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

Thank you, everybody, for joining us again. As our day continues, really excited to have Gates Industrial joining us and who better than their CEO, Ivo Jurek. He's been with the company now through the journey coming out as a separate company, a lot of heavy lifting. And then of course, the step back around of pandemic was obviously unforeseen, but kind of coming out of that and hopefully COVID issue is mostly behind us, let's hope, but other issues are afoot when it comes to Fed, to geopolitical. So a lot we can talk about, but Ivo Jurek, obviously, thank you for taking the time. I'll turn it to if you have any kind of opening remarks, things that you want to make sure investors hear about Gates, some key initiatives that you're thinking about, and then I'll be happy to take it from there with questions.

Terrific. Thanks. Thanks for inviting me, and always a pleasure to participate at your conference, David. And look, Gates has had an interesting journey since the IPO. We have put a good measure down to what I think somebody termed as a Trump -- President Trump, China recession. Once the recession start coming and breaking through, we go straight into a global pandemic and that we have been operating over the last couple of years in a very, very interesting operating environment. But when I take a look, in particular over the last couple of years, so maybe the last 2 years of the pandemic, Gates has performed very, very well throughout 2020 to 2022. And yes, we like to compare ourselves to a premium industrial peer group, some of the much higher multiple industrial -- multinational industrial companies. And when I take a look at '19 -- sorry, when I take a look at '20 and '21, Gates kind of performed very much in line with the premium industrial peer group in '20. So that peer group was down 8% to 9% core. Gates was down about 8.6% on core, so right smack in the middle. And when you take a look at '21, we have delivered, despite all the difficult impediments that everybody had to deal with. We have delivered 21% core growth in 2021. So nothing to be ashamed of while that same industrial peer group of premium peers have delivered about a 13% core growth. So we feel good about how we have positioned the company. We have delivered terrific results. We have delivered record level of revenues for the company in its history in 2021, and nearly record level of profitability. So the company is in a very good shape. Over the last 3 years or so, we have positioned the company to take advantage of number of secular growth trends that we believe will be with us for a very long time. I've spoken a lot about chain-to-belt opportunity for the company. Meanwhile, we have kind of segmented that opportunity into personal mobility and micromobility based chain-to-belt that has continued to deliver terrific results just over the last 4 years, basically coming from about $20 million of revenue in 2018 time frame to nearly 4% of the total company revenues. So do the math, about $140 million, a terrific amount of growth over that period of time, and continue to accelerate. And the industrial -- diversified industrial opportunities with displacing the industrial chain by Gates' highly precision engineered carbon reinforced belting that offers tremendous amount of, not only ESG benefits, but operating benefits for the companies that adopt our solutions. So we're very optimistic about those secular type opportunities. And frankly, exiting 2021, we've exited with the markets -- the end markets that we participate in a very good shape. Perhaps all markets with the exception of our participation in automotive OEM markets are in expansionary period of time. And so we are very well positioned to take opportunity on those growth trajectories as soon as we start seeing much greater breakout of the impediments that everybody is facing vis-à-vis raw material, COVID and logistics and distribution. So in a nutshell, we feel good about where we sit. I think we have great set of opportunities out there over the midterm. And we're really excited about being able to share those with our investors and the analyst community in greater detail next Tuesday in New York in the Grand Hyatt and Park Hyatt during our Investor Day.

Yes. No, that would be great. I will definitely be in attendance. Regarding Russia, Ukraine, just to level set everybody, can you give us a sense of direct exposure? Are you voluntarily shutting down sales in those parts of the world? How does it also maybe filter through your supply chain, maybe into Tier 2, Tier 3, Tier 4, that's having greater challenges to get nickel or whatever the raw material might be? Just curious how you're sitting down with your operating folks and getting that feedback and maybe some tactics that you're taking?

Yes. I think it's a great question. First of all, I would remiss if I didn't share the horror under which we watched the atrocities that are unwinding in Ukraine. I think it's absolutely uncalled for, and it is a terrible situation. That being said, we have very de minimis amount of revenue that we generate in the region, very low single-digit. Low single-digit amount of revenue that we generate out of Russia and Ukraine, and we have been very proactively looking at, frankly, getting ourselves to a position where we are no longer supplying anything in advance of the sanctions to that region. We don't believe that the amount of revenue we generate is material, and we do not rely on any raw material supply out of Russia for the products that we manufacture. So our exposure is reasonably limited. Again, very low single digits in terms of revenue exposure and no material dependency on raw material supply out of Russia.

Okay. And given though that situation, unfortunately, is also causing a little, let's say, sustainability to some of the inflation that might have been more than transitory already, but this obviously gives it maybe even a little more fuel to that fire. How does that make you think about when you can get price cost back to being margin neutral, not just price cost neutral, but margin neutral. You can take us through the timing on that and maybe some of the recent events, how that impacts the calculus?

Yes. So David, we have been, I think, pretty realistic about what we believe we will see with inflation in 2022. Honestly, we have seen that inflation ramp up quite significantly in the second half of 2021. And we did manage to be price material, economics neutral. So not margin neutral, but certainly price material, economics neutral. We've had a little bigger gap in Q4. That certainly impacted our operating margins in Q4, and we've anticipated -- and we've guided for a compression of margins through Q1 as well. But we believe that Q4 and Q1 of -- certainly Q1 of 2022 will be kind of the peak of the impact that we will see on our margin vis-à-vis inflation. We've anticipated that we'll continue to see energy spikes. We certainly are going to be very proactive to manage any further increases in energy costs globally that we may see as a result of this invasion -- unlawful invasion into Ukraine. And should we start seeing a dramatic acceleration beyond what we plan on, we will continue to roll up more pricing. Absent that, we anticipate that our pricing, certainly in the second half of 2022 and as we exit 2022, should be adequate for us to be margin neutral vis-à-vis inflation that we have seen and we are seeing at this point in time. So we have enough price that we have rolled in. Pricing has been rolling in from the beginning of Q1, so from beginning of January. It will take few more months before it ramps up through other channels, all the customers globally. And again, we believe that Q1 of this year is going to be the most impacted quarter of the year. And as we exit Q1 into Q2, we will start getting more positive on price, material, economics as well as margin economics.

And that said, well, 2Q is better, the margins in aggregate, EBITDA margin still down year-over-year in 2Q, but you're so comfortable and given the comp, I think people would hope so, right, third quarter, your margin should be back to being up year-over-year. Is that a fair...

That's how we envisage, David, that it will develop. Now obviously, getting back to your point, should inflation ramp up further, we will continue to take prices and we'll continue to adjust for inflation as we see fit.

And when it comes to your product being so replacement channel centric, it's easy for me to sit here and say, hey, that -- I mean, somebody's belt breaks on a car. I mean, you can charge what you want. I mean, you obviously have, if not number one, clearly one of the very top brands in the industry by far. You just would think it would be a fairly easy market. And I appreciate at your end, there were some timing issues and trying to work with customers. I don't try to get October 15 and November 1 increase, if you're going to have one in January. But the reaction that you can have if inflation works against you, the mechanism now that we're not around a year-end issue, if I told you your costs are going to surprise you by 50 bps come 2Q or 3Q, how quickly can you get that in? And again, being a replacement channel, it's easier for me to say then you execute. But I would think it wouldn't be that challenging to get a price increase through?

Look, it isn't really how challenging is the price to get through the channel. I think that the channel understands and is more than receptive in being able to take whatever inflation is running through the manufacturers' database. The complexity gets in when you start talking about repricing the entire price book. We supply tens of thousands of SKUs to these replacement channel customers and it's about the mechanics of being able to get all the right pricing, so that they can take the price to shelf on their end. And so we still believe that 90 days is the right timing for us to be able to get this pricing into the shelf at our customers. But look, if there is a situation where we believe we need to do much more dramatic set of steps, we can certainly do that much faster. Look, we ultimately price on shipment, so as we get pricing rectified, all the shipments that goes post price increases get invoiced at the new pricing. So we have levers that we can pull in any emergency and should we see more significant disruption in 2022 than what we have seen in 2021, we will do that. But we also believe that our relationships are important. They are relationships that have been built over 100 years of history as Gates Corporation, we value those. And we want to be effective and efficient in rolling pricing into the end market. And that's how we have -- that's the decision we have taken in Q4, and we believe it was the right decision. And we will certainly reasonably quickly catch up to the inflation that we have seen over the last 90 or 180 days.

Well, I haven't gotten the impression supply chains are improving. Would you say they're at least going according to your plan this year and thus -- again, outside of any geopolitical shock on cost, the availability of your components so far that you need, the raw materials would you say is no better, but you just give me the playbook, I know my pricing will kick in and that's sort of the situation? Or have you seen some pockets maybe it's improved or it's gotten worse?

Yes. Look, David, we're actually in a little bit maybe unique situation because we use highly engineered compounds. Many of these compounds -- number of these compounds actually have been impacted in 2021 by the Korean War Act that was enacted in combat of the COVID-19 pandemic. And so we had more constraints that we have had to live with in 2021 from number of very critical raw materials that we utilized in building our products. I would say that the Korean War Act has expired at the end of December. And so in my call in Q4 -- on my Q4 earnings call, I stated that we're actually seeing some green shoots in raw material supply. And so we are starting to get somewhat cautiously optimistic that as we exit Q1, we will be in much better situation that we have been in 2021. Basically, green shoots, I didn't say we are off to the races. We've got to get that material into our factories, and we've got to position it in the factories of point of use. So things are improving, but they're not great yet. There are still raw material shortages. But yes, I would say, they are not as broad-based as what we have seen in 2021. And so we are more cautiously optimistic, and we believe that as we enter Q2 and we work through Q2, we should be in much better situation than frankly, what we have seen in the second half of 2021 in particular.

When I think about that and I think about your individual business segments, is there 1 of the 2 segments that should benefit most from those highly engineered compounds being more available? Is it the belt side? I mean, the PT power transmission business? Or is it the FP or really no distinguishing feature between the 2 that would benefit?

David, there is no real distinguishing feature. I mean, I think that on 1 side, you could say that we have more benefits on the power transmission side. Unfortunately, some of the other constraints that we are still living with are also impacting the power transmission business. And so I would say, net-net it is hitting or it is improving across the portfolio in a measured meaningful way for both of our product segments. But we will still be dealing with some degree of material constraints, I think, well into 2022. But again, we've managed through significant constraints in 2021, we will certainly be managing through some of those that will remain in place. And some things will get easier and there are things that are getting easier. And we are, again, cautiously optimistic that things will be better for us as we enter Q2 of 2022.

And if I have my numbers right, it seems like you're implying EBITDA margins flat for the year, right, down year-over-year in the first half, growing in the second half. We come back to basically flattish margins year-over-year, the EBITDA margins. Is there something distinguishment between PT and FP on there year-over-year? Like fluid may be in a position to be up a little bit and PT is down. Is there -- can you give me a little color on how to think about the margin by segment?

Yes. Look, David, we don't necessarily guide by the segment, as you know. But both of these segments behave reasonably well in harmony with each other and as long as we can secure raw material, as long as we secure labor to be able to convert the raw material into finished goods, both of these segments will benefit. Again, both segments are getting a good level of pricing on the products that we merchandise to our customers. So I'd be expecting that maybe the growth is going to be a little better in Fluid Power in 2022. But look, we still believe that if you eliminate the comps and the comps in the first half are also very difficult because we have 2 of the best quarters in the company's 110-year history in Q1 and Q2 of 2021, so comp is an issue. You really didn't have lots of inflation in first half of last year and that inflation crept in, in second half of the year and as I indicated, we still believe that we're going to be challenged in the first half of the year with price, material economics to a degree until we start getting the right side up in the second half of the year. So the comp as well is an issue that comes to play in the first half. But I would say that I would look at both of these segments kind of more in harmony and both will benefit.

Can you give us a little insight into China? I mean, I think if I'm going to have it right, maybe it's 11%, 12% of your revenues, not huge, but clearly not immaterial. Can you give us a sense, I mean, have a little more, I think, auto OE exposure there than maybe the average geography as you're still kind of building out that auto business into more of a replacement-focused business. But any insight you can give us on maybe how the government is signaling to your folks on the ground about kind of post Olympics, post-Chinese New Year, what is -- generally for a lot of people have been a down market. I know China for you last year was up, I think, 19%. But I think it was down in the fourth quarter. Can you give us a little color on what you're seeing on the ground?

Sure. David, from a strategic perspective, we have spent, I would say, considerable effort to continue to build our industrial business, and frankly, our broader presence in the replacement channels. And I spent quite a bit of time over the last few years to talk about and highlight that and felt pretty bullish about what it is that we were doing. Our business in China, in Q4, has been primarily impacted by a decline in automotive OEM and the construction equipment demand. So again, in the first-fit channels. So the auto OEM in the construction channel in Q4 were reasonably weak. Our growth initiatives are targeting diversified industrial and personal mobility end markets, very much similar to what we have talked about more broadly from a company perspective. And we have shown very good progress in China with those initiatives as well. And we see plenty of good opportunity there for those initiatives to ramp up. So if I kind of look at the puts and takes, well, we have a good level of confidence presently with China is that we can once again deliver a core growth, kind of in the mid-single digit level as we work through some of the impediments in the automotive business in the first half. I think that the situation is getting a little bit better, maybe, is a good way to characterize on the auto OEM side, as we get past the Olympics and some of the restrictions that were layered in China in Q1 post Chinese New Year. We believe that industrial activity is going to pick up in second quarter, and that bodes well for our business, and gives us even greater confidence that we will again deliver another year of positive core growth in China. And China has been a very good business for us. It is a large economy. It's an economy, it's probably the largest industrial economy and again, I underline the word "industrial." And so I believe that we have plenty of runway to continue to deliver growth and continue to scale up our business there. We don't really import anything out of China anywhere to any country outside of China. So everything that we have China is for China, and we believe that those opportunities to continue to capitalize on the growth in China are still very robust and remain intact.

Given the leverage you came out on the IPO over 5 years ago, right, I think it was 5 or 6x levered, something like that. Now you're a lot more, I'd say, in a healthy position at 2.5x, 2.6x net debt-to-EBITDA. How should I think about your comfort with now really leaning forward with the balance sheet? Or just given -- I mean, from the Fed, the geopolitical, whatever it may be, right, COVID recedes and we have other things to worry about, where are you in your appetite to really use the balance sheet in '22? Or is it a little more of a wait-and-see, kind of block and tackle more on the price cost and the margin and then it's more of a 2023 story on maybe leaning forward with the balance sheet another year of deleveraging, let's say?

Yes. Look, I mean, as you said it very eloquently, we have not really had the balance sheet to put to work in a meaningful way over the last few years. And so I'm really delighted that we got ahead of our time frame on delevering the company. And that really speaks volumes about our ability to deliver cash flow, continue to grow the business and continue to grow earnings. So all of these 3 attributes helped us to delever the business faster than what we've anticipated. That being said, we are now in a position to put the balance sheet to work. There are tremendous amount of opportunities in terms of M&A. Look, yes, maybe people are starting to ask themselves, hey, should I be doing M&A during an environment that maybe somewhat problematic, but we believe that if the opportunities to add a good company into our portfolio are there, we will lean forward to do something. We also believe that our stock is undervalued as we have gotten an authorization to buyback over $200 million of shares from -- of the asthenic shares in the market place. And we will certainly continue to ensure that we do that and that being said, we continue to invest in our business in terms of organic growth. Again, I spoke a little bit about some of -- our situation vis-à-vis the growth opportunities that are out there. Generally speaking, the investment into organic growth initiatives is the one that's got the highest IRR, and so we will continue to prioritize that. But I think there is room for us to do all 3 and we will not wait until 2023 to do a combination of them. We'll continue to ensure that we do the right thing, and we return capital to shareholders, as well as we invest in opportunities that will generate the highest return for our shareholders.

Is it fair to say from that answer that share repo is at least as high in the priority near term as M&A?

Absolutely. Absolutely yes. Look, David, we are carrying way too much cash on our balance sheet, and we don't need as much cash. So we've got plenty of opportunity to do a share repurchase as well as do M&A.

And when it comes to M&A and when I think of your bigger initiatives, they feel more PT centric. But when it comes to M&A, is that an oversimplification of also where you want to invest? Or do you feel your core strength maybe is more differentiation, more core PT, than Fluid Power where you're just not quite as dominant as you are in PT in than Fluid Power space?

Yes. Look, I would say that maybe it feels that way because we have spoken about FP maybe from '18 to '19. We've made a major investment to scale up that business. And frankly, it's delivered very strong returns for us. I mean, our FP business last year grew 24%. I'll put a number out there against anybody. And I'll also remind you that we are a top 3 market shareholder in fluid power globally. So we're actually one of the biggest market participants globally in FP. And we believe that we've kind of spoke our peace. We are well positioned. We revitalized the portfolio, and we execute on that strategy kind of as a run rate strategy. So we are in a very good shape in FP. We haven't really done all of the same amount of work in PT. And maybe that's why it feels like we talk more about the PT. We are revitalizing our portfolio, which we started a little bit later than we started on Fluid Power. And we believe that, that secular opportunity in chain-to-belt is so large that we've got to be laser-focused on our execution. And frankly, we've got to make sure that we don't run out of capacity to be able to support the continued growth of a pipeline of opportunities in new business that we have allocated -- that we have won and have allocated to Gates over the next 18 months, which is quite substantial. And so our focus on PT is do just that, stay focused and continue to execute and revitalize the portfolio. On FP, we're in a very good shape.

And the factories that you've built that now finally have some tailwind to really fill them up. Have they given you most of that benefit so far, in the sense of -- you mean, obviously, '20 was unfortunate to have the factories ready to turn on, provide better margin than the volume did show up. But with the volume in '21 and now the start of '22, from here, is it more traditional operating leverage? Or is there still a lot to go with those factories versus the legacy footprint? Are the new factories that much more profitable and so a headroom to grow?

Absolutely. I think that the new factories gave us everything that we've anticipated. Gave us the position and proximity to these markets. But we have grown really, really nicely in Fluid Power in Europe, in particular, where factory that we built in Poland has been the first factory that we had in the European community producing fluid power, and that's delivering terrific results. Factory in Mexico that we have doubled in size in 2018, has been delivering terrific results for us. So we feel that those factories are doing exactly everything that we've anticipated. Again, remember, we have stated that we wanted to build those factories to scale Fluid Power and give ourselves an opportunity to reposition our manufacturing footprint to locations where it is easier to find people and to globalize our business. And so we have done just that, and we are very pleased with what happened. And we believe that as price, material economics are going to start leveling off, at some point in time in the near-term future, we will see a very nice expansion of operating margins as well.

I'll leave with this. Is it fair to say you seem fairly comfortable with the numbers out there for the year and kind of how you're seeing it play out on, be it margin or revenue, however you get there, you seem pretty comfortable with kind of where The Street is and how we're thinking about the numbers for '22?

David, today, I absolutely am. What I have learned over the last 2 years is that there's always going to be the next challenge. We got to be ready for it. And I think that this organization, this company and the management team is ready to deal with the next challenge, although we would all like to see a degree of stability in the economics out there. But we are very realistic about what is potentially going to occur in the near-term future and we'll manage through it. We believe that we have a great business, highly engineered precision components that are critical in applications that they are used that need replacement. That's a really wonderful position to be in, and we are very optimistic about 2022 and beyond what we can deliver in terms of servicing our customers, facilitating, and transition to more efficient manufacturing footprint for our customers, easier use of our products, and ultimately generating greater returns for our shareholders.

Sounds great. Well, I really appreciate you taking the time. Hopefully, you have some other good meetings the rest of today and we'll be watching. So really appreciate it, and we'll see you in person next Tuesday. That's great.

Thank you.

Thank you. Really appreciate it, Ivo. Have a great day, and thank you, everybody, for listening in.