SGS SA (OTCPK:SGSOF) Q2 2022 Earnings Conference Call July 19, 2022 8:00 AM ET
Company Participants
Toby Reeks – Senior Vice President, Investor Relations, Corporate Communication and Sustainability
Frankie Ng – Chief Executive Officer
Dominik de Daniel – Chief Financial Officer
Conference Call Participants
Paul Sullivan – Barclays
Suhasini Varanasi – Goldman Sachs
Sylvia Barker – JP Morgan
Neil Tyler – Redburn
Rory McKenzie – UBS
Arthur Truslove – Citigroup
Operator
Ladies and gentlemen, welcome to the 2022 Half Year Results Conference Call and Live Webcast. I’m Alice, the Chorus Call operator. I would like to remind you that all participants will be in listen-only mode and the conference is being recorded. The presentation will be followed by a Q&A session. [Operator Instructions]
At this time, it’s my pleasure to hand over to Toby Reeks, Senior Vice President, Investor Relations, Corporate Communication and Sustainability. Please go ahead, sir.
Toby Reeks
Thank you very much. Good morning, good afternoon to you and welcome to SGS first half 2022 results conference call. We all hope that you’ve had a good start for the year and we are going to be able to meet many of you at our Investor Days later on this year in November.
In a few moment, I’ll pass over to Frankie and Dominik, who will run through our presentation and then we will move on to Q&A. When we have Q&A, as per usual, please stick to a maximum of two questions. And if we have time at the end, we can answer further questions if they haven’t already been asked. Once we have taken questions from the call, I will then read out any questions that are sent to us on the web and then finally, we do hope to finish in 50 minutes or so.
So without further ado, I will hand over to Frankie to start the presentation.
Frankie Ng
Thank you, Toby. As usual, I will give you a highlight of our performances for the first half. Dominik will provide you in more details our financial review and I’ll cover the business outlook for the second half of this year, as well as the full-year 2022 guidance and then we will follow as Toby mentioned by Q&A.
Let me start with the financial performances. I have to say, despite the difficult market conditions faced during the first half, including the war in Ukraine, the current global [economic context] [ph], the China lockdown, and the absenteeism by COVID, I’m pleased to report a strong set of results highlighting the resilience of our global network. These results are driven by the strong underlying performances in our strategic focus area and our commitment to invest in the long term.
You can see total revenue increased by 6.8% at constant currency while organic growth was 5.38%. Our adjusted operating income stands at CHF458 million, a 1.6% increase at constant currency compared to 2021. The first half margin was heavily impacted by COVID-related restriction in China. Excluding China, adjusted operating income, growth was double-digit.
Our ROIC stands at 18.4%, compared to 17.8% same period last year. And our basic earnings per share of CHF36.78 is a 1.4% increase compared to 2021. Regarding the COVID situation, in terms of health impacts to our colleagues, I’m glad to say that the new variants are much [milder] [ph] and we have had very few civil cases within our global network.
However, the impact of COVID on operations is still important. The 2.5 month of lockdown in China was the primary one, but also we continue to have high level absenteeism across the network due to COVID-related sickness, which is having a clear impact on our operational management. The situation was quite severe in January and February, much better in March till May and we have seen again an increase in June in part of the network.
Additional preventive measures has been put in place to mitigate risks and support our colleagues. I’d like to take the opportunity here to thank my 96,000 in the network for their dedications in ensuring the day-to-day running of operations and supporting our customers and the communities where we operate.
As outlined in our strategy, which we presented to you in May 2021, we are on the journey to become a more sustainable and more data driven company. We have made good progress and are in-line with our strategic planning. As you can see, the revenue under our Sustainability Solutions Framework increased from 45% to 47% in 2021.
We have also migrated 9% of revenue to our next generation digital platform, services and solution confirming our target of 20% by 2023. Dominique will provide you more details on the progress made in our Level Up initiative in a minute, I will highlight a couple of the achievement during the first half.
All our Knowledge Certification business have now migrated to our new CertIQ application platform. These applications set the foundation for an end-to-end digital journey for customers in terms of interaction with SGS. The development of our [indiscernible] network is continuing with expect to opening of three new facilities by end of this year. The market relations and the current demand are in-line with our expectations and we will further reinforce our leading positions with this development.
Our objective of migrating our services to a new digital ecosystem continues with good progress made in our digital lab initiative, digitizing the customer journey, and new digital service offering. The more mature new digital service being Digicomply with which you are all familiar and [true of] [ph] upcoming solution for the e-commerce sectors, which we will tell you more about in due time.
Acquisition continued to be an important part of how we allocate capitals to support our strategic priorities area. We made three acquisitions during the first half. [Gas and electricity] [ph] services based in the UK will enhance our expertise across the gas instrumentations measurement and [indiscernible] industry value chain, particularly in the sector of pharmaceuticals, semiconductor, food and beverages.
Ecotecnos, based in Chile, is specialized in monitoring the impact of industrial activities on the aquatic and marine ecosystem. These services are in-line with our focus on developing new [indiscernible] related solutions to protect the biodiversity, the environment, and the local communities.
AIEX based in France is a technical inspection and entity specialist in the nuclear sector. It provides critical services to ensure the safety of nuclear plants and support our long-term vision related to energy transition. We have also acquired the remaining minority stake of two companies during H1.
[30%] [ph] of AMS, Advanced Metrology Solution based in Spain, the initial investment into AMS was made in 2018, and this [indiscernible] our position in the 3D metrology and dimensional measurement inspection in the aviation industry, and 49% of SGS Digicomply. If you recall, Digicomply is a JV created by SGS that specializes in [work order and] [ph] monitoring in the food sector using latest digital technologies.
The solution is now in [food production] [ph] and have been endorsed by many of the leading food manufacturers. We’re now developing the solution for other sectors such as cosmetic and non-food.
Finally, after the first half closing, we have announced two subsequent acquisitions. proderm in Germany, significantly reinforced our leading global position in the cosmetic and personal care testing having innovative capabilities and strong scientific expertise. Silver State Analytical Laboratories, based in the U.S. is a specialist in the environmental testing of water and salt. Their expertise will further complement our network of [rubber trees] [ph] in North America.
All these acquisitions support key sustainability development goals and comes under our sustainability solution framework. They are supporting our mid-term ambitions of reaching 50% of group revenue by 2023. On that, I’m going to hand over to Dominik for a detailed review of our financials.
Dominik de Daniel
Thank you, Frankie. Good afternoon, ladies and gentlemen. I will start with the overview of the financial highlights for the first half 2022. Frankie already mentioned the operating highlights in his introduction with revenues of CHF3.3 billion and adjusted operating income of 458 million and a free cash flow of 11 million.
Revenues for the Group in constant currency increased strongly by 6.8%. Adjusted operating income increased by 1.6% to 458 billion in constant currency, leading to an AOI margin decrease of 70 basis points to 14.1%. This reduction is solely related to China where our business was impacted by the lockdown between mid-March and end of May. Excluding China, the adjusted operating income is growing double digit in concentrate.
Net profit after minority interest increased by 1.5% to 276 million under review, while adjusted EPS was up 3.9% to CHF40.37. Cash flow from operating activities declined by 23.1% to 263 million, due to higher networking capital requirement to support the strong revenue growth.
Organic revenues increased by 5.8% in H1 2022, out of which approx. 2.5% is a function of price increases to pass on the majority of the absolute cost inflation. The contribution from acquisitions is with 1% limited and reflects several smaller, but strategically very important additions to our network. The currency impact was the 1.6% negative, leading to revenue growth and actual rates of 5.2%.
Moving on to the revenue growth by business. Organic growth in connectivity and products was moderate with 3.1%, which is a result of the lockdowns in China. In the month, China wasn’t affected by lockdowns, the unit experienced high-single-digit to double-digit growth. The best growth was achieved in Softlines, given the very strong performance outside China namely Turkey, India, and Bangladesh.
Also connectivity experienced above average growth, given recent investments and the strong performance of [Prideside] [ph]. Heartline organically declined given the change in situation in China and automotive in [general] [ph] in the first half 2022. Revenues in health and nutrition increased by 8.9% supported by the continued focus on M&A in Health and Nutrition.
Organic growth was 5.2%. Food grew organically above the divisional average, supported by the growth across the network. Health science grew organically below the division average, impacted by significant reduction in COVID vaccine related testing. Revenues in Industrial Environment increased by 6% in [constant rate] [ph], while organic growth was 5.6%. A strong demand for environmental field services, offset lower volume in non-destructive testing and supply chain services in field services and inspection.
Technical assessment and advisory delivered double-digit organic growth continuing to benefit from the increase in supervision and consulting work in Latin America and from a very strong performance in Eastern Europe and Middle East. Public mandates revenue declined due to loss contracts in Africa, partly compensated by price increases in Latin American vehicle compliance services.
The 7.6% organic growth in Natural Resources was driven by a double-digit growth in laboratory testing and Metallurgy and Consulting. Growth in mineral commodities was strong, in oil and gas commodities solid, while agricultural commodities were negatively impacted by metrological conditions and trade restrictions.
Knowledge [posted] [ph] strong organic growth of 8.4%. Growth was achieved across all SBUs and regions. The strongest growth was developed by consulting, primarily driven by the strong performance of [MainPoint] [ph] benefiting from strong demand for supply chain optimization and performance improvement services.
From a regional point of view, we delivered almost double-digit organic growth in Americas, while organic growth in the other regions was mid-single-digit. The Eastern Europe and Middle East countries achieved double-digit growth across the majority of its end markets. Growth in the African countries was high-single-digit, while growth in key European countries was to a large extent moderate to solid.
In the Americas, revenues increased by 10.7% in constant rate, while organic growth was about 9.9%. The strong growth was notably driven by double-digit growth in several [Latin] [ph] key countries and the USA while growth in Canada was solid. The organic growth in Asia of 4.7% was significantly impacted by the lockdown in China, which experienced a small revenue decline.
In the most markets, in Asia Pacific, we achieved mid-to-high single-digit growth, while India, Singapore, and Bangladesh posted double-digit growth. FTEs at the end of H1 2022 increased by 3.9% versus prior year, primarily driven by organic additions given the demand for our services. Average FTEs in the first half 2022 increased to 4.1%, clearly lower than the total growth of 6.8%. The magnitude of the change by region needs to be set in perspective with the revenue increase.
Overall, we showed a good increase of productivity only in Asia Pacific, the differential between revenue growth and [FTE growth is limited] [ph], given the conscious decision, to not actively reduce headcount during the lockdown in China to secure the full recovery potential, which was already evident and started in the month of June.
The adjusted operating income increased at constant currency by 1.6%, which reflects an organic growth of 1.2%, as well as a small contribution from acquisitions of 0.4%. Currency had a negative impact of 1.4% leading to approx. stable AOI in the period under review. The very modest increase in adjusted operating income in constant rate is primarily driven by the lockdown in China. Excluding China, our adjusted operating income would grow double-digit. Consequently, [our margin] [ph] decreased by 70% basis points to 14.1%.
On this slide, I would like to provide you an update on our Level Up initiatives. The following objectives and milestones we achieved in the first half 2022. Project Prometheus was kicked off. The purpose of the program is to outsource IT infrastructure, application maintenance, and application development to reduce the time to market for new solutions and to reduce costs. This program will build a strong basis to roll-out our new solutions globally in an accelerated manner.
We established a builders organization to design and develop new technology based products initially focusing on higher productivity. We introduced Salesforce as the new global CIM. We implemented CertIQ as the global knowledge platform. For the second half of the year, we will focus amongst others on the following objectives. 20% of [lab revenues] [ph] will be covered by the digital lab concept.
We continue to invest in the global digital lab core model for environment, food, and industry. We will add additional 15 countries to our finance shared service center setup, covering approximately 60% of group revenues with the regional financial shared service center set-up at the end of the year. The successful WCS program will cover three additional labs.
We are fully on-track to achieve our 23 Level Up objectives. We will continue to increase the scope, in terms of [group revenues] [ph] coverage, and additional functionalities to the different digital lab platforms, as well as to CertIQ. Acceleration of productivity gains will be realized.
Moving on to the margin by division. Our Connectivity & Products businesses mostly geared to China. Despite a negative margin impact from the lockdown in China, we were able to increase the AOI margin by 30 basis points, which is a result of cash collection recovery of bad debt in trade facilitation services and improved profitability in cybersecurity and strong performance from key affiliates such as Turkey, India, and Bangladesh.
AOI margin health and nutrition decreased to 12.4% from 15.5% in the prior year, affected by the end of COVID vaccine related testing, the impact of the lockdown in China in the second quarter, as well as the continued investment into our global lab network. AOI margin industrial environment decreased by 100 basis points to 8.6%, due to COVID restrictions in China, collection delays from certain government contracts, as well as the mix effects as we are winning a couple of sizable value generating [contracts] [ph] in Latin America with very low invested capital.
AOI margins in Natural Resources increased by 20 basis points to 12.8%. Good margin increases in laboratory testing and Minerals Commodities, they are partly compensated by lower profitability levels in oil and gas trade, as well as Agri Commodities. The margin decline of 60 basis points to 90.1% knowledge is primarily a function of changes in the geographical and service mix.
Operation at working capital stands at 1.8% of revenue, reflecting the strong growth. These [all levels] [ph] remain strong and sustainable. Networking capital was negative in H1 2020 and H1 2021. However, this year’s number of 1.8% is still materially better than what we have seen in the years 2019 and before.
Furthermore, despite the continued strong growth, we believe we will finish with a negative working capital at the end of 2022. Cash flow from operating activities decreased by 23.1% to 263 million due to higher working capital needs given the growth of the [corporation] [ph]. We spent net 153 million in investing activities, which considers also 11 million for a couple of smaller bolt-on acquisitions.
Dividend payments, as well as the NCI transactions amounted to 611 million. We bought back on shares for an amount of CHF51 million. We paid back CHF250 million bond and increased short-term borrowings by CHF592 million. All this leads to a cash position of 1.1 billion at the end of June 2022. Gross CapEx for H1 2022 increased by 4% to 156 million and is a percentage of revenues with 4.8% on the same level as in the prior year.
To sum it up, our revenues in H1 2022 increased by 6.8% of which 5.8% organic. While the lockdown in China impacted our growth and especially our profitability in the first half 2022, we experienced a strong growth recovery in China in the month of June. Our adjusted operating income increased by 1.6%, held back by the lockdown in China. Excluding China, [AI growth] [ph] was double-digit. Our joint invested capital increased by 60 basis points to 18.4%.
With this, I hand back to you, Frankie.
Frankie Ng
Thank you, Dominik. So let me now go through the outlook for our five division for the second half of 2022. Note that all the divisional growth outlook comments here relates to the second half organic growth [indiscernible] integrations to the overall group average.
Let me start with connectivity and product. Connectivity and product organic growth should be well above group average. Connectivity should see its growth momentum carrying on into second half with acceleration of our cybersecurity services demand. Softline will continue its growth pattern with solid pipeline in many countries, including China, Turkey, Bangladesh and Vietnam.
Growth in Hardlines will be stable with some improvement expected in the Toys & Juvenile product testing volume, offset by continued supply chain disruption in the all the Hardgoods sectors. Growth in Trade Facilitation will remain stable due to the termination of government contract in Africa and impact on [indiscernible] to the situation in Ukraine.
Health & Nutrition organic growth should also be well above the group average. Health Science will accelerate growth in the second half as new project comes online replacing the COVID vaccine volume. Those contracts are signed, but have different start dates during the second half. Talent acquisitions remained an issue that needs to be carefully managed, especially in certain key regions such as North America.
Solid growth to continue in the second half in food with positive market outlook and new SGS facilities adding capacity, particularly in Latin America. Cosmetic and hygiene, growth should accelerate as well in second half as some of the project delay on operational resources issues seen in the first half has been addressed.
Moving to industry and environment. Industries and environment organic growth should be below group average. Group momentum will continue in both having safety and technical assessment services in-line with the momentum seen in first half with a strong project pipeline in most geographies.
Supply Chain Services and activities related to oil and gas sectors will see limited growth in the second half due to supply chain disruptions and the completion of some oil and gas OpEx projects. Government mandate growth will remain flat with contract termination in some countries, unlimited growth in our vehicle statutory inspection activities.
Environmental Testing growth should accelerate in the second half supported by better market conditions, less reiterated disturbance, and a catch-up on delayed projects such as [legitimate] [ph] testing program in Europe.
Now the resources organic growth should be broadly in-line with the group average. Mineral-related services, particularly testing activities will continue the growth momentum in second half with new on-site project coming into operations. While they are concerned related to possible economic slowdown, the current demand for [ore] [ph], steel, copper, cobalt, and coal remains strong.
Agricultural services will remain under pressure. While we expect a slightly better crop prediction in Europe and North America, however, this will be offset by trade disturbances in Ukraine and Russia. Oil and gas trade and testing should continue to benefit from steady volume increase, so we expect growth in the second half to be similar to the first half level.
Knowledge organic growth should be also brought in-line with the group average. The underlying market condition for [certification] [ph] remains solid with increasing requirement for skin such as medical device, information security, and in the food sector. Growth in the second half will continue to be held back by the challenging comparable to 2021, which was a very significant year and generate a higher volume than usual.
New drivers for ESG regulations with further support market growth in the midterm and SGS is well positioned to capture this growth with our comprehensive suite of ESG-related services. The very strong growth of our consulting activities will continue in the second half. Demand for technical operational support, which provides improved efficiency and cost control, is increasing against some challenging market conditions for our customers.
So, in terms of outlook for the remainder of the year, the full-year 2022, so, mid-single-digit organic growth improved adjusted operating income with margin at the similar level to prior year, strong cash conversions, and then best-in-class organic return on invested capital, operating investment into our strategic focus area with M&A as the key differentiator, at least maintaining the dividend and utilized our new share buyback program on an opportunistic base as part of our flexible capital allocation strategy. This is just a reminder of our 2020, 2023 mid-term target in which I mentioned earlier we’re still on track to achieve what we presented to you in May 2021.
In conclusion, I would like to mention that we will continue to support all our colleagues across the network affected by the Ukraine war, in particular those who have remained in Ukraine. We’ll continue to monitor the situation and take actions to ensure they’re having safety and well-being. Also, I would like to express my personal gratitude to all my colleagues who have volunteered in supporting our different actions and particularly my colleagues in the neighboring countries of Poland, Slovakia, Hungary, Moldova, and Romania who have provided logistics support to assist our Ukrainian colleagues and their families.
On that, I’m handing back to Toby for the Q&A sessions. Thank you.
Question-and-Answer Session
A – Toby Reeks
Hi there. Yes. Welcome to the Q&A part of the call. Remember, if you do wish to send a message, you will be – do that via e-mail, so you can do this over the call. So, we’ll take our first questions and please [Technical Difficulty] with two questions each from Paul Sullivan. Paul, please go ahead.
Paul Sullivan
Yes. Thanks, Toby. Good afternoon, everyone. Just, yes, a usual couple from me. The outlook statements by division read quite well, but your full-year mid-single-digit guidance implies a second half slowdown if you strip out the China lockdowns. So, can you give us a sense of what you’re building into your thinking and expectations in terms of pricing, the broader economy, and the balance between recovery and further lockdowns in China? And then secondly, can you walk us through the bridge back to flat margins for the full-year? And specifically how much of the – feels like 40 million, 50 million in China shortfall in the first half can come back in the second half? Thank you.
Frankie Ng
I’ll take this. I mean, first of all, I mean mid-single-digit is a range, right. And obviously, there’s also opportunity to be at the upper end of this range. And I think we also have to see this guidance in light of the overall uncertainty, which we have in the economy. We are optimistic, but generally, we think the outlook statement, mid-single-digit is the right number, but don’t want to rule out that it’s more at the upper end for sure.
Now, from a pricing point of view, pricing impact was from the 5.8 organic, 2.5 was pricing, and there is still a bit more coming in, but this could be the trending. And then from the economic outlook, I mean, things can change. We know it’s an overall challenging market condition and this is also in light we have to see this outlook.
Regarding China, whether they are locked on happening or not happening and how long they are or not – how long they are, that’s for us very – it’s not possible to charge for us. We wanted to outline here more what was the impact of China in that regard for the first half. Regarding the second point, if we think about China, we – in the month in which we didn’t have the impact of lockdown, we had actually really good growth, high single digits even double-digit, for example, June, but I think June has to be seen also in the light that the lockdown just finished.
So, it was for sure also some extra work in the month, but at least it shows that the supply chain is functioning. And this is how we also manage our cost base to [stay] [ph], basically, they are to assume kind of what we – expect those at the beginning of the mid-to-high single-digit growth. So, obviously, it may be not possible to recover the full impact of not generated potential profits in the first half from the lockdown, but some of which we could cover, and based on this, we feel comfortable to have a similar margin like in the prior year for the whole year.
Toby Reeks
Very clear. Thank you. Shall we move on to the next caller please? [Indiscernible], do you want to go ahead.
Operator
[Operator Instructions] Ms. Varanasi, your line is now open.
Suhasini Varanasi
Thank you. Hi, good afternoon. Thank you for taking my questions. Two for me please. Is it possible to quantify the revenue impact from the China lockdowns, [Technical Difficulty] in the order of [0.5%] [ph] or so? And which division saw the most impact? This can probably help to model it out, if God forbid, we have something else coming up in second half? And second, we’ve seen a fall in margins in Health & Nutrition and Knowledge, and Health & Nutrition, it’s on the COVID contract [indiscernible] plus something else, Knowledge is because of the mix, how should we think about the normalized margins for these two divisions on an annualized basis, please? So for Health & Nutrition it’s on the order of 14% to 15% maybe, knowledge maybe 19.5%, 20.5% would love to get your thoughts there? Thank you.
Frankie Ng
So, first of all, if you look for China, so the revenue impact was only a 0.5% down in the first half because basically the good growth we had in [Jan, Feb, and June] [ph] was more or less not completely, but almost offsetting the revenue reduction in March, April, in May. But as I mentioned before, we plan the organization for a different group profile. Therefore, of course, we had more costs.
If you think about the margin development in Knowledge, in Knowledge, it’s really about – it’s about the service mix. Are we getting very strong demand in consulting work where their margins are a little bit lower than in the more traditional business. It’s also fair to say that we compare, especially last year with a very tough comp now because we had last year the year where we have additional, this three-year cycle where we have additional audits.
So, we could definitely do every three years a higher productivity. And I think what is partly, it needs to be also partly considered is the fact that last year a lot of audits still happened, very much remotely, which is from a cost to serve model, of course, more efficient than having this on-site and now we start to have much more on-site audits again. It’s already in the run rate, and this is partly also driven by the regulators.
So, from this point of view, last year’s margin was, I would say also exceptionally strong. On the Health & Nutrition part, it is definitely fair to say that we are very strong on vaccine related testing last year, and surely, we have given to those clients a priority and we are not able to get to serve other demand which potentially been there. And subsequently, this business was also respectively well priced as a priority has value and had the pricing.
So, it will take – we are very confident to replace the volume. I mean, if we look today, excluding vaccine related testing, we’re growing double-digit, but and it will accelerate, but, of course, it takes some time until this project starts, and we need even more volume because now we have, let’s say, good prices, but not exceptionally high prices.
So, the margin gap will be definitely still there or you could say maybe last year’s [margin] [ph] more from a short-term point of view had a bit of excess potential. So, it will take some time to narrow the gap in that respect.
Suhasini Varanasi
Got it. Thank you very much.
Toby Reeks
Thank you very much. Should we move to the next caller? So [indiscernible], please go ahead.
Unidentified Analyst
Hi, good afternoon. I got two questions. First, you sort of flagged the benefits in I&E from collections and sorry, the negative impact from collections and then at the same time in connectivity, there was some sort of benefit from the collections. Can you just help us quantify that? And are those one-offs, do you expect them to repeat in the second half? And the second is really around the free cash flow and working capital clearly, sort of, it has picked up, as the revenue growth has picked up, but is 1.8%, do you think is sort of sustainable level beyond FY 2022 as well or we should expect sort of an increase in that as we go along?
Dominik de Daniel
So, I mean, if we look to the net debt development, I mean, for the whole company, it’s neutral right? So basically, there is not higher or lower net bad debt expenses this year versus prior year, but there are shifts within the units. They are definitely still in the single digit millions, but it’s fair to say that the more meaningful positive impact was the collection in trade facilitation services, so C&P. And this was not completely offset by more bad expense in I&E, but I&E was the biggest one with more bad debt expense. There were a couple of other things in other regions, but it’s still in a mid-single-digit level.
And for the working capital, obviously, there is strong growth. And I think, if we look to the trends in working capital, it is – DSO are strong. Actually, they are one day down. So that’s good to see. So, it’s not because of increasing days or it’s just growth and activity. And surely here and there are more errors on the payable side, which are, yeah, sometimes it’s just the timing of certain payments versus when the activity happened.
Overall, we believe we will continue to have strong working capital in the future. As I mentioned also in my remarks, for the end of the year, I believe [working capital] [ph] and percentage of revenues at the end of the year will be still negative, not to the same level like the last two years, but still negative. And I mean, of course, there’s more growth. There is more need, but you need also to consider that our Level Up initiatives and in terms of centralizing billing and adding more to centralized billing, we’ll [indiscernible] have to make structural improvement to partly offset the need in terms of good growth.
Toby Reeks
Thanks very much, Dominik. As a reminder, you can submit questions by [indiscernible] feedback, I guess. So next, please, could we have Sylvia, if you have – two questions if you want?
Sylvia Barker
Yes. Hi, good afternoon, everyone. So let me just – could I go back, so just to make sure they understand the China impact. So China itself grew by 0.5…
Dominik de Daniel
Negative, negative.
Sylvia Barker
Sorry. Negative. Sorry. Negative 0.5, and you would have been, I don’t know, [8x] [ph]. So, the, I guess the negative impact in the half is, kind of 40 million, 45 million and then whatever dropped through [you’ve got] [ph] on top. I guess that’s the right way to think about that. And then just to check on Russia and the Ukraine, so you’ve previously said that that’s about 2% of overall group sales. It doesn’t seem that you’ve exited, you’ve just reduced kind of business activity or at least business development, but can you just confirm if that 2% is still unchanged overall within the [indiscernible] numbers?
Frankie Ng
Maybe I’ll answer the second part of the questions, then Dominik can confirm the first part. Yes, you’re right. In terms of activity in Russia, as we mentioned in our press release, we’re still active in Russia, but we have first stopped all of our business development activities. We have stopped all new investments. We are basically working on existing contract that the revenues has decreased, so it’s below 2% now of the group.
Frankie Ng
I think that covers that actually, doesn’t it? So, next, please, could we have Neil from Redburn. Please go ahead, Neil.
Neil Tyler
Connectivity products, the margin impact of improved collections, can you just help me understand which of the two years, this year or last or two periods is the abnormal? I mean, presumably you’ve improved [collections] [ph] and you hope to keep them there, but that’s the first question. And then secondly, with regards to the outlook and the focus on M&A, I understand there’s been a couple of deals post June 30, but you’re not spending a great deal in M&A at the moment, so can you talk a little bit about what the pipeline looks like, please? Thank you.
Frankie Ng
So, if we look for the whole group, there is in the last 2.5 years as a group, nothing abnormal, so to say. There was a bit more bad debt expense in the year 2019, but the full-year 2020, 2021 is comparable, and the first half this year is also comparable, but obviously, there could be always some movements between divisions like we have it now in the first half this year.
On the M&A side, I mean, reflect at the beginning of the year that we don’t expect very sizable transactions because, you know the kind of more sizables in our industry, they are all well known. We know what will most likely come when to the market, which is of interest and we didn’t foresee an [indiscernible] that sizable things which we are looking for will come in the market that of course could sometimes change, but so far that’s basically the case, but we see, of course, continuously interesting opportunities, which are smaller partly, yes, very small, which are small, but which are of high strategic interest and we will continue to go after them if they make [strategic decisions] [ph] and basically meeting our EVA criteria, but for this year, we’ll be not a significant amount of M&A spending. Next year, it’s too early to say how ability of targets pricing and so on develops.
Toby Reeks
Thank you. Very clear. Thank you, Neil. Next to go is Rory McKenzie from UBS. Rory, please go ahead.
Rory McKenzie
Good afternoon. It’s Rory here. Firstly just on natural resources, your commentary suggested that [tends] [ph] to slow in H2. Is that just a strong growth in Minerals in tough comparators or can you be a bit clearer where else the slowdown we should worry about? And then secondly, looking at customized audits, it’s clearly been a pretty busy period for changing reporting requirements [on these plans] [ph] to do so in Europe. Can you just explain today how big customized audits are in knowledge relative to the traditional certifications? And what percentage of your customer base currently is taking up some kind of ESG related audit service today? Thank you.
Frankie Ng
Maybe I’ll start with the second part. So, in terms of the new reporting requirements, which will be effective next year. And in fact, it’s not all the companies. Typically, there’s about 50,000 plus companies, if I’m correct. The schedule is over three years and not over one-single year. So, you’re not going to see all those company. And second is, most of these, more the larger companies can regard to go on the first batch and then the SMEs and so on.
So, we have seen a quite a lot of increase of demand for these [connectivity’s] [ph]. We are offering services to our customers. In fact, there’s a mix between some kind of consultancy to help them to navigate the new requirements, especially in the SME propositions where they have less, maybe less expertise in dealing with this kind of requirement, the larger company has usually the one internal structure. So, we’re dealing with that in terms of services.
[Ultimately] [ph], in the medium-term, we’ll start to look at the validation with [indiscernible] of those audits or those requirements. So, it is an evolution of the market. So, we’re seeing more demand for us to help [indiscernible]. Obviously, we can’t do consulting and certifications in a one-point time for the market for time being in our – to use more on the consultancy part of the processes and in the medium-term.
So again, our target proposition for the time being is to SMEs. The larger customers has their own structures, but the ones that we start to request for a certification will be stepping in as well to see whether we can offer those services to them. I don’t have an exact numbers in terms of how much [we certified] [ph] because what we do for our customers in terms of ESG certification for the time being is voluntary because the requirement is not coming to a mandatory stage yet. So, is more, as you say, customized voluntary certifications that don’t have the numbers.
The first question was…
Rory McKenzie
On Natural Resources, is the guidance for a slowdown in the second half, is this – does this relate to Minerals or Tough Comparables?
Frankie Ng
I think if we looked at, in general, we are very, very optimistic and upbeat when it comes to Minerals testing or is it Minerals Commodity. Obviously, there was also a big of a pickup already in the second half last year, so the comps get a bit tougher. And I think it’s fair to say that obviously some of this business like especially agriculture is impacted from certain trade restrictions and while my restrictions happened, yeah, rather early, it takes some time until they’re really in the system. So, we expect maybe from this point of view a bit more difficulties, but it’s not, I would not call it a slowdown. I mean, the growth rate is maybe a tiny bit lower.
Toby Reeks
Thank you. Next on the call is Arthur from Citi. Arthur, please go ahead.
Arthur Truslove
Thanks, Toby. I think you mentioned that the – first, I think you mentioned that the oil and gas trade activity is a little bit less profitable than perhaps it had been before, firstly just wonder whether that was linked to the issues in Russia and Ukraine, if not then sort of what were the issues? And then question two, just on the Energy CapEx side, both in terms of renewables and in [diesel] [ph] and gas, just wondering sort of how you’ll stay in the second half of the year in terms of that? Thank you very much.
Frankie Ng
Sorry, Arthur. I did not really understand that…
Dominik de Daniel
The first question was related whether there is an – whether that the lower margins oil and gas trade is more a function of price pressure or more a function of Russia?
Arthur Truslove
Whether it was [indiscernible] Russia and Ukraine or something like that? I’m just trying to get a thoughtful of the reason was [indiscernible]?
Dominik de Daniel
Yes. I think, as I mentioned earlier the Russia impact is limited to the SGS Group is less than – as mentioned earlier, now it’s less than 2% of the group. The pressure on the oil and gas margin is still remaining at the price pressure that they are – the excess capacities, the trade is getting better. We’re seeing growth, but the competition is quite high. So, when we talk about pricing, strategy and so on, there are sectors in which pricing is more difficult than others.
So, on the oil and gas, at least one of those sectors where what pricing is leading more challenging and this is reflecting to the margin. I would say the Russian current sanction restrictions are not the bigger part of the margin evolutions. And the second question was, I’m sorry, I did not hear as well.
Toby Reeks
Sorry. Arthur, could you repeat the second question?
Arthur Truslove
Yeah. It was just around how do you look at the outlook for revenues relating to energy CapEx? So that’s both oil and gas and also renewable energy.
Dominik de Danie
Okay. So the outlook for energy CapEx oil and gas. I mean, we do very little oil and gas.
Arthur Truslove
[Indiscernible]
Frankie Ng
So there’s certainly an evolution in terms of the CapEx spend into the infrastructure. We hear a lot of discussion with our customers about putting more CapEx into refineries also because of the fact that the oil price is high, but we are – we have – we hear a lot of discussions planning, but for the time being, it does not hit directly our activities yet. On the other hand, we are – we’re seeing much more demand in terms of renewable, whether it is wind farms in South America.
We’ll secure a few contract there.
If you can put nuclear as renewable energy depending on how you see it, we’re also seeing a more increased demand into the technical expertise for the nuclear sector as well.
Arthur Truslove
Thank you very much.
Toby Reeks
Thank you, Arthur. And the next to go is [Kate] [ph] from Bank of America. Please go ahead, Kate.
Unidentified Analyst
Hi, thanks for taking my question. Just as we think about the second half of the year, could you remind us how much exposure you have to Germany and the industrial sector in particular just given the potential risks to gas supply? And then of that exposure, any details that you can give around how much is, kind of more volume driven versus more recurring or regulatory base would be great? Thank you.
Toby Reeks
Okay. So why don’t we talk a little bit about the volume related business and any cyclical parts of our European business in general? I guess that’s probably the question, especially focusing on Germany.
Dominik de Daniel
I don’t have the exact number for the oil and gas specific related activities for Germany.
Toby Reeks
I think it’s more that, if Germany, correct me if I’m wrong Kate, but if Germany is impacted, the economy is impacted by higher gas prices or gas sources, it would impact the industry, which might not be able to function, how would that impact our business?
Unidentified Analyst
Oh, yeah. Exactly. I’m just – oh, I’m sorry. Go ahead.
Dominik de Daniel
Sorry, Kate. Sorry. Yes, in fact, we do like every other laboratories, we do have contingency plan, so obviously, it depends on the extent of the severity of the impact to Germany for the energy sources being cut and up. So, we do have contingency plan across the group. And typically in our business continue plan, we also look at several events and some of the activities will be migrating to our neighboring countries like Belgium, Netherlands, and France and so on because we do have across the network similarity in terms of the capacities that we have.
So, these are under study. In fact, this is part of our business continuity planning studies. If the severity goes the extent that we have to – we cannot function in Germany, and we have to migrate all those volume out, France, Italy, Netherland and Belgium will be the country will be migrating some of those volume. The exact impact of how much this means to our businesses is difficult to quantify because I don’t know yet. I can’t tell you how much of the economy will collapse in Germany for the time being, but we have contingency plan.
Toby Reeks
I guess the other part of the question referred to, how cyclical is our business in Germany, how regulatory driven is it?
Dominik de Daniel
Everything linked. They depend on sectors again. You look at all the raw material activities that are extremely regulated. On the infrastructure activities, you are looking at statutory control and so on? Is all regulated. The food activities is regulated in a sense that you need to meet certain criteria, so quite a lot of activities is regulated across the different spectrum of our customers. Some of them has a specific requirement, but they go in line against the [regression fees] [ph] on the background as well.
Toby Reeks
Thank you very much. The other thing is that we are starting to see some refineries opening up in Germany again and coal power stations, which obviously counters that cyclical element. The final caller on the line is [Paul] [ph] from Credit Suisse. So Paul, please go ahead.
Unidentified Analyst
So, a question on supply chain disruptions. In the auto section, you mentioned that you expect Hardlines, Toys and Auto to improve in the second half. Are you seeing any easing in terms of supply chain issues in those areas?
Frankie Ng
Yes and no, it depends on the product. I mean, if you look at the automotive sectors, the – we see a little bit of the easing of the supply chain, but not too much. So, on the automotive sectors, we are very cautious about that. On the toys, on the general products, things seems to be more stable these days. We see an increase in terms of volumes. And we’re still seeing some of the difficulties in the different kind of Hardgoods product.
The logistics with the components on is still problematic, but we see different increase of different volume, but the automotive sector is probably the one that is more challenging.
Toby Reeks
Thank you very much and that brings the questions on the call to an end, but there are some questions online. So, I will attempt to group them because these were submitted, some were submitted prior to the Q&A session. So some of them are probably updated. A lot of them cover China and quantifying that impact, and I think we’ve covered that enough already. So, if you do have any additional questions, please just send them to me.
Dominik, we’ve got a few on quantifying the impact on pricing, in particular our ability to continue increasing our prices given the inflationary environment.
Dominik de Daniel
I mean, if we look to it, I think in general, we increased prices 2.5% in the first half of [indiscernible] the vast majority of absolute cost inflation, whether it’s wages or non-personal cost inflation. It’s a very strong focus of us because we see high inflationary levels. And from this point of operations very focused on it. So, I guess it’s 2.5% with further increase throughout the year and there is, of course, a strong need also at least in the short to mid-term to work on it and we are very committed. But I also think and it’s important also to see that overall, I would say that the tech industry is very rational, more rational than maybe other business services sectors in that respect.
Toby Reeks
Absolutely. Another one for you, Dominic, as well. So, we’ve got some comments asking for some guidance around full-year net debt levels and free cash flow conversion. I guess, obviously, the dividend was paid in the first half and we’ve, sort of got clear guidance around CapEx. So, maybe talk about the other factors.
Dominik de Daniel
Yes. So, I mean, I mean, if we look to it, I mean, we have a pretty clear dividend policy where we say [CHF80] [ph] and we will only increase the absolute dividend if we are down to a payout ratio in 75% to 80%, which will be this year, not the case. Obviously, the payout ratio will drop looking to our outlook statement in that respect.
We have, from a working capital point of view, we had some need in that respect, but as I mentioned before, assuming a slightly negative working capital and percentage of the balance sheet at the end of the year and a bit more CapEx we still should be able to have a kind of similar free cash flow. So, from this point of view, the net debt will go a little bit up because we announced the share buyback, which is basically on top, but it’s not that it’s not overall that [mater] [ph] in that regard.
Toby Reeks
Thank you very much. Maybe one for Frankie. If there were more lockdowns that came in China, what measures can we take to mitigate those effects?
Frankie Ng
Yes. I think, again, we need to differentiate the city which was locked down. So, if you look at the lockdown that happens in the first half was Shenzhen and Shanghai. Shenzhen for about 10 plus days and Shanghai for 2.5 months. These are the two largest operational side of the SGS Group in China and certainly Shanghai is one of the largest in the group.
So, the full lockdown of those two sites certainly has a major impact. Where – and especially the length of the China lockdown did not allow us the ability to move samples to the rest of the network within China. As I said, we have contingency plan, but the lockdown was much longer than anticipated. And top of that, our own customers was in lockdown, so we couldn’t even send our own inspectors and auditors to their site. So, they also [acquired a considerable] [ph] impact.
So, if we look at the future, in terms of lockdown, we do see some spot lockdown in China still ongoing, but we have a much more flexibilities [Technical Difficulty] around because the [Technical Difficulty] is quite large and we have duplicated a little bit moving out [Technical Difficulty] until we assess a little bit of footprint so that we can move sample volumes and they’re doing more across the network in more even way, but obviously, if there’s another lockdown of a month or two in Shanghai considering the size that we have in Shanghai would be something that we have an impact, but if it is one of the smaller sites that we have in [indiscernible] or Beijing, the impact would be much smaller because we’ll be able to take the volume and move it to [another lab purchase] [ph].
Toby Reeks
Thank you very much. I haven’t given names, given names to the questions because they’ve all been grouped so far, but Caroline Price from Fargo has got a couple of questions around the magnitude of the recovery of bad debts in connectivity and products and the end of some PCA contracts. I’m not sure if we actually disclose those details, but could you talk a little bit about how that will impact the C&P business as we go through the rest of the year?
Dominik de Daniel
So basically on the C&P side, so the kind of [indiscernible], they are not that meaningful because obviously the key driver for the acceleration of growth, like Frankie also said in the outlook statement is really the recovery of China, which, yes, that the CMP is really benefiting from it given the big impact of China for the C&P business.
In terms of collection of bad debt in C&P, there was great effort. So, it was a positive thing in the first half. As I said in the question before, it’s in the single-digit million. There was also in the second half last year, they did quite a good collection in that part, but in the C&P part, there is no other big outstanding. They are also so basically all bad debt whilst completely recovered.
Toby Reeks
Thank you very much. And then we’ve got two more. So, the first one is from [Stefan Boller] [ph]. And he would like to ask, given 96,000 employees and personal costs, sorry, I should say about 50% of revenues, how are we managing the impact from that?
Frankie Ng
Yes. In terms of wage inflations, obviously, we calculated all that into our – sort of two aspects. So, first is in terms of pricing strategy, we do calculate into reflecting to our pricing strategies, the biggest cost base that we have in the group, which is people. So, this is factored into the pricing that Dominik has been talking about. And second aspect is also a question of continuing to implement those efficiency measures that we put in place.
So, part of the cost inflations where these wages orders is compensated by the price increase and the other part is also continuous evolution of our optimization in terms of productivity gain and so on across the operations that makes the difference. So, we are we will – for the company, we managed to balance the two.
Toby Reeks
Thank you very much. And for the final question, which again is a, sort of mix with a few people asking. In terms of the investment plans in the second half, where are our key focus areas?
Frankie Ng
You want to go Dominik? So, the key focus area, as I said, again, number one is, have a nutrition. We will continue to expand our network of strategic area of focus or [having nutrition] [ph] has a few new project into the discussion of our planning so that we will continue to invest. Connectivity and product, I mentioned the three [indiscernible] lap that will be established across the network with the [support of Brightsight] [ph].
We also have a few more CapEx investment into the wireless activities. These are the traditional. The Knowledge businesses will continue to expand, but this very little CapEx is more people related. And we also have a few on-site labs coming on board with Minerals, which is in support of our evolution. In terms of the market evolutions, these are, I would say, from top of my head, the larger CapEx we’re looking at.
Toby Reeks
Thank you very much and thank you to everyone for joining us on the call. As I said before, we do hope to able to meet many of you face-to-face at our Investor Days later this year. And with that, I will end the call. Thank you very much.
Frankie Ng
Thank you.
Operator
Ladies and gentlemen, the conference is now over. Thank you for choosing Chorus Call and thank you for participating in the conference. You may now disconnect your lines. Goodbye.
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