Gates Industrial Corporation plc (GTES) Earnings Call Transcript & Summary

Great. Good afternoon, everyone. Welcome to the fireside chat with Gates Corporation. I'm Jerry Revich form Goldman Sachs, and I'm delighted to have with us from Gates, Ivo Jurek, Chief Executive Officer. Ivo, thank you so much for joining us today. Nice to see you.

Thanks, Jerry. It's truly great to be here with you as well. Good to see you again, and welcome everyone on joining us on this call today.

Thank you, Ivo, for making time for us.

Really strong results for you folks just a day or 2 ago. And I'm wondering if you could talk about, as you folks enter this recovery, how do your strategic priorities stack up heading into this cycle compared to what the strategy looked like 2 to 3 years ago.

So really, really great question, Jerry. Thank you. Look, maybe I'll start going back to 2018 when we went public. Look, we knew that this business still needed to be improved. I spoke about it during the IPO. There was additional opportunity to rationalize our footprint, revitalize our product portfolio, improve the efficiency of our SG&A. And frankly, we knew that we needed to reduce the amount of debt leverage that we were carrying post IPO. So if I go fast forward into 2019, a ton of challenges in 2019 induced by the China trade war, then we ran into 2020 and the pandemic. Look, we never stopped really improving our business, and we continue to make investments, particularly into our growth initiatives. During that time, we've also strategically started to reposition our portfolio of business. And we've taken about $100 million of automotive OEM business out by selectively taking programs that were primarily focused on hybrid vehicles or full EVs. We've offset this reduction of automotive OEM presence with investments in our industrial markets through programs such as chain-to-belt initiatives that I've talked about quite a bit over the last couple of years. We've put strong emphasis on industrial end markets, in particular, and we felt that there are some substantial secular tailwinds that we can capitalize on when we take into account not just the internal focus, but also we start seeing the sustainability focus that was coming into it. So this focus on innovation, broader product revitalization and the new strategy has resulted, frankly, in above-market growth over the midterm. We've also paid down over $300 million of debt at the end of 2020. And frankly, now we expect our leverage to be in the range of 2 to 3x, as I've discussed on the call yesterday, by the end of 2021. And this clearly opens up additional opportunities for us for strategic M&A. So in a nutshell, quite a journey since '18, but I think we stay -- we remain focused on our initiatives and now we can introduce the strategic M&A into it as well.

And Ivo, part of what's really interesting about the business is, you folks are putting up really strong margins this year, and it was nice to hear on the conference call to -- in addressing Ashok's question that you're looking for really strong operating leverage next year as well. Can you just talk about the operating leverage that you expect over the course of the recovery? I think what we've seen in -- out of other companies and for your business, even in '18, once demand really ramps up, it's tougher to deliver continued margin expansion because labor productivity becomes tougher and you face other challenges as the cycle wears on. So can you just talk about your ability to manage those headwinds in this cycle? And how much visibility do you have on the ability to deliver the types of growth margins you spoke about in the earnings call?

Yes. Jerry, so you are spot on. It always becomes more difficult, but I think that with repositioning our business, becoming more productive, giving ourselves the opportunity to be in regions where we can find labor and make the labor more productive, the revitalization of our product portfolio, we certainly believe that our long-term incremental margins on incremental revenue should be in the 35% to 40%. And we're quite confident with our ability to deliver those type of leverage numbers on incremental revenue beyond 2021.

And can you expand on that point in terms of ramping up your footprint in areas where there's more readily available supply of labor? Can you just talk about the difference in the footprint today versus 3 years ago?

Yes. So look, we have made a great deal of progress with restructuring. We've talked about restructuring basically since we came up from the IPO. We focused prudently on North America. We focused on Korea, and we are focused on Europe. We have built out 3 large facilities: 1 in Mexico, 1 in Poland and 1 in China. We have increased our size and presence in China. And it comes down to 2 reasons. Number one, we wanted to have a greater ability to support our in-region, for-region strategy, which we have accomplished with an investment. And then, by the way, getting into areas like Mexico and Poland, where people still -- there is a very large available pool of employees, potential employees that you can go and hire that are eager to get good-quality well-paying jobs while we are providing it. And frankly, that's given us the ability, frankly, to get that access to labor, which is much more difficult in places like United States. And I think today, again, we are all dealing with that as well as with Eastern Europe, not that easy either. So the transformation, that footprint transformation has given us the opportunity and put us in a position to be able to be much better off than we were in 2018.

And Ivo, based on the performance that you folks are delivering this year, you're not that far off from your Analyst Day target of 24% EBITDA margins at a sales level that's lower than what you had contemplated would take to get there. So can you talk about what has gone better than planned? As you have mentioned, restructuring was always in the plan. And so it feels like, based on the market performance, that they're tracking ahead of the long-term targets. I would love to get your views on what elements of the plan have been -- have surprised to the upside.

Yes. Jerry, thanks for the question. I think this is a great question. And I know that you participate on all of our earnings calls since the IPO. And I think during the depths of the recessions, I think we have been asked many times, "Hey, what about your midterm vision of the $4 billion of revenue and 24% EBITDA? Do you believe that you can deliver it? Or do you -- are you -- what is the status of those?" Right? And for a long period of time, I says, "Look, we are not decommitting." And one of the reasons that we are not decommitting is because we have the line of sight on our organic initiatives. And we put a very significant amount of work and effort into those. And certainly, those are now starting to layer into our results, as you've outlined, I think, terrific set of results that we have demonstrated yesterday. But we have had terrific results in Q4 of last year as well, starting to demonstrate the outperformance and the market share gains that we believe we are now taking away from our main competitors that are kind of in that low single-digit level. And that's quite substantial. When you layer on top of that the fact that we are in a very early stages of the market recovery, we have a very constructive view on the overall macroeconomic backdrop. Look, our balance sheet is in a very good shape with line of sight to a midterm target of 2 to 3x leverage that I've outlined a couple of minutes ago. And I believe that, that gives us optionality to go through M&A on the top of that organic sort of grade initiatives that we have. On the margin side, our ongoing restructuring, product and process innovation in our Gates production system deployment is positioning us truly in an excellent position to expand our margins over the midterm toward a 24% target. And if I can remind everybody, our midpoint of our EBITDA guide for this year has been raised by 90 bps to about 22.7%. So I think we have -- we feel pretty good about where we sit. And then again, I just think that we have a great backdrop from both macroeconomics as well as from our initiatives that give us the opportunity to -- give us the confidence that we can get back on track and meet or exceed those midterm objectives that we laid out in 2019.

And Ivo, can we expand on the M&A part of the conversation? What types of businesses would be a good fit for you? How does the pipeline look? What sort of sizes businesses are you comfortable with?

Yes. Jerry, look, we have a great deal of interest in broadening our strategic positioning. We participate in a very large marketplace that is highly fragmented. So we see lots of opportunity for further market consolidation. But we don't have just an interest in market consolidation. Our interest is to strategically advance our key priorities, which is continue to scale up in faster-growing economies. And those economies, as we discussed, are some of the Eastern European economies, Asia, Latin America. I think those are great places to be, and/or add technology to our portfolio that we see that there's a great deal of transformation that is happening with propulsion and electrification of passenger cars as well as heavy-duty truck. And we think that there are opportunities out there to add to our portfolio of continuing to leverage and build out on the opportunity that we believe is out there for us for many, many decades to come.

And in terms of how active the portfolio is now, how much of your time do you personally spend evaluating M&A? Or is this something that you're going to look at once your work leverage lower over the course of this year?

Yes. Look, we have a small team that is dedicated to M&A, our business development team. We have a number of folks in that organization. And we've never really stopped developing the opportunities and the relationships with potential target companies out there. And so that continues to happen. I spent a good amount of time every month on reviewing those targets going through the industrial logic and looking at the opportunities that are out there. But I would also say, Jerry, "Look, the valuations are pretty frothy to say the least." And we want to make sure that when we do a deal, that we don't dilute our financial performance and that we see -- we have a good line of sight to generate strong returns for our shareholders and for Gates as well. So we're going to be pretty disciplined. We have terrific, terrific set of organic opportunities ahead of us. And so we are not starved for growth. We will continue to deliver nice growth above market, but we feel that M&A gives us the opportunity to further accelerate that growth rate, and we'll do what makes sense for our company and for our shareholders.

And just to shift gears a little bit here. You recently released your sustainability report. I'm wondering if you could talk about what environmentally friendly investment opportunities do you see for Gates or Gates products? Where is the most attractive green ROI, if you will, for you folks?

Yes. Great question, Jerry. And I want to point out that because we have released the updates to our environmental, call it, the ESG report, it isn't just a, "Hey, look, Gates is just getting on board with this very important direction." I mean we have been working on environmental responsibility and governance and social responsibility for, frankly, ever since I joined the company. But as a part of what we are trying to accomplish at Gates, we have coined a term internally that we call eco innovation (sic) [ eco-driven innovation ], which is an intersection of material science, process engineering and product engineering. Frankly, it is a very integrated approach to innovation that we have taken into new product development, where we are trying to achieve kind of, if you would think about it, 3 things. One is to drive differentiated performance, and that's differentiated performance for our customers and to help them meet their sustainability goals through the use of our products. Belt drive -- our belt drives are a good example of that. They are clean, quiet and generally much more efficient than the alternative technologies that we are trying to replace. On newer Fluid Power products, those products are lighter in weight than the products that we are traditionally replacing and we have traditionally built, which improve energy efficiency, fuel economy, if you would. And on customer product side also, it improves customers' ability to assemble them in their operations. So it dramatically improves the ergonomic factors associated with the employee satisfaction side. Two, we are trying to reduce our environmental footprint for our products. An example in here may be the more environmentally friendly ethylene elastomer materials. That is what we do to make newer belts. It is a new compounding methods that we have developed. And the method, frankly, is eliminating chlorinated compounds. And the last or third, if you would, is to improve our processes. And that gives us, in general, an ability with our new products to be more efficient to make. So in essence, we consume less energy. We consume less water. We generate less waste that we send to a landfill and so on and so forth. So it's kind of a holistic approach to environmental movements that, frankly, we are very proud of, and we're making great progress across the corporation.

And one element of your opportunity set is within electric vehicles. And in the past, you've spoken about your content opportunity being about 20% higher in electric vehicle platforms versus internal combustion engines. I'm wondering if you could talk about your aftermarket parts strategy related to EVs. How is the stocking of your EV parts going at your major partners? Can you talk about how that distribution channel is developing?

Yes. Sure. I think it's a great question. But let me maybe take it first to kind of what the content opportunity is, and I'll come back to what we are doing on the aftermarket components, right? And so Jerry, you're right. When we -- in the very early stages when we were starting to get involved, we kind of said, "Hey, look, we got maybe a 20% improved content opportunity." And I got to tell you, we really undershot that and underestimated what actually that content opportunity was as we got more in-depth into build-out of that portfolio. So let me give you a couple of examples. So if you take a look as an example in the thermal management system on an ICE versus an electric vehicle, there's a huge difference there. On ICE platform, you might have a mechanical water pump that we are manufacturing today that may sell for kind of $18 to $15 depending upon the size and the vehicle. And that same water pump on an electric vehicle -- and by the way that electric vehicle now may have 2 or 3 of those water pumps, will range in selling price of kind of $30 to $130, simply because of the power output that's required. And by the way, those water pumps are all electric. So they need to function on demand, not just always on or always off. You also have on ICE maybe $20, maybe $25 in average of thermal management hoses that is a big product portfolio component for us. Versus EV, that content is kind of $110 to maybe $230, and then simply because that hose that may be 1 meter long in an ICE vehicle now has multiple branches, and it is ran across the entire platform because the platform is the content of a battery. And the battery needs to be cooled. Now you also need to cool that inverter, and you need to cool the motors. So that complexity grows dramatically. The size of that cooling mechanism grows dramatically. And so that ultimately is driving a substantial content improvement for us as well. So I think that as you can probably agree, we have significantly undershot that original estimate of maybe 20% improvement in content. Now that being said, in the aftermarket, yes, we continue to build out our catalog of parts for EV platforms. We today have the content for over 25 vehicles, but it is still very early on as there's very few EV vehicles that are being in the traditional sweet spot. And remember that sweet spot is kind of 7 to 12 years for Gates for the replacement channel. Now if you combine that with the fact that there's about 1.4 billion vehicles on the road today, less than 1% of those vehicles are EVs. And again, if I go back to the sweet spot, that 7 to 12 years -- 12-year-old EVs, less than 0.1% of that car part is in those aged EVs. So we've got some time where it's going to play out. We are getting ready. We are building this coverage. We are very excited about it. But it will take time before it becomes a meaningful part of our playbook. But again, we are ready, and we're going to be #1 market shareholder just like we are today with traditional technologies.

And Ivo, are you stocking with the same with the same partners that you're stocking on the ice components, NAPA, et cetera? Is that -- are you able to essentially leverage your relationship to push those products through that channel?

So Jerry, they are frankly spending quite a bit of their own time to figure out how will that ultimately impact their business, and they want to be the same market leaders as these propulsions evolve. So we're spending time. We are focusing on how can we help them. And we are trying to all collectively figure out what is the best means to get these devices, these products into the marketplace, into the end users' hands to help them repair. Even though that car part, that aged car part is very small, help those customers to get the products that they need. So we believe again that we have time. We believe it's going to take some time to evolve. But both of our largest channel partners are certainly focused on that, and they also want to be the leaders in the transition as it occurs.

And on the conventional ICE products, you folks have benefited from lots of platform fragmentation and so with all your range of SKUs. How are you seeing that fragmentation playing out in the EV world? Is it a similar dynamic where you have a broad range of architectures and parts that are beneficial for you folks?

Sure. I think that the technology is still evolving. And if you -- I can give you a couple of examples, right? I mean if you take a look at the original Model S and you take a look at Model 3 Tesla, as an example, very dramatic evolution of the battery cooling and the inverter cooling technologies. And I think that we are in the very early stages of getting through what is the most efficient method to actually cool these batteries and these inverters and these motors. And so my anticipation, Jerry, is that, that will continue to evolve. And just like what you have seen with the combustion engines, there will be a fragmentation. There will be different topologies that folks want to do. And I think that ultimately, you will see similar type dynamics occur on EVs where it's all about power output per cubic centimeter or cubic decimeter of space. And that will require all of these parts to come together and continue to evolve as the temperatures rise. You still have the same impediments associated with NVH, so heat and vibration and all of these noise attributes that are very destructive to products that we manufacture. And we are looking at a range of technologies and developing most importantly organically, developing a differentiated set of technologies that we believe will position us to be a market leader in water pumps, electric water pumps and in battery cooling.

And in terms of the replacement cycle, can you talk about how that compares for belts versus electric water pumps and cooling systems? Anything we should keep in mind about the cadence once EVs become a greater part of the population?

Yes. So look, our sense is that it's way too early to be able to have any reasonable sample size of how this is going to play out in terms of replacement rates. But a couple of points, okay? First and foremost, we manufacture products that age. So if you take a look at engine cooling today in an ICE vehicle, the products that we manufacture just age. They don't die because there's too much pressure. They don't need to be replaced because somebody broke through that hose. They, generally speaking, need to get replaced because they age, and that impacts your ability to cool. And so since we are using similar type engineered chemistries, we know that those chemistries are going to age as well. We know that the vibration doesn't go away. Vibration is kind of a killer of components. And so we anticipate that car is a car and so the replacement rates will be somewhat similar. Now if you take a look at water pumps as an example, the electric water pumps, they have more duty cycles. You have more duty cycles. You will, generally speaking, probably run similar replacement rates that you see on water pumps today, maybe even higher replacement rates. So we take a look at -- if we take a look at something that is maybe more similar to a full EV, say, a platform such as Toyota Prius, that's got a reasonably good population out there that has been on the road for a substantial amount of time. Some of the bigger, more frequently repaired items are the electric water pumps that drive the cooling for that hybrid inverter, and we believe that, that's probably a good indicator of what we will see in the future with the type of components that are deployed or they are similar or identical components that get deployed on full electrics.

And Ivo, your strategy on internal combustion engines from the automotive first-fit standpoint is to only focus on hybrid or high value-added application. What's your strategy like in EV? Is the first-fit market any more attractive to you for EVs than for ICE vehicles?

Yes. Look, we are participating on EVs. We believe that our investors want the assurance that we can be a market participant into the future. And so we continue to win new business. Whether or not it is on passenger cars, I think a quarter ago on an earnings call, I spoke about a couple of platforms that we've won on on-highway industrial applications or heavy-duty trucks. So we are a big participant there, and the content on heavy-duty trucks are even bigger than the content that I described for passenger vehicle. So we will do a strong demonstration platforms with the OEMs. But Jerry, again, our overall philosophy has been that over the long term, we are the replacement company. And we will continue to function in that manner as long as we demonstrate to the external world that we have the technology and that we have the capability to not only compete but provide the most effective solutions on the electric platforms. So it's going to be a balance.

And in terms of the off-highway opportunity set, obviously, much earlier in that product life cycle. But can you talk about what are your opportunities if we're looking at electric, let's say, scissor lift, instead of a diesel? What's the content for you folks compared to the hydraulic systems that you would sell for those applications now?

Yes. So I would say that our primary focus today has been on the on-highway applications. I think that those companies and those applications are much further along than I think any of the off-highway applications. And so from where I sit, the content on the on-highway applications are about $600 for us. $600 to $700 per platform, which is about 3 or 4x of what it is on the diesel-type application on highway. And so we continue to build out that portfolio. We work with customers. We'll talk more, I think, about that set of applications on our next earnings call, but we are very constructive on the on-highway. And as the off-highway technologies continue to develop, we will be there with products that support that as well.

And Ivo, if we just shift gears to talk about your distribution. Obviously, that's where your business is really differentiated, based on the ability to service, call it, 370,000 plus SKUs within a day or 2. Can you talk about how your distribution footprint has evolved over the course of the pandemic? And can you talk about how your logistics systems have evolved? Any increases in online order rates and efficiency gains exiting the pandemic?

Yes. Look, so it's kind of a combination of questions both on the -- just on the physical distribution centers and maybe a little bit of a digital in here. But let me try to tackle both of them on 2 different attributes. We're going to take a look at our physical presence with kind of a brick-and-mortar distribution. We have a very robust network. We are globally deployed. We have strong locations, and they make sense relative to our manufacturing footprint and frankly, our customer locations. So I think that we are in a very good shape. When I take a look at what are some opportunities for us, I think that we have opportunities, frankly, to advance our distribution in developing economies. So I take a look at Africa, I take a look at Asia, I take a look at India, those are opportunities that we believe we can continue to grow further. We continue to build out our channel presence. So people first, location second, products third. And the innovation that we've put in place gives us the opportunity not only to solidify our presence in the developed economies, but also in the developing economies. So I feel that we're in a good shape. Now when I think about digital, on the digital side, we've made quite a bit of -- we have made quite a bit of interest because frankly, Jerry, we were not as contemporary as I would have liked to be coming into the IPO. And we knew that we wanted to do that. And again, I spoke a little bit about that during the IPO process. So if I take a look at what we have done, and most of that work has been done latter part of '19 and throughout the pandemic-induced 2020, last -- late last year, we have launched something that we call Gates Connect. Gatesconnect.com is a self-service portal for our existing channel partners and OEMs. They can place orders. They can check the order status, and it facilitate an ease of doing business with us. We've spent a ton of money and resources on doing kind of rudimentary things, if you would. We've upgraded our EDI tools. We have added a whole bunch of capability in our product configurators, price and quoting tools, so we can do that faster, design tools that make it easier for our customers to take our products and design them into their applications. We have globalized our CRM platforms. We've just tried to make ourselves more contemporary as a business and an easier business to do with. Now on how does that impact our kind of e-commerce platforms? Look, we have digitized our catalogs. So not only to make it more customer-friendly and give them the opportunity to have content at their fingerprints (sic) [fingertips], but coming back to ESG, eliminate all the paper. I mean it is very wasteful to print all of these paper catalogs. But most importantly, when you print a paper catalog, it's already obsolete, right? So that platform is now feeding our website. And that website is feeding our e-commerce platform that is our own internal platform as well as our customers' platform. So we are focused on developing a content for all of our products, kind of 360-degree photography, greater application content and infographics that drive much more clearly articulated value proposition. So when you take a look at it, we're making big investments into digital front end, and we believe that we are positioning ourselves not only to take advantage of the shift from maybe simply a brick-and-mortar model and take advantage of that e-channel shift, but frankly, make it much easier for our brick-and-mortar channel partners to enable their own digital aspirations that they have. And I can tell you they all are investing heavily in becoming much more digitally enabled as well. So we spent quite a bit of time. I think we have a very focused effort, and I think that we are well positioned to be able to capitalize on that shift.

And then in terms of the proportion of your orders today that are shipped digitally or processed digitally without direct human contact, is that a meaningful part of the business today?

It's about 20% of our business, Jerry, and it is growing very rapidly. And we like to enable ourselves that way because there's nothing more inefficient than actually getting people talking to each other on a telephone when they are trying to figure out what they should buy. So if you can drive more of your customers to the digitally enabled process, it not only becomes more efficient, but it also becomes much more accurate and much more satisfying. And I think that, that continues to drive stickiness to our company.

And in terms of the processing cost savings, do you folks -- does it move the needle in terms of total overhead costs? How -- obviously, it's more efficient, but is it to the point where it's contributing to margins?

Jerry, we don't look at it that way. The way that we look at the efficiency is by going in and reinvesting the savings into inside sales, into front-end to drive things like chain-to-belt, and more design engineers. So rather than continue to grow the pie of SG&A and R&D, create efficiencies that you can then reinvest in your business.

Yes. Very interesting. Well, that's all the time that we have today. Ivo, really appreciate you making time for us. And nice visiting with you. Thank you very much, everyone, for joining us.

Thank you, Jerry.