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

Good morning, everybody. Thanks for your patience there where we got mic-ed up. I hope everybody is enjoying lunch. For the folks at home, I guess you're probably enjoying the afternoon at this point if you're on the East Coast now. But thanks for joining us on day 2 of Laguna. On stage, I have the team from Gates: Ivo Jurek, CEO; and Richard Kwas as well from the IR team. Guys, thanks for joining us. Always a pleasure.

Ivo, maybe just to start us out, I mean we've heard from certainly a number of companies across end markets the past couple of days. It seems like a lot more good than bad going out on there, despite some macro indicators that might give you pause otherwise. You guys certainly have a lot of diversity and have made a lot of kind of good pivotal investments yourselves. What are you seeing out there? Anything that's sort of catching your attention, and maybe we can jump into some more [ deep type ] questions?

Yes, I think this is great, and thank you for hosting the conference, a great conference as always. Look, we came out of Q2 feeling actually reasonably good. Q2 was a little bit better than what we anticipated. Yes, we have some nice growth regionally. U.S. was down slightly, but off probably the best performance in the company's history in North America, and so it was down very low single digits. And when we provided guidance for Q3, we felt that it's kind of more of the same. Business is doing reasonably well. Yes, lead times are shrinking a little bit around the entire portfolio. But the end market, the consumer demand remains reasonably bland. So you do see some choppiness, particularly in the industrial applications, but it's more driven by people getting used to that they can buy products on the much shorter lead time than necessarily the end market rolling over. So we feel reasonably good about where we sit from a demand perspective. And on the call, on the Q2 call, we said, look, China is not as great as what we anticipated. I mean we've printed 28% core growth in Q2, which on a print looked really good, but the underlying comp was really easy versus prior year, and it was not as good as what we have originally anticipated. And we feel that there are incremental headwinds in China kind of for the remainder of the year. And while we are very bullish about what's happening in China with our automotive businesses, we think that the industrial businesses are going to take some more time to recover post-COVID. So net-net, not bad, being cognizant of the fact that there's choppiness out there, but overall, the book-to-bill ratio stayed very, very supportive of what we anticipated that we're going to see in the second half.

And I think that sort of supply chain accordion effect is probably worth digging into a little bit more because a lot of companies experience that differently. I think there was probably a point in time when we were talking about this a year ago, where, in some cases, you guys were the golden screw that folks were waiting for in some of your markets. If you had to characterize sort of this compression cycle around shrinking lead times versus inventory destock, versus underlying demand, it sounds like underlying demand isn't really the toggle that is particularly disruptive. But do you see it more as customers just trying to get their orders aligned? Or is there actually too much inventory sitting out there somewhere?

Look, I mean I think that it's really -- for us, it's somewhat difficult to characterize because when I take a look at the inventory metrics, I would still assert that inventory is reasonably well aligned to the underlying demand that our customers are seeing. But that being said, everybody is focused on the overall working capital efficiency. And so as you start to normalize your overall underlying performance, I think that people are looking and taking advantage of the fact that, hey, look, I don't have to over order well in advance knowing that maybe I will not get everything that I want to. So now I can order -- because the situation is normalizing, I can order what I need. And I know that I can get it within a much shorter period of time. So it is in time with my underlying market demand. So I think that I characterize it more as a choppiness rather than the classic destocking because we really haven't seen the end market rolling over. That being said, it won't, but it's not happening today. And so I think that if you also consider the fact that we are nowhere really near peak industrial demand, I don't think that it is overly scary out there. I think that we will see some incremental destocking, more choppy type performance, but I just don't think that you're going to see this massive destock that you classically have seen in the past.

Right. Makes absolute [ sense ]. You mentioned China there a little bit at the onset. I think matching some of the slowness other folks have seen with similar business models. How long does it take to, you think, sort of wash out either some excess on the inventory side? I know a lot of what goes on there is kind of tied to what they want to do on stimulus, so maybe a little hard to forecast. But for the stuff that is maybe a little bit more, I'll call it, microeconomic, how do you see that progressing?

Look, for us in China, it's kind of a story of 2 sides. Our automotive business is doing actually quite well in China, both on the OE side and then on the replacement side of our franchise is doing actually quite well. And we also have a little bit of a secular tailwind in auto replacement side of the business in China because it is the largest car parc in the world that's finally getting to what we call our sweet spot. It's about 6 years of age, and our sweet spot is 7 to 11. So it is approaching very quickly what we would expect to be a very accretive growth driver well into the future. So that's good, and we are seeing the benefits of that. I would say that the industrial set of applications and markets are a little more dislocated. And I think that there is a fundamental end-market demand issue. Whether or not it is commercial construction, so you see excavators, heavy-duty truck that is struggling there, you see kind of an overall industrial activity with the slowness in kind of electronics and slowness in kind of the consumer side of the business, demand drivers, so that may take some time, and that may require some stimulus from the government side. But we're still long-term constructive on China. Our business is China for China. It's about 10% of our revenue. And we still anticipate that even with all of the headwinds, as you are thinking about second half of the year, we still believe that we will deliver positive core grow, maybe low single-digits positive core growth in China. So it's not that bad. It's not as good as what we anticipated, but we are still having growth drivers because of the diversity of our portfolio.

I want to follow up on that car parc comment, sort of hitting the sweet spot or hitting your stride on that replacement cycle. Certainly something you referenced in the past as well. I kind of want to visit some other regions on that same thought once we've talked about China. But I think one maybe key difference for China is that at least in that initial kind of surge in auto production, I don't know if anyone would have said that the useful life of those cars is going to be quite equivalent to what you see in the U.S. Like I think my dad drives a pickup that's 20 years old.

Thank you.

Yes. I think China, by comparison, probably don't have a lot of those rolling around, but yes, I'm sure he's a Gates customer, whether he knows it or not. What do you think sort of that age of fleet or maybe useful life dynamic plays into some of those normal maintenance cycles? Does that kind of temper it a little bit or even accelerate it because these things wear out faster for them? What's your thought?

In China, specifically, it's behaving the way that most of our markets are behaving. The cars are aging. I think there was a lot of skepticism about oh, the Chinese, they're not going to hold on to their cars as long. You have a first owner, and then you have a second owner and then you have a third owner, just like you have in the U.S. or in Western Europe. And so the car market is developing very, very similarly as what we have seen in the Western world. So that's a really good dynamic. What we are watching today for, there are really 3 dynamics that are driving consumption in the automotive replacement side of our business. And that is age population, which is the most important. Second of all is kind of a consumer confidence, right? It's do I have a job; do I feel good about my economy; and three, how many miles we are driving? And so while the car parc is aging nicely, presently, I would say that you see somewhat of a negative consequence so maybe less positive consumer confidence. That results maybe in a little fewer miles being driven. But that's a temporary state. As the economy starts to recover, people feel better. They drive more and the car parc is going to get into the 7 years of age. And we feel like that's going to be a really positive driver for us into the next 5-plus years' cycle.

Yes. Makes sense. How would you sort of size up the car parc in age in the U.S. by comparison? Again, I know it's something that we've talked about in the past. I guess, maybe over time, we've lost track of where we are in the age of the parc and where that is for you guys.

So the great news about U.S. is that it is the oldest car parc ever. It's over 11.5 years of age. So that's a really good opportunity. And I think that's one of the reasons why you see some -- such a strong dynamics with that part of our business. And it's doing very well. It continues to grow, and we believe that we are very well positioned to continue to take advantage of that. And it's not dissimilar in Europe, if we are on the subject, right? I mean, car parc is aging in Europe as well. And we see a very -- I mean, we have been printing some very, very strong quarters despite the loss of business in Russia that we have all experienced in the industrial Western world complex. So -- so we feel really good about the automotive replacement side of the business. And I think that you and I had this conversation, I think, in 2019, where we kind of got a little bit of a dislocation from the China trade war during the Trump era set of actions where we have seen a little bit of a sharper destocking in the first half of 2019. And I think our folks were looking at it, say, "Hey, look, we thought its business more stable." The business is very stable. It's a really good business to have, and it's got very strong market dynamics globally, and we believe that it will provide a very good stability for us well into the future.

That makes sense. I know that over the last several years, you've sort of been more selective, I'll call it, on the OE side. At the same time, there have been an awful lot of changes on the OE side, including what's happened in EVs and all the new platforms and start-ups and near-shoring and I could kind of ramble on that all day. How do you assess, like how happy are you with where you've gained content relative to just how new some of these platforms are and kind of building that base in what should be a pretty healthy market is on transition? Are you finding that sort of easy to do because they're new customers or more difficult because maybe they're more price sensitive? I don't want to kind of lead the witness too much, but how would you assess how that's gone?

Look, first of all, I will start with -- we are Uber excited over what the energy transition in transportation propulsion has to offer. Whether or not it is in the passenger cars, it is in the last-mile transportation, which I don't think that we spend enough time about talking because I think that there are some really big opportunities to fundamentally change how packages are being delivered by Amazon or UPS or FedEx, what have you with many stops, very short hops. I think that there's a real opportunity there to electrify that -- that segment of transportation and it's a very large consumer of mid light-duty vehicles and then heavy-duty transportation. And we play a role in all 3 of these subsegments. We're very judicious, and we see very good content opportunity for us. But again, as we said at a number of my meetings, we're going to be very judicious. We want to make sure that we can generate the right returns for our shareholders in participating in the OEM applications. I don't think that we have seen -- or we have a real clarity who the winners and the losers are going to be yet, whether or not it is in the pass cars or on the mid light-duty vehicles. And so we are well positioned across the traditionals and also some of the nontraditional participants that are emerging across all 3 of these segments. So we feel really good about that. But the story or the book is not going to be written for the next 10 to 15 years, right? And then if you recall, the most important segment, again, for our business in the automotive is replacement business, 7- to 11-year old vehicles. So there, what we are doing is we are focusing on building out our content and building our product line coverage on the electrified propulsion vehicles that are available today. But to put it into perspective, there is about 1 billion cars, ICE-based cars, that are in that sweet spot, the 7 to 11 years old globally for us that we service on daily basis. Your dad's 20-year-old pickup truck is one of them. There is about 675,000 of electrified vehicles that are 7 to 11 years old. So I want to be pragmatic. We are positioning ourselves to be the leader for the next 50 years, 100 years and we are going to do the work. We're going to make the investments to make we have the product line coverage so when these customers need to repair these cars, we are there, and we are working with a number of our channel partners to get ready for them, in particular, to support the transition into secondary repair, and we will be ready when they are ready.

When we ultimately do have a higher percentage that is electrified, obviously, the configuration is different. I know that the content story is similar, maybe even a little higher, I think, potentially on EVs versus ICE. But is anything sort of unusual or proprietary where you really need to get spec-ed in upfront to be part of the longer term? Or is it comparable to ICE where there's a lot more fungibility and you may OE with somebody, but you'd replace with Gates?

Yes. So first, let me start with it is a core part of our business. So we are not a fringe player on the outside that is trying to participate in some new scale, scale that business. We're investing money in development of technologies. We've talked about development of electric wire-pump technology, new technology, as an example, that's doing quite well. We've talked about the development of the portfolio associated with battery cooling, inverter cooling, motor cooling. That's doing quite well. So those are products that we manufacture today. And we feel that our position is strong, and we have a good cost base to be able to participate. Now on the content side, when you think about that, the content on BEV versus ICE for us is almost 2.5x the content. So when on ICE you're thinking about maybe $125, $150 of content for Gates; on BEVs, we're kind of talking about $300 plus of content, and it's all predominantly driven by the size of the battery cooling that you need, the coverage that you need to have and the secondary pumps that are required to pump that coolant in. And as this technology continues to develop, you've got to continue to evolve your technologies because now the customers, they don't just want to cool the batteries. Your problem of driving in a winter is as bad as it is driving in the summer. So now you need to -- now you need to heat the batteries in the winter, so you can protect the range. So the technology is scaling up. It's getting more complex, and it just drives our ASPs up. So it's all very good for us. But we will need that buildup of that car parc, and we will need the ramp-up of the technology, consumers adopting the technology and then having the technology to age. So we are getting ready today, but we believe that middle of next decade, it should be where we start seeing some real tangible scaled benefits for our company.

That makes sense.

Very exciting, though.

Yes, it sounds that way. On -- going back to sort of this kind of near-term supply chain phenomenon that we've all lived through and are now working past, as customers have normalized some of their activity, has there been any pushback on price? I can't imagine there's been a lot of deflation or disinflation in your categories, and certainly, labor is not. But are you finding that prices have been sticky even as those folks are reprioritizing we need as much as we can as fast as possible?

Yes. Look, we have never -- and I have faced some criticism to be quite frank with you where they were folks that are saying, "Hey, look, your products are so critical. Why don't you just ask for any price?" Our view is that we want to do -- we want to retain our customers.

Yes, you don't make it on the front though.

No, you don't make lots of friends that way. We want to be fair and equitable. Our philosophy has been that we want to ensure that we don't penalize our shareholders, but we don't want to penalize our customers either. It is in our interest to continue to stimulate demand. And so our philosophy has been, "Hey, look, we will cover inflation to the tune of being neutral to our EBITDA margins, and we have delivered that over the last 2 years, and we will continue to deliver that throughout 2023. So rather than just go out and just price ad nauseam, we price fairly. And we need to focus on internal efficiency, so driving productivity, driving 80/20, driving incremental restructuring are all opportunities that we have that we can drive gross profit improvement that ultimately results in EBITDA margin improvements. And that's frankly how we feel that we will be able to get to that kind of midterm target of 24% plus EBITDA. So we are not de-committing from any of our midterm targets. We feel actually pretty positive about having an opportunity to get there now as you start getting more stability in the supply chain as transportation has normalized, as labor has normalized. Yes, you're going to have inflation. We will continue to price for inflation, and we will continue to now focus on driving internal productivity, so we can drive margin expansion through fundamental operational execution rather than just leaning on price that you pass on to your customers.

That makes sense. Anything on the productivity side that has been, I'll call it, deferred just as a function of being preoccupied elsewhere? Obviously, there's been a lot of spinning plates the last 2 years. Where are you kind of refocusing on the productivity side?

Well, when I was sitting here with you, Josh, last year, we were talking a little bit about the inefficiencies that were settling into our business associated with the lack of availability of raw materials, so incredible amount of disruptions. That's kind of abated, and we are now having an opportunity to just fundamentally look at, hey, look, how do I produce demand for my customers on 5-day basis instead of 6-day basis, right? So I don't have to use the premium overtime. And so I think that you're almost starting at Stage 1, where again, you have tremendous amount of productivity activities that are available to you. So we are reenergizing our operations teams. I think our operational teams understand that the disruptions that we have all faced from COVID era abated and that we all now can focus on the fundamental gross profit improvement through operational execution. We are always focused to be the best operators of our assets that are out there. And we believe that those opportunities are reasonably tangible, reasonably short term, and they are filtering through the improved gross profits that we are reporting on the last couple of quarters, right? So I think that it's recovering, it's repairing, and I think that, that journey is going to continue over the short term here.

Understood. Following up on something that you and I were talking about briefly before we stepped up here. Mega projects are sort of the second most popular buzzword in industrial, I guess, after AI, thus far this year. Obviously, you guys have a lot of diversity in the model and not necessarily like a big CapEx exposed name. But are you seeing that pull in the business, either from customer orders or even just customers saying, "Here's something that we're thinking about and want to be ready for over the next 6, 12 months"?

Yes. So look, I think that what's most underappreciated about Gates Corporation is that, frankly, Gates is everywhere. We've talked about it during the IPO period of time. And when you think about large-scale projects or mega projects, we actually touch every one of them. We are starting to see some of those effects, whether or not it is in heavy-duty truck, in excavators, combine harvesters, in build-out of roads and the infrastructure that will actually house the big battery plants and so on and so forth. Now think about the fact that when you're putting equipment in those battery plants, that they are building batteries for BEVs, that equipment is going to use Gates' cells. That equipment is going to use Gates' hydraulics to activate the actuation that makes those batteries. And then you are getting into a process like a razor, razor blade, right? You are in there and you're going to be generating the replacement cycle for those products. So we're not directly citing that, "Hey, look, I'm putting a transformer on a pole, and I can link it to rebuild of an infrastructure grid", but we touch the transformer, we touch it from enabling the mining company to mine for copper. And we transport, we help to transport that raw copper into a smelter. We have equipment in the smelters, and we have equipment that ultimately help the power company to build a transformer. We have equipment that yes, we have components on the equipment that will lift the utility worker to hang the transformer on the pole. So frankly, we are everywhere, and we are touched by this large cycle of investment that's coming here in North America, but also it's coming in Western Europe. And that's really good for us for a midterm cycle of revenue generation.

Sounds like we got plenty to look forward to. I see we're coming up on time. I really appreciate you guys taking the time. Always a pleasure. Thanks for coming.

Thank you very much.

Thanks, Josh.

Appreciate it.