WEG SA

BOVESPA:WEGE3

Earnings Call Transcript 2022-Q2

[Operator]

Good morning, and welcome to the Conference Call of WEG to announce the results of the second quarter of 2022. We are transmitting this conference call along with its slides in our Investor Relations website at the address ri.weg.net. And after its completion, audio recording will be available in our IR website. [Operator Instructions]

Any forward-looking statements contained in this document or statements that might be made during this conference call about future events, business prospects, operational and financial projections and goals and to the potential of future growth of WEG are mere beliefs and assumptions of the company's management, because they are based on information currently available. Forward-looking statements involve risks and uncertainties and therefore depend on circumstances that may or may not occur. Investors should understand that overall economic conditions, industry economic conditions, and other operational factors may affect the future performance of WEG and may lead to results that will be materially different from those expressed in such forward-looking statements.

Now we would like to remind you that this conference call is being conducted in Portuguese and you're listening to the simultaneous interpretation into English. Today with us in Jaragua do Sul, we have Mr. Andre Luis Rodrigues, CEO and CFO; Andre Menegueti Salgueiro, CFO and IRO; Wilson Watzko, Controller; and Felipe Scopel Hoffmann, Investor Relations Manager.

Please, Mr. Rodrigues, you may start.

[Andre Rodrigues, CEO and CFO]

Good morning, everyone.

It's a pleasure to be with you once again and to announce the results of WEG on this conference call. We will start with the highlights of the quarter where the operating revenue grew 25% as compared to Q2 '21.

We have maintained a good performance in the main markets where we are operating, reinforcing our strategic direction of developing products and solutions of greater added value to our customers. We had a strong performance in the domestic market with good demand for our business of low voltage electric motors, reducers, automations and especially business related to the generation of renewable energy and energy transmission and distribution.

In the foreign market, demand for industrial business is still very busy, with a growth of 23.7% in local currencies as compared to the same period a year earlier. The adjusted EBITDA was BRL1.3 billion, up 14.5% as compared to the adjusted EBITDA in Q2 '21.

The adjusted EBITDA margin ended the quarter at 17.4%, down 1.6 percentage points from last year's adjusted margin. Throughout the presentation, Andre Salgueiro will provide more details about this performance.

Lastly, ROIC fell as expected in this quarter as we are going to see on the next slide. It dropped 5.3 percentage points as compared to Q2 '21, reaching 26.9%. An important part that we should highlight that from this quarter on ROIC will suffer a greater effect of the impact of the booking of non-recurring ICMS credits on the PIS and COFINS calculation basis since 2Q '21.

The operating income after taxes over the last 12 months no longer has the greatest benefit of these credits which were booked in Q2 '21. But on the other hand, our invested capital still considers most of the adjustments since the amount of taxes to be recovered are still booked in our balance sheet.

In addition to this effect, the growth of invested capital is explained, especially, by the greater need of working capital and higher CapEx which also contributed to the reduction of the ROIC, despite the growth of the operating profit after taxes over the last 12 months.

Now I would like to turn it over to Andre Salgueiro to continue.

[Andre Salgueiro, CFO and IRO]

Thank you, Andre. Good morning, everyone.

On Slide 5, you can see the evolution of our business areas in the markets where we are operating, starting in Brazil, where the performance of industrial electronic equipment continued positive this quarter. The good demand was heavily pulverized in short life equipment. This is of equipments such as electric engines, reducers and zero automation products with a highlight on agribusiness, pulp and paper and mining segment.

In the GTD area, we had a relevant delivery volume of wind turbines, as well as an increase in demand for distributed solar generation. T&D business was another highlight, with good volume of revenues driven by large transformers and substations for projects related to and transmission auctions along with transformer sales for distribution networks and industries.

In commercial engines and appliances, there was a reduction, which was already expected in domestic market. After strong sales volume in the same period last year, it's worth mentioning that we noted a gradual resumption in sales volumes at the end of the quarter, especially in engines for home appliances. Lastly, the demand for paints and varnish products maintained high level of sales with emphasis on sanitation, mining, and metal structures.

In the foreign market, the continuity of the industrial investment observed in recent quarters was an important factor for the performance of industrial equipment area, despite the uncertainties of the macroeconomic scenario. Sales of short life equipment showed significant increases in revenue, especially low voltage electric engines who's demand is very pulverized among different industrial segments.

In GTD, revenues showed typical fluctuations of long life businesses, mainly after deliveries of significant T&D projects in Colombia and South Africa and steam turbines in Europe throughout 2021. In North America, our main region of operation in this business area, we continue the process of increasing the capacity utilization of the new transformer plant in U.S., taking advantage of the opportunities present in this market to build a robust portfolio for coming quarters.

In commercial engines and appliances, the positive sales volume is explained mainly by the good economic activity and market share gains in countries such as Mexico and China. And in paints and varnishes, Brazil's exports to Latin American countries and sales of other operations abroad, both in Mexico and Argentina, have contributed to the growth in this quarter.

Slide 6 shows the EBITDA performance in 2022, with a reported EBITDA showing a 9.8 reduction over the same period in the year before. The EBITDA margin ended the quarter at 17.5%. It is important to highlight and in Q2 '21, we booked non-recurring credits related to the exclusion of ICMS from the PIS and COFINS calculation basis.

Adjusted for this effect, the EBITDA grew 14.5% compared to the same period of last year, with EBITDA margin 1.6 percentage points lower. The challenge is a global supply chain and the consequent increase in raw material costs, together with a change in the product mix and the increase in energy and freight costs still bring pressures to the company's operating margins.

Finally on slide number 7, we show the evolution of our investments. In Q2 '22, we invested BRL226.1 million in modernization and expansion of manufacturing capacity, machinery and equipment and software use licenses, 55% of which were meant for production units in Brazil and 45% meant for industrial complexes abroad.

Now I end my part and turn it back over to Andre.

[Andre Rodrigues, CEO and CFO]

Before moving to Q&A, I'd like to talk about some of our latest accomplishments and comments on our prospects for the remainder of the year. With regards to achievements, I would like to highlight the following events.

In June, our company was the highlight in the Broadcast Empresas Award given by Agencia Estado in partnership with Getulio Vargas Foundation. We were the number one company out of 204 companies with shares traded in B3 that generated the most value to shareholders. We also received special awards in the categories of sustainability and new markets.

Recently, we announced the beginning of the development of the new wind turbine platform with the power 7 megawatts and routers that will be 172 meters wide, which will be the largest machine under development in the Brazilian market. And this week we formalized the creation of WEG Algeria, our joint venture focused on commercial engines and appliances to serve Algeria and North Africa.

Finally, the outlook for the remainder of the year. Number one, we mustn't forget the macroeconomic scenario is more challenging for the rest of the year. Global inflation at high levels and the consequent increase in interest rates in major markets can interfere with the level of growth of the global economy and consequently of our businesses, especially short life ones.

On the other hand, we understand that our competitive advantages help us a lot with that regard. We believe that our business model based on the verticalization, long-term vision, and especially diversification of products and solutions with different exposures to economic cycles help us not only expand our range of opportunities, but also mitigate risks and uncertainties in times of turbulence, like this that we are experiencing. Therefore, despite the challenges presented in the macroeconomic scenario, we expect to deliver another year of revenue growth and profitability within the company's expectations and historical track records.

Now, I end my presentation and we may move to our Q&A session.

[Operator]

[Operator Instructions] Our first question comes from Lucas Laghi from XP Investments.

[Lucas Laghi, XP Investments]

Good morning, Andre Rodrigues and Salgueiro. Congratulations on your performance. I would like to discuss two things with you in terms of renewable. First, I'm going to talk about solar and then wind. So starting in solar, could you give us an idea about the mix in the segment of distributed generation, especially thinking of larger projects or smaller projects such as in homes, small and middle-sized businesses and how do you see the growth prospects for the different sub-segments in 2023, which will be year where higher inflation and interest rates as we saw before and the new regulation in terms of distributed generation? So, I would like to understand the positioning of the company and the growth prospects for the different sub-segments in distributed segments? And then I'll ask about wind. Thank you.

[Andre Salgueiro, CFO and IRO]

Hi, Lucas. This is Mr. Salgueiro answering your questions. And in solar, first, we break down solar distributed generation and centralized generation. So WEG works on both fronts offering products for the two types of segments.

So the segment of distributed generation, both centralized generation has been growing, especially because of more recent projects that we have announced and the most important is the one at [indiscernible] we are providing transformers and substations. So the break down today is more or less 90% going into GD and a little bit less than 5% goes to centralized generation.

If I understand your question, it's more specific about the breakdown in GD. In GD, WEG has a biggest share in the three phase projects, which are the projects where the customer perceive a value, so there is an engineering company with know-how and knowledge. Today, most of our GD is formed by the three phase, and then we have some exposure in mono phase, which is homes, but it's kind of small in the -- as a share of the whole. I don't have the exact numbers to give you now, but the vast majority are related to the three-phase projects.

We have mini-power plants, it's slightly bigger in industry, large commercial projects. So the dynamics of growth looking into the future is, overall, we believe and we are confident that solar generation will continue to grow in Brazil. Of course, macroeconomic conditions such as inflation, maybe even FX rate might have an impact in the cost of commodities and solar plates. But here in Brazil, we have a combination of good solar radiation and slightly higher energy costs.

So solar power makes sense regardless of what happens and what might happen is that it might grow slightly slower -- more slowly or faster. So the mini-power plants, which are the projects that are related to remote generation, they are likely to have a smaller growth and even accommodation of revenue after this year. But other segments in GD, high consumption in retail and even small customers should continue growing in the mid-term.

[Lucas Laghi, XP Investments]

Well, great. While this is exactly what I wanted to know. I want to know the breakdown in GD. Now as to wind power, I would like to understand the timing when the profitability will come back in WEG. So I can think of contracts that you closed in the past and many players are having difficulties. And my question is, when are we going to see the resumption of profitability of WEG's wind turbines considering that the projects are reflecting the lowest equation between higher costs in the chain?

So are there products to be delivered this year in 2022 that already are related to this equation, or this is more into the future? Your contract with [indiscernible] that should be delivered in 2022 would have this normal profitability? And the last point, how are using capacity today in terms of win in WEG and can we think of improved margins at the consolidated level, just because of the lower share of wind because other segments will grow more along the year? So these are the points thinking about wind in the company.

[Andre Rodrigues, CEO and CFO]

Well, thank you very much for your question. Wind, in practice, is the business with the longest cycle in the company. So we have a contract, which was the first that we announced with a new machine with 4.2 with Alianca.

It has just been delivered and we announced it in early 2019. So the timing is kind of long. And as time went by, new contracts were signed, the cost structure changed and then we adjusted prices. So naturally as time goes by and we deliver our next project, what we see is that there is a catch-up of profitability.

Now when we look at the information that were announced related to Alianca contract [indiscernible] we can have these perception. And as months go by, our expectation is that in our portfolio today, it's starting 2023 for the whole year and 2024 from today until the end of next year and the beginning of 2024, we should see this regularization, but it's not going to be anything abrupt. It's going to be gradual.

So this is more or less a dynamic. And so overall speaking, considering everything that is going on, projects today have a margin that is lower than our track record, because of the cost structure. Once we catch up, it will take a while.

Wind, even when the scenario is normal, it's still a business with lower margins than average margins. And if other businesses grow or grow more than wind, we are likely to improve the margins, if we consider just that effect. In terms of capacity, today we have our plant with capacity to produce eight turbines per month, more or less. And then we have this capacity until the end of next year 2024. We are not expecting to increase capacity. If we have conditions and if market demand grows a lot, we may reconsider this and increase our capacity over the next few years.

[Operator]

Our next question comes from Lucas Marquiori from BTG.

[Lucas Marquiori, BTG]

Hello, good morning. I have two questions to ask. Thank you very much for the call. Number one is, I would like to ask about the backlog of products and contracted products, especially U.S. and Europe. If you're seeing an increase in demand or increase in backlog because of higher energy prices, especially in Europe because of the gas thing that is going on there. So, for example, in Turkey, how could the Turkey plant help become more competitive in order to gain market share? I would like to know more about the scenario in your new markets. And the other question which is a slightly simple, could you talk to us about the working capital, inventory and your basings? Thank you very much.

[Andre Rodrigues, CEO and CFO]

Hi, Lucas. Thank you very much for your questions. So first I will talk about the backlog and the long cycle dynamics. First, starting with electrical electronic equipment, industrial ones, so the orders are being placed as in last quarters. Overseas the highlight is oil and gas, mining, pulp and paper projects related to that. The portfolio is healthy for future months. And we have good prospects to build the positive portfolio until the end of 2023.

When we go to generation, transmission and distribution, the portfolio of orders is still robust with deliveries being programed for 2023 and early 2024 as Salgueiro has talked about the wind turbines. And it's very positive, especially for T&D in North America and Central America.

Now short life, it's more limited to more or less three months into the future. So what we see today is that in the second half of the year its performance was very positive. Some countries have some fluctuation, but even so above average as compared to the year before. So in short cycles or short life we are talking about slightly shorter time spends.

As that continues, one of the avenues of growth which is to go international and as you said, having a plant in the future. So it's going to be an assembly line and might become a full factory in Turkey will help us to go into new markets. As in our industrial strategy in Mexico, always creating additional opportunities.

And another example is the low voltage engine manufacturing plant in India that is going to help us in this process. So the message is, we are not seeing long cycle, it's doing very well short cycle. We're still at a better level than we were last year and we are doing our homework to continue the process of going international and seek new opportunities.

As to working capital, we haven't had any major changes as compared to what we've been reporting over the next quarters. We were very fortunate in increasing our inventory level as a strategy to assure the continuity of our businesses. We have always been reporting that no -- none of WEG's customers had any shortages of our products, because we have this verticalization which is a competitive advantage.

But there is a penalty in terms of inventory levels. Along the second half of the year, we are going to see a reduction and other performance educations, both in terms of accounts payable and accounts receivable, everything is business as usual. So the increase in working capital, yes, it is concentrated in inventories.

[Lucas Marquiori, BTG]

Thank you very much for your answer, Andre. Now follow-up, this thing of increasing energy costs, especially in mature markets, I'm talking about Europe. How long does it usually take until it's reflected in your backlog. Should we convert it into orders? When you see commercial, do you see any increase in demand just so that we can have a feel of the energy market in Europe?

[Andre Rodrigues, CEO and CFO]

Well, in terms of energy and new opportunities for energy generation in Europe, we do not have a significant exposure. It's very small in Europe. We have gas turbines which might generate good opportunities, but this is not WEG's main or core business and we may have some other opportunities in generation, but it's not immediate. Things will start to happen from now on.

[Operator]

Our next question comes from Victor Mizusaki from Bradesco BBI.

[Victor Mizusaki, Bradesco BBI]

I have two questions. First one is similar to Lucas. In terms of inventory of raw materials, how long is the impact of raw materials, reflecting in WEG's margins in the second quarter, our inventory level is higher in terms of providing products to customers, but there is this time mismatch between spot prices that dropped. So how -- what should we expect in terms of fluctuations in WEG's margins in the future? And the second question is related to the 7 mega wind turbine. How does it impact WEG's competitiveness, both in Brazil and in other markets such as U.S. market?

[Andre Salgueiro, CFO and IRO]

Hi, Victor. This is Salgueiro. Thank you for your question. As to inventory, you should remember that we do have the inventory issue. And as Andre said in his last question, they have -- they're slightly higher considering the global supply chain. But another factor that we should mention is that, some raw material, especially copper, so in order not to have the impact of fluctuation, that is so significant in -- on spot prices directly in our inventory.

So that we have predictability, so to have accurate timing. So if we consider inventory levels that we have, plus protection structures and pricing, I think it will be something like six months or a little bit more for us to see this transition of changes in raw material cost, so that this is somehow reflected in our results.

As to the wind turbine, we have recently announced the development of our 7 megawatt wind turbine. We should mention that this is the biggest machine ever developed for the Brazilian market. And I think that -- and thinking of prices and profitability, so in absolute terms, it will be necessarily bigger than 4.2 megawatts. However, relative prices in terms of BRL per megawatt, we will provide the gain for each equipment user. So we are expecting higher profitability than we are practicing today. So, yes, the expectation is that this is a new product, a new technology that will provide better profitability than the current machine.

[Victor Mizusaki, Bradesco BBI]

Just one point, would this allow you to take this wind turbine, the 7 mega wind turbine to India and have a slightly faster ramp up of your operation also in U.S.? And we see WEG with a very strong presence in transmission and in transformers, does it open this market for WEG in the U.S.?

[Andre Rodrigues, CEO and CFO]

Well, specifically talking about India, we're certifying the 4.2 machine and today it's -- as far as we know, it's the biggest machine available in that country. So I think that now we have many, many opportunities to explore with a 4.2 machine before we think of the new machine in trying to find opportunity for it.

So focus today is much more in Brazil. So one thing that we may try to find in other markets in the future is that the new product that has a modular configuration with components -- separate components that make [indiscernible] and then if we have the opportunity, we can try and find new market as you said in the U.S.

[Operator]

Our next question comes from Andre Mazini from Citibank.

[Andre Mazini, Citibank]

Hello, thank you for the call. I have a question about electric mobility line. How is the certification of electric cars going in Europe, which is the next market after you focused on LatAm? So Europe will be starting the production of new electric cars in 2025 and we will increase demand. So we have a partnership with Volkswagen. Should we expect other partnerships. We know that BYD is in Brazil. It has three plants with new models. We have more partnerships and even considering batteries. Thank you very much.

[Andre Rodrigues, CEO and CFO]

Hi, Mazini, thank you for your question. As to electric chargers or recharge stations, we have -- our main focus is Brazil. So at first I want to address Brazil. We think that Brazil has a big opportunity for growth. It's always good to reinforce WEG. It's the only company that has developed and manufactures this product here in Brazil and this is a market that we know really well.

So we already have a network of distributors, integrators that can help us in this business. And this is being reflected in the partnerships that we've been announcing with chief OEMs. So major OEMs of electric vehicles, especially light vehicles, whenever they announce light electric vehicles, they approve WEG as partner in terms of chargers.

We are already working in Argentina and we have a focus in some other countries in Latin America. In any way we can imagine that this product even though we are starting it here in Brazil, it can have more exposure than just Latin America.

We sent some recharge stations, especially to our affiliates in Europe, but there is still a certification process that has not finished yet and the commercial efforts at first is very much concentrated in Brazil and in Latin America. So I think that Europe and other regions will be left to the future. As to the powertrain, it's always good to stress that, in our case, at least for now, the focus is powertrain for heavy vehicles, whether trucks, buses and some other kinds of vehicles. But this overall vehicle, on heavy vehicle, the main partnership is with Volkswagen where recurring delivery is taking place, but we have some other partnerships that have been announced.

We have a bus with Volkswagen, we have a partnership with Marcopolo that is developing an electric-powered bus, developing it with WEG's powertrain. And if we have the opportunity of having new partnerships, and continue developing this market, we are paying attention at everything and we'll continue to discuss with potential customers. So this is major focus of our commercial team to seek these partnerships and to develop these markets here in Brazil.

[Andre Mazini, Citibank]

Very clear. Thank you very much for your answer. Have a good day.

[Operator]

Our next question comes from Gabriel Rezende from Itau BBA.

[Gabriel Rezende, Itau BBA]

Hello, good morning for the space. I have two questions to ask. Number one, relates to your CapEx budget. As you announced in the beginning of the year, it looks like that the level in the first quarter and the second quarter is going to be BRL1 billion to get to the BRL5 billion that you are expecting for 2022. How are you thinking about this amount? Is it going to be lower or in a scenario where the -- considering the commodity prices, a scenario that might be more favorable to your budget, are you going to deliver the same CapEx with a more controlled budget?

Number two, regarding transmission lines. A few weeks ago, we had the auction that was very interesting, a BRL15 billion investments to be made over the next few years. How much of that could be addressed to WEG? How much is coming from the auction? Is it going to benefit you, by how much?

[Andre Salgueiro, CFO and IRO]

Hi, Gabriel. Thank you very much for your questions. As to the CapEx, it was BRL1.5 billion, bigger than the last few years, because of the delay of projects that were carried over from '21 that we did not implement and also to support our current levels of growth of our company. Slightly, before I answer the question in terms of the outlook, as a reminder of this capital budget, about 55% I meant for Brazil and 45% for overseas operations. And even with BRL1.5 billion, if we realize BRL500 million, something like that, in Q1, we expect to be at BRL1.2 billion more or less.

This is how much we will be able to execute, but not because of delay or cancellation of projects. This is more related. So we approve the budget and then projects evolve. And it's natural that a few things are left for the next year. Considering our visibility today, this number will be much closer to BRL1.2 billion for the year. And of course the delta of that amount will be carried over to next year.

Gabriel, as to the last transmission auction, the main piece of news is that we -- once again we had a significant auction. In 2020, 2021, auctions were much below average, especially because of the pandemic and now we are back. And we had an auction of 15.3 billion in terms of estimated investment, which is very good for this industry as a whole. In terms of expectation, nothing has been contracted or signed in terms of the projects that have been awarded in the auction.

They will be discussed over the next few quarters in terms of its commercial terms, but there are some players that have won some slots of the auction, which historically have a close relationship with our company. Nothing has been effectively contracted, but considering the volume of investment expected for the next few years and considering that this auction had a higher amount in terms of investment, this is positive news for us and good prospects for our businesses in the future.

[Operator]

Our next question comes from [Jonathan Krones] from JP Morgan.

[Unidentified Analyst]

Good morning, everyone. Congratulations on your results. First about margins. You've been saying for a few quarters that there is the mix in wind and its impact and there is an EBITDA margin, which is at about 7.5%, 18% and copper has slowed down recently. So, I would like to ask about T&D in the international market. Could you give us some more color on that? And in the release, you mentioned that the important units were delivered in the year. Could you disclose that us? Thank you very much.

[Andre Salgueiro, CFO and IRO]

Hi, Jonathan, thank you very much. In terms of margin for the future, in terms of what we have announced earlier this year, so in 2021, the margins should be within these expectations. We have no indications that there will be any additional reduction as shown in the last quarter of 2021. So it shouldn't be below 17.2% and shouldn't exceed 18%, it would be in between.

So I think that what happened in the first quarter, I'm talking about the recurring margin and in the second quarter, it is in line with our expectations. We should always say that even though margins are lower, slightly lower than what we had in the last two years, I think that the level at 17 something, it's a level where we still deal with pressures in terms of seeking raw materials.

In the second quarter, this disturbance in the global supply chain and the increase of revenue of businesses that usually have lower margins such as renewable energy, such as solar and the wind turbines, I think that this is a very healthy and good margin for the company. You talked about the trends of copper prices.

Yes, we are seeing a trend of stabilization in some cases, reduction of our raw materials such as copper. It seems that this is a more structural movement, but it's good to remember that it takes a while to be reflected in our cost structure. So I think that this effect, if it is in fact structural and really takes place, we should see its effects more in the future, not immediately, because there is inventory that we bought at the prices that we had before.

Jonathan, as to international GTD, this is a business area that has grown a lot in the last few years, especially after the acquisition of our transformer business in the U.S. So this has been the main highlight in growth. And specifically, this year what happened is that we reported this last year that there were some very important projects going on in South Africa, in Colombia, and also some deliveries of important projects in steam turbines in Europe, which ended up creating a relatively strong comparison basis in 2021.

Now, in the first quarters of '22, we can see the T&D businesses as a whole are growing, especially in North America, but because of other regions, when we show the total consolidated number, we can see a drop in revenue. In -- any way, the outlook is positive. In September last year, we opened our third factory in the U.S. Now, we are investing to increase T&D capacity in Mexico and a second one in U.S. And the portfolio, as they said, considering previous answers, it's positive, especially considering our businesses in North America.

So we have positive prospects and the external market is going to grow over the next few quarters. And we look at the comparison basis, comparing the second quarters compared to the first quarter, so we are going to continue from now on.

[Operator]

Our next question comes from Andressa Varotto from UBS.

[Andressa Varotto, UBS]

Hi, good morning, for taking my question. So I would like to ask about electro-electronic equipment in Brazil. Could you give us more detail about long cycle versus short cycle in the domestic market? Thank you.

[Andre Rodrigues, CEO and CFO]

Hi, Andressa. Thank you for your question. Well, actually, in industrial electro-electronic equipment, both in Brazil and overseas, we still see quite positive demand from the industrial standpoint. Even though when we analyzed the details, we see that demand is very pulverized in all industrial segments, which confirms the fact that industrial demand is positive.

So here in Brazil, we see segments, such as agribusiness and mining doing very well. But somehow, what we can say is that demand is positive for all products, especially industrial engines, reducers, and automation. Some new businesses that are being developed are part of industrial electro-electronic equipment.

For example, digital businesses. So when we add up all the businesses with the good dynamics of the manufacturing market as a whole, we have the growth performance, both compared to last year, but also compared to the first quarter of this year.

[Operator]

Our next question comes from Regis Cardoso from Credit Suisse.

[Regis Cardoso, Credit Suisse]

Hello. Good morning, misters Rodrigues and Salgueiro. Two topics I would like to touch on. Number one, more general, about this risk of recession. And do -- are you thinking of slowing down your investments? And so, considering the risk of recession, I could understand the timing for capacity ramp-up, both in India, China, and now Algeria. So how much of that capacity depends on a faster pace of economic activity? This is one question.

The second question is about margin. And there is been a drop in sequence. And my question is this reduction in margin and how much of it is explained because of turnover? How much of it can be explained by the FX rate, because BRL was higher before? And also, how much of it is explained by the mix, as we mentioned about the wind turbines, and ultimately, whether this is commercial issue and margin pressure in the competitive environment?

[Andre Rodrigues, CEO and CFO]

Hi, Regis. Thank you for your questions. Number one, we are not seeing any need to change our base in our investment strategy because of a possible recession very soon or in the long term. Number one, the company has a long-term vision and have a strategic plan, and we are very disciplined in executing our strategic plans. Much to the opposite, these new plants that we are opening help us to have a share in markets where we are not present today, where we have a low presence, that help mitigate in unfavorable economic conditions.

As to timing, our plant in India is ready. It's just -- we are just waiting about the local issue of installing in the electrical wiring or aspects locally. We are finalizing almost all civil works in China, number one, it will be in assembly line, components would be manufactured in China and Brazil and made available to the local market for the assembly so that WEG can start participating not just in the Turkish market, but in other countries around, and this will happen over the next few weeks.

In Algeria, as we ended the JV, as we announced this week, we are expecting to start production in Q4 this year. So everything that these three projects, it's a matter of a few weeks -- of some weeks or a few months to start contributing and adding growth opportunities for the company.

As to margin, once again, we consider that margin is within expected levels. If we look at the adjusted margin in the first quarter, 17.7%,17.4% is just what we were expecting. It contributed to this short drop in margin. So the FX rate, for sure, if we consider the FX in the first quarter is 5.3 now, 4.92. There was a 6% reduction. And then if I bought raw material at the higher FX rate with 5.23 and I'm going to export at a lower FX rate, there is an impact on margin. There is also an impact on the issue of growth on the renewable energy, so on wind and solar that are businesses -- wind is that the production capacity of the first quarter was the same as in the second quarter. But solar and solar and wind are businesses with lower margins that may have an impact.

But we are not seeing any impact -- the commercial issues having an impact on margins. So once again -- so within the macroeconomic scenario, we are dealing with all operational difficulties. So this is a diagnosis of the margins in the second quarter.

[Regis Cardoso, Credit Suisse]

I understand. Thank you very much. Congratulations on your performance.

[Operator]

Our next question comes from Bruno Amorim from Goldman Sachs.

[Bruno Amorim, Goldman Sachs]

Hello. Good morning, everyone. Thank you for taking my question. Number one is about operational leverage. So in the last few quarters, most of that idle capacity that was created in the last crisis of 2015/2016 was being used. Can you give us an update, product type and geography, where do you have any capacity for operational leverage? Where are you planning investments to continue to grow?

And the second question is a follow-up regarding distributed generation in terms of GTD. And you mentioned especially that was a lot of pre-buy because of expected changes in regulation next year. And I would like to understand whether this limits the growth next year, or if there is a very difficult comparison basis, is it still possible to grow. That was my question. Thank you.

[Andre Rodrigues, CEO and CFO]

Hi, Bruno. Thank you for your question. As to the utilization capacity, in fact, we have grown a lot in recent years. We have grown in operations here in Brazil and in operations -- in overseas operations. So, on the whole, I would like to give you a vision in terms of our capacity and it's never going to be 100%. We can say this is completely for all operations in terms of engines and automation, also including WEG Power. This is where we have middle voltage and also, T&D operations. So, these operations are going on today and we are investing. Andre has just answered about CapEx. And the biggest CapEx this year is for that, so that we grow on those operations, we are expediting our investment program.

We still have some capacity in some long-cycle operations, especially outside Brazil, especially in terms of generation, hydro, thermal and medium voltage engines. Now, we have some capacity in commercial engines and appliances here in Brazil, because of this dynamics and we still have some space in paints and varnishes, where we could have some growth without demanding much increase in capacity in terms of qualifying the business unit.

As to GD pre-buy, even the word pre-buy, we have been hearing a lot about that in 2019 when regulation was supposed to change and then it took a little bit longer. But the fact is that for 2023, the regulation hasn't changed.

So it's right to say that 2022 is a positive year, and part of that is definitely the projects that people are trying to advance to make them fit into the older rules, and in some cases, even along the first months of next year, because recognition of the request for connection of the projects and then you can still work for a few months to complete the project. But there is some effect along this year and this is bringing a higher demand. And, obviously, this is going to create a comparison basis that is strong next year.

Now, to talk about the expectation for next year, it's still kind of early. So, we're talking about GD. It's a short-cycle business. So we have a portfolio. Our portfolio is usually three, four months that we have a visibility. And we imagine that part of GD and then, power plants are likely to fuel a slightly higher impact. And then this part of the businesses historically was not so relevant, but it started becoming more relevant in 2022, because these project are being advanced along the year. And the rest of GD, involving high consumption and retail, in theory, should continue to be developed.

So, it's hard to imagine what will be the performance next year. But the fact is that we have a stronger comparison basis this year and a challenge in order to have a growth. Especially, the robust growth that we have had along the last few years will definitely not be possible next year. Not to imagine what will be the effect and how this market is going to develop next year. We are only going to have a better visibility once we get closer to the end of the year.

[Operator]

Ladies and gentlemen, we are now ending our questions-and-answer session. I would like to turn the conference over to Mr. Rodrigues for his closing remarks. Please, Mr. Rodrigues, floor is yours.

[Andre Rodrigues, CEO and CFO]

So, once again, thank you all very much for your attendance, and see you in our next call.

[Operator]

WEG's conference call has now ended. We thank you very much for your attendance. Have a good day.