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

Well, thanks very much, everyone, for the last session. I think today, it's my pleasure to have Ivo Jurek, Chief Executive Officer of Gates Industrial. Gates has obviously been public for around 5-plus years -- 5 to 6 years now. So we've enjoyed having you at this conference and welcome Ivo.

Maybe first off, interesting business, touches a lot of different geographies, many different industries, distribution, OEM, industrial, automotive, personal mobility. So maybe sort of give us your sense of investors seem to be [ racked ] this week and in a way that they were not for the last 3 or 4 months. How are you seeing kind of demand right now? Are you worried about customer inventories, worried about destocking? Maybe just sort of broad thoughts on that, first of all.

Sounds good. I think that that's a question that is very relevant in today's environment. And as I said on our call, maybe a few weeks ago, we have seen a reasonably strong demand across all of our end markets. And as you pointed out, Julian, we are quite diversified. We touch lots of different end markets. And we have delivered a Q4 where we have seen strength everywhere. I would say that the weakest performance in our end markets were diversified industrials, and it was basically nearly 10% core growth. So everything else was above that, right? So clearly, price was a big part of it. But we've delivered mid-single-digits volume growth as well. So when I take a look at the underlying demand, and that's in the face of having a very weak China, obviously, from COVID perspective. So when you take a look at how the January finished, January basically similarly performing as what we have seen in Q4. Our book-to-bill remained above 1, which was very solid. And we have just not seen a meaningful change yet to demand that we have experienced in Q4. Now we've talked on our earnings call that end of Q4 was significantly impacted in China with COVID. Obviously, January was significantly impacted with COVID and Lunar New Year. The activities are starting to rebound, and it is performing very much in line with what we have anticipated. So you're going to see a recovery in Q1 in China. And then obviously, Q2 should be quite reasonable taking into account that Q2 of last year was very weak in China. So when you take a look at our guidance, right now, we felt that the demand is solid, but we're also being pragmatic. And we felt that at some point in time, you will start seeing some level of destocking, predominantly driven by customers getting more comfortable with supply chains. And so our view is that perhaps in the second half of the year, you start seeing some inventory coming out of the channel and that's what we have planned around as the year progresses.

And I guess, how to put it, how scientific or precise is that sort of destock assumption? Like did you try and look at it by region or market? Or you just say, okay, bottom up salespeople and the regional managers are saying, I don't know, 3% volume growth in the second half, let's assume some destocks that will just take off 4 points. I just want to understand like how did you come to that destocking assumption?

Yes. So look, I mean, our view has been that when you look at the inventory levels, and you take a look at our POS reports, the POS reports are very healthy. There's not excessive amount of inventory in the channel presently, but that's based on the present run rate of sell-out, right? If sell-out decelerates, the conversation becomes a little bit different. And so we've actually taken a reasonably pragmatic view and says, look, we think that there's going to be kind of mid-single-digit decay in the second half of the year in volume attributed to destocking. We have a couple of points of growth driven through mobility and energy markets that are very, very robust, very buoyant, and you have price. So when you put those 3 components together, that's kind of how we revived at kind of the back half of our guide. So we still -- we're being pragmatic on the volume side on the run-rate business, but it could be better, right? But I don't think that we have a real scientific purview that can call out 3 quarters out, what's going to happen. We are a short-cycle business.

And the reason it's sort of back half is just because short term, as you said, January felt the same as Q4. So there's no reason to assume it happens imminently.

Right. Presently, that's kind of how we view it. And then if you take a look at the composition of our business, Julian, a big chunk of our business is in automotive replacement. And that business has got some very, very positive dynamics, right? It's got the oldest car fleet ever. Folks are not necessarily able to replace aged cars with new ones. You have very high miles-driven numbers in the Western world, and you see a very strong rebound in China even early in January. So that, to us, feels like this -- they should serve as a little bit of a catalyst to have a less impactful demand destruction, if you would, if that occurs. So we got kind of different dynamics. And we've always attributed the automotive replacement business as being well more stable business. And we believe that, that's going to be playing itself out in 2023.

And then one thing in your end market sort of outlook that I noticed it's small, but sort of the auto OEM and mobility piece, you assumed wouldn't grow this year. And that was -- I just thought that was -- it seemed low given most industrial companies are assuming, call it, low to mid-single-digit growth in auto OE, and mobility, you've got some very good outgrowth. So...

Right. So let me first point out what that slide represents. That slide represented our global view of the end markets. Not necessarily what we believe is going to happen with our business. So when you take a look at the underlying markets, we kind of felt that the underlying market should grow kind of low single digit when you rank it all up, right? So that's the underlying market demand. When we take a look at mobility as an example, I mean, we still believe that mobility is going to deliver a really nice growth, because for us, it's -- we're not necessarily dependent on the end market growth. For us, it's a conversion story. We are reconverting chain to Gates belts. So it's a penetration story, not an end market unit growth story. And I've discussed on our earnings call that we have a very large pipeline of opportunities, and we believe that we ought to be in a situation that we continue to deliver a very high rate of growth over the next couple of years. When you take a look at oil and gas, we feel quite good about the energy markets, and we are really well positioned. We have done a good amount of innovation over the last 3 or 4 years. We've gotten into some interesting unique applications and in fracking spreads where we replaced some hard piping with flexibles that we manufacture to prevent some leaks and make it a little more user-friendly to [indiscernible] those spreads out. So we have some incremental growth there. When you take a look at OEM -- Auto OEM business, we always saw that the IHS is a little too optimistic. And I think that you recognize how I've been somewhat conservative on the estimates, and I feel that we were a little bit closer to our estimates with what happens with the unit builds. And so we've taken a more conservative view of what we anticipate the auto OEMs are going to be able to do, because I still don't believe that they have licked all of their supply chain issues. And at some point in time, you will also start dealing with the consumer and impact, right? I mean the cost of acquisition of the car is up quite substantially. The yields on the loans and leases are going up and is that going to impact how build. So we're just taking a different perspective.

And then on sort of personal mobility, specifically, very good business for you. Maybe remind us of the scale of that today? And what do you think about the growth rate there as you look out?

Yes. So I remind everybody that the business was kind of a $20 million size business for us in kind of 2019 time frame. We have exited 2022 at $200 million run rate. So we've grown that really, really nicely. We've committed during our I Day last year in March, we anticipate that the business should be growing kind of in the mid-20s to 30% compound annually for the next 3 to 5 years. We're participating in a massive marketplace. I mean the business opportunity is kind of $12 billion to $15 billion for Gates Corporation. And we believe that today, we have a less than -- we have less than a couple of percent penetration. We want to drive that penetration over the midterm to 5% to 10%. And so as I do that compounded math, I mean it's pretty big heady numbers. Now we think it's going to take a little bit of time. But we have been demonstrating that we grow that business very, very nicely, and we can continue to do that well into the future.

And how does the -- sort of the profitability of that look versus the segment average, let's say?

So the profitability is above company fleet average. And so it is not only a great opportunity to deliver growth. But as we mix up more towards the revenue that's generated out of that end market, we also mix up our gross margins and EBITDA margins.

Got it. And I guess a couple of, I don't know, secular topics I wanted to get your thoughts on. One was, and your business is global. But when you look domestically, there's a lot of chat the last 2 years about onshoring, reshoring and so forth in North America and Europe. How do you see it when you talk to your customers? Do you think it's something real or just a topic that comes up every few years for decades? And then secondly, in the sort of auto world, specifically the electrification momentum is very, very strong. Is it sort of playing out as Gates hoped in terms of growth, but also your dollar of content per vehicle?

So let me start with the onshore question, right? So the onshoring question, I think, it's an interesting question. But I think that you almost need to ask yourself kind of -- is there a different driver, right? I mean I think that the geopolitical events were kind of shocks to the system. But I think if you take a look simply at how much it costs you to do business in China today versus what it was 20 years ago. And if your business was based about, I'll make it in China, I'll import it back into the U.S., I just don't think that you're going to be doing that over the long term, because the labor rates are much more costly, logistics and distribution, all the bureaucracy duties and so on and so forth. So I think that if you are consuming your output in North America, I think it's just pragmatic to reshore the production. And you'll reshore into the U.S., so you will be reshore into Mexico. And I believe that it's already happening. That represents tremendous opportunity, I think, for many companies that are in industrial automation, and it bodes really well for us. When it comes to industrial chain-to-belt or just the belt-to-belt opportunities that -- where we participate. So I actually do believe that there's going to be kind of a longer-term secular trend for companies to bring production back into North America. Switching on the electrification for a second. In terms of electrification, I think the electrification is a very interesting and unique opportunity for Gates Corporation. We have quantified that we kind of have a $300 content per vehicle, I would say, that on the industrial applications, the heavy-duty truck, as an example, that's much bigger content, it's kind of $600-plus per rig. What we have anticipated that's going to happen is happening. We have highlighted on Q4 as an example that lots of our business in automotive in Q4 was driven by the automotive applications. So that's around that set of applications. But we have also deployed a strategy of selective participation in automotive. And selective participation means that we just feel that we don't need to be in an OEM application, and we are the biggest, broadest brand in automotive replacement globally in every region that we participate today, we are #1 or #2 market shareholder, typically #1 market shareholder. And we do that with very limited participation in the OEM side. So we're focused on building our portfolio for car parc that exists. And presently, we believe that we are #1 in the portfolio availability of the existing electrified platforms that are on the Street today globally. But for us, in order that opportunity to materialize into a sizable revenue, we need that car parc to scale up, and we needed car parc to age. And so we're still projecting that even with the accelerated rates of growth that you see today, we still don't anticipate that it's going to become a meaningful opportunity for us until sometimes 2035 because, again, remember we play big in kind of that 7 to 12 years old vehicle fleet. So you're going to scale it and then you need to age it. And that's just a matter of time. So we're very excited about it. But I think that we are more excited about some of the near-term opportunities that we can execute personal mobility, industrial chain develop and then, frankly, broadening our participation in diversified industrial space.

Got it. And on the latter point, how do you attack that exactly? Like it's a vast, broad market, how are you prioritizing this region or this specific vertical within diversified industrial?

Yes. So again, I think it's a really interesting question to answer. When I take a look at where we were successful in personal mobility as an example, we've kind of evolved from 2019 in how we drive that penetration, and we had to do a couple of things. Number one, we had to design a set of digital design tools to enable the desires of the equipment makers to spec in a belt-driven drives rather than a change-driven drive. And so we have done that. We have developed a little broader portfolio, so that we can actually offer not just the belt, but we're now offering those end users, the entire drag so the pockets as well as the belts. And that has accelerated the penetration rate. So when you take a look and you say, "Hey, look, I want to spec it into the OEM space in diversified industrial." So we have started in Japan, because Japan has a great base of machine builders. And it's really kind of a hard place to penetrate for an American company, if you wouldl. And we have seen an incredible set of design wins and a really substantial growth of industrial chain-to-belt penetration in diversified industrial space in the machine builder space, and we have taken the approach that we've taken personal mobility. Now when you take a look at places like North America, as an example, in North America, we are prioritizing existing installations and converting existing drives that utilize chains and converting them into belts. And that's a little bit of a different approach. There's a little different sales cycle. There's a little different application engineering cycle that's assigned to that. And so we're balancing these 2 approaches, and we are focusing on where you have lots of machine builders. We are focusing on the OEM applications. When you have a broader base that is already established like in North America, we are going in, and we are focusing on prioritizing existing facilities.

Perfect. And how do you think about the sort of the scale of the opportunity in dollar terms or the, I don't know, market share or share of the TAM that you had? Again, in personal mobility, it's a more discrete, easier to isolate market. So you can say we're going to go from 2 to 7.5 or whatever share. There were sort of industrial by nature, it's math. Yes. so okay. But the point is any share gain is meaningful extra dollars for you?

Absolutely. Look, I'll point out to -- when you're thinking about how Gates is growing. When we went public, about 16% of our company's revenue was contributed from Automotive OEM business. We exited 2022 with about 8% of total revenue out of Automotive OEM. We have grown the company. And we have all said that selective exit, if you would, with much better, much more robust, much more profitable revenue that we have generated. We feel that we are in a place where we kind of got the stability to the automotive business that we want to have. And so we also believe that incremental growth rate, everybody is asking us, hey, how do you -- so what's the metric that we should use to judge how you grow? So we said, look, we think that it's kind of an industrial production plus 200 to 400 basis points above industrial production growth. And we're really very comfortable that we can grow that, because the opportunities on mobility side with chain-to-belt and on the industrial side with chain-to-belt. By the way, the question to -- I mean, the answer to your question is we are about 1% penetrated -- less than 1% penetrated in the industrial chain-to-belt. But we are so early, and we believe that we have tangible wins. We are solving very tangible problems that our customers have. I think in one of our calls, we talked about food producer where they had a real issue with the chain drives clocking up from the production process that they had and they're running those plants 24/7 lights out. They had to shut down kind of day every 2 weeks to clean those drives. So you've completely eliminate that from occurrence. And the payback is pretty big for those companies. So we believe that the value proposition is very robust. And we are now taking a step by step and going and driving penetration. And it's a long-term opportunity for the corporation.

That's helpful. And maybe switching away from the top line to margins for a second. I think this year, you've got about 100 points of -- basis points of operating margin dialed in with sort of flat volumes on the top line. So maybe expand a little bit on the confidence of that margin uplift. And more broadly, sort of 80-20, how full through the organization is that process? What are the areas that you think are left to keep driving it?

Yes. Great question. Look, we've kind of quantified that we're saying just normalized operating performance. So -- and by normalized, I don't mean, hey, look, we need to go back down to 2006 or 2015, I don't think that we're going to see that level of normality or normalcy. If we just don't have any more geopolitical events, and we kind of operate in the environment that we have seen in Q4, just operating in that environment, there's about 200 basis points of improvement to margins for us. Not expediting materials from one region to another, from one location to another, getting a degree of kind of a run rate stability in your factories where you're kind of level loaded, not having to expedite and pay premium labor rates for a Sunday operations so that you can support your customers. Those things represent kind of 200, 250 basis points of improvement on margin. And to us, that's kind of a given in a run rate for us. That gets offset slightly by additional costs associated with variable comp that comes in that got obviously hit in 2022. So that offsets kind of that 200 basis points of 2022. As a result, you kind of -- you kind of guided to 100 basis points of improvement, right? And then so when you start with that, then we believe that 80-20 standardized productivity, which we have demonstrated that we drive quite nicely in a normalized environment and restructuring should add another kind of 200, 250 basis of gross profit and EBITDA margin improvement. And then the volume that we have talked about with better mix should give you another 50 basis points. So if you go back and you start at the exit point of 2022 at 19% EBITDA, and you add kind of that 250 basis points normalized run rate to the 19% and 250 basis points in 80-20 restructuring and productivity and 50 basis points in volume, you kind of get to that 24% plus that we have described. And frankly, for us, we think that this is kind of that 24 to 30 months' time frame that we should be able to reach that. Giving a more specific answer to 80-20, we've just started the journey. We have deployed 80-20 process on our automotive replacement side of the business in second half of last year. It's proceeding quite well. We are learning the process quite well. So we believe it's a significant opportunity. Once we have done with automotive replacement globally, we will deploy it on the rest of our business. And for us, it's not just 80-20 on the portfolio, because we have been doing lots of work with innovation to reducing complexity below the skin. This is kind of reducing complexity above the skin a little bit and looking at optimizing pricing processes and looking at how you treat different customers. All customers are important, but there are some customers that are more important than others. And it's just a fact of life, right? So we are very excited about that process, but we're also very excited by deploying the process in our corporate processes. We can quite significantly lean out how we do day-to-day business and look at our front end, back end and eliminate some waste in a process.

That's great. And then maybe sort of free cash flow, a very strong end to 2022 on the cash flow profile. How are you thinking about the pace of sort of working capital normalization? And so if you're 2x levered later this year, there is the scope to start to do things that last with the cash kind of how excited are you about that. And on M&A, do you think Gates has the ability to sort of bring on decent sized targets or they'll stay small until we get more used to doing deals?

Yes. So look, very happy with the free cash flow generation in Q4. I think there was a lot of skepticism where we can reach it. But what I'm even happier about is that we actually started to already eat into our working capital at the end of Q4. So we believe that we have a significant opportunity to drive inventory down. We are seeing more stability in supply chain. We certainly anticipate it's still going to take maybe a quarter or 2 before we actually see the logistics worked out on getting the materials placed where we need them in a standard mode of transportation. But if you put that aside, we believe that we have a good opportunity to take inventories down. We don't necessarily reducing the output in our factories. We can start at a reasonable clip eating into those inventories that have been brought in. The other thing remember, big part of working capital for us has been we delivered a pretty outsized growth over the last couple of years and that drove receivables up. And ultimately, that puts some pressure on cash conversion. But our commitment is to deliver 100% cash conversion over a long-term future. We have done it prior to making the massive investments in CapEx in '18 and '19. So there's nothing fundamentally inherent into the business that says that we -- that this is some heroics that we're going to have 1 year, 100% cash coverage. This is something we're going to do year in, year out. Now we generate terrific cash flows. So converting that 100% as a percent of adjusted net income gives you a lot of optionality at that point in time. And so that optionality for us, we view that with elevated interest rates, the best use of capital maybe in 2022 is to pay down more gross debt, that's going to improve your cash flow, it's going to improve your EPS. And as you exit '23 , you now have an optionality to take a look at some of buybacks. You have optionality and you have a pretty strong balance sheet at that point in time, a much stronger balance sheet. And then that you can start thinking about M&A that's a little more scaled up. I just think that I don't necessarily subscribe to the -- I'm going to go in and buy these small companies. It's too much work. And generally speaking, it's kind of tough to make a difference. And there are lots of companies out there that Gates like, if I can borrow that term, highly engineered, precision engineered mission-critical replacement cycle. And there are lots of companies that are good size that could be good targets to put together with Gates and create a very interesting unique asset. So step one, let's execute on '23, let's pay down some more debt and demonstrate that this is a sustainable level of performance.

Fantastic. Well, that we'll switch to the audience response survey. So if you could take up the gray devices. Do you currently own the stock? [Voting]

That's 50% now. So there's an opportunity there. The second question is around sort of the bias or general kind of view towards Gates right now? Positive, negative, neutral. [Voting]

So generally, a very positive view. Thirdly, when we're thinking about the sort of earnings growth algorithm of the company. And here, I think the pace that we're trying to use is kind of broad industrials or U.S. multi-industry would be the peer set for Gates. [Voting]

Okay. So sort of above in line. The next question, we're looking at kind of what should Gates do is that balance sheet optionality starts to kind of rear its head. What can it do with the balance sheet. [Voting]

So [indiscernible] wave, but no one seems interested in dividends, particularly which is interesting. And people are very comfortable with M&A. Valuation-wise, what PE on next 12-month EPS should Gates trade at? [Voting]

So mid-teens -- sort of mid-teens, I guess, 15, 16x. So this question is really around sort of why is it 15, 16x, '21 or 25x? What's the biggest kind of drawback faced by the business or the company today? [Voting]

So execution and then -- grows to a degree. The next question is -- or the last question, should I say, is around ESG. Does it matter or not for investors in Gates? [Voting]

In general, it's been about 30% answers for question 1 and 70% for question 3. This is a new question this year, we added, so we'll see how it develops in the future, but fairly balanced, some people thinking about using it in future. So with that, thanks so much, Ivo, for this discussion.

Thank you. Thank you very much.