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

Thanks everyone for being here. It's my pleasure to have up next, the CEO of Gates Industrial Corporation, Ivo Jurek. Ivo, thanks very much for being here.

Maybe start off with kind of broad thoughts on the demand environment. It's been very uneven. You also have a very global presence, so a good perspective on different geographies and what's going on. And yes, maybe just lead off there, please.

Yes. Thank you. Thank you for hosting us today. So look, when I reflect on our Q4, it was, as you said, uneven demand environment. But we're starting to actually maybe think if you would about green shoots. We have seen core growth in -- across Asia. So in China as well as in East Asia and India. Both of those grew about 3.5%, 3.6% on a core basis. And what was quite interesting to me was that it wasn't driven by any specific set of applications or application or end market. It was reasonably broad-based. So almost everything was inflecting positively. So I think that, that's really a first more positive data point that we have seen. When I look at the demand across the company, surely the comps were easier. But Q4 was less bad everywhere than what we have seen on aggregate for the full year. So I think that there's probably possibly another positive sign that things may be improving. And then if you start extrapolating into some other peripheral potential green shoots, you start seeing that folks that are involved with electronics are starting to talk much more positively about those markets improving. So I think that you almost need to see a validation in electronics. You need to see validation in Asia before you start forming a firm foundation in places like the U.S. I'd say that if you look at the PMIs, you have seen 29 months of negative PMIs all the way through January of 2025. That's unprecedented. You got to go back to kind of late '40s where we started to collect information on PMI to see that this was the worst period of time in that period of time. February, we started to see positive inflection. While February was actually north of 50, I think it was 50.9. You already start seeing to see improvement in January as well. January was nearly 50. So we need maybe a couple more months of inflecting performance in PMIs and I think that we can start talking about nascent recovery in industrial end markets. Now I'm much more positive about '25 than I was in '24 when we were sitting in this conference, but that being said, we certainly did not -- we did not forecast an inflection in our guidance for 2025.

And when you look at the various sort of industries or channels, OEM versus distribution, are there any that you'd call out as you mentioned electronics but any others where we'd say, distributors in x industry vertical, their inventory levels are super low. Anything like that you'd call out where you're watching for who's had the most prolonged or deepest downturn where you feel, okay, this is the one closest to a bottom or a trough.

Yes. Look, I mean, I think that the diversified industrial or call it discreet [Audio Gap] see that inventories have drawn down quite a bit in those end markets. I think that you're starting to see some positive green shoots there as well. You listen to Rockwell Automation, what they had to say in most recent earnings call. You talk about Cognex, that's in industrial automation. I think that you're starting to see bottoming out in logistics and warehousing equipment that has been in a super prolonged compression of demand. So I think that those are things that should be much closer to inflection than not. Look, we have a good exposure to ag. Ag has been in 7 quarters of significantly decelerating demand environment. All the ag manufacturers have been not only reducing their builds for 7 quarters in a row, but they have been taking significant amount of channel inventory from their dealer lots. So I don't think that I'm prepared to call that ag has bottomed, but my sense is that ag is going to be significantly less bad in '25 than it was in '24, and you could start coming closer to maybe balance in the second half of the year. So I think everything is getting less bad as we enter 2025. The question is, when will it invert and is it going to invert in first half of the year or second half of the year or the beginning of 2026, that's still, I think, to be determined. But we will define either way, I think that we have taken into account, again, in our guidance, we have taken into account that we don't need to see the volume behaving positively to be able to continue to execute on our journey of margin expansion.

Yes. And on the top line, you have a slightly -- you got some growth dialed in for the back half year-on-year. Is that just a function of sort of seasonality and comps and that kind of thing? It's not really about the end market getting better.

Yes. I would say it's predominantly comps in more than anything else. Second half of '24 was very, very weak. And we anticipate that while, again, we are not forecasting any inflection in demand. The comp is just so easy to deliver very slight growth over the prior year.

And the EMEA region, you didn't touch on yet sort of that was down, I think, 6% plus for you last year as a whole organically. What's kind of your perspective for the year ahead? And if you were to look ahead x months and think about some geopolitical changes there, what should we expect on the industrial side, if anything, to change?

Yes, look, my sense is that Europe will take some time to get out of its doldrums. I think that there's no real -- there's no real driver or inflection point that you can look at and say that's going to pull it forward. Historically, Europe relied a lot on China economic activity for demand of its goods. I think that may be somewhat dislocated. I think that the Chinese companies and the Chinese manufacturers have a significantly lower level of reliance on imports of German tools and machine sets. So my sense is that even if China starts recovering more rapidly or more consistently, I don't think that that's necessarily going to pull the German economy out of the present situation. So my sense is that if there is a positive catalyst for Europe, my sense would be that could be potential end to the conflict in Ukraine and the rebuilding of Ukraine could become the catalyst for Europe to reaccelerate its growth. But as we all know, that's probably still sometime into the future, it's not necessarily something that we can account for today in the next quarter or 2.

Away from sort of cycle dynamics, I think auto replacement, data center, mobility were some of the more secular drivers you've talked about on recent calls. Maybe help us understand where Gates is across sort of each of those 3 and the kind of scale it has across those?

Yes, it's a great question, and it's a question that points out kind of into how we have positioned this company. We are seeing positive behavior in existing legacy type portfolio end markets and applications. So like automotive replacement, that business has done really well for us over the last couple of years. The business is going to continue to do well in 2025. The market dynamics are very positive. Used car prices are really not coming down. They actually staying stubbornly high even while new car prices are moving lower. There is just not enough inventory out there. Those cars are lasting longer. So the aged car fleet continues to grow and continues to age, and that's a very positive catalyst for our auto replacement business. We have also taken more market share last year. We have signed up a large channel partner where we are starting to fully ramp up the support of their demand. That account alone represents about 100 to 150 basis points of growth on our entire franchise globally. So it is meaningful, it is chunky, it's meaty, and we are very excited about that, and that will continue the trajectory of delivering growth in AR. We've talked on Q4 call that our personal mobility business finally after 7 quarters of destocking, has inverted. We have delivered 20% core growth in Q4, and we certainly anticipate a similar growth rate in 2024 for that set of applications for us. So we are very optimistic. We exited the year with about $300 million of design wins under our belt on personal mobility. So that business is quite well positioned to deliver on our long-term target of about $300 million of revenue generation out of personal mobility by 2027, and we feel that we are well positioned to do that. And then ultimately, in data centers, very exciting space, while it's been developing kind of in a very measured way, we have developed a number of new products for this application, specifically tailored to deal with the requirements of either immersion cooling or the dielectric liquid-based cooling from direct to chip all the way through some of the large-scale infrastructure cooling. We are working on a significant number of projects. We talked about that on our Q4 calls, which has most recently gotten specified on one of the largest server -- United States server makers. I think we've got that actually this week. So we're very excited about that. We're negotiating with hyperscale operator to provide them with portfolio of our products in support of a data center that they're planning to build out. So the opportunities are reasonably broad. We scoped that market of about $1.5 billion. And we believe that we will have a good presence in that market. And if we generate $100 million to $200 million of revenue over the next 2 to 3 years, that's actually pretty chunky for us, and it's actually meaningful for our company in terms of revenue contribution to our incremental growth rate. So quite an exciting opportunity. And for us, it's really exciting because we are also demonstrating that as we have developed an electric water pump for applications. That has proven to be very compact, high efficiency, high throughput of cooling that's being delivered in the smallest footprint. We've developed a relationship with CoolIT. They became very excited about that pump. And ultimately, we've developed that pump into the application that they used in data centers. And now we are scaling the technology up into other applications for use with other manufacturers from servers to rack manufacturers to the infrastructure manufacturers in various different sizes. So I think a very exciting opportunity that has been developed organically.

[Audio Gap] strategic effort, kind of where are we on something like auto OE where maybe it's more around pruning to get margins up. How do you feel sort of strategically about the position you want in, let's say, off-highway given the cyclicality?

Yes. Great question. So look, if I kind of reflect where we sat around the IPO time with our automotive OEM business, automotive OEM business represented about 15-some-odd percent of total revenues in 2018. So we've removed a rather substantial chunk of our revenue, and we didn't shrink the company. Our company is still somewhat bigger than it was before we start pruning that revenue out of our portfolio. My sense is that that's not going to go up, and it probably is going to continue to shrink in terms of the contribution to the overall company's revenue generation, not necessarily by significantly shrinking the dollars, but more by growing other segments of our business more rapidly and that by default, is going to make that revenue contribution smaller in the future. Our on-highway and off-highway presence is still reasonably sizable. But our focus today is on building demand creation with M OEMs. It's focused on personal mobility, penetration of data centers and penetration of other stationary type applications in the industrial space. And we believe that, that mix not only give us the opportunity to, a, generate a more profitable revenue stream, more durable revenue stream, we also believe that it will give us an opportunity to reduce the level of cyclicality that we have historically seen with our portfolio. And I think that we have, frankly, limitless opportunities to do that. Whether or not it is in some of these applications that we have already discussed or applications like industrial chain-to-belt that we've built over the last 4, 5 years, we've got a very nice base of revenue. Now it's time for us to go in and deploy similar demand creation methodology that we are using for mobility and go and start penetrating the M OEM space. And I think that we can do that over the next 3 to 4 to 5 years. It's about a $7 billion market TAM that we should focus on converting over the next 10, 20, 30 years. Again, we will not convert everything in the $7 billion TAM. However, we believe that we ought to own pretty significant meaty chunk of that $7 billion. And so I think the opportunity is there and it's kind of limitless for our company. And we are very excited about what we have in front of us from an organic perspective.

And then switching to profitability. You have this goal to get gross margins up 200 points or so into 2026. Sort of what's the confidence in that? And then you have the material cost and conversion cost levers, kind of where do we stand on both of those?

Well, let me start with what we have committed to our shareholders during last year's CMD. So during last year's CMD, we said, look, our target for exiting '26 is to deliver 42% gross margin and deliver 24.5% EBITDA margins. We said we're going to need about 150 basis points of that improvement is going to come from growth of volume. So we said about 3% to 5% company growth over 2 to 3 years period of time is going to give us 150 basis points of margin improvement. The rest is going to come through productivity initiatives, 80/20 productivity, material cost reduction and footprint optimization. Well, lo and behold, we didn't see any volume inflection. Actually, the reality is that we have seen a mid-single-digit volume declines. But we've delivered 200 basis points of gross margin improvement and 140 basis points of EBITDA margin improvement despite the negative headwinds from volume. So we've exited the year about 40% gross margins and 22.3% EBITDA margins. So we got 200 basis points to go on gross margins, 100 basis points out of that remaining 200 basis points will be realized when we complete our footprint optimization project. So we exit '26 with that incremental 100 basis points run rate. The other 100 basis points of gross margin improvement plus they are going to continue to come from raw material savings, they're going to come through 80/20 initiatives and pricing optimization as well as 80/20 driven productivity improvements in our factories regardless of what happens in -- to us with volume. So we believe that we can deliver the 24% growth -- I mean, the 24% EBITDA margins and 42% gross margins even if we don't see a rebound in volumes. If we see rebound in volumes, we'll get there a lot faster because as we have indicated, we believe that we can deliver 50% to 55% incremental leverage on incremental unit volume of revenue improvements over present run rate. So we feel that we are in a very good position to be able to deliver it by end of '26 regardless of volume or earlier should the volume inflect.

And you still think that you have that outsized operating leverage early in the upturn and then it sort of matures after that?

We believe that, that leverage of 50% to 55% is going to be with us for 12 to 18 months from the beginning of the recovery.

And as you work through the footprint and the material cost, the conversion costs and you've seen the top line sort of behave as it does, does that make you kind of extend the programs or you'll see where you get to in '26, see what the top line is like then and then decide if more has to be done?

Look, I think as we are embedding 80/20 more fundamentally across our enterprise, I think we are always identifying more opportunities of what we can do, but we're also being pragmatic. We want to make sure that we don't make the mistake of doing [Audio Gap] I think that we've put a good program in place. We have strong projects that are being deployed and executed on. And when we get to 26%, I think we'll have more exciting opportunities to talk to our shareholders about because we don't view the 24.5% EBITDA margins as kind of the final destination. So we kind of view that as an intermediate destination for our company.

And then on pricing, maybe help us understand kind of where you stand in terms of that contribution to sales now? And what's the confidence it can just be kind of -- if you see higher costs from various types of tariff, do you think you and all your industry peers are going to quickly follow suit and pass those on?

Yes. So 2 sides of the question. So let me kind of get the baseline question, price material economics. So we have historically -- the company has historically been able to pass on kind of economics through price. So we have embedded about 100 basis points of price in our 2025 guidance. So that kind of gets you on volume flat-ish, right, for the year, net of price. And we believe that, again, we will deliver a decent improvement in operating margins and in gross margins even with that flat volume being in place. The second part of the question, what would you do if there are some substantial tariffs? Let me kind of take a different way to tackle that answer. First of all, Gates still has a rather substantial footprint of manufacturing in the United States. We certainly don't have near enough capacity in the U.S. to support all of our demand should something very disruptive occur vis-a-vis tariffs. But we're in by far better position than a significant amount of our competitors that don't have that footprint. There may be one more competitor that has another decent amount of footprint in terms of one of the product lines, Parker. But the rest of our competitors are either importing from China, India, Malaysia or Europe. If tariffs are applied, there is kind of the other side of that coin as well that could represent good opportunity for Gates Corporation to take more market share. Secondarily, we don't have a ton of exposure to imports from China to the U.S. simply a de minimis amount, about $20 million that we import from China on a $3.5 billion base. And we have very little exposure to imports from Canada to the U.S. We do have a reasonably good substantial amount of imports that come from Mexico. Mexico is a good secondary operating base for Gates Corporation for North America. And should tariffs come to play a role on Mexico imports, we would price for those.

Got it. And then on the sort of cash usage side of things. Since the IPO, really, it's been around sort of debt reduction and then some share buyback and the valuation obviously lends itself to a high ROIC from buybacks. But when do we think Gates could get more expansive on acquisitions? And when it does, would it look to move into adjacent areas or bulk up in markets that are maybe more recurring?

Julian, when my stock re-rates. My stock trades 12, 13x EBIT to EBITDA, and we are all in on going and going full gear on M&A. All kidding aside, look, we have done a good job on cash conversion. We generate a ton of free cash flow just between 2017 and 2023, 7-year period of time. On average, we have converted at 97% free cash flow conversion against net income. So we are generating good free cash flow conversion through a very extended period of time. We will deploy cash to pay down more debt and buy more stock. Until such time that we feel that our valuation is in line with making it super dilutive to go out and do M&A. There's lots of good targets out there that are at or very near adjacency to us that I believe would be highly accretive to our corporation. But I frankly don't need to be paying premium to somebody else's shareholders so that I have the privilege to restructure their company and drive synergies so that I can hold serve. So I think that it's really important to re-rate the stock. I think the stock is rerating. It wants to re-rate. I think people are starting to recognize that we are a super high-quality industrial company with durable demand, with durable earnings and durable cash flows. We trade significantly are lower than some of the peers that are much higher multiple companies that have the same financial profile. So I believe that once that rectifies itself, there will be a significant opportunity to go out and do M&A. And moreover, I think that we are demonstrating that we are reasonably [Audio Gap] I think that we needed to also prove that to the investment community that we can operate our assets before we go out there and start adding some other assets to our portfolio.

When you think about, yes, the quality aspect we can see in the operating margin, for example, when you get to that 2026 targets, do you see any natural ceiling or no? The operating margins can move up. When we look at what some of the peers are doing in the U.S. industrial landscape, high 20s is very plausible.

Absolutely. I think that we have a very durable portfolio. We manufacture mission-critical components that have a natural replacement cycle. They're highly engineered. I don't see any reason why we could not continue to drive further efficiency of operating assets to reward our shareholders with higher level of profitability. I think that that's very natural, and we ought to be able to do that.

Perfect. Well, that will switch to the audience response survey. So I think the first question is around sort of current ownership of Gates, so a lot of no still. The second question is around sort of general bias to the name right now, slightly positive. Third question it's around kind of through-cycle earnings growth for Gates versus the multi-industry average, so kind of 60-odd percent in line. Fourth question is around uses of excess cash, so very kind of even spread. Fifth is around valuation, I think, and kind of what PE should Gates trade at, so generally a slight discount to the market multiple. And then the last question is kind of why does it deserve that discounted valuation? So generally kind of core growth, the biggest concern. Great. Well, thanks so much, Ivo.

Thank you.

Appreciate it.

Thank you very much.