Hello and welcome to the Signify second quarter and half year results 2022. Throughout the call, all participants will be on listen only mode, and afterwards there will be a question and answer session. Please note this is limited to one question plus one follow-up. Today I am pleased to present Eric Rondolat, CEO, Javier van Engelen, CFO, and Thelke Gerdes, Head of Investor Relations. Please go ahead with your meeting.
Good morning everyone, and welcome to Signify's earnings call for the second quarter and half year 2022. With me today are Eric Rondolat, CEO of Signify, and Javier van Engelen, CFO. During this call, Eric will first take you through the business and operational performance, after which Javier will review the company's financial performance for the second quarter and half year. Eric will then discuss the outlook and closing remarks. After that, we will be happy to take your questions. Our press release and presentation were published at 7 o'clock this morning. Both documents are available for download from our investor relations website. The transcript of this conference call will be made available as soon as possible on our investor relations website. With that, I now hand over to Eric.
Thank you, Thelke. Good morning, everyone, and thank you for joining us today. Let's start with some of the highlights for the second quarter on slide 4. We delivered 5.1% comparable sales growth, driven by continued traction of the professional segment. This was achieved despite headwinds from the war in Ukraine, lockdowns in China and an overall weaker consumer environment. This illustrates the improvement in our growth profile, fueled by the continuing shift towards connected lighting. Nominal sales, including FX and acquisitions, increased by 14.1%. The adjusted EBITA margin declined by 140 basis points to 9.5%. Net income increased to EUR 248 million, and free cash flow was EUR 135 million. We successfully completed the acquisitions of Fluence and Pierlite in May.
We also divested a non-strategic real estate, the non-operational gains of which are included in the net income. On the next slide five, we see Signify's overall Q2 performance. We increased the number of connected light points from 100 million in Q1 to 103 million at the end of Q2. LED-based sales represented 84% of total sales. Nominal sales increased by 14.1%, with comparable sales up by 5.1%. Adjusted EBITA remained broadly stable at EUR 174 million in Q2 compared to EUR 175 million last year. EBITA margin decreased to 9.5%, a 140 basis point decline versus Q2 2021, as the lower gross margin was partly offset by operating leverage and indirect cost savings.
Net income increased from EUR 82 million to EUR 248 million, primarily driven by the gain from the disposal of non-strategic real estate assets. Finally, free cash flow was EUR 135 million, which Javier will explain in more detail. Now, let's move on to our divisions, starting with Digital Solutions on slide 6. The division top line performance remained strong, with comparable sales growth of 11.6% and an adjusted EBITA margin of 9.5%. The double-digit CSG growth was driven by continued strong traction in the professional segment across most markets. I would like to highlight that the CSG growth was driven by a healthy combination of volume, price and positive sales mix.
The nominal sales growth of 24.4% includes positive FX variances as well as the acquisitions of Fluence and Pierlite. Adjusted EBITA margin decreased by 120 basis points to 9.5% as price increases compensated higher input costs, but with positive sales mix and operating leverage only partly offsetting the sudden FX movements. On the next slide 7, I would like to discuss a couple of business highlights of our Digital Solutions division. We installed our BrightSites solution in the city of Tampere in Finland. BrightSites provide super-fast wireless communication using high-quality LED streetlights. It removes the need to dig and lay fiber connections throughout the city, while requiring only a fraction of the time and cost compared with traditional methods.
This allows the city of Tampere to accelerate the deployment of present and future broadband IoT applications, such as 5G, Wi-Fi and smart city services. Next, as we are celebrating 15 years of leadership in developing horticultural lighting, I would like to highlight the following project. We are helping Vikai Luos to make the switch to 100% LED lighting for both its strawberry cultivation sites. The installation follows a successful partial switch to LED last year, and the full LED installation provides considerably more light in its greenhouses, more efficient plant growth and energy savings around 40%. Let's now move on to the next division on slide 8.
In the second quarter, the Digital Products division reported a comparable sales growth of 2.6% on a strong comparison base of 20.4% last year. The positive CSG was driven by strong demand for LED electronics, while consumer connected sales slowed down versus the strong comparison base in the previous year. The adjusted EBITA margin was 10.6%, driven by a gross margin decline impacted by the higher COGS base and negative effects and sales mix. Moving on to slide 9 for the business highlights of digital products. We launched various new products for Philips Hue, illustrating the continuous expansion of this range. We also added new features to the Hue app. With a new sunrise wake-up style, users can mimic the sun appearing over the horizon with a rich, colorful transition from blue to soft orange light.
We also added the new demo mode to the app through which both prospective and existing Philips Hue users can explore the full suite of features that Philips Hue has to offer. After the launch of the ultra efficiency bulb in Q4 last year, we now launched the first ultra-efficiency TLED class A in Europe. We extend the ultra-efficiency family with the most efficient LED tube today on the market. That saves up to 44% of energy consumption versus a standard LED tube. This innovation breakthrough is having great market response as it brings a great response to increasing energy prices. Moving on to slide 10 and conventional products. Comparable sales declined by 13.8%.
The adjusted EBITA margin declined to 15.5% as significant Q2 price increases were not sufficient to compensate the sudden negative impact of energy and transportation costs and FX. Next, I would like to discuss our sustainability performance on slide 11. The cumulative carbon reduction over our value chain is ahead of track. This is mainly driven by the sales of energy efficient and connected LED lighting, which help reduce emission in the use phase of the products. Circular revenues increased to 31% well on track for our 2025 target. Circular revenues are helped by the upgrade to serviceable luminaires. Our brighter lives revenues of 26% are slightly off track due to a shortfall of UVC disinfection lighting and LED electronics.
We have identified, initiated follow-up actions and remain confident that we will be able to achieve our 2025 target. The percentage of women in leadership positions of 27% was on track. We continue to drive actions to achieve our 2025 commitment, including inclusive job posting and diverse hiring panels. In addition, we conducted training sessions together with Hult International Business School. These trainings equip our teams with the right tools to realize our diversity ambitions. Slide 12 highlights that this quarter we successfully completed the acquisitions of Fluence in the U.S. and Pierlite in our Pacific region. First, the acquisition of Fluence strengthens our agriculture lighting growth platform. We previously already had a strong horticulture lighting business in Europe with a global reach.
With Fluence, we are extending our position in the attractive North American horticulture lighting market. Fluence will operate as an entity within the agriculture lighting business of Digital Solutions. The acquisition of Pierlite strengthens our position in Australia and New Zealand. It will help combine Pierlite's indoor portfolio with Signify's indoor and outdoor lighting portfolios while adding Pierlite's leading access to the Pacific distribution channel. With this, let me hand over to Javier, who will take you through the highlights of our financial performance in Q2.
Thank you, Eric, and good morning to everyone on the call. Let me dive straight into the key financial highlights on slide 14, where we are displaying the adjusted EBITA bridge for Total Signify. Adjusted EBITA in absolute euro terms was about flat versus Q2 2021, mainly as we have continued to successfully offset cost of goods increases of EUR 83 million by price increases worth EUR 86 million. Also, the negative currency impact of EUR 9 million, mainly the result of the Chinese RMB strengthening versus the euro, was offset. The adjusted EBITA margin did decrease from a record level of 10.9% in 2021 to 9.5% in Q2 2022.
Gross margin was down 290 basis points versus 2021 due to the sudden rise of energy prices, the strengthening of the Chinese RMB, and the continued negative impact of the disrupted supply chain on inventories, warehouse costs, and distribution expenses. Indirect costs decreased by only EUR 2 million as we continued to invest in marketing to support our growth momentum. As a percent of sales, though, indirect costs decreased from 30.6% to 29.3% of sales, thereby helping us to offset part of the gross margin pressure. On slide 15, let me talk you through our working capital performance during the quarter.
Versus Q2 2021, working capital increased by EUR 514 million to EUR 783 million, or from 4% of sales to 10.5% of sales. While inventory volume stabilized in Q2 versus Q1 2022, in value terms, they increased by EUR 515 million versus Q2 2021. About two-thirds of this increase was due to higher unit value and USD and RMB strengthening versus euro. The other one-third represents inventory volume increase due to both longer lead times and as a result, also lower forecast accuracy. Other components of working capital net out to about zero as higher receivables, partly due to higher-level disputes, are offset by higher payables and other working capital items.
Based on the structural working capital improvements we had made prior to the current supply chain disruption, we are confident that we will return to previous mid- to low single-digit levels as soon as supply chain lead times reduce. On slide 16, you can see our net debt and leverage evolution. At the end of June, our net debt position increased by EUR 371 million to EUR 1,749 million, mainly as we were able to partially finance both the 2021 dividend payment and EUR 183 million and the EUR 297 million acquisitions of Fluence and Pierlite with a positive EUR 135 million free cash flow.
The 135 million free cash flow is the combination of a 59 million cash outflow from operating activities and a gross CapEx and a 194 million euro of proceeds from the sale of non-strategic real estate assets. As a result of the higher net debt, our net leverage ratio increased from 1.6 times to 1.7 times. On slide 17, I briefly summarize our first half 2022 performance. Overall, we continue to see solid top line growth, thereby seeing continued strong recovery from a COVID-affected half one in 2021. In half one 2022, growth is mainly driven by continued strong traction in the professional segment.
On the consumer side, decreasing consumer confidence and high inflation negatively affected H1 2022 sales, following a strong acceleration of connected lighting in the first half of 2021. For the second year in a row, we did achieve a double-digit Adjusted EBITA margin as compared to the H1 of 2020. The combination of pricing, mix, and indirect cost discipline allowed us to more than offset both the higher input costs and the incidental costs linked to the shortage of components and supply chain disruption. H1 free cash flow generation was -EUR 54 million this year, mainly as the inventory buildup due to longer supply lead times was not fully offset by proceeds from the sale of non-strategic real estate assets. With this, I'm handing back to Eric for the outlook and some closing remarks.
Thank you, Javier. I will conclude with the outlook on slide 19. We maintain our comparable sales growth guidance of 3%-6% for the year, driven by the continued momentum in the professional segment and our solid order book. At the same time, we revise our adjusted EBITA margin guidance to 11%-11.4% for the year, reflecting the lower margin performance in Q2. For the remainder of the year, we are taking adaptive measure and expect margin headwinds to ease in the second half of the year. We remain firmly committed to investing in our business and driving not only our long-term growth objective, but also to support the momentum we continue to see in our business.
We now expect a free cash flow of 5%-7% of sales in 2022, including the proceeds from real estate divestments. We expect to return to our previous target of over 8% as soon as the extended supplier lead times no longer require us to carry higher inventory. With that, I would like to open the call for questions with which both Javier and myself are happy to answer.
If you'd like to ask a question on today's call, please press star one on your telephone keypad. To withdraw your question, please press star two. The first question comes from the line of George Featherstone from Bank of America. Please go ahead.
Hi. Morning, everyone, and thanks for taking the questions. My first one would be around the organic growth outlook. You've delivered two quarters now in succession of organic growth at the top end of the guidance you set for the year, obviously getting clear traction on pricing, but you've not raised organic growth expectations for the full year. Just like to try and understand that, considering you've got an easy comparative in Q3, what you're expecting for volume growth in the second half of the year.
Yes. Good morning, George. Effectively, we are at the end of H1 at the higher end of the guidance that we have given for the year. Nevertheless, we are cautious regarding the potential. Well, I don't know if we have to say potential. I think we are facing a recession at this point in time. What we don't know is the magnitude of that recession moving forward. Effectively, we have an easier comparison base in Q3, but a much harder one in Q4, especially on the consumer-based business.
This is why we've maintained the 3%-6%, which, when we have done our detailed forecast for the full year, which has happened at the beginning of this month, we believe we have the capacity to maintain it. As you know, there is still an uncertainty in H2 regarding the recession scenario. That's the reason why we've done it like that.
Okay, thank you. Given I've only got one follow-up, just on the connected demand in professional, I'd just like to try and get a sense of how the typical payback period has changed at this point with the energy costs where they are compared to last year.
Yes. It really depends on the segments, and it depends on the country energy prices. In some segment applications where the return on investment was three years, it has come down to one. It's quite substantial. Where it was sometimes difficult to base an investment only on energy efficiency. You know, when we had an ROI which was rather around seven to eight years, this has come down to three to four years. We see a renewed traction on energy efficient lighting. We see also a renewed traction on connected as it brings additional energy savings.
I would say that in some specific segments, in the industry segments, now customers understand fully what our systems are bringing, not only in terms of energy efficiency, but also in terms of workspace optimization and in terms of improving the productivity and the safety of people at work which is fundamental also for the return on investment. If you bring all these criteria together it's only a matter of weeks, so that helps also the decision to invest. Now, you have. You may remember, George, that we brought to the market the ultra energy efficient bulb in Q4.
Now we're continuing with a new form factor in Q2, which is the LED tube, where we can reach 44% more energy efficiency than the available ones on the market today. That's also another very important one because this was one part of the market where it was difficult to reach the right level of return on investment. Now, with the price of energy going up and with this new technology that helps to do further savings, we are betting a lot on that technology. The bulb will be touching the consumer, but also the professional market and the TLED and the LED tube will touch mostly the professional market.
Okay. Thank you very much.
Before moving to the next question, please be reminded that the questions are limited to one question plus one follow-up. The next question comes from Philip Lawlor from Goldman Sachs. Please go ahead.
Good morning. Thank you for taking my question. I have two on the guidance, one being just on the free cash flow margin target. Just seems kind of low, characteristically low for the second half of the year, given it also includes the one-off in one H. If you can give some more color on that for the second half on how you think that will progress.
Yeah. Thanks, thanks, Philip. It's a good question. If you look through the numbers, and we've also mentioned it in the presentation, in the script, if you look at the first half, we end up the first half. If you exclude the proceeds of real estate assets, we end up with a negative cash flow. If you go back to the underlying dynamics, it's the buildup of inventory that's happened over the last three quarters, and therefore the payments we've done to finance that inventory in the first half of this year. If we start with that as half one, then if you look at half two, we will return to a much more healthy generation of cash flow.
If you compare it with the guidance, you will still see that our second half cash flow generation will probably more than to the tune of EUR 400 million that we have to generate. At this point in time, we don't see a significant improvement in supply chain before the end of the year, we do think that we'll have an improvement on inventories, as we also volume-wise are adjusting our outlook for the year in a more conservative way. We don't think we're gonna get back to the levels of working capital or inventory that we had before all the disruption.
Therefore, the guidance includes what we have done in the first half, including the real estate proceeds, but the second half is of course a much more healthy cash flow generation, and that's where the guidance between 5% and 7% comes from.
Okay. Got it. Thanks. Just a quick follow-up on the comparable sales growth target for H2. Just, can you give some more color on the split between price and volume going into the second half?
Going to the second half it's a bit more complicated, but I can tell you where we stand now because it's very different across the businesses. If you look at the comparable sales growth that we have experienced in Q2, I would say the majority of it is price, but it's very different when you look at the divisions. I would say that there's a lot of price in the Consumer Products division, meaning that the volume is a bit more negative than what we see on the CSG. We are slightly negative in volume in Digital Products, so its price brings the CSG to 2.6%. When it comes to the Digital Solutions division, most of the growth is volume.
We see the first signs of the recession clearly appearing on Digital Products. But on Digital Solutions on the professional part of the business, we see that volume is still there. You know, the order book that we have at the beginning of this quarter if we take the same approach as we did in the previous quarters, and if we look at the normalized quarter because Q2 last year already had some backlog, but we still around 50% above the backlog that we used to have when we start the quarter. I mean, backlog order book.
At the end of the day, we see more volume coming from Digital Solutions and the professional segment than the consumer business, which has started to slow down as we commented already in the previous earnings call.
Perfect. Thank you very much.
The next question comes from the line of Jingyi Zheng from Credit Suisse. Please go ahead.
Hi. Good morning, Eric, Javier, and Theke. This is Jingyi from Credit Suisse, and thanks for taking my question. I would like to ask about the revised guidance on margin for 2022 and its implications on the second half. If we take margin guidance at midpoint, our calculation would imply some flatness to slight improvement in the second half after about 80 basis points down year-to-date in H1. Could you talk us through your thoughts on that and how you see the various actions helping margin progression in H2, and where the improvements will likely come from?
Yeah. Thanks, thank you for your question. If you look at the margin guidance, exactly what you're saying, we expect that, after the decline we see in Q2, that we will see a recovery coming into the second half of the year. The reason why we're projecting that is we expect slightly less headwinds than what we faced in Q2. More specifically, if we plan out the full second half, if you look at the key reasons why we have seen a deterioration of margin in Q2, it was FX. It was also some impact we had on warehousing and distribution costs. We also took some write-downs of some specific inventory items where demand has dropped. Those negatives that we had in Q2, we expect that they will not reappear in Q3, Q4.
What we expect is, number one, pricing will still be an element, and we expect that bill of material pressure will slightly come down. As you know, we've seen prices in the market going down on a number of materials, but also on logistics. Number two, we have started early in the year a lot of work on refocusing the organization also on cost savings, product cost savings. So we will be working on bill of material savings, and we have already some specific results where we can take costs down. They will not all rotate in this year because of inventory, but we have other items where inventory is lower. We will see some of those savings already coming through.
If you take that balance, we believe sequentially, our margin will recover in Q3 and then in Q4, and then we will be closer again to the margin and the profitability we had in last year, second half. We see a path to recovery with the visibility we have, but it's shifting the organization back to making sure we get more cost savings from the products, from redesigning products. With demand going down in general in the market, we do see an easing of the pressure of cost in general, inflation in general in our P&L.
Thank you. That's very helpful. Can I also touch a bit upon the consumer segment in particular? How much is Hue as a proportion of sales? As I understand, the product line is accretive to margin, and last year, Hue benefited from investment in DIY. This year, we'll be seeing some impact from consumer confidence. Essentially we're trying to understand to what extent Hue can drive the margin improvement. Thank you.
Yes. Good morning, Jingyi. You know, in the past, Hue was certainly a driver in the margin improvement was one of the businesses that drove margin improvements in the digital products division for sure. So let's talk about the consumer market first and the way we see it. You know, in general all over the world, maybe with some nuances probably that there's a bit more dynamic in the U.S. market than there is in Europe at this point in time. On the side of North China, which is an important market for us because it's our second biggest market. Given the situation of the zero COVID policy, we were still quite substantially impacted still in Q2.
Overall, we see a consumer market which is going down, and that's also the case for Hue. We need also to remember that the base of comparison for Hue last year was absolutely huge. You know, we had a very strong double-digit performance. You have consumer confidence, which is going down, and you're comparing to a very high base. That's how we need to judge the performance in Q2. Moving forward we're still extending, as you probably have seen, the range with new products, with new innovation in the app.
By experience every time we do this, we drive more business of customers who have the existing ecosystem already installed, and they increase that ecosystem. But this is the dynamics around that business. You may remember that, we have also bought a company called WiZ to be also present in the smart home
On the WiZ based on smart home communication. On that business which is today much smaller than Hue, we've seen still a strong traction as we are penetrating the market with a new offer, while on the side of Hue, we are more established. It's going pretty much with the market dynamics. I think at this point in time, we're not losing market share, and we have put in place the means that are gonna help us to capture whichever growth there is in front of us. At this point in time, the market is going into a slowdown.
From a margin perspective these businesses and the smart business of Hue is clearly accretive as we have set it to the Digital Products division.
Got it. Thank you very much.
The next question comes from the line of Martin Wilkie from Citi. Please go ahead.
Yeah. Thanks. Good morning. It's Martin Wilkie from Citi. Just a question on the margin progression in the quarter. When we look at the bridge, the net price number looks to have been slower in Q2 than it was in Q1. You had a positive EUR 5 million from mix pricing, the COGS benefit. Just to understand, you mentioned earlier that there are these mix differences clearly by division, and it is that difference, but relative to Q1 and less positive than net pricing just to do with mix. Was it this inventory write-down you mentioned earlier? Just to understand what's going on in terms of that net price number. Thank you.
Let me try to take it, Martin. When you look at the bridge, the first thing is if you look here at the pricing income, you've seen over the last couple of quarters that that number has been increasing, so we do see positive traction on pricing. If you remember, kind of Q4 last year was about EUR 30 million, went to EUR 60 million, is now EUR 80 million. You basically see that that is really moving on as we expected pricing implementation to be going through the market, along the year. When you look at the cost of goods number here, to have the right comparison versus bill of material and other cost of goods, we should break out that number. From the 83, there's about EUR 55 million of that, which is bill of material.
If you compare those EUR 86 million versus EUR 53-55 million of bill of materials, you do see that we've been able to price for what we expected to come in terms of inflation of bill of material. There's another EUR 20-30 million or EUR 25 million in that cost of goods, which is more related to the sudden impact of distribution costs due to energy costs sudden spike. I don't wanna call them incidentals because we know that some of that will continue, and this is the part of the cost of goods, EUR 83 million that we were not able to immediately correct for pricing.
Fundamentally, the pricing of EUR 86 million does cover our bill of material cost increase, but then some of the write-downs, the distribution and warehousing cost sudden increase that we've seen has not yet been offset by the pricing that we have. It's kind of splitting out that EUR 83 million to make it really comparable versus some of the bridges we showed in the past.
Thanks for giving that. Really helpful. Sorry, go on.
That's all right, because you still had the question of mix. If you look at the mix, if I try to make it simple. If you look at the company total, mix has little impact on the total company. When you look at it by division, though, it does have a significant impact, especially on Digital Products because of you. But that negative mix that goes within Digital Products is then offset at the global level by the mix between Digital Solutions, conventional, and Digital Products. On a total company level, mix does not have a significant impact. Within the individual divisions, especially in Digital Products, it does have a significant impact.
Yeah. Thank you. That's really helpful. To follow up just on the currency number, because obviously you've talked about the appreciation on the Chinese renminbi impacting you here. I mean, how do you think about that cost in terms of I mean, if we could think of that as just another piece of cost of goods sold inflation if you're purchasing components in China and selling them globally. It seems like you're less concerned about that continuing to the second half. Just to understand how you think about that currency exposure.
If you break down, Martin, the currency, to make a long story short, we are short in RMB, we're long on US dollar, but we are much more short on RMB than US dollar, which means that the net effect of the weakening, I would say, of the euro versus those two currency is a negative. How to look at that from a cost point of view? When the RMB strengthens, we normally have that in our cost of product calculations. When I talked about the price increases that we have guided for in the market, that was including an assumption on what would happen with the Chinese RMB. The problem in Q2 has been that the sudden drop of the euro versus, especially the RMB, is something that was not factored in into our pricing decisions.
In principle, for the imports of the products that come in RMB, we would normally include a transaction exposure, as we call it, as part of cost of goods and as part of things that we should price for or find offsetting cost savings for. It is just this Q2 impact where you had a sudden 9% drop of the euro versus the RMB that we were not able to react against immediately. For the rest of the year, we think, or you can't predict exchange rate, but if we assume the current exchange rate, we would still have a year-on-year potentially negative impact in Q3, but then in Q4, the comparable starts being different. We still see an impact in the rest of the year, but probably will get less towards the end of the year.
Eric will still add some comments if you want.
Yeah, just to complement and to take a bit of distance, Martin, just beyond FX, because if you look at the performance in Q2, we need to look at the gross margin because we have a gross margin decline of 290 basis points, which is quite substantial. There are a few elements in those 290 basis points. There is the FX, but this is one element. Javier just commented in detail on what we see coming for the rest of the year. We have the cost of logistics, which is impacting quite substantially the performance in gross margin in Q2.
I can give you very precise examples that we had some routes between China and U.S. where we paid the spot rate, which is much more expensive than the one that we have negotiated because we had not forecasted these routes in our agreements. We had a very strong business in the U.S., so we had to continue to flow the markets with products. That is something that we have started to tackle during the quarter, and we believe we can improve that for the rest of the year. Another element is obsolescence, which is on two very specific businesses. One is UV-C. You know, when we started the UV-C business, we were targeting surface and air.
In hindsight, the business is more geared towards air disinfection. You know, as you know, there's 10,000 times more infection that come from air than surface. We had products that we had developed in surface and that were declared obsolete. On the other hand, part of that obsolescence is also touching quite strongly the conventional part of the business. As with energy price rising, a lot of our customer growers in the horticulture business are moving to LED and not anymore using conventional technology. We had to declare obsolete some of these horticulture conventional product. The last element. Obsolescence, we managing it, and we think it's gonna improve in the coming quarters.
Then the price of energy has also been an element to consider in Q2, and there are a few actions there that we're driving specifically on our industrial sites to try to mitigate that exposure. Two hundred and ninety basis points, that's how we explain it on the gross margin. What is also good to see is that there is operating leverage because at the level of the operating margin the impact is only on 140 basis points. As Javier has explained on FX and as I have commented on the other elements, that's how we're gonna work on these different buckets for the end of the year.
Great. Thank you. That's very helpful.
The next question comes from Akash Gupta from JP Morgan. Please go ahead.
Yes. Good morning, everybody, and thanks for your time. My first one is on China. Maybe if you can provide more details on what you saw within the quarter, particularly the exit rates towards the end when we had some lower impact of lockdowns. What are your expectations for China in rest of the year, given we are seeing mixed signals out of the country?
Yes, good morning, Akash. Look, China has been, after Q1, again in Q2, a detracting market for us on the growth side of things. The impact of China is negative on our overall growth, quite substantially so. You know, I cannot say it's been very volatile during the quarter because China goes into ups and downs of opening and closing, opening and closing. Nevertheless, the good sign is that the quarantine has also been revised from 14 plus seven days, it is now seven plus three .
I believe this is also a good illustration that the strategy of the government in china is adapting to the reality of the situation and to the severity of the COVID impact there. We expect to have an improvement in the second half of the year. There are projects that are waiting to be delivered. We see an improving situation in H2 very clearly. I hope that China will be a positive growth factor in the second half of the year, which has not been very clear in the first half. Exit rates, it's very difficult to say because the situation is very volatile.
If I don't speak too much about the exit rate, I can speak about the improvement which is expected in the second half.
Thank you. My follow-up is on earlier topic of COGS inflation that you briefly touched upon, that you have seen some prices of components coming down. Maybe if you can elaborate more, on that. I think energy prices are still going up, so cost of glass and glass-related materials might go up but.
I don't know what's happening on the chip side and some of the other components and as well as logistics cost. If commodity or COGS prices go down further down the line, is there any risk that you may need to take inventory write down in the late end of the year?
I guess a lot of work, different elements. On the component side, the situation is a bit mixed, but on you know on mechanics on metals you know on plastics on optics, we think that there is a potential for us after big increases in the past quarters to come back to a situation where we should be able to bring some of the cost down. We have started negotiating with our suppliers. Now you know the new format of management of the supplier prices has changed completely you know from the one-year negotiation session that we had previously. Now it is an ongoing and permanent discussions we are having with our suppliers.
When on one hand we give them a commitment on volume, but on the other hand, we wanna have a commitment on savings. We have already started to get from some of our suppliers a commitment on pricing going down. It's gonna take place probably in q4 that's when we're gonna see the impact of it. But it's important for us to start to do this for the beginning also of 2023. When it comes to potential ops write down inventory, we're not there yet. It depends where the level of our inventory is gonna be at that point in time. We haven't simulated it yet.
What is important for us is to try to gain some improvement at the level of the gross margin. It doesn't mean that if we're capable to bring our gross margin to a higher level, we will immediately reduce prices. It's for us to manage that situation well in order to make sure that we surf that new wave properly. It's very tactical, but we have already put the efforts in place to get an improvement there.
Thank you.
The next question comes from Marc Hesselink from ING. Please go ahead.
Yes, good morning. Thanks. First question is on the trade-off between growth and your margin. Is it a trade-off that you can deliberately make at the moment? Or is the fact that you keep your growth target but lower the margin simply dictated by the market? If it's your choice, then what kind of thinking is behind it?
Marc, good morning. That's a key question. Today our position is the following one. Growth is the most important for us because this is what we had structured the whole organization to go for at the beginning of the year. I think we've commented very clearly to all of you that that was the objective. Meaning that even in the performance that you see in Q2, there are some investments for growth, especially in digitization of the company. You know, the offers, our processes, our customer interfaces. That's what we want to keep on doing. At this point in time reducing our cost to be able to improve operating margin is something that is possible to do now. We need also to understand that one percentage point of gross margin is 5% of cost.
It would require a big effort on cost, which we believe at this point in time would not be the right strategy. Now, moving forward, if we have a recessionary situation at the level of the economy, which is bound to last for a long time, if that would have a consequence on the top line, and that we would not be able to grow the company, as much as we want, we would have to go into another strategy, of reducing costs. What we believe is that there should be a positive traction on everything which is bringing energy efficiency, given the prices of energy. This is where we are positioning the company, both on the consumer segment, but even more so on the professional part of the business.
We believe that we should be able to grow, and growth is clearly our priority at this point in time.
Very clear. My second question is on the one-time net debt EBITA target for the end of the year. I think it depends a little bit on where you end up in the guidance for margin and free cash flow. What's your thinking behind it? If you reach that point, is that also the point then to think again on share buybacks? Given all the uncertainty, you want to have a bit more, maybe a bit more flexibility there? Thanks.
Marc, I'll take this one. You've seen that in terms of net leverage where we are today. We have also stated previous calls that we wanted to further go down in terms of leverage to closer to the 1x multiple. In view of working capital inventory, it might take slightly longer to get there, but the trajectory is still there. Which takes then back to the question that you're referring to in terms of capital allocation that we have always talked. Again, if you look at the performance of the company so far, underlying, if you take out the one-time hits in Q2, underlying is still healthy and we have not changed our strategy, neither our plan, our approach to capital allocation, which means dividend for the shareholders.
As soon as leverage is at a level that we feel we have the opportunity to acquisitions and there's opportunities, we'll go for acquisitions. We've always said like dividends, deleverage. When deleverage is at a good level, then also M&A, as you've seen from the acquisition of Fluence and Pierlite, becomes a reality because we can drive inorganic growth with the cash we generate. If obviously we don't have the right ideas to invest ourselves, we return the money back to the shareholders. That priority has not changed in the current environment or what we currently see from, let's call a recession point of view. We hang on to that one, as you've seen from the acquisitions we've done. Again, we now see inventories being slightly higher.
As soon as we get them back down, our leverage will again improve and the question will remain on the table, do we have the right opportunities for organic and inorganic growth? Again, as Eric said, growth focus, and if we don't, then we'll return money to the shareholders.
Great. That's clear. Thank you.
The next question comes from Joseph Zhou from Redburn. Please go ahead.
Hi, Eric. Hi, Javier. Thank you for taking my questions. I have two. First is on your free cash flow. Obviously, the lower the guidance implies some a very substantial cuts in the underlying free cash flow in the second half, given that you also enjoyed a EUR 194 million one-off real estate gain in Q2. Basically it looks like majority of that is actually working capital. Can you maybe help us understand the details of those in the second half? In terms of breaking it into inventory. Are you still going to build inventory or is that mainly going to be payables or receivables, etc?
What kind of a working capital to sales ratio do you expect to happen in the second half? And maybe do you expect any more real estate gains in the second half as well? Some details will be appreciated. Thank you.
Thanks, Joseph. I'll take the question. Let me start from the high level, and I'll drill down into some of the detailed questions. First of all, as we mentioned, if you look at the performance on free cash flow in the first half of the year, it's obviously not where we wanted to be, but the silver lining here is that it's clearly all tied back to inventory. The structural improvements we've made in the last years on receivables and payables are there. We have a bit of an opportunity on receivables and also the disruption of supply chain. Products are arriving on time. There's a bit more disputes on how to collect money, but that is fundamentally if you look at our days on hand.
Sorry, days receivable or if you look at our payables, structurally, we're still in a good place after what we have in the last couple of years. You narrow it down, all down to inventory. If you look at inventory, and here I'm gonna slightly adjust perhaps what you said, if you look at our guidance, 5%-7%, if you take into account that in the first half of the year, we were negative on free cash flow excluding proceeds, but then positive proceeds still for the second half of the year, it's significant cash flow generation. Just like that, we expect to recover also the gross margin from a cash flow generation. The second half, in fact, is gonna be not far away from the cash flow we generated last year. How do we expect that cash flow generation to come?
Number one, again, keeping the discipline on receivables and payables as we have been doing all along the last quarters. Indeed, the key question here is on inventories. We believe at this point in time that inventory buildup is reaching its peaks versus what we have seen in the last number of quarters. With the payment terms we have, it also means that we have now at the end of Q2 actually paid for most of those inventories we have. That's also why you look at the balance sheet, you see that the payables has come down more than the inventory has increased, which means that we have paid for the inventory we've been building up in Q4 last year, Q1, Q2 this year, and then we expect in the second half our inventories to go back down.
As you know, normally by the end of the year, our inventories go lower because we prepare for a slightly lower sales season in Q1 of any year. We do expect inventories to go down, not yet to the levels that we were used to because of the fact that we do not expect supply chain to be fully regularized, which means that we're still sitting on goods in transit, and selling some of the stock we have at hand. We do expect inventories to go down towards the end of the year, with my receivables and payables remaining at a healthy level. The dynamic is really about managing inventory. Inventory is built by being very optimistic. Remember last year, this time we talked about light at the end of the tunnel. We're preparing for growth.
We're really investing in also building capacity to sell to the market. We started off very well Q4, Q1 this year. Q2 became more difficult with the crisis, so that inventory has now flushed through. At least we will not have a significant further inflow of inventory or providing, of course, that the world doesn't collapse in Q4. That's something that at this point in time, we do not foresee forcing.
Javier, my second question is really on the inventory write-down. You mentioned about the UV-C and certain conventional products, which makes sense. Are there any other products that go beyond when it comes to the current inventory write-downs? Also, do you expect to have more in H2 given that you've been building inventory?
Look, Joseph, we have a very tight policy on inventory valuation, inventory write-downs. It's also with the auditors, obviously. Whenever we close the month and the quarter, we look at potential obsolescence, and whenever we see a risk, we take those provisions. That's number one. We don't change that policy quarter to quarter. The inventory obsolescence provisions that we have currently taken are in light of what we see, where we see efficient.
The majority of those provisions have been taken on the conventional side, on UV-C, surface disinfection and also on the horticultural conventional business. We believe in general the inventory we have is inventory that was ordered for our normal products, so it's high inventory, but it's healthy inventory. It's gonna take a bit more time to get them through the system. It's also a question about limiting the order intake that we have. But fundamentally, we look at the health of our inventory. We have in our forecast, I would say, some provisions for obsolescence, but they're normal levels of obsolescence that you would have through the years, and there will be some coming in Q3, Q4, but not to the levels of Q2 at this point in time.
We follow our standard rules in terms of the visibility we have today. We do expect that the impact we saw in Q2 will not repeat to that extent in Q3, Q4. Okay?
Thank you very much.
Yeah.
The final question comes from the line of Sven Weier from UBS. Please go ahead.
Yes, good morning, and thanks for taking my questions. I joined the call late, so apologies if you commented on those two questions already. The first one would be on the Digital Solutions margin trajectory in the second quarter, which I'm trying to square. Because if I understand it correctly, most of the CSG and DS was volume, and not so much price. I guess the energy cost impact you mentioned overall is probably not affecting DS so much. If I understand you correctly, there was no major mix impact outside Digital Products. The currency, I saw the overall impact was 110 basis points on the group margin against 130 in Q1. I'm struggling a bit to square the 120 basis points margin decline in the division in Q2.
That's the first one. Thank you.
Yes. Good morning, Sven. well there are a lot of different elements that are impacting the gross margin. I talked to them previously, so I don't know if you were there, but I said it's about FX. If you look at the gross margin of the group, it's 290 basis points decline. One part is FX, one part is logistics cost, one part is obsolescence, and one part is the price of energy. I would say that the three divisions are touched by this, but the conventional product division is the one that is the most touched because you see that the delta in terms of operating margin in that division is quite substantial, because we're talking about how much is it?
310 basis points for the conventional products division, when it is much less for DDS at 120 basis points. You would say that what we see in DDS is basically the impact of FX, which is pretty much the same for that division at the end of the day. We've been able to get much less impact on the digital division than on the conventional division because of logistics and energy and obsolescence, which are more touching the conventional part of the business. That's the way you should read it.
You know, there were a lot of elements that were impacting the gross margin, 290 basis points, but we've been able to compensate and create operating leverage because at the end of the day, for the group, it's only 140 basis points at the level of the operating margin. For Digital Solutions, it's a bit less than that. It's 120. probably on the three divisions, this is the one that has, I would say, performed the best under those circumstances.
Okay. Understood. Thanks for this additional color. The second question was just coming back on inventory, but not your inventory. I was wondering about the channel inventory that you see, because my perception is it's getting a bit more elevated, especially on the consumer side, but maybe also on the professional side. How do you think about how that is impacting your pricing agility in the second half? Wouldn't you think that there is some pressure from channel inventory in the second half?
Yeah, very good question. On the channel inventory, we see no major over-inventory on the professional channel. On the professional channel, I would say that the inventory of our customers are at the right level. The inventory on the channels of our consumer go-to market has increased and quite substantially in the past semester. We are working with our customers to bring that inventory out, but we are not doing it through promotions and price decreases. That's not what we wanna be doing. We try to pull the market rather than reducing prices.
It's true that there is a bit of overstock, which could potentially limit further the top line, but we would try to avoid as much as possible, doing too strong promotions to flush that inventory out. We prefer to have a good demand well, taking that inventory rather than doing big promotions. I mean, that's the strategy we have, and that's the principle that we have applied so far.
Thank you, Eric. That's great. Thank you.
There are no further questions. I will hand back to your host to conclude today's conference.
Ladies and gentlemen, thank you very much for attending today's earnings call and for taking part in the Q&A. If you have any additional questions, please do not hesitate to contact us. Again, thank you very much. Enjoy the rest of your day.
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