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, Investor Relations and Strategy, sitting opposite me. Gentlemen, thank you so much for joining us.
Thanks, Jerry.
Thank you.
Good to be here.
So, you know, from a high-level standpoint, you know, I just wanna revisit the Analyst Day conversation you folks laid out. Some pretty interesting targets for 2026, you know, margin expansion of three to four points. And what we've seen since then is markets have been weaker, but you've taken your margin guidance for 2024 higher. So 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?
I think so.
Yeah.
So the primary driver for 2024 has been the material cost-out program. What we did in 2023, after we went through you know 2021, 2022, 2023, we saw you know significant increase in a lot of our input material costs you know 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, you know, 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 had changed, and so we put together a three-year plan, you know, for 2024, 2025, 2026 to take a significant amount of material cost out, you know, through our, you know, kind of our DNA, of our business, which is material science. So, you know, that's been the, like I said, the primary driver, for the improved gross margin, improved EBITDA margins for 2024, and you know, we still have a you know, significant runway, for 2025 and 2026 to drive further margin improvements, as a result of that material cost-out program.
In terms of the other part of the three-year journey that you folks laid out was, the manufacturing footprint improvement. On the last call, you mentioned now we're talking about the high end of the range. Can you just talk about where we are, on that journey? You know, how many facilities are impacted and the cadence of the benefit?
Yeah. So we announced that we were targeting $40 million of savings over a two-year period, 2025 and 2026. And so we'll get about 40 mil, 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, you know, formally said, you know, what the cadence of that saving is gonna be, you know, through the years of 2025 and 2026. So the way to think about it is, you know, as we ended 2024, as you end 2025 and head into 2026, you know, we should be $16 million better starting 2026 than we were in 2024. And then as you exit 2026, we'll have the full 40 million of savings as we enter 2027 compared to the end of 2024.
And so as we get more clarity and as we make, you know, more announcements and we do more communications within the organization, you know, we'll lay out what the cadence of those savings are gonna be, you know, for 2025 and 2026 on a more quarterly kind of basis, right? You know, how much of that savings is gonna be there, so.
So Jerry, maybe to wrap up your original question about that midterm target of kind of that 2024 to, you know, 25% EBITDA margin by 2026 that we stated at the CMD. So if you take $40 million exiting 2026 of footprint realignment, it represents, you know, somewhere around 150 basis points of profitability improvements. And then as Brooks has outlined, our ability to continue to drive 80/20 material cost reductions, which kind of represents another 100 basis points. Take a look at our midpoint of 2024 guidance for full year at 22%. You know, you're kind of right there, and you have kind of 50 basis points of potential upside to, you know, to offset some headwinds that, that probably will come in that you don't know.
And so taking into account that, you know, we feel that, you know, 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 a credit to what we do and would give us the opportunity to perhaps get there a little bit earlier. We would have gotten otherwise. But, you know, we believe that, you know, forecasting upturn in markets is kind of a foolhardy process, and we will stick to what, you know, what we can control.
And in terms of, you know, the manufacturing footprint, and obviously, you have to communicate the impacted facilities first. But 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?
Yeah. Look, for us, it's really less about kind of a cost attribute of operating facilities. You know, labor cost is, generally speaking, a small component of cost of goods manufactured. For us, it's more about having factories that are more modern, that are in close proximity to a larger pool of available labor. Because as you go through these cycles, you know, 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, you know, 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.
You know, 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?
Yeah. Look, you know, 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, you know, Europe and Asia and Mexico. Obviously, we have a large footprint in Mexico as well. So, you know, we feel that we have a unique positioning where we could, you know, 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 favored jurisdictions. You know, if you think about China, higher tariffs on China is gonna 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. They're already 301(a) tariffed anyways. So if, you know, the tariffs go up by 10%, you know, we'll, you know, price for that. With Mexico, you know, 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, you know, likely outcome would be if there was a tariff on Mexico-produced goods, we would price for it.
So the benefit to Gates would be at the pricing line as opposed to market share?
I think both, because there are competitors that are importing from Asia that may be disproportionately impacted. And, you know, as you become more competitive from your ability to supply from a locally sourced, non-tariffed, production sites, you have an opportunity to capture some market share as well.
And then, you know, on the material cost reduction side, you know, you folks have been awfully good at this for a while in terms of taking material costs out. And, you know, environmental science 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? You know, how much runway do you have to continue to drive savings beyond the plan?
Look, I think that Brooks outlined it earlier. You know, sometimes you try to take lemons and turn them into lemonade. And, you know, 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, you know, we had to get pretty quickly after re-engineering polymers. And, you know, we do lots of our own polymer processing in our factories. And so, you know, 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, re-engineer your materials, get into 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, you know, there's a huge opportunity. I mean, we buy, you know, nearly $1 billion of those commodities. We felt that we have a large runway to be able to attack and take, you know, some percentage of that cost out and attack the biggest commodities and, you know, go, you know, go one by one." And ultimately, that becomes rather meaningful for your overall franchise. And, you know, 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 different sources for 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, you know, use your own asset to do all the further refining of those processes. So do more internalization and do deconstruction of commoditization of items that we purchased and re-engineer your own materials that you ultimately use to construct the end units that we manufacture.
Yeah. And there, there's a great part of this is there's an element of timing to things. You know, some things you can, you know, get after almost immediately, right? And so supplier development, you know, looking at alternative, you know, 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, you know, kind of have a three-year glide path on things you can get done immediately, things you can get done in the shorter term, and then things that, you know, 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 three-year period.
And in terms of 80/20, so you folks are applying that across enterprise. Now that's an initiative that feels like should have some runway just given the nature of the principle. Can you talk about your assessment, you know, having implemented in I believe two 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, you know, that, that is, you know, that is kind of fundamentally what, 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, you know, kind of at a traditional point in place, which is kind of at 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, you know, those are, you know, those are kind of tangible but relatively easy things to do.
And then, you know, 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, you know, that journey is just at the beginning for us, certainly on the back end in our manufacturing facilities. And we believe that, you know, we have many, many years to go and optimize and deploy 80/20 in the facilities. But we also believe that, you know, 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 you know, we just don't believe that there is a predefined end point. We think that we can do that for a very long time.
And so, you know, it sounds like just putting the pieces together. And so we've got the 20%-25% margin target for 2026, but feels like we've got a few arrows in the quiver that could, over time, drive margins to be above that point if you continue to find opportunities in 80/20, material sourcing.
Look, I'm, you know, I'm not going to reestablish new targets in here, but I don't think that you are thinking about it incorrectly. You know, we never said that, you know, 24%-25%, you know, EBITDA margins for us is kind of the end point, right? There's a balance in what you wanna do. But look, you know, our business is not dissimilar to what somebody like ITW or IDEX has. You know, we have a high-quality, highly differentiated product portfolio. We manufacture highly engineered, you know, mission-critical components that have a natural replacement cycle built in them.
You know, we believe that, taking into account our market presence and market positioning being top one, you know, to top three player in every market we participate in, we believe that we have an opportunity to continue to operate in the vicinity of, you know, 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 that neighborhood.
Very interesting, and you know, one aspect of your journey to drive profitable growth has been, you know, right-sizing 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 gonna stay as a percentage of the business, or, or should we be still thinking about auto aftermarket coming down?
Yeah. Look, the auto OEM business, you know, we. I would use the same term as that as I've used on 80/20. You know, 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 that business, so we are happy from that vantage point. But look, you know, our core growth initiatives are around industrial applications. And as we scale up the industrial applications, as the markets repair themselves, we believe that, you know, that portion of our overall business is going to continue to shrink, not necessarily in terms of, you know, absolute numbers, but in terms of percent of contribution as the industrial businesses scale up, ramp up, and grow more rapidly.
Got it. And, you know, on the industrial part of the business, you know, what we've seen for construction equipment, farm equipment, etc., 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?
Yeah. Look, higher power equipment, higher, you know, higher horsepower equipment is more accretive to what we do. We operate in the higher, at the highest pressures, in hydraulic applications. That's very, you know, that's very beneficial to what we do. But, you know, we're also gonna be, you know, pretty prudent in looking at how we scale out some of those businesses. We, you know, we feel that we not only have opportunities in kind of the mobile applications, which are, you know, which are great, but they're also rather cyclical, as you know. You know, we also feel that we have a great deal of opportunities in stationary applications, in industrial across the industrial landscape.
You know, those applications are, you know, places where we believe that we can operate well: industrial automation, you know, molding machines, you know, 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, you know, centered around the mobile equipment.
Let's talk about data centers then. You folks have an opportunity there. Can you just talk about the Gates approach, in terms of what data center components apply and, you know, how are you thinking about the opportunity and competitive positioning for Gates?
Yeah. Look, you know, it's a new set of applications for us, to a strong degree. I think that it's a, you know, it's an application that will create kind of a $1.5 billion plus or minus market opportunity for the products that we manufacture. You know, that's a $1.5 billion TAM that we didn't have 18 months, 24 months ago. That's evolving. You know, 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 centers. 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-cooled 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. You know, we've taken a little different approach in developing products, again, that are within our 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 2026, 2027, and beyond.
Can you put that $1.5 billion into context for me? What's the TAM for the company before data centers?
The 1.5 billion is just an additive TAM to.
Right.
What we have been doing historically, right? And I think that's, as we have represented historically, I mean, we are participating in a large TAM market regardless. So, you know, this is just an addition on rather substantial amount of opportunity that's out there for our company.
Right. Maybe, you know, another way of framing that question is, you know, relative to that 1.5 billion TAM, what can Gates share of that look like?
Yeah. Look, again, I'm not gonna try to frame what we think that we can get. But if you think about that, there are kind of three large-scale, credible players in that space. And that's Gates, that's Parker, and that's Danfoss, right? These applications are mission-critical, and you know, you are protecting in terms of providing the cooling of very expensive apparatus, very expensive servers, very expensive chips. And what we have seen, I think, 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 three 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's playing in that market?
Yeah. Who's playing?
Oh, the three players are playing and, you know, and as the market is evolving, we continue to adapt different sizing of the product portfolio. Look, you know, you may start a project with a data center operator, and you may start with a fluid conveyance product that is kind of one to two inches in size. And by the time that you are done, you know, you're providing them a four-inch type application. And that means a 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 gonna be solved.
Are you generating revenue from this end market today?
We are. Small, small amount of revenue. I mean, obviously, we are with some partners like Lenovo. We are with, you know, in some data centers that have already been built. It's not, you know, of the size that, you know, 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 are trying to solve is 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 gonna essentially increase the Gates addressable content.
Exactly. And, you know, ultimately, that just going to represent them by far as more significant opportunity to drive revenue generation.
You know, typically, the more complex a problem, the higher the margin you get for solving it.
That's the right way to think about it.
And then, you know, 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 aftermarket for pumps and things like that has been a big focus as the fleet population has grown? Can you talk about what your experience has been?
Yeah. Let me frame it kind of in a little bit of facts and figures, and I think that.
Sure.
That kind of puts into perspective some of the things that we are dealing with. First of all, we are super excited about electrification of propulsion. As we have outlined, you know, it's approximately $3 in electric application versus a dollar in ICE application for us, for our products that we manufacture. So we are super excited. However, that being said, you know, there's nearly 2 billion ICE vehicles on the streets around the globe. There's about 22 million vehicles that are electrified. You know, so this disparity is rather substantial.
So today, you know, for us and in a foreseeable future, you know, we just don't see that this is gonna be a sizable seismic-type opportunity that, you know, we should spend lots of time talking about until we start seeing more significant penetration of that car park population. And that's gonna take time. And, you know, it's frankly just math, right, Jerry? I mean, there's about 80 million cars that are being produced every year. And let's just say in a good year, it's, you know, 25% of those are electrified. So, you know, call it kind of 30 million cars that would potentially or 25 million cars that would potentially be electrified over the midterm. It just takes decades to get to that $2 billion, $2 billion car set of, you know, wheels that are on the streets, right?
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.
Just to add on that, the average age, globally speaking, of electric vehicles is under three years globally. It's a little bit higher in the U.S., but still a ways to go to get into the sweet spot, which we characterize as seven to 15 years. That's gonna be an opportunity for the company as you look out over the long term.
Okay. Well, you know, we've spoken about this in the past, the fact that you're positioned well with U.S. auto distributors. Presumably, you should be getting the first look on those additional SKUs.
Yeah.
Is that fair?
Yeah. It's fair. But again, you know, it's so de minimis, right? I mean, the scale is so small. I mean, the aged car park is about 700,000 cars, right?
Mm-hmm.
In the United States, ICE is over 200 million, you know. So, you know, just a big disparity still.
Yep. And, you know, from a distribution standpoint, you know, 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?
Yeah. Look, over the you know, I would say that over the last three or four years, we have invested quite a bit in ensuring that we have adequate amount of capacity, that we launch products that give us advantage in terms of cost positioning. And then thirdly, into refinement of our supply chain, being in region for region, ensure that that capacity is available when you need it, for whatever customer you may need. And you know, we've made a tremendous amount of progress to a level where today, our fill rates 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.
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 100-150 basis points of enterprise-wide growth in 2025. You know, really nice, chunky, and meaty design win and customer win. We think that, you know, we can continue to do that as the service levels stay at the rates that we are able to do.
Yeah. And, on that note, congratulations on that win. The reason for the win? What feedback did you get from the customer? 'Cause 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?
Yeah. 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 is lots of, affinity towards our brand. And two, you know, I think that the two parties felt that it was the right time to be able to, create a partnership together. And, you know, so everything, the stars kind of aligned, and the company's performing well. And we feel that we can protect, you know, we can protect all of our customers and be able to service all of them well.
And, you know, 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 end demand ticking higher? Any green shoots to talk about?
Look, we believe that, you know, we are starting to see inflection in personal mobility, you know, that has been really tough for kind of two and a half years, post-COVID. So we think that we are starting to see some green shoots there, which, you know, likely be maybe flattish in Q4 and then start seeing acceleration in 2025. Look, we believe that, you know, diversified industrial channel is bottomed out. Restocking more or less worked itself out. We've had, you know, the lowest decline in Q3 year over year, in terms of that market segment probably in two and a half years. So we believe that we have seen kind of the stocking play has played itself out there. You know, 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, and there's good pragmatic underlying demand there. And, you know, and some of the other markets that are maybe less accretive, like ag and commercial construction, that's probably gonna take a little bit more time to work itself out.
Yep. Super. That's all the time that we have today. Please join me in thanking Brooks and Rich for coming out for our conference. Thank you, gentlemen.
Thank you.
Yeah. Thanks, Jerry.
Thanks for having us.