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

Good afternoon, and thanks for joining us at the Wolfe Transports and Industrials Conference. We're going to kick off the afternoon session with Gates. Very pleased to have CEO, Ivo Jurek with me to chat for the next half an hour on some of the key initiatives in place there. But Ivo, I know you've got some more remarks. So let me hand over to you, and then we'll get into Q&A.

Good. Thanks, Nigel. Delighted to be here and real quick. Look, I mean, I think that as we progress through 2022, we certainly are all aware of the complexities in the global economy and what the global economies are dealing with. That being said, we remain focused on our long-term strategy and continue to execute with a focus on meeting our customer demand. And improving our service levels for our products Look, when I look back since our IPO, we have been repositioning the company with focus on innovation and frankly, opening new markets and opportunities for our products while improving our balance sheet. We are very pleased with the fact that we've made very significant progress all 3 fronts. Our innovation and new product introduction process is working, and it's not only significantly increased our NPI sales index and thus improve our competitive positioning of our company overall, but also has facilitated the opening of doors for new markets where we compete against nontraditional competitors like industrial chains deployed in mobility and in industrial automation space to mention a few. It has progressed so that we have reached a level of revenue generation in these new market opportunities. So are significantly ahead of what we had anticipated when we introduced this opportunity in 2019 to our shareholders at that point in time. And it's significantly ahead of the time. So we are solving issues that we are dealing with on our recent earnings call vis-a-vis capacity constraints that maybe hold back a little bit our ability to supply the product to the demand that we see there. But we are continuing to position our customer demand, and we are focusing on the incremental opportunities down there. So we are very pleased with our progress here. And lastly, since our IPO, we have continued to significantly improve our balance sheet. And we are now in a position where we have optionality and the optionality is such that we can focus further reducing our gross debt. We can focus on returning capital back to our shareholders. We have buybacks and true M&A activities that will add some incremental technologies to our portfolio. So while we certainly are cognizant and we believe that there will be impairments ahead of us, we are focused on managing through those environments just as we have done through the time since we went public. And more importantly, we are focused on the long term to continue to drive strong returns for our shareholders and stakeholders that we have within our universe. So with that, I'll now turn it back to you for some M&A.

Thanks, Ivo. Yes. I mean you've had your fair share of headwinds since becoming a public company in tariffs, COVID, supply chain issues and even a war in Europe. So it's hasn't been easy. And I was going to kick off with -- just given the backdrop of potential slowdown, obviously, U.S. consumers deal with a lot of headwinds right now. Are you preparing for a slowdown and maybe taking some measures around that? Or are you really preparing for a growth reacceleration? It certainly seems from your prepared remarks that you are really preparing for growth of reacceleration. Is that fair?

I think it's fair. Look, we are also being pragmatic, we are focusing on both eventualities. Although we do have businesses where we've built a significant amount of backlog. And clearly, our demand dramatically outstrips our ability to supply, particularly in some of these newer areas that are very exciting for us, and they'll be here for very, very many decades to come. We're also being guided that there will be some challenges, and we're going to be able to respond to those challenges. And so we're not trying to ignore one for the other, but we're trying to take a balanced approach, so that we manage in a very strong execution on the short term, but we also focus on not giving ourselves impediments that we don't have to give ourselves for the long-term strategy execution that we are excited about.

So to my mind, it's -- the key things are how solid and stable is the backlog. Can we count in that backlog even if we do go into a slower environment? That's the first issue for me. And then secondly, the ability to convert that backlog, i.e., the supply chain pressure points. So maybe you can just talk about the first -- the backlog stability. Through prior downturns, how stable is that backlog been? Have you seen cancellations? How solid is the backlog over the next 12 months?

Yes. So as management -- first of all, I'll remind everybody that we are really not a backlog business, we are a book and ship business. So anytime we develop backlog, it actually is not something that makes me happy because that only states that our demand significantly outstrips our ability to supply. And when I think a little bit back, maybe 3 years, 4 years back, the backlog remained quite solid. We really never experienced cancellations. But we pretty quickly consumed that backlog when the economy went in to a substantial slowdown. But that being said, through April and May, we have continued to see very constructive order intake. And so certainly, over the midterm, we believe that we have sized up the impediments, and we believe that we are in a position to deliver what we committed to the shareholders.

Okay. And maybe just the market on the supply chain issues, Ivo. Obviously, China is a big sort of gating factor during the quarter. And obviously, you've embedded that into your framework. But just maybe talk about what you're seeing through April, May in terms of supply chain constraints and maybe more importantly, perhaps some of the resin capacity issues as well?

Yes. So I think that on our earnings call, I indicated that we have made significant progress with reducing dramatically the amount of headwinds that we have seen from the supply chain, particularly from raw material availability. We're dealing with -- we used to deal with maybe a dozen items big to weak, but we've now already gotten down to maybe 1 or 2 items, and we are making some progress in the specific resins that particularly go into automotive OEM applications in particular. We believe that in the second half, we will have that worked out as well, but that's probably the one more meaningful remaining item vis-a-vis supply chain and raw material availability. And a big issue for us in Q4 and Q1 was COVID. And clearly, that has worked itself out certainly in North America and Europe, but that is a rather significant impediment in China as we operate in the present quarter there.

Okay. And obviously, labor was badly impacted by the COVID restrictions. Maybe just focus on the U.S. because that was obviously heavily impacted in Q4 and to some degree in Q1. How is that trending? And in terms of labor retention, the ability to hire and fill vacancies. What kinds of wage increases are you putting through to solve those problems?

We have seen the most significant wage increases, frankly, to be put in place kind of in Q4 of last year, where we have reindexed cost structure. And we've entered '22 with basically the run rate that we believe is going to continue to make us a competitive and attractive employer, particularly in the manufacturing facilities in the U.S., in particular. We still have some hotspots where here and there, you have a distribution center that you're still struggling with getting workforce fully staffed, but the labor availability issues in North America, in particular, a significantly less onerous than they were in the second half of last year. And so we feel reasonably good where we sit today. It is not a massive impediment. It's certainly nowhere near what it was in 2021. And as we exited Q1, and I stated it on the call, we feel -- we thought it was -- March was the first month where we kind of felt more normal if there is such a thing in North America operations, specifically.

Yes, normal is not a word we use much of these days. That's good news. Obviously, you provided a lot of specificity around China in your sort of 2Q commentary. Just wondering how is that playing out versus the plan, in terms of your plants, supply chain, logistics? Any help there would be appreciated.

So look, we've, I think, taken a pretty pragmatic view of what we anticipate to see in China in the second quarter. And so far, it has been playing more or less in line with how we have envisaged that the quarter is going to progress. We really can count on dramatic improvement in the lockdowns of Shanghai, we looked at it more what it was like in some of the Western economies when the economy shut down, and we said basically, it's going to take 3 months to reopen. Now that being said, all our facilities are operational presently. We only have one facility that's frankly located inside of the Shanghai City property that is operating at reduced capacity, but it is operating. The biggest impediment that I think we all are dealing with in China is intercountry logistics that is much more problematic than I think folks have envisaged and certainly us as well, but we are solving that problem as well. And we certainly believe that demand is holding okay. It's your ability to get raw materials into your factories and then ultimately get the finished goods to customers that are calling you, "Hey, where is my stuff?" And how can we get the products from your warehouse to our facilities? So it's plan more or less kind of how we've anticipated. It will be impacted quarter -- it will be pretty dramatically impacted quarter, but not beyond what we have anticipated.

Okay. And you think that, again, using the word normal, do you think 3Q might look a little bit more normal from a trend perspective?

Oh gosh, only if I had a crystal ball. I think that it really depends on what happens with potential infection rates in some of the bigger cities outside of Shanghai. Shanghai, I think, is going to be more normal in 3Q, but will that be an environment where they are not locking down some other cities, I think that that's everybody's guess.

It feels like it's going to be two forward one back, two forward one back, for a little while. That's fair. And then I do want to get on to some of the longer-term initiatives that you've referred to, things around innovation, especially, but maybe just talk about Europe because you're very globally diversified, so you can give us some good perspective in terms of the geographies. It sounds like North America is -- remains pretty strong. Europe is a big debate right now in terms of the inflation impacts and potential that's there. Are you seeing any boring signs in Europe?

No. I would say that the biggest impediment that we have faced in Europe so far is the effect of reducing our presence in Russia in line with the sanctions. And I would say that more or less the inflation that continues to ramp up, predominantly, associated with escalation in energy costs. From a demand perspective -- demand actually in the industrial applications have been rather strong, maybe a little bit to my surprise, but we have built a very nice business in automotive replacement in Russia. And so when I take a look at some of the end markets, we will be dealing with some comps and some impacts with some of those decisions, particularly associated with the war in Q2, but the underlying demand so far has remained reasonably solid. But I think that we all are in same boat. We are all thinking, hey, can that remain at this level? Or is there the effect of inflation that will start rolling into potentially demand structure. So far so good, but we are very laser focused on managing our European business, particularly day-to-day.

So we've heard some companies talk about some pushing to the right with the inflation. It doesn't sound like you've seen much of that. I don't -- but it wasn't enough.

I think that the big issue in Europe again from an inflation perspective is the escalation of energy cost. We have to account quite a bit of energy. It's going to show up in inflation. But that being said, we are being very proactive in pricing. And that is something that I view customers starting to understand a little more, so where surcharges that you apply or frankly, just raising prices to take it into account. I think inflation is going to remain, and it's going to be headed for everybody, and we're very focused on managing through and get to our stated objective to exit the year nondilutive to our margin vis-a-vis inflation from accelerating that.

Okay. So just I do want to just make sure we understand the dynamics around this. Number one, on pricing. Are we pretty much done with prices here? Or do you expect to still roll through price increases over the balance of this year? And then in 1Q, obviously, margins were impacted by price cost, but that's more of the mathematical impact. I think on a dollar basis, you are very neutral. Would you expect to remain sort of -- I think you've talked about as you exit the year being margin neutral on price cost. Is that fair?

That's fair. Look, the inflation -- I'll say, we are continuing to deal with a very dynamic environment. So obviously, you layer in plans, and you believe that you have scoped it all in an things change. So we continue to offset inflation dollar-for-dollar repricing. So going back to your original question, hey, do you think that you are done with price? I don't think that you will ever be done until you see inflation rolling over. So what we are done with is we are done with not being quick on our feet. And I think that we continue to be pretty proactive in adjusting pricing as it needs to be. We -- from where I sit today, Q1 inflation was a little bit higher, and we have taken additional pricing actions in Q1, and those will benefit us as the year progresses. If inflation continues to roll in, it is inevitable that you will have to take prices, and we are prepared for that. But from everything that we see today, Nigel, we certainly believe that we can continue to reaffirm our commitment to deliver and exit the year being nondilutive inflation price economics. So we still anticipate that price economics is going to get to a level where we will not be taking a dilution to EBITDA margins in the year.

That's great. We've never seen -- generally speaking, industrial pricing is pretty solid through slowdowns or disinflationary periods. And -- but we've never seen, not for long, the scale of inflation. So I'm just curious, what is your perspective on that? Do you think that you can keep some of these price levels through maybe a rollback in resin prices?

Yes. I think that, that's an interesting question that I think that we all would like to have an absolutely crystal clear answer to. What I'll say is that over 65% of our business is in replacement channels. And generally speaking, you have probably a more significant likelihood that you will retain pricing on the products that go through channel. We anticipate that it's going to become more choppy with OEM pricing, obviously, the OEMs have loss of pricing power. They are built to be able to bid these contracts. And I think that everybody will have to make your own decision whether or not they are prepared to compress margins, so whether they want to continue to generate a reasonable return. And I think that's where the word is coming from.

Yes, absolutely. Maybe let me talk about innovation, Ivo. It's easier to get sort of like distracted from that. But maybe talk about the NPI vitality, how that's been trending some of the investments you're making. And obviously, we spent a fair amount of time talking about industrial chain-to-belt. That's a very large TAM opportunity for Gates so maybe talk about where we are in that process.

Look, I mean, I think in case we've done many really good things with the business that help us to make dramatic progress and repositioning our franchise, but I'd say that innovation is one of the things that is really over successful. We set up very substantial goals where we said, look, we want to more or less refresh our entire portfolio of products that we manufacture. So we're touching just about every product line that we have vis-a-vis innovation and launching new, more innovative, more cost competitive products into the marketplace. So when I took over, and I think that's kind of IPO -- during the IPO price, we were talking about low single digits of NPI Vitality Index. Today, we are in teens. So we've made a very dramatic progress with innovation, and we are well on the way towards our stated objective of 20% plus of NPI vitality. And we believe that we're going to get there over the next couple of years. So that's doing really, really well. And as we said, that's doing kind of a couple of things, right? Everybody is talking about, hey, will you be able to hold on to your pricing to protect your margins? We kind of added another element. And for us, the other element of gross margin improvement or expansion is being more competitive and that you get through innovation. And that's kind of why we have been so hell bent on driving to refresh our portfolio. And we believe that that's going to pay a big role in our ability to maintain and expand our margins -- normalize our margins as this process start normalizing into the future vis-a-vis inflation. Now coming back to the second part of your question, the industrial chain-to-belt initiative, but that initiative is not all concentrated diversified industrial end market, it also in e-mobility or personal or what we call personal mobility. And we continue to see a very strong growth. There are lots of talents that drive the adoption. And as I said in my prepared remarks, we actually saw significantly ahead that we were running into capacity constraints in the products that go in the industrial chain-to-belt applications. And so I talked the last couple of quarters about adding specific capacity and adding capacity and repurposing, some of the industrial equipment that we have. And we are now in the process of launching the capacity to give ourselves an opportunity to continue to trend it going forward. So it is an opportunity that is a multi-decade opportunity for us. We have a better technology, cleaner technology, more energy-efficient and more quiet technology, which we believe that resonates really strongly with the end users. If I just take a look at industrial chain to belt, what did we do last quarter? Did we continue to drive the design wins that give you a line of sight on how that's going to evolve into the future? Absolutely. We've converted a large multinational forest product manufacturer in the last quarter, a large pump applications in LNG facilities, all very relevant to what's happening today in the world. One of the largest -- world's largest manufacturer in cotton processing equipment in India as an example, a large manufacturer and more important garden equipment that has gone away from actually direct drive into a Gates belt-driven application. So the opportunities are endless. The runway is very long. And yes, it will take some time, but we are doing better than we anticipated, and we believe that this is an opportunity that gives the company more stable, more profitable and long-term opportunity to continue to drive profit.

That's great. Thanks for the detailed answer there. Before I want to wrap up on our balance sheet capital allocation, but I do want to touch on the EV opportunity. I think you first started socializing maybe some of the content opportunities on EV platforms back in 2019. Obviously, we've seen a lot more launches since then. So just maybe talk about where you sit right now on the sort of the EV penetration curve?

So look, I start always with kind of the boiler plate bullets that I think is essential. Our business in automotive is fundamentally focused on replacement channels. In automotive applications, that means vehicles, there are 7 to 12 years old. That is our mission statement. The business is 3x our OEM business. And so as we discussed EVs, yes, they are a great opportunity for Gates. We have a substantial content uplift in product lines that we are a leader -- that we have a leadership position today, particularly in the thermal management and water costs. So when you start thinking about that opportunity, right, there's about 600,000 EVs in the marketplace today that are in the sweet spot, right, out of all the populations. Again, the sweet spot is 7 to 14-year vehicles. And if 600,000 EVs is on a car park, globally, that's 1.4 billion in size. So although we are very excited about that opportunity, Nigel, it will take quite some time to ramp up. We need more EVs come to service into use. And then we need those EVs to age so we can offer replacement components in the functions that we serve today. So we have a large OEM pipeline both in automotive and heavy-duty truck, but we are predominantly focusing on thermal management. We are focusing on steering and other accessory type applications. So we are very happy with where we sit, but it will take time to scale up that opportunity.

So you don't need to be on the OE platform with the OEM to participate in the aftermarket opportunity for EVs?

Absolutely. That is the case. We do not need to be in the OEM market. We will be. But very selectively. We worked too hard to shrink our OEM business for the last 5 years.

Right. And then just finally, maybe in the couple of minutes we've got remaining. You talked about the balance sheet and the dramatic change in the balance sheet leverage since the IPO. You've got optionality on free cash flow here. And the question I've got is, number one is when do we start to see conversion improving, i.e., these work capital pressures, when do you think those get behind us? I understand why that's been the case, but when do you see that happening? And then where do you sit here on allocation? It seems like your stock price is a great investment right now. But what's the pipeline for M&A looking right here?

Yes. So look, free cash conversion, we believe that we're going to be 90% plus in 2022. I think we stated it on our last earnings call, maybe the natural question is why aren't you, 100% plus, right? I think the issue is that with the dynamic of this particular year, we anticipate stronger second half and there will be a little bit of headwind in terms of cash conversion, particularly on the receivables side. Look, inflation is driving higher pricing. It's also a little bit of a headwind terms of receivables and inventory. But we believe that it is all scale and that's going to get normalized. And I don't think that our shareholders are going to be unhappy with 90% plus cash conversion as a measure of adjusted EBITDA. On the capital allocation strategy, look, at this point in time, we anticipate to maintain a very balanced approach that provides for a long-term value creation item, by the way, agree with the share price. I think the share -- the stock is too cheap. But taking that into account, we believe that share repurchases have the highest risk-adjusted return for us. And as you have seen recently, the Board has been very supportive of that idea, and we nearly completed the November of last year authorization to purchase about $200 million of our stock. So that being said, we need to be very balanced. We also have an opportunity to reduce our gross debt. For some shareholders, that is an important factor. We have plenty of cash to be able to do that, and we're also seeing some opportunities in particularly bolt-on M&A in technologies that we have existing. So we will be very disciplined. We have an opportunity capital. We generate very strong cash flows, then we will deploy cash to return the cash back to our shareholders, it's important to us.

Okay. Great. I think we're out of time. So any closing remarks?

I think that as you indicated, since 2019 when we became a public company, we've dealt with an endless stream of challenges. We are prepared for these challenges, but we continue to demonstrate that we come much stronger after every one of these specific set of challenges that are layered in front of us. And we are ready for this one as well. And the future of the company is terrific. Company is in a very good shape, and we have a terrific mission, that we believe we can continue to execute on.

Ivo, that was great. Thanks for your time and good luck out there.

Thank you very much. Take care.