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

Okay. Well, good afternoon, everyone. Thank you for joining us. I'm Jerry Revich from Goldman Sachs, and I'm delighted to have with us the executive team from Gates. Immediately to my left, we have Brooks Mallard, CFO; Ivo Jurek is the CEO in the middle. And then we have Rich Kwas Vice President of Investor Relations and Strategy, sitting opposite to me. Gentlemen, thank you so much for joining us.

Good to be here.

So, from a high-level standpoint, I just want to revisit the Analyst Day conversation, you folks laid out some pretty interesting targets for 2026. Margin expansion of 3 to 4 points. And what we've seen since then is markets have been weaker but you've taken your margin guidance for 2024 higher. So it feels like we've got a good start towards the margin expansion journey. Can we talk about the drivers of outperformance relative to your business plan so far despite the market headwinds as a starting point for the discussion?

So the primary driver for 2024 has been the material cost-out program. And so what we did in 2023, after we went through '21, '22, '23, we saw the significant increase in a lot of our input material costs, particularly around petroleum-based resins, compounds, carbon black, things like that. We also saw the displacement in the supply chain as a result of the Russia-Ukraine war, where it took some capacity offline. And while we were able to price for that, we also wanted to take a look at our total material spend and say, "Hey, look, this is kind of a paradigm shift. Let's look at our -- in terms of our total material spend, let's look at our suppliers. Let's look at our kind of longer-term negotiations with those suppliers. Let's look at our compounding and mixing and see if there's a more cost-effective way to do some of this, right? Because a lot of the inputs have changed. And so we put together a 3-year plan for '24, '25, '26 to take a significant amount of material costs out through our kind of our DNA of our business, which is material science. And so that's been, like I said, the primary driver for the improved gross margin, improved EBITDA margins for 2024. And we still have a significant runway for '25 and '26 to drive further margin improvements as a result of that material cost-out program.

And, in terms of the other part of the 3-year journey that you folks laid out was the manufacturing footprint improvement. And on the last call, you've mentioned now we're talking about the high end of the range. Can you just talk about where we are on that journey? How many facilities are impacted and the cadence of the benefit?

Yes. So we announced that we were targeting $40 million of savings over a 2-year period, '25 and '26. And so we'll get about 40 -- we'll get about 40% of that savings as we exit 2025, and we'll get the balance of the savings, 60% as we exit 2026. We have not formally said what the cadence of that saving is going to be through the years of '25 and '26. So the way to think about it is, as we ended '24, as you end '25 and head into '26, we should be $16 million better starting '26 than we were in '24. And then as you exit '26, we'll have the full $40 million of savings as we enter '27 compared to the end of '24. And so as we get more clarity and as we make more announcements and we do more communications within the organization, we'll lay out, what the cadence of those savings are going to be for '25 and '26 on a more quarterly kind of basis, right? How much of that savings is going to be there.

So Jerry, maybe to wrap up your original question about the midterm target of that 24% to 25% EBITDA margin by 2026 that we've stated at the CMD. So if you take $40 million exiting '26 of footprint realignment represents somewhere around 150 basis points of profitability improvement. And then as Brooks has outlined, our ability to continue to drive 80/20 material cost reductions, which kind of represent another 100 basis points. Taking a look at our midpoint of 2024 guidance for full year at 22%, you're kind of right there and you have kind of 50 bps of potential upside to offset some headwinds that probably will come in that you don't know. And so taking into account that we feel that we are focusing on the things that we control. We're not forecasting inflection of end markets. Obviously, if we get an inflection of end markets that would be accretive to what we do and would give us the opportunity to perhaps get there a little bit earlier than we would have gotten otherwise. We believe that forecasting upturn in markets is kind of a full [ hearty ] process, and we will stick to what we can control.

And in terms of the manufacturing footprint and obviously, you have to communicate the impacted facilities first. But for -- in terms of parameters, are we taking older facilities offline? Or is it a geographic view of higher-cost manufacturing? Can you just give us a little context behind these actions?

Yes. Look, for us, it's really less about kind of a cost attribute of operating facilities. Labor cost is, generally speaking, a small component of our cost of goods manufactured. For us, it's more about having factories that are more modern that are in a close proximity to a larger pool of available labor. Because as you go through these cycles, our biggest issue historically has been when the inflection in demand occurs, you have a hard time finding adequate amount of people to work in the factories. And so as we are thinking about that, that's kind of the bigger parameter for selecting what projects we are going to do, and that's kind of how we think about driving efficiencies.

And you folks are obviously in country, for country from your footprint standpoint. What's your view if we do have tariffs implemented on Chinese imports how would that impact the industry? How would that impact your customers?

Yes. Look, we kind of have a bifurcated view of tariffs. First of all, we still have a rather large manufacturing footprint in the United States. We're a little bit unique from that perspective because in the space that we participate, vast majority of our main competitive landscape imports products from Europe and Asia and Mexico. Obviously, we have a large footprint in Mexico as well. So we feel that we have a unique positioning where we could, with some more sensitive applications, we could potentially take some more market share as the opportunities open themselves up as people end up getting a little bit more squeezed from some less favorite jurisdictions. If you think about China, higher tariffs in China is going to be impactful to some industries across the U.S. footprint. For us, we actually have very little that we import from China to the United States. We import roughly $25 million of goods. There are already 301A tariff anyways. So if the tariffs go up by 10%, we'll price for that. With Mexico, we believe that we are uniquely positioned, a, because we have a large manufacturing base in the U.S.. And two, because we're competing against folks that are primarily importing goods in, we feel that likely outcome would be if there was a tariff on Mexico produce goods, we would price for it.

So the benefit, the Gates would be at the pricing line as opposed to market share?

Well, I think both because there are competitors that are importing from Asia that may be disproportionately impacted. And as you become more competitive from your ability to supply from a locally sourced non-tariff production sites, you have an opportunity to capture some market share as well.

And then on the material cost reduction side, you folks have been awfully good at this for a while in terms of taking material costs out and environmental sciences is really core to what you folks do material science is core to what you guys do. So what's different about your approach to material cost reductions now? How much runway do you have to continue to drive savings beyond the plan?

Look, I think that Brooks outlined it earlier. Sometimes you try to take lemons and turn them into lemonade. And what we have lived through with the -- frankly, the destruction of the industrial assets for petrochemical processing in Ukraine and having Russian assets that were coming offline and frankly, overnight losing a decent amount of capacity. We had to get pretty quickly after reengineering polymers. And we do a lot of our own polymer processing in our factories. And so we've just rediscovered the power of what material science can do to you that it is not just to drive innovation forward kind of in the pure new product introduction type way. It's also deploying material science to protect your supply chain, reengineering materials, getting to more commoditized, sub commodities and then give yourself the opportunity to go out there and protect your supply chain. And once we've gone through this process, we've kind of looked at each other and say, "Hey, look, there's a huge opportunity. I mean we buy, nearly $1 billion of those commodities. We felt that we have a large runway to be able to attack and take some percentage of the cost out and attack the biggest commodities and go one by one. And ultimately, that becomes rather meaningful for your overall franchise. And we certainly believe that we have an opportunity to do that for the next couple of years at a minimum.

Really. And just so I understand the process. So we're essentially bringing the R&D team and having them look at a single part of the purchase stream at a time, starting with the highest volume buckets and looking at our different sources we're coming up with a similar essentially compound through different methods?

That's it, and utilize our own asset to a fuller extent, right? Again, we are processing these compounds. We are mixing our own highly engineered polymers. So maybe instead of buying some pre-mixed compounds, go in and start buying more of those commoditized commodities and then use your own asset to do all the further refining of those processes. So more internalization and due deconstruction of commoditization of items that we purchased and reengineer your own materials that you ultimately use to construct the end units that we manufacture.

Yes. And there's a great part of this is there's an element of timing to things. Some things you can get after almost immediately, right? And so supplier development looking at alternative materials from a cost perspective, negotiating on cost, things that you can get immediate benefit from. Some things take a little bit longer in terms of getting some of the testing done and then some things require a little bit of capital investment. And so it's a nice way to kind of have a 3-year glide path on things you can get done immediately. Things you can get done in the shorter term and then things that maybe take a little bit of the medium term to get done. And so it's a good way to resource plan, and it's also a good way to have a nice smooth glide path on getting that gross margin expansion over a 3-year period.

And in terms of 80/20, so you folks are applying that across the enterprise. Now that's an initiative that feels like it should have some runway just given the nature of the principle. Can you talk about your assessment having implemented in, I believe, 2 regions now what you folks are learning as you're implementing it? And how long that runway could be?

Look, I think what we are learning is it's an incredibly powerful tool. That is kind of fundamentally what we have learned. The second fundamental item that we have learned is that we are deploying 80/20 as a way of running our business. So while we have started kind of with the traditional point in place, which is kind of the front end, looking at your portfolio, refining your portfolio, adjusting your portfolio, looking at your pricing structure and adjusting your pricing so that you have appropriately separated A items versus the B items, those are kind of tangible, but relatively easy things to do. And then when you start applying 80/20 in your factories, you actually start realizing the power of what that tool can do for you in terms of accelerating productivity where you have potentially historically had difficulty driving more productivity out of your existing assets. So we think that, that journey is just at the beginning for us, certainly on the back end in our manufacturing facilities. And we believe that, we have many years to go and optimize and deploy 80/20 in the facilities. But I also believe that there is no end point to 80/20. 80/20 is a way of life. And I think that you have a -- it's a kind of a continuous improvement process. You have an ability to continuously refine your portfolio. You have an ability to continuously update your pricing structure and policy and deploy that into the marketplace. And we just don't believe that there is a pretty fine endpoint. We think that we can do that for a very long time.

And so, it sounds like just putting the pieces together. So we've got the 24% to 25% margin target for '26, but it feels like we've got a few a few arrows in the quiver that could, over time, drive margins to be above that point if -- if you continue to find opportunities in 80/20 material sourcing?

Okay. I'm not going to reestablish new targets in here. But I don't think that you are thinking about it incorrectly. And we never said that 24% to 25% EBITDA margins for us is kind of the endpoint, right? There's a balance in what you want to do. But look, our business is not dissimilar to what somebody like ITW, IDEX has. We have a high-quality, highly differentiated product portfolio. We manufacture highly engineered mission-critical components that have a natural replacement cycle built in them. And we believe that taking into account our market presence and market positioning being top 1 to top 3 player in every market we participate in. We believe that we have an opportunity to continue to operate in the vicinity of those high-quality industrial assets over the longer-term period of time. There is nothing that necessarily should prevent us from being able to operate in the neighborhood.

Very interesting. And one aspect of your journey to drive profitable growth has been rightsizing the auto OEM part of the business. Are we at a point where the business that we have within that book. We're happy with, that's where it's going to stay as a percentage of the business? Or should we be still thinking about auto first-fit is coming down?

Yes. Look, the auto OEM business, we -- I will use the same term as I've used in 80/20. It's a continuous improvement. We'll continuously assess it. We don't necessarily feel like we need to aggressively continue to drive down that contribution of revenue for our company. We make good level of profitability on the business. So we are happy from that vantage point. But look, our core growth initiatives around industrial applications. And as we scale up the industrial applications, as the market repair themselves, we believe that portion of our overall business is going to continue to shrink, not necessarily in terms of absolute numbers, but in terms of percent of contribution as the industrial businesses scale up, ramp up and grow more rapidly.

Got it. And on the industrial part of the business, what we've seen for construction equipment, farm equipment, et cetera is, labor costs have gone up, just more productivity investments, higher horsepower, bigger machines. What are the implications for Gates from that standpoint feels like an opportunity for maybe higher market share given the quality aspect of what that entails. But can you expand on that and whether that's an opportunity?

Yes. Look, higher power equipment, higher horsepower equipment is more accretive to what we do. We operate in the highest pressures in hydraulic applications. That's very beneficial to what we do. But we're also going to be pretty prudent in looking at how we scale out some of those businesses. We feel that we not only have opportunities in kind of the mobile applications, which are great, but they also brought a cyclical, as you know. We also feel that we have a great deal of opportunities in stationary applications. In industrial, across the industrial landscape. And those applications are places where we believe that we can operate well, industrial automation, molding machines, different type of industrial apparatus deployed across the industrial complex that offers a great deal of opportunities for growth for us as well. So it's not all centered around the mobile equipment.

Well, let's talk about data centers. So you folks have an opportunity there. Can you just talk about the Gates approach in terms of data center component supply? And how are you thinking about the opportunity and competitive positioning for Gates?

Yes. Look, it's a new set of applications for us to a strong degree. I think that it's an application that will create kind of a $1.5 billion plus or minus market opportunity for the products that we manufacture. That's $1.5 billion TAM that we didn't have 18 months, 24 months ago. That's evolving. It's changing very rapidly as we are moving forward. And our approach has been to go and develop and design application-specific product portfolio. So most recently, we have launched our Data Master fluid conveyance line of hoses that have been specifically tailored for applications in data centers. They're halogen-free, they're metal particulate free to ensure that it complies with the highest, most restrictive set of applications in the data center. So we believe that it's a differentiated line of products. We have -- obviously, as we have announced about a year ago, we have developed a partnership with CoolIT, where we are offering industrial pumps that go into liquid cool data centers. We believe today we have the highest power density and highest flow-through rate pumps available in the marketplace and that should position us quite well in an application where space is at a premium. So we've taken a little different approach in developing products, again, that are within a core where we have a right to play and where we are anticipating that as this emerging application continues to ramp up, it will be accretive to our revenue generation opportunity kind of in '26, '27 and beyond.

And can you put that $1.5 billion into context for me? What's the TAM for the company before data centers?

Well, the $1.5 billion is just an additive TAM to what we have been doing historically, right? And I think that as we have represented historically, we are participating in a large TAM market regardless. So this is just an addition on a rather substantial amount of opportunity that's out there for our company.

Right. Maybe another way of framing that question is relative to that $1.5 billion TAM, what can Gates share of that look like?

Yes. Look, Again, I'm not going to try to frame what we think that we can get. But if you think about that, there are kind of 3 large scaled credible players in that space. And that's Gates, that's Parker and that's [ Stanford ], right? These applications are mission-critical, and you are protecting in terms of providing the cooling of very expensive apparatus, very expensive servers, very expensive chips. And what we have -- I think what we have seen is that the clients, the data center operators, the builders of the infrastructure, they want to do business with players that have a sustainability and power to stay around and provide high-quality products. And I think that these 3 players are of scale and probably will share a decent amount of that market share between each other.

And who's playing this market now?

Who is playing in the market? The 3 players are playing and as the market is evolving, we continue to adapt different sizing of the product portfolio. Look, you may start a project with a data center operator, and you may start with a fluid conveyance product that is kind of 1 to 2 inches in size. And by the time you're done, you're providing them a 4-inch type application. And that means completely different set of problems that you are trying to solve, completely different set of dynamics, different flows, different cooling parameters. So this business, and again, I think that that's why we are trying to be more cautious about sizing up what that opportunity is. We think that it is a decent opportunity for us, but we also believe that, this is still in process of scaling up with lots of changes in how the problem is going to be solved.

And, are you generating revenue from this end market today?

We are, small amount of revenue. I mean, obviously, we have with some partners like Lenovo, we have in some data centers that have already been built. It's not of the size that we believe is dramatically accretive. It's part of our run rate revenue base, but the new opportunities with the new infrastructure that is being put in place, those opportunities are unique in nature. The problem that they're trying to solve a much more significant in terms of thermal management issues that they are seeing in the servers and in the chips and in the application.

Got it. So we have a commercial product today, and given where the market is headed and what the industry has to solve for, we're going to potentially increase the Gates addressable content?

Exactly. And ultimately, that's just going to represent them by far a more significant opportunity to drive revenue generation.

And typically, the more complex problem, the higher the margin you get for solving it?

That's the right way to think about it.

And then in terms of electric vehicles. So obviously, we've seen a slowdown in the adoption rate. Can you talk about what you folks are seeing in terms of your focus on penetrating the market, aftermarket for pumps and things like that has been a big focus as the field population has grown. Can you talk about what your experience has been?

Yes. Let me frame you kind of in a little bit of facts and figures, and I think it kind of puts into perspective some of the things that -- that we are dealing with. First of all, we are super excited about electrification of propulsion. As we have outlined, it's approximately $3, electric application versus $1 in ICE application for us, for our products that we manufacture. So we are super excited. However, that being said, there is nearly 2 billion ICE vehicles on the street around the globe. There's about 22 million vehicles that are electrified. So the disparity is rather substantial. So today, for us and in the foreseeable future, we just don't see that this is going to be a sizable seismic type opportunity that we should spend lots of time talking about until we start seeing more significant penetration of that car park population. And that's going to take time. And it's -- frankly, it's just math, right, Jerry? I mean there's about 80 million cars that are being produced every year. And let's just say on a good year, it's 25% of those are electrified. So call it, kind of 30 million cars that would potentially or 25 million cars that will potentially be electrified over the midterm. It just takes decades. To get to the $2 billion -- 2 billion car set of wheels that are on the street, right? So we are ready. We continue to build our portfolio, but we remain highly focused, laser-focused on ensuring that we support our present customers and the present set of applications.

And just to add on that, the average age of globally speaking, average age of electric vehicles under 3 years globally. So it's a little bit higher in the U.S., but still ways to go to get into the sweet spot, which we characterize as 7 to 15 years. So that's going to be an opportunity for the company as you look out over the longer term.

Okay. And, we've spoken about this in the past, but the fact that you're positioned well with U.S. auto distributors, presumably you should be getting the first look on those additional SKUs. Is that fair?

Yes, it's fair. But again, it's so de minimis, right? I mean it's -- the scale is so small. I mean the aged car parc is about 700,000 cars, right, in the United States, ICE is over 200 million. So it's just a big disparity.

Yes. And from a distribution standpoint, one of the hallmarks of Gates is just being able to deliver thousands of SKUs to customers at 24 to 48 hours of notice. Can you talk about what the company is doing to continue to drive improved logistics, anything interesting happening with your competitive position there that's worth highlighting?

Yes. Look, over the -- I would say over the last 3 or 4 years, we have invested quite a bit in ensuring that we have, a, the right amount of capacity that we launched products that give us advantage in terms of cost positioning. And then thirdly, into refinement of our supply chain, be in region for region, ensure that capacity is available when you need it for whatever customer you may need. And we've made a tremendous amount of progress to a level where today, our fill are kind of best-in-class fill rates. And we believe that, that's what's opening up incremental opportunities for us to take more market share across many of the markets and one of the big market share wins that we have talked about in our Q2 or Q3 earnings call is adding a sizable channel partner in North America to our AR business. That will represent about 100 to 150 bps of enterprise-wide growth in 2025. So really nice chunky and meaty design win and customer win, and we think that we can continue to do that as the service levels stay at the rates that we are able to do.

Yes. And on that note, congratulations on that win. The reason for the win, what feedback do you get from the customer because Gates has been doing business the right way for a long time for these sorts of customers. So why now versus the last bid cycle?

Yes. Look, frankly, I think, a, because today, we are highly differentiated in our service. Two, we continue to have the highest brand awareness in the marketplace. There's lots of affinity towards our brand. And two, I think that the 2 parties felt that it was the right time to be able to create a partnership together. And so everything the stars kind of aligned and the company is performing well, and we feel that we can protect all of our customers and be able to service all of them well.

And at the beginning of our conversation, we spoke about how strong the margin performance has been despite weaker end demand. Are there any parts of your footprint where you're seeing demand taking higher? Any green shoots to talk about?

Look, we believe that we are starting to see inflection in personal mobility that has been really tough for kind of 2.5 years post-COVID. So we think that we'll starting to see some green shoots there, we should likely be maybe flattish in Q4 and then start seeing acceleration in 2025. Look, we believe that diversified industrial channel has bottomed out, destocking more or less work itself out. We've had the lowest decline in Q3 year-over-year. In terms of that market segment, probably in 2, 2.5 years. So we believe that we have seen kind of destocking play itself out there. And now we just kind of wait for an inflection of manufacturing PMI. And I think that you will start seeing some green shoots there in that market. Automotive replacement is in good shape. There's good pragmatic underlying demand there. And in some of the other markets that are maybe less accretive like ag and commercial construction, they're probably going to take a little bit more time to work itself out.

Well, that's all the time that we have today. Please join me in thanking, Ivo, Brooks and Rich for coming out for our conference. Thank you, gentlemen.

Thanks for having us.