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

Mike Halloran here, industrial analyst with Baird. We're pleased to welcome the Gates team with us today. Ivo Jurek, CEO, is on stage, as he give some prepared remarks, rich glasses is buried in the audience. Decided he want to be on stage with us. So he's going to give some quick prepared remarks, go through kind of the overview on Gates and then we're going to do a Q&A. Any questions you have, let me know, raise your hand. I'll make sure you get called on if you feel more comfortable, fire me an e-mail to the room e-mail address, and I'll make sure we get your questions involved that way. So with that, Ivo, thanks for coming. Floor is yours.

Thank you. Good morning. I thank still. Yes, I'll keep it pretty, pretty cool and chill here for a few -- just a few slides. As Mike said, I'm Ivo Jurek, chief Executive Officer of Gates Corporation. I'm very excited to be here with you today and share a few more outlines about Gates and some of the opportunities that are available to us to drive what we believe is a significant shareholder value over the next couple of years. So with that, let me just really quick legal things here and that -- some of the remarks include forward-looking statements within the meaning of the Private Securities Litigation Reform Act that are covered by the safe harbor disclaimers. So with that, let me move to Slide 3 that provides a very brief overview of our company. We are well-diversified $3.6 billion company with strong profit margins, an attractive free cash flow generation and characteristics. Our business is supported by approximately 15,000 associates and over 750 engineers who are the foundation of our innovation efforts. We believe we have the broadest distribution footprint globally in our product categories with over 100,000 ship to locations globally. About half of our revenues come from North America, and we serve a very diversified mix of end markets. Almost 2/3 of our revenues for our business, come through replacement channels, with the balance going through the OEMs. A very nice mix that provides resiliency through the cycle. Moving now to Slide 4 of the presentation and overview of our product line segments. Our transmission business is the company's heritage, and we are a clear global leader in our core markets. We engineer and manufacture belts and related components that power drives in demanding applications across a very broad range of end markets. And importantly, they do wear out and need a replacement at very regular intervals. Our Fluid Power business, where we are 1 of the top 3 premier global players supplying hydraulics and fluid conveyance products across a very wide range of applications and also end markets. Similar to Power Transmission, these products are highly engineered, but also operate in harsh applications and also need to be replaced quite regularly. On the next slide, we illustrate our capital allocation strategy. Over the last 3 years, we have steadily improved our balance sheet position while investing in our business and returning capital to shareholders. As you can see here, our net leverage ratio has declined to 2.6x, more than 2 turns decline since the mid-2020s. In addition, we have deployed almost $450 million to share repurchases over that period of time. We expect to finish 2023 with net leverage ratio at 2.5x, a reduction of 0.3 turns versus 2022, and that includes a $250 million share repurchase completed earlier this year. We intend to remain very balanced with our capital allocation over the midterm. So before we go to Q&A, Slide 6, our key strategic priorities. We are highly focused on driving productivity across our supply chain and operations. Our utilization of 80/20 is helping to reduce our business complexity and yielding operational and financial benefits. We're making investments in growth such as personal mobility and industrial chain-to-belt and allocating resources to product innovation and product improvements. And finally, as alluded to earlier, we are improving the capital structure of the enterprise, which we believe will increase strategic optionality and enhance shareholder value long term. So with that, it's a very exciting time at Gas Corporation. We have very experienced committed teams globally, executing on the significant opportunities we have, and I truly believe the best days are ahead of us. With that, I'll turn it over to Mike.

Thanks, Ivo. Again, if you have any questions, raise your hand or send it to the session for e-mail address. So maybe we'll just start higher level here and apologize for the scraggly throat. It is better though than Friday. Maybe you talk about differentiation from a product standpoint, right? One thing we get a lot of is you see the products, and I don't know if people understand the material science that goes into it and the R&D efforts that go into it. So maybe some high-level thoughts on that piece.

Look, innovation and R&D investments are key differentiating factor into what we do. We operate our products fit in very harsh and hazardous, very durable type environments. And our customers rely on the quality and reliability of the products that we manufacture. We are in Power Transmission, the undisputed global market share leader and technical leader in these products. And in Fluid Power, we are a top 3 manufacturer globally in these applications that require high premium type construction of materials. So we believe that innovation and R&D spend are critical in staying in the right position where we write fully belong. What I would also like to indicate is that over the last 5 years, we have made substantial investment in innovation. When Blackstone, our sponsor, purchased the company, the company had a very low level of new product vitality. The vitality was very low single digits. We are presently approaching a 20% target of NPI vitality with Fluid Power products already being at or above that level of vitality and the Power Transmission getting and accelerating its product vitality being at kind of the low teens presently. So while we still have a little bit of work to do on Power Transmission side, we're making tremendous progress in being able to drive innovation in what traditional has been very conservative type end markets, and that brings benefits substantially for the enterprise.

So why don't we start higher level on the demand side and then we'll dig a little bit into the 2 segments going to some secular thought process on that. What are you seeing from a high-level demand picture as we sit here today? And any kind of thoughts there and will dig off that?

Yes. Look, we kind of pride ourselves on being very transparent as we report our results throughout the quarterly cadence. And we have been quite vocal about some of the choppiness that we have seen in industrial end markets, frankly, over the last 4 quarters. And while, perhaps, it's maybe today, more apparent that there may be a little more destocking type activities than people anticipated. We kind of felt that there was some level of uneven demand that was already occurring, basically, kind of from Q4 of last year. And it was showing itself up in Europe 1 quarter in maybe North America in another quarter and then in China in second half of 2023. So our sense is that there is some uneven demand, but we have already seen deceleration in those end markets over the last 12 months. The automotive business and kind of a broad level is performing very, very well, both on the OEM side, which we have a reasonably small presence and only about 8% of our company's revenue is in the automotive OEM space, but that's performing quite well, about mid-single-digit growth in most recent quarter. And the automotive replacement market, which is by far, more important to us, that represents about 25% of the company's revenue is performing as well as slightly better than the auto OEM end markets. So kind of almost tale of 2 stories there. Automotive in a very healthy spot and industrial is still a little bit choppy.

You mentioned the destocking piece. Where do you think we are in the destocking piece for your channels? And when does that become at least a comparison oriented tailwind? I mean, demand still could be going down, but when does that comp, at least, become more positive for you?

Yes. So from our vantage point, it's really very tough to predict when destocking is going to end because it's also partially sentiment driven, right, where people sentiment get impacted and perhaps, the logic doesn't necessarily dictate that you already are starting to see maybe greater stability in the markets than what the external environment is telling you. So my sense is that from a comparative perspective, it should become a tailwind in the second half of 2024. But as I said, I'm a little bit of a contrarian why I'm not prepared to talk about '24. My sense is that '24 could be potentially a little bit better than maybe most people feel. All of the end units that you take a look at whether it is the heavy-duty construction machinery, end units, ag units, we're not really coming from a peakish volume growth side. The volumes have been kind of muted, lots of price that was driving top line growth and profitability enhancements. And so that's kind of a good news, I think, for companies like Gates where if there's a decel, you should see much more muted deceleration rather than coming off a very sharp peak driven volume, peak driven expansion. So if you think about ag, you're thinking about commercial construction, you're thinking about heavy-duty truck, that's kind of, to me, what that represents a more muted unit volume deceleration. On the other side, I believe that's going to be quite all right. Autos, both new builds are coming from a reasonably low base. And the replacement side of the business that is important, again, to us has some very strong market dynamics. I mean the car fleets in the Western economies are aging very dramatically. They are the oldest in history, both in United States as well as in Western Europe. So that represents a great opportunity. And if you think about China, China is the largest car park in the world, and it is very quickly approaching the aged car fleet that is important for a company. That China car fleet is going to be about 6 years of age next year, and the sweet spot for our products is 7 to 11. So we're kind of on a press a piece of some nice tailwind as well as we move forward. So we feel reasonably good about the Auto business moving into '24.

So let's take into the 2 segments and then we'll talk about the margin profile. The Power Transmission piece, maybe talk about the chain-to-belt initiative you have traction and what the customer response looks like.

Yes. So chain-to-belt for Gates represent almost an unprecedented growth opportunity that we believe we will be executing on for the next 20 to 30 years. It's kind of a $7 billion to $8 billion market opportunity where we are competing against nontraditional competition, which is industrial chain. Well, why is it that we can compete, Traditionally, we think that a chain, steel chain is more tough and better transmitter power than a polymer-based composite belt, where we have developed a belt that is capable of transmitting same amount of power as an industrial chain, that belt is much more ecologically friendly. So from an ESG perspective, the end user are getting tremendous amount of value. They don't need to use lubricants. Lubricants are corrosive and danger us. You have an improvement in productivity because you don't have to tighten the chain drive where the chain drive needs to be tightened relatively frequently, once every 2 weeks, once a month. When you put a belt drive, you don't have to tighten the belt drive for a year, 1.5 years. So you get productivity improvements. And ultimately, also get operational improvements through lower energy consumption. So we're providing a better solution. Today, that solution is still a little bit more expensive than the traditional chain-based solution. But we are very quickly working towards getting to parity in cost structure. We believe that over the next 18 months, we're going to be able to do that, and it's going to continue to open up more opportunities, particularly in the industrial space where point of acquisition is as important as the improvements in efficiency. So we're doing quite well there, and we believe that that's a very long-term opportunity for us to drive above-market growth. The second part of that story really is very exciting as well, and that's personal mobility. In the personal mobility spaces, we are replacing what we all traditionally know as a chain on our bike or a motorcycle, e-scooter. And when these devices get electrified, the need for our belt is even more unique because we have a capability to transmit more power than a chain under very rapid acceleration. So we believe that, that's another almost an unprecedented opportunity for us to grow well into the future. And we've taken that business from 2018 when the business was maybe cash, $20 million or so, 2022 when that business was approaching $200 million. So we've demonstrated we can convert these opportunities and that those are real we have a tremendous pipeline of new business that we are winning with the OEMs, both on the e-bike, e-scooter and motorcycle side of the business. And as we kind of get through what I would call the pandemic destocking activity in personal mobility, we are very confident that we can get to that $400 million target on personal mobility kind of by the '25, '26. So we can still envisage doubling of that business over the next 3 years, which is quite a unique position for an industrial company to be in.

So yes, let's take those 2 separately then. What's the payback and what's the total cost of ownership benefit for an industrial company buying into this chain to belt thematic?

So we've developed a really cool digital tool where we go into factories, and we work with factory managers, and we give them a demonstration on pay back if they switch from an industrial chain to a Gates belt-drive. And the payback actually varies. It depends on the applications and the size of the drive, how many hours per day they operate those assets. The payback may be as short as 6 months. And generally speaking, I would say that the payback in an industrial complex is somewhere between 6 to 18 months. So it's actually quite reasonable. The biggest issue for conversions in that space is actually shutting the drive down for 1 to 2 weeks to be able to drive that conversion. So we have, over the last several years, we have highlighted a rather significant spectrum of opportunities that we have converted and the conversion is actually quite interesting, anything from belts moving baggage apparatus in airports to heavy-duty air conditioning systems to pharmaceutical production lines, logistics and distribution warehouses. So it's a whole slew of industrial apparatus that we have been able to demonstrate that we can convert, and we're very excited about it. Now the other side of that story is working with the OEMs. And we have seen tremendous amount of opportunities with industrial robotics where these belts are offering a highly precise capacity to drive motion. And so many robotics companies have been able to convert certain type of robotics into belt drives because it's cheaper construction and much lighter robots. And as that becomes important, that's a really nice opportunity for us as well.

Maybe talk about the sales cycle. How do you go about convincing the person across the table from you that this is a worthwhile for their time and investment?

So I think the big issue in here is driving digital tool set. And so we are making quite a bit of an investment to get to a position where we can ease the design cycle for the designers of these drives because as you can imagine, people have been designing chain drives in industrial apparatus for 150 years, for a long time. So it is something that you don't have to think about. It's ingraining you. And so we are developing tool sets that make it much easier for these folks to be able to design these drives into these apparatus because we believe it's going to be critical not only to convert an existing installed base, which we have been doing reasonably effectively, but it's going to become a force multiplier for us to get to the OEMs and to these niche machine builders that design equipment on a daily, weekly basis to be able to switch away from those industrial chains. The value proposition actually is rather interesting because we all care about productivity today. If you're running industrial assets, productivity is really important. And interestingly enough, productivity is not that easy to get these days, right? So being able to go into a designer who says, "look, you put this apparatus and you put -- you substitute a chain with a belt. You're going to be able to offer your client much larger, longer run times, where the time between service is significantly larger." And that's a real big selling feature for these systems.

On the personal mobility side, maybe just talk about the confidence in the profile of the category, meaning you're talking about a destock here. I certainly get questions about what the true long-term growth profile is or there's a saturation level. Maybe just go through some of the information and data you guys have collected to give that confidence.

Yes. So look, on the destock side, I mean, there's a ton of publicly available data that clearly points out that there's destocking that has been happening probably from middle of last year, and that's probably going to continue all the way through the middle of next year. And that's -- you can see a large unit volume peak in the COVID era, and we are finally starting to descend on the end units produced and sold in personal mobility that is at kind of 2019 run rate. So we're starting to see that peak has been chopped off and you're starting to see kind of the underlying market consumption of those units. So that's the good news. Still need to work itself through. And again, we believe that maybe middle of next year that will occur. Putting that aside, there's over 200 million personal mobility devices that build every year around the world. Today, we have about 1% market share. The math is really quite straightforward. The value proposition is great. If I let you ride a bicycle that has gated carbon drive on it, you will never want to ride a bike with a chain. I promise you that. They are -- it's clean. You will never get your hands dirty. You don't have to maintain the chain just like you don't have to maintain the chain on an industrial drive. If anybody lives around ocean, you can keep your bike inside of a garage and your bike will still rust and it will become useless after about 18 to 24 months. With Gates Carbon Drive, well, it requires no maintenance. So you need to do a pump some air into those tires. So the value prop is really, really good. And so what we are focusing on is truly driving that penetration rate, right? So we started small in 2018, lots of skepticism about why would anybody do that? I think we have scaled the business up nicely. And it's not an easy feat to grow business in 3 years from $20 million to almost $200 million. not an easy feat to grow it from $200 million to 400 million. We recognize that. But we believe that the penetration we can go from 1% penetration to about 10% penetration over the next 5 to 7 years and the math speaks for itself, it's rather dramatic. And over the long term, is there really a need for a chain drive? I happen to believe that there is a need for a chain drive that all chains should be replaced with Gates drives. And is it going to happen? Time will tell. We have a high degree of confidence that we will be able to get debt penetration. Our design wins would speak towards our ability to win in that market segment. There will be more competition at some point in time. We are the pioneers. We have created this market opportunity, and we believe that we have the best market position out there. And we will continue to innovate. We'll continue to drive from the top end of that apparatus to a bicycle that you can buy it at Walmart at some point in time. That will take some time, but we're very excited about it.

No, I saw them when I took my 7-year-old daughter to get her a new bike, there were a bunch of them in the store I hadn't seen it before.

I'll give you a plugging. You can buy them at Costco, if you go in and buy a priority bike that's got a Gate drive and you'll love it.

I got to get a membership to Costco first, Ivo.

I'll let you use my card.

Nice. Nice. Nice. I don't know if it's cost effective for me to fly to Denver to pull that off. But let's say, I drove to Denver, maybe talk about a segue to the auto piece here. I still get questions about EVs. It's a good bridge between the 2 segments. I think there's a misconception about what EVs mean for you, holistically. So just talk about the tailwind that can provide longer term, longer term?

Absolutely. Look, electrification of propulsion is a terrific, terrific business opportunity for Gates. And we should not misconstrue a muted enthusiasm from our side for a lack of opportunity or risk. Our content grows from about $125 to nearly $300 ICE versus electric vehicle, electric propulsion on a vehicle. Our content is predominantly in Fluid Power. In Fluid Power, we develop products that provide thermal management for battery, for motors and for the inverter. And we used the word thermal management because these batteries presently not only need to get cooled, but they also need to get warmed up in winter, if you are in the Northeast area. If you live in Denver, you have cold weather and snow you get a significant reduction in range. So this battery needs to have a much better thermal management. And that's ultimately the large opportunity for us. But as I stated, we are very thoughtful about how much OEM business we take on board. We spent quite a bit of time over the last 5 years. We have reduced our exposure to automotive OEMs rather dramatically by nearly $150 million. And we are going to be very thoughtful about what business we're going to go and take on. So as I said, we are an aftermarket participant, 7 to 11 years of age. And so firstly, you have to make these EVs, then you have to sell them and then they have to age to 7 and 11 years. So for us, the market opportunity for BEVs is more in 2030s rather than in 2020s. But that doesn't mean that we are standing still. We continue to develop our broad portfolio. Today, we have probably the broadest coverage of all of the BEVs on the road. The numbers are still very small. There's only about 700,000 BEVs that are 7 to 11 years of age. They are mostly Tesla. And we have a very, very strong presence on those. And if you take them to an independent repair shop, we'll be able to repair them with Gates products. So that being said, I think that over the next 15 years, it will be a very nice tailwind for our business.

So last question here. Why don't we talk a little bit about the margin opportunity, 19% margins, was it last year, opportunity set to get to the mid-20s? A lot of that's in your control, some of its volume. Maybe talk about the piece that's in your control. It's almost 500 basis points. What are you doing internally to make sure you get there? Some of it's catch-up supply chain, everything. A lot of it though is operational improvements in your control?

Absolutely. Look, starting with the 19% because I think that there was a good baseline from last year. And again, I remind everybody that last year, we -- none of us at the management felt we have done a great job in managing our business. It was all driven by conflict in Ukraine, with lots of industrial assets got destroyed, and we were impacted with highly engineered polymers that we utilize in our portfolio, and that impacted our ability to run our assets effectively. But 19% would have still been the best profitability in the company's 113-year history prior to DLBL. So it wasn't -- it wasn't a terrible output despite the fact that we thought it wasn't great. But coming back to that opportunity, which is by far more important. Look, about 225 basis points from the margin recovery resides just in the supply chain normalization. And we basically delivered that in 2023. So we feel that the margin recovery from the supply chain disruption is behind us, and that will be getting into the baseline here. Still have a little bit of a goal from a comparison perspective in Q1 of next year, but as far as I'm concerned, we pretty much deliver that improvement. Secondarily, we have enterprise initiatives. Our enterprise initiatives are around productivity, 80/20 and restructuring. That represents about 250 basis points of market opportunity. And we believe that, that is doable with and within our control without necessarily having to rely on significant unit volume growth. And we have about 50 basis points of improvement that we will deliver through standard volume rebuild at kind of 35% to 40% incrementals. So volume growth is a very small component of getting that 500 basis points to that 24% EBITDA. And we feel that we're in a very good position to be able to do that.

Well, great. Well, please join me in thanking Ivo for his time.