Gates Industrial Corporation PLC (GTES) 2021 Q4 法說會逐字稿

Good morning. My name is Chris, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the Gates Q4 2021 Earnings Call. (Operator Instructions) Thank you.

Bill Waelke, Head of Investor Relations, You may begin.

Thank you for joining us this morning on our fourth quarter 2021 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 fourth quarter and full year 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. which may not be updated until our next quarterly earnings call, if at all.

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 with the overview outlined on Slide 3 of the presentation. The fourth quarter marked the conclusion of an excellent year for Gates. Our global teams delivered strong revenue growth, benefiting from solid execution of our strategy to reposition the company's business exposure to higher-growth end markets. The investments we are making in material science, innovation, targeted incremental capacity and our unwavering commitment to service our customers position the company to grow by winning new business while managing demand during these challenging times.

Our proactive approach to pricing, particularly early in the year, enabled us to remain price/cost neutral for the year. We delivered incremental margins of nearly 35% despite the rapid rise in inflation we experienced in the second half of the year. Free cash flow generation was also strong, enabling us to significantly reduce our net leverage from 2020 levels.

In the fourth quarter specifically, the supportive underlying demand and order trends continued in both of our segments. Despite our focused execution, we were not able to satisfy all customer demand. Channel inventories remain relatively lean. Our book to bill in the quarter was well above 1, and our backlog is at record levels. Global order rates are strong with North America, in particular, seeing the highest monthly order rate in the company's history in January. From an operational perspective, we navigated ongoing material and logistics availability issues as well as greater-than-expected COVID disruptions that significantly impacted our production efficiency.

These temporary external challenges notwithstanding, we delivered results in line with the guidance we provided and maintain a supportive market outlook for 2022. While many of the operating environment challenges persist as we work through Q1 2022, we anticipate these issues will start to abate in Q2. While we are taking a pragmatic view of the operating environment, we expect to deliver another strong performance in 2022.

With that, let's move into more of the detail on the quarter's results on Slide 4. Total revenue of $816 million, including core growth of over 3%, put us at the top end of the range we provided. Our teams executed well, in light of the operating environment, and delivered another quarter of growth as compared to a record Q4 2020. From a channel perspective, replacement outperformed our OEM business. Our focused growth initiatives in mobility and recreation and diversified industrial end markets once again delivered the most significant growth, offsetting the decline in sales to other OEMs. Our sales to automotive replacement customers performed well, delivering modest growth on a very strong performance in Q4 2020.

Our fourth quarter adjusted EBITDA was $140 million for an adjusted EBITDA margin of 17.1%. As expected, this included a margin headwind of approximately 200 basis points, specifically related to price/cost, which is being addressed with additional pricing that went into effect early this quarter and will progressively ramp up. Despite incremental operational challenges in the quarter, our profitability was in line with the midpoint of the guidance we provided. Although we expect most of these operational challenges to continue, there are signs that some of the most critical material availability issues are beginning to improve.

Our adjusted earnings per share were $0.31 in the quarter, representing an increase of 55% compared to the prior year period and included some favorable tax items that came through in the quarter.

Moving now to Slide 5 and the highlights in our segments which both saw exceptional core growth in 2021. Our Power Transmission segment had core growth of over 20% for the year, led by high 20s growth in industrial end markets. Additionally, we saw over 90% growth in Mobility & Recreation. The strong industrial end market growth in the quarter offset the decline in automotive OEM. Our long-term strategy to reposition our portfolio of business continues to progress well, beyond key industrial chain-to-belt wins in semiconductor processing equipment, warehouse, automation and robotics.

In Q4, we announced entry into an exclusive strategic relationship with Gogoro, a rising electric scooter manufacturer in Asia. This partner is pioneering a smart, rechargeable battery exchange ecosystem to enable growth in sustainable micro mobility and utilizes the quiet, maintenance-free operation of Gates Carbon Drive belts in its drive system. We also secured an additional key win with a leading electric vehicle manufacturer on a new platform, further reinforcing our solid position as these end markets move towards electrification. Overall, in Power Transmission, our pipeline of opportunities is growing. Conversion and order rates are increasing, and backlog has continued to build.

Our Fluid Power segment saw core growth of 24% in 2021, led by strong performance in diversified industrial and off-highway end markets. In the fourth quarter, our revenue grew approximately 8% year-over-year, led again by diversified industrial end market and included notable acceleration in the energy end market. We continue to build our order book, securing key wins with our new products in stationary hydraulics, forklift and construction applications in particular. We are also making nice progress with respect to innovation and recently launched a further expansion of our differentiated hydraulic product line, opening up additional new market opportunities for the company.

With respect to profitability, we delivered solid margin expansion in both segments for the full year. In the fourth quarter, margins in both segments were impacted by operational challenges I mentioned during my opening remarks. The Power Transmission segment was further impacted by investments we are making in additional production capacity, in support of the book of business our teams are delivering through successful execution on our strategic business growth initiatives.

With that, I will 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. Our diversified and global business delivered strong full year performance, including record revenues in Q4 of 2021. In Europe, we saw over 30% growth in industrial end markets, which more than offset the decline in auto OEM and was led by the diversified industrial and off-highway end markets. Replacement channels continued to perform well with both industrial and automotive end markets delivering solid growth.

Moving to North America, we saw high single-digit growth in the industrial end markets in Q4, led by mobility and recreation, energy and diversified industrial. Our total sales into replacement channels also performed well, offsetting the decline in auto OEM.

China performed broadly in line with our expectations in the quarter. We saw low double-digit growth in our industrial replacement channel, which was offset by first-fit declines, primarily in the construction, automotive and on-highway end markets. Despite the near-term slowdown, we remain bullish on our business in China, particularly the investments we've made in the replacement channels over the past several years.

Finally, our businesses in South America and East Asia and India had varied performance in the quarter. South America saw solid growth across all end markets, led by diversified industrial and ag.

In East Asia and India, strong growth in the industrial end markets was largely offset by the decline in auto OEM.

Moving now to Slide 7 and some details on key balance sheet and cash flow items. We generated strong free cash flow in the quarter with conversion on adjusted net income of approximately 160% and year-over-year growth in LTM free cash flow of over 20%. Our full year free cash flow conversion was negatively impacted by discrete tax items which increased adjusted net income without providing a corresponding cash benefit in the period. Without this effect, our full year free cash flow conversion was above the 80% guidance we provided.

Net leverage improved to 2.6x, well within our targeted midterm range of 2 to 3x, further increasing capital allocation flexibility.

Our return on invested capital remained strong at 22.4%, representing a year-over-year increase of 720 basis points.

Moving now to Slide 8 and our outlook. We are introducing our expectation for the full year core revenue growth in the range of 5% to 9%. We anticipate the majority of our end markets and regions will remain supportive but are taking a measured view and still anticipating some level of continued material and labor constraints through the first half of the year. Our outlook for adjusted EBITDA is between $755 million and $805 million, taking into account the ongoing uncertainty in the operating environment as well as price /cost headwinds in the first half of the year.

On our last earnings call, we mentioned the transition to adjusted earnings per share guidance and accordingly are providing our expectation of $1.20 to $1.30 earnings per share for the year. The midpoint of this guidance reflects a $0.15 operating increase, offset by a $0.27 decrease made up of tax and other, primarily as a result of the discrete tax items in 2021. We expect the first quarter to have the most significant impact from operational inefficiencies with moderate sales growth from Q4 driven by normal seasonality and pricing and modest sequential margin expansion. Since our last call, we have implemented multiple price increases, in line with our current view of inflation and we'll continue to take further pricing actions as necessary. With respect to cash flow, we expect full year CapEx to be in the range of $100 million to $120 million and free cash flow conversion greater than 90%.

With that, I will turn it back over to Ivo for some final thoughts.

Thank you, Brooks. Moving now to the summary on Slide 9 and a few key takeaways. I would like to begin, to wrap up, by thanking our Gates associates around the world whose efforts and perseverance drove our outstanding full year performance. Their commitment and execution during these challenging times was truly remarkable.

Our investments in material science, innovation and our business growth initiatives demonstrated solid progress. We are accelerating the transition of our revenue towards higher-growth end markets, particularly in applications, with clear secular tailwinds. As a result, we delivered solid financial performance and have entered 2022 well positioned to deliver another year of profitable growth and value for all of our stakeholders. With a stronger balance sheet, capital allocation optionality is high as we continue to evaluate opportunities to supplement our growth and return capital to shareholders. Although we anticipate challenges ahead, our business is on a strong footing, and we believe the investments we have made provide a foundation for substantial opportunity moving forward.

With that, I will now turn the call back over to the operator to begin the Q&A.

(Operator Instructions) Our first question is from Deane Dray with RBC Capital Markets.

Congrats on hitting your deleveraging target. I know that was an important milestone for you all on the commitment, so we like seeing that come through.

Thank you.

Just so we're calibrated, you said that you were not able to satisfy all the demand in the fourth quarter. We're hearing that from so many companies. Are you able to size what it was, either dollar amount or percent of organic? And did that all go into backlog? Have there been any cancellations out of backlog, anything meaningful there?

Yes. Thanks, Deane, and it's a great question. Look, I mean, the way that we would size it is that we -- kind of mid-single digit for the quarter was the impact of what we felt we were not able to deliver. And as I said in my prepared remarks, the business remains very strong. Our bookings rate is very strong. January was quite solid. And so while we have been in a mode where demand is being greater than our ability to supply, but I also mentioned that we are making good progress on adding incremental capacity for some of the most constrained products that we have. And we would expect that the capacity is going to be coming online sometimes early in Q2, and we certainly anticipate that we should be getting -- we should start making some progress on eating into the backlog. And as you know, we have book and ship business, so we don't like to have a high -- highly elevated backlog.

Coming back to the question about backlog cancellation, we really have not seen any backlog cancellation at this point in time. And frankly, all the conversations that I am having with the customers are more associated with we would like to get more products, not we are anticipating to cancel our orders. So we're doing everything that is possible. And certainly, our teams globally are performing at a remarkable level, taking into account this environment to satisfy the demand.

That's all good to hear. And just a second question would be on how you are transitioning to include adjusted EPS guidance. As what you said you would do last quarter, you're doing it now here. That's a sign for us, the maturity of the company, visibility. So it begs the question, I don't know, for you, Ivo or Brooks, can you talk about the cadence -- expected cadence of earnings throughout the year, especially just with regard to seasonality? And maybe you can start with comments on the fourth quarter, just puts and takes. You comment about the tax items that are not repeating. That would be a great place to start.

Yes. So let me try to -- there's a few things to unpack there. So let me start with we expect the seasonality, I think, of the business -- we really haven't had normal seasonality for a couple of years in a row, right? You had COVID, then you had last -- and then you had '21. So we expect the seasonality. Normally, we're kind of 51-49, first half versus second half. We expect that to be a little bit more weighted to the second half as we work through some of these external headwinds in the first half. So we do expect it to be maybe more 50-50 or 49-51, first half versus second half of the year.

I think, secondarily, on the -- if you think about some of the one-off items related to tax, we expect that to be much more normalized. In general, when you think about the tax planning we've done and you also think about the improvement in earnings, that's just created some estimate changes and changes in how we look at deferred taxes and valuation allowances. We're hopeful we've got a lot of that behind us so that tax rate is really more normalized in that low 20s, and so you won't see as much noise there.

And then I think the third thing on the cadence. Again, on the profitability side, the first half is going to be tougher as we work through the labor-related or the omicron-related, COVID-related labor issues in the first part of the year as well as getting really fully ramped back up on some of the material issues that we had in Q4. I mean, we're seeing those get a little bit better, but we still have some work to do to get fully -- to get all that material fully into the system and get output from it. So we definitely expect to see the second half a little bit better than the first half or better than the first half from a profitability perspective.

That's really helpful...

Did I answer all your questions?

Yes, you did. Really appreciate it. Look forward to seeing you all on March 8.

Thank you.

Our next question is from Nigel Coe with Wolfe Research.

So I think -- price/cost, I think you mentioned was 200 basis points of dilution to the margin in 4Q. Just wondering how you see that in 1Q. And really, are we seeing peak inflationary pressures right now? Have we seen it? And then just curious as well, how much of the 5% to 9% organic embed price increases?

Well, let me handle the price question first. So what we had said on price/cost for -- if you think about 2021, right, it was a headwind on margins of about 200 bps in Q4 and for the full year of about 50 bps. And we don't really talk about how much of our total volume is price versus -- I mean, our total core growth is price versus volume. We've always been -- we always haven't talked about that, but we talked about more as the margin impact.

If you think about as we move forward into 2022, we certainly expect to be price/cost positive from a dollars perspective. And our goal is definitely to be margin neutral from a price/cost perspective. So I'll leave it to that on -- leave it at that on the price/cost side. And the first part of your question, remind me what that was again.

This price/cost dynamic, 200 basis points of dilution, how does that look in 1Q? And do we get to neutral -- sorry, do we get to neutrality in 2Q?

Well, I think it's kind of back to what I said before, right? Price/cost in the first half of the year will be better than we were in Q4, but then that will ramp into the second half of the year. And that's really part of the profitability question as well. Some of it's going to be the production headwinds that we see in the first half of the year that should abate as we move through, and then some of it's going to be the price/cost dynamic. As we get all the price layered in the first half, we really almost look at price on a quarterly price increase basis as you've seen inflation ramp. And so we feel good about the pricing we've got laid in. Q1 will be the toughest quarter from a price/cost perspective, and it will get sequentially better each quarter as we move through.

Nigel, maybe additional color on pricing. So look, I mean, we've gone -- we've priced several times last year as the inflation ramped up quite significantly, particularly in the Q4. On the last call, we've discussed that we're announcing additional pricing steps. We felt that we wanted to work through with our channel partners to ensure that we don't -- frankly, we don't create chaos in repricing the price book, and so we have that layered in. Pricing is rolling in from the beginning of this quarter, and we will be taking additional steps if needed, but we feel that we are in reasonable shape to be able to deliver price/cost and margin neutrality for 2022.

Great. My follow-on, a quick follow-on is now you're on an EPS guidance basis, the share count matters a bit more. How much of your $200 million buyback do you have dialed into that guidance range?

We haven't -- we don't really consider that. I mean, because we've got so much opportunity with capital allocation that we really haven't dialed anything in so far.

Our next question is from Josh Pokrzywinski with Morgan Stanley.

Brooks, if you don't mind help us out a little bit on the sequentials into 1Q, especially adjusted EBITDA margins. I mean, I think, historically, we can look back, and I don't know if there's necessarily a pure cadence. You mentioned they haven't had a normal year in a while, but they usually look like they're down 4Q to 1Q. How do you see that trending this year?

Well, if you go back to what I said in the opening comments, right, we expect modest profitability as we move from Q4 to Q1 improvement. There's still a lot of uncertainty in the market or in the external operating environment when you think about the omicron impact on our labor availability and being able to get stuff out the door, and so that's why we're being a little bit cautious on how the year is going to start out. We do expect that to moderate as we move through Q1 and into Q2, and we expect to be back to a more normalized production cadence sometime in the first half. And again, we're going to be cautious in terms of getting out over our skis and when that happens because some of it's just unknown. And then we expect in the second half to be significantly better and to be back to more normalized operating cadence. So hopefully, that helps frame it up.

Yes, that's helpful. I must have missed that in the opening remarks as well, so I appreciate that. And then just second question on some of these consumer, kind of recreational verticals that you talked about where you guys have seen some strength, how big is that as a percentage of the business today? It seems like it's been pretty healthy, but what's your visibility like into those channels? Any observations you'd make around kind of inventories or overall kind of customer help there would be useful.

Yes. Thank you, Josh. As we've discussed, this has been a strategic initiative of ours, particularly as you look at that market continuing to evolve very nicely. And we continue to invest not only in product line coverage and expanding our product line coverage to have a full range of applications from kind of the mainstream bikes to our high-end motorcycles getting electrified where our products play really quite nicely with quiet and efficient and reliable belt drives. We believe that we are kind of at the early adoption of these products and the electrification of these, as you said, more consumer-based applications. We believe that it's got a very long trajectory.

I think that during our secondary offering, we have outlined that there's about 100 million bicycle; e-bikes and motorcycles that are built annually, and we anticipate that over a period of time, kind of over the next 8, 9 years, about 30% of that population should get electrified, and that represents a very strong set of opportunities for us, particularly as we have quite a substantial content on these.

And so we are quite excited. It's grown very strongly. It's around 4% of total revenue. So as you well pointed out, Josh, it was nearly 0 in 2017, and it's nearly 4% of revenue in 2021, and so we anticipate that, that is going to continue well into the future.

And look, our teams are executing very well on this initiative. And this is also one of those areas where we have seen a significant constraint of our capacity. So coming back to your inventory question, we really don't have any inventory in the channel. We see people demanding more of our products. And frankly, we are somewhat struggling keeping up with that demand, but we are very well positioned. Incremental capacity is coming on stream, and we are very excited about this opportunity well into the future.

Our next question is from Mike Halloran with Baird.

So on the backlog, just could you help give us some context here? How long is that stretching out at this point versus what does that look like historically? And then as you think about backlog starting to normalize, what level of normalization is embedded in the guidance at this point?

So Mike, a really great question, and I remind everybody, we are not a backlog business. Obviously, we have book and ship business. So any time that you have backlog, it means, frankly, that you're having difficulty keeping up with demand. And the backlog has reached record levels. We've just not been able to meet all of the demand and we're doing everything that is possible to be able to do that.

As Brooks outlined in his comments, we have been hit pretty hard by raw material supply that, frankly, is exacerbating the issues that we are dealing with. So it's really not completely driven by our installed capacity. It's really been exacerbated by polymers, chemical additives, some steel and aluminum from various baselines, and so the backlog has increased by about $70 million in second half of the year. And we've really not embedded a lot of it in our guidance, particularly as we're being reasonably cautious on when we believe we're going to kind of see the breakthrough from our suppliers, their ability to supply to our underlying demand, the raw materials that are required.

And then, frankly, although we believe that the raw material supply situation is getting a little bit better, and we are getting maybe slightly better visibility, the biggest issue that we are dealing with in Q1 is obviously omicron that has been hitting factories quite hard and the level of absenteeism has been pretty tough to overcome.

So in a long-winded way, the backlog is high, very little embedded in our guide of being worked through, and we are very optimistic that things will get a little bit better. And when they do, we will be able to catch up the demand.

Excellent. And I know the first-fit market has some different end market characteristics, but that's a market you highlighted as maybe a little softer but feel optimistic about. What's giving you optimism? And maybe just give an outlook on how you think those markets track as we move forward here.

So we said that the -- our weakness in the OEM market has been particularly driven through the weakness of the automotive OEMs. I'm not going to go into the litany of issues that they are facing. We have been reasonably realistic about that business recovering. We didn't really believe that it's going to recover in second half, and it really didn't, and it got a little bit worse. And what I would say is that we are going back to those automotive OEM accounts as well and telling them we really can't supply you, even at that reduced level of demand, predominantly driven by the polymer supply issues in this highly precision engineered belts that go into that end market.

And so that was a probably more impactful headwind for us in Q4, and we are being reasonably realistic about what we believe is going to happen with the other OEM end market in 2022. We certainly don't believe that it's going to be as rosy as maybe some of those forecasts are coming out, and we are not planning on substantial recovery. So we -- I think that we are being realistic about what's going to happen with the OEM end market.

Now conversely, on the industrial side, we see a good amount of strength. Again, we've discussed a lot of the personal mobility and a good amount of -- obviously of the Hydraulics business is going through the industrial first-fit end market, and that remains quite strong, and our customers are quite bullish, and they certainly believe that they see a prolonged cycle with demand for their products. And ultimately, that filters in demand for our products.

Our next question is from Jerry Revich with Goldman Sachs.

Yes. Could you just -- I'm wondering if you could just expand on cadence conversation that we've had over the course of this call. It looks like we had really good supply in the early part of the 2021. So correct me if I'm wrong, but I believe your comments about omicron imply year-over-year revenue is down year-over-year at the start of the year, Ivo, and then which would certainly imply double-digit organic growth exit rate in the fourth quarter, just the way the makeup of the guidance appears. Is that right? Am I understanding your omicron comments and the comps comments correctly? Can you just talk about the revenue cadence that you're expecting on a year-over-year basis? I know we spoke first half or second half but on a year-over-year basis.

Yes. So if you go back to my comments in the prepared remarks, when I said this was modest profitability, sequential improvement and then moderate top line improvement sequentially as we move from Q4 to Q1. So we were impacted in Q4 by material shortages. At the end of the quarter, omicron started to -- COVID started to be more of an issue. I think as we move through Q1, we think some of the material issues will start to improve, but we still got to work through these COVID-related absenteeism, particularly in North America, where it's moving through our factories and impacting our ability to produce.

As we -- as I said, we expect the first half of the year to be a little bit less than the second half, which is a little bit of a reversal from normal seasonality. Again, just normal importation marks as it's not been a normal kind of 2-year run here.

But really, that's the cadence that we're expecting right now based on what we know. Now if things get better, maybe they get better. If not, we're taking a cautious view. Hopefully, we've got that sized right. But that's really the cadence that we're looking at right now, and that's kind of our best visibility to it at this point in time.

Okay. I appreciate the color. And then, separately, you mentioned the new EV manufacturer win this quarter, Ivo. I'm wondering if you could just talk about since the last Analyst Day, what's been the cadence of new awards versus your expectations. And is it possible to have a similar conversation, sizing the revenue opportunity for you folks for the electric vehicle business, the same way you step through it on the consumer side?

Yes. Absolutely, Jerry. If you bear with us, we'll unveil the -- all of our thoughts, the opportunity, the size of the opportunity on March 8 at the Analyst Day. We certainly view that as a very sizable opportunity for our business. We'll be talking about some of the directional changes that we have been making. I'm actually quite pleased with the amount of design wins and business awards we have been awarded. I mean, I think if you go back maybe throughout 2021, I don't think that a quarter has passed that we haven't gotten a nice new design win or business award in electrification.

So we like our auto business. We have been molding that portfolio around where we believe our technology serves the most to our customers. And we believe that over the midterm and the long term, we have even more substantial opportunity as the electrification takes hold. And we are spending quite a bit of our R&D resources to be not only ready but to maintain our leadership position, particularly in automotive replacement channel. And we certainly believe that, that will be the case as the years pass on and these car fleets get bigger, the electrified car fleets get bigger, and they age and get to a point where we, frankly, like to operate, which is that 7- to 11-year aged car fleet. But more to come during our Analyst/Shareholder Day in early March.

Our next question is from Julian Mitchell with Barclays.

Maybe just wanted to understand a couple of things around sort of inventories and cash conversion. So many industrial companies this earnings season have been telling us that their own inventories are sky-high, but all their customers' inventories are rock-bottom. So just wondered about your perspectives on that and how plausible do you think such a bifurcation really is.

And then when you look at Gates' own inventories, you're guiding for a big step-up in cash flow conversion in 2022, even with CapEx up substantially. So just maybe talk through the cadence around that working capital liquidation over the balance of the year.

Sounds good. Julian, it's a great question. Let me start, and then I'll pass it on to Brooks because this -- I think there's quite a bit to unpack in that question as well. But look, when we assess the inventory levels, particularly as we generally speak, we are focused on the replacement channel. And so as we are looking at the replacement channel inventories, they remain, I'll term it, reasonably lean.

All of our customers want to buy more. I think I said it earlier on the call, Julian, the calls that I'm getting from our customers, from the CEOs, Chief Purchasing Officers are not [held up]. We are worried about the demand. We need more your products since you are preventing us from building our devices. And so we are very much kind of in front and center of helping them to get their products into the marketplace.

So based on kind of the point-of-sale data that we see and that we track very carefully, the indicators are that the inventory levels are not overinflated. Again, I think I addressed the OEM part of it, and so our sense is that we are in a reasonably good shape.

From our side, I would point out that we are trying to secure some of the key raw materials that we can get our hands on, to be honest with you. So whether or not it is the highly engineered compounded resins, that has been a real issue. Some of them have been impacted by the Defense Act that was enacted last year. That's, of course, been removed very late last quarter. So we are seeing a little ease of some of those critical resins and adders to our manufacturing processes easing off.

We have quite a bit of in-transit inventories due to some of the logistics inefficiencies that you see out there, and I would say that that's probably kind of the -- at a high level would we see vis-a-vis inventories in the channel in some of the -- some kind of more global inventory items that we hold. I'll pass it on to Brooks for some additional color as well, though.

Yes. So from a cash conversion perspective, I think we had some headwinds in 2021. Certainly, I think relative to the cash taxes versus the GAAP taxes that we saw, that won't repeat. And then I think on the AR side, clearly, with a lot of the pricing that's going in, you're going to see some higher accounts receivable as you move through the year.

But the real opportunity for us is inventory. We have been highing -- holding higher inventories as we tried to procure certain strategic materials as well as really elevated in-transit materials as transit times of, in many cases, more than doubled. And so not only are you -- do you have more material on the water, but then you're trying to procure more material because you've got more material on the water. So you're trying to get more material in to have on hand because you're not sure about the transit times.

So we think, net-net, we have more of an opportunity with inventory that will help us drive down working capital. From a cost perspective, the payables and the increase in material cost sort of wash out, and then that's how we get to our improved cash conversion number.

And then just my follow-up question on trends in China. Gates has a very good perspective on that market and a large presence. And your sales there, I think, were down mid-teens in Q4, having been down low single digit in Q3. So maybe tell us how you see the first quarter starting out in China year-on-year? And any expectations for the full year, maybe relative to that 6% to 9% from wide core growth guidance?

Yes. I think it's a great point, Julian. Look, let me start with the bigger picture, right? We anticipate in 2022 a growth, a positive core growth in China, and we certainly are maintaining our positive long-term outlook. We anticipate we are being realistic. You are seeing all the news flow that's coming out vis-a-vis omicron and the shutdowns that they have in China. Some of our business is, frankly, consumer business, particularly in the AR channel. People are driving a little bit less. But that being said -- Olympics also not helping out.

But that being said, we anticipate that in 2022, our growth in China is going to go back up to kind of the mid-single-digit level, again, driven by our design wins and activity in Mobility and Diversified Industrials, in particular, in addition, starting to see a little more of the automotive replacement business strengthening again after maybe 2 quarters of uncertainty there in China.

And so we are -- over the long term, we are very bullish on China. We are very bullish with what we have done in terms of building our presence and tapping into some of the growth trends that I have talked about for the company. Those growth trends are associated with opportunities in China as well, and we did see some choppiness in Q4. But for the year, we believe it's going to be more kind of mid-single-digit growth.

Our next question is from David Raso with Evercore.

I'm trying to get a sense in the guide if there's any volume growth baked in. Because when I see the margins is flat, year-over-year implied, but the revenue, up 5% to 7%, maybe a little negative on currency, but call it 6% to 7%. It was -- maybe price/cost is a drag on the margin, but you're saying price/cost is neutral to the margin. So maybe what it is, is most of the revenue is top -- the top line is mostly pricing, and there's no operating leverage. It's solely margin neutral which would explain it. But then I'm trying to think about some of the comments about some supply opportunities getting a little better and so forth. So I'm just trying to figure out, do we have any volume growth built into the guide for this year? And thus, we would think you have a little operating leverage on that better volume?

Yes. So let me start with kind of the financial part of it, and then I'll let Ivo talk about the commercial part of it. Like I said, we've been -- we never really split out between volume and price. There is volume baked into our guide, so I'll say that and leave it at that.

I think on the operating leverage side, what you have to think of is we're still working through some pretty significant issues around omicron and around operating headwinds and things of that nature. And while our target is to be margin neutral on the price/cost side, we've got some work to do to get there.

Having said that, the comps in the first half of the year of 2022 versus 2021 are tough, right? I mean, we had 2 of the best quarters in the company's history in the first part of '21. And so we'll -- as we work through the operating headwinds in the first half of the year and we get to the second half of the year, I think the incrementals and the overall kind of operating margin fall through -- will get better as we progress through the year.

But we've just got to work through these operational headwinds in the first half of the year because they're significant, right? I mean, when you're dealing with this level of absenteeism, that's a cost headwind as well as a production kind of margin headwind, and so we'll work through that. And we'll still deliver solid incrementals, just not what we think our long-term incrementals are going to be, which are still intact. We still think as we work through these price/cost issues and some of these operational headwinds, we're still really confident in our 35% to 40% incrementals.

So David maybe...

but not the incrementals, just making sure, just the -- yes, I appreciate that. Sorry, go ahead.

For all those reasons I listed, right? Price/cost, which, from a margin percentage now, right, so from an EBITDA margin perspective, it's a little bit lower than our normal incrementals, but then also from an operating efficiency headwind, those are things we're going to have to work through in the first half as well.

So David, maybe let me kind of just add a couple more things to what Brooks said, right, and come back to -- look, again, the underlying demand and the order flow activity is very strong. We have been in the moat of demand being significantly greater than our demand. Now when you compound that with the significant material, freight and labor availability issues, we're just being realistic about what we are seeing in Q1. We certainly expect that for the year, volume is going to be up as the first half weakness gets better with -- and some of the incremental capacity investments that I've mentioned start kicking in as well.

So we also, all in, expect that we will be getting healthier operationally from a material and a labor perspective, and we anticipate that we should be in a position to start converting some of the backlog and start catching up to the underlying strength that we see with our orders. But this is probably the most challenging operating environment that I have ever seen, and I'm certainly very proud of how our associates around the globe have been able to step up and support the customers to the best of our abilities.

I appreciate that. My follow-up on the pricing actions that we discussed at length last quarter thing, let's not do it right toward the year-end. Let's start Jan 1, and it will be a bit of a substantial increase. What has been the feedback in the sense of getting that pricing at the timing that you expected and the magnitude when it comes to -- that they're accepting it and obviously if you have any visibility into the point of sale? The -- how the end customers handling it, but particularly the timing of what you expected to get and the magnitude?

Look, I mean, we have done exactly what we said on that call, on the Q3 earnings release. We worked with our channel partners. We've brought in the increases that we have discussed on that call. Look, nobody is scratching their heads and say, "Why are you doing that?" Certainly, a pretty substantial level of inflation that they see across everything that they purchase. We have gone across the globe. We have not touched any region or any customer, and these are ramping through to the quarter. Many of them have been effective January 1.

And we are just -- we are being very realistic about what happens with inflation. And if inflation continues the trajectory that it was on Q4, we will take more price, if needed. Presently, we believe that we have scope inflation and pricing in such a way that we anticipate for the year to be margin not dilutive, but it will be a situation that has to get worked through as the year progresses.

And let me just add to what Ivo said. We've got really, I think, strong value-added pricing teams in place. They do a good job working with our commercial teams, and so we're -- in addition, as we work through making sure that we cover inflation, we're also constantly making sure that we're value pricing all the products that we make and everything that we bring to the market. And we're using this opportunity to go back and look at profitability by product line, and quite frankly, make sure that we're getting the right pricing level for the value we bring to the table.

And so it's a tough effort. There's been a lot of work that's going on. But our value-added pricing teams do a great job. They do a great job working with our commercial teams, and they're very upfront and communicative with the customers on all those fronts.

I forgot one quick clarification, sorry. Tax rate, you mentioned getting back to the low 20s on a normalized level. What is the tax rate we should be modeling within your guidance for the year?

21% to 23%.

And that's sort of the cadence, just 21% a quarter makes sense. There's nothing unique at the moment?

Yes. That's right.

Our next question is from Andy Kaplowitz with Citigroup.

Ivo, last year at this time, you talked about Gates being positioned to deliver mid-single-digit market outperformance, and I think you're positioning toward high-growth industrial markets, and your new product vitality index has continued to accelerate. You've got chain-to-belt, these new products in Fluid Power that you introduced over the last couple of years. So how do you think about market outgrowth in the context of the 5% to 9% organic growth guidance you gave for '22?

Andy, if I take into an account what was the underlying demand, we would be in a position to be a little more constructive in the market outgrowth. I just think that we are being very realistic associated with what we are seeing in terms of the raw material shortages, particularly in the resins that we use as well as the omicron situation. But the underlying demand, again, is positioning us to deliver a very robust market outgrowth once we work through the issues associated with labor and raw material shortfall.

Got it. And, Ivo, maybe you could give us a little more color on how to think about auto replacement and auto markets and what's baked into your '22 guidance. I know you said low double-digit auto replacement growth in Q4 more than offset a pretty big decline in auto OE, which I think was more China based for you. But -- and I know you said you're more skeptical around auto OE coming back quickly in '22. But as the global car part continues to get older, given production so slow, could we see an extended replacement cycle for you guys?

Yes. Look, the auto replacement business has been absolutely terrific for us over the last 6 quarters. And we've continued to deliver a very nice growth in Q4 as well off an absolutely terrific comps in Q1 '20. We believe that auto replacement is going to continue to grow kind of low to mid-single digits in 2022. But just like everything else, it is also impacted by raw material supply and labor challenges that we deal with across the entire enterprise. So the more we work those through, I think the more we capitalize on the market -- the underlying strength in the market.

And you very well pointed out, Andy, that we believe that the life cycle on vehicle life is extending. And if you extend that life, you need to repair, you need to take better care of those vehicles. So we believe that the underlying trend is very positive in AR. Vis-a-vis automotive OEMs, we are more skeptical about the OEM's ability to ramp up production. We have been very skeptical in 2021. I think that we were being viewed as overly negative. I think that Q4 got a little bit worse than what we have anticipated, and our view is that auto OEM business may kind of be flatline in 2022. I get it that, that puts us as an outlier, but I need to see the recovery before we become more constructive on the global carmakers' ability to ramp up production and keep with their underlying demand.

And Ivo, just to clarify, is auto OE flat? Is that kind of what's in your guide for '22?

It's maybe very low single digits up, Andy.

Our next question is from Jeff Hammond with KeyBanc Capital Markets.

Just on -- I guess what we've been hearing is maybe a little bit better price and availability on some inputs like steel and resin, but it seems like you're still seeing acute inflation and availability. Can you just maybe speak to where those challenges are most acute still?

Yes. So I would say that -- I mean, we are starting to see some green shoots on raw material availability as well, Jeff. I would say that raw material availability was -- I would say that it peaked in Q4. That was really tough. We are starting to see more available material for our consumption, pretty much across the board. There are still some that are highly constrained, that may not break through, certainly in Q1 or Q2, but the number of resins or additives in -- the polymer additives that we are being highly constrained on is significantly reduced in the amount of the types of additives, so also, I would say, maybe getting a little bit better.

The biggest issue really is omicron for us in Q1. We have operating facilities that have reasonably low vaccination rates, production facilities, and those facilities are impacted quite significantly. And so I would say that the way to think about Q1 and maybe the beginning of Q2, but I'm hoping, really, Q1 is that as omicron works through, we will be in much better situation. And certainly with -- combined with our additions in incremental capacity, we should be a little more constructive as we get into the second half.

Yes. The only -- I would add on the inflation question. You remember, even though people have been raising prices throughout 2021, there's still the beginning of the year price increases that roll through from a lot of suppliers. And so even though you've seen elevated inflation and there's still more that you're going to have to price in as you move to the -- as you move through 2022.

Okay. And then just on order -- because I'm struggling a little bit versus like the supply constraints versus any kind of underlying order slowing. Is China kind of the only market where you're seeing maybe some true deceleration versus what's been a pretty healthy overall order environment?

Yes, Jeff. I would say that China has been the only region, frankly, where we have seen weakness in Q4, where we anticipate still a degree of weakness in Q1 but predominantly driven by some of the external issues associated with the Olympics and Chinese New Year and a little bit of the restrictions that the government is placing on Omicron cases that they see there.

But we're also seeing that, that should improve as we exit second quarter and you also start seeing more manageable comps. And as I said, I think to Julian's question, we anticipate that we will be, for the year, mid-single-digit positive on core in China. So we certainly see some positive outcome on China as well in '22.

I would say just that...

This concludes our question-and-answer session. I'll turn the call back over to Bill Waelke for any closing remarks.

Thanks, Chris. Before we disconnect, just wanted to briefly mention our upcoming Investor Day, which is planned now for the afternoon of March 8 in New York. If you've not received any information and are interested in attending in person, please contact us at investorrelations@gates.com. Thank you for your interest in Gates, and have a good rest of the day.

Ladies and gentlemen, this concludes today's conference call and webcast. Thank you for participating. You may now disconnect.