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

Everybody, excited for the next presentation, one of the stronger stocks year-to-date. Little strong rally in some of the small caps to start the year. We'll see if that can continue. Maybe your feedback will provide some stimulus for that. Sitting next to me, as you all probably know, CFO of Gates, Brooks Mallard. Long history with Gates, where all the bodies are buried and all that good stuff. So thank you for taking the time. I appreciate it.

Pleasure to be here.

And Richard Kwas, Vice President of Investor Relations. Great to have you here. How long at Gates now?

Thank you. Coming up on 3 months.

You were better work at 3 months.

I don't know as many body. I don't have the [indiscernible] on the body's, but I'm learning.

You're learning. I appreciate it. So with that, again, feel free, raise your hand. We ask questions. No prepared remarks, so I'm going to launch right into some bigger secular trends. Obviously, when people think of onshoring the factories that are coming in the U.S., you would think maybe we're going more belt than chain. So maybe try to weave in how you view your content story on if we're getting more factories in Mexico, more factories in the U.S., how should we think about your exposure to that from a factory perspective, chain to belt, particularly that growth theme?

Yes, there's really going to be 2 growth vectors for us to the extent that onshoring becomes a thing. One is certainly chain to belt, right? And so diversified industrial is one of our bigger growth initiatives that we have in the company. We're a relatively small part of a big universe in terms of chain and drives and belts and drives and things like that. And we think we can increase -- continue to increase our market share there for many years. And so to the extent that new rooftops go up and/or existing factories get refurbished and new equipment comes in, we're going to participate in that and participate that in an accelerated way with our chain-to-belt initiative. So there's going to be a lot of belts going in there, and a lot of drives that go with belts and things that we spec in. I think the other part of that is to the extent that there are new rooftops going up and there's construction equipment and heavy-duty truck equipment and things like that, we have a nice footprint there as well, particularly in our Fluid Power business. And so to the extent that there's more heavy-duty truck, more construction equipment that is fueling the onshoring, we will participate in that as well. So there's 2 nice growth vectors for us in both parts of our business.

Terrific. China, suddenly, over 10% of sales, not an immaterial player. Obviously, it's a little bit higher when China is stronger. I'm asking most companies today. PMI 53. Does it feel like 53? And if it doesn't yet, what are the tells for you that this recovery maybe has some legitimacy versus some recent?

Yes. So look, we had a view of China when we gave our guidance, and that view really hasn't changed. Q1 is going to be tough as the recovery from COVID in Q4 continues, but then we think the rest of the year is going to be pretty constructive. So we think overall, the growth is going to be mid-single digits for the year. Probably high single digits negative growth in Q1. So we think the rest of the year is going to be pretty constructive. And Q1 is a little bit tougher comp because last year, they didn't have the COVID. And this year, they've got the COVID coming into the quarter. And after that, the comps get a little bit easier, too. And so when you have the comps getting easier, you don't have the COVID stuff and then you get the recovery starting to work in there, we think the rest of the year looks pretty good.

And for you, your largest exposure is Auto OE?

Yes. Auto OE. We have a nice automotive replacement business there as well. And then I think some of the -- certainly, as those 2 recover, that's going to help us.

Our lunch speaker, our firm's China strategist was speaking to, it's going to be consumption. That's going to be the biggest part of the recovery in China. So hopefully, that speaks well to your auto potential.

I think that miles driven. As starts to open up again and people start to drive more miles, that will open up the aftermarket again.

But it's fair to say given you're a little early in your China penetration than North America, obviously, you're hugely aftermarket in North America. China is a little more balanced because of where you are in the...

100%.

Financial leverage. I think the midterm target of 2022 was 1.5x net debt to EBITDA, right? And the leverage obviously this year ended up closer at 2.8x. The timing for that 1.5x, how important is it to -- are we still targeting that 1.5x for the certain time frame? Or is it -- obviously, the working capital, the cash flow, I mean things didn't quite go as maybe [indiscernible] plan in the last couple of years pandemic-wise. But how should we think about the determination to get that leverage down?

Yes. So look, there's -- I think there's 2 really good ways for us to deploy capital in the short term, right? We talked about paying down debt. Interest rates are high. We want to take our gross debt down. That improves earnings, it improves cash flow, it helps the business. In addition, the way that we can pay our debt down with some of our term loans, it actually provides us flexibility as we move out into the midterm or longer term, where we wanting to do some meaningful M&A. Okay? Having said that, we want to be opportunistic as well with our ability to buy stock back. We participated in a meaningful way in Q1 of 2022, where we bought a significant amount of shares from our major shareholder. And we want to be opportunistic if -- and flexible and nimble if that opportunity presents itself to be able to participate in that as well. And so -- but we think both of those are going to really enhance shareholder value, whether we're increasing our earnings per share and increasing our cash flow or whether we're accreting earnings per share by buying back stock. We think both of those are great kind of really low-risk options, and we generate a ton of cash. The past couple of years with the inflation and the working capital management have been a little bit tougher. But we feel like a lot of that is in the rearview mirror, and we ought to be generating a lot of cash as we move forward.

Okay. So your majority owner maybe coming to market, you want to be there to support that deal.

Right. And we did that in Q1 of 2022, and that's -- again, that's a good way to return value to shareholders.

The personal mobility opportunity seems to be particularly large. But it's interesting the 2-wheeler market gets the greatest opportunity, the way you think about it. Can you take us through that a little bit more what you're seeing on 2-wheel versus the other opportunities within personal mobility and if there's any skew at all in profitability between the pieces of personal mobility?

Yes. So let's start with the profitability side first. So we really have a compelling technology with the belt and the carbon cord and the strength of it and how it works, particularly as you migrate to electrification. And that's really the key. The more electrified that whole space becomes, we're in pole position there to continue to grow with the market, right? And so the 2-wheeler really becomes bike, e-bike, scooter, motorcycle, all these different applications that are becoming more and more electric, and thus needing the belt drive, the belt and then the metals that go with the belt drive. And that's just a much better solution. And so the way that we're thinking about it is even if the mobility market remains relatively flat in terms of the number of units that are built, it's going to move more and more toward electrification, and we're going to take more and more market share as it becomes more electric. And so that's kind of how we're thinking about it over the next 3 to 5 years.

I think you're roughly $200 million.

Yes, $200 million.

Of that $200 million personal mobility business today, what is the mix when it comes to motorcycles versus bicycles? I'm just trying to get a sense of...

Yes. I mean it's -- I think it's mostly e-bike, bike, scooter with a little bit of motorcycle. But the application goes across all the -- it's -- the application goes across all of those different products.

But when we hear of -- actually, I lost track of the date. The $500 million target for personal mobility, what is the time frame on that? Is that sort of a...

It's a midterm time frame. So kind of maybe that's about over 3 years.

[ So middle of the decade. ] The jump from $200 million to $500 million. First, how would you describe at $500 million, let's say, the profitability of personal mobility versus company average? And then what are the biggest drivers from the $200 million to $500 million in particular? Are there any particular geographies? Is it like in India with a bunch of 2-wheelers? Or is it more classic developed world, electrified?

Yes. Well, look, I think the -- it's really ubiquitous across all geographies because you're seeing these e-bikes and scooters and things, they're popping up everywhere. I mean just walk around the city, and you can see people waiting to riding them, driving them everywhere. And we feel like it's going to continue to be above fleet average because we've got the preferred technology. And we continue to come up with new material science, new products with new -- that have specific applications based on what the end user need is. And so we think the profitability is going to continue to be above fleet average, and it's going to continue to accrete margins for the company as it goes from $200 million to $500 million. And really, you're not talking about a huge increase in terms of market share. So you're talking about going maybe from very low single digits, maybe 1% to kind of 4% to 5%, and that gets you there. And actually, that would get you significantly above $500 million. We're going to get that kind of market share level. So...

Yes. I mean for a company of your size is actually $300 million at above company margins is not immaterial.

I agree.

When it comes to the -- when I first really got involved in the stock and hearing all the negative EV thoughts. And -- but the idea of the timing belt going away, right, and obviously, you're dominant in that timing built. But the idea of the EV water pump, just to manage the heat issues around EVs, can you give us a better sense of where we are in getting maybe more aggressive and we want to build more of our own pumps instead of private label? Just where are we in that evolution? And I know there's been a little -- all right, you want to -- we can win a couple of OE businesses, if you want. We'll show it. But you want a business model still be aftermarket-centric, right? So you can give us a little update on how you're viewing why do you feel the need to maybe just show the world you can win some OE platforms? And second, can you keep the content, if not even higher than traditional of these? I'm going to replace a belt that's going away with the timing of the engine, so I'm going to get the water pump business.

Right. Yes. And it's not just a water pump. It's all the cooling, the cooling...

The Fluid Power...

The power that goes throughout the -- actually, the entire car because the architecture is through all the inverters and -- the batteries and the inverters, so it's through the entire car.

And there's still a few belts for some ancillary.

Right. Like the electronics steering and things like that, right?

But the water pump is a big dollar content, where like I'll trade a belt for water pump, especially just pure revenue. Yes.

And so look, we've been developing electric water pumps for the past several years, the technology. And for us, it's really around making sure that as the vehicles in operation gets into the right sweet spot for us, which is kind of 7 to 14 years old, so when vehicle gets 7 to 14 years old, that's when it's in the sweet spot for the replacement cycle, right? And so we constantly look at vehicles and operation, models and operation, and when those are going to kind of hit that sweet spot so that we're ready with the products, they've been tested, we've got the industrialization done, and we can start to supply our business partners with those products, whether it's the FP products in terms of the Fluid Power tubing and things like that or whether it's the electric water pumps. So we're looking at both those together.

And the patience to wait for the EV market aftermarket which -- that's some years down the road. Should we look at this as like we're ready for when it comes, but we're not going to dive into low-margin OE business? But to make sure you're there to win the eventual EV aftermarket, what's the strategic play? Is it -- it's going to be the same channels that we sell to right now, belts, it's just making sure we get the shelf space. We get the mind share that you dominate right now for the belts from auto.

I think -- no, I think that's exactly right. And look, we make this point a lot, right? As a percentage of sales, North America is our lowest automotive OE business. And it's our biggest automotive replacement business, right? And so we know how to do this. This is our business model. We're constantly looking at updating our product portfolio to make sure we can service all of our partners out there and make sure they have the right parts on the shelf to be able to sell through different stores and distributor networks. And so we're constantly looking at that and making sure that we're going to be in the sweet spot when the time comes and the demand is there. And I will say this, too. We've also -- even though we've participated somewhat in Auto OE market in terms of the electrification of vehicles, we've also participated on the heavy-duty truck side. And so electric water pumps, Fluid Power, things like that, we've had some nice business wins on that side of the business as well.

But at this stage, the scale is still -- you're mostly private labeling at this stage. Makes sense. The book-to-bill staying above 1. Should we assume that's sort of where we are right now? And we're still -- because I think you've said like we're starting the year book-to-bill above 1. And is that something that you would argue that most of your markets are still more the gating factor supply than demand? Because when you go through some of your end market guides, yes, there's a couple of flat in there, right? And some people would say, you hope Auto OE is not just flat, but mobility, right. I mean I'm just kind of get a sense of book-to-bill is above 1. But are there some markets where it's -- we said book-to-bill in aggregate above 1, but some are below. Just getting a sense of nuance...

I mean we don't -- Yes, we don't really comment on the book-to-bill by market. But well, a couple of things, right? I mean there is a seasonal element to the business. So you do tend to see orders and sales pick up through the first half of the year. So it's not uncommon to see that book-to-bill moving in that direction. And we're still trying to normalize and stabilize the supply chain, right? And we're still trying to get all the materials we need. We're getting most of the materials we need now, but getting them positioned, getting them into the factory, making sure that we've got the people and the right parts scheduled and kind of all those ancillary things that we said were a headwind from a profitability perspective in the back half of 2022, just getting all those aligned is going to help us kind of satisfy customer demand as we move forward. And then I think the last thing, too, is we've been pretty upfront with, look, we think that things have -- they were constructive as we move through Q4. We talked about them being constructive in January. But we do think, as we get more toward the back half of the year, yes, things are going to moderate some, right? I mean people are going to get more confident in the supply chain, maybe they take their lead times down, maybe you see some different things happening. And so you're going to see things moderate in the back half of the year.

Easy for an analyst to say you have to execute and call the customer. I must say I was a little disappointed in the aftermarket position that you have. And the work we do in the channel that you're like [indiscernible], you don't even -- I mean it's Gates as a gate hose. It's not just a tissue paper. It's -- you're the brand. That's what you put. The inability to push price earlier, not saying lessons learned, but in hindsight, why were you not able, willing with that market position in an aftermarket application, nonetheless, to not go, look, we need it now. I'm not going to wait until January. I don't care if it's November 1, we're going to do it now. Just, so I understand the business model a bit. I want to hear that much aftermarket with that dominant position. A little surprised.

Yes. I think there was a couple of things, right? I mean, I think there was a rate of acceleration of some of the inflation, particularly on the freight side, which really came to kind of quicker maybe than anticipated. And look, we have long-standing relationships with these customers. We typically give 60 to 90 days of notice. That's not only as a courtesy, but it's for them to get prices up on their shelves for them to get the prices into their system, whether it's the books or the computer systems, the ordering systems, the EDIs, all these kind of things. And you're talking about tens and tens of thousands of SKUs, so it's no small task. And so we knew we were going to take a small bit of short-term pain, but we also knew that we would come out at the other end of it and be where we wanted to be. And as we exited '22, our stated goal was to be at EBITDA margin neutrality. That's how we ended 2022. So we feel pretty good about where we are from a price versus cost perspective. And we feel confident as we move forward, we're going to be in good shape.

And given the auto aftermarkets, something like 30-plus percent of the company's revenues, the channel inventory there today versus historical. Just so we get some sense of supply chains loosen, more expensive to carry work in process for them to bring "back to normal." So for a simple exercise, if auto MRO stayed flat, how much destock is there to get that channel back to normal? Is it 10%, 5%? I'm just trying to get the magnitude.

Well, look, I wouldn't hesitate -- I mean I hesitate to put a guess on that because what we're seeing right now is basically inventories and point of sale and shipment numbers fairly equal. I see a lot of -- I was not in a situation where we feel like...

Is it 5%.

Well, there's a big disconnect between what's in the channel, what's being shipped and what's going out the door.

So that said, then your second half guidance was predicated on that gap widening. Is that -- so we're just making that logical assumption as the supply chain loosens, you're just going to see that gap widen.

Yes. I mean you're going to see as lead times shorten, right, as backlogs come down some, that just naturally kind of shrinks the inventory. And so you're going to just see some kind of natural progression of that is lead times shorten.

And so I don't know how good your data is to the channel to really know like, oh, I know exactly the inventory I have. Of the end markets that seem to be most, there's very little destock going to happen there even if supply chain loosens versus that's an area that there's -- you loosen that supply chain, these guys are taking it down 20%. Can you give us a little color between your end markets? Which ones feel like, yes, they were really carrying some excess inventory because of the work in process supply chain?

Yes. I mean, I guess, look, I would say that probably the -- on the distributor -- on the distribution side of the business, and we've talked about this before, is the industrial business has been a little bit more choppy. And I think that's reflective of kind of what's going on in the supply chain and then trying to make sure that they get as much product as they can. And I would say maybe not quite as choppy on the automotive replacement. And then if you look at our guide for next year and kind of what we think is going on with the end markets, kind of plays out that way, kind of stable low digits for the automotive replacement. And on the industrial side, a little bit more headwind as things normalize. So that's kind of the way I would portray it.

And for the Auto OE being flat, how much of that is China off to a slow start in January? And auto for you, OE China is not immaterial. But in general, can you take us around the globe a little bit on. Do you -- really looking at Auto OE flat North America?

Yes. Well, I mean I think what we're thinking on Auto OE is, look, over the past 2 or 3 years, people have thought that, oh, the supply chain is going to normalize, this is going to be okay, that's going to be okay. And I think we're trying to take a pragmatic view of it. Supply chain is still not completely fixed. Interest rates are higher. Is the consumer going to feel it? Is that going to make them a little bit less reluctant to go out and buy a new car maybe or lease a new car because they're paying more money for something else. And so we're just trying to take a pragmatic view of how this inflation works its way through the economy.

Yes. I mean there's going to be a theme here at some point where it's like, who benefits from a loosening supply chain and which of the companies to go, hey, I can destock them. You're a little bit at risk given the MRO business. But then on the OE side, that's obviously upside. So I was just trying to get an interplay between those third party and those forecasters have been -- have not called the supply chain inefficiencies in the last 2 or 3 years. So it's one of those where -- has forecasting got awful in the last couple of years?

There is now a lot of upside to project a lot of growth in the last 2 or 3 years, we've been expecting a lot more growth.

And remember, the automotive OE part of our business was 8% in 2022. So it's not a huge meaningful part of our business. I mean it's still an important part of the business, but it's not a huge meaningful part of the business. And so a flat or up, I mean...

Yes. I think I was just trying to figure out if you're a little bit at risk of supply chain loosening, your customers can destock you. You've sort of put that in your guide, though I'm just trying to figure out what's maybe that subtle offset of that is more of an [indiscernible] direct.

I think the offsets for us is we're going to continue to have these growth initiatives, where we're going to outgrow the market and outgrow maybe some of the supply chain loosening, and we talked about it. It's changed about mobility. And then on the Fluid Power side, it's all the new products we put in place and the new material science, new technologies that have really helped elevate the margin on that over the past few quarters to being almost equal to...

And the facilities you build in FP, subtle [indiscernible] just a couple of years now, but starting to get them filled up. The margin profile of those factories versus what they, let's say, replaced, what's the margin profile just as those new products? And can you remind us what's being built in those factories?

So it's really a hose, right? And so there's different kinds of hose, spiral hoses. There's also a couplings that we make. We make components for couplings, and then we assemble the couplings. And then we take those and assemble them into hose assemblies, right? And so really, what we've done is we've done a couple of things. We've made the business a little bit less complex under the skin with the products that we make. And then we've also improved the material science, improve the construction and the flexibility and what they can do. And then we've kind of reindustrialize. So invested some capital, so we're a little bit more efficient in how we make all these different products. So it's a better margin profile than the stuff that we had before. Now we had to lay out some capital. We had to spend some cash. We took a little bit of a beating for that back in '18, but it looks pretty good now. So...

You answers question as you'd like. But of the year guidance metrics, which are the ones that you feel most comfortable with and which ones you knew when you did the guide a little more challenging? Just a degree.

For '23?

Yes, just what you already provided.

Well, I mean, look, I think the -- for us, the ones that are always a little bit more challenging are the ones that are a little bit more outside your control, and so that's really the top line. And so because really, you kind of look forward and say, okay, here's what we think is going to happen. But then there could be existential events, good or bad. People could start feeling much better about the economy. And all of a sudden, the top line guide comes up, and you feel a little bit better about things. But from a cash flow perspective, from a margin perspective, the things that we think we can control as we look forward, we feel really comfortable about that. It's kind of the outside the 4 walls of Gates stuff. That's always a little bit...

The idea of the destock in the second half of the year, very logical. But have you seen customers suggest their supply chains are loosening enough to say, "Hey, we're going to slow it down."? How much is it a theory versus...

Well, I mean we haven't -- I mean it's still too early, I think, to call anything on that, right? And I think you're still kind of waiting to see what happens with the supply chain.

So you haven't had the phone rang a few times going, hey, we're...

Not me personally.

No. Okay. Any questions for Gates? Well, I appreciate you taking the time. Obviously, the stocks had a nice balance the first couple of months of the year, I think people get more and more comfortable with some of the names had a little more financial leverage. But obviously, I think the deleveraging is pretty important, and over the supply chains treat you well. That strike that balance. I don't open up too much. But at the same time, I know you've had some supply issues yourself. So I appreciate it. Thank you so much for taking the time.

Thanks for having.

I appreciate it.

Appreciate it. Thanks very much.

Thank you.