Okay. Good afternoon, everyone. Welcome to this afternoon's session with Gates Industrial Corporation. I'm Jerry Revich, and I'm excited to have with me today David Naemura, Chief Financial Officer. Also joining us from Gates is Bill Waelke, Director of Investor Relations. Gentlemen, thank you very much for coming to visit.
Thanks for having us, sir.
Dave, maybe as a starting point, what's really interesting about Gates is the business model where you folks have built over 60% of your sales as aftermarket. Can you talk about the company's strategy historically that's enabled that structure for each of your two businesses and steps that you're taking today to defend that pretty attractive structure?
Sure. That's a great question. We consider ourselves the aftermarket guys, and it's easy to tool up a dozen, 15 00 SKUs to service OE equipment, but you can only service the number of parts in an aftermarket portfolio having tooled it up over a series of decades, really. Gates is a 100-year-old company that has kind of built this legacy. That, in combination with the brand loyalty, means we don't have to be on original equipment to be the replacement equipment in the aftermarket. The best example of our aftermarket franchise is probably the automotive aftermarket in North America, where we have a 99.99% product coverage. It's really that product coverage that allows us to be a reliable distributor to someone as broadlined as, say, NAPA or O'Reilly's.
We have great brand affinity with the end user, which would be an independent mechanic in our case because our products that we make would get replaced outside of a warranty period frequently by a wholesale mechanic that uses a wholesale distributor like a NAPA or an O'Reilly as an example. For someone to penetrate that market and to have that SKU count, it's very difficult, and that's one of the moats, both on the industrial side and on the industrial and automotive side, why it's hard to penetrate and kind of the value proposition for us in the aftermarket.
In terms of your leading competitors from an aftermarket standpoint, who would your number one competitor be in each of your two businesses?
It varies by region. In the United States, on power transmission products and automotive applications, you'll see Dayco. You'll see Continental's division, ContiTech. On the fluid power side, you'll see Eaton, Eaton Hydraulics. You'll see Parker. You'll see more of the European brands in Europe, so maybe Manuli, Alpha Gomma, Continental, a bigger presence in Europe. When you get to Asia, it's more of the Japanese: MBL, Mitsuboshi, Kondo. On the fluid power side, you'll see more of the Bridgestone. Eaton and Parker are global players. We see them in hydraulics. We tend to be a little more competitive in the higher-end hydraulics, which Gates tends to play a little more in premium applications. It really varies kind of by region and by product.
Any of those competitors that you mentioned that are making strides towards improving their range of SKUs, or who do you consider is the most significant threat to you folks?
Good question. I think it varies. The most competitive landscape from a coverage standpoint right now is in China, where you've got the largest, most diverse, most complex car park in the world, and you have no aftermarket, really. It's developing. The key to developing the aftermarket is getting the coverage of the parts required in this most complex car park. I would say we are by far leading the way. I think we've got coverage of over 90% of the necessary parts in the car park. We believe the next competitor is probably somewhere sub-80. That's a number of people, a number of big names that would be competing for that. Most of the names I've already said, really.
In terms of the other part of your strategy in China, has been to increase the location count. Can you talk about where we are in those efforts? In terms of the opportunity set, how much larger could your location count in China get from, call it, 2018 levels?
Development of the distribution network in China is very nascent. The larger players have not emerged. There is not a NAPA. There is not a Motion Industries emerging yet. There are four or five players that look like they are in the mix to emerge, and we are competitive with all of them. In this last quarter, I think we grew about 18% in the automotive aftermarket in China, and that is just a function of how the car park has developed over the last number of decades. We see our parts get replaced in kind of a 7-11 year timeframe, so we have really a long tailwind of growth associated with that. How it will develop exactly and at what rate is yet to be determined? I would hesitate to speculate because I do not think anyone knows. It is so kind of early stage. We think we are well-positioned.
We have relationships with the guys that we believe could emerge as large players. A lot of what we do is we go to cities that we target, and we target the end user. We help them understand that we have the catalog necessary to help them know what part goes on what car, which is a strategic advantage that Gates brings to the table. We help them understand where our products get distributed through, and we help create demand to pull through our distribution network.
Taking that same question globally, as you look at your distribution network today, where are the most meaningful opportunities? Where is the white space in terms of geography or maybe product range that you think your distributors have opportunities to effectively grow the location count and augment the same store sales growth that you would otherwise get?
I think there's two answers here, Jerry. The first one is at a very macro level. In developed markets, we're about 70% aftermarket and about 30%—sorry. Yeah, in developed markets, about 70% aftermarket, about 30% first-fit applications, be it automotive or industrial. When you get to emerging markets, which is over a third of our total business, that relationship flips. We're about 70% first-fit applications. That is how these markets develop. We would anticipate over time that that balance would continue to shift in emerging market locations, which is how you develop these aftermarkets, but it's also an opportunity for us to continue to find growth in the aftermarket. Specific to fluid power, we are very well-penetrated in hydraulics in North America and very under-penetrated internationally. That is both a first-fit and an aftermarket statement. We would see international aftermarket hydraulic applications as a real big opportunity to further our aftermarket revenues, both through further penetrating products and through expansion of our distribution network.
In terms of the product difference, how meaningful is it in international markets, or is it converging in terms of the product mix post the move towards tier three in China now and eventually tier four? Does that converge?
There's some convergence. We have a lot of product that can be sold, that can be produced out of any of our plants, sold ubiquitously around the world. There are some local standards that we adhere to. Generally speaking, we have products that we sell globally, and we manufacture them in region for regions. We get a lot of questions about China. We manufacture a lot in China, but not for the United States, for China and for Asia. We have recently added capacity to a hose plant that we own in China, and we have built a new hose plant in Poland. That hose plant in Poland is the first meaningful increment of capacity we have had on the European continent. The capacity that we have put into China allows us to produce for those markets where we are under-penetrated.
We have introduced new products, really two products, something we call MXT, which is the first kind of large innovation in high-end hydraulics we believe in quite a while and allows us to make a lighter, more flexible product, which is meaningful if you're routing hose or putting it on mobile machinery and you want to be energy efficient. We are also introducing something we call Pro Series, which expands our offering amongst premium hydraulics and addresses spec ranges that we did not previously address and opens $1.5 billion-$2 billion of additional market space for us.
Can we dig in on the point you made a moment ago, Dave? You folks are China for China. What about the rest of the industry? What do you view as the impact of the tariff structure? What proportion of the market do you think is impacted that's not China for China?
I hesitate to answer that because I would be speculating, to be honest. I do not understand enough about other folks' business model and what they supply out of what plant. In our case, we have a few specific products that we make in China for the North American market that are on the power transmission side. Frankly, they are water pumps. Most of our other products, we are in region for region, so less tariff impact directly from direct tariffs. I continue to believe that most of us are more impacted by indirect impacts of sales to Chinese customers that export machine builders, original equipment folks that are exporting out of China to the United States or other regions that are more dependent on sales into China, maybe Europe, maybe some of the other Asian countries as well.
In terms of what proportion of your sales in China would you estimate, or guesstimate if the case might be, are actually exported to the West in terms of based on your sense of your end customers?
It would be a smaller percentage, but it'd probably be maybe 10%, something like that. Still, for China, which is about 15% of our total business, 10% being affected in other countries' sales in, I think is something we've seen a pattern with. Our biggest markets are automotive markets because those have been the fastest growing. We're quite under-penetrated, frankly, in industrial, in one of the largest industrial economies. We continue to grow even regardless of that.
Can we talk about water pumps? Not a huge part of your revenue stream, but it'll be interesting to hear about your decision tree because from what we're hearing, China cost structure plus 25% tariffs is not very competitive against producing in other places in Asia or even potentially investing in automating in the US. What's that decision tree look like for you?
I think it's too early for us to make a decision around moving a water pump business. I think we have to see how things develop. We do it with a joint venture partner in maybe a little less expensive part of China. I think we are waiting to see how things develop. I mean, the 25% tariffs are just going in. Who knows how long these things last? I think we would have a wait-and-see approach to making a decision on something, as you point out, isn't the biggest view for us.
In terms of the pricing pass-through, I think what we've generally seen is companies have pretty good ability to pass through tariffs to the end customer.
I think that's true. Again, our pricing hasn't been as much tariff-driven because we haven't been as directly impacted by tariffs. Last year, we saw a reasonable amount of raw material inflation, which we were, as others, successful in passing through. I think in our case, a combination of brand and a higher percentage of aftermarket presence probably makes that a little easier than it may for some others.
Dave, the other area that you folks really spend a lot of time on at the analyst day is talking about the new products. You touched on high-end hydraulics. What's that revenue ramp opportunity on the conference call? You spoke about a point or two, the total revenue contribution in the back half of this year. How quickly does that ramp into next year? And how should we think about the adoption path?
Stopping short of giving a number for next year, I'll tell you that I think it's a pretty steady ramp. We look at the front end of how the funnel builds. We have assumptions around how quickly things move through funnels, how quickly things convert, and at what rates. We're seeing a lot of excitement around the new products, both on the MXT side for the penetration of Pro Series, but then also on what we call Chain to belt, which is really resonating with end users. The pipeline is building well. I think Ivo quoted a large number. There's probably $150 million-$200 million of pipeline, right, which are opportunities, not orders. We think some percentage of those convert. More importantly, we're seeing velocity in the building of the pipeline. We're relying on second-half revenue contribution and higher than first-half revenue contribution Of course, we'll look for a 2020 contribution much higher than what we saw in 2019.
Much higher than 2019.
Yeah. Yes. I mean, we'll continue to grow.
In terms of the end markets trends, can you just take us around the world and talk about areas where you're most optimistic on outgrowth? Sounds like China aftermarket is one, but maybe step us through the next couple of areas. On the flip side, which markets or geographies you folks are concerned with end demand?
I'll maybe go back to a few of the things we talked about on the conference call. First of all, China, which before the move to 25%, we think we saw a flattening of China. We saw growth in March and April, and we kind of called mid-single digit growth on a core basis for the year in China, which would be different than what we saw in Q4 and Q1. We believe, market aside, we continue to have opportunities to further penetrate industrial end markets, which we see as generally steady, particularly in North America. Maybe not as high a growth as we had thought we would see, but growth. Where we definitely saw greater softness, we kind of called out Europe, which we saw is softer than we had thought, honestly, on all fronts. We were well-documented in the automotive first-fit issues.
That is something that we knew coming into the year that we think is about consistent with what we had thought. I think more broadly, we're seeing softening in Europe. We remain bullish on emerging markets. India's got to get through some elections and other things, but India's been a great growth driver for us for a number of years, and we see that continuing. We look to further penetrate industrial applications in a lot of markets, including places like Japan and Korea and India, obviously, as well as further penetration in Europe, where we just haven't had the fluid power capacity to properly service what's a very large industrial market.
You are at a point in the cycle where you will have capacity, especially with the fluid power capacity in Eastern Europe. Can you talk about how you expect that push to play out? How we're getting some pretty quick gratification on the new product side. How would you think about the pace of contribution from the new plant and the opportunity to penetrate the market with all of your SKUs?
I always remind people we decided to build these plants not when we saw a recovery of the industrial end markets in 2017, but really in 2016 when we were still in what we considered a pretty robust industrial recession. We did it not because we anticipated market recovery, but we did it because we had a lot of conviction around these new product initiatives and the ability to take share, particularly internationally. With the kind of comeback of the markets, we found ourselves in a position where we were tapped out. We have these new initiatives. Without the plants, we would not be able to produce, frankly, products to satisfy the initiatives. I think the ramp will happen maybe a little less than we thought a year and a half ago, but the growth that we will see will be facilitated by the new plants. What'll drive it is adoption of the new products. We'll see what that rate is. Kind of as we talked about earlier, we're bullish on that. We think these plants give us opportunity to play in regions we haven't been able to play as strongly in. You can't support an OE in Europe with hoses coming on a boat from China. It's just hard to do.
In terms of your first-fit business, I'll break it up into two parts. Can we just touch on auto first-fit opportunities from here? Obviously, you're very focused on only profitable business. So what does that translate in terms of what the pipeline looks like as you have the eventual in terms of platforms rolling off that you folks are on, that others are on, and rebid opportunities? What's the mix of all of that if we're sitting here five years from now and the next platforms are full production rates? What's Gates' market share from a first-fit standpoint compared to what it is today?
First of all, our first-fit market share is very low. We, frankly, do not bid on more business than we bid on. It is about 15% today of our overall business, down from maybe a lower 15%, down from maybe 19% a few years ago. That is a combination of things. One, we have bid on fewer programs, and therefore we have attrited some of our share. Maybe we have tightened the strategic filter around what we bid and why we bid over the last three or four years as we have had a new management team come into place. That has been an impact. Also, the market has turned down, particularly in the second half of last year. In Europe, it was significantly driven by the new emission standards. That has probably hurt us a little worse because we play a little more heavily on diesel platforms.
That has reduced the size of the business. The lack of incentives in China, a little slowing of the economy over there has seen the automotive first-fit production decline and level out, decline on a year-over-year basis, and probably level out this year. For us, we'll introduce new innovative products into automotive first-fit. We don't see it as the big growth area for us. We see it as somewhere we want to play to be innovative, remain relevant, help support our aftermarket brand and our aftermarket franchise for decades to come. We've always said we wouldn't mind keeping it flat, but make it more profitable. Kind of keeping it around a $500 million type business through the cycle. As we trip programs off now, eventually replace some of that with a little more innovative programs and kind of try to hold a level of business, but again, make it a little more profitable, a little more strategic, a little more value add to our OE partners. Also, that will help further support the aftermarket.
When we're talking about holding the line at that $500 million run rate, is that an inflation-adjusted number in your mind?
Yeah, probably.
In terms of you mentioned the diesel headwind in Europe, are we at the point where all of the platforms that we expect to roll off have rolled off, or are there any pieces that we should keep in mind? By that same token, any new platforms coming online that you've already won?
I don't know the answer to that, Jerry, but I suspect there's probably still a little more attrition to come on a net basis.
In terms of your industrial first-fit business, can you talk about the opportunities set there? We spoke about the new products, so maybe weave in what the market share outlook is for that part of the portfolio.
I think over a period of time here, a couple of years, we would anticipate taking share because we're bringing innovative new products, and we have a big OE presence internationally. We have some definitely domestically. We think there's more opportunity internationally. We think introducing the innovative new products gives us a competitive advantage. I think we're coming out of a time of constrained supply where the OEs were getting all of the demand they could get, and everyone was working hard to satisfy them, of course. Not all of us did a great job of that. Now we're going to have hopefully more capacity, and demand will normalize, and we'll be able to get back to more of a normalized state.
Do you think they're destocking an industrial OE now after not being able to get their hands on enough last year?
Maybe. I think when we talk destocking, it tends to be more associated with our distribution channel. I think there was a period of time when everyone was getting their hands on everything they could to avoid getting in a situation where they were maybe having lines shut down. I would not be surprised if there was some inventory level reduction there. As we have talked about, destocking is a phenomenon. We have been more focused on the distribution channel and, frankly, mostly North America.
Let me pause there to see if there are any questions in the audience. Yes, the mic is right behind you.
Could you just review where you guys stand within automotive in terms of the shift to hybrid and electric vehicles? When you look at your part SKUs, are there some that are vulnerable given that you guys like to innovate? Are there places it could be an opportunity? Maybe just recap that. Thanks.
Sure. Thanks, Barry. I mean, cutting with an axe, right? These propulsion technologies are going to migrate over time. We are the aftermarket guy. We look at how the percentage of propulsion technologies grow over a period of time. What we see in the next, frankly, decade, maybe decade plus, is that 7- to 11-year-aged car park, the largest growth will be from hybrid, full, and mild hybrids. That is an area where we have good technology and good content. Those are highly engineered systems in small compartments, which plays well for Gates. ICE, or traditional internal combustion, will continue to cede some share to hybrid and eventually electric. Electric will become a meaningful part of the car park someday. As we look over the time horizon, I think this is directionally correct. I'm not going to quote data other than say it's probably a mid-single digit component of the aged car park, still probably 10 or 15 years from now. It doesn't become that meaningful to the aftermarket for quite a while, but we're very focused on what will in the near term, which is the continued growth of hybrid technologies. If that helps.
Dave, from a KwanaCrunch standpoint, can you talk about are there any product types that are not within the Gates portfolio that would make sense where you could add value with your distribution or manufacturing footprint?
Look, as propulsion technologies continue to evolve, we will continue to evolve with it, right? I would foresee a number of electric water pump applications, heating and cooling, fluid conduit applications for electric vehicles. There'll be content. There'll be actually a lot of content. It'll shift from maybe a little more power transmission to a little more fluid power. That's going to develop over time. Right now, those are OE products that we make some of each of those, but we don't play very big. We'll continue to advance that as we see the aftermarket developing. It'll be an evolution over coming years.
To Barry's question, you folks have done well in innovation. Is there a scenario where your OE market share is higher with some of these products than it has been, as you mentioned, low market share from a power transmission standpoint historically on an OE basis?
I think there are those opportunities. Whether they develop that way, we need to see. There are some new technologies we're working on. Actually, I think it was in Q1, it might have been in the fall, even in the fall of Q1, we put out a press release that talked about a number of new products that we're putting into amongst all propulsion types that we're putting into the market currently. Without going into anything specific about products to come that haven't been announced, I would say yes, that's obviously an opportunity. You will see us bring out some new innovative products that could influence the first-fit market, I think.
In terms of acquisitions, you've made a couple of deals at attractive multiples and expanded the customer base. How would you characterize them, the pipeline now, and what's your appetite if you were to find an interesting fit to lever up towards the high end of your target range at this point in the cycle?
Look, the deals have gone okay. Rapro is a good example. We talked about one of the things we pick up with Rapro is we pick up more capability in automotive fluid power, which goes directly to particularly engine hose and the new advanced kind of modular engine hose technologies. Also, we pick up SKUs for that product line for the aftermarket. It's hard to tool up thousands of SKUs. With Rapro, we get the European SKUs for something we already do well in North America. Our appetite remains good, remains opportunistic. We're focused on growing the business and doing what's right for the business while being mindful of deleveraging. Having said that, when the right deal comes along, we'll do the right deal. There's nothing imminent, nothing in the pipeline today. We believe that we get more optionality over time as we continue to deliver. We play in large, highly fragmented markets that are attractive for acquisition, frankly. We think we can get attractive returns. We think it's an attractive target base. Over time, our optionality will increase, and we anticipate taking advantage of that.
In terms of your M&A framework, let's say an opportunity emerges and we see Gates acquiring a business, what are the thresholds that that business will have to meet?
It honestly depends. I think if it's a classic bolt-on, we're looking for double-digit ROIC by the second year if it's truly a bolt-on. That means it really does accelerate strategy, and we're able to go in and tear out costs and integrate it at the rate we should be able to integrate it. If it's not a bolt-on, the returns will be less than that. ROIC of double digits, third or fourth year, I would say.
That is not on tangible capital. That is all in?
All in. Yeah, all in price. Each deal is a little different. I think we look at what helps us extend our aftermarket portfolio, what gives us new technology, what gives us capabilities from maybe a commercial or a product or an engineering standpoint. We're always kind of looking at all those things. Look, there's a good pipeline of opportunities out there, and we continue to be active. In our situation now, we'll continue to be very disciplined when it comes to acquisition.
Dave, from an R&D standpoint, can you talk about the mix of projects today, how that's different from two years ago? Are you spending more on product costs versus new product introductions? Can you give us a flavor of how you're allocating the budget?
Yeah. R&D's percent of sales is pretty low. We're at about 2%, 2.2% over time. Our objective over the last three or four years has not been to grow or reduce that, but it's been to get something different for it. What you see us doing is working on far, far, far fewer, but far larger opportunities. MXT is an example of that. MXT's a new product, but it's also a product that helps us take costs out of the product. New product and VAVE, reenergizing both of those bases. Really, just frankly, that's the best way I can say it, looking to get more out of our R&D spend by focusing on larger, more meaningful opportunities.
Dave, you mentioned you had a couple of new plants that have come online. Can you talk about the technology capability that you're able to deliver in the new plants and the opportunities for efficiencies to ramp over time with the new generation technology versus what part of the footprint that was built 20, 30 years ago looks like?
Yeah. Great. First of all, all the new plants are built with globally homogeneous equipment and process. As opposed to we use this brand of machine over here and this brand of machine over there, we have harmonized on one set of equipment. We've harmonized on one set of manufacturing processes. Those are all capable of making our newest products as applicable as well as our appropriate—I use the word legacy, but our appropriate kind of current products is probably a better word. We're outfitting about a third of our plant in Mexico and about a third of our plant in Poland. We finished completing capitalization of a full plant in China that was already about half to two-thirds full. The most important thing is we're able to make in a consistent manner the same product anywhere in the world of our newest generation products.
Good. Time for one last question. As you think about some of the new technologies that have come out from a process standpoint for predictive maintenance, anything along those lines that could really move the needle from a Gates standpoint?
We haven't introduced anything. I will tell you, given our material science background and the material science work we're doing today, we continue to look at those opportunities. We understand the push in that direction. We think there's opportunity. We haven't introduced anything yet, Jerry, but I would tell you we continue to look down those lines.
Okay. Good. Please join me in thanking Dave and Bill for coming out and visiting with us. Gentlemen, thank you.
Thank you.