For real?
I haven't sat here yet, so.
Oh, just wait.
Should we stand? Should we make the walk?
I don't think you want to.
Here.
Yeah, this is noisy.
It's noisy.
Do you want to stand?
No.
I don't care. We can do this.
I can do it. Yeah.
All right. Am I on? Okay. All right. Next up, we have with us Gates Industrial. We have Dave Naemura, who's the Chief Financial Officer. Thank you very much for being here.
You're very welcome.
I think we'll use the same format in terms of it will just be informal Q&A. Because I'm up here, if you have a question, just raise your hand. In the back, they have a mic that they can bring over to you guys. I guess first, I think about it as when you guys first went public and you talked about sort of your total addressable market of being about a $60 billion market versus I think your sales this year will end up being or I'm sorry, your sales in 2019 will end at about $3 billion or so. I guess can you just talk about any changes in your view or how you view your total addressable market versus you went public?
Where do you think sort of the biggest opportunities for market outgrowth for Gates or content, just giving you a smaller piece of a much bigger pie, I guess?
Okay. I think our total addressable markets, which we see is probably about $30 billion.
30? Okay.
Sixty combined with the two pieces.
Yeah, that's what I meant. Sixty with the two.
I think it's about roughly the same size. We measured that back towards the end of 2017. I think obviously we saw significant expansion in 2018, particularly on the industrial side, primarily driven by hydraulic applications. I think we've seen a lot of that growth come back this year with the downturn, particularly in mobile equipment. We play in very large, very fragmented global markets with a number of competitors where we have different competitors by application, different competitors by region. We only have a few real global players on the hydraulic side, people like us, Parker Hannifin and the Eaton hydraulic segment within Eaton, a number of power transmission players, some European-based folks. We're the largest North American-based team. Then you've got some Japanese players.
In any event, those global players tend to not make up more than maybe 30% or 40% of any given market. They are very highly fragmented global markets. I think the biggest opportunities, in our opinion, remain expanding our addressable market in hydraulics, where historically we've played in—we really only play in premium applications, but there is a broader range of premium applications that we can service. By introducing new products, which we are introducing now, we believe we can increase our addressable market by a couple of billion dollars. On the power transmission side, what we have really targeted is alternative technologies. We make power transmission belts, right? You can use more than a belt to transmit mechanical power between two devices. You can use cables. You can use industrial chain.
We think particularly industrial chain is an opportunity where in many of the applications you would use industrial chain, actually a belt is a better application. It's cleaner, weighs less, more energy efficient, and more environmentally safe. We have a specific initiative that we call Chain to Belt, which is to use our material science capabilities, which allows us to build belts with unique capabilities that we believe for many applications can compete with industrial chain. Probably the best example that kind of everyone gets is a bike chain. A bike chain is a very small industrial chain that has bushings and bearings and has all the dynamics of a typical chain. It rusts. It gets derailed. It needs to be maintained. That's an application that we've replaced with a belt.
We're targeting a number of personal mobility applications, particularly electric applications where there typically tend to be high torque applications. E-bikes, e-scooters in emerging markets, those are very good applications for a Gates belt. In many of those cases, we use one of our more sophisticated belts, something that's not reinforced with metal or with a textile, but rather reinforced with carbon fiber, which is something many people do. I think we're known for doing it kind of the most and probably the best.
Okay. I guess just another question as we think about your strategy longer term. Some of the peers that you talked about, in particular Parker Hannifin, maybe Eaton a lesser degree, but they've sort of shifted their strategy over the past couple of years, focusing more on end markets, which are viewed as more stable, or product lines which are more highly engineered, shifting, I guess, less on the traditional sort of mobile equipment type market. I am just trying to understand how you think about your strategy in that context. I mean, is that an area, understanding you have more of an aftermarket recurring earning stream versus first fit versus for your peers?
I'm wondering if you think about markets or products differently to reduce the overall cyclicality, or does their lack of focus in those markets present a greater opportunity for you in terms of market share growth?
Sure. Obviously, I can't speak to their businesses.
You can speak to it.
I'll speak to ours. We are happy to be the specialists in what we do. We think we are the premium provider of fluid power products and power transmission products globally. The end markets that we address provide opportunity for diversification. We sell a lot into mobile hydraulics because, frankly, that's a lot to mobile equipment because that's a lot of where premium hydraulics go today. A number of our initiatives are targeted towards stationary applications. On the power transmission side, on more MRO and end markets such as material handling, where precision movement and a synchronized belt, small synchronized belts are very good for positioning products. Stationary hydraulics in manufacturing applications as well, machine builders, lift applications, those sorts of things. We're happy to be the specialist, but we're very focused on continuing to diversify the end markets that we address.
Okay. Any questions in the audience? No? Okay. I'll keep going. What was I going to say? I guess another thing, just again, getting back to sort of when you guys first went public and some of your longer-term targets. Let's take 2020 out of this because we all know it's going to be a difficult year. I think when you guys first came public, you talked about, I think, longer-term 5% organic top-line growth or that you could grow 150 to 200 basis points above sort of industrial production or demand. I think you also talked about longer-term targeting 10% EBITDA growth. I'm just wondering if, based on what you see, if those are still the correct longer-term targets for Gates.
Yeah. Fair question. That is our long-term target. We haven't updated that. The one thing I would say, Jamie, is that our long-term target didn't contemplate what we ended up experiencing in 2019. I mean, being in mostly, virtually all short-cycle business with no backlog. Really, we don't get much of a forecast either. We tend to fulfill many orders within 48 hours of receiving it. Again, 65% of our revenues are through aftermarket. The order comes or the order doesn't come. We have been dramatically impacted kind of on the front end of the recession. I think we led into the recession. I think history would say we tend to be a little faster out on the backside as well. I would say we came in thinking the year would be up mid-single digits.
We're coming out of a 2018 environment where, frankly, we were struggling to keep all of our customers happy, particularly on the fluid power side in hydraulics, where it was kind of globally a constrained environment, particularly at the most premium end of applications, into a year where we saw obviously significant destocking and reduction of end-user demand. When we talked about in February of 2019, when we came out with our first investor day following our IPO the year prior, we introduced our long-term targets, but we hadn't contemplated this year. The midpoint of our guidance for the year is negative 6% core growth, which will be the second largest decline in the history of the business. We don't think there's market share loss. We think it's just a function of where we play in the industrial downturn.
It has been compounded by some of the known automotive first fit issues that we see in China that we have also seen from the emission standards uncertainty in Europe. We are starting to round trip those downturns. We think we have not taken a position on when this industrial downturn will round trip. Historically, these things have been kind of five to eight quarters in nature. Looking back at our business, I think this is different times given some of the extraneous concerns around trade and other matters. We are taking it month by month and trying to determine what will happen as we get into 2020. Long way of saying, yeah, we did not anticipate this kind of year.
Longer term, let's take that 2020 outside off the table in 2019. Longer term, is that still the right way? Or will we at some point rethink those? Because again, they're longer-term targets and they don't assume.
I think it is. I mean, and you've properly framed it. We've kind of stated our view of our model as global industrial production plus a few points. That's how we've historically said it. We think that holds true. We think that the initiatives we have around emerging market growth, around expanding our addressable market, and the new products we're bringing to market position us to compete well in the places that we play and outperform industrial production.
Any questions in the audience? Yes. Go ahead.
Andrey, just wait for the mic.
Thank you. It's Andrey from Credit Suisse. I just wanted to pick up on your point on destocking and inventory cycle. What are you seeing on that kind of from that month-to-month cadence? Have we gone to the maximum point of destock? Has there been any kind of restock or end of destocking?
Sorry, besides auto, which it sounds like you feel like you're closer to the end. Are things getting better? Are there other markets that are, I guess, getting worse or better?
Separate automotive aftermarket, which we think is a far different dynamic than really the big issue going on, which is industrial distribution. We saw further deceleration in the end market activity and further destocking through the third quarter. I think you asked the right question, which is how far can it go? The answer is we're not sure. I will tell you, I've personally been a little surprised by the level of destocking we've seen. I think there is some prior precedent to say we're going to see things snap back a little bit too hard. That's probably our biggest worry, that too much inventory comes out of the channel. Then we have to put inefficient stress on our production environment to help our customers kind of satisfy the demand when it does come back. We're trying to work with those folks.
Specifically to your question, we did see continued destocking. It varies by region. Particularly in North America, we saw continued destocking in the third quarter. That is as far as we have gone relative to our public statements. When will it end or is it at a rational point? I would only say that I have been surprised by the level of destocking.
If I may, is that general kind of industrial distribution, the guys who stock everything that have been destocking, or is there a particular kind of vertical they can identify within that?
I'm speaking of general industrial distribution, but I think we've seen it there and in some specialty applications like oil and gas. For the most part, where it's most notable is in kind of general industrial distribution.
Thank you. The last one, just on pricing trends, how do you see that developing? Does pricing tend to be generally pro-cyclical for you, or do you think even in 2020 when maybe demand is kind of down H1, flat up H2, what do you think price can do in that kind of environment?
We'll see what happens with the pricing of raw material inputs. Historically, we've done a very good job. I believe we've probably led the market up in pricing. With 65% of our revenues into independent distribution, we were well positioned to price. That, combined with our strong brand, particularly in developed markets, but in emerging markets as well, has positioned us well to price. In 2019, we'll be price-cost favorable for the full year, but we are round tripping a lot of the price that we took over the course of 2018. That begins to anniversary. When we think about 2020, we tend to go into a year thinking about it being kind of price-cost neutral. We'll see how it develops. I don't think it'll be nearly as robust of a pricing environment as we saw in 2018 or even the second half of 2017.
We will see how the year develops. We have demonstrated historically that we will respond pretty proactively to the market environments.
Go ahead. Okay. Hold on. Let me just wait for the mic there because I think the webcam.
Thanks. In that same sort of long-term context of mid-single digit revenue growth, how do you think about optimal capital structure for net debt to EBITDA? What do you think sort of normalized levels of trade working capital are and sort of normalized CapEx to sales for the business? Thanks.
Sure. Maybe I'll take those in reverse order. From a CapEx perspective, the business has historically run kind of 3% of sales plus or minus, with that being kind of half maintenance CapEx and half growth CapEx. We have elevated the level of CapEx spend through 2017 and 2018 as we've built additional fluid power capacity, primarily at our large manufacturing campuses in emerging markets, namely Mexico and Poland. We have always said that we would normalize that back towards historical rates. I think you see us coming back there this year. We would anticipate in the next few years being still around that 3% plus or minus. From a working capital perspective, the business has been operating recently at a reasonably inflated working capital level that we would anticipate coming back into kind of normal bounds.
We tend to run at a higher working capital level anyway, given the nature of some of our customer base, plus the finished goods inventory that we need to carry to satisfy the service level agreements that we have with our customers. That tends to run as a % of sales around mid-20s. It's kind of been running closer to the higher 20s recently. We would anticipate working back towards the mid-20s over the next few years. From a leverage perspective, our stated objective is to deleverage to three times. We had entered the year thinking that exiting 2019, we would be close to that. Given that we didn't come close to our EBITDA objectives, we'll exit the year at a higher leverage ratio than that. Look, we started as an LBO five years ago at a significantly higher leverage level.
Post-IPO proceeds, we were below four times. Currently, at the end of the third quarter, on an LTM basis, we were below four times as well. Our trip to three times has been slowed, but we still see that as kind of an intermediate-term objective, depending on if and when or what we do from an acquisition standpoint. We've done a few deals in the past. We're always looking at deals. From a capital allocation perspective, we always say we will do what's in the long-term best interest of the business, which may include doing a deal which would impact the timing of deleveraging. We'll do what's in the long-term best interest while also being mindful of leverage.
I guess I'll go. A lot of industrial companies in the third quarter, maybe even second quarter, have talked about sort of streamlining their cost structure. Can you talk about some of the actions that you've already taken and whether you're contemplating incremental actions and how we think about the cost-cutting actions that are more sort of variable versus structural, I guess is what I would say, and how that impacts your cost structure longer term?
As we think about, maybe just stopping at gross margin for a minute, as we think about our manufacturing capabilities, the challenge this year has been first getting our variable cost structure right. As we said on our third quarter release, we think we've exited the third quarter more or less right-sized to the near-term volume environment. Beginning in the middle of the second quarter, really kind of mid-May, we saw pretty good deceleration of our end markets. We saw a lot of inventory coming out of the channel in a real step function down. We think because of our high level of aftermarket, because of our lack of backlog being mostly, if not all, short cycle, we tended to see these impacts a little earlier than others. As a result, we've been trying to get our variable cost right-sized.
It took really all of May and through the end of September to get that right. That does not address our fixed cost structure. That is something that we were already looking to do beginning now where we have done a few smaller things and announced our first plant closure. We have actually accelerated some of the things we had in mind, not to necessarily take manufacturing capacity offline, but to take advantage of some of the new, more efficient production capacity that we have built, and also to take advantage of some of the productivity we have driven into our existing footprint, which should allow us to consolidate some subscale sites. We have announced a program that will more impact 2020 and 2021, which includes addressing a number of larger sites. We have 50 plants globally.
We're probably looking at four or five, the consolidation of four or five of those sites. I would also say that we still have some opportunity below the gross margin line. The business hasn't benefited from things like shared service centers and some other efficiencies that we will continue to build over the next few years that allow us to drive more money out of kind of traditional G&A spend and invest those dollars into R&D or feet on the street, things that will drive growth for the business.
I guess just a longer-term industry question. I've covered this space for way too long, almost 20 years now. I remember when, I don't need to bring Parker Hannifin up again, but I remember when Don Washkewicz would put up this slide of the motion control industry and how big it was and how fragmented it was and that there should be, which you play in part of that, right?
Right.
There should be broader consolidation, you know what I mean, throughout the market, which never really seems to materialize to some degree in the markets that you participate in. Can you talk to whether you think there's benefits to broader consolidation within your market and why or why it hasn't happened, or do you think that's perhaps an opportunity in the downturn for the broader industry?
I can say that these are incredibly large, incredibly fragmented markets. Why there hasn't been more consolidation, I can't really speak to. I do think there's opportunity for the right, for some players. I mean, we all have targeted, specifically addressable markets in what is a very large TAM. I think there is opportunity for bolt-on and even transformational type things for a number of businesses out there. Beyond that, I don't know, but I think these are markets that, given the fragmentation, are ripe for some level of consolidation. Given the geographical disparity and given the number of local players, it's tough to see. I wouldn't imagine there's going to be consolidation on a grand scale, but I think there's room for consolidation personally. How that develops, I don't know.
Okay. Any questions in the audience? Okay. I'll keep going. I guess I think similar to what's implied in your guidance for the fourth quarter, I think similar to other industrial companies, the fourth quarter margins are implied worse versus the third quarter as everyone's looking to right-size, cut productions, get inventory sort of adjusted. Is that the right way to think? I'm just trying to, how do we think about the fourth quarter, recognizing you haven't guided yet for 2020?
Sure.
In that context, how should we think about the different variables besides volume, positives and negatives that would, you know what I mean, impact your margin? And we shouldn't use fourth quarter, I guess, as the run rate into 2020. Is that the right way to think about it?
I think that's the right way to think about it. It's a little complicated. We start analyzing the quarters in detail and looking at the, there's things in the comp year over year. We really tried to give some insights to this on our third quarter call. Ultimately, you back away from the noise, and I'll talk about the noise in a minute, but when you back away, I think the fourth quarter, we're operating at a run rate that represents us being reasonably right-sized. The least efficient quarter for the year that we will have had is the third quarter, where we were kind of still seeing a significant amount of deceleration. We were in the process of getting our variable cost structure right. Those inefficiencies get capitalized in inventory and really kind of roll out in the fourth.
Those, from a P&L standpoint, impact the fourth. We try to strip away the timing and look at our absolute performance, and we think we've got things about right-sized in the fourth. You start looking at incrementals or decrementals rather on a year-over-year basis. The fourth quarter of 2018, we actually had incredible incrementals. It was based on just the timing of some one-time things that, from a decremental standpoint, come back and hurt us this year. Again, when you strip away kind of some of that timing stuff or one-time stuff, I think at the end of the day, we're performing at a pretty good jumping-off point level heading into the year. I think we'll exit the year plus or minus with inventories in pretty good shape and variable cost structure in pretty good shape and some pretty good plans around reducing our fixed cost footprint.
Okay. I guess I'll keep, not to bring Parker Hannifin up again, sorry, but they guided for 2020, so it's a good way to get you to talk about things. I think when they guided, and they were due fiscal year end, but people were surprised by the organic growth guide of down 6% relative to what potentially other multi-industries will talk about in terms of how they're thinking about organic growth. I guess why it matters for your business, if you think they're right, I think the North American guide was down 6%, aerospace was up 4% or 4.5%. International industrial, I think the implied guide was down like 11.5%. How do you think about that in the context of what they're saying about industrial organic sales declines in 2020?
Obviously, I can't comment on that at this moment.
No, we can talk about it.
I'll tell you, look, 2020 is a developing situation. I can't speak for how others are thinking about it, but we're very much taking it month by month, and we're going to get into our Q4 release and get a few more months of data to see what we think it means. I think, again, not being a backlog business and probably leading our way into the downturn, our timing might be different than others out there. These things tend to be kind of probably more or less, again, five- to eight-quarter type industrial recessions. How far in is debatable, but I think there's a reasonable case for being four quarters into the current industrial downturn.
How long it'll last, I think, as I said earlier, I think there's some uncertainty too, given some of the extraneous events and being in an election year and some of the other things that could impact the timing of the downturn. I think it's a dynamic environment with enough uncertainty that it's very difficult to make the call right now. We're watching it day by day, I guess. That's the best I can say.
Okay. Any other questions that are out there? All right, I guess. Let's see, what do we have? I guess on the.
David, on that point.
Yeah, I think we need a mic.
David, you mentioned the five-day quarters, industrial pause, whatnot, dynamic environment, election year. Can you just give us an insight into your boardroom? Is that backdrop hailing you from doing something that's a little bit more forward-leaning as you go into 2020?
Great question. The answer is no. I think one of the things we have really prioritized is continuing to invest in the business and prioritize the strategic spend. To the extent we've drawn back investment dollars, not doing it in the areas where it might hamper some of our what we think are large strategic opportunities. We believe the business is poised to exit this downturn stronger than any other downturn we've seen. From the new product pipeline, the work we've done on VAVE, as well as manufacturing processes and the manufacturing capacity and capability of the business, we think the business is in as good a shape as it's been. Unfortunately, some of these things have been hampered by the industrial end markets where we've targeted a lot of our growth initiatives, but we're continuing to position ourselves for when the markets do come back.
We think we'll be in a position to compete well. We have continued to prioritize that spend, both from an OpEx perspective, but also from a capital perspective. Thanks. That's a good question.
Hi. I'm not looking for any insights into what Blackstone is currently thinking today about their ownership stake in you, but I was wondering if you could provide a bit of historical context and color about, high level, what were some of the business characteristics that drew them to take a position in your company whenever that started? What was it that they liked about just the bone structure of what you do on a day-to-day basis?
Sure. Obviously, I don't speak for Blackstone, but I can hypothesize from my opinion. Gates is a great American company. It's been around since 1911. End users know the brand. It's synonymous with quality. It's a global brand. We're continually surprised as we go around the world, even in emerging markets where you wouldn't expect people to know the brand as well as they do. We're continually surprised by the brand affinity that Gates has with end users. Gates went from family ownership for up through, I think, 1996. It was owned by a British conglomerate for a while. That conglomerate went through a round of private equity ownership, which I might characterize, I wasn't here, but I might characterize it as maybe kind of more of a financial engineering type of ownership. Gates was isolated, and I think it was considered generally the crown jewel of that process.
I think what I believe there was a good operating play to be had. Given the dynamics of Gates with the global brand recognition, the good profitability, the strong cash flow generation, and the large diversified end markets with high aftermarket exposure, were all very attractive, I would suspect. With the opportunity to maybe add a team of industrial operators led by our CEO, Ivo Jurek, and a lot of the team that he's been able to put together, I think most people would look at it and say that's probably a pretty good opportunity.
I guess I'm just last if no one else has another question. I mean, is there anything else as you sit here and you've been the CFO of Gates that you think the market, and you look at the multiple of your stock, what the market underappreciates about Gates as we get through this sort of short, I'm an optimist always, so I'll assume a short-term downturn, but a shorter downturn versus normal.
I think the point I made earlier.
What pushback you get from investors that we might underappreciate?
I think the thing that's underappreciated is I think everybody sees the downturn, which I think obviously we need to focus on things that are within our control. As I talk about having the business well-positioned exiting the downturn, I think those are the things we're focused on. Aside from just the industrial downturn, there are other compounding events like I talked about a few of the automotive end markets. Automotive First Fit isn't a big part of our business. It's about 15% total, and it's very important to the aftermarket franchise. In China and in Europe, that's kind of compounded the top-line impact we've seen recently. When you strip it away, I think we're performing very well competitively in the markets that we serve. Again, we're positioned well to exit the downturn.
I think we continue to focus on those things that are within our control. We continue to invest in those areas that are important to the business. For everything you read in the news, we're still very bullish on China. We've talked recently about starting to see more of a bottom in China. We have an automotive aftermarket business in China that is growing at kind of mid-teens level in what is a developing aftermarket environment. It will be the largest aged car park in the world in five or some years. We believe we have a leadership position there. We're continuing to focus on important initiatives like that. When the markets turn and the markets will turn, we think we're well-positioned.
Sorry, go ahead, Andrey. Just wait for the mic. What, no, you can. Go ahead.
Thank you. I just want to come back to kind of more big-picture stuff and maybe at risk of opening big kind of worms. When we think about the industrials and the big things that are going on, there are things like electrification of everything. All the motion is becoming electric rather than combustion or hydraulic. Digital, everything's getting connected. You learn how to run it better once you use less parts. Everything as a service. Across these three things, we can kind of see a few risks for Gates here, but probably there are also opportunities. Just wanted to take your view on kind of how we can run through this and kind of weigh them up on, and then what are you doing as a company to position yourself in that context?
Yeah, it's a good question. I think as propulsion technologies change over time, I think it results in different opportunities. The classic example is automobiles. Automobiles today use a lot of mechanical power transmission products. Electric vehicles of the future will use more fluid power, heating, and cooling. Batteries need to be heated. Batteries need to be cooled. Electric water pumps on an electric car. I talked a little bit about personal mobility and how high-torque electric applications like e-bikes and e-scooters are very well-suited for the belt products and technology that we have. Verticalization of people moving to cities and lift applications and distribution of products and precision movement and warehousing and distribution. I think the opportunities change, but I think we see plenty of opportunities given the major trends that we see towards urbanization, mechanization.
Even if you, I know Deirdre was in here earlier, but there's a lot of farm equipment that's going AI. Look, there's going to be a lot of belt-driven applications on those machines as well. It's incumbent upon us to stay ahead of the times. Given the investment and the advancements we're making on the R&D side, we think we're well-positioned to be on the forefront of these things. In the near term, if you went back to last summer, maybe about a year ago, we had an announcement of a bunch of new products. You see us targeting things like hybrid applications in automotive. Those are complex applications, start-stop applications. Those are belt-driven applications that are more complex than historical applications. We see more content for Gates on a hybrid car than we do a traditional ICE engine.
There are industrial examples of that as well. I think the opportunities change, to your point, but I think there will be plenty of opportunities.
Thank you.
Great.
You're welcome.
We're probably all set unless someone has a last or final question. No? Great. Thank you very much, David.
Thank you. Appreciate you guys' time.