Hello and welcome to Day 2 of the Barclays Industrial Select Conference. My name is Trish Gorman. I work with Julian Mitchell on the U.S. Multi-Industry Team. Today we have Ivo from Gates Industrial Corporation. Thanks for joining us, first of all.
Thank you.
I guess just starting out, when we look back at 2019, a major topic was the destocking. I do not know if there is a way to quantify kind of how much of the declines in 2019 were market-related versus customer-related in destocking. If you could just kind of remind us your anticipated timeline for when you think we will get through that destocking in both Power Transmission and Fluid Power.
Great. I think good questions in here. When I look back at 2019, our core growth in 2019 was about negative 5.6%. I would say that predominantly driven by quite a negative sentiment that has developed certainly over the second half of the year, particularly with mobile hydraulics. Mobile hydraulics decelerated quite substantially. Coming back to that negative 5.6%, about 200 basis points of our negative core growth was what we would associate with destocking. The destocking was pretty substantial, and it has added a pretty significant amount of pressure on our top line in 2019. That being said, on the fourth quarter call, I have stated that we see that the inventories and the channels have leaned out quite a bit as we exited 2019. We still feel there is a reasonably negative sentiment, particularly on the mobile hydraulic side or mobile equipment side.
We anticipate that we will continue to see a degree of destocking through Q1 and probably bottom out in Q2. In the second half of the year, we anticipate that we will see supply and demand more in balance with the underlying market performance.
Okay. That's very helpful. I guess in this downturn, you guys have taken a lot of action to reduce your cost base and emerge with a leaner footprint. How are you feeling about your positioning to capture volumes when growth returns? Maybe any lessons you learned from two years ago with the capacity constraints?
Yeah. Look, in 2016, what most people forget was the last industrial downturn. I've been on board for about five years, and I've been dealing with a second industrial downturn in five years. It just puts things in perspective when people feel that GDP has been growing and everything has been quite okay. Actually, the industrial economy has gone through a couple of downturns already. In 2016, we decided that we needed to build incremental capacity. We felt that the incremental capacity will give us the opportunity to do two things. Number one, expand our presence in some under-penetrated regions like Europe and Asia. Number two, we've spent lots of time and focus on revitalizing our hydraulics product portfolio.
We felt that with the new product introductions, we will get a good opportunity to expand our market presence and market share with the local presence in manufacturing. We also felt that we needed to build and broaden our footprint to execute on our longer-term plan, which was to reduce our less efficient manufacturing footprint. I think that they've gotten lost a little bit in the translation when we've talked about capacity expansion because everybody was dealing with a very significant supply-demand imbalance. We continuously stated that the purpose of that expansion was dual: A, drive growth, and two, give ourselves the opportunity to reduce our fixed manufacturing overhead. End of 2019, we have announced a good-sized restructuring program.
We've announced that we will be taking about $60 million of charges over the next two years, 2020- 2021, to reduce about four or five rooftops that should give us about a $40 million improvement in our fixed overhead. Now, that being said, we also stated that we are not planning to take any capacity de facto. We're just collapsing less efficient, smaller sites into larger, more efficient sites that give us a greater opportunity to flex up and down with volume.
I guess as volumes return, what type of incrementals should we expect to see on this growth?
In 2019, we've delivered about 55% decremental margin, which, taking into account our gross margin profile, is a little bit worse than what you would anticipate. Conversely, we anticipate a significantly greater incremental margin as we progress through 2020. We anticipate that the fixed overhead realignment will give us an opportunity to deliver better incrementals than what we have seen during the last down cycle for an intermediate period of time.
That's helpful. I guess on everybody's mind has been coronavirus in China. I know it's an important market for you guys. I think as of the last quarter, you guys were expecting production to come back on February 10. Maybe just any commentary on what you think the impact might be and kind of how your expectations have changed there.
Yeah. First of all, we got a pretty significant amount of headcount in China associated with our manufacturing footprint. We have about five facilities in China. First and foremost, we are worried and concerned about the well-being of our employees. So far, we have been very fortunate to not have anybody that has been impacted by coronavirus. That is a good thing. All of our facilities are now up and operational to the tune of about 40%-50% capacity utilization. The capacity utilization is predominantly impacted by the availability of labor. As you know, it's a migrant workforce. In post-Chinese New Year, most of the employees returned from their home provinces into our sites. A number of those employees have been quarantined for two weeks. A good amount of employees are coming off quarantine on Monday of next week.
We frankly anticipate that we should be kind of up at the 60%-70% capacity utilization next week. As we enter into March, get to about full capacity utilization. We anticipated that by February 10th, we would start production. We actually started production about three or four days later than what we've anticipated. The ramp-up has taken a couple more weeks than what we have anticipated originally, but not too much different than what we thought when we reported in our fourth quarter.
Okay. Would you expect to see that demand come through in the second quarter, or is it kind of just gone once it is?
Yeah. In our case, we certainly believe that the demand just got pushed out into second quarter and beyond. We anticipate that as this gets worked out, although nobody can really give you a firm answer yet because I think the Chinese government is dealing with all of those issues presently, and I think they're trying to get their arms around that. We certainly believe that the demand just gets pushed out into Q2 and Q3 and Q4. We still anticipate that we're going to have a very good year. As you mentioned earlier, we exited 2019 with lots of positive signatures in our business in China. I think that we've outperformed the market very, very nicely across all of our product categories. We believe that that's going to carry through once we work out the issues associated with the coronavirus.
Awesome. I guess looking at end market trends, I know on the call you'd seen some signs of stabilization in industrial. Maybe if you could touch on kind of what trends you're seeing now in your end markets, maybe where you think growth is going to come from throughout 2020.
Yeah. Gates has about 65% of our revenue derived from the aftermarkets. One of the things that we like a lot about Gates is that aftermarket presence. It makes the quality of this business very high. When you see deceleration in markets, unfortunately, you also see kind of a double whammy with the destocking that you will see through the channel partners. We anticipate that the destocking, as I said earlier, is going to work itself through certainly North America through the first half of 2019. We've planned on a reasonably negative market environment, particularly in the mobile industry in the first half of the year. In the second half of the year, you will start running against much easier comps.
If you look at what we have taken into account for our guidance, I mean, we set our guidance at 50 basis points of core growth at the midpoint. We certainly still believe that the market environment is exactly what we have anticipated at the beginning of the year. I mean, we are frankly still at the beginning of the year, but we are not seeing anything presently absent of some more significant disruption in China that should change our view on 2020.
Okay. Great. I guess just shifting to kind of deleveraging. I know you pushed out that target slightly. How are you thinking about deleveraging now? How does that impact your medium-term capital allocation priorities?
Yeah. Look, we had a terrific year with cash generation in 2019. We generated nearly $270 million of free cash flow that we put on the balance sheet. We exited the year with nearly $600 million of cash flow on the balance sheet. That gives us some flexibility on how we think about what we want to do with that cash. Our primary priority remains deleveraging. My sense is that we will get to our next target of deleveraging to three times or below leverage in 2021. We are not really that far out of being able to get to that initial target that we have communicated to our shareholders and the market. We feel pretty well positioned to be able to deliver that next year. From a capital allocation perspective, we are always looking at bolt-on acquisitions.
Again, as I said, we have over $600 million of cash on the balance sheet. We do have some flexibility. We have to see some good quality assets that can be very additive to our strategy, whether or not it is expanding our product portfolio, where we can drive incremental growth, or expanding our geographic presence, or giving us an opportunity to get into new higher growth markets. We continue to look at those potential acquisition targets. Presently, there is not anything that we are active on, to be honest with you. Probably repaying some debt is going to be a priority for us.
Understood. On free cash flow, 2019 was very strong, especially Q4. Guidance for 2020 is for over 80%. Kind of how should we be thinking about moving pieces within free cash flow this coming year and then maybe a longer-term sustainable run, right?
Yeah. Let me start with longer-term first, that I think is a pretty straightforward answer there. Look, we have outlined during our last year's investor analyst day that our overall target is to convert adjusted net income at about a 95% rate. We believe that that remains to be our intermediate target to get to. Over the last two years, we have had more extensive CapEx requirements where we were building three new facilities. We finished those projects, frankly, in the first quarter of last year. We anticipate that our capital investment is going to normalize around 3% of sales. That also was our longer-term stated objective.
As the growth returns, we believe that the pieces between inventory reductions and accounts payable and CapEx at 3%, frankly, should give us the opportunity to continue to deliver at that 90%-95% cash conversion to adjusted net income. We do not see any reasons that we could not deliver that over the long term. That is our primary objective to go and execute on.
Okay. Maybe just specifically on 2020 with the guidance for over 80, what are the moving pieces within that? Kind of what's changing from 2019?
You know, we will require to rebuild some working capital on the back half of the year. The way that the math works, there's actually a reasonably good amount of growth that will occur in the second half of the year. Early in the year, we just provide a guidance that we believe is reasonable for our shareholders to build their own plans around how we view cash generation. We certainly anticipate that we ought to be able to do at least 80% or better in 2020. There isn't anything that is lurking out there like an incrementally large amount of CapEx that we want to invest. I think we've guided about $100 million of CapEx for 2020. We still believe that those are good projects that we want to invest in.
That is about the rate that we foresee to go and execute on at this point in time in the year.
Great. That's very helpful. You touched on it a little bit, but I guess on the acquisition front, if you were thinking about expanding in geography with Fluid Power being around 70% North America, what other geographies are attractive to you? Would you look towards expanding into those?
Look, I think that our big priority today is to expand much more significantly in Europe. Fluid Power business overall is heavily weighted to North America. And we like that. We are a big player in North America. By the way, we are launching a ton of innovation. We believe that we still have an opportunity in North America as much as everywhere else around the globe. We have underserved the European market. We have a great brand in Europe. We have a right to play in Europe. Historically, Gates has not had a manufacturing presence in Europe. We have built a nice business in Europe in hydraulics over the last 20, 30-some-odd years without having a large-scale facility. We have built a facility in Poland over the last two and a half years or so.
We have a ton of innovation that's coming into the market as we speak. We believe that we are in a very good position to very nicely scale up our business in Europe in particular. We also scaled up our facility in China. We have two factories in India. We believe that there are great opportunities to continue to drive growth in China and India in particular, again, on the back of the investment that we have done in China in capacity expansion. We have a very nice-sized, very large factory. The new innovation that is coming forward with the products that we have launched in 2019 and frankly that we are launching, that we will continue to launch in 2020.
We feel that we are very well positioned to be able to take market share in global hydraulics, not necessarily just in one region or another. We feel that we have an opportunity around the globe to be able to do that.
Great. I guess on that end with new product development, I do not know if you can quantify it, but what percentage of sales comes from those new products right now? Do you have a longer-term target?
Yeah. Great question. Again, I'll come back to what I said last year at our investor day. During that meeting, I stated that about 2016 timeframe, we were generating about 5% of our revenue from new products that were younger than five years. Our long-term target is to get that number to 20%. We believe that we will get to the 20% of NPI Vitality Index by 2023. We feel that all the activities that we are working on are going to support that objective. As I said, I feel that we have done already a very significant amount of work in Fluid Power. Our Power Transmission business and product line is now ready to receive the same level of attention. We believe that we will start introducing a ton of new products from 2020 and beyond.
By the time that we are done, maybe with 2021, we are thinking that we will be more or less done with revitalizing most of our core product lines across Fluid Power and Power Transmission. As you know, the industrial companies are not terrific in relaunching new products. This is a very complex set of projects that we are working on. More importantly, we have got to demonstrate that we can actually take that innovation and offer it to all of our customers and give them the incentive that they certainly should see with that innovation, that it is important and essential for them to adapt into their machinery.
Awesome. That's great. I don't know if anybody in the audience has any questions I want to ask. Okay. Another one from me. On chain and belt, are there any updates you can give us there in terms of where you think you are in that journey and what it kind of looks like maybe in the near to medium term?
Yeah. We still believe that we are in very early innings of this journey. Along the way, I started speaking about Chain to Belt initiative maybe 18 months ago. We have kind of a couple of hundred million dollar revenue base that we derive from what we call synchronous belts. Much of that, a good amount of that revenue is going into elimination of industrial chain and moving towards Gates' belts. Since then, we have split that initiative kind of in three. As we think about Chain to Belt today, we are thinking in terms of industrial Chain to Belt. This is anything heavy machinery, grain silos, and aggregate materials, and asphalt manufacturing facilities, and so on and so forth. The second kind of category for us is what we call personal mobility.
I think bicycles, motorcycles, e-scooters, e-bikes, and any device or electronically controlled skateboards as an example, right? That initiative is progressing really, really well. I spoke about having about $100 million of design wins with personal mobility alone. We believe that that's a category, it's a product category and set of applications where we have probably the easiest time to drive adoptions because the value prop is not just clean cut, but it's very sensible. The third piece is light industrial automation. Anything associated with distribution and logistics. If you go to any large e-commerce company warehouse, you take a look at their goods moving equipment, and you start seeing that the chains are being gone from that apparatus and belts are being deployed.
That's a very good area for us where we believe that we have lots of value that we can bring robotics. In robotics, particularly in the heavy-duty industrial robots or robots that you would see in car manufacturing facilities and so on and so forth, those robots have something that we call gear-to-gear control. Those robots are now switching into belt-driven apparatus because it allows them to have these robots lighter, they have greater motion, and they can be more compact. Lots of value in there. As you can probably see from my voice, I'm very excited about it. Again, I believe that we are in early stages. This is a secular opportunity that is going to be with us for the next 20, 30, 40 years.
We believe that about a $6 billion market gives us a lot of runway over the next foreseeable future to ramp up and drive a nice incremental growth for our company.
Great. Great. I guess just one more kind of looking at longer term as well. Your operating margins relative to peers are higher than peers. Even in 2019, they've down slightly. Over time, is there more room to grow operating margins? If so, kind of where do you see that coming from? How would you drive that?
Yeah. Again, coming back to that 2019 analyst day, we said that our target over the next intermediate period of time is to deliver kind of 24% EBITDA margins. Despite the fact that we have taken a setback a little bit here in 2019, we still believe that we will be able to deliver that EBITDA margin during the next upcycle. We have expanded our production capacity in places where we have a lot more flexibility. We have also put the capacity in places that it is a lot cheaper to operate in. We are resizing our fixed manufacturing overhead. We believe that all of these things, plus the level of innovation that we are putting into the marketplace, will give us a high degree of confidence that we should be able to deliver on that midterm objective of raising our earnings to that level.
Great. That's very helpful. If no more questions from the audience, I guess we'll move on to the audience response questionnaire. Do you currently own this stock? Yes, overweight, market weight, underweight, or no? No? Everyone? Okay. Moving on to the next question. What is your general bias towards the stock right now? Positive, negative, or neutral? Pretty much everybody's neutral or positive. In your opinion, through cycle EPS growth for Gates will be above peers, in line with peers, or below peers? In line with peers looks like most of the answers, which is greater than last year. Your opinion, what should Gates do with excess cash? M&A, either large scale or bolt-on, share repurchases, dividends, debt paydown, or internal investment? Debt paydown seems to be clear winner there. In your opinion, how about multiple of 2020 earnings should Gates Industrial trade?
Less than 10, 10-12, 13- 15, 16-18, 19- 21, or above? Most think 13-15 times or 16-18. Last question, what do you see as the most significant share price headwind facing Gates? Why do you not own more of the stock or why do you not own it? Say core growth, margin performance, capital deployment, or execution strategy. Most say core growth. That is similar with 2019. Thank you guys very much for coming to our conference. I hope everybody has a great rest of their conference day.