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

Good afternoon, everyone, and thank you again for joining us as we round out Day 1 of the UBS Global Industrials and Transportation Conference. I'm Damian Karas, analyst on our electrical equipment and multi-industry research team. We're pleased to welcome Gates Industrial Corporation for this fireside chat. Joining us from the Gates team, we have CEO, Ivo Jurek. Now before we get into the Q&A session, let me first turn it over to Ivo to kick things off.

Thank you, Damian. Let me just briefly share with you why I believe this is such an exciting time at Gates. We have put a great deal of energy and investment into transforming Gates over the past few years, building off the company's strong foundation. Throughout the challenging market environments of 2019 and 2020, we've continued to invest in a revitalization of our product portfolio, our manufacturing footprint and our focused growth initiatives. We are now starting to see these investments to pay off with a meaningful contribution and acceleration of growth momentum. Early in my tenure here at Gates, we said about rebuilding our innovation capabilities and test our teams with revitalizing our entire product portfolio. This is well underway and not only opening up new opportunities, but also leading to improvements in sustainability for us as well as our customers. We are seeing our new product vitality pickup throughout the company, and we are excited about the progress. The economic momentum is building across most of our end markets, and we believe we are in the early stage of industrial recovery. On the top of this, our substantial above-market growth is supported by improving economic conditions and the success we are seeing with our innovation investments and growth initiatives. We believe the business is well positioned to achieve our midterm growth targets. From a profitability perspective, we have a terrific set of organic opportunities across our segments and ongoing Gates production system initiatives that support future margin expansion. We believe our recent investments in capacity, new products and restructuring, all provide runway for us to achieve our midterm target of 24% EBITDA margins. Our cash flows have proven quite resilient and when combined with our improved profitability, we allowed ourselves to make significant progress to delever the business with a near-term goal of about 3x net leverage, and that's being squarely in our eyesight. This not only creates nice optionality for us to optimize capital allocation, but also it gives us the opportunity to have a good runway for future prosperity of the company. So with that, Damian, I'm happy to take some questions and move to Q&A.

Terrific. Thanks for that introduction, Ivo. [Operator Instructions] So Ivo, it's been quite the journey since the start of the COVID pandemic to today. I was wondering if you could maybe first reflect a bit is there anything that you've learned about your business over the past year that you'd say really stands out? And secondly, as you kind of see things today, where would you say Gates has the most room for improvement or any issues that are really front and center for you?

I think it's a great question, Damian. So look, 2020 was very tough, obviously, but we've pivoted quickly to operate in a safe manner, putting the safety of our employees first and foremost. I think it was critical throughout this pandemic. We also worked quite hard to ensure we were able to continue to support our customers, many of our customers which operate in essential industries. When we originally deployed our in region for region manufacturing strategy, it was to shorten our supply chain and frankly, operate in close proximity to our customers. But during the pandemic, this strategy allowed us to flex better and serve our customers well around the globe. So in return, we believe this positions us well with customers today as well as it did over the last 12 to 16 months to frankly drive improvements to our market share position. Maybe to the second part of the question, what -- how we can improve the business better, what -- how we have altered our portfolio. Maybe let me go back to that a little bit and address that question a little more. Yes, look, I always have to go back to kind of 2018 when we went public first. We've talked about a significant additional opportunity to rationalize our footprint, revitalize our product portfolio, improve the efficiency of our business and, frankly, improve the efficiency of our SG&A. And most importantly, we knew that we needed to improve the balance sheet that we were operating within. So we really haven't changed the strategy even looking back to '20 and '19. It's been all about operating our business better. We've been focused on the longer term, which I think has been important for us and to drive innovation, execute on our targeted initiatives to deliver above-market growth. So when I look back at the challenges that we faced in '19 and '20, we continue to make those investments in product development and all of those growth initiatives. And that's been helping us to reposition our business and frankly, juiced up a little bit our growth rate. And I think we have been reporting some substantial growth certainly over the last couple of quarters. During the time, we also dramatically reduced our automotive OEM business. And so from the '18 to '20, we recused that OEM business by nearly $100 million. But it's a pretty substantial sum of revenue for a company of our size. And we've decided maybe in 2017, '18 time frame that we will only focus on hybrid and ultimately electric applications. So we are doing that. And so that offset, we targeted that offset of automotive revenue with industrial investments. And frankly, we are seeing that with programs such as chain-to-belt, industrial Fluid Power initiatives. And that -- I think that, that's been paying nice dividend for our company.

Great. Yes. No, absolutely, you've been putting up some pretty impressive growth numbers the last couple of quarters. Really appreciate all that perspective. Maybe if we just honed in on the growth opportunity a little bit more, if I'm being honest, I think, when most people see industrial belts and hoses, their initial response is less than exuberant. So maybe you could just talk about what has you really the most excited about the future, whether you're talking about specific products you've launched, commercial initiatives, some of the secular trends, maybe just kind of lay out the growth case for Gates.

Damian, I think that one of the reasons that they are not excited about it is because they don't quite understand it. Everything they do, there is probably a Gates in an application that our folks are using across maybe consumer all the way to industrial applications. But really coming back to the fundamentals of that question. Look, we believe that innovation is the foundation that's driving our growth. We are developing product that is differentiated, it is highly protected technology, and all of that is critical to driving future growth opportunities. So this innovation, frankly, is opening our doors to new markets and new applications that are friendly secular in nature, such as e-commerce-driven logistics, food and beverage, pharma and chemical manufacturing, stationary manufacturing equipment, industrial automation, robotics, personal mobility. I can name many of those. And as you start reflecting on these applications, you actually start realizing that, gee, maybe I didn't really think that a robot will have Gates belt in it. Did I? And that's really kind of, I think, maybe that misnomer. Now the increasing focus on ESG in the industrial world, is, frankly, accelerating the demand for our products. Why? Well, it's because our products are clean, they are more efficient. They increase uptime. They reduce the need for maintenance. And that is a dialogue that makes it much easier for us to approach customers with applications such as converting industrial chains to clean Gates manufacture, differentiated balance. So then we are seeing this in our results now. Markets have improved somewhat. Our sales of Fluid Power as an example of the new products, including Fluid Power in the most recent quarter, we're up 90%. Our mobility business grew 80%. And we saw a very significant lift in our industrial chain-to-belt business as well. Those are huge markets. And we are in very, very early stages in of these initiatives. So while we may not see this level of growth every quarter, Damian, we do see a very steady, long-term opportunities for our business, and that gives us confidence that we can deliver above-market growth rate that we have committed to our shareholders.

Understood. I definitely want to ask you a little bit more about the chain conversion. But maybe just thinking a little bit about the market share gains that you're saying that you're achieving now that we're a part of the growth that you're seeing is clearly macro-driven. I was wondering if you could maybe share a tangible example or 2 of that your evidence that you're seeing market share wins or a product success that you're having, if you could maybe kind of relate it to an example.

Sure. Look, I can reflect over the last couple of years, there has not been a quarter where we have not continuously talked about numerous design wins in very attractive end markets and applications. So every quarter, we come out and we delineate with both of our product segments, how and where we are winning. Frankly, there hasn't been a quarter where we haven't seen a number of very exciting wins across both of these product subsegments from chain-to-belt to industrial Fluid Power to mobility and others, right? Most recently, we've talked about key design wins in health care, e-scooters, industrial automation, stationary manufacturing, ag, construction equipment, heavy-duty EV trucks, to name a few. All we need to do is just reflect over the last couple of quarters, and you see a true spectrum of very exciting design wins that now, frankly, are starting to turn into billable revenue from our customers for our products. So as I look at the attribute that we have undertaken about the transformation that we have driven for this company and frankly, that is differentiated our product performance and that is what is helping us penetrate these very diverse new set of applications, customers and, frankly, end markets.

Great. So one question that I do get, right, when they look at your business is fragmented market and high level of profitability, the question being kind of if there's some capital injection that comes in at some of your competitors, would they be able to kind of catch-up to you quickly. What are your thoughts on that?

Yes. Look, our advantage, frankly, the way that I think about our company, is that we have 2 of scale product platforms, okay, our Transmission and Fluid Power. And that, in itself, Damian, drives incredible amount of focus and intimacy into applications and end markets. And frankly, that will differentiate Gates from others. And that level of understanding gives us the opportunity to drive innovation; to, frankly, drive applied material science into our product portfolio. I've spoken on numerous occasions about we are focused on building out off scale material science capability, and we have made significant investments over several years into that, and we have built development of our own industrial process technologies. And then when you combine these 2 subsegments, that's what's giving you an opportunity to drive that innovation. Now I respect our competitors, but I also believe that we are in stages where we will continue to drive generational product development progress in our platforms. We won't stop where we are today. We will continue to drive the innovation. And frankly, the -- that folio. And I've spoken about the targets kind of over the mid-term of 20% plus is what, I believe, is going to put us on a pedestal that we can remain. We can continue to drive high levels of profitability. We can continue to drive growth of our company. And frankly, we can enable our company's reducing the weight of their equipment. It is higher uptime, it is reduction of energy consumption and so on and so forth. So I feel actually quite good about where we sit competitively. And I believe that as a competitor, at some point in time, will catch up with us, we will have the next level of innovation that we'll be bringing into the marketplace.

Great. So I want to come back to the chain-to-belt conversion. Maybe for those investors that aren't as familiar with Gates, maybe you could just kind of begin by giving your perspective on the opportunity, what it means for you. And then I would have a few follow-up questions on that.

Yes. So look, chain-to-belt is actually a very interesting opportunity for Gates. It's about an approximately $8 billion market that is presently served by industrial chain and Gates does not manufacture industrial chain. So it is an opportunity that is secular in nature that we believe we are very differentiated from other competitors of ours. We will be -- we are competing against non-traditional competitor, which is an industrial chain. Look, we are seeing a real momentum that has built in that -- in those conversions from a very strong foundation that we've built over the last 3 years. And now that momentum is actually supported by increasing focus on ESG trends that are, frankly, front and center for manufacturers around the world. Our teams are very focused. They're really energized by the breadth and the momentum of design wins we are delivering. We're delivering them in end markets such as food and beverage, farm. And why is that happening? Well, it's happening because we are driving elimination of safety hazards in those facilities because you're not using lubrication. You don't have to shut down the equipment to lubricate those drive mechanisms. You reduce energy consumption because our belts drive mechanisms lighter and more efficient. And frankly, it gives you an opportunity to get most out of the industrial assets that are deployed. So I think it's a really good value prop and we are seeing the adoption, by the way, both at OEMS, where we are trying to seek, but we're also seeing a momentum in end-user operators where we are converting industrial chain in existing installations. So this is a business opportunity that is very secular in nature, and we anticipate it will add to our growth for very many years to come because, frankly, we are bowling in this opportunity. So some maybe borrowing a baseball analogy. We actually kind of feel like we are just putting our unison, not even entering the playing field yet.

Wow. Okay. No, that's great. That was, I think, change about for a number of years since you've been public, and you mentioned some good momentum now that you're seeing, but it sounds like you think this is a -- really a multiyear, maybe even a kind of a multi-decade type of buyout.

Absolutely. Look, I will find the category of multi-decades. Again, look, it's about an $8 billion market. And from what I said, why couldn't we have 25% penetration, 30% penetration of that market? I mean can we get more? Yes, we could. But 30% on $8 billion market, that's a big opportunity, it will take time. And in 2019, I said, well, we're kind of targeting $200 million of incremental revenue that we should be able to generate kind of by the 2023 time frame, and we are well on the way to be able to generate that level of revenue or more by that period of time. So to say, hey, look, these guys are probably going to get to $200 million, $250 million of revenue by '23. The guy said it's $8 billion market size. That's why I feel that we are just putting our unison. And we are seeing adoption to pick up. It's becoming much simpler to drive those conversions because people are starting to get it, and they see the value and we will thrive for many years to come.

That makes sense. Now you mentioned that you're seeing the conversions both on the first-fit new equipment as well as, I guess, some aftermarket, some retrofit, if you will. Maybe if you could talk a little bit about -- I mean, obviously, the aftermarket, the installed base is a much larger portion of the market in a given year than the new equipment market. So maybe you could give us a little bit your perspective on, I mean, kind of what is the difference in the adoption rate between those two markets and then thinking more about the aftermarket, the replacement market. You guys are in a lot of different end markets, applications. What's the best way to think about the life cycle for your product offering in the belts that -- so as we think about how the adoption curve might move?

Yes. So look, the adoption curves varies, right? So let me give you a couple of different examples. And I'll try to cover -- I think, at the spectrum of the questions that you have posed to me, Damian, with this. So look, let me give a really easy example. It's the example in OEM adoption for solubility, right? You go in, we are not going to convert e-bike or an e-scooter or a motorcycle from a chain-to-belt unless you convert it at the design with the OEM. So there you go and you target the OEM, you go in and you replace the drive mechanism. And whatever they committed to do, they all do. So if they commit to you about, they're going to drive a belt adoption. You can take a look at Harley-Davidson, if you have Harley-Davidson, you will only get it with a Gates strap as an example, right? And so it will be a really good example on OEM design adoption, not about the break, about the, well, where and at some point in time, you will actually get to replace the dock. And it just depends on your duty cycle. So how often do you ride your motorcycle? Do you ride it every day to work? Do you ride it for pleasure, right? And then we'll predetermine how often you will replace that. There is a huge infrastructure of industrial facilities that have been built out over the last 50, 100 years, right? And in those facilities, just about every apparatus has a drive and that drive, generally speaking, has an industrial chain. And so what we are targeting is we have built a small organization of folks that are targeting very specific industries and going from certain target industries to go and convert manufacturers. So the most recently, and I believe I have spoken about that on my Q1 earnings call, we have converted a very large manufacturer of food products in one of their facilities. And one of the reasons that they have done it is, frankly, because they grew frustrated by the amount of lubrication they needed to do to their chain draft. And so they are looking for an opportunity to improve their uptime of operating their equipment. And so we went in and we converted that one facility. They have 85 facilities in the United States, and we will convert every one of those 85 facilities. And it's a food manufacturer that's manufacturing products that anybody that's got kids is probably using their products. And how many of those facilities are out there? So that was one of their specific food product types. And so we see that, that resonates with our customers, uptime, efficiency, energy conservation, they are all important. And by the way, once we install it, depending upon your upside, you will still replace those balances, but instead of shutting a facility once a week, twice per week delivery gate, you may replace that down once a year. And so that value prop is quite substantial.

Makes total sense. Really appreciate all that color. Maybe we can move on to, I guess, kind of thinking about electric vehicles and the opportunity there. It's something that you've characterized as being favorable long term to Gates and that you'll -- I think, you've estimated kind of about 20% or more content on EV as opposed to an ICE vehicle. But I guess, help us think a little bit about, since you primarily play in the aftermarket rather than the first-fit market for EV, what that means for your business, given that, I think, a lot of your product under the hood is sort of on maybe a 7- to 12-year kind of replacement cycle, if you will. So should we be thinking that kind of EV is maybe in a decade is where it's really becomes a robust opportunity for you? But maybe just help us walk through the thinking on that.

Yes. Clearly, Damian, I think that you are thinking about it the right way. Look, we are in very early stages of the adoption of EVs, as we all know, it's very exciting. But I think we all agree, we are very early here yet. So we are developing new products, and we're expanding our product cap coverage to continue our leadership position in the automotive replacement market around the world in particular. And so as you said, Damian, the replacement channel business, where our primary focus resides, generally targets vehicles that are 7 to 12 years out. And so we still have quite a bit of time before those markets fully develop. So that being said, we are seeing significantly larger content opportunity on electric vehicles with an emphasis on thermal management system. And as we all probably understand, thermal management is critical because you don't want to have a thermal-runaway event with batteries or inverters and motors, this will be a bad, very bad thing. So we are very selectively participating today on the OEM side of the business. In line with our long-term strategy, we will participate, but only in line with how we are thinking about the need for our participation there. And while we are very excited about the future opportunity for Gates here, we believe it will take some time to materialize as the adoption growths evolve. So maybe 10 to 15 years down the road, we ought to be realizing some really nice growth from electric vehicles.

Interesting. So you're strategically being very selective in where you play in the OE market for EVs?

Absolutely.

So where you're playing in thermal management, how do you feel like you're performing? Are you sort of gaining -- what's your kind of market share that you're capturing in this very small market right now?

Look, we are very much focused on highway industrial applications. We've talked about a couple of reasonably good-sized design wins there. We anticipate those will start ramping up pretty quickly in production. We have good presence on the leading EV manufacturer today. So we have nice products and nice presence there. We just try to make sure that we don't overcommit ourselves, Damian. And again, we want to protect our long-term aftermarket revenue stream, which we believe is critical. And frankly, that's where we are most comfortable to operate within.

Okay. No, makes sense. So I want to kind of switch over to the margins in the business, and you alluded to earlier, sort of this medium-term target of 24% EBITDA margins. I guess just kind of looking where you're at today, right, if you compared it to 2018 prior peak in the business, looks like this year kind of you're projected to sort of be at the same level of sales and it looks like kind of a similar level of margin. Just wondering kind of why is that, that you're sort of kind of flat margin over the 3 years? Anything that stands out? And help us to think about, right, how are you going to get to those 24% sort of medium term target. Is it all about volume? Or is there other stuff in the mix there that you kind of have in the hopper as well?

Yes. So look, although I think we all would like to put COVID-19 completely behind us. We are still -- let's remind ourselves, we are still managing through impediments that are driven by it. Whether or not it is labor shortages, it's material disruption. But frankly, let's also remind ourselves of geographic spots and still here, front and center. Certainly, in 2021, and we anticipated that, that is something that we're going to continue to deal with. If you recall back our Q1 earnings call, we have very [indiscernible] our guidance for 2021, and we feel very positively about how the year is developing. Now kind of coming back to how and where we will get to that 24%-plus EBITDA margins, we are fully committed to the midterm target. And we believe that we've set the target in 2019, and we believe that we can deliver to that target within the same set period of time, which is, frankly, remarkable taking into account that we have gone through trade war induced recession followed by a pandemic. So we feel quite well where we sit in. But how do we get there? Look, the healthier end markets are going to help vis-a-vis value, our gauge production system improvements are driving incremental margin performance and our recent investment in capacity and new products as well as restructuring is how you should think about getting to that 20%, 24% plus in EBITDA margins. So we feel good about '21. We do feel that there are still impediments we need to manage through. And frankly, we feel quite good about being able to get to that 24% target that we have committed to our shareholders in 2019.

Right. Yes, I wanted to ask you what your expectation is for level of investment from here. I mean is it -- you kind of have to sustain your current level of investment or even increase it? Or do you have an opportunity to kind of put the brakes on that a little bit, given you have been investing quite robustly the last several years, and now a lot of that product is coming commercial market and the restructuring and other operational initiatives you've taken.

Yes. I would say that, look, the transformation that we were talking about is more or less behind us. And we are now entering the phase of kind of continuous improvements and driving growth. And that being said, from a CapEx requirement, our business is pretty -- is starting to stabilize kind of at 3% of sales. And we believe that, that's kind of a good CapEx investment. We believe that most of our large restructuring is behind us. We have the capacity in place that we believe is going to be supportive of driving organic growth and driving above-market growth rate. And frankly, that is how we are thinking about the time frame that we have entered kind of into the next 2 to 3 years. 3% of sales of CapEx, this is still a good amount of capital that you can deploy. And when you take into account that about 1% of CapEx is required for maintenance, we still have 2% that we are guiding that we will be spending on organic initiatives. Frankly, those are really good, high ROIC projects. And we believe that those are also projects that are the lowest risk projects. And so we feel that we are in a good place. Again, as you said, most of the significant investment behind us, we are well positioned to deliver the results that we've outlined that we can visualize.

Got it. Got it. How about the supply chain issues? Maybe you can just kind of give us an update there. I think it sounded like first quarter, you've been managing them fairly well without a lot of hiccups. Just wondering if things have gotten any better, any worse. Has your visibility changed at all around that? And also maybe just where you feel like you are being able to manage some of these inflationary pressures, which is an increasing investor concern right now?

Yes. I mean, clearly, I can understand that sentiment. Look, as I said in my Q1 call, I'm very proud of our supply chain team and how did team and operating teams have responded to these global challenges we were seeing with the supply chain shortages, fairly on a number of fronts. It wasn't one issue only -- it was multiple of issues, whether or not it was chemistry, so steel, precision steel, aluminum and so on and so forth. Our team managed quite well. And frankly, we continue to manage through these various supply chain disruptions in a reasonably good shape. We feel that the chemistry and the steel inputs are improving, but we certainly don't believe that they're going to go away until maybe the latter part of second half. We believe that these things are going to remain. I think that most folks don't quite understand is the impact that the Texas winter storm in February had on disruption in chemicals, manufacturing. And I think it'll be all kind of living through that. When you combine that with the labor shortages and all the issues that the spectrum that manufacturers are dealing with, I think that it's probably likely that, that's not going to work itself out certainly until the end of this year. It's been very challenging, of course, for our team, I'm sure, for our competitors and our customers, but we are managing through these impairments as well as is expected, and we anticipate that we should put it behind us as we exit 2021. Now in respect to inflation, look, I think, we are all dealing with elevated levels of inflation. We do have over 60% of our revenue that comes through the distribution channel. We have an ability to reasonably rapidly put price increases in place. We have taken pretty proactive stance at the beginning of the year. We have raised prices. We are now seeing those prices flow-through. We have been raising prices to OEMs. We have a number of contracts that have an escalation process. So we have enacted dose. But frankly, we are going to -- our customers that don't have the escalations as well. Those are never easy conversations, but those are conversations that are very important to be had, and we believe that as we exit Q2, we'll be in a reasonably good shape to deal with, frankly, the escalation in inflation that we all see. So on Q1 earnings call, I said that we believe that we will offset inflation, not just material inflation, but also logistics inflation, dollar for dollar, and we believe that, that remains to be the case.

That's all very helpful. So we've got a few minutes left here. I do want to ask you about capital allocation. You're going to be in a position here kind of for the first time since you've been public where you're delevering naturally pretty quickly. And I think you're going to kind of get down to certainly under 3x, about -- maybe about 2.5x leverage by the end of the year. So could you give us a sense what's capital allocation? What's the V-belt Gates acquisition going to look like? Have you been nurturing a pipeline in the last few years? Are you just kind of starting to build that out today? Educate us on capital allocation.

So, look, first and foremost, our primary priority remains to delever the balance sheet. I say, as you can imagine, a company like Gates that came in slightly higher elevated leverage into the public market, that was an important parameter. We are going to get below 3 times. We're going to get there pretty quickly. And as you said, we should be in a reasonably good shape exiting 2021. That being said, it does clearly open new avenues with additional optionality going forward. We have significant organic growth opportunities that we continue to fund. First and foremost, we are not short on organic growth opportunities. But clearly, M&A becomes another option for us to drive this growth but we're going to be very disciplined in our approach. We have a small team of people that we've put in place some time ago. It is not a new team, that team has been cultivating a pipeline of opportunities. Let's remind ourselves that we participate in a very large, very fragmented markets. And so we have a good pipeline of opportunities out there. But I think that what is extremely important for us is we are going to remain disciplined. We do not need to jump in and overreact to M&A because our balance sheet is improving. We have more than adequate amount of organic opportunities and when we find the right opportunity to go and acquire and acquire it at a fair valuation, we will do that to ensure that we drive the returns that we anticipate from those type of activities.

That's really helpful. And I think we have time for one last question here. So when I think about how a lot of multi-industrial investors think and what their -- what's important to them, free cash flow, free cash flow conversion is something that gets asked about quite a bit. Now your free cash flow conversion has had a tendency to whip around a bit so far in the early years. I'm wondering, is that just kind of a byproduct of the nature of your business? Or do you feel like there's things you can do to maybe drive more consistent-free cash flow over time?

Yes. So look, let me start with the fact that we have built a strategy that we believe was built around investment and repositioning the business. And the strategy was inactive way before we went public. And then necessitated, significantly enlarging our operational footprint and giving ourselves an opportunity to become more efficient and ultimately drive that efficiency through to earnings. And I believe that we are demonstrating that. So you're right, we are consuming a little more cash that we were generating in the first couple of years post public exit -- or entrance. 2021, our guidance for cash conversion is at least 80%. But that takes into account a very robust growth that we are seeing across our business. And we are supporting that growth with working capital. I think that it's necessary. And we are generating receivable and these receivables will ultimately turn into cash flow. Then being said, we do see an opportunity to continue to improve our capital efficiency over -- working capital efficiency over the mid-term. And we are focused on that. We think we can do better. So typically, our business has delivered at or above 100% free cash flow conversion. And frankly, that is the appropriate way to think about our business.

Okay. Great. Well, I think, we have to leave it there. Unfortunately, we're short on time. But Ivo, I want to thank you again for taking the time to talk with us today. And thanks to all of those who tuned into the meeting. Have a great day, everybody.

Thank you.