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

So hi, everybody, Mike Halloran here. We got Ivo and Rich, who are going to help tell the Gates story today. Ivo Jurek, the CEO, is going to tell -- give some quick intro comments, talk about a few things that he's very excited about for the organization. Then Ivo and Rich and I are going to have a fireside chat run through whatever questions you all might have. So if you have questions, let me know, Either e-mail me or raise your hand, and we'll make sure to incorporate it. But Ivo, thanks for coming. Appreciate it.

Well, thank you, Mike. Thank you for having me here today, and I'm quite pleased that then I can provide you with an update on progress that the Gates global team has made on some of the terrific opportunities available to us that we anticipate shall create a long-term value creation for our shareholders. Before we get started, let me make sure I get my skills coordinated in here. So before we get started, let me remind everyone that some of our remarks include forward-looking statements within the meaning of the Private Securities Litigation Reform Act that are covered by our safe harbor disclaimers. So with that out of the way, let me move to Page 3 of our presentation. And here is a brief overview of our business. For the full year 2024 kind of to set the foundation, we've generated about $3.4 billion in global revenues. We are an industrial leader in Power Transmission and Fluid Power applications. We are well diversified geographically and across end markets with over 2/3 of our revenue coming from replacement of reoccurring markets and applications. Historically, we have grown more than 2x industrial production and have multiple attractive secular growth opportunities available to us to add to our growth algorithm. Our business possesses solid levels of profitability with an adjusted EBITDA margin well above 22%. We pride ourselves on driving strong returns on capital with ROIC above -- solidly above 20%, while we continue to strengthen our balance sheet towards our midterm target of 1.5x net leverage. 2024 represented another year where we've delivered exceptional results in a very difficult macro environment. On Page 4, here's a brief overview of our Q3 results we've released a couple of weeks ago. We grew revenues 3%, including approximately 2% on core. We realized 90 basis points of year-over-year increase in adjusted EBITDA margin and generated seasonal record in adjusted EBITDA dollars and margins. We've delivered strong year-over-year growth in adjusted EPS, and we have been driving very solid operating performance in a subdued end market demand. It was another quarter of solid execution by our Global Gates teams. Moving to Slide 5. Over the last few years, we have been focused on designing activities in secular markets that are additive to our leadership position in our traditional markets. We anticipate that the focused execution in the secular growth drivers position us well to deliver above-market growth as we enter 2026. We believe that our traditional industrial markets are troughing as we exit 2025, and we expect them to improve next year. In our secular growth opportunities, we anticipate significant market outgrowth. Our Personal Mobility business is generating over 20% this year, 20% growth this year, and we expect the growth to accelerate and ramp up to approximately 30% compound annually through 2028. We have nascent data center business that is positioned well to support anticipated strong adoption of liquid cooling technologies used in advanced AI-centric data centers. While this business is relatively new, it is ramping up nicely. We continue to advance our industrial chain-to-belt initiative with strong emphasis on converting machine OEMs to use belts to help power their applications more effectively, more quietly and generate lower overall carbon footprint to the life of the application. So collectively, we believe these initiatives can add approximately 200 basis points of outgrowth over and above traditional and market participation. On Slide 6, we dig a little bit deeper on our opportunity in Personal Mobility. Over the last several years, our commercial and engineering teams have built a solid pipeline of opportunities to convert traditional chain drives into Gates' belt drives in 2 wheel devices. One of the fastest-growing segments in the 2-wheeler market are e-bikes, which are anticipated to grow at double-digit clip and in developed markets through the end of the decade. e-bikes as well as e-scooters and other electrified 2-wheeler applications are scaling up well. We are anticipating to participate significantly as we expect a greater share of this market to adapt the belt drives, which deliver improved efficiency and compelling performance relative to alternative systems. Additionally, we continue to broaden our product portfolio, higher volume applications. We anticipate our revenue base to more than double over the next 3 years and expect the business to be a meaningful contributor to our top line growth rate. As you can see, the total addressable market here is significant and we have a strong opportunity to continue to expand our market share through 2028 and well beyond. On next page, I'll outline a bit more opportunity in the emerging liquid cooling application in the AI-powered data center market. As you know, these new chip stacks generate rather significant amount of heat by powering AI-centric computing needs. We see the liquid cooling solutions are expanding significantly. And while we are in the very early stages of application growth, we anticipate it become highly prevalent moving into the near-term future. We have an expanding product offering that supports the cooling needs across the entire data center architecture from facilitating waterflow as the water enters the building to efficiently conveying fluid to cool server racks and other infrastructure in the white space. We estimate that our content per megawatt is approximately $100,000 plus. We are working across a broad spectrum of customers, from hyperscalers, server manufacturers to EPCs and other customers across this rapidly growing application set. We have been investing in the front end of the business by building designated application and commercial teams as well as the back end of the infrastructure to support the volume requirements as our customers scale up. We have an emerging revenue opportunity with pipeline that currently exceeds over $150 million and is growing nicely. We are excited about the revenue potential for this business and anticipate achieving revenue in the range of $100 million to $200 million by 2028, which would be very nicely accretive to our revenue base. On Page 8, we wanted to discuss our progress with the various margin initiatives. On the left side of the slide, we would like to remind you as to what we expected would happen back in 2024. At that time, a substantial amount of our expected margin improvement was related to self-help initiatives. However, we did assume 100 to 100 basis points of margin expansion would be contributed from operating leverage associated with an estimated 3% to 5% core growth compound annually to 2026. On the right-hand side of the slide, we show our progress and where we stand presently. We expect to end 2025 with approximately 22.5% adjusted EBITDA margin at the midpoint of our full year guide. Since the end of 2023, we have absorbed the negative impact of lower industrial volumes as seen on this chart, and still expanded our adjusted EBITDA margin 160 basis points through self-help initiatives, such as material cost reductions and our 80/20 initiative. We recently announced the restart of our footprint optimization program and expect savings from that initiative as well as continued incremental savings from material reduction projects to deliver additional approximately 150 basis points of structural margin improvement next year and into 2027. This would position us well to achieve our anticipated adjusted EBITDA margin target as market demand begins to inflect positively, volume growth would be additive to our anticipated margin goals and lead our adjusted EBITDA margins above the 24.5% target, all else equal. What we see is the potential for outstanding execution that should position Gates amongst the premium peer set we comp ourselves against. So on Slide 9, we've taken a first view of how we view the performance of the end markets where we participate, but staying away from providing you with 2026 guidance. We are quite cautiously optimistic that the industrial economy is going to turn in 2026. We anticipate our major end markets are going to experience flat to improving demand next year. We believe improving market trends, coupled with contribution from our secular growth initiatives should drive positive core growth for our business in 2026. Lastly, I'll -- before I turn it over to Mike for Q&A. I want to summarize our thoughts. First, we delivered solid Q3 results with core revenue growth, attractive margin expansion, strong EPS growth year-over-year and nicely improving balance sheet metrics. Second, we have secular growth drivers in place that we expect to contribute to outsized growth on a go-forward basis. And lastly, we believe we are a high-quality asset with further opportunity to enhance our structural margins. We anticipate our market to begin to recovery in '26 and our balance sheet is well positioned to help us drive shareholder value into the future. Thank you. And with that, I'll turn it over to Mike for a Q&A.

Great. I want to bring the clicker too because I think some of the questions might refer back to the slides. But why don't we start on just this slide right here, which goes in conjunction with the next one. I think a lot of the inbound questions after the call were about the margins and what you were thinking for growth next year. And I think there was probably a little bit of a misconception here. The way we interpret it, and I'd love your response to this is you just essentially increased the volume-neutral margin target that you have organizationally without making a comment on whether there was growth next year. But internally, I think you do think there's volume growth, you're just not sure how much, right? Is that a fair thought process?

Yes, Mike, I think it's a great question, and I think it's super fair to represent it other way. I would probably go maybe one step further and state that we certainly anticipate growth next year. What we've tried to get across to our shareholder base and to the sell-side community is that, look, as you are building your models, as we have these moving pieces around the structural improvements that we are driving to our business, here are the puts and here are the takes to the cost and to the benefits. And moreover, I think ineffectively perhaps we wanted to get across that we are going to get to our anticipated targets from our Capital Market Day in '24, actually without the help of margins. So if you think about that...

Without that volume.

Sorry, without the volume contribution. So if you think about that, as the volume in flex, and we do anticipate growth in '26, we anticipate that, that will be accretive to our 24.5% margins kind of rolled over into 2024. So ultimately, I think we are kind of updating the structural profitability of our business. And we feel actually quite good about what we have done with the business with having to deal with number of complexities in the operating environment.

And where do you think you are in the footprint optimization and material savings in terms of the execution and laying out the plan and then getting the internal buy-in.

Yes. Look, we have been on a journey of material cost reductions for the last couple of years. And that has served us quite well, that has been a big driver of our margin expansion. 80/20 has been a big driver of our margin expansion. And we anticipate that there are still solid opportunities to continue the journey. And again, we anticipate that in '26, there's going to be yet another leg up in material cost reductions. We believe that we are in early stages of 80/20. So we should have many, many years forward going to drive 80/20 forward. In the footprint optimization, this is going to be a phase that helps us to complete what we have discussed with our shareholders, I want to say kind of a year ago. So that will come -- this will complete that phase, and we always have more to do. There is not a lack of projects. So we certainly fundamentally believe that we will have an opportunity to continue to drive efficiency of our footprint to continue to drive improvements in how we service our customers, better proximity to our customers and offer them products that are easier for them to use, purchase and distribute.

And you referenced early stages of 80/20, which implies some mobility potential relative to what's laid out on this chart. Maybe talk about where you are in that adoption curve as well as how you look at what the fundamental output or goal or vision of success looks like.

Yes. Look, when we started this process, I think that everybody was starting with me on kind of the front end, the cascading optimization of the product portfolio, looking at rebalancing our pricing structures. And I would say that, that has been done quite well across our footprint, well adapted, well understood by our teams and really implemented without much of much of an impediment, if you would. I'd say that the opportunity, and I feel, and I think we spoke about it perhaps sometimes last year, I truly believe that you have a massive opportunity in the operating footprint with deployment of 80/20, the optimization of your builds, the optimization of how you approach scheduling and building your products, how do you optimize what pieces of equipment, what lines you're going to deploy on what type of products that you manufacture do offer you some good opportunities to continue to drive nice improvements on the back end. And I think that that's in the very early stages of our deployment.

And maybe some just end market thought processes here. First question is just how do you look at the inventory levels from a channel perspective? And where do you feel like things have just flat out bottomed. Some of those are probably where you'd see growth next year coming off the bottom, coming off a destock. But how do you think about the inventory levels, fundamental bottoming?

Yes. So look, I think that when you think about it from kind of the channel partners, my sense is that what we believe is that the channel inventories are in a good position in the replacement markets. I think that they have been bottoming out over the last couple of years. We have been talking about destocking for a while. And I certainly believe that we are in a good position vis-a-vis inventories in the channel. I think where we have seen perhaps some deterioration in 2025 has been around the heavy machinery equipment builders. So I think that you are starting to see better situation where the ag equipment, dealer inventories with commercial construction equipment dealer inventories. I think it was reasonably painful, but I think that, that situation is getting better. I think that we can have probably a 2-sided conversation about do we think that that's in a place where it needs to be? Is there a little more to go? My view is that perhaps there's a little more to go, but I think we're in a significantly better place than we were entering 2025. And I think that the heavy-duty machinery manufacturers, I think, have done a good job in taking builds down reasonably significantly in '25 to clear off the inventories and position themselves for more positive inflection in 2026. So all in, my sense is that most of our market exposure while we don't necessarily anticipate that it's going to be off to the races. Everything is going to turn green. We do see green shoots across significant amount of our end markets and significantly less bad performance in others that bodes quite well for '26 I think.

And what do you think it takes to normalize things out from here? Do you think it just takes normal sequentials, gradual type recovery and that's enough. Do you think it takes some sort of catalyst from a market perspective, rates, tariff uncertainty? I mean, you tell me, what are you looking for most to get comfort that, that base is at a more normal level?

Yes. Look, I mean I think that you're going to start getting some policy certainty. I think that folks are getting comfortable with what would happen around the April time frame, I think people are getting comfortable with how to operate their businesses, what impact it has on your business as a business operator. I do believe that inventory overhang was there. And I think that that's getting cleared out. I do think that you have some positive that we -- historically, we would all be reasonably excited about and nobody really is paying attention to at this point in time. And that's the accelerated depreciation benefit that you're going to have in CapEx deployment. So that could potentially be a nice catalyst into some bigger pieces of investments in equipment and plants that people will do. So my sense is that, that all should be supportive of inversion of the PMI behavior that we have seen and I mean, PMI has been trending up. It wants to -- I think it wants to break through 50 and get north of 50. I don't think none of us are smart enough. And certainly, I know on our end here as a company that we can predict when it's going to happen, but it does feel like it finally does want to invert and move properly into that positive growth trajectory.

So the data center piece, you put a press release out last night about an innovation on the thermal line side there. I think the straightforward question here is talk to your entitlement to win and play in this marketplace and where the differentiation in your product is versus a competitor product?

Yes. So look, we've built a pretty strong portfolio of moving liquids inside of the data center. So everything from pumping that liquids to transferring that liquids from point A to point B, not just through the infrastructure, but also through the devices themselves. And that is a breadth of capability. And if you think about the nascence of this opportunity and the importance of thermal management and as these chip stacks are getting more sophisticated and generate more heat and the need for liquid cooling becomes prevalent. And certainly, my sense is that vast majority of that infrastructure is going to be liquid cooled as we move into the future. That presents a very substantial opportunity for our organization. And the fact that we do have a good understanding of how to move the liquids, how to simulate the flows of these liquids from the input all the way through on chip cooling that positions us really well and differentiates us from some of our other competition. Moreover, I would remiss if I didn't say that everything that we do for data centers is not a general standard product that we manufacture. We have applications specifically engineered these, and every one of these components that we manufacture has some degree of competitive advantage against any of our competitors. And so we feel good. We feel well positioned, we are a leader, a global leader in fluid conveyance in harsh and hazardous applications, and this is kind of a front and center for us when you think about the requirements, the precision, the leak-proof necessity of these assemblies. And frankly, we offer supplemental services that we have not done for some of the other folks when it comes to offering some of these assemblies for folks like the hyperscalers that we do business with.

And does anybody else offer the kind of the suite there where you have the connected, the couplings and then the thermal. I mean, does anybody else offer that as a package? Or is that part of what you're referring to?

Yes. I think that we are unique in that space. I think that you have folks, I mean, obviously, there's plenty of competition in this space, plenty of folks that offer couplings, plenty of folks that offer hoses a different subset of competitors, that offer pumps. But I think we are kind of unique in being able to move fluid from the entry all the way to the chip. And that also gives us kind of a, not only right to play, but it invites us to the table as the thermal management becomes such a critical attribute and thermal management is going to become more significant in the design of these data centers as we move forward. And again, we believe that, that positions us truly well in not only being able to capitalize on some of these opportunities, but also seeing our total available market to scale up and become bigger as there is a greater clarity about what's being put in place.

And then switching gears back to just kind of a higher-level thought process here. What's the thought with capital usage. Obviously, the internal piece is the focal point first and foremost with the restructuring, funding growth, et cetera. How do you think about the equation of buybacks versus starting to think about M&A.

Yes. Look, I think that this is kind of an amazing conversation for me taking into account that when I started at the company, the company was 7x levered a long time ago, 10 years ago. We are finally in a position that our balance sheet is super healthy at 2x net leverage well on the way to below 2x leverage by the end of this year. We have most recently announced a new share buyback authorization by our Board of Directors. We have gotten an authorization of about $300 million. We certainly anticipate to use it fully in the next 12 months. We still have a desire to continue to pay down debt. We have repaid another $100 million of gross debt in July, we are very close to our midterm target of what we have committed to the Street. So I think that those are 2 levers that we can do. But we generate a ton of free cash flow. We have a ton of cash sitting on our balance sheet that we can deploy to other uses other than buybacks and paying down debt. So we will start pivoting much more intently towards kind of a bolt-on type M&A activity where we can improve our portfolio, we can broaden our geographic leverage, but we will do anything around our core franchise and do things that will be highly additive to what we do in our profitability.

Please join me in thanking Ivo and Rich for their time today.