Good morning, and welcome to the Gates Industrial Corporation Q3 2022 earnings call. All callers are in a listen-only mode. Following the presentation, there will be a question- and- answer session. To ask a question, you'll need to press star followed by the number one on your telephone keypad. To withdraw your question, please press star one again. As a reminder, today's conference is being recorded. It is now my pleasure to turn the call over to Bill Waelke, Head of Investor Relations. Please go ahead, Mr. Waelke.
Thank you for joining us this morning on our third 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 third 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 two of the presentation, which provides a reminder that our remarks will include forward-looking statements within the meaning of the Private Securities Litigation Reform Act. These forward-looking statements are subject to risks that could cause actual results to be materially different from those expressed in or implied by such forward-looking statements. These risks include, among others, matters that we have described in our most recent annual report on Form 10-K and in other filings we make with the SEC. We disclaim any obligation to update these forward-looking statements. With that, I'll turn things over to Ivo.
Thank you, Bill. Good morning, everyone, and thank you for joining our call today. Before we begin, I would like to take this opportunity and thank Bill for his support over the last 4+ years in helping Gates to stand up and operationalize our investment relations structure as a public company. Bill is moving on to a new role at a different company upon completion of this quarter's earnings cycle, and we will be making further announcements about the IR leadership role transition over the next month or so. With that, I'll begin on slide three of the presentation. Our global teams executed well and delivered high single-digit core growth while facing an operating environment that was incrementally more challenging. The underlying demand for our products remained positive, with largely stable order rates across most of our markets and a book-to-bill ratio that remained well above one.
Our backlog stayed elevated primarily as a result of incremental raw material availability challenges and labor disruptions, as well as stable order rates. Our profitability improved sequentially in the quarter. While inflation moderated in certain areas, it remained elevated overall, and we saw notable acceleration of energy and specific petrochemical input costs. The inflation in the quarter was higher than our expectations. However, the pricing actions we have implemented allowed us to exit the quarter in a margin-neutral price cost position. While the availability of some supply chain inputs improved, we continue to face supply disruptions associated with highly engineered polymers in particular, and we anticipate this situation continuing in the fourth quarter. While we expect these disruptions to moderate next year, we are updating our outlook for 2022 to reflect their impact as well as that of the incremental inflation and additional FX.
Although end market demand remains largely supportive, in light of the current macro uncertainty, we are initiating the next phase of our footprint optimization plan, the details of which Brooks will cover later in the presentation. As we prepare to enter 2023, we believe our business is well-positioned. We anticipate starting the year with a robust backlog that will supplement the prevailing demand levels of our mission-critical products. We also are in a positive price cost position with expected carryover benefits and incremental pricing actions that we believe will offset the elevated levels of inflation we have seen. Finally, any easing of the supply chain impediments will reduce the substantial headwinds we have experienced in 2022. Moving now to slide four.
Our total revenue was $861 million, with core growth of 7.6%, offset by FX headwind of approximately 8%. We saw core growth in all of our end markets, with the highest growth rates in industrial. Our mobility business delivered another quarter of solid growth, and the energy end market continued to benefit from increased activity in the field. Ad and construction applications included in our off-highway end market also remained robust. Third quarter adjusted EBITDA was $178 million or a margin of 20.6%, representing sequential improvement of 70 basis points. Incremental negative FX impact, supply chain disruptions and escalation in material and energy input costs were offset by a solid pricing performance and cost controls globally. Adjusted earnings per share were $0.31, flat to the prior year quarter.
Moving now to slide five in our segment-level results. Our Power Transmission segment had revenue of $523 million in the quarter, including core revenue growth of 5% and negative FX impact of 10%. Excluding the suspension of our business in Russia, which was almost entirely within this segment, core growth was over 8%. The segment was also disproportionately impacted by the shortage of the said petrochemical inputs. All regions had positive core growth, led by the industrial end market, with energy, off-highway and mobility showing the strongest growth. Our Fluid Power segment had revenue of $338 million in the quarter, including core growth of 12% and negative FX impact of 4%. We saw solid performance across all end markets, with the strongest growth coming in energy, on-highway and automotive replacement.
The industrial First Fit business also performed well with growth in the high teens and the key design wins in off-highway and on-highway applications. Prior investments in innovation continue to pay off, with core growth from new products of over 20% in the quarter. With respect to profitability, our Power Transmission segment was impacted primarily by operating inefficiencies related to raw material shortages, the start of new production capacity, and incremental negative effects, as well as the escalation of petrochemical input costs. Despite these challenges, the segment saw sequential margin expansion of 60 basis points. Our Fluid Power segment generated strong margins in the quarter. With much less exposure to material availability challenges and no start-up inefficiencies, the segment delivered year-over-year margin expansion of 300 basis points. I will now turn the call over to Brooks for additional color on our results. Brooks?
Thank you, Ivo. Moving now to slide six and the regional breakdown of our core revenue performance. Underlying demand remained broadly stable and we delivered core growth in all regions. We are tracking to deliver solid full-year core growth despite the polymer supply headwinds, COVID shutdowns in China, and suspension of our business in Russia. In North America, we had double-digit core growth in nearly all industrial end markets, led by energy on- highway and off-highway. From a channel perspective, we saw the largest growth in sales to OEM customers. Backlog in North America remains elevated due to engineered polymer supply issues and labor availability challenges that resulted in operational disruptions and impacted our ability to drive the anticipated reduction to our past dues within the quarter. Demand trends in EMEA have also remained supportive, and we delivered solid 6% core growth in the quarter.
We saw double-digit core growth in all industrial end markets led by energy, mobility, and off-highway, as well as in the automotive replacement business, ex Russia. Our business in China had positive core growth, representing a significant acceleration across all end markets from the large COVID-driven decline in Q2. Underlying demand in the automotive First Fit market remains solid, which is where we saw the highest growth rate in the quarter. Lastly, our businesses in South America and East Asia and India had varied results in the quarter. South America delivered another strong performance with core growth of 18%. We saw double-digit core growth across all end markets led by energy, diversified industrial, and off-highway. In East Asia and India, we saw modest growth as the region continues to see supply chain disruptions and longer lead times.
We are pleased with our performance overall as we continue to execute in the face of ongoing operational disruptions. Moving now to slide seven and some details on key balance sheet and cash flow items. Our free cash flow in the quarter was $73 million, representing a conversion rate of 82%. A significant increase from the second quarter as working capital investments began to stabilize even as we continue to deal with supply chain challenges. Net leverage declined from 3.3x in Q2 to 3.2x in Q3, and we continue to expect to see net leverage at or below 3x at the end of the year. Moving now to slide eight and our full year guidance. While the overall demand environment remains largely constructive, we have not seen the anticipated improvement in our supply chain situation, which has negatively impacted our production volumes.
Accordingly, we are modifying our outlook for core revenue growth, which we now expect to be in the range of 5.5%-8%. We are also updating our adjusted EBITDA and adjusted earnings per share outlook to reflect the impact of lower production volumes as well as incrementally negative FX, higher inflation, and greater- than- anticipated operational inefficiencies. Our expectation is for adjusted EBITDA to now be in the range of $660 million-$690 million with adjusted earnings per share expected in the range of $1.07-$1.15 per share. While we are pleased with how we are executing through these external issues and believe they are largely temporary in nature, we do expect it to take longer than originally anticipated to see them normalize.
With respect to free cash flow, we anticipate our conversion to be approximately 50% of adjusted net income due to the continued supply chain issues. Moving now to slide nine and the footprint optimization plan Ivo mentioned earlier. As we have stated before, we continually look for opportunities to simplify and strengthen our operating model in addition to reducing costs. This phase of the plan involves spending approximately $45 million in restructuring costs in the balance of 2022 and in 2023 to achieve approximately $25 million in annual savings. We expect to hit the full run rate of savings in the first half of 2024 and ultimately see a total cash payback of less than two years. With that, I will turn it back over to Ivo for some final thoughts.
Thanks, Brooks. Moving now to the summary on slide 10. I would like to wrap up by thanking our customers and suppliers for their partnership and our global Gates associates for their grit, determination, and effort as they continue to deliver strong performance in the face of the challenging macro environment. While significant uncertainty remains, we stay focused on managing what has been in our control and continuing to drive incremental improvements across our enterprise. Given the ongoing challenges associated with raw material, logistics, and labor, we are proactively pivoting to the next phase of footprint optimization and business simplification projects to drive the efficiency of our business well into the future. The pace of positive secular industry trends continues to accelerate, and we are well positioned to capture future demand in these secular opportunities.
We will continue to direct investment in innovation and business simplification towards higher margin NPI and end markets, giving us confidence in executing upon our midterm growth strategy. With that, I'll now turn the call back over to the operator to begin the Q&A.
Thank you. As a reminder to ask a question, please press star followed by the number one on your telephone keypad. In the interest of time, we ask that you please limit yourselves to one question and one follow-up question. Thank you. Our first question comes from Andy Kaplowitz from Citigroup. Please go ahead. Your line is open.
Hey, good morning, everyone.
Morning, Andy.
Ivo, you mentioned that book-to-bill is still significantly over one. We know you're still significantly constrained by supply chains, but have you seen any bigger demand slowdown in any of your large end markets? I mean, it doesn't seem like you have seen any weakening of demand, for instance, in personal mobility. Maybe give us more color on channel inventories as well.
Sure. Look, you know, as I said in my prepared remarks, we see the demand remain actually quite stable. I'd say maybe even better so than, you know, what you would have anticipated taking into account the challenges that you see in these, you know, in the markets globally. Personal Mobility is very strong. We continue to be on a pace of substantial additions of revenue into our backlog. It's probably one of the areas that we have been most impacted with our lack of ability to eat the backlog as we've perhaps anticipated at the end of Q2. If there's one area that, you know, that is somewhat more choppy or perhaps a little bit softer, I would say that's European industrial replacement.
We do start seeing some choppiness there. You know, it's in my mind, less related to channel destocking and more related to some weakness that's rolling in the industrial replacement segment of our business. Outside of that, you know, China is recovering nicely. Asia is doing fine. I'd say Latin America is very, very strong, and North America is very solid as well. You know, it's not an issue of demand for us at this point in time. We certainly recognize that can change, but that's not the situation. Channel inventories, you know, I think that everybody would feel that they are elevated.
In my mind, you know, the channel inventories remain more or less in line with the underlying end market demand. You know, from a demand perspective, I think it's reasonably all right.
Got it. Then Ivo, to the point of supply chains, is it possible to quantify how much production inefficiencies are hurting you in Q3 and/or in Q4, you know, given your new guidance? You did suggest that supply chain could get better as you go into 2023. Are you getting any more visibility toward, you know, polymer availability, as you go, you know, late here this year?
Yeah. Look, you know, I would say that it's the inefficiencies and, you know, primarily associated with lack of supply are kind of in the 300, 350 basis points of top line. That's probably a good number to use. I would say that, I mean, we do see improvements in ability to source raw materials. That is a fact. You know, particularly on the metal side of our business, metals are really not an issue. We are seeing, you know, lead times shrinking and the ability to secure those materials is quite all right. When it comes to polymers, I think that's kind of a bifurcated story.
We actually are able to secure the polymers that we need to support our customers' run rate business. The issue is the spottiness of supply. You may get the polymer that you need, but you may get it two weeks late than you anticipated or than the supplier has committed. You know, that drives very significant set of issues for you vis-a-vis your ability to not lose production days of output. You know, I would say that the polymer issues are a big headache for us.
We do believe that it is improving somewhat, and we are more cautiously optimistic that, you know, into Q1, it could be, you know, it could be less of a headwind for us, or 2023 should be less of a headwind for us, from the polymer side. I'll also say, you know, I know that you didn't ask the question, Andy, but I'll also say that the inflation on polymers, you know, is certainly not abating. We are taking that into account. We are, you know, we are pricing for it, and we continue to roll out more price increases to, you know, to keep up with the inflation that we see on the polymers in particular.
Appreciate the color, Ivo. Thanks.
Our next question comes from Jamie Cook from Credit Suisse. Please go ahead. Your line is open.
Hi. Good morning. I guess two questions. One, I'm just trying to understand the fourth quarter margins. It looks like you expect core growth to be better than the third quarter, and the revenues are comparable, but the margins are down considerably from the fourth quarter relative to the third quarter. Just trying to understand that cadence there. Then my second question, to Andy's Q&A, you said the European industrial replacement business was weaker. Can you just help us understand how big that is for your business? You know, what were the declines like in that? Did that continue into this quarter? Thanks.
Hey, Jamie. Let me take the first part of that question. From a margin perspective, there's really a couple things, right? One is, as we talked about, there's more inflation rolling through, particularly on the polymer side. We've seen polymers continue to go up, you know, quarter-on-quarter, you know, kind of in the low double-digit range. Think around 10%. You know, the pricing for that tends to lag a little bit. We'll price for that, you know, as we get into the first quarter and we roll out our New Year's price increases. I think the second piece is a combination of additional operational inefficiencies that we've talked about.
You know, Q4 is always gonna be a little bit, you know, tougher from a seasonality perspective. Then you roll in, you know, the additional operational inefficiencies, which are really costing us, you know, kind of in this 250 basis points range of cost, you know, both from an external and then kind of an internal perspective. It's not insignificant. Those are the two primary drivers of the decelerating profitability from one quarter to the next. I'll let Ivo pick up the second part.
Yeah. Jamie, on the industrial replacement in Europe, you know, I said we saw choppiness, you know, that's different than decline. I mean, the business still grew mid-single digits in the quarter. You know, I don't wanna say that the business is falling off a trajectory of growth, but we just see kind of softness in certain areas, and it represents about 8% of revenue.
Okay. Thank you.
Our next question comes from Deane Dray from RBC Capital Markets. Please go ahead. Your line is open.
Thank you. Good morning, everyone. Wanna thank Bill for all his help and wish him all the best.
Morning, Deane.
Thanks, Deane.
Hey, can we start with free cash flow? You know, cutting the guide, you know, this has been a sector-wide phenomenon. It's not a Gates issue singularly, it's everyone. Can you give us a sense of your line of sight on free cash flow conversion for 4Q? It looks like it's about a 300% conversion, which is only a little bit above your historical average, so it does not look like it's heroic. But maybe just your line of sight, you know, what has to happen right in terms of receivables, backlog conversion and so forth.
Yeah, Deane. Look, you know, if you looked at our Q3, you know, cash conversion, it was above 80%. We're starting to get back in the area, you know, of where we wanna be. Not there yet in Q3, but getting closer. Then Q4, you know, is gonna be one of the better, you know, cash conversion quarters that we've had in, you know, in the company since we've been public. Now remember, we've also got the VAT receivables rolling in that I talked about last quarter. That's given us kind of, I think, we talked about a $40 million favorable tailwind, which to your point, you know, makes the numbers for Q4, you know, look a little bit better.
When you look at the back half of the year, you know, we feel like we're starting to get more stable and more normalized. As we start to move forward, we, you know, will be back to, you know, less on this, you know, big, kind of working capital investment with all the inflation and the inventory and the supply chain issues. As we head into 2023, be in a much more stable position. We, you know, we like where we are in the second half of the year. You know, obviously, you know, changing your guidance is not great. But we really like where we are in the second half of the year from a cash conversion perspective.
Good. Appreciate that color. For Ivo, the extent that you can you flesh out the plans for the footprint optimization, maybe the timing, the regions, the number of plants? You know, if I look at the payback, it's just under two years, so it really does look like all real estate, not people, because that would be a quicker payback. Just some context and color, any specifics you can provide would be helpful.
Yes, Deane. Thank you for the question. We will provide greater color on our next call, Deane. We are still working through some regulatory approvals and announcements within, you know, within Gates here, within our four walls. We would like to get through that before we give you a real breakdown on, you know, the number of facilities, where those facilities are located. This project's a great project. There's a terrific payback as you stated. You know, this is just a continuation of the, you know, of the cycle of productivity improvements that we see we still have available for our franchise. We will continue to do that as we see fit. We are seeing the opening now to be able to start executing on a couple of these projects. You know, we feel great about being able to have the opportunity to execute them.
Good. I fully appreciate you gotta make all those announcements first. Just lastly, I might have missed it, but the extent any color on October.
Yeah, look, I think that October has been more or less in line with what we have seen kind of in Q3. Again, bookings remain stable. I would say again, kind of what I said about Europe industrial replacement, again, spotty, not falling off the cliff, but spotty. You know, still dealing with the headaches in the supply chain that we have outlined in Q3. We are able to keep up with our customer demand, which is, you know, really terrific. This is probably for the first time in, you know, in a while that we have been able to do that.
We are servicing, our service rates are improving, but unfortunately, we're just not able to eat into our backlog that we've anticipated when we set our original guidance in July. October, you know, more or less the run rate that we have seen in a third quarter and, you know, we are working through some of these issues and executing well, and really proud of how our global Gates team is executing so far.
Thank you.
Our next question comes from Jeff Hammond from KeyBanc Capital Markets. Please go ahead, your line is open.
Yeah. Hi, good morning.
Good morning.
Morning, Jeff.
Hey, best of luck to you, Bill. So just on the, you know, the supply chain issues, but, you know, I think you mentioned labor as well. I'm just wondering if you're seeing any kind of improvement there, the labor market getting a little looser. Then just as you think about kind of supply chain and labor, you know, into 2023, like, is that 250-350 basis points headwind, kind of the comp and, you know, how much of that do you think kind of goes away into 2023?
Yeah. Great input, Jeff, thank you for your question. Look, you know, I would say that the labor shortages are getting better. You know, I don't think that the labor shortages, and we don't intend to say that the labor shortages are, you know, are the, you know, the major impediments. I would say that labor shortages, particularly in distribution centers in North America, are still spotty. You know, we are still having difficulties with ensuring that we have all of our shifts staffed up and we got, you know, all the people at the right set of distribution centers that we need. I would say that that's probably the biggest issue on labor, particularly in North America, as I said.
Out of the 350 basis points of lost productivity in the second, you know, in the second half or in Q4 here. You know, our sense is that we should start seeing that abate as we enter the front end of 2023. You know, I'm not in a position to be able to tell you that it's gonna be gone by January 1, but we are seeing improvement. It's just the reliability and predictability of when that supply, generally speaking, lands in your facility. You know, that's gonna be the area of focus for us. Logistics is improving obviously, so the reliability of logistics is getting better. That has been a real issue for us.
I would say that, you know, the combination of these things should abate as, you know, as, you start seeing greater stability globally, across the outputs as well as across moving goods from point A to point B. Yeah, I would say, you know, first half of the year it's not, you know, it's not unreasonable that in the first half of 2023 you should start seeing this to abate.
Okay, great. Just on, you know, as you think of 2023, and, you know, it sounds like there's still, you know, inflationary pressure, just talk about, you know, pricing you're contemplating into 2023 and then, you know, any carryover and you know—
Kind of broke up at the end there. Can you repeat the back half of that question?
I mean, just pricing, you know, into next year, what your thoughts are, you know, with the continued inflation?
Yeah. You still kind of broke up at the end, but I'm gonna assume that what you're asking about is just pricing in the next year. Look, you know, again, you know, we've done a phenomenal job with pricing. You know, we in the third quarter and in the second half of the year, you know, we're gonna be at EBITDA margin neutrality as we suggested, and actually a little bit ahead of schedule. You know, we've got additional price increases that we roll out at the beginning of the year. You know, we're going after all segments, all regions, all customers.
In addition, you know, we're looking at some, you know, specific areas that have been probably more heavily affected by some of the polymer and supply chain issues, and we're gonna go a little bit more there. We're very confident in our ability to continue to get price to offset inflation as we move forward into 2023. We really, as we think about our issues as we move forward, we don't really see the pricing as a big issue. We think we've got that, you know, kind of square in our sights, and we feel comfortable with where we are.
Okay, great. Thanks so much, guys.
Our next question comes from David Raso from Evercore ISI. Please go ahead, your line is open.
Hi. Thank you. I was curious, the pricing that you're seeing now, how much of the fourth quarter organic growth is pricing? The pricing actions for next year, have they been communicated yet to the channel?
The pricing actions for next year have been communicated through to the channel. You know, we anticipate that we will continue to roll them forward. Again, I would say, Dave, that there are some areas that are more impactful than others. You know, we are now being much more selective. As Brooks said, you know, we've got to margin neutrality price cost-wise earlier than what we've anticipated. We've also seen escalation of inflation, particularly when it comes to energy costs in Europe. Certainly, the engineered polymers and petrochemicals continue to be on a trajectory up, not even on a trajectory of flattening. I just wanna make that clear, and I'll let Brooks chime in on your price, on your specific pricing.
Most of the price, you know, most of the organic growth, you know, year-over-year, you know, Q4- to- Q4, is price, right? Let's not forget, you know, we still have the Russia headwinds, we still have material headwinds. You know, Ivo had talked about that being 350 basis points. I mean, that's kind of the right number, 350-400 basis points. Then also FX is a huge headwind still, right, as we head into Q4 year-over-year. I would say, you know, kinda 80%-90% of the organic core growth is gonna be price. Then also remember that you got that 400 basis points of volume headwind really related to Russia and material supply issues.
I know you don't wanna give margin guidance for 2023, but if you were in our shoes trying to think about what you know today, let's assume no further degradation in the supply chain, the actions you've communicated on pricing for next year, how should we think about incremental margins next year? One clarification, the fourth quarter does not include any restructuring charge in the guidance. Is that correct?
Well, I mean, restructuring is an add back. You know, we're still working through the timing of when some things are gonna be announced and when we're gonna take some of those charges. I think from a cash perspective, it probably will be de minimis, but I don't know that for sure. We're really not contemplating that in our guidance right now. Does that answer your question?
On the margin question, yeah, thank you for the fourth quarter clarification. On thinking about incrementals for next year, and again incorporating what you're thinking about regarding pricing, obviously you have some carryover currency as well to think about, but if you could just give us some framework. Because it sounds like the savings were highlighted as a 2024 event, so I wasn't sure if we can think about any savings in 2023. If you can just kind of wrap it all together, just so, look, we can have our own thoughts on the top line, the price carryover. Just trying to get a sense of looking at that fourth quarter margin, and I know it's not a great seasonal quarter for margins, just how to think about incremental margins for 2023. Thank you.
Look, I, David, I think that, you know, I would stress that we are still going through a financial planning for 2023, as you can appreciate, predominantly driven by the volatility that you see, right? I mean, we set our you know, we adjusted our guidance in July and, you know, we have seen a very substantial incremental headwinds associated with FX and, you know, some more disruptions in supply chain and labor and so on and so forth that we all certainly, you know, appreciated and anticipated that will get better. I would, you know, I would probably defer a better conversation after our Q4. Look, we do anticipate we're gonna get, you know, a small amount of savings from the restructuring in the back half of next year. We will inform you more effectively about what we anticipate vis-à-vis 2023 after our Q4 call.
I appreciate that. Thank you. Bill, thank you for all your help, and best of luck.
Yeah. Thanks, David.
Our next question comes from Jerry Revich from Goldman Sachs. Please go ahead. Your line is open.
Yes. Hi, good morning, everyone.
Morning, Jerry.
Ivo, I'm wondering, can you just talk about conceptually, you know, nice to see that you folks are pricing to offset inflation, but, you know, we're not able to offset the higher logistics costs with the current pricing actions based on third quarter results and guidance. So conceptually for business with as strong of a market position that you folks have, you know, what's keeping you folks from taking a more aggressive stance on pricing so that we're not only offsetting the inflationary impact with commodities, but the operating challenges that you spoke about on the call? You know, how are you thinking about potentially pricing for those as you think about 2023?
Jerry, let me kinda you know kinda correct the framework here. We are definitely getting price for the uptick in freight costs from an inflationary perspective. We're getting freight, we're getting material. And quite frankly, in fact, we've started to incorporate energy into our framework in terms of getting price. What we haven't fully covered is both the internal and external disruptions that are causing some of our operational inefficiencies and then also some of the volume impact that flows through and then causes some margin dilution. From an inflation perspective, right, we're getting price and then more, you know, to get to EBITDA margin neutrality. What we're not getting is the operational inefficiency and volume offset from a pricing perspective. Quite frankly, we think that's kind of the right approach to take.
Yeah. Brooks, you and I are saying the same thing. You're offsetting inflation, but this is a really hard operating environment, and everybody's facing what you're facing. You know, other companies are just being more aggressive in pricing for the logistics challenges. I'm just wondering, given your market position, how are you folks thinking about, you know what, we need to push pricing another 2 points, to essentially price in this risk of further inefficiencies from getting the right material to the right place, given COVID-zero policies and other supply disruptions?
Jerry, let me take it a little different tack. We are fully recovering inflation across all of the inputs. This is not— the inflation— Price material economics, including energy and logistics, is not the issue. Again, our issue has been the disruption that the lack of supply that we see in our manufacturing facilities. We just don't believe that that's something that our customers should pay for. This is something that, you know, we've got to deal with, and we are dealing with those issues. We continue to take price, you know, taking into account that we are in an inflationary environment that is not slowing down, perhaps despite popular belief. We will continue to do that until such time that we see inflation abating across all of our inputs.
That being said, the headwinds that we have highlighted for Q4 are more operationally driven through the availability of raw materials than anything else. I think that that's how you should think about it. For inflation, we will offset inflation.
Ivo, when do the operational challenges improve? Is there a range of tight components that you're tracking or polymers, et cetera? Can you just give us a sense on what your best sense today on when that availability might improve?
Well, Jerry, I thought in July, I thought that the availability is gonna improve in August and September and October. You know, clearly, you know, that call was not the right call. I would again, I would probably say that perhaps the availability is getting better, but the reliability and predictability of when it will arrive is not. As I said earlier, Jerry, I think that first half of 2023, we should start seeing abatement of these issues. Again, both we are seeing improvement in logistics reliability, which has been a real issue. Again, we are moving large quantities. We are not moving you know, small boxes of goods.
I mean, we are moving tens of thousands of kilograms of polymers to you know a reasonable amount of facilities globally. I think as we see improvement in logistics reliability, we will be you know seeing improvements in our performance. What I'll say is that when you take a look and you almost have to think about it in you know vis-a-vis our product line segments. You take a look at our FP segment, and we have done tremendous amount of work in that you know 2017, 2018, 2019 time frame, making investments in NPI, making investments in material science and engineering. We have engineered lots of these overly dependent, single source, highly constrained polymers out of our supply chain. You see that you know that's really paid off.
I mean, we have not seen the same level of supply chain issues. We have not seen the same level of disruptions. Lo and behold, we got a terrific core growth and strong level of profitability that is filtering through because we have limited, almost nonexistent, shortages there. You see all of that impact rolling into our Power Transmission segment. We are now in process of, frankly, doing the same thing that we have done on PT. We're making investments in incremental, more efficient capacity. We're making significant investment in NPI innovation. We are engineering lots of these highly constrained polymers out, giving ourselves an opportunity to have much broader supply chain and raw material availability to support the production as needed, when needed, where needed.
You know, we are feeling very confident that we will see sort of, you know, coming cycle, the same level of benefits in PT that we have delivered in FP.
Yeah, I appreciate the discussion. Thank you.
Our next question comes from Julian Mitchell from Barclays. Please go ahead. Your line is open.
Thanks for squeezing me in, and thanks to Bill for all the help the last few years. Maybe just the first question around any color you could give on the segment margins. You know, you have that 200 basis points decline in Q4 sequentially firm-wide. You know, any color on how that affects each of the two segments. I'm just trying to understand the capacity aspect here. You're adding capacity in PT, I think, and there's some inefficiencies there, and then you're sort of taking out capacity as well. Is the capacity reduction in both divisions or more centered on fluid power because you're adding more in power transmission?
Let me take the front end of that question, Julian, on the capacity attribute. The capacity that we are adding in PT is predominantly focused on product lines where we see a tremendous amount of growth, and also really a rather substantial growth in our backlog and past due backlog. Particularly associated with Personal Mobility and industrial chain development. Business continues to grow tremendously. Our design wins in that space continue to grow tremendously. And for better or worse, our past due and the backlog continues to escalate quite dramatically there. The capacity is very specifically focused on that sub-segment of our end markets and Power Transmission business.
The other capacity that we are refreshing, frankly, in PT is capacity on our industrial and automotive Micro-V belts, where we have developed a new manufacturing process that gives us a fundamental improvement in substantial drive towards productivity. I would say that those are the two areas where we are adding capacity. You shouldn't really think about our moves as moves that will extinguish capacity. We are not capacity-rich. We are keeping with our growth of our business presently, and our desire is really not to extinguish capacity. Our desire is to drive productivity, reduce the complexity of our business, and reduce the complexity of our footprint. I think that that's kind of how you should think about it.
We will give you more color about that on the next quarter's earnings call, as we get through all of our approvals and all of our announcements internally so that we can give you a clear-cut delineation of where these projects will be and how they will be impacting the various segments of our business.
Yeah. On the first part of the question, we, you know, we don't really want to get into the guidance by segment. You know, just take into account what Ivo said about each of the segments and how they're performing and what the drivers are. I think you can draw your own conclusions from that. We don't want to get into forecasting by segment.
Fair enough. Just my follow-up on China. You know, I think you had a very insightful perspective, you know, back in the early summer that China was not having a V- shape recovery after the Shanghai lockdowns. You had low single- digit growth in the quarter in Q3. How are you assessing the slope of that China recovery today?
Julian, I think it's a steady recovery. I mean, I think that, you know, we see month-on-month improvements. You know, we anticipate that, you know, we're probably gonna see mid-single digits growth in Q4. You know, it's definitely getting better, but, you know, let's remind ourselves that, you know, there is quite a bit of, you know, set of challenges that are coming out of China with this rollout of the COVID, zero-COVID policy. You know, almost every day you see a new city getting impacted. We, you know, we are cautious about what's gonna happen in China. You know, we feel that the business is recovering more or less in line with what our anticipation was.
You know, we don't certainly anticipate that it's gonna be, you know, any dramatic growth that you're going to see that will truly require lifting of the zero-COVID policies, and I just don't see anything that is actually occurring in China. We are hopeful that it will occur, but so far, you know, it is still, you know, very challenging there.
Great. Thank you.
Our next question comes from Michael Halloran from Baird. Please go ahead. Your line is open.
Hey, good morning, everybody. It's Pez on for Mike.
Good morning.
Just a quick question. Good morning. Just a quick question, going back onto the supply chain side of things. I'll take a little bit of a different approach. It's my understanding that there's not very many suppliers for these highly engineered polymers. Could you maybe just provide a little color on your discussion on the suppliers and maybe what some of their limitations have been that are causing some of the spottiness that they're seeing and causing delivery issues?
Look, I think that the biggest factor that you see is that there are fewer very large global companies that frankly are dealing with the core of, you know, call it the feedstock that then ultimately gets subjected to incremental processing. You know, number of the suppliers is in Europe, and number of the suppliers is facing extremely challenging conditions associated with a dramatic escalation of energy inputs. As you probably may know or, you know, may not know, you know, the petrochemical industry is extremely energy intensive. I think that that's one set of attributes that's driving their desire and ability to process as much material while they are ramping post-COVID.
Ultimately, you know, you certainly see some restrictions, particularly in Europe, with the supply of the feedstock that you know in the past used to come from Russia that now they scramble more and try to get elsewhere. I would say that, you know, that's a big attribute. The second attribute is, hey, look, I mean, it's you know from an end market perspective, there's lots of demand for refined petrochemicals and you know specialty polymers. We are dealing with that. You know, we are engineering some of these polymers out. We are engineering around this. As you can appreciate, that is not you know an overly simple task.
We produce products that are mission-critical and generally speaking, operating in harsh and hazardous environments. We've gotta be very thoughtful about engineering these things out of substituting these materials with, you know, more effective solutions. Now, we have done that on the FP side. Those products also obviously are operating in harsh and hazardous and mission-critical applications. You know, we're making great progress on PT side as well. But it is a complex challenge to solve.
That color is super helpful, Ivo. Thank you. Switching gears a little bit, it seems like there was a bit of a divergence in First Fit versus aftermarket trends. Could you maybe provide a little bit of color on what you're seeing between those two applications specifically?
Sure. I mean, First Fit continues to grow in the teens, and the replacement side of our business is growing in mid-single digits. What I would try to point out is that, you know, we've had a very strong business in Russia and, you know, most of it went through the replacement channels. If you kind of think about it, ex-Russia, you know, our core growth would have been about 300 basis points higher. You know, kind of low double-digit growth. Most of that would have come through the replacement channels. Absent Russia, the replacement business actually is doing quite well too.
Got it. That's super helpful. Thanks, Ivo. Thanks Bill, for all your help.
Thank you.
We have no further questions in queue. I would now like to turn the call back over to Ivo Jurek for any closing remarks.
Well, thank you very much for joining us for our Q3 earnings call. Again, we truly appreciate Bill's support over the last four-plus years. We'll miss him here, but I will be making additional announcements about the replacement for Bill's role here at Gates, and I certainly look forward having the opportunity to share with you our results in early February post Q4. Thank you and enjoy your holidays.
This concludes today's conference call. Thank you for your participation. You may now disconnect.