All right, thank you everybody. For our next company, I'm excited to have Gates Holding here. It's a, it's a little newer story for a lot of the other day. You know, it's an interesting story where the company's gonna evolve too, and really, you know, have a great management representation here with David Naemura, CFO, and Bill here from Investor Relations as well. I want to thank you both for coming, and we're here to learn.
Great.
Thank you .
Thank you.
Take it away.
We appreciate the opportunity to be here. As I said, as David said, my name's David Naemura, CFO of the company, and I have Bill Waelke with me, our Head of Investor Relations. Typical forward-looking disclaimer, safe harbor. We'll make a few forward-looking statements, but actual results may, of course, differ. I'm gonna go through a quick interview and love to get the questions and answers and satisfy any questions you guys may have about the business. A little bit of what we'll hear today. At Gates, we're the replacement folks. Two-thirds of our business comes through replacement channels, through distribution. We'll talk about that. We have a very, very highly diversified product offering that goes into a variety of end markets in a variety of geographies.
We're a market leader in most of the places we play, with over 83% of our revenues coming from number one, number two, or number three positions globally. You know, we've got a history of now two rounds of private equity ownership. What people, I think, misconceive is that that means there's no margin expansion left for this business. We've demonstrated tremendous margin expansion over the last few years, and we'll talk a little bit about why there's significant opportunity for further margin expansion for Gates in the future. That's a little what you'll hear today. The Gates vision, you know, this business has not historically experienced, or the industries that we play in have not historically experienced a large degree of innovation. We have reintroduced that to our products and to the markets in which we participate.
It is very much consistent with the history of Gates going back to 1911. A combination of our innovation, our brand strength, which is a 100-year-old brand that end users have a great affinity to, and our global footprint that allow us to have the opportunity to grow at rates greater than the markets, and as a result, of course, generate strong free cash flows associated with that. At a glance, 2018 was a record year for Gates. We had about three, a little over $3.3 billion in revenue and generated adjusted EBITDA margins of 22.6%. We operate the business under two segments or, or product lines, if you will: power transmission, which is transmitting mechanical power between two devices. Think a pulley or a sprocket. We make the device, typically a belt.
It can be a toothed belt, like a synchronous belt, or a friction belt, an asynchronous belt, to transmit power between those two devices, or fluid power. Fluid power is everything from conveyance of fluids to hydraulic hose. Hydraulic hose and premium hydraulic hose, in most cases for Gates, premium applications is where we play, and it is where the Gates brand promise is most important, where the cost of downtime is incredibly expensive relative to the cost of the product. Both of our segments have scale and global presence and are over 60% replacement or distribution sales. Going a little bit further into our two segments, our power transmission segment, just under $2.1 billion in 2018, grew on a core basis at 3.6%, growth driven by a strong year in industrial end markets and automotive replacement channels.
We service a lot of automotive end market, but through replacement channels, which is unique and has a different dynamic and is focused on an aged car park that is 7 years- 12 years old. Within that, we provide a large skew count of replacement parts relative to the cars in that local area. We are the number one player in the products we serve into this end market, and we have opened many or most of the emerging market territories in the world and are very involved in places like China that have a very large growing car park, benefiting from the, you know, the years of growth in registrations in recent years.
I noticed that, I noted that two-thirds of our business goes through replacement markets and serves a very diverse set of end markets, everything from camera lenses and ATMs to automotive, automobile applications and industrial applications as well. The markets in power transmission that we participate in are highly fragmented and very large and are about $30 billion in total addressable market size. On the fluid power side, our fluid power segment, about $1.2 billion in 2018, again, driven really by a very, very strong year in hydraulics, resulting from many of the end markets, industrial end market strength that we've seen. Hydraulics is probably about two-thirds of our overall fluid power business. Again, over 60% of the revenues in our fluid power business go through distribution. Our fluid power business is, geographically, more heavily weighted towards North America.
We believe hydraulics and premium hydraulics, which is our largest category and our most competitive category, that we have a significant opportunity for further international penetration. We will talk in a minute about some of the capacity we have recently stood up. We have a new hydraulics manufacturing plant in Poland that is the first of scale hydraulics manufacturing plant we have had on the European continent. We completed the fit-out of half of our China plant. We had half capacitized. We have now fully capacitized that plant to further penetrate emerging market opportunities in Asia-Pacific. The fluid power markets that we participate in are roughly similar in size to our power transmission markets, about $29 billion of total addressable market. I keep talking about replacement channel presence. Gates, Gates were the, were the aftermarket guys. Roughly two-thirds of our business is replacement channel in nature.
Fundamentally, we make mission-critical parts that are used in harsh and hazardous applications that must be replaced on a regular basis. There are applications where the cost of downtime is incredibly significant relative to the cost of the product. You're not gonna save $5 and put an inferior product in there. You buy Gates, you understand the Gates brand affinity, and you ensure uptime. We kind of refer to that as the structural attractiveness of the product and the aftermarket presence, and we think it's borne out over decades, decades of proof points. From an end market perspective, we have highly diversified end markets.
This chart shows from both the replacement or two-thirds side versus the first-fit side how the end markets we address play on the replacement channel side, then on the first, and on the automotive side, be it replacement or first-fit, how that exposure relates to developed markets and emerging markets. What you see is a wide range of applications across numerous end markets. About 30%... 36% of our revenues are generated from a broad set of industrial markets in the industrial replacement channels, and about 26% of our revenues are generated from automotive replacement channels. That is related to sales of applications on a car park that is generally 7years-12 years aged. On the first-fit side of the business, we generate about 22% of our revenues from first-fit customers in construction, agriculture, heavy-duty truck and bus end markets.
On the automotive side, in 2018, about 16% of our overall business went into automotive first-fit with a pretty good mix between developed market and emerging market. Geographical diversity of the business, we have a nice balance of business across developed and emerging economies supported by what we call our in-region, four-region strategy. We manufacture for the most part in the region that we want to sell, sell the products. Our markets are very highly fragmented, especially in emerging markets. Our global footprint allows us to serve customers locally, which is important given the structural importance of the products, and to compete with local players as well. Getting quickly into a few of our growth opportunities, we like to address industrial power transmission, which, along with emerging markets, and we will talk in a minute about our fluid power growth opportunities. It is something we are very excited about.
On the left side of this slide, we talk about chain-to-belt market opportunities. The three segments here under chain-to-belt represent about an $8 billion market opportunity for us. The far left side, what we call industrial chain-to-belt, is our initiative to convert industrial chain on mobile and fixed industrial applications to a belt or a synchronous belt that we would call a Poly Chain. We have some unique product capabilities that allow us to compete head-to-head with an industrial chain, as well as certain other industrial, alternative drives, but primarily, primarily chain. The middle section here, personal mobility, is targeted applications like bicycles, e-bikes, e-scooters, motorcycles. We use our Carbon Drive technology, which is a carbon-reinforced belt, into these applications. We have 100% of Harley-Davidson as an example. We do a number of bicycle applications.
A lot of the new OE platforms we're winning in emerging markets are e-scooter and e-bike related. Something we call precision motion control, which we also believe is about a billion-dollar market opportunity. You know, think material handling, material movement. This isn't necessarily the conveyance belts, although we do make some of that. This is the drives underneath the conveyance belts and the motion to get products from one segment to another, and it's impacted by very diversified end markets. On the far right is belt-to-belt. This is a segment of the market that was invented by Gates decades and decades ago, and we look to continue to expand our product leadership here. On the fluid power side, we talk about our industrial hydraulics opportunities.
Ultimately, as much share as we have, being a number one, number two, or number three player globally, we're still reasonably underpenetrated outside of North America in premium hydraulics. With the new increments of capacities I mentioned in China and Europe, we will be able to get, we should be able to gain share in these two very large hydraulics markets. We're driving innovation. We've introduced new products to the hydraulics world where, frankly, there hasn't been a lot of innovation over the last 20 or 30 years. You'll read about in some press releases we've put out the new MXT family of hoses, which are very innovative. You know, we are a leading player across premium hydraulics, but frankly, we didn't play across the whole spectrum.
We have introduced new products now to increase our addressable market in premium hydraulics by a couple billion dollars. You see a little tractor there. The blue hoses were the ones we made before, but we stopped our spec range at about 2,500 PSI, around there. There is a set of premium hydraulics around the 2,000 PSI range that we now make as well, which allows us to get more coverage in that premium range. At the end of the day, the core of Gates is our material science heritage, and it differentiates us. It allows us to build belts like I talked about, Carbon Drive, that can, frankly, do things that other people's belts cannot. It allows us to compete against industrial chain where others would find it difficult, and we get to introduce new products like MXT.
We're very focused on, on, on innovation here at Gates. You know, I've been at Gates since about 2015. I joined at the same time our CEO, and we admittedly inherited a reasonably low vitality index. That vitality index now is probably maybe getting close, it's high single digits or maybe 10%. We have a vision in the next few years of getting that up to 25% over the next two to three years, given the new technologies we've introducing, we've introduced and the product roadmap that we have yet to come.
We're introducing innovation, again, in markets that haven't seen innovation in a while that give us an opportunity to disrupt existing markets with new processes, manufacturing processes, and new technologies that ultimately should result in an opportunity for us to increase our manufacturing and production efficiency as well as take share with, you know, innovative, innovative new products. Not the first time you've seen a slide like this, but we think about value creation and using our material science and R&D heritage as well as our commercial capabilities and replacement market presence as an opportunity to grow the business at a rate faster than global industrial production.
With that, translate that through to earnings growth by increasing efficiency in R&D, operating our factories more effectively and more efficiently using the Gates operating system, and then using that gross margin expansion to further invest a portion of that in sales and marketing, in R&D consistent with, you know, driving value to shareholders. We have delivered reasonably consistent core growth. This business was impacted in 2015 and 2016 by the industrial recession as we sell over half of our end markets are industrial related. Given the diversified, both geographically and end market diversification of the business, you can see that in 2015, on a core basis, we were only down 140 basis points. In 2016, on a core basis, we grew 250 basis points. Since then, the industrial markets have recovered well, and we saw the benefits of those in 2017 and 2018.
In 2018, we had core growth of 5.9%, and that's with a very difficult automotive first-fit market in China and China overall market in the second half of the year, as well as a lot of automotive first-fit headwinds coming out of Europe, which us and many others have seen given recent regulatory developments. We have a guidance that we just recently published on our last earnings call for 2019 of 3%-5%, which we think on a core basis, which we believe is consistent with the long-term vision we've always talked about, which is global industrial production plus a few points considering the environment in Europe and China that we've carried into the year. We have a strong track record of free cash flow generation. We target 100% free cash flow conversion of our adjusted net income.
We tend, we have tended to increase our working capital efficiency over time. We did not have as high a conversion in 2018. We had lower conversion for us historically and was a result of two factors. One, the increased capital spend associated with building our new fluid power hydraulics facilities. Two, on a gross basis, not a core basis, we grew the business 10.1% in 2018, and we provided a significant amount of working capital associated with that growth. We have a very high working capital requirement at around 25% of sales. Although we try to make that a little more efficient every year by about 50 basis points, we still have to provide a lot of, a lot of cash flow associated with sales. We think those things normalized in 2019, and we see our conversion being greater than 80%, returning towards historical levels.
Our capital expenditures will come down from the $180 million in 2018 to about $150 million in 2019. We've always said this business should run at about 3% of sales of capital, with about half of that being maintenance and half of that growth. We'll work our way back towards that over the next, you know, probably get back there over the next year or two. We've demonstrated, well, Evo and I have always said we'll always do what's right for the business from a capital deployment standpoint in investing in growth, the long-term benefit of the business while being mindful of deleveraging. I think we've demonstrated that well over the last few years, a reasonably balanced approach to capital deployment. We invested significantly in the plant capacity that we needed to continue to grow with the industrial end markets.
We've done three M&A deals over the last two years, deploying about $160 million of capital in 2017 and 2018. We've consistently deleveraged. We started our journey. The original LBO of Gates was over seven times net leverage. At the end of 2015, sorry, at the end of 2017, leverage had been reduced to 5.1 times. Use of the IPO proceeds in January of 2018, plus an additional $150 million of cash on hand, has helped us get down to 3.4x net at the end of 2018. We've stated that based on our outlook and our improvement to free cash flow conversion, we would anticipate net debt being below three times, sorry, leverage being below three times on a net basis at the end of 2019.
From a long-term target perspective, we talk about $4 billion plus in a three- to five-year time horizon. The $4 billion plus is really consistent with our mid-single-digit view of the world, that is based in global industrial production plus a few points, the plus a few points driven by our large organic growth initiatives that provide us the ability to grow faster than the market. If we grow, we should continue to expand our adjusted EBITDA margin. We reflect here as greater than 24%. Implied in the guidance for 2019 is 23%, which is 50 basis points approximately improvement over 2018. We also have an internal measure of ROIC, which adjusts for the LBO intangibles and fair value in the balance sheet.
When you adjust for that, a reasonably classic calculation, this business should continue to deliver, if you will, a tangible ROIC of over 20%. In, you know, quickly summarizing, we're the replacement-focused folks. We don't have to be on first-fit applications to win the aftermarket, and we behave accordingly. We're highly diversified across a number of end markets, geographies, and applications. We have organic growth that's fueled by innovation and positive long-term secular growth trends. We believe all of these reasons result in Gates being a compelling opportunity. Appreciate your time. I'm happy to take any questions.
I've got a first one. Given your opportunity, especially outside of North America for fluid. When I think about the growth profile, the three to five-year target, less than a 5% sales CAGR, I guess my first question is, what do you assume for the end markets in that $4 billion guide? And if you could help us in detail, give us auto and industrial replacement, auto industrial first-fit.
Implied in the three to five-year guide, of $4 billion plus, I think if you did the math, you would say it implies a CAGR somewhere between 4% and 6%. I think it really bookends.
4.9 to be exact, but what's the underlying market? I was trying to get a sense of that.
I think we see two to three points of positive global industrial production plus a few points beyond that. I think automotive first-fit for us is probably a flat business through the cycle. We turn down more business in automotive first-fit than we take. We're not really a true market participant. Therefore, the market may grow. It's less our objective to grow the first-fit component of our business, more to stay relevant because it is a reference for our aftermarket business. Therefore, you know, that goes down from maybe 16% in 2018 to, you know, 15% or 14% in 2019. It continues to decline a little bit. We think the industrial markets probably don't grow at the rate they had been growing but remain reasonably, reasonably healthy. We have to drive a couple points above that.
That's the opportunity for the hydraulics expansion, and, frankly, chain to belt. If we think of the big three growth drivers, one, a third of our business is in emerging markets. We believe, you know, emerging markets are a double-edged sword, but we believe emerging market presence gives us an opportunity for outsized growth in things like the Chinese automotive aftermarket, which, given the rate of registration growth over the last number of decades, there's a positive tailwind to the automotive aftermarket development in China, you know, for, again, decades, decades to come. Emerging markets is one component. The hydraulics expansion, both in increasing our product range as well as international penetration as well as new product. That's now, and we're really seeing that kick in after we've launched MXT and got the new capacity online.
That should fuel growth over the next few years. The largest opportunity is clearly chain to belt, going after that $8 billion of addressable kind of greenfield segment for us. That will be longer term. The combination of those three initiatives is why we think we would get a couple points above the market. Price cost is also kind of in the calculation. Price cost was very favorable for us in 2018, and we think that will be less so. We think 2019 is less of a pricing environment, but also less of a raw material environment, inflation environment. We always look at price as an opportunity to offset raw material inflation. We have successfully done that, and that is kind of how we think about price. Some additional detail, I guess, there.
I see an SU8 from Mike. I apologize. One second. Chef over here. Thank you. Thank you. On the auto side, replacement, how much of that is warranty versus non-warranty replacement? And maybe just talk about kind of from channel standpoint, you know, how much is dealer versus independent globally?
Yeah. For us, this is independent. And this is, really, when we say automotive replacement, we're talking independent out of warranty. So we target the independent mechanic. Our parts tend to fail, again, in that 7-12 year timeframe, so outside of when it's repaired at the dealership. Because we, you know, North America is a good example. Less than 2% or around 2% of our revenues come from automotive first-fit in North America, but we have 65% probably of the aftermarket business in North America. And so we really disassociate our aftermarket business from the OE application, and we're going to win the independent in that 7-12 year timeframe.
Just to make sure I understand, then, when you put up those market sizes, are you talking specific those market sizes of replacement or specifically non-warranty replacement?
There might be something in there, but I would say it's 99% non-warranty replacement.
Okay. Thanks.
You bet.
If I can just follow up on that. You said out of that 16%, 2% is U.S,. Can you kind of break down the other 14%?
About half of that 16 is going to be emerging market, with China being the biggest component, roughly. Roughly half of our emerging market exposure would be China. The largest developed market, if you will, say 8 points roughly is developed, the biggest component there is going to be Europe, which is a very large synchronous market. Beyond that, kind of Japan, probably. Korea, I would put, you know, Japan and Korea are big markets, so I would put Korea in the emerging market, I think, by our definition. China and Europe are the big markets for us.
Thank you. I have a quick question. I know you said leverage in a few years less than 3, so it could be 2, 2.5. When I think of you at 3.4, to get down below 3, your EBITDA this year is roughly, call it $800 million. A 0.4 turn is only $300 million plus, $320 million.
Yep.
If you're going to generate, let's say your numbers are right, you're doing $3.5 billion-$4 billion of revenue a year, your free cash flow every year should be at least $300 million-$400 million. I mean, you should easily be less than three. Is there any other need for the free cash flow besides deleveraging right now? That's the focus.
No specific need, and we are focused on deleveraging. We also think M&A can be a very important part of the story here. I think what we've said is our opportunity for M&A probably gets a little more, we get a little more latitude as we get below three times, you know, is two times the right leverage for this business, probably someday. We think, we think given the highly fragmented nature of the markets and our ability to add value to a deal through both innovation, our technology, application of the Gates operating system, you know, replacement channels, that M&A could be an opportunity. You know, we've always been focused on three, and for now, that's the milestone. I think we're committed to getting below.
All right. We're about out of time. So if anybody has a last question, raise your hand. Otherwise, I think we'll call it a presentation. All right. Thank you very much.
Appreciate that.
Thank you very much.
Definitely appreciate David Naemura. Thank you.