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

Great. Well, thanks, everyone, for being here. It's my pleasure to have up next Gates Industrial. Ivo Jurek, Chief Executive Officer. We'll go straight into Q&A. Thanks very much, Ivo, for being here.

First question, I suppose, you've gotten a fairly cautious or what have you, revenue guide for this year, sales down low single digits. Maybe talk through some of the bigger headwinds there? And to what extent you can tell if it's destocking or final demand? And is that even a useful distinction to draw?

Yes. No, I think that you're right. What I would start with is that we have taken a pragmatic view of 2024. We do see that some of our end markets have slowed down. So end markets like ag, as an example, pretty well documented sort of challenges here. We anticipate that On-Highway is going to slow down slightly. It's coming off a couple of really good years of Class 8 trucks built. So we anticipate that's going to be less bullish in '24 than perhaps it was in '23. But overall, to your point, we believe that we are seeing kind of the underlying market demand matching supply or supply matching the underlying market demand. So I kind of fall in the same category as you, Julian. I don't think about what's happening today as destocking. I think that that's kind of played itself out, to be honest. And if it hasn't played itself out, it's kind of at the ninth inning of playing itself out. So I'm also cautiously optimistic about what we could see in 2024. But we just decided that it was probably more pragmatic to take a more cautious approach to '24 with guiding top line down 1% on core and driving our adjusted EBITDA up 30 bps midpoint. So a pretty cautious approach.

And are you sort of anticipating much difference as we go through the year. The comps move around a little bit in 1 year, 2-year stacks and so forth. But how do you think about sort of base demand firm-wide aside from the comps?

Yes. So we anticipate very, very slight improvement in second half. Look, overall, I think that the underlying market demand is not that bad. It's actually reasonably solid across the portfolio. While you are seeing some cautious approach to it. I mean, yes, there's lots of green shoots as well. We have had terrific performance in our Latin America business over the last couple of years that remains actually quite all right. We've talked on the Q4 earnings call a couple of weeks ago that we are seeing green shoots in China. Europe is probably going to be more challenged than anywhere else. I would say geographically, but the business actually is not terrible. And we anticipate that while second half is going to be slightly better than the first half. The difference in growth rates is predominantly on the top of more favorable comps.

One market, I think people have trouble kind of figuring out trend growth or through cycle growth is personal mobility. There's a big boom, a big down. We've seen that in many industries in a way the last 3 years. That one's interesting because it's more nascent to a degree. So what's your kind of assessment there? Like have you rethought the degree of investment you want to put into it? Or any update on personal mobility?

Yes. So let me start with it. There was a very small exposure that we had in 2018. It was less than $20 million of our revenue. By '22 as we kind of -- we exited '22, we got the business to be 4% of our revenue. So it was rather substantial scale up over a 4-year period of time. So we were growing very, very rapidly in the business. Fast forward to '23, you start seeing some of the destock coming in, in the second half of '23 through '24. We believe that the destocking is going to be over by midyear of this year. And we're getting back to the stability of the underlying market-driven demand we believe that we will be very quickly reaccelerating back to double-digit growth rate. Now, while the destock has been happening over the last 3 or 4 quarters, we've continued to win a significant amount of new programs. And I think on the Q4 earnings call, I said that just -- if you kind of dollarize it, we have seen a 20% increase in design awards '23 over '22. So the projected growth rate is going to reaccelerate very quickly back to double digits. And we still are pretty firmly embedded in the camp that over very near term, we should see that business to get to that $300 million, $400 million range. So it will require pretty significant reacceleration again. But we don't anticipate that until 2025, to be honest with you.

Yes. And then you mentioned that sort of destocking largely run its course in most industries. Maybe a slight improvement in demand trends in the second half. In general, thinking about the slope of recovery coming out of this slowdown? What are some of the factors that you're paying closest attention to? And it feels like it was a very -- quite a long volume downturn, but shallow sort -- is the upturn just kind of a mirror image of that? Very gradual low single-digit sort of growth?

I will use that word, pragmatic, I think somebody mentioned to me how many times we've used the word pragmatic on our earnings call. But that's exactly what we are trying to be. We are trying to look at that and look historically, what we have seen in the downturns and upturns. So while the downturn has been reasonably shallow to your point, it's been reasonably extended as well. I mean lots of the volume decay has been masked by pricing. Pricing environment was very robust as was inflation, obviously. So our sense is that the recovery probably is going to be reasonably normalized because of the extended nature of the downturn. And the industrial, the manufacturing PMIs have been quite negative for a very significant amount of time. I mean, you have to go down with all the way to kind of 2020, I mean 2000, apologies all the way back to 2000 to kind of get the same length of industrial downturn, right? So I would say that you could anticipate that the recovery should be normalized. But again, in our view, it's probably not until much later part of '24 into '25. Of course, I could be wrong. And if everybody will see the recovery come earlier, Gates will as well because there's nothing unique or peculiar about our short cycle business.

And then in China, you have a very large or a large waiting serve a lot of different industries. You've been cautious on the recovery slope there. How do you see it now? It's been a year, I guess, since people are last excited about any kind of big reacceleration. It's a sort of base case of stable market at a fairly low level?

One of the nuances that you've got to be cognizant of when you're thinking about our business in China is that, our business in China actually didn't slow that much to be honest, right. It's predominantly driven through the translation of FX. So our locally denominated revenue base has moved slightly down, but it's all of the devaluation of the renminbi that will give you that vague in terms of revenue deceleration. So -- but that being said, we actually are seeing almost green shoots everywhere in China. Now we don't -- again, we don't anticipate that you're going to see a massive growth of reacceleration of growth. Our business in automotive replacement, which we have our largest market share in China in the products that we manufacture there for the automotive replacement side of our business that has been growing even over the last 12 months, actually rather substantially. And that offset the deceleration on the industrial applications. But as we exited '23, we have seen positive inflection in On-Highway in China. We have started to see better behavior in terms of the commercial construction equipment. So the excavator unit builds are no longer decelerating, they're stabilized. We are starting to see a degree of stability in the diversified industrial space. And if you look at some forward indicators, you can take a look at the machine tools orders with Japanese manufacturers for Chinese customers, there is a sign of inflection there as well. So my anticipation for China is that it's going to be slow, steady recovery. We anticipate kind of a mid-single-digit growth in 2024 in China on the back of strong performance of automotive replacement.

Got it. And then in the U.S. market, a lot of talk around stimulus and shoring, hard to sort of delineate how much there's really been in terms of -- sort of dropping through intercompany orders and so on. What's your assessment of that? You have some exposure Off-Highway to some of the sort of mega project aspect. Then, of course, in diversified industrial, you have some sight on that shoring element as well. So let me talk about that. Like is it visible to you any sort of secular tailwinds like that?

I think the major projects that are well documented, right? So somebody building a battery assembly plant for BEVs you see that and obviously, that's good when they're building the building, and it's good when the putting equipment. We have products in those projects. But I wouldn't say that we have seen massive wave of infrastructure building projects yet at this point in time. We don't really anticipate that to occur until maybe '26 -- '25, '26. Whether or not reshoring is going to be happening in a substantial way in the United States. I think that that's TBD still. There's lots of projects that are happening in Mexico, obviously. So I mean, there's some puts and takes on reshoring. And I think that it's good not just for Gates Corporation, it's good for many different companies that are involved in industrial and industrial automation.

Yes. And you mentioned the sort of battery element. Taking sort of that EV transition in total, how are you thinking about that play out. Your last Investor Day, you gave some interesting sort of detail around ICE versus EV. We'll get an update on that fairly soon, I would imagine at the Investor Day coming up. But any kind of thoughts around that transition? And what does it mean for Gates again, since you gave those -- that last update.

Look, I think that our exposure to BEVs, again, wherein its light vehicles or medium- to heavy-duty vehicles is not really changed fundamentally. The content that we have described that we will be able to capture in those applications is playing itself out as we have presented. What's also playing itself out the way that we've presented thought that we have anticipated is the adoption. I think that we have been viewed somewhat skeptically from the earlier period of time as we forecasted that there's going to be a level steady -- kind of a steady-state growth rate of BEV adoption. And I think that it's embedded in a very pragmatic view that you need infrastructure, you need charging capacity, you need power generating capacity, power distribution capacity, and that's not been completely built out yet in this country as it hasn't really been built out in Europe either. And so there will be a steady growth in adoption of those technologies. But I just think that most of these forecasts were overly optimistic, and we've never really embedded them into our revenue forecast. Now I'll also remind everybody that our play is predominantly in the replacement side of the business. And as we have discussed in 2022, you have to firstly get that car park in use and then you have to age it to be 7 to 14 or 11 years of age, and that will take a significant amount of time. So we didn't anticipated we're going to see anything meaningful until sometimes around 2030. And I think that, that will be proven correct with that forecast.

Yes. Got it. And I think firm-wide Gates kind of headline market share versus your TAM is mid-single digits or so. What are some of the areas where you're most infused about share gains that you're making right now. Or areas that you're investing into to get share up the next kind of 3 or 4 years?

Yes. Look, we've outlined the large market opportunity with industrial chain-to-belt initiative. And we believe that, that remains to be very strong, solid runway opportunity for us, very secular in nature. We continue to make good progress. We continue to convert more industrial chains into highly engineered Gates carbon drive-based systems. I think you can probably sense the level of enthusiasm that I continue to have for personal mobility. I think that, that opportunity, frankly, is unprecedented in nature. And there, I think that you will see a greater adoption of electrified propulsion substitute for 2 cylinder ICE, dirty ICE motors that I used in some of the developing economies like in India, Indonesia and to a degree still in China. So those opportunities are large. And when you put an electric machine on a 2-wheeler, you will want to adapt Gates carbon drive. It's more efficient, it's greener, it's quiet. So those opportunities remain very strong, and we see a significant amount of design wins, as I said earlier, and I believe that, that's going to add a pretty significant opportunity for us to drive premium growth through the cycle over the next cycle. Look, we have an incredibly terrific automotive replacement business. We love the business. It's a great business, and we believe that we still have good opportunity to deliver nice steady growth, both in developed countries through just fundamental blocking and tackling and taking more market share, as well as in developing economies. And out of the plug-in for what we have done in China. China -- competing in China is never easy, but we have built a #1 market share position in China in a growing market with car park that is still not in a sweet spot. And we continue to believe that, that opportunity remains to perhaps more than double our presence there in that end market. So we have good opportunities about new secularly driven market penetration opportunities as well as we have opportunities with our existing business, legacy business that we believe we can go and execute on.

Got it. And then one, sort of switching away from the top line, enterprise initiatives you started to talk a lot more about there are decent earnings tailwinds this year already. Any sort of sense you can give us around -- and again, the Investor Day we'll hear much more detail, but any sense of kind of the broad levers there, maybe what's different about these initiatives versus kind of what you've been doing since Gates went public in terms of sort of typical productivity measures?

Right. Our enterprise initiatives, they're going to be focused kind of on 3 main streams. And I'm not going to front-run the Investor Day, but you have one stream that's going to be around 80-20. So simplifying our portfolio, optimizing your pricing, optimizing the way that you price your products and the future contracts. And frankly, driving productivity across your enterprise through making that enterprise more efficient. Two, focusing on kind of a traditional productivity. The traditional productivity over the last 3 to 4 years has almost extinguished itself because it was very hard, right? You had COVID, then you have supply chain issues, you had disruptions associated with logistics, you had a lack of availability of labor and so on and so forth. So we believe that reaccelerating that back and reigniting the powerful productivity motor is going to be -- it's going to be very important. And we anticipate that as we exit '24 into '25 and '26, you're going to start seeing some nice productivity from that initiative. And then what we have focused on primarily this year and that's where kind of that $0.07 of earnings accretion comes from is all driven around material cost reduction. And in a strange way, in the second half of 2022, when we were dealing with some of the most disruptive raw material supply challenges for our company that came from the availability of supply of highly engineered polymers. That kind of crystallized our need to stay focused to minimize the opportunities for those disruptions to come back. So we have engineered lots of complex materials out of our supply chain. But two, in a way that gave us a jump start opportunity to focus on driving material cost reductions out. And so when you combine that with the desire to reduce your portfolio complexity, I think that you are having a very powerful engine, that is different than what we have done in terms of, kind of driving, kind of overall productivity from '18 through kind of '19 and '20. We believe that, that represents a very powerful earnings accretion opportunity for us for the next 2 to 3 years. And I'll say the last item that we'll talk a little bit more about is complexity, our operating footprint complexity reduction, right? So we have an opportunity to drive some restructuring projects forward. Again, we would not anticipate benefits from those until sometimes into '25 and '26. But we have a very powerful set of initiatives that we believe will give us an opportunity to not only control our own destiny in a -- even if it's a muted growth environment. We won't need that growth to be able to get to our midterm earnings targets. But it truly will make it easier when you get that asset growth coming back, but we believe that we can deliver a very powerful earnings accretion as we move forward. We don't necessarily having to rely on volume growth.

And when you think about the sort of operating margin entitlement, once these initiatives are in the run rate of the business, I think sort of 24% plus is the existing medium-term margin goal, where there's some industrial business out there aiming for close to 30%. Is there any reason that once these initiatives are sort of in the rate, I can't get into that kind of high 20s?

I don't think so at all, Julian. And I think what we've got to get through that intermediate destination before we move on to the next journey. But the way -- when I think about this business and I look at our business, nothing is telling me that not have an operating model similar to ITW. Our portfolios are very similar. So our financial returns should be very similar like ITWs as well, and I don't think there should be anything that prevents us to do that. We got 2 large off scale segments, product lines. Both of them, we are top 3 market participants globally in. Everything that we make is mission-critical, highly engineered and has a significant powerful recurring revenue engine attached to it. So we feel that nothing should really prevent you from being able to continue that journey and evolution of the firm.

In the next couple of years, assuming you get back to volume growth, say next year and you have these enterprise initiatives. Is the way to think about the operating leverage sort of 35%, 40% plus EI savings on top? So you have 2 or 3 years of whatever, extraordinary incrementals or do you think that 40 percentage rate all in is the right level still?

Well, I'll say that at least for the first 4 quarters when you start having some volume growth, you should start thinking about that 35% to 40% plus 1,000 to 1,500 basis points. So I think 45% to 55% incremental on the first kind of 4 full quarters. And could that continue beyond that? We'll have that conversation when we are done with the first 4 quarters of growth. And look, I mean, I do believe as well that we should start seeing more accretive market conditions sooner rather than later. But again, we want to be very pragmatic about not necessarily relying or forecasting when that's going to happen, wait until that happens. So we will deliver revenues that is very similar in terms of growth or better than premium industrial peer group.

And I think you had a sort of S&P ratings upgrade very recently. So clearly, there's a lot more sort of optionality now on the balance sheet emerging. How do you think about trying to mix up the portfolio through M&A versus just the valuation so low, you get kind of super normal returns on the buyback?

Look, let me start with kind of a little plug-in, right? I mean, since we came -- became a public company in 2018. We have dealt with nothing but significant 5 years of calamities that were noncompany induced, right, they were macro driven, right? So from an industrial recession, that was induced by the trade war with China into pandemic, supply chain shortages, labor shortages, logistics disruptions, war in Ukraine with Russia, right? So we've operated in a very, very negative marketing environment. We have created a firm that is higher quality, more robust, I think, more predictable, a company that has demonstrated we can deliver strong free cash flows of the revenue that we generate, improved profitability, reduced some overhang with some revenue that we were less interested in. We've reduced exposure to auto by 500 basis points in that period of time, we still delivered good growth and came out of it with a strong balance sheet. So I believe that we are coming to a point where we will have all levers available to us to deploy our balance sheet. But when I think about where our valuation is today, I can generate risk-free returns buying my stock back. I can generate risk-free returns, paying off some of the higher cost debt that is still residing on our balance sheet. And I would say that, that is what I will be focused on over the short term. As we exit '24 into '25, naturally based upon the true high quality company that we are, we should anticipate some level of re-rating without the overhangs that may have existed there. And when that happens, we will be much more proactive on adding to our portfolio. We have a tremendous amount of capacity to do M&A. We have been looking at different companies. We have been thinking about what would make strategic sense for us as well. But at this point in time, I think it's more pragmatic to go in and continue to buyback stock and pay down debt.

Perfect. I think that will move to a sort of audience response survey please, the first question, and then you can use the gray boxes to vote. But if you look at that, the first one is sort of, do you currently own Gates? So in general, not much. So a lot of opportunity. The second question really around sort of general bias towards Gates at the moment. Very neutral to positive. Third question is around kind of earnings growth for Gates versus the broad industrial average through cycle. So in general, sort of in line with peers. Fourth question around uses of excess cash, which is starting to become a lot more relevant now for the company. So in general, buybacks, the most popular by a distance. The fifth question really around valuation, so sort of the current year PE multiple. So mid-teens, mid- to high teens. And then the last question is what's the biggest barrier to people why don't they own Gates today. So organic growth, the biggest headwind or drawback, I suppose. So great. Well, thanks, everyone, and thanks so much, Ivo, for being here. Thank you.

Thank you. Appreciate it. Thanks a lot.