe a month of shutdown in Shanghai and then things start reopening. Clearly, that did not occur. Shanghai was shutdown nearly through the month of June, significantly impacting the business activities there and across China as well. However, we did exit Q2 in a much better cadence than what we have experienced in April, May and June. So it was progressively better. And clearly, July has come in significantly better as well than June. So we have seen the progressive recovery, a really nice progressive recovery. But we just are being realistic that we don't feel that it will be as sharp of a snapback as what we have seen in 2020 when China just snapped back very, very sharply. So from our perspective, we anticipate that we will be probably somewhere in the high single-digits down in Q3 and kind of low single-digit to flattish exiting Q4 in China.

Got it. Appreciate the color. And then given that dynamic and all the moving pieces this year, I'm wondering if you expect your fourth quarter EBITDA margins to be the highest of the year, which I think would be different than normal seasonality. But given that production cadence as well as price-cost, it sounds like that might be the case this year. Can you just comment on that, please?

Yeah. Hey, Jerry, this is Brooks. So look, I think that's pretty close. I mean as -- the way we're looking at it, we think we're going to have more muted seasonality. Typically, you do see a little bit of a tick down in Q4. But given the capacity, we've got coming online and the additional pricing that's going to ramp through the year, we think it's going to be more sequentially even. So I would say that's probably correct. Pretty close to Q3, if not maybe a little bit slightly up as we exit the year. And when you compare to how we exited the year in 2021, right, in significantly better shape, price, cost, repair basically done and then now just getting after repairing the margin impact of some of these supply chain challenges and things like that. So we feel pretty good about where we're going to be when we exit the year.

Great. Appreciate it. Thanks.

Your next question is from Mike Halloran of Baird. Please go ahead. Your line is open.

Hey. Good morning, everyone.

Good morning.

So kind of working off that last question there then, demand seems fine across most of the verticals. Obviously, you've got some China pressures. You've got some capacity coming on. So at what point do you think you're going to start working your backlog down and start moving towards whatever that more new normal looks like?

Yes, Mike. Look, we've anticipated in our previous guidance that, that's going to start happening, kind of, in Q3. We now believe that we should start seeing backlog coming down kind of towards the end of Q3 into Q4. The incremental capacity that's coming on stream is basically installed, and we are now just ramping that capacity up. We're also working on a number of different alternatives to our -- particularly predominantly Power Transmission supply chain issues and raw material availability issues. And as you can probably appreciate, the conflict in Ukraine and Russia has significantly impacted further the availability of petrochemicals. And so that's something that we are dealing with. And although we are not buying anything from there, the world's capacity, whatever miniscule capacity was available in the front half of the year has completely evaporated and things became even more complex. So -- but we have a line of sight on alternative solutions, and we believe that we should start seeing backlog coming down as we exit 2022.

And then on the demand side, you listened to the commentary and again, excluding the challenges regionally in China and the Russia side of things, it sounds like you're pretty confident in what the current demand trajectory looks like. Maybe just some thoughts by end market as you're thinking about back half of the year into 2023. If there's any sign of cracks emerging somewhere or is there acceleration potential in other parts of the portfolio? Just some puts and takes as you think about your demand.

Yes. So look, obviously, the known challenge is right, China. I'm not going to spend a lot of time on it. We have – excuse me, delineated that issue. Despite the fact that it's very challenging, again, it is getting progressively better. Europe is impacted predominantly for us presently through the loss of revenue that we have had in Russia. But all the industrial markets seem to be in a reasonably good shape. That being said, we are being cognizant of the fact that everybody is being nervous. The situation with the supply of gas for industrial activities in Europe is something that we are thinking through and any potential impact either on supply or on demand. But so far, Europe is in a good shape. North America is very robust for us as the numbers indicated coming out of Q2, and we have a significant amount of opportunities to be able to maintain a reasonably good trajectory of growth in North America. We still -- I can tell you, I'm still receiving more calls about supply availability than anything else, even as we speak. And I would say that an incredible strength we see in Mobility and still, Diversified Industrial. Those two end markets are real standouts for us. And both on the Mobility side, not only is our backlog growing, frankly, quite exponentially, but we see an incredible amount of design win activities. So yes, we are very cautious about what's ahead. And I think that we try to balance the caution in our prepared remarks, but we also are balancing that with a reasonably good situation that we see still with present level of demand for our product.

Thanks Ivo. Appreciate it.

Your next question is from Josh Pokrzywinski from Morgan Stanley. Please go ahead. Your line is open.

Hi good morning guys.

Good morning, Josh.

Ivo, on the -- some of these temporary costs that are kind of getting in the way, things like expedited freight. If you were to add up all of those, what do you think the impact is now? And then how do you see those progressing over the next kind of several months, quarters, whatever time frame you have visibility over?

So here's the way I would frame it. So the cost I would say, are multiple, right? There's the freight cost. There's the cost of having your factory in place and ready to go, but the material doesn't get there, so you have these operating variances and things like that. And so, the way that I'll frame it up is as we progress through the year and we get to the end of the year and you can kind of see where our margins are going, you can do the math yourself and you look at how we exit the year. When we think about getting back to where we want to be from a margin perspective in the short term, right, we've got a medium-term goal of 24%. But first, you have got to get to 22% and then 23%. When you think about the difference, kind of how we exit the year and where we want to get to, it's primarily those operating variances. And then on top of that, kind of the additional missed volume by not being able to get that product out the door. So, as we exit the year, price/cost in very good shape and then we've just got to get back to those other couple of pieces, and we'll be back where we want to be from a margin perspective.

Got it. And then in terms of kind of the broader ecosystem that you guys are operating in with some of your OEM customers -- and doesn't just have to be auto OEM. But I'm guessing that you guys are not the ones kind of holding up the process. Any sense for what their inventory of your stuff would look like, or if they're giving you any information about kind of where some of the bottlenecks are? I guess, the point here being, if those guys do start to see a slowdown, are they sitting on more of your inventory and maybe there's a bit more risk there? I don't know if that's imminent, but just trying to gauge where you guys are fitting in that production schedule?

Yes. Josh, I can tell you with certainty, maybe that's the only certainty that I have today, that we actually – that our OEM customers across the spectrum from automotive through every industrial customer that we service have no inventory of our products. If you wanted to buy several of our commodities today, frankly, it would take you a very long time to get them. And there are cases where we are actually holding our customers up with their ability to finish their products. I mean our demand across a good amount of our portfolio is very solid, but we're also balancing the issues that I have described in my opening remarks, associated with the availability of a couple of these resins, the highly engineered compounds that we use in numerous applications, particularly in Power Transmission. But there are also some Fluid Power product lines, particularly in engine cooling and battery cooling, that we are not as current as we would like to be. So we're doing everything that we can to support our customers' most critical needs. But I would say that presently, inventory across the OEMs is not an issue that I'm worried about at all.

Got it, very helpful. Appreciate it.

Your next question is from Jeff Hammond of KeyBanc. Please go ahead. Your line is open.

Hey, good morning, guys.

Good morning, Jeff.

Just wanted to try to spike out a little bit this $50 million EBITDA reduction, it's -- core growth is unchanged. But just how much is FX impact? How much is either price/cost taking longer, expedited freight, supply chain? And I don't know if there's a mix dynamic around China versus the offsets to the slower China?

So look, it's about 40% FX and the rest of it is the combination of supply chain challenges, slower improvement in China and the other things that Ivo has talked about. So about 60% of it is operational. All the different things we talked about, about 40% of it is FX.

Okay, helpfu. And then just back to Josh's question around just -- are you seeing any share shifts around having availability or all your competitors are kind of in the same boat?

Right now, Jeff, I would say that the industry is in a reasonably same shape. Our Fluid Power, obviously, segment is performing extremely well. And we do have some availability across Fluid Power, just not in some of the secularly attractive lines that we are facing some constraints. So I think, it's predominantly Power Transmission. I think everybody is struggling there, but we feel very confident about our ability, to not only maintain but to expand our market share, particularly as our capacity will come online. I would note, Jeff, that the amount of designing activity that we see across both of the segments is very, very strong, maybe stronger than we have seen in a couple of years. So we feel pretty good about, what the future holds not ignoring the facts about the uncertainty from the macroeconomics.

Okay. Perfect. Thanks, Ivo

Thank you.

Your next question is from Julian Mitchell of Barclays. Please go ahead. Your line is open.

Hi. Good morning. Thank you. I just wanted to focus on the organic sales guide. So, I think you did about 4% growth in the first half and in the second quarter. Just wondered, in Q2, how much of that 4% was price? And then the second half, you're saying will grow sort of low double digit organically. Maybe help us understand sort of the price versus volume within that, please?

Yes. So look, our price was a little north of 10% in Q2. And then we had all the headwinds that were really driving the offset of that, which was the volume piece. You had the China lockdown, you had the full-on Russia impact and then you have the supply chain issues that we talked about, which really impacted us. And then that was offset by some more -- some actual secular organic growth that we had. So I mean, that's really the number, if you took the total core growth and took the 10% -- a little bit over 10% off of it that would give you the volume piece. And all those headwinds, that we talked about more than outstripped that volume piece that we talked about.

And then -- sorry, in the second half, you've got low double-digit core growth guide. So is that kind of 10 points of price and then two points of volume, something like that?

No, we don't have as much price in the second half, as we did with the first half. So I would say it's certainly less than that.

Okay. But there's some volume growth dialed into the second half organic growth guide.

Yes, there is. I mean, there's some small fees, remember, right? We've got backlog reduction, and then we've got -- you kind of got normal seasonality and then you got the year-over-year impact that you're going to get from Russia and things like that. So you kind of add all that up, and we have a little bit of volume growth and then most of it being price -- maybe kind of actually -- probably maybe more flattish on volume, flattish to a little bit up.

Okay and thank you. And then just my second question around the free cash flow. So it sounds like the inventories are going to stay high through year-end. But I think you need, I don't know, something like $350 million of free cash flow in the second half, after minus $120 million in the first. So I don't think the earnings is having a huge step-up half-on-half. So just trying to understand, that swing in free cash flow of $500 million or something, where is it coming from, if it isn't inventory liquidation? And when you do liquidate inventory, does that carry a big sort of -- normally, when companies bring down inventory dramatically, you get a gross margin headwind. Do you think you'll see the same?

No. Well, first of all, I'm not sure that improved -- that profitability comment is 100% correct. We are going to see improved profitability in the second half versus the first half. So there's really four things that are going to drive the improvement in cash flow. And you have to remember that we have a pretty seasonal operating working capital normally through the business, right? So we have a buildup of working capital and then a bleed off of working capital. But there's four things that are going to drive it, right? One is improved profitability. One is the collection of some of these VAT receivables that we had talked about -- that I talked about in my prepared remarks. The normal seasonality on working capital and then the inventory reduction to more normalized levels. And so if you add all those up, that's really how you get there.

Got it. And as the inventory comes down, the fourth lever, you mentioned, does that have any gross margin impact?

No. I think our inventory has been more -- I mean, the inventory reductions we're going to see are going to be more around raw material and how much width we hold in the business and not quite as much on the finished goods side. So, we're not overly concerned about that as we work through the back half of the year. Remember, we still got a lot of past due backlog. And so we're trying to be as efficient as we can in terms of, what we build and how we build it and get it out the door.

Perfect. Thank you, Brooks

Your next question is from David Raso of Evercore ISI. Please go ahead. Your line is open.

Hi. Good morning. Thanks for taking my questions. I apologize, if I missed this. What is the total revenue growth guide for the year? So 7.5% organic, what's the currency now? And what was it, the drag in the guide?

Hold on just a second. Let me grab it here. So for the full year, we're looking at FX kind of in the 3% to 4% range. Yes, headwind.

Okay. Yes, I'm just trying to figure then--

Closer to 4%, actually.

I mean, basically, if it's 3.5% or 4%, it's still sort of, hey, we took out $50 million of revs and took out $50 million of EBITDA. And I guess I'm trying to figure, the second quarter you actually operated pretty well with a lot of the same negative dynamics you're speaking of for second half being in place. So, is it more a function of -- it doesn't get worse in the second half, it's just not allowing you to improve in the second half the way you previously expected? Just to be clear, again, the second quarter, you operated relatively well. Is that all the same? It's nothing getting worse. It's just not allowing you the sequential improvement that you expected.

Yes. No, I think it's right. We're not getting -- I mean if you look at our guide, we're getting better in the second half. We're just not getting as--

I'm talking about the change in the guide, though. Like basically, to take out 50 revs and 50 EBITDA is a pretty dramatic decremental. But the issues that are causing it were in place in 2Q and you actually operated okay.

No, not -- well, yes, but we're getting better -- remember, we're going to see 100 to 175 basis points of incremental margin improvement in the back half versus Q2, okay? So, we are getting better from Q2. Now, what changed from the guide was the China COVID lockdowns are going to be more exacerbated, but probably the bigger issue, definitely the bigger issue is the impact of the raw material shortages and then the supply chain issues on our operating reliability and our operating efficiency. And so that's really what changed from the guide. But let's not lose sight of the fact that we are calling for 100 to 175 bps of profitability improvement over Q2.

Yes. No, I appreciate that. But given you raised the core revenue guide, it still seems like you're getting the material at least enough to raise the guide on organic. It's just costing you more to get it, is that the idea, right, that you -- that's why the decremental is so bad on the revenue change, it's so high?

Yes. Well, I would say that there's a pricing element in there, too, right? And so it's not just the volume piece. So, there's a pricing element in there, too. But yes, it's costing us more to, I think, make it. I think the operational impact of some of these supply chain efficiencies issues are greater than anticipated.

And then when it comes to the additional capacity -- sorry, can you give us a little more color on how much is being added and where? And I know I shouldn't even be asking the question, I guess, does it help at all with the key polymer availability and the cost to produce with the new capacity coming on, or is this more of a -- no, we still need the rest of the supply chain to do their part. But when they can, we'll have incremental capacity to ramp up?

So, there are a couple of things, Dave, about the incremental capacity. First and foremost, it's an incremental capacity that's going to give us an opportunity to fulfill the order flows that we are seeing for particularly Mobility, industrial change about and several of our industrial and automotive specialty pipelines. So, that's where the capacity is coming in. Those specialty pipeline, the last piece is also going to give us an opportunity to ultimately sometimes in the future, be in a position to potentially do some restructuring activities with less efficient operations. So, we're kind of adding two pieces of capacity. One is incremental capacity that's going to give you simply growth and the other one that's going to give you over a longer term an opportunity to produce product more efficiently.

So, very high margin capacity coming on given the type of products that you just discussed, what's coming on stream.

It's an accretive margin capacity that is coming online. Yes. That being said--

And it sounds like -- older inefficient costs. Can you quantify a little bit what the impact might be? Just a sense of -- is this adding an extra 5%, 10% of capacity across the whole company, be it in high-margin products, but your revenue thought process?

I would probably guide it somewhere -- maybe not -- in the 5% plus or minus, that's probably the right number to think about this. Coming back to your original question about the polymer, the issue with the polymer is not something that we manufacture. This is a raw material input that is highly engineered that is in an extreme constrained supply. And so two things are happening. Number one, the price continues to escalate for the polymer, traditional supply and demand type of situation. And two, there's just simply not enough of it around the world, taking into account how much capacity came offline through the conflict in Russia and Ukraine. So, that is an issue that we are trying to address. We have a line of sight of being able to address it. We are doing a couple of things. One, we are qualifying other sources, of course, that we have long-term partnerships with. And two, we're also engineering alternatives around that raw material supply. We believe that we should be in a position to start seeing some level of relief in Q4, particularly through that engineered solution, but we're just not counting -- taking into account everything that's happening in the world, we have not really been able to depend on lots of certainty over the last 12 to 18 months. So, we just want to be realistic about our ability to ramp everything up and be in a situation to take -- be in a position to take advantage of both the incremental capacity on one side and to the solution to that raw material input.

Your next question is from Deane Dray of RBC Capital Markets. Please go ahead. Your line is open.

Thank you. Good morning everyone.

Good morning, Deane.

I just want to follow-up on that where we left off there, and it relates to Josh's question too, where Ivo, you said that you've had some challenges with being able to supply some of the OEs. Is that related to this raw material availability of these resins? And have you just left the OEs in a lurch or are they getting sourcing elsewhere? Is there any market share loss or everyone's in the same boat, can't produce that particular product?

So, Deane, everybody is in the same boat because this is a reasonably common polymer that is used in the products that are impacted. So I think that the OEMs -- they're getting what they need, but they're getting it similarly to kind of what we are getting our raw material. It's just tough to be timely and it's tough to fulfill perhaps all of the demand that they would like to, if they were interested in building a little bit of a buffer. There's just no ability to build any buffer, because the raw material is just simply not available. So I would tell you that we have not -- certainly we have not been notified nor we have seen any loss of market share through an order flow. And I apologize, but I -- kind of the front end of that question escapes me.

No, you addressed that, Ivo. And then second question, for Europe, are you factoring in any risk of energy rationing in any of your manufacturing plants?

Deane, we are pretty forward-looking about our ability to look at alternatives to the energy that we use, particularly in natural gas. So we are putting the contingency plans in place to be able to continue to operate our facilities in a reasonably constrained environment from that energy input. So we feel, okay, about having gas alternatives. But obviously, time will tell how severe it may be, and we have, I think, taken a pragmatic view of what it will do to Europe in the second half.

And just last one for Brooks on guiding to the low end of the previous CapEx range. Is there anything that's been pushed out on particular projects, anything you can share there?

No, nothing has been pushed out or anything like that. It's just a matter of getting projects done and completed.

Deane, I would probably add that similar to your ability to secure raw materials, it is as difficult to secure some components of key capital equipment to be able to complete these projects. So lots of these projects are stretching out. And I would say that it's one of the headaches that you have, if you have been adding capacity presently in this environment is just a level of uncertainty with being able to get some of these critical components. We don't know if you can get variable speed drives or controllers and so on and so forth. So all of that has an impact, not just on your ability to produce products, but also when your ability to produce some of these larger capital projects.

Yes. We've heard a number of companies say exactly that, Ivo. So that's completely understandable that, that also gets reflected in lower CapEx. So I appreciate that color. Thank you.

Your next question is from Andy Kaplowitz of Citigroup. Please go ahead. Your line is open.

Good morning everyone.

Good morning, Andy.

Ivo, could you talk about the resiliency that you expect of Personal Mobility and Diversified Industrials as we know you've been focused on investing in those businesses. Obviously, you told us they've been strong. But do you have any concerns about Personal Mobility's exposure to consumers? And then as you go out into 2023, are these end markets for Gates going to be big enough, where assuming they hold up, they can materially improve the trajectory of Gates' organic growth?

Yes. Look, I mean, I think that Personal Mobility, right, I mean you can take two -- kind of two takes on it line. Consumer gets impacted and then could that impact the business, and our view is that probably not because they are at such an early stage of penetrating those markets with belts that replace chains. And as that -- as the electrification of Personal Mobility scales up, we just see a very robust demand for a decade plus that could represent an opportunity for us to offset maybe some other headwinds that you may have in more challenged economic environment. And the business is starting to get pretty meaningful. Obviously, three years or so, it was less than $20 million and it's going to approach a couple of hundred million dollars in 2022, and it could be bigger if we had a supply. We just, as we discussed, trying to ramp up that supply as soon as we can and the backlog is very robust, particularly on the Mobility and it's quite substantial. So we are very excited about what can happen there. We believe that the similar opportunity exists in industrial chain-to-belt, particularly as folks are much more focused on efficiency in operating industrial assets. We all have to do better reducing CO2 footprint, and that plays -- that bodes well for this initiative, for Gates Corporation for a very, very long time. So, although, I can't clearly be able to tell you what will happen in 2023 vis-à-vis macroeconomics and all of the end market demand, we continue to be focused on executing what is within our control, keep making investments in both new product development, new product launches and capacity expansion in support of this more secularly impacted opportunities for us. And we believe that, that's a great future that lies for us well into the end of this decade.

Very helpful. And then I think you mentioned Auto Replacement in the low 20% growth range, which obviously is still quite strong. So you can talk about what you're seeing in that business? And then, with the understanding that auto first-fit continues to be smaller part of your sales, maybe you could talk about your expectations now given the still pretty difficult auto production environment.

Yes. Look, the Auto Replacement in the 20s that I mentioned was in the Fluid Power segment of our business, Andy. So it's in -- on the engine cooling side, kind of the battery cooling side, the electrification piece that we have spoken about in the past. So that's an area that has gone very, very fast for us. On the automotive first-fit, look, the automotive first-fit, and you know I think that, as you recall, I have been very, very negative on auto first-fit because we just didn't believe that there is an opportunity to recover that quickly from the supply chain shortages. And we remain very cautiously negative. We believe that it will take much more time for the supply chain to heal for the automotive OEMs. They are making calls every day about what vehicles they are going to build, and we don't anticipate a very significant increase in volume growth in the second half of this year. But that being said, they're just not building lots of cars. So what will happen if the economy flips upside down, is there kind of the traditional significant downside to it? I would say that probably not so. I think that you will see maybe more muted impact on the auto OEM side than maybe historically. So it's kind of -- it's a tale of two stories, and we believe that there's not an upside in the second half for auto OEM, and we also believe that it's probably not a dramatic downside even as you extrapolate what potentially the economy may look like in 2023. AR is staying very good. Unfortunately, most of our AR business in -- I mean, most of our business in Russia was AR. So from comps perspective, comps are very difficult when you take into account the Russia situation. But outside of Russia, that business continues to do quite well.

Appreciate the detail.

Your next question is from Nigel Coe of Wolfe Research. Please go ahead. Your line is open.

Thanks. Good morning everyone. So, we've sort of really attacked the second half guide, I guess, we've gone through it in more detail. Just obviously, we're -- I think we're forecasting -- this is a question for Brooks, roughly level sales in dollar terms versus the second quarter. And typically, we see a drop down quite -- quite a significant drop down in the second half of the year. So, I'm guessing China is part of that, but also the -- you talked about shipment backlog. So I don't know if you've given the dollar backlog number, Brooks, but if you could just maybe just give us a little bit of color in terms of where that backlog sits today versus normal levels that would be helpful.

Nigel, the backlog is at all-time high. I will say unfortunately because, as you know, we are a book and ship business, not a backlog business, but the backlog is over $100 million. And just for reference, it's kind of two times what it was during the peak of 2018. So we've built quite a bit of backlog. Lots of the backlog is coming from Personal Mobility and lots of the backlog is coming in from some of the more constrained lines, some of them in hydraulics and some of them in engine cooling. So it's very robust, and I can now tell you that I am looking extremely towards the day that the backlog drops, and I will not look at that as a negative. I'll actually look at this as an incredibly positive situation because we will be more in balance with the underlying market demand.

Yes. And the one thing I'll remind you of too is, we are going to get significant pricing tailwinds in the second half versus the first half as well as all the pricing that we've put in place comes online. So that's going to be a benefit as well.

So, higher dollar price, but lower year-over-year prices because of comps, again. Understand that. And then just a quick one for you, Ivo, on Europe with the potential for gas rationing, and I'm just wondering how are your customers thinking about that or preparing for that? I don't know if there's eventuality or potential. Is there any preproduction going on ahead of that, or is it just a case of let's see what happens? What are you seeing out there?

I wouldn't say it's just a let's see what happens. I think that there is a tremendous amount of anxiety, Nigel. I think that everybody is thinking about, how they will operate, should that eventuality come to fruition, just like what we are doing, right? I mean, we are looking at what optionality we have for our industrial assets. And we do have some optionality in some of the larger plants, and we are enacting on those contingency plans. I just think that the problem that you are facing right now is there’s just simply no capacity. And so, even if you were willing to carry more inventory, it is very difficult to be able to build that inventory up ahead of any potential disruptions. And I wish that I could give you a better answer than that, but I just don't see any buildup. Certainly, I see no buildup in the OEMs, and I do not see buildup in the replacement channels presently.

No, that’s very helpful. Thanks, Ivo.

Your next question is from Jamie Cook of Credit Suisse. Please, go ahead. Your line is open.

Hi. Good morning. Just a quick follow-up. Can you comment on whether the cadence of sales changed throughout the quarter and sort of trends that you're seeing in July? I know you said China -- you commented on China. Some of your peers noted that Europe got better snapback in July. So what you're seeing basically in July? And then just a clarification, just on Julian's question on the cash flow. Can you just -- sorry, where exactly do you expect inventory levels to be as we exit the year? Thanks.

Yes. So, look, China much better. Europe, I mean, we actually had a pretty solid performance in Europe, absent Russia, in second quarter, and we kind of maintain the purview that it's more of a status quo. Nothing is going off the rails. And I cannot also tell you that anything is snapping back because we just didn't see a significant decay. I mean, absent of Russia, I mean, our business in Europe was kind of high single digits in Q2, which is pretty good.

Did that continue into July? Because other people were saying that July -- were mentioning strength in July. So I'm just trying to figure out how the trend is post the quarter.

Yes. Jamie, as I said, I mean, I think that, it's kind of a status quo for us. It remains very positive still. I mean, I think positive, I would say. So no change to trajectory in Europe. Of course, China is changing trajectory. So China is healing. Again, we haven't put lots of back-end recovery in China, but there is potentially a situation out there that China could perform a little bit better than what -- certainly what we anticipate, absent of any additional incremental shutdowns that they could potentially instill. The answer to inventory, we believe we will start eating into our inventory as we exit 2022. Again, we are not baking in any dramatic change in our finished goods inventory, but we start seeing that we will exit at a lower point than we have been operating over the last 18 months. So we are, again, not taking any production offline. We can't do that at this point in time. Demand continues to exceed our ability to supply. But we are balancing what we make, we are balancing the use of more of the WIP that we have on hand and the raw material that we have been able to secure so that net effect is a lower inventory level.

Yes. And just a little bit more color on that. We'll be down year-over-year fairly significantly, but we won't be back to our normal inventory levels. We'll still be carrying elevated levels of inventory over what we normally would.

Okay. Thank you. That’s helpful.

Yes.

There are no further questions at this time. I will now turn the call over to Bill Waelke for closing remarks.

Thank you, everyone, for your time and interest. As always, the team here is available for any follow-up questions or discussion. Otherwise, we look forward to updating you again after the third quarter. Have a good day.

This concludes today's conference call. Thank you for your participation. You may now disconnect.