To have next up on the agenda Gates Industrial. We have Ivo Jurek, the CEO. Ivo, thank you for joining us. I appreciate it. Since we're now in this virtual world, where are you dialing in and connecting from today?
Good morning. Good afternoon to everybody. I'm actually dialing in from my office in Denver, Colorado.
Appreciate that. Ivo, we were very pleasantly surprised, and pleased to see the company's announcement after the close last night. This is certainly consistent with the macro theme that we've been seeing of sequential improvement. You all had a pretty compelling, positive pre-announcement after the close last night. Give us an overview of what's changed in the quarter, and then we've got a few questions for you about it. Take it away.
Great. Thanks, Dean. Look, I mean, we've, we have seen improving trends. We've mentioned them on our Q2 call. You know, that gave us, you know, significant confidence seeing that continuation of those improving trends through August and into the middle of September. That gave us the confidence to raise our revenue outlook yesterday. We are quite pleased with that as well. You know, we are seeing a very significant improvement, versus Q2, approximately 20% sequentially, which is a very broad-based recovery from where we exited Q2. We've previously talked about the resilience of our business, in particular in our automotive replacement business. And, you know, we expect that, that business itself to actually print positive core growth, core growth in Q3, which is terrific for us to see.
Although our first fit customers did not really begin to see any improvement in Q2, we have started to see some, you know, slight improvements as we exited Q2. You know, it has continued somewhat. Certainly the first fit customers are not performing as well as what we are seeing with our replacement markets. Geographically, look, we spoke on my Q2 call that we will see mid-single-digit core growth in China. We still continue to be the case. Europe is recovering a little bit faster than what we have seen in North America, despite the very difficult first fit environment. That first fit automotive environment in particular, we do not anticipate to recover until 2021. However, you know, we have been talking about, you know, less of an importance of auto first fit for our business, well into the future.
You know, I think that this recovery and the performance that we are demonstrating is actually demonstrating the lower reliance on auto first fit that I think typically our shareholders have been concerned with. From segments perspective, FP is recovering as rapidly as PT. PT is going to print better numbers than FP.
That's all great to hear. One of the points, and maybe you can provide some additional color, is, since you, so much of your product goes through distribution, do you have any sense of the sell-in versus sell-through? And is this a restocking by distributors, or are you seeing, you know, you talked about the, the aftermarket. Is that, is that actually what's drawing this uptick?
Yeah. Look, I maybe get a little bit long in the tooth talking about destocking. We started talking about destocking in the second quarter of 2019, and I think folks were a little bit surprised about that. When we exited 2019, we felt that we would continue to see some industrial destocking through the first half of 2020, which, you know, obviously we have seen. Maybe it's been a little bit more exacerbated by COVID. On my last call, I anticipated that we would exit Q3 more properly aligned between the underlying market demands and the supply into the channel. That certainly is what we are seeing. We are not really seeing any rebound in inventory restocking yet. We are seeing an improvement in the underlying market fundamentals.
You know what? That's really encouraging. I kind of wasn't sure you would be as exact or precise in terms of the sell-through versus restocking. Is your sense that there's inventory in the channel? It makes sense at current levels, or is there a restocking that could still come through too?
I mean, my sense is that the inventories in the channel are quite lean.
I think as, you know, as we exit 2020 into 2021, you know, we could see some restocking to occur as those markets start behaving, I guess more robustly than they are even today.
Great. Any color on the orders in term, I know it's an uptick in orders, but in terms of size of orders, is there any sort of market intelligence you get from that as well?
You know, we do not report, color on orders. We obviously track our orders. What I would tell you is that our orders remain above our invoicing. So our book-to-bill remains positive, which I think bodes well for the future.
Good. All right. I just wanna step back, and I always enjoy reminding investors that Gates is over 100 years old. And in your debut as a public company, you know, not too long ago, you know, this was not exactly the macro that you all had planned for. You did embark on some capacity addition that was needed. You made those investment decisions. There's a bit of a trade war that caused some destocking, and then COVID happened. You know, assuming that you've survived all these and you made all the right actions, you know, what does this say about your positioning now here today with the restructuring that you've taken, the capacity that you've added? Where's the business plan stand today?
Look, Dean, I do not think that I could have summed it out better. Sometimes, when you reflect on what has happened since we have become a public company, we truly had to deal with a significant amount of adversity. I feel quite positively about where we sit today. I think that we are trying to manage for the long term without necessarily ignoring the short, you know, short-term effects that we have to deal with. We have positioned the company onto a trajectory to be able to capitalize on recovering markets. We have positioned the company, I think, on much more solid footings when it comes to driving innovation and introducing a significant amount of new products into the marketplace. That was the original pretext into putting some of the capacity in place.
Frankly, positioning the company with a capacity around the globe to be fully in region for region, to minimize any potential supply chain disruptions, whether or not they are macro-driven or micro-events-driven, the company has been positioned really, really well. When we started to take on the capacity expansion, we also anticipated that we wanted to dramatically streamline our overall fixed overhead footprint. We had a number of facilities that were great facilities with terrific people that were manning the equipment in those facilities, but those facilities were subscale. Scaling up and putting that capacity into not only lower-cost countries, but more importantly, into countries where we felt we have good access to available direct and indirect labor was very important for us.
As we exit this period of the first three years in which we have been a public company, we are exiting with improving macro. We are exiting with a terrific amount of new products, and we are exiting with a lower cost. We are well-positioned to not only accelerate our revenue generation, but do it at improved gross margins and earnings to go along with that improving top line.
I just want to pick up on one of your points, Ivo, that was really important, is the idea that you really did not do much in the way of layoffs or big salary cuts. Those were conscious decisions because in many ways, if you cut too deeply, you really sacrifice your growth opportunities on the other side. As we talk about those decisions and what is the consequence of having done that and preserved your growth potential, what does that mean about incrementals on the other side?
Yeah, absolutely. Look, you know, we felt that we have to be a good corporate citizen and take care of, number one, take care of our employees, take care of our customers, and give ourselves the optionality to react to changing market demand environment. As we have experienced, we are a very short-cycle business. We do not have lots of visibility. We wanted to err on the side of being able to react. That resulted in us taking, frankly, decisions that, as you have highlighted, no furloughs, no real fundamental reduction in salaries. All of our employees have been paid, as we have paid them historically. You know, we have not cut any 401(k) distributions or any contributions, anything of that sort.
You know, from that perspective, when the market improves into 2020, and we are seeing the early signs of that recovery today with our recent announcement yesterday, we believe that it positions us to be in a situation where, frankly, we do not have to talk about COVID. I want to be in a situation where we can talk about clean results. As revenue improves and we are delivering significantly greater incrementals, and I have come on the record to state that we expect to deliver incrementals in the first year of post-recovery, that those incrementals be greater than our decrementals were in 2019. As you know, Dean, our decrementals in 2019 were about 50% driven by the capacity expansion and by that trade war that has significantly reduced our top line. As we exited 2019, we have started to realign our cost base.
That helped us as we entered into that COVID-19 impacted world. We feel very good about where we sit. I believe that we will deliver incrementals in 2021 on incremental revenue that are in excess of 50%.
Wow. All right. That seems aspirational, but the numbers support it based upon the kind of leverage that you have. It is something we will be watching carefully. Let's pivot and talk a bit about the business model and the level of complexity that you have and maybe some efficiencies that you can ring out. I remember the first time I saw the business and I was struck at this extraordinary number of SKUs. You can provide a, you know, a timing belt for a 1957 Chevy pretty quickly when that model has not been in production for decades. Just talk about that, that SKU 360,000, what that means to manage and how you get through that complexity issue.
Yeah, absolutely. Thank you. I mean, we do have a reasonably complex business model. You know, on the top of the complexity of SKU count, which you have very effectively outlined, you know, we also, because we are an aftermarket-focused company, we pride ourselves on being able to supply over 95% of all orders that we receive today within 72 hours. Not only do we have an incredible complexity to the SKU count, that by the way is a massive moat, competitive impediment for others to come in and compete with us, but it also gives us a great deal of pleasure to be able to be highly effective in the fulfillment side of our business.
You know, from where we certainly sit, one of the things that I have envisaged when I start talking about driving innovation forward, innovation had two underlying tenets for us. Number one, completely revitalized our product portfolio. As you know, Dean, it is very complex to do when you have 400,000 or 360,000 SKUs. Number two, industrial companies do not do that well. We felt that as a hundred and nearly 10-year-old company, we were due to be able to completely revitalize the portfolio. The second tenet of the revitalization of our portfolio was to significantly reduce the complexity under the skin. We wanted to go in and launch these products that would be comprised of a significantly smaller number of major product lines, yet not impacting our ability to supply that 1956 Chevy to our customers.
I think that we are well on the way to be able to accomplish both of these objectives. That, by the way, is going to do two things for us. Number one, new products, as we always have been able to demonstrate, generate more gross margin. That reduced complexity also gives you a better efficiency that you will realize that will ultimately translate itself into an improvement in gross margins well into the future. Those were the key tenets of, you know, looking at our business model and reducing the complexity of that business model and drive reward for our shareholders.
That's great to hear. I wanna pivot over to the balance sheet and the amount of leverage that Gates has taken on. The way I look at the leverage today, it's not the same the way we looked at it last quarter when it seemed like, oh, we're in the middle of this downturn. How are you gonna come out of this? You're emerging from it. The debt burden seems a heck of a lot more reasonable, given the upper trajectory of the business today. Just give us a sense of where leverage stands, the deleveraging plans, and free cash flow generation in the business.
Yeah. First, let me start with the fact that as a public company, we certainly recognize the importance to equity investors of bringing our leverage down. I have been on the record that, you know, my interest is to very rapidly come below three times levered. We were well on the way to deleverage to that level, until, you know, we have entered the trade war-induced recession. Fast forward to COVID, we, you know, we anticipate that we will peak at five times gross leverage. We also anticipate that as we are exiting Q3 into 2021, we will start seeing a very nice deleverage to reemerge.
I do wanna point out that throughout this period of time of uncertainty, a great degree of uncertainty, the company has continued to generate a great deal of free cash flow, even in a very difficult Q2. We have never been stressed to repay our debt or service our debt. We have not had to tap any lines of credit. We have not had to increase financing or borrow more money. We have over $600 million that's sitting on our balance sheet that gives us a great deal of flexibility to look and not only, you know, look at potentially reducing our gross leverage down with that available cash that's sitting on a balance sheet, but also we believe that those improved business conditions are gonna give us an opportunity to pretty dramatically drive that gross and that leverage ratio down pretty quickly.
That's great to hear. In terms of, one of the things I find interesting is how much material science is involved in the business, and just, and the amount of new product introductions that you've been able to maintain despite all some of the macro pressures. Just give us an update there, new products and the role of material science.
Yeah. Look, Dean, again, I'll, you know, I'll kind of say the obvious. We, you know, we haven't decommitted $1 throughout this period of uncertainty that has been directed to innovation and to capital investments to drive higher rates of growth in the future. Significant portion of our innovation is centered on leveraging material science as well as process innovation. Those two tenets go hand in hand. You know, you cannot truly leverage the material science if you're not going to drive innovation in terms of new processes. There have been a tremendous amount of chemical advances or advances in chemistry, but the processes have not been advanced to leverage that innovation in chemistry.
We have been focused over the last couple of years on building our own industrial process automation to be able to do just that. Whether or not it is carbon fiber reinforcements that give us an ability to build carbon drive belts that give us an opportunity to accelerate our chain to belt set of opportunities, we see a great deal of increase in revenue generation from that initiative. Also, our processes that we have deployed in those new factories that we have built are such that give us the opportunity to dramatically reduce cost as we drive these new innovations into the marketplace. We are quite excited about that.
We believe that, you know, in an example of, of, say, belts, you know, I've spoken about, about the carbon drive ad nauseam historically. One of the first things that we have done in this industry, in the belt industry, is we have eliminated chloro prints as a part of a chemical compound that you have to use if you want to build belts. We have substituted, you know, chloro prints that are not, not environmentally friendly with ethylene elastomers. Those ethylene elastomers are very difficult to process. Again, you know, there is a good innovation out there in material science, but if you cannot process these new materials, you will not be able to, to build these new products that, that we are launching.
That is a really good example of when I say, hey, look, we need the process innovation to be able to leverage the chemistry. That is probably one that I would highlight.
Great. Some of the investors or investors had the ability to send me questions. I did get a question. Someone wanted to get an update on the $40 million structural cost out initiative, how that has progressed. Is it, you know, what the timing and the payback is?
Yeah, absolutely. On the last call, I have, you know, I have given an indication that we anticipate to get about $38 million-$40 million of that structural improvement in 2021. That is comprised of closing a couple of factories, a couple of distribution centers, realigning our European footprint, establishing shared service center in Poland. All of these projects are on time, on target, and we certainly anticipate to be able to deliver those incremental savings. In 2021, we talked about about $40 million of savings, and that $40 million is basically offset by about $20 million of restructuring costs. The net savings in 2021 will be incremental to $20 million net of restructuring.
Great. That's, that's real helpful. Maybe touch on the, you know, and I get this question often, and, you know, all the, the opportunities in electric vehicle. Just give us, you know, as you see it today, the conversion to electric vehicle, what's that mean for your business, the dollar content, and so forth. It's a frequent question, and I think there's some really interesting perspective that you can add.
Yeah. Look, we are quite excited about the potential adoption of electric vehicles. I do not spend a tremendous amount of time speaking about the opportunities on electric vehicles, and I think I need to do a better job of doing that. You know, one of the things that we always want to ensure is that we are focused on the opportunities that are the nearest opportunities for us to deliver growth. Although we are very excited by electric vehicles, we still anticipate that the adoption is going to take some time. Gates benefits the most when there is a large installed base of devices in the marketplace. We still believe that is going to take some time to drive that significant adoption that will translate into an age car part, which is the most important metric for us.
Now, in terms of content, you know, the reason that we are very excited about EVs is because if I look at a content that we have on, say, a straight combustion engine-driven power, powertrain, and I use that as a, you know, kind of, a unit of one or 100%, the content increase is about 20% greater on an EV for our products than it is in an ICE. So although I do understand that there may be some degree of, some degree of concern that folks have about companies like ours that, you know, hey, look, what's gonna happen to your business? What's gonna happen to our business? It will naturally grow with a greater adoption of EVs. You know, we are quite excited about that.
That's great. Just to clarify, that's not just power transmission, but that's also fluid power. That's including both segments, correct?
That is correct. The biggest opportunity that we have on EVs is obviously in fluid power, in battery cooling in particular, more specifically. That being said, we do have opportunities on power transmission, and we are working on several programs for the leading supplier of electric vehicles today, on deployment of those products into that application for that vehicle manufacturer.
I just wanted to circle back on the commentary regarding the positive pre-announcement that you started with, just to make sure I got this correctly, that auto replacement is looking to be positive growth in the quarter. It's been a while since we've seen any of our companies posting positive growth. I just wanna make sure that it's not sequential, but that's a year-over-year number.
That's correct, Dean. We anticipate that the automotive replacement market will print a positive core growth, core, core growth globally for us.
have any sense geographically how that breaks out?
Sure. You know, China obviously is performing quite well. Europe in AR is performing quite well. North America in AR is performing quite well. The three biggest markets where we are, where we have a dominant market share are performing very, very well in AR.
Gee, it seems as though that's an, you, your sense it's not just an inventory replenishment, which is awfully surprising or just, it's so encouraging is how I'd phrase it.
I think, Dean, one of the, you know, probably misunderstood misconceptions is that, you know, some of these markets are not going to benefit from COVID-19. I believe that actually the automotive replacement business in particular is benefiting from COVID-19 because people are forced into personal mobility. Whether or not it is an automobile, it is a bicycle, it is a motorcycle, it is an RV, I think that you are seeing some short-term positive pickup, and we are benefiting from that pickup. I believe that that's going to stay with us for an intermediate future.
Yeah. I saw some references that our auto analyst, Joe Spack, had done, the phenomenon of more people buying second cars, because you've got more people living at home. People need second cars. A lot of times those are used cars, and that's certainly, that's right in the sweet spot for you guys in terms of an age car park, in terms of replacement.
Absolutely. I think that what you'll start seeing is that even millennials will start buying those vehicles because they wanna get around as well. I think that they're all sick and tired of sitting in their homes. Many of them are vacating their beautiful apartments in big cities and moving back to their parents' basements.
I can attest that I've had one of my adult kids doing that, but he's not in the basement. That looks like we're out of time here, Ivo. I just want to thank you for participating in our conference. I want to congratulate you on weathering what was some extraordinary pressures on your business. You know, you didn't change anything in terms of your approach on a daily basis and how you communicate to the street and what your business model was. If that's the kind of consistency you'll be able to look back on, you know, with a sense of satisfaction, I think, in terms of the business model works, it holds up to some extraordinary pressures, and then you get to benefit on the recovery.
Thank you, Dean. I, I, we like our business and we like where we sit.
Good. Terrific. Thanks for participating. My best to you and the team. We will call this the Gates presentation to a close. All the best for everyone. Thanks for participating. Bye now.
Thank you. Bye-bye.