Earnings Call Transcript - GTES Q2 2022

Operator, Operator

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 a question-and-answer session. Thank you. Bill Waelke, Head of Investor Relations. You may begin your conference.

Bill Waelke, Head of Investor Relations

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.

Ivo Jurek, CEO

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 a 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 the 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 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 Mallard, CFO

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.

Ivo Jurek, CEO

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 the 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 the 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.

Operator, Operator

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

Jerry Revich, Analyst

Yes, hi. Good morning, everyone.

Ivo Jurek, CEO

Good morning, Jerry.

Brooks Mallard, CFO

Good morning, Jerry.

Jerry Revich, Analyst

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 assume the fourth-quarter exit rate for the lines of business in China? Thanks.

Ivo Jurek, CEO

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 anticipated that we'll see maybe a month of shutdown in Shanghai and then things start reopening. Clearly, that did not occur. Shanghai was shut down 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.

Jerry Revich, Analyst

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?

Brooks Mallard, CFO

Yeah, Jerry, this is Brooks. I think that's pretty close. We're expecting more muted seasonality this year. Typically, there's a slight decline in Q4, but with the capacity coming online and additional pricing increasing throughout the year, we anticipate a more consistent sequential performance. I would say it's likely to be similar to Q3, if not slightly higher as we end the year. Compared to how we finished 2021, we're in much better condition with pricing, costs under control, and repair work largely completed. Now we're focusing on addressing the margin impact from some supply chain challenges. Overall, we feel confident about our position as we close out the year.

Jerry Revich, Analyst

Great. Appreciate it. Thanks.

Operator, Operator

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

Mike Halloran, Analyst

Hey. Good morning, everyone.

Ivo Jurek, CEO

Good morning.

Mike Halloran, Analyst

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?

Ivo Jurek, CEO

Yes, Mike. We have anticipated that this would begin to happen in the third quarter. We now believe that we should start seeing our backlog decrease towards the end of the third quarter and into the fourth quarter. The additional capacity that is coming online has basically been installed, and we are currently ramping it up. We are also exploring alternative solutions, particularly related to Power Transmission supply chain and raw material availability issues. As you might understand, the conflict in Ukraine has significantly affected the availability of petrochemicals. Although we are not purchasing anything from that region, the global capacity that was available earlier in the year has almost disappeared, complicating matters further. However, we have identified potential alternative solutions, and we believe that we should see our backlog begin to reduce as we head toward the end of 2022.

Mike Halloran, Analyst

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.

Ivo Jurek, CEO

Yes. The known challenge is China, and I won't dwell on it. We have addressed that issue. Despite the difficulties, conditions are gradually improving. Europe is currently affected mainly by the revenue loss we have experienced in Russia. However, all industrial markets appear to be in reasonably good shape. That said, we are aware that there is general nervousness in the market. The gas supply situation for industrial activities in Europe is something we are considering, along with any potential impact on supply or demand. But for now, Europe looks stable. North America remains strong, as the figures from Q2 indicate, and we have numerous opportunities to sustain a good growth trajectory there. I can assure you that I am still receiving more inquiries about supply availability than anything else. We see significant strength in Mobility and Diversified Industrial, which are standout markets for us. On the Mobility side, our backlog is growing rapidly, and there is a substantial amount of design win activities. While we remain cautious about the future, we are trying to balance that caution with the positive situation of current demand for our products.

Mike Halloran, Analyst

Thanks Ivo. Appreciate it.

Operator, Operator

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

Josh Pokrzywinski, Analyst

Hi good morning guys.

Ivo Jurek, CEO

Good morning, Josh.

Josh Pokrzywinski, Analyst

Ivo, regarding some of the temporary costs that are affecting us, such as expedited freight, what do you estimate the current impact to be? Additionally, how do you see these costs changing over the next few months or quarters, based on your visibility?

Brooks Mallard, CFO

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.

Josh Pokrzywinski, Analyst

Got it. Regarding the broader ecosystem involving your OEM customers, not limited to auto OEMs, it seems that you are not the ones causing any delays. Do you have any insight into their inventory levels of your products or any information they might have shared about where the bottlenecks are? The concern is if these customers experience a slowdown, could they be holding more of your inventory, which might pose additional risks? I'm not sure if that situation is urgent, but I'm trying to understand how you fit into their production schedules.

Ivo Jurek, CEO

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.

Josh Pokrzywinski, Analyst

Got it, very helpful. Appreciate it.

Operator, Operator

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

Jeff Hammond, Analyst

Hey, good morning, guys.

Ivo Jurek, CEO

Good morning, Jeff.

Jeff Hammond, Analyst

I wanted to highlight the $50 million reduction in EBITDA. Core growth remains unchanged, but I'm curious about the impact of foreign exchange. How much is due to the delays in pricing and costs, expedited freight, and supply chain issues? I also wonder if there's a mix effect related to China and the factors offsetting the slowdown there.

Brooks Mallard, CFO

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.

Jeff Hammond, Analyst

Okay, helpful. And then just back to Josh's question about whether you're noticing any shifts in market share due to availability or if all your competitors are experiencing similar situations.

Ivo Jurek, CEO

Right now, Jeff, I would say that the industry is in 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.

Jeff Hammond, Analyst

Okay, perfect. Thanks, Ivo.

Operator, Operator

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

Julian Mitchell, Analyst

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?

Brooks Mallard, CFO

Yes. Our price increase was slightly over 10% in the second quarter. However, we faced several challenges that offset that increase, particularly in terms of volume. The lockdowns in China, the ongoing impacts from Russia, and supply chain issues significantly affected us. On the positive side, we did see some genuine organic growth. If you consider the total core growth and account for the just over 10% price increase, that would clarify the volume aspect. Ultimately, the challenges we encountered outweighed the volume increase we mentioned.

Julian Mitchell, Analyst

In the second half, you have a low double-digit core growth forecast. Is that around 10 points from price and two points from volume?

Brooks Mallard, CFO

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.

Julian Mitchell, Analyst

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

Brooks Mallard, CFO

Yes, there is. There are some small fees to consider. We have backlog reduction, normal seasonality, and the year-over-year impact from Russia among other factors. When you put all that together, we anticipate a little bit of volume growth, but it will likely be more flat on volume, possibly slightly up.

Julian Mitchell, Analyst

Thank you. My second question is about free cash flow. It appears that inventories will remain elevated through the end of the year. You mentioned needing around $350 million in free cash flow during the second half, especially after a negative $120 million in the first half. I don’t see significant earnings growth from one half to the next, so I’m trying to grasp the expected swing in free cash flow, which seems to be about $500 million. If it’s not due to inventory liquidation, where is it originating from? Also, when inventory is liquidated, usually companies face a gross margin challenge. Do you anticipate experiencing a similar effect?

Brooks Mallard, CFO

No. First of all, I’m not completely convinced that the statement regarding improved profitability is entirely accurate. We do expect to see enhanced profitability in the second half compared to the first half. There are four main factors that will contribute to the improvement in cash flow. It's important to note that our operating working capital is typically seasonal, which means we experience a buildup followed by a drawdown. The four factors driving this improvement are: increased profitability, the collection of some VAT receivables I mentioned earlier, the usual seasonality in working capital, and a reduction in inventory to more normalized levels. When you combine all these elements, that’s how we achieve the expected improvement.

Julian Mitchell, Analyst

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

Brooks Mallard, CFO

No. I think our inventory reductions will mainly focus on raw materials and how much we hold in the business, rather than finished goods. Therefore, we are not overly concerned about that as we progress through the latter half of the year. Keep in mind that we still have a significant amount of past due backlog. We are striving to be as efficient as possible regarding what we produce, how we produce it, and ensuring timely delivery.

Julian Mitchell, Analyst

Perfect. Thank you, Brooks.

Operator, Operator

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

David Raso, Analyst

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?

Brooks Mallard, CFO

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.

David Raso, Analyst

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

Brooks Mallard, CFO

Closer to 4%, actually.

David Raso, Analyst

Essentially, whether it's 3.5% or 4%, we've still removed $50 million in revenue and $50 million in EBITDA. I'm trying to understand that in the second quarter, you performed quite well despite many of the negative factors you're mentioning for the second half still being present. So, is it more about not worsening in the second half rather than achieving the improvement you initially anticipated? Just to clarify, in the second quarter, your performance was relatively good. Is that correct? It's not that things are getting worse; it's simply that you're not seeing the sequential improvement you expected.

Brooks Mallard, CFO

Yes, I agree. We're not experiencing a decline. If you look at our guidance, we anticipate improvement in the second half, but it’s just not as significant as we had hoped.

David Raso, Analyst

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.

Brooks Mallard, CFO

Yes, 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.

David Raso, Analyst

Yes, I understand that. However, since you have raised the core revenue guidance, it appears that you are at least acquiring enough revenue to increase the guidance on an organic basis. It just seems to be costing you more to achieve that, correct? That's why the decremental is so significant on the revenue change; the increase is quite high?

Brooks Mallard, CFO

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.

David Raso, Analyst

Can you provide more details on the additional capacity being added and its locations? Also, does this new capacity contribute to improving the availability of key polymers and reducing production costs, or do we still rely on the rest of the supply chain to fulfill their roles? When they do, will we then have the incremental capacity to increase our output?

Ivo Jurek, CEO

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 pipelines, 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.

David Raso, Analyst

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

Ivo Jurek, CEO

It's an accretive margin capacity that is coming online. Yes.

David Raso, Analyst

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

Ivo Jurek, CEO

I would probably guide it somewhere in the range of 5% plus or minus; that's likely the right number to consider. Returning to your initial question about the polymer, the issue with the polymer is not something we manufacture. It is a highly engineered raw material that is in extremely constrained supply. Two things are happening: first, the price of the polymer continues to rise due to traditional supply and demand dynamics; second, there simply isn't enough polymer available globally, especially considering the capacity that has come offline due to the conflict in Russia and Ukraine. We are actively addressing this issue. We have a plan in place that involves qualifying other long-term partners as sources and engineering alternatives to supplement our raw material supply. We believe we could start seeing some relief in Q4, particularly through the engineered solution, but given the current global circumstances, we cannot confidently rely on a lot of certainty over the last 12 to 18 months. Therefore, we want to be realistic about our ability to ramp everything up and optimize both the incremental capacity available and the solutions for that raw material.

Operator, Operator

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

Deane Dray, Analyst

Thank you. Good morning, everyone.

Ivo Jurek, CEO

Good morning, Deane.

Deane Dray, Analyst

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 is everyone in the same boat, can't produce that particular product?

Ivo Jurek, CEO

So, Deane, everyone is facing similar challenges because this is a fairly common polymer used in the affected products. I believe the OEMs are getting what they need, but it's akin to what we are receiving regarding our raw materials. It's difficult to be timely and to meet all the demand they might wish to fulfill if they were looking to create a buffer. However, there simply isn’t the capacity to establish any buffer because the raw materials are unavailable. I can assure you that we have not been informed of any loss of market share through our order flow. I apologize, but I seem to have forgotten part of your question.

Deane Dray, Analyst

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?

Ivo Jurek, CEO

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.

Deane Dray, Analyst

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?

Brooks Mallard, CFO

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

Ivo Jurek, CEO

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.

Operator, Operator

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

Andy Kaplowitz, Analyst

Good morning, everyone.

Ivo Jurek, CEO

Good morning, Andy.

Andy Kaplowitz, Analyst

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?

Ivo Jurek, CEO

Yes, I believe that in Personal Mobility, we can view this from two angles. On one hand, consumer impact could influence our business, but we feel it’s unlikely at this early stage of market penetration with our belt products. As electrification in Personal Mobility progresses, we expect strong demand over the next decade, which may help counterbalance some challenges from tougher economic conditions. Our business has grown significantly; just a few years ago, our revenue was under $20 million, and we are on track to approach a couple of hundred million dollars in 2022, with the potential for even more if we can ramp up supply. We are working hard to increase that supply, and we have a solid backlog, especially in Mobility. We are very optimistic about the opportunities there. We also see similar potential in the transition from industrial chains to belts, especially as there’s a growing focus on operational efficiency and reducing carbon footprints in industrial operations. While I cannot predict precisely what will happen in 2023 regarding macroeconomic factors and end-market demand, we remain committed to executing our strategies, investing in new product development, launching new products, and expanding capacity to leverage these long-term growth opportunities. We believe a promising future lies ahead for us well into the end of this decade.

Andy Kaplowitz, Analyst

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.

Ivo Jurek, CEO

Yes. The Auto Replacement growth in the low 20% range that I mentioned is in the Fluid Power segment of our business, specifically related to engine cooling and battery cooling as part of the electrification initiative we have discussed previously. This area has been progressing very rapidly for us. In terms of automotive first-fit, I have been quite skeptical about it due to the prolonged supply chain shortages, and we remain cautiously negative about its recovery. We believe it will require significant time for the supply chain to stabilize for automotive OEMs. They are making daily decisions on vehicle production, and we do not foresee a substantial increase in volume growth in the second half of this year. Moreover, production levels remain low. If the economy were to experience a downturn, we do not expect the typical severe impact on the auto OEM side. Instead, we believe any impact may be more muted compared to historical trends. Thus, we see a dual narrative, with no upside anticipated for auto OEMs in the second half, and likely no dramatic downside even as we consider potential economic conditions in 2023. Our accounts receivable performance has been strong. However, the majority of our accounts receivable business in Russia makes comparative analysis challenging, given the current situation there. Outside of Russia, that segment continues to perform well.

Andy Kaplowitz, Analyst

Appreciate the detail.

Operator, Operator

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

Nigel Coe, Analyst

Thanks. Good morning everyone. We have really focused on the guidance for the second half of the year, analyzing it in more detail. We're predicting roughly stable sales in dollar terms compared to the second quarter. Typically, we see a significant decline in the second half of the year. I'm assuming China contributes to this, but you've also mentioned shipment backlog. I'm not sure if you've provided the dollar figure for the backlog, Brooks, but if you could give us some insight on how that backlog compares to normal levels, that would be helpful.

Ivo Jurek, CEO

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.

Brooks Mallard, CFO

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.

Nigel Coe, Analyst

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?

Ivo Jurek, CEO

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.

Nigel Coe, Analyst

No, that’s very helpful. Thanks, Ivo.

Operator, Operator

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

Jamie Cook, Analyst

Hi. Good morning. I wanted to follow up on whether the sales pattern changed throughout the quarter and what trends you're noticing in July. I know you mentioned China, and some of your peers remarked that Europe showed a stronger recovery in July. What are your observations for July? Additionally, could you clarify your expectations regarding inventory levels as we approach the end of the year? Thank you.

Ivo Jurek, CEO

Yes. So, look, China much better. Europe, I mean, we actually had a pretty solid performance in Europe, absent Russia, in the 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.

Jamie Cook, Analyst

Did that trend continue into July? Some others were indicating strength in July, so I'm trying to understand how things have been progressing since the end of the quarter.

Ivo Jurek, CEO

Yes, Jamie, as I mentioned, I believe we are maintaining a positive status quo. There has been no change in our trajectory in Europe. However, China is experiencing a change. China is recovering, and while we haven't depended heavily on back-end recovery in that market, there could be potential for better performance than we currently expect, assuming there are no new shutdowns. Regarding inventory, we think we will start reducing our inventory by the end of 2022. We are not anticipating dramatic changes in our finished goods inventory, but we expect to finish at a lower level than we have over the past 18 months. We are not reducing production at this time as demand continues to exceed our supply capabilities. However, we are managing our production, utilizing more of the work-in-progress inventory and securing raw materials, which will result in a lower inventory level.

Brooks Mallard, CFO

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.

Operator, Operator

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

Bill Waelke, Head of Investor Relations

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.

Operator, Operator

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