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

So we are very excited to have Gates Corporation with us and Ivo Jurek, who is the CEO, and even now we're just talking, it's been many years of you coming to this conference. Thank you for that. We appreciate that.

And so maybe just to kick things off, just maybe get it out of the way. Like talk about sort of what you're seeing in Q1? I know it's only been a couple of weeks since earnings. But what's interesting about you, Ivo, is you kind of talked a little bit about green shoots in your industrial space, [indiscernible] inflected a bid. I get the question all the time of whether that's just prebuy or what's going on. And you've actually done a little bit better in Asia, too. So maybe talk about if you've seen any big changes versus your core business guidance of down 1% in Q1 to start the year.

Yes. Thanks, Andy. So let me kind of get the -- maybe the second question that you had, pre-buys. Gosh, looking at our Q4, although it wasn't bad, it wasn't terrific either. So if that was a prebuy, I don't know what world we would be living in. So I just don't believe, I don't see any prebuys anywhere. And I think that people are trying to figure out exactly what the industrial policies going to be. It isn't like you have one country that is being targeted for some unfair trade practices or what have you. So I think this is much more complex. And I think that the cool has -- will prevail and everybody is sitting on the sidelines to try to figure out exactly what the policy is going to be. Once you understand the policy, you will go in and deploy your response. And we have multiple model scenarios that we will deploy. So I don't believe that there's a prebuy, certainly not in our portfolio. Look, kind of the overall question, we just came out of the earnings. I think it's quite good, I guess, overall. We've done a good job. Our team has done a terrific job, delivering sell results. And I don't really see any underlying change to the trend yet. So when I say, we are starting to see some green shoots, look, Asia was up in Q4. And from my historical perspective, operating a number of industrial assets, I always want to see Asia recover. And it wasn't China. It was China and East Asia and India. So all of Asia was up about 3.5. So low to mid-single digits. And it was broad. So it wasn't one market or one application. So everything was up slightly. And that, to me, is quite positive. If you start listening to some of the reporting companies from our industrial universe, and I won't name any, but some that have an exposure to electronics, all of those reports were much more constructive. And in general, you want to see electronics recovering, Asia recovering. Then you went into January, you start seeing that PMI was more constructive. It was slightly under 50%. February PMI, was north of 50%. So there's starting to be a formation of trends that I certainly would consider green shoots. And while we haven't forecasted in our overall Q1, nor full year guidance and inversion in markets, I would not be surprised at some point in time this year if things trended to be more positively than what all of us are forecasting.

That's helpful. So I want to step back for a minute on Gates. You do have strong global market positioning. And you've often highlighted product innovation as a key differentiator. So maybe start with what goes into maintaining competitive edge. I think you've talked at the gaining share despite going through the pandemic, and you've got supply chain pervasions, now some macro headwinds. So maybe talk about the business model. What you've been able to -- why you've been able to maintain or gain share across key categories?

Yes, I think it's a great question. Look, first of all, let me start with the fact that everything that we do is mission-critical. We don't really have a portfolio of products that are kind of nice to have. And then something that you have the optionality or not to replace it. I mean, if your belt breaks in your automobile, you will be told to a dealer and they'll have to fix it for you. If you are operating a combine harvester or a heavy-duty earthmover and you burst the hydraulic hose, you stop and you have to replace it. So it is mission-critical. It's important for the operation of those -- of that apparatus. So we're fortunate that we have products that need replacement. Throughout the history, the company has been built on innovation. And I would say that over the last 10 years, we have dramatically sped up the introduction of new products. We have done that through cultivating, developing and improving material science capabilities. So I view Gates today as a material science industrial technology company, not just a company that's producing industrial products. We have taken our new product introduction Vitality Index. Probably, from kind of around 5% in 2015, '16, to nearly 20% today. We have a midterm target of having about 25% NPI vitality. We are well on the way to deliver that over the next couple of years. And that's just demonstrating the vitality in the power of innovation. When you do that, you tend to develop better products. Generally speaking, you get products that you have a little bit of a more competitive advantage in addition to maybe functional advantage. And I think that, that's a foundation to not only being relevant and contemporary but also to be in a position to take more market share from your competitors. And then lastly, I would say, post-pandemic, it was a very interesting time. Our company has been stressed, primarily as Russia invaded Ukraine and lots of industrial assets on highly engineered polymer process petrochemical baseline, polymer manufacturing technology were destroyed or came offline, we had to go back and relearn how do we actively engineer compounds that give us an elimination of need for reliance on those assets. And we have done that. And as we have done that, we've also learned that if we operate our assets better, we are more efficient. We focus on building the right levels of inventory, and we deliver incredible fill rates for our customers, and we really put our customers front and center and take their needs into foundational value building proposition of our company, you can start thinking about taking market share. And we have demonstrated. And most recently, we've spoken sometimes middle of the year about a major new share gain in North America in one of the most important markets that we serve, automotive replacement. We've taken -- my second largest automotive replacement partner in the country that we've just are ramping up. So -- and we feel that there is more of these type of wins out there across our portfolio.

Yes. No, that's very helpful, Ivo. And then I think the other thing that you've evolved and gotten better at is just execution flat out, like you've gotten very good at execution. You've been talking about these enterprise initiatives now for a little while. So maybe talk about -- I know you reiterated your 42% gross margin, 24.5% at the midpoint adjusted EBITDA margin targets for '26, despite much slower-than-expected growth. So can you elaborate on what's been better than expected so far with enterprise initiatives? And talk about your confidence level as you ramp up on operational excellence and footprint rationalization that you can, in fact, offset a weaker macro if growth is still slower than your targets?

Yes. Well, thank you for your kind words, Andy. But I think that our team has executed really well. Look, we've set our 42% gross margins and 24.5% midpoint EBITDA margin targets last year at the CMD. And when we were setting those targets, we said about 150 basis points of improvements will come through incremental volume fall through. Now the macro wasn't great last year. Obviously, our volume was slightly down, but we have delivered over 200 basis points of gross margin improvement in a volume down environment and that fell through kind of that 140 basis points of improvement to EBITDA. So we exited at 22.3% EBITDA margin and 40% gross margins. So we still have ways to go. But we're also now feeling really positively about where we sit. And for the 2 -- next 2 years, we have opportunities to continue to drive 80/20. We have opportunities to continue to drive material cost savings. We have opportunities to drive standard productivity even in unit volume environment. And we believe that, that's going to give us kind of 120 to 150 basis points of improvement. And then when we are done with restructuring. And we anticipate to be done by Q4 of next year [ with ] '26. We will get the incremental 100 basis points of improvement. So even if volume does not improve, we will be right on the money at the midpoint of the 24.5% and the 42% gross margins. And we believe we can do that without that volume increase.

I feel like your attitude toward that changed a little bit over the last quarter or 2, just if I'm picking up something. You sound more confident rather than -- did something happen over the last couple of quarters that allow you to gain more confidence that even if you don't grow that fast, you can still hit your target? Like has it just been good execution last couple or something else happened?

I think that our team is becoming much more comfortable in executing in difficult situation. I think we have gotten to realize that we really can rely on improvements in macro. We don't control that. We do control what happens within 4 walls of Gates Corporation. And the team is buying into the strategy. And when you execute good things happen, I think shareholders are happier. All of our stakeholders are happier. It's obviously nice for our employee base as well to like -- to look kind of all-time high in our stock price versus looking at kind of the mid-teens that you kind of churn and turn at the level of a real -- just unrewarded expectation.

Correct. Yes. Well, Citi Group has gone up finally a little bit too. Okay.

By the way, my stock goes hand-in-hand with yours. I don't know. There's some correlation there.

Yes. Okay. Anyway. And so then just taking a step back, you've highlighted secular tailwinds across your business, industrial automation, electrification mobility, infrastructure build-out. I think these trends from your perspective, what has played out as you expected? Where did investment slow? And which secular trend would you say you're most excited about as we look at '25 and beyond?

Yes. So look, I'm super excited about personal mobility. I've been on the stake for 3 or 4 years. We have had a really good run. And then in '22, we've started to see a massive destock post COVID. That spread is all out. We're now seeing reacceleration of growth. We have exited '24 with over $300 million of pipeline of opportunities that our team is working very diligently on securing. We certainly believe that we've kind of sized it as -- industrial mobility should be kind of a $300 million business for us by '27. I believe that we will deliver that. And that represents a very nice growth and very nice algorithm to add to our growth trajectory. Look, I'm actually really quite excited about what's happening with data centers. And many questions that I get about data centers is say, hey, when will you get a meaningful revenue. I do think that we will start seeing some nice flow through, sometimes in '25, latter part of '25 into '26. And we are working with the best companies in the world from the hyperscalers to folks that build black and white boxes for servers. And that's really exciting. We have developed through innovation, specifically tailored products, and I would say probably the only products that are tailored for data center use and fluid conveyance. We've launched that in November last year. We have probably the smallest, highest density -- high power density cooling pumps that are available in the marketplace today. We got great couplings. So these opportunities are pretty meaningful out there, and I'm pretty sure that while we've been all of them, I do believe that we're going to win a fair share of those opportunities as we move through '25. So to me, that's very exciting. Look, we used to speak quite frequently about changed about in industrial applications. The discrete and industrial automation slowed down over the last couple of years, and it was another very challenging environment. But we're seeing some real resurgence in interest in the technology and in lower power consumption, improve productivity and up-cycle, uptime of equipment in use. So I believe that over the next 10, 15, 20 years, that's going to be a great opportunity. That's a $7 billion market size opportunity for us. We won't take giant chunks in 12 months. But over the next 20 years, how much of that $7 billion is attainable or reachable by us? I think a pretty good chunk of revenue become out of that opportunity. So I'm pretty excited. I feel that we have positioned the company to execute well on organic initiatives that are the lowest cost of acquisition in the highest IRR opportunities that we can execute on.

It's helpful. If '27 personal mobility looks like $300 million, what does data center exposure for Gates look like in '27?

Look, I don't see any reason why that couldn't be $100 million to $200 million in incremental revenue. I mean, this -- it's real, it's tangible. I think that people are making major investments in that infrastructure. We will be there, and we will have our fair share. I mean, to us, it's about a $1.6 billion, $1.8 billion TAM. The players in that space needs to be respected companies in their field. We have a right to play, and we are probably 1 of the top 3 players that will participate.

And right now, that business is very small.

Very small. Yes. I mean we have invoiced a good amount of revenues last year. But I would say that this was almost done through haphazard where the operators would go into our industrial distributors and buy it from there like kind of general industrial products rather than specifically tailored for application product.

Okay. And so we talked about this a little bit, Ivo, at the beginning, like -- but if we go around it's by region, China has been better for you than most. So maybe we could just talk about that. Could you highlight 1 or 2 areas where Gates strategy allowed you to perform well or best maybe versus the geographic environment. China comes to mind, but you maybe -- we're just worse in China early, I don't know, like what do you think about that question?

Look, I think that China has been a very good place for us historically. And I believe that China is going to be just fine for the -- not so distant and distant future for the company. Since I came to a company in 2015, we have had -- and we have deployed a strategy of in region, for region participation. So China for us is -- China is for China. We don't really export anything from China to the United States. And we haven't since, I want to say, maybe 2017. So we have a China team that is very industrious that is building out capabilities in industrial applications. We have built a wonderful automotive replacement business in China. We are #1 market shareholder in the products that we manufacture in China. Not many companies can say that about anything that they do. I think that bodes well for us. And even last year, when people are kind of down on China that business grew for us high single digits, right? So I feel that we have a good franchise that is nicely profitable, highly accretive to the company, and a team that can execute. I'll say the other area that we have done really well is Latin America. We've done really well in North America. We have great assets positioned in the region. Again, we support the region from Brazil. We do some fulfillment from Mexico. And that business has grown very, very significantly over the last 3 to 4 years, where I believe we have the next set of opportunities actually in the United States. We have positioned the business well. We have the right innovation. We are starting to take market share from markets where we have not only a birthright to participate in, but we're actually the leader in those markets. And so I think that North America is positioned well to deliver a nice amount of growth over the next 3, 4, 5 years.

So Ivo, let's think that so, like maybe kind of -- and twine with another question I wanted to ask, which is about auto replacement, in general. I think it's underappreciated a bit for you guys. Wherever you do auto replacement, but let's just start with the U.S. because you said to me in the beginning, right? You're adding more channel partners. So like maybe talk about U.S. auto replacement. Can you add more channel partners? Like how do you -- I mean that's a big add in itself. So like -- so maybe talk about how that's going, share gains in auto replacement in the U.S. because you already have high share, if I'm not mistaken.

We do. But I think that I spoke a little bit earlier around how I think we have relearned the importance of fill rates and servicing our customers. If you do that, everybody wants to do business with Gates. It isn't that customers really need to convince customers to do business with Gates. Customers want to do business with Gates. But it's always up to Gates whether or not we will have the capability to support those customers. So when we've added that large channel partner in the U.S. in AR, I spoke with the CEOs of both of my present customers. They're both very, very important, super important partners that we have done business over 75 years, right? So longevity was key. And the one thing that they told me is, hey, don't screw it up, right? And what they meant by that is to ensure that you can execute because adding thing only to have breakage somewhere else does not really work. And so our fill rates today, while we have added a very substantial accounts to our customer registry has been -- it's been executed in a flawless fashion. All 3 of these super large accounts, we service them -- in total service levels within 72 hours of order drop, we service those accounts in 97%, 98% fill rate. That's really hard to do when you are -- you're doing that with no forecast, no visibility to what their demand is going to be, and having the large rapid turnover of volume. So I think that, that's been critical for us to do that. So do I think that there is more of these share gains? Actually, I do. But before we embrace on that, let's make sure that we maximize the opportunity with the 3 accounts that we have these 3 large out of 4 in the U.S., and we deliver further growth through innovation, portfolio coverage and the fill rate.

Very helpful. I turn it over to the audience in a second in case the audience has any questions. But let me ask you about the opposite side of that, which is auto OEM. I guess the business has sort of stabilized for you guys, but you "still deemphasizing" in a bit, you tell them. But how do you sort of grow from here when builds still look pretty lethargic, if not down? Can you use MPI to outperform builds? Like how do you think about penetration to like you and I talked about EV penetration being higher than [ ICE ], but now maybe it's better to be the opposite way around. You tell me.

Look, my view have -- and you and I have known China now for a while. In my view has always been -- look, you've got to be pragmatic because when people are talking that everybody is going to be driving an EV tomorrow, we understood that's impossible. It's simply impossible because of the infrastructure, and there were no assets in place to support it and so forth. But look, there will be a need for all of these technologies. Is electric vehicle, the ultimate technology? I don't think so. I mean I think that there's going to be a next generation, whether it's hydrogen or whether it's a technology that is similar to that, my view is that EV is just kind of an intermediate stop gap that's less than optimum to be honest with you because carbon footprint that you generate in an electric vehicle of a life in great, it just isn't. So there will be different solutions. And we're going to be technology agnostic. We will participate as long as we can make the returns that we have committed to our shareholders, and we expect for the products, the innovation and the services that we generate. So if we can make those returns, doing business with the car companies, we will. But if we can, we've got plenty of opportunities elsewhere. And look, our focus is not just to stop a 24.5% EBITDA margin. To me, that's an intermediate stop. I got to get there before I said the next target. So let's just get there and let's continue to evolve the portfolio and the mix so that we give ourselves the opportunity continue the journey towards better returns.

Do you think auto OE stays at the kind of 10% portion of the business? Or does it keep going down over time?

I don't know that it's going to stay at 9% or it's going to be 7%. What I know is it's immaterial to me. And I don't really lose a sleep or I don't lose focus from some of the other more secular opportunities where we are placing lots of investment. We are building organizational capability and the front end and the back end to be able to capitalize on those opportunities because, a, they are more interesting, they are more durable and they're going to be with us for the next 100 years.

Yes, that makes sense. Any questions from the audience? Anybody want to ask a question? Okay. So let me ask you about, you mentioned discrete automation in markets like that. It's part of your diversified industrial business. So I think you have diversified industrial below single digits in '25. Maybe elaborate on what the customers are telling you now because that business has been tough for the last couple of years, but like maybe a little bit better this year. And separately, you talked at your Investor Day about mid-single-digit midterm growth of the market. Do you think this market can be one of your higher growth markets moving forward?

I think it can. Look, Gates is not a unique company in dealing with some dislocation of the market. Again, let's remind us, so it's 28 months of negative PMI, unprecedented since what the 40s, early 50s, 1952. So the economy doesn't feel that way, but the manufacturing economy was per dislocated, right? So whether or not it's Honeywell Intelligrated, Cognex Rockwell Automation, all very fine companies, right, all dealing with a significant dislocation. My sense is that's bottoming out. And when business stabilizes, those are very good business opportunities that we participate in -- along the side the Rockwells and the Intelligrated. So I'm pretty excited about seeing some of the bottoming out. And again, I don't know that it will be accelerate in Q2 or Q3 but I'm certainly feeling much more optimistic that we are bottoming out or maybe we have already reached the bottom than that we are still going down. So I think more positive than negative in my mind. And as the green shoot turn a better signs of green, I think that will be pretty well positioned to capitalize on what comes our way.

That's helpful. And so I want to double-click on personal mobility again because you seem pretty excited about it. I think it turned positive again for the first time after 7 quarters, but it was up 20% at a pretty big [ inflection ], of course, off a lower base. . You talked about inventory levels having normalized. You gave sort of that potential for $300 million in '27. So it seems like you're pretty confident this can go back to a 20% growth business over time. But sort of what is Gates doing to make sure you get there? Like is it NPI that it's going? And what are the trends that you see because 20% is a big number, so like how can you get there?

Look, I think we've guided for the year, up 20% as well. So we feel that recovery should continue. What are we doing? Well, look, we are adding our front-end capability. We are broadening our customer base. We have doubled down on innovation and we have broadened our participation, not just across the super premium products, but we are now offering solutions for mid-level applications, so kind of mid-level bikes and scooters. And that's got a ton of new opportunity. One of the biggest categories in bike categories is a mountain bike. I think that's probably not too surprising. And we've never really had a solution for that. We have a solution. We have a number of customers that we have signed up that we'll start production of their bikes in '26. So I think that we have a degree of visibility that this thing can get back a full level of juice that it had before '22. And our portfolio is broadening, our customer base is broadening and our team is executing well. They are quite excited about the opportunities they have ahead of themselves. So I think that we'll get very close.

So I want to talk -- I want to pivot and talk about margin. We already talked about some of your improvements. You mentioned that materials really have been a big reason why you've been able to get gross margin up. Has there been anything specific that went into that you've been focused on strategic sourcing or value add and value manufacturing innovation. Like what has been so successful in that?

Look, again, I think that -- I don't want to overuse the term taking lemons and making late. But when that '22 and that got hit with the polymer shortages, we had to very quickly pivot into reengineering our polymers and do it fast. . We had to reengineer our processes so that most of our stuff is certified and by customers or by third-party agencies because we make mission-critical products. So we had to develop processes that streamline innovation that levered our material science capabilities, start redesigning polymers to maybe lower common denominator commodities that we could then mix in our mixing capabilities into new polymers and then qualify those products with customers and with third-party agencies. . I think we have done a terrific job. And when we have done that, we've actually realized that what we have accomplished, was not only to support our customer base with the products that we're already buying, but we've actually design cost out in that process simplification. And so then we look to each other and say, "Hey, look, why can't we do it across all of our raw materials. So we've developed a 3 years plan. We were executing on that plan. And we feel that what we learn in '24 was terrific, and we feel that we still have a couple more years of being able to execute as much as what we have done in '24.

Got it. And then I also want to look at 80/20 again. Maybe an update on where you are in terms of the rollout? How many regions do you start implementing 80/20? And how are you thinking about the progress you can deliver in '25?

Yes. So I would say that the best progress we have attained today is in North America. I mean North America is fully on board with front-end 80/20. So across all the businesses that we do. And our teams are optimizing, they are streamling our portfolio, we are optimizing our pricing structure. It's becoming a way of life our folks. We have done a number of work streams on the back end, so in the factories. And what we're starting to realize is that the benefit in the back end may be actually bigger than on the front end, but it takes a lot of effort, and it takes kind of retraining how you run your factories, and the fulfillment model that you have. So we have about 4 work streams in North America. And as we complete those work streams, we will start putting it across specific facilities where we can get rather significant, I think, rather significant benefits. In Europe, we are well underway in the front-end process. We have done the industrial replacement as well as the automotive replacement side of that business. We still have a ways to go on the OE side, and we have yet to void in the factories and the factories will start couple of specific work streams, I would say, maybe midyear in Europe. So we're making a good measured progress. But I would, Andy, that's going to be a 10-year journey. This isn't a journey that ends in 2026 or 2027, this is a way of life. I try to 80/20 my personal life, it works, it's great. It's the -- you get a huge benefit when you focused on much for a number of things that are impactful. And that's really what 80/20 is.

Sure. And then maybe let's take that over to cash flow, right? Like -- so I think you exited '24 still higher than your working capital as a percent of revenue target. So like where can you tackle working capital as a percent of sales? And what's the opportunity?

Look, I mean, we recognize that we have high ratios of working capital. But what we have done is we have reconfigured what we put into our inventories, right? Look, while we have not accounted for potential upturn in 2025. We believe that we are a lot closer to it. And we've learned from the last couple of up cycles and what we see early in the recovery. And so we wanted to make sure that we have the right mix of products in our warehouse so that not only we can maintain the high levels of service and the initial upturn occurs, but that's also our opportunity to purely organically take more market share away because your competitors in general, are not as well positioned as you could be. And we feel that we have at an expense of carrying a little higher level of inventories we believe that we've positioned the business to take advantage of the up cycle that only that happens this year or in Q2 or Q3, whatever, we will be ready for that uptick to occur. But that being said, look, we believe that we probably have a couple of hundred, maybe 300 basis points of opportunity to take working capital at a more meaningful level that will translate into meaningful improvement in our cash flows as well, obviously.

So you have a midterm net leverage target of 1 to 2x, you're currently just above that 2.2%, right? You mentioned on your earnings call that you had the ability to reduce leverage, 0.5% a year based on cash generation. . But stepping back, your balance sheet is in good shape, right? So the question is, what do you do with it? Obviously, you've remained committed to organic investments. We've talked a lot about that, share repurchases, dividends. You've got -- you do have a strong ROIC now. So curious how M&A could help if it all accelerate the growth over time? How do you think about it right now?

Look, M&A is going to play an important role at some point in time for Gates Corporation. I think that we have earned the right. We have cleaned up the balance sheet. We've made the business more profitable, more stable, I think, more desirable for shareholders and for customers to do business with and so on and so forth. But one of the things that we are only starting to see now is that the stock is starting to re-rate slightly, right? We're still trading at about 9x EV-to-EBITDA multiple, while we are delivering premium financial metrics. And if you take a look kind of the average EV-to-EBITDA multiple of the companies in the universe that we compare ourselves to, those companies having the same lot of average financial performance as we do, they're trading at 5 or 6 terms higher than we are, right? And I don't think that there's any reason for that dislocation. So I believe that before we start doing any meaningful M&A, we need to see the stock we rate. When it starts rating. And again, I'm not talking that we need to be trading at 16x, right? But the stock should start rebating at 11, 12 times and then you can start having more meaningful conversation about M&A. Meanwhile, we'll continue to buy back stock. We'll continue to pay down debt and continue to make organic investments in the highest IRR projects that probably you can do. And that will also kind of ensure that I'm going to be here with you next year other than do and ill faded M&A and then potentially not...

You've been a main stay, we don't want to lose you. So just be careful buddy. So last question, I've asked this question to you before, and of every company here this year. What are the top 2 or 3 innovations and the structural changes affecting your company over the next 5 years? And are there any emerging industry trends that are perhaps being overlooked the current discourse?

Yes. Look, I mean, I think AI is going to play a good role well into the future. I'm sure that that's not a surprising answer. And then look, I think that there's going to be innovation that is driven by a substantial amount of technological change in an industrial complex. The industrial complex is going to continue to automate. It will continue to drive productivity. And with all of those movements come opportunities for industrial technology companies be part of the solution. And sometimes, we don't really see clearly around the corner. But as you approach the corner, you start realizing how these opportunities can come and become large and meaningful. And I would put for Gates Corporation, I'll put data center opportunities there. Like, I mean, we've developed the industrial electric pump from our work on electric vehicles. We've developed a really cool pump and a cool IT, a nice data center infrastructure participant, looked at it and said, "Hey, this is really cool. We could use this. And we have adapted the technology and has worked into a very unique opportunity for operation to participate in a tremendous secular growth opportunity into the future. So I think that those are things that we need to stay front and center, grounded, stay focused and execute, execute, execute.

Well, on that note, Ivo, thank you very much. Appreciate your time.

Thank you. .