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

Hi, everybody. Michael Halloran with Baird. We're pleased to welcome the Gates team. One of the people decided he wanted to do real work. Ivo came on stage, Rich, no comment. But we're going to do kind of a normal thing. We're going to have a some opening prepared remarks. We've got a few slides to go through, and then we're going to have a lively Q&A session. So if you have any questions, please let me know. Raise your hand if you want. We've got the signs on the side that show you the e-mail that you can use to send an e-mail to me, and I can certainly weave the questions in. So Ivo, really appreciate your time today. Thank you.

Thank you, Mike. I appreciate it. I'll stand up in here for a second and look, I'm very excited to be here today and provide an overview of our Gates story. We believe we have many positive catalysts and initiatives in place to drive our business and create meaningful shareholder value over the midterm. I mean it would be good if I actually, I think, put this on. Well, that's just the standard before we get started. Let me remind everyone that our remarks include forward-looking statements within the meaning of the Private Securities Litigation Reform Act that are covered by our safe harbor disclaimers. With that out of the way, let's move to Page 3 of the presentation. And I'll start by giving you a brief introduction and overview of our company. Simply put, we are a material science company that supplies mission-critical components to our customers. Almost 2/3 of our sales are to replacement markets and we possess global reach and scale. In 2023, we generated sales in excess of $3.5 billion and almost $750 million of adjusted EBITDA. We generate high returns on capital and very solid free cash flows. On Page 4, I'll cover how we have performed historically through 2023. We compare ourselves to a very strong peer of industrial companies listed at the bottom of this page. On the left, you see that we have grown our core sales at about 4% compound annually since 2016. And we just wanted to make sure that we take a historically good period of time. So we're not cherry-picking some very specific periods of time. And we are performing in the middle of the peer group results. Our performance includes about 60 basis points of headwind from our philosophy to deemphasize our automotive OEM business as well as loss of highly profitable Russia sales because of government sanctions. On the right side of this display, we show our historical margin performance. At the top, you see our gross margin performance has been slightly ahead of the industrial peer group. We are highly focused on driving our gross margins into the low 40s on a sustainable basis. And as a reference, we anticipate exiting at approximately 40% at the midpoint of our earnings guidance in 2024. On the lower right, our adjusted EBITDA margin has averaged about 21% and we are striving to increase it into the mid-20s over the next couple of years. Again, at the midpoint of our 2024 guidance we anticipate we will exceed 22% adjusted EBITDA margin for the full year. On Slide 5, we show some of the metrics from the previous page through a different lens. On the left, you see historical core sales compound annual growth rate for Gates and the peer group plotted against the current EV to EBITDA multiples. On the right you will observe the average historical gross margin performance across the group compared to our present EV to EBITDA multiple. Our fundamental performance is consistent with our peer group who trade at much higher multiples. Sliding to Page 6. We are a low intent -- low capital intensity business. Over the last 5 years, our CapEx to sales has averaged about 2.5% and free cash flow conversion has averaged close to 100%. On Page 7, we illustrate our returns as we approach the balance sheet management and capital allocation. We have high returns on operating assets in excess of 20% with aspirations to expand it into the mid-20s over the next 2 to 3 years. Our net leverage continues to decline, and we expect to be approximately 2x leverage by the end of this year. Lastly, we had a very balanced capital allocation strategy, historically, devoting excess free cash flow to a balance of debt paydown and share repurchases. On Page 8, you can see Blackstone ownership has declined significantly in 2024, and they currently own less than 5% of our shares outstanding. As such, our trading liquidity has grown meaningfully over the past 18 months. Lastly, before I turn it over to Mike for Q&A, I want to summarize our key messages on Page 9. First, we expect to outgrow the market over the midterm. Historically, we have grown 2x industrial production, and we have exposure to secular trends such as mobility and data centers that should benefit our growth over the midterm. Also, we continue to build new distributor relationships and aim to expand our share of wallet with existing channel partners. Second, we possess strong margin and anticipate further improving them through 2026. We have set a target to achieve an adjusted EBITDA margin of 24.5% at the midpoint by 2026, which is about 250 basis points higher relative to the level we expect to deliver in 2024. We anticipate the vast majority of this improvement will come from improved gross margins, which we estimate could increase into the low 40s over the next 2 years. And lastly, we have thoughtful and balanced capital allocation strategy. As our balance sheet continues to improve, we believe that we have more optionality to pursue meaningful external investment over the midterm. Thank you, and I'll turn it over to Mike.

Thanks, Ivo. Appreciate it again. If you have any questions, just let me know. We will make sure, we weave them in. Let's start high level. The question I still get a fair amount is an opener from clients. It was just -- how do you look at what the differentiation that you offer to the marketplace is? Very simple question. But when you talk -- when you look at why you have a sustainable edge with your distribution base or your channel or specific customers, where does that differentiation come in from your mind?

Yes, sure. Look, first and foremost, we provide mission -- highly engineered mission-critical products. It is not nice to have. If something breaks, you will have to replace the products that we manufacture. Second of all, over 115 years of our existence, we have built strong reputation for quality and reliability. We have built strong customer relationships and very significant balanced brand awareness frankly, globally, which I have been fortunate enough throughout my career to work for many high-quality brand names. But I have never worked for a company that has the level of brand name resonance globally across all markets. And I would say that lastly, we have deployed material science into the fullest extent to drive innovation forward. And over the last 7 or 8 years, we have been able to take our New Product Vitality Index from very low single digits to nearly 20%, and we are on a trajectory to deliver about 25% NPI vitality kind of over the next 2 to 3 years. And that's fueling significant interest in what we do. It continues to reinforce the vitality that we have and the brand equity that we have built with our customers.

So how do you think about that from a competitive dynamic perspective. I also think -- I agree with everything you said, but I also think you guys go after your markets with probably a little bit more focus than some of your core competitors who have other things that maybe steal a lot of their time and capital.

I think that that's probably another very meaningful point that is worthwhile exploring. Look we have 2 product lines. We like both of our product lines and we are top 3 market participants in each one of those product lines globally. There are very few companies that can talk about having that level of market presence and ability to continue to reinforce your market opportunities across the globe. And so I think that you are correct. We are very focused. We are not confused about what we do. And what we do, we do with high-quality effort and high-quality results.

So maybe let's touch on where you think the biggest growth vectors are from a portfolio perspective. Maybe just highlight a couple of the areas where you're putting incremental time and incremental attention to. And we can use that as a jumping point to dig into some of them.

Yes. So look, we have a number of secular and a number of kind of traditional market opportunities, right, cyclical opportunities. We've talked on our Q3 earnings call, we've talked about signing up a very large channel partner in North America that to us will add kind of 100 to 150 basis points of organic growth rate, next year on the entire franchise in the automotive replacement side of our business. That's really big. That I would put that as a very meaningful opportunity in the cyclical side of our business, right. But we have earned the right to do that. And we have demonstrated based upon the new product introductions, the capacity expansion and the revitalization of our manufacturing assets that we are reliable partner for more customers than we have historically served. So that's a really good example kind of the channel expansion with the secular or cyclical side of our business. But we have lots of really interesting and exciting opportunities in the secular side of our business. We have spoken since about 2018 about opportunities that we have in personal mobility. Between 2018 and 2022, we have grown that business from about $20 million to kind of nearly $175 million, $180 million scale. It was a massive amount of growth for an industrial company from a very small base. Now that business has gone through destocking, really tough couple of years post COVID. Now that business is inflecting as we speak. And we have committed to our shareholders during our CMD in March that the business should be kind of a $300 million to $300 million plus or minus by 2026, 2007 (sic) [ 2027 ]. So not only do we have a high degree of expectation and visibility that the business is going to reaccelerate. We're actually now starting to see some green shoots that we should start seeing that.

What are some of those green shoots?

My sense is that while in Q3, we have kind of seen a less bad -- negative core growth if there is such a word...

Kind of a little further through some of the destock.

Absolutely. My anticipation is that in Q4, we're going to be at worst case, flat year-on-year, maybe with some positive core growth. So we are now starting to see a much stronger order flow in personal mobility...

And where is that in the personal mobility side?

It's pretty much in the e-bike and the bike space that has been the most impacted by the destack. So yes.

How important is that inflection in personal mobility for the margin goals.

How important is the personal mobility inflection for the margin goals is the question.

It actually isn't -- we still anticipate that we can deliver 24.5% EBITDA margins by 2026 even without inflection in end markets. Now we don't anticipate that there will not be inflection, but we feel that we have enough levers that we have put in front of ourselves to be able to deliver that margin expansion. Because I don't think that any of us can really predict when will market inflections occur. Now obviously, if we get market inflection and we continue to deliver organic growth that's accretive to what has been happening over the last 2 years that makes it significantly easier. But without organic growth, we have enough levers through restructuring that represents about 100, 150 basis points of margin improvement through deployment -- further deployment of 80/20, continuation of driving material science effort in materials reengineering and taking material cost out of our cost base. And ultimately, taking some pricing over the next couple of years. We believe that still can deliver that 24%, 24.5%.

How is the mix on that personal, on your margin?

That's a very good margin. It's above fleet average.

So what are some of the other secular pieces then that you would talk to?

So some of the other secular pieces, most recently, we have started talking quite a bit about our presence in AI data centers, in AI data center cooling.

And what specifically do you do within that? Because I get that a fair amount, and I'm not sure people see some of the fluid transfer or the belts and think, yes, data center.

Look, a huge problem in an AI-based data center is power dissipation. There's an incredible amount of heat that these NVIDIA chips generate. There's a high concentration of these servers, very narrow space, very small, very confined space, and they need to get that heat out. So over the last 20 years, data centers have shifted from fluid cooling into air cooling that is no longer possible with AI data centers. You got to get back to a liquid cooling and a very high efficiency liquid cooling. And so we have a presence with high-efficiency electrical pumps. And it's an interesting inflection of development of the technology. It's a technology that we have developed for electric vehicles. And we have been able to take that technology that we have developed for EVs. And again, we have developed a highly compact size pump with high efficiency. And that's -- that happens to be super important in these data centers because space is at a premium, efficiency is a premium. You need high flow rate of liquids coming through the racks that hold the servers. And so that's a product line that we provide and our partner CoolIT, was the first partner that we have signed up. And now we continue to develop and expand our portfolio of these water pumps going from 100 liters of flow per minute to 1,000 liters of flow a minute to 10,000 liters of flow a minute. So it's scaling up quite dramatically. We provide fluid conveyance products. So think about it as a hose, but it's a highly engineered hose. It's a hose that can't have any metal particulate contamination in the polymers and couplings. So really nice set of opportunities, about $1 billion to $2 billion market TAM that we haven't had historically.

Absolutely. Any other ones you want to touch on before we talk about a couple of other topics.

I think it's a good segue to move on.

So if I think about the cyclical side of things, it's been some pressure points, some destock in some areas, some end markets, machinery side, still soft. Auto it's certainly been volatile and not -- more of a headwind than tailwind. How are you thinking about your end markets as you move into next year and your ability to sell and match, sell out and ability for those markets to maybe start at least being neutral to slightly positive?

Yes. Look, really good question. I think that I'll start with something that probably most people already know, 24 months of negative PMI, right? A very long period of time. You got to go back to 1989 to have the same level of negative PMI performance. While the performance was that impactful, we still managed to deliver gross margin expansion and EBITDA margin expansion in that negative end market backdrop. So coming back to what do we think into 2025. Look, my sense is that if we haven't finished the destocking in a channel, we are kind of at the last inning of the inning of destock. But my sense is that the inventories are getting very, very lean. We have a reasonably good visibility on a sell-out and sell-in and the inventory stocking and it is not unusual for me now to have conversation with our channel partners about, "Hey, look, I think I'm a little bit too lean in what I hold." So my sense is that will inflect and it will become not a headwind into '25. And if you look at my Q3 results in diversified industrial, that's probably the best indicator of that actually happening in reality because we were 50 basis points negative core growth in diversified industrial globally. And that's vastly our channel performance in diversified industrial, right? And that's the best negative core growth in the channel that we have seen probably in 2 years. So that just tells you that I think you're coming more towards the end of the destocking cycle than not. On automotive replacement side of the business, that's a very healthy business. We have been -- we continue to grow.

And you have that tailwind...

We have the tailwind. We've actually been very mindful of making sure that we have the right level of inventory to be able to support that new incremental volume that's coming for us and that we are prepared for the inflection in the manufacturing PMIs. Okay, that being said, we've talked about personal mobility that's inflecting already as we speak. So couple of markets that are going to be, I think, still headwinds next year. We certainly believe that ag is not going to be very constructive. I think that is rather well thought-out topic and spoken about topic. But my sense is that while it's not going to be constructive, we think it's going to be significantly less negative to us than it was in 2024. The OEMs have been very aggressive in taking production out throughout this year. And I think that they are fully intended to go and manage the inventory in the channel on their end, but I think that there's a ways to go. So I think that the first half will be tough on ag. Is it going to inflect in the second half? Or is it going to -- in second -- in third quarter or second half? My sense is that probably towards the latter part of next year, this is going to become less of a problem for everybody. Commercial construction, kind of a similar story. I think it's tough. But my sense is that, that's probably going to be inflecting more in the second half of the year. More definitely because I think that there's lots of pent-up projects that are on the books for people. And my sense is that should be in a little better shape. Still negative, but in a little better shape than not. And on the On-Highway. On-Highway is kind of plus or minus in 24. It's slightly better than what I thought that it's going to be coming into the year, but it's probably mid-single digits down. We've anticipated that it's going to be worse than that. But taking into account that you have a regulatory change in 2026 with Class 8 heavy-duty trucks we anticipate that it's going to be more positive in '25 than negative. So kind of net-net, there are some puts and takes, but we believe that we're kind of reaching the end of negative performance on growth.

It makes a lot of sense. Any regional commentary, specifically how you think about China from here? And any impact from the China stimulus from your perspective?

I think still TBD. We've -- I think we continue to demonstrate that we are printing differentiated results in China. We have a terrific business in China. We love our business in China. We have a good presence there. I don't think that we really know yet the impact of the stimulus. I think that there's more to go. I think that they will have to do more to stimulate consumer support. I don't think that they have really addressed that yet.

No, I completely agree. Completely agree. As long as we're on the international or the China side, why don't we dovetail in, how do you think the regime change could impact your business? Any thoughts on how you're positioned if tariffs do indeed come? Any broader thoughts?

Yes. Look, we import about $25 million of products in the $3.5 billion base from China to the U.S. The $25 million is already on 318 tariff -- tariffed, right? We've raised prices. It's as simple as that. So the amount of products that we import is not that meaningful. If there is more significant tariff, we'll raise prices again. If it becomes really problematic, look, I'm going to pick up the 80 machines and just going to move it to a facility wherever I need to move it to. But we have bigger projects that are more meaningful. They are more accretive to our profitability level. So we've just not felt that this is something that we need to do.

Well, why don't we use that as a segue then. You touched on some of the margin drivers earlier in the previous question. But maybe talk about some of the work you're doing on the facility side, some of the internal initiatives to help drive that margin higher, the efficiency higher organizationally, regardless of what the volume curve looks like?

Yes. So look, we -- about a year ago, we've talked that we have a bunch of projects that were on the docket to optimize our footprint in August or so. We have announced that while we are closing 4 facilities in '24 and '25. We have -- we are on a trajectory to close 3 of those facilities by December. So we are well on the way. That represents about a $16 million run rate benefit by the end of 2025. So we are certainly on the trajectory to deliver that. We have more projects that are on the docket that we will talk about again when we are ready to announce them. That will give us about a $40 million benefit by the end of 2026. That's a pretty nice chunk of that margin improvement, and we have a good visibility on being able to execute that. Again, I talked about the material cost out. We've had a nice material cost out in 2024. That's been 1 of the big positives that have been driving our margin expansion, gross margin expansion. We feel we have kind of a couple more years of that level of activity that we can continue to deliver and the opportunity to take cost out. So that probably represents another 75 to 100 basis points of opportunity. And then we've talked about 80/20. And 80/20 we have done lots of work. For us, it's a way of driving our franchise on a forward-going basis, its deployment front to back. We have done quite a bit of work on the front end of our business in 80/20. So looking at portfolio optimization, looking at optimizing pricing, we still believe that we have more opportunity to do that. But what I'm learning and embracing is the back end of 80/20. That's by far more powerful than the front end that you see. And we believe that we have many years of benefits that can accrue to our results. So we feel pretty positively that even with very muted end market environment, again, the 24.5% EBITDA margin delivery in '26 is certainly within the realm of high degree of possibility for us.

I mean, I look at it as maybe phrasing it differently. Demand environment, it is what it is. The volume piece probably underperformed relative to what you were hoping at the Analyst Day. But it feels like the things in your control are at least tracking if not ahead of schedule with maybe more things identified that could be a tailwind for longer than maybe what you were talking about at the time.

Yes. The only nuance that I would adjust is that I think that '24 is developing the way that we thought it's going to develop.

For sure, coming the year.

25. Again, I can't -- I don't think that none of us can really predict what's going to happen with the back-end environment. But some of the things that we envisage are going to get better, they are getting better. Personal mobility is getting better. We're actually taking maybe more market share than we thought we are going to take during the Analyst Day. We're just not going to -- I'm not going to opine on when I think that actually the PMI is going to...

Yes, there's absolutely no incentive for you to do that. So last 1 here, how are you thinking about capital usage? You talked about a balance sheet in much better spot, Blackstone's almost out. But I know based on a few slides how you feel about where your multiple is. I'm guessing buyback is still the priority for you. At what point does that shift? Is it price gets to a certain point from a stock perspective? Or is it what the right asset comes our way and we start thinking a little bit about both?

Today -- the way that I would answer it today is, as you said, and I think that we made a pretty compelling case that our stock is still inexpensive. And I think taking into account that the sponsor overhang is gone. At some point in time, the stock is probably going to re-rate. So I think we've got some time, and while it's still inexpensive, we'll continue to share buyback. But we've also stated that we want to pay down gross debt a little bit further. So we want to get below $2 billion of gross debt. We want to get very quickly towards the 1.5x leverage, which I think is just going to simply give us that capacity to be able to deliver and have that flexibility to do what we need to do.

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

Thank you.