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

Well, good morning, everybody, and welcome to the Midwest IDEAS Conference. Presenting is going to be Gates Industrial Corp., traded on the New York Stock Exchange under GTES. On behalf of the company, we have Rich Kwas, VP of IR. Rich?

Thanks, Erol. And thanks to the team here for hosting us. Really pleased to be here and share the Gates story. We are based in Denver, Colorado and been around for now 113 years. So have a long history, and we've been public since early 2018. And so we have a nice history now as a public company. So let me get into it and we can do some Q&A in a little bit. First, the forward-looking statements and legal disclaimers here. And then here's some background on our strategy here. So there's three pillars. We really are focused on driving organic growth and outgrowing our key end markets. I think if you look over a long term, you'll see that we've grown organically about 4% since 2016. And so which is a decent performance considering the cycles that we've gone through in COVID, et cetera. And so our target here through 2026 is to grow at a 3% to 5% CAGR. We typically grow 2x industrial production. And so if you think about us in those terms, we should be able to drive close to mid-single-digit growth. And then in times when industrial PMI really picks up, we should really be able to outgrow 3% to 5% in those short periods of time when PMI is really rising. We typically have a good correlation with industrial PMI. So as you watch over the -- hopefully, the next couple of quarters, for a turn in industrial PMI, we should respond pretty quickly to that. We're also focused on margins and return on invested capital. We have a target out there at 24.5% by 2026. Our guidance this year is 22% adjusted EBITDA margin. And we have several strategic enterprise initiatives in place to drive that margin performance. So -- and I'll get into that in a little bit. And then historically, we've done a pretty good job balancing our capital allocation priorities. So we've done a significant amount of debt reduction since we've been public. And then we've also returned capital to shareholders via share repurchases, more targeted over the last few years. And that -- some of that's been helping our sponsor sell down their position and facilitate that sell down. Currently, Blackstone is 8 point -- owns 8.4% of our shares, and that's down, just to put that in context, that's down from 63% in May of 2023. So a fair amount of progress made over the last 15 months. Here's just an overview of the company. You could see about $3.5 billion in revenue. I'd highlight that our ROIC at 23% is pretty strong relative to a lot of industrials you see out there. I always kind of think of 20% plus as being a good bogey, and our target over the next couple of years is get into the mid-20s. You could see on the bottom, the breakdown. One of the key tenets is that second pie chart, the channel mix. It's about 64% or 65% replacement, balances OE. So what that does is it provides -- mitigate some of the typical cyclicality you would see from an industrial company. We have a big installed base out there across many of our end markets, and we're able to supply replacement parts on a continuous basis. You can see geographically and from an end market standpoint, we are pretty well diversified. One of the areas that is a growing end market, even though it's been -- had slowed down over the last year or so is personal mobility. You can see on the right side there, the yellow piece -- yellow slice there, that's really focused on 2-wheelers. So think of it as bikes, e-bikes, scooters, motorcycles, and we have carbon drive technology that is very advanced technology and competitive, and we're really the strongest player in the space in terms of supporting the electrification of 2-wheelers and have a good position in that market. The reason I point that out is that's a market that had been growing double digits, has slowed down as the bike market has gone through some destocking. But as we get into 2025, we expect that to reemerge as a good grower for us. And right now, it's about -- as highlighted here, about 4% of sales, and we expect that to grow over time. The other thing I'd note is that perception wise, you may think of us as being having a lot of auto, I'd say. Look at the right chart and our Auto OE is now 9% of sales. When we went public, it was 15%, 16% of sales. We've done a -- what we call selective participation in that market. And so that piece -- that mix of sales we expect to stay where it is or decline over time. We've a couple of product segments that we report on. Power transmission, this is the majority of our sales, and you can see the products here. Think of it as belts, tensioners, sprockets, and we -- some of the key product lines here. And you could see the benefits here. We have, what's called, a chain-to-belt initiative, that's focused on converting chain-to-belt for industrial applications. Our personal mobility business, that's been a key tenet and key strategy within that, converting chain-to-belt for 2-wheelers, and we have an opportunity over the long term to drive that in the industrial space. And you can see here the mix of sales is pretty similar to the corporate average with 63% coming from the replacement market. The other thing I'd note is we have a strong market position on a global basis, but it's still a fragmented market, as you can see it's a $40 billion total addressable market, and we have only a small slice of that. The other product segment we have is Fluid Power, a little less than 40% of sales. Again, fragmented market. Opportunity over the long term to consolidate the market potentially, also a good mix of replacement sales is even higher than the power transmission market. And think of this as hoses and couplings. I'd say one of the more exciting areas here that is starting to emerge for us as you probably have seen with the emergence of AI and the need for the build-out of data centers, particularly how those are going to be cooled. There is a focus -- a greater focus on liquid cooling as a solution for data centers. And we have an opportunity to play a nice role in that over the long term. I'd say right now, this is an emerging focus for us. It's still nascent. But data centers can be a nice opportunity, we think, over the next 5 to 10 years for growth. On the growth side of things here, you could see on the left side, this is a snapshot of how we performed since 2019. I think from my perspective, we get, I'd say, criticized a little bit because of our perception of our growth. And we have a -- there's a perception out there, we don't grow. This chart shows that we've outgrown some of our key competitors over the last 4 years. And I think if you look at some research that's been publicly available over the last couple of months, as I mentioned, 4% is kind of the number that we've been able to drive over the last several years, 6, 7 years organically. And that's kind of in the middle of the pack versus 20 or 30 different industrials. This is a more targeted subsegment. But I think the focus is we do grow the business. One of the things here as our balance sheet continues to improve, there's going to be an opportunity to do M&A. The company went public at 4x net leverage. Now we're at 2.3x the net leverage. Our target is in the 1 to 2x range. And there's going to be an opportunity to add acquisitions over the midterm. And so that's going to be a focal point from a capital deployment standpoint. And so that will also augment -- longer term, we think it will be a good way to augment our growth. You can see just -- I'll kind of briefly cover this, above-market growth, margin expansion and deploying capital. Those are our strategic, a few of our focuses or key focus on growing -- expanding the business over the next years and driving shareholder value. Here is our eco innovation system. One of the things that I think is underappreciated for the business is material science. So if you ever get to Denver, please feel free to reach out. We have our headquarters there, but we also have a tech center there, where we do a lot of materials testing. And so we take a lot of different compounds and polymers and develop new recipes. And we're testing on a continuous basis to make our products less expensive, more durable, more robust and find new ways for applications -- to apply them to new applications. So I think the material science is one of the key tenets. You can see -- we noted the adjusted EBITDA margin at 22% going to 24.5% as the target. Our gross margins right now are going to be above 39% this year, which is pretty good for an industrial company relative to what you see -- you normally see out there. We have a target to get that into the 40s. And so I think when you think about our margin profile, material science is a pretty important driver of that. You also can see we're focused on process engineering, product engineering. That's, again, kind of off using the material science as kind of a core to drive that process engineering, we can find ways to be more efficient in our factories and improve our asset utilization. And then product engineering is really, again, using the material science to find new ways, new products for different applications. And this is NPI, new product innovation. Our vitality rate is now in the high teens. We have a target to get that into the mid-20s. And you can see the product launches over the last several years that they've been consistent and growing, and you can see down on the lower right, in addition to personal mobility and chain-to-belt, we've actually also grown our product -- new products in the auto replacement business. Auto replacement is a nice business for us, very strong on a global basis in terms of marketing position, and we continue to reinvent new products or reinvent our product lines there. Here is our key enterprise initiatives. These are kind of the tenets of what's going to get us to 24.5% adjusted EBITDA margin. We are positioned for secular growth themes. I talked about personal mobility, I talked about data center. We are using digital tools to help our customers, make it -- facilitate their ease of doing business with us. And then as I mentioned, material science investments are ongoing. We also embarked over the last 24 months on 80/20 initiatives throughout the organization. We were pretty aggressive over the last year or 2 in the auto replacement space, and we're deploying that to industrial replacement, and that's continuing to evolve here. So we see that as contributing to the margin trajectory over the next couple of years. And then we really feel from a margin standpoint, a lot of this is in our control. We have a lot of self-help that's in our place. We certainly don't want to see the industrial markets pick up over the next year, and that would be beneficial to us. But we feel from our margin target that we're able to -- a lot of it is in our control and our ability to getting to that 23.5% to 25.5% adjusted EBITDA margin range. Again, this is kind of a reiteration of what we're focused on, material cost reduction, operational excellence and footprint optimization. So material cost reduction, we're going to grow our margins this year over 100 basis points on an adjusted EBITDA basis, and that's in a down volume environment. Not all of it, but a decent chunk of it is coming from material cost reduction. And that's kind of, as we've outlined it over the 3-year period, the material cost reduction initiative is a little more front-end loaded than the other two. And so we're starting to see benefits from that. And so I think as you look at our financials, you'll see margins up with organic revenue down and volume down. So you should think of that as volumes come back, the opportunity could be nice over the next couple of years in terms of incremental margins. So we expect that will continue to contribute, but probably at a lesser rate -- at a lesser rate as we go through into later into '25 and into '26. As volumes start to rebound over the -- hopefully, over the next year or 2, we'll have the opportunity to drive better productivity. One of the things that I think has been lacking primarily due to COVID supply chain phenomenon is productivity. We have lost a couple of years of productivity benefits. So as volume -- with the supply chain stabilizing in volumes, stabilizing and improving, we see that productivity in the plants are -- is going to get stronger here, and that's going to contribute to our operational efficiency. And I'd also put in there that 80/20 is going to be an ongoing driver of that operational excellence as well. And then the last piece is footprint optimization, and we talked about this 6 months ago or so at our Capital Markets Day, we updated on the Q2 call that we intend to pull forward some of our footprint optimization by a couple of quarters. And so we have footprint optimization in place here that is going to start here later this year. We had intended at the Capital Markets Day that will really -- is going to launch in earnest in 2025. We pulled that forward a little bit opportunistically. And what we've indicated is that about -- it's a $40 million total savings. We'll get 40% of that run rate by the end of 2025 and then the balance at a run rate by the end of 2026. So think of it as from a dollar standpoint, some benefit in '25, more benefit in '26, and then there'll be some lap over benefit in '27 from a dollar standpoint. Here's visually a good way to think about where we were in 2023 and where we're going in 2026. And you can see the material cost reduction is a key component. And the operational excellence and footprint optimization is going to be the driver of reducing our conversion costs. On the footprint optimization, the one thing I'd also mention is there's a little bit of fixed asset takeout within that. But think of it as we're redeploying capacity to facilities that have better labor availability and are more optimal from an operating standpoint. And if you think about some of the consolidation activities that we'll have over the next couple of years, the point of that is, as volumes get better and up cycles emerge, we hope what we plan to do with this is be able to drive higher incrementals and more consistent incrementals when the cycle turns. And so in the past, we've had some challenges here and there with regards to supporting that volume increase. This footprint optimization is going to put us in a place to drive stronger incrementals. Here's just the margin walk. You can see we do have some operating leverage factored in there for the next 3 years. That's within the 3% to 5% CAGR. You can see material cost reduction is the biggest component, as I highlighted earlier, footprint optimization and another 50 to 100 and then productivity in 80/20 is about 50 basis points at the midpoint. We also have some R&D investment inflation factored into this. So we haven't just looked at all everything sunny side up, everything is good, and we don't factor in any incremental cost that may emerge in the business. So we factored that into the margin target. Free cash flow conversion, you can see over that 3-year period, which was an interesting 3-year period for industrials because of supply chain, COVID, et cetera. We did 79%. The peer group average was 81%. So more or less right there. Last year, we did 110% and outperformed that group. And you could see our -- we're targeting 100% over the midterm. So think of it as -- this year, we're going to do -- we're expecting to do 90-plus percent. Last year, we did 110%. So we're averaging out of 100%. So think about over a period of time, we'll be right around 100%. You can see the assumptions here around how we're -- our cash needs, et cetera. I'd also say that one thing here that is on a tax standpoint, just from -- more from an EPS standpoint. On last quarter's call, what we've done is we've gone to an operating adjusted tax rate on a go-forward basis, which is 26% to 28%. So the tax rate is a little bit higher than what's indicated here. We've had a lot of volatility with our tax rate, if you look back historically, since we've been a public company. The 26% to 28% is a number that we feel comfortable with. And there's potential opportunity that, that could get trimmed with some tax strategies that are put in place. But think of it as that's going to be more consistent rate going forward. And we've really tried to strip out the volatility because if you look back historically on an adjusted EPS basis, it's bounced around a bit. You can see this was going back from 2020, mid-2020 to the end of last year, how we've deployed our cash, and you can see how we spent it and deployed it. So you can see the CapEx. We've -- as in the middle too, you could see share repurchases and debt pay down were about pretty similar. Now this year, we refi-ed our debt. We got upgrades at S&P and Moody's, and we refi-ed our debt stack in June. That was very successful. We were able to generate some modest annualized interest savings. And then also, as I mentioned, we did with the Blackstone sell-downs here, we've been opportunistic with buying back shares from them. We did a $50 million buyback in February. And then more recently, a couple of weeks ago, we did $125 million buyback. So our balance sheet, we would expect to be somewhere around 2x by year-end on a net leverage ratio. And our target is 1 to 2x. If -- for our business, you should think of our business as all else equal, if we don't do anything with capital deployment in any given year, in a normal year, we'll usually reduce our net leverage ratio by about 0.5 turn. So the business generates good cash flow and can delever in a fairly quick manner. There's a capital structure, again, 4.3x at the end of 2020, our target is 1 to 2x, we'll be probably near the top end of that here at the end of this year. So opportunity to continue to further reduce that and get that under 2x. Our credit ratings here have -- this is a little bit -- there's some updates here on the lower right, we got an upgrade at Moody's and this -- the S&P, you could see is that reflects the upgrade from earlier this year. And so again, the balance sheet is improving, getting better, and it's going to create opportunities for us to explore other longer-term strategic opportunities that may arise over the next several years. Again, with the buyback and debt reduction, I'd say right now, those are still two of the key focal points here. We do have a target of wanting to get our gross debt down below $2 billion. This is just another illustration on net leverage and where our target is. Here's an EPS walk with getting out to 2026, and you could see the midpoint at 210. And again, we factored in some incremental SG&A investments here as a partial offset, but you can see how the walk works here. And then this is kind of a summary of what we expect -- where we expect to be in 2026. And so I think if any of you look at our valuation relative to these financials. I humbly say there's a disconnect. So there's -- and that could create some opportunity. And -- but we feel like we're on a good path here with where we are with the business to drive these results over the next couple of years. And hopefully see a much higher stock price over the next couple of years. Again, we've been around -- now coming up, we're going to be finishing our seventh year as a public company. This is -- we've had -- we've gone through cycles. We've demonstrated ability to be resilient. We've learned from things that -- in cycles we've gone through as a public company, including COVID and the supply chain issues that emerged post-COVID, along with the various we've seen since 2018. So we think this business is very resilient. It's in strong position to drive financials, very compelling financials over the next few years. A lot of this is in our control. and we're building optionality for the future. And so I'll stop there and see if there are any questions.

[question inaudible]

Yes. It's -- so the question is why explain this chain-to-belt initiative and the advantages of change. So if you think about -- or a belt, excuse me. So if you think about belts, they -- versus the chain, first of all, they're quieter. So there's just less noise, less disruption. If you think also think about a chain versus a belt, there's more maintenance required in general, lubricants, et cetera, to support that. And belts, you can put a belt on and it will be very little maintenance required over a long period of time. And so if you're thinking about from a risk of production, if you're a manufacturer and a facility, there's generally going to be less -- much less disruption with a belt versus a chain. I think also, if you think about the environmental benefits in general with chain versus belt with the oil and lubricants and other things needed to support chain, you don't need that with a belt. So from an environmental standpoint, as companies are more focused on the environmental wear and tear, if you will, from their facilities that emerges, belt is an opportunity to take that out of that equation. And longer term, there is -- from a durability standpoint, and if you ever get to Denver, let me know, but we show that the belt is extremely strong. So like you have a perception that chain is going to be stronger than belt. We have instances -- we have shown instances at our CSC, and we have examples that we show belts can hold very, very, very heavy equipment. So it's on par, if not better, from a durability and application standpoint. So I think one of the things that we're working on with that initiative is -- and we've had successes with in food and beverage, in -- at airports on replacing chain with belt. So the there have been instances of that where we've had good successes. I'd say there's an opportunity for us from a commercial standpoint to work more closely with machine builders to get designed in directly into those machines because the chain has been around for over a century, it's kind of the de facto technology that's picked -- that's currently chosen and it's the path of least resistance if you're a machine builder. So the opportunity for us is really to highlight the opportunity here and get designed in. And that's not going to be an overnight phenomenon, but we've actually in the last 6 months or so, reformulated our commercial strategy around that. And I think there's going to be some benefits that starts to emerge over the next 3 to 5 years. Yes.

[question inaudible]

Yes. So we've not been specific with that, but if you think about our corporate average gross margin in the 39% plus range, think about the aftermarket replacement piece is going to be higher than that. So -- and it's decently higher. And then if you think about the OE, first-fit mix, whether it's auto or industrial, it's going to be lower than the corporate average.

[question inaudible]

Yes. I think -- so our balance sheet has kind of been a completely limiting factor for us. So we really haven't done anything of any significance as a public company. And that's been -- as you can appreciate investors look at anything that's certainly in the 3 range, but even in the 2 range as being a little risky. And I think we're starting to move into that bandwidth where we can start to entertain that in terms of potential transactions. I'd say we're going to be pretty cognizant of where we are trading as -- from a multiple standpoint and where the targets would be, which generally for good industrial businesses are going to be in the double digits on an EBITDA basis. So that's certainly a consideration. I think from a share repurchase standpoint, our stock is still discounted versus the peer group, and you could argue that, that's the most, the most attractive risk-adjusted deployment of capital. So -- but I'd also say that we're also paid to grow the business long term, and we have to position the company for the next decade and more in the best position possible. And so M&A is going to be a piece of that, but we're cognizant of where we are trading right now. And so I think it's -- it all goes into the equation. And I think also that our leverage reduction getting into the ones on a consistent basis would be beneficial as well. So -- but we're preparing to put some seeds in place around getting the competencies internally at the company to be able to prepare to support potential M&A over the midterm. Other questions? Okay, no. Yes.

[question inaudible]

Yes, it's still somewhat early days, I'd say. We're certainly, I wouldn't say -- I don't know if we're quite -- our CEO would say, well, we're putting the unis on. I think we're a little bit past that. We're very early innings. And we've had success so far in our auto replacement business that is beginning to roll out across our industrial replacement business. And so we kind of look at it as a journey in terms of there's not likely going to be any one year where it's this huge windfall of savings and benefits. It's going to -- really if you're doing it right, it's over a consistent basis over several years. And that's how we look at it. And so that's the focus. And I'd say that think of it as even beyond 2026, we think there's going to be certainly opportunity for us to continue to implement it, hone it, improve it and get savings from it. I think one company that we look to as -- from an aspirational standpoint, is ITW over a long period of time, they did a fantastic job of executing that. And so we look at how they've done it. And that's something that I think you should think we would try to emulate, so.

[question inaudible]

No, they've been -- we've been facilitating their sell-down. So opportunistically. It hasn't been every transaction. So the question is that have we been buying shares back from Blackstone directly. And then in the times when we've been repurchasing shares, we have been buying shares back from them directly because we feel it solves one of the issues for the stock. It helps solve it at least and progresses a solution. So the $125 million we recently repurchased along with the $50 million we repurchased earlier in the year were from them, so.

[question inaudible]

Well, so I'll give you a little history. Blackstone bought the company in July of 2014, took it public in early 2018 and is still an owner here in 2024. So, yes, I can't speak for them, but I think just giving you the pieces of data probably helps you get to a conclusion. Any other questions? Well, if you -- thanks again for your time. And if you get out to Denver, feel free to reach out.