My name is Lee Sandquist. I'm on Julian Mitchell's team here at Barclays. Big thank you for David and Ivo joining us from Gates Corporation today. Maybe just starting off, could you talk about the current demand environment, markets around the world? What are you seeing from a regional perspective?
Sure. Thank you for inviting us, and we're delighted to be here and share some thoughts with you. As we have, we just announced our Q4, and I think that we've been quite specific about the demand profile or the demand environment on that call. Nothing has really changed since our call last week. Look, we've seen a slowdown in some markets. I think none of those were a surprise to most people. Certainly, we've talked about China quite a bit. We've seen that significant slowdown in automotive first-fit. We've actually talked a little bit about that slowdown at the end of Q3, but that was primarily driven by very high comps that we have had from prior two years, Q4. We did see a greater impact on auto first-fit business in China at that point in time.
We've also seen some slowdown in some industrial applications in China, particularly with products that are directed towards importers, the folks that manufacture equipment and import, export it, I guess, to the U.S. and Canada and Japan and Europe and so on and so forth. Those folks were much more cautious about taking on inventory for the projects that they've had. That was something that we anticipate is going to filter through Q1 and Q2. We certainly see, expect, and anticipate that that slowdown is going to continue in China throughout the first half. We did see a slowdown in Europe in automotive first-fit business, but in a similar fashion, we have signaled and we've accounted for about half of the slowdown that we have seen in Q4 through rollout of programs and projects.
We have seen about half incrementally, primarily associated with the new emission testing standards in Europe that I think folks are still working through. Again, we anticipate similarly that we will see continuation of weakness in that market in Europe throughout the first half. Outside of those couple of specific areas, we have seen a very solid environment in industrial applications, and the industrials have given us the opportunity to offset our automotive first-fit business. We have delivered nearly 4% core growth in Q4, offsetting a pretty significant weakness in the auto first-fit business.
Within China, how much of this temporary weakness do you think is related to the tariffs? If we do see some resolution on the tariff front, how quickly can that snap back?
Yeah. I think that's a good question that all of us are thinking and spending lots of time figuring out. My sense is that there was a generally slower growth environment in China. It's a maturing economy. My sense is that the trade conflict accentuated the problems. My sense as well is that as we get closer to some degree of resolution, I believe that China is going to take proactive steps to reverse the negative effects of growth, and we should start seeing, we expect sometimes in the second half of 2019, more positive behavior of the economy.
Since you brought it up, could you just—I think it is important to distinguish your auto exposure and the delta between aftermarket and OE? Can you just talk about that difference a little bit and inform the crowd?
Sure. Gates got a reasonably small amount of revenue targeted towards the automotive first-fit markets. About 17% of our revenue in 2018 was directed towards that market, about 26% into automotive replacement market. The dynamics between those two markets are quite different. The automotive aftermarket is primarily driven by the aging car fleet. For us, it is a seven to 12-year-old car fleet that is pertinent to us. The market dynamics for that market segment are, frankly, quite positive. In the emerging world, in the advanced world, in the advanced economies, we have finally gotten on the other side of the registration declines from 2009, 2010. What was a reasonably good headwind for the automotive aftermarket in the developed world in the prior four or five years has now turned more towards a tailwind. In emerging economies, the market dynamics are quite good.
The market dynamics in the automotive replacement business in China are very good because we are dealing with 30 years of positive car registration growth. We expect that we will have a tailwind in that marketplace well into the future. As an example, as our sales into the first-fit market in China declined by mid-double digit, we have actually grown our revenue in China aftermarket by mid to high- double digits in the same quarter as well. There is the dichotomy that we are talking about. We feel that we have lots of opportunity and supportive markets in the aftermarket, which is in the automotive aftermarket, which is by far a more important piece of our revenue generation.
Outside of automotive, which end markets are you most excited about heading into 2019?
Look, I mean, we're quite excited by the exposure that we have to the industrial market space. We have a very broad exposure to the industrial complex. We do everything from supporting high-pressure hydraulics and machinery for machinery builders like Caterpillar and John Deere to industrial applications in light industrial distribution centers, in a sense, powering the fleet, the power conveyance, movement of goods in distribution centers, and everything in between. We touch, frankly, every corner of the industrial economy. We're quite excited about the prospects that we have in our business to continue to expand our presence in those markets. We've talked about a number of growth initiatives that we have that are associated with our expansion into the industrial space further.
We firmly believe that the market dynamics for delivering that growth through the innovation that we are putting forward are still very, very positive.
Aside from broader economic factors, one internal factor, if you will, that has been limiting growth has been capacity constraints. Where are utilization rates today? You guys have been taking proactive measures to make sure that you have the capacity available. Can you just talk about the timeline from here?
Sure. We saw capacity constraint in really hydraulics, which is about 65% or 70% of our fluid power segment. We play at kind of the premium end of hydraulics and the higher pressure applications. That globally was a reasonably constrained supply chain. We had begun in 2016, really before the recovery of the industrial end markets, to build out additional capacity, really associated with our broadening of our addressable markets through new products and through new innovations that we are bringing forward. We were already midway when the market snapped back. We began to bring up basically two and a half new plants this year, a brand new footprint in Mexico at our campus there, right next to a sister plant. That began coming online here in the third and fourth quarter. We had completed outfitting a plant that we had kind of half full in China.
We filled up the other half, if you will, and that began towards the end of Q3. Most recently here, coming out of the year-end, we began commercial shipments out of a plant in Poland. This should give us capacity for about $150 million-$200 million of additional annual revenue. It will allow us to continue to grow with the hydraulics markets. We are very well penetrated in North America, but really under-penetrated in premium hydraulics internationally. Putting a plant in Poland will be the first upscale plant we have to service the European market. Additional capacity in China will help us serve the emerging markets in Asia Pacific. That is a couple of years' worth of growth, at least probably, but it allows us to continue to grow with what is really pretty healthy end markets.
Now, as you've gone through this process, what are some lessons learned about that transition? What are some of the negative externalities that you've seen along the way?
Sorry, I didn't quite understand the question.
Negative externalities in terms of unexpected costs, unexpected plans.
In the second half of the year, we had startup costs associated with the new plants, but really it was almost overshadowed by costs associated with running at full utilization on our existing footprint. Examples of that would be expediting freight, running at high-cost temporary labor. We were making moves to get every ounce of production we could out of our existing footprint. Accordingly, we were doing some things that were reasonably costly in the near term to get production moved from place to place in, honestly, in a little bit of a too fast fashion, but to allow us to get maximum production. We service a lot of global OEs, and we can't shut those guys down. We were doing everything we could. Those costs will abate as we get into the new year.
We'll still have some startup costs, particularly in the first half of the year, but I think in the second half of next year, some of those costs should be favorable on the compare side. We're talking maybe $8 million-$10 million YoY , so not the biggest number, but we can get back to more normalized growth. We're seeing supply and demand normalize in the marketplace. We're seeing a little more normal activity, which is good. Still a good environment, still robust growth, but a lot of the pent-up demand is normalized.
Now, in the medium term, the change about conversion is a pretty exciting topic for you guys. I know you've talked about it quite a bit. I was wondering if you could just provide a little bit of background, maybe give some examples of where you've had initial success there and then quantify any opportunities.
Sure. I think that that's a large secular opportunity for a company. We are very excited about it. We have identified an opportunity of potential available market of about $8 billion. It is very, very sizable. It's an area where we will not be competing with traditional competitors. We're going to be competing against a competitive technology called roller chain. We feel that we are in a very good position to be able to go and penetrate those markets with very advanced products that we are developing and we have developed in the past. Now, one of the misnomers is that we are starting from ground zero, and that's really not the case. We actually have over $200 million of revenue today that we derive from what we call, or what we have coined, the chain conversion opportunity for us.
We have a tremendous amount of pipeline that we have built at identified opportunities. Frankly, we have added a nice double-digit amount of growth that turned into revenue in 2018 into that revenue as well. That being said, our sense is that the highest growth rate or higher growth rates that we will see from adding to that revenue are going to occur kind of in the 2020, 2021 timeframe as we launch some of the new technologies that we are putting in place. When we think about this opportunity—excuse me—we think about this opportunity kind of in three different work streams. One work stream is primarily focused on industrial applications, which would be a thing kind of lumber mills, thing aggregate manufacturing facilities. The second work stream that we have put together is in personal mobility.
Personal mobility is anything from bicycles to motorcycles in a developed world to scooters in the developing economies. That market itself is about $1 billion in size, plus or minus. We have about $50 million of baseline revenue there. Again, very nice base to build upon and a highly differentiated technology that we believe is positioning us towards continuing to drive the trajectory of growth there. The third stream is quite interesting, and we have really not talked a lot about that in the past. It is a stream of an adjacent technology that we have in our portfolio. We have, again, about $40-$50 million revenue base in that technology, and that is a technology called TPU, so thermoplastic polyurethane-based belts. That market is, again, quite a sizable market and multi-billion dollars market opportunity.
The applications there are in the pharma, food, light industrial distribution markets, and so on and so forth. We feel like we are very well positioned. We have actually quite a sizable presence in that space already, and we feel very constructive about what it means for the future for a company.
Taking a step back, how satisfied are you with the level of innovation at Gates? It seems like last year you had some pretty good success with the MxD launch in premium hydraulics, but any other examples would be great.
Yeah. Most recently, if you go on our website, we have made an announcement actually into automotive first-fit business technology that's targeted towards mild, full hybrids, and electric vehicles. We've launched about five new technologies that are nicely differentiated that we are quite excited about what they will deliver for us over the mid to long term, particularly in the aftermarkets. We are frankly working across our entire portfolio on full revitalization of our product lines. As we move forward, I think that there are lots of exciting announcements that are pending across our broad portfolio. I would encourage everybody to keep on watch for this announcement come forward.
Okay. Based on your growth rates and these comments, it seems like obviously the result has been market share gains. Can you talk about your market share presence across the business right now and if there's scope to continue increasing share?
Sure. One of the things that we probably have not gotten across to most of our potential and future investors is that Gates competes from number one, number two, and number three market position across about 80% of all of the products that we manufacture. If you think about it, that is a pretty staggering statistic. There are not too many industrial companies that can make that statement. We are starting from a position of strength across pretty significant parts of our technology. We believe that continuing on the trajectory of innovation, we can frankly take additional market share.
Despite the fact that we have such a strong market positioning, we're playing in very large markets where if you aggregate the top four players, as an example, in hydraulics, if you aggregate top four or five market players, we all combined would have less than 45% market share. What this means is that we are all large players with reasonably good market share, but we are playing in a very fractured market with a great set of opportunities for a player that continues to innovate and continues to expand its capabilities, whether or not it is a production capacity that we have put in place or new products that are differentiated and solve some specific problems that our customers are looking to have solved. We believe that we can continue to take a good amount of market share well into the future.
One more on growth. Can you just discuss the rise of EVs, how it impacts Gates' dollar per vehicle content?
Sure. That's a great question. When it comes to electric vehicles, I'll give you maybe a little more complex answer that you may be looking for. But when we think about propulsion, and EV is just a different type of propulsion of an automobile, we think about automotive propulsion in four different segments, if you would, starting with ICE on one side of the bookend. The other bookend is full EV. The middle is mild and full hybrid. Okay? On internal combustion engine, we have about $175 of potential available content per vehicle. If you take a look at the other bookend, we have about $225 of potential available content on full electric. Things get better for us as we move from ICE to full electric. In the middle, we have also about $225 of potential available content.
As the technology gets more complex, the opportunity for Gates gets bigger. What we are trying to get across to our investors is that, frankly, we are ubiquitous in the opportunity. We do not really necessarily care about what propulsion is used, and we just like to see the advanced propulsions scale up more rapidly.
Right. Now, shifting gears to efficiency and profitability, can you discuss the Gates Operating System, how it is differentiated versus the operating systems of your peers?
Sure.
I'll let you take the.
Sure. I spent seven or eight years with Danaher prior to coming here, and I think it's maybe a good comparison. I get asked all the time, "How is the Gates Operating System similar to Danaher, and did you guys design it based on some of your roots and some of these other businesses?" The honest answer is no, and it couldn't be almost a little more different. In the case of Danaher, the Danaher business system, my experience from my tenure there was that it was first and foremost founded in a culture, and it was developed over a multi-decade period of time. Whereas with the Gates Operating System, it was of a much more tactical design. We had a very fragmented business that had disparity of process.
We really used the Gates Operating System as a way to define what we think is best-in-class global process and to orient an entire business very tactically around that. It is how we drove 300 basis points of margin expansion, gross margin expansion, and even some margin expansion from 2014 to 2017 by basically coming to our plant footprint first of 39 plants and saying, "Okay, if they have 39 different ways of doing things, we're going to apply the best operating system we could." In our case, it was taking the focus away from labor productivity, which is only 7% or 8% of our bill of materials, and moving it to overall equipment productivity, which had a dramatic effect, and then doing that consistently across our global footprint.
Similarly, in product development, in the way we run the back office, and the way the relationship between R&D, product lines, commercial workforce, we've defined those things in those processes as well. A lot more tactical and a lot more designed at getting our entire business centered around kind of best-in-class processes. That helps.
Now, one similarity with Danaher is your high degree of aftermarket revenue. Can you just talk about what is the ideal level of aftermarket as a share of sales and if there's any large differential in margin profile between aftermarket and OE?
Sure. Look, we're the aftermarket guys, right? I mean, 65% of our revenues are from aftermarket applications, and our aftermarket goes through aftermarket channels. What's the right number? It's not 100%, but it's probably somewhere between 60%-70% on a consistent basis. A little appreciated fact about Gates is that we do not need to be on the OE application to win the aftermarket business. That's why we're not so concerned about automotive first-fit. We're not worried about that in warranty repair. We're happy to be the off-warranty repair on that car that's seven to 11 years old. Similarly, on high horsepower mobile machinery or construction equipment, the aftermarket user is perfectly happy to put Gates hydraulic hose.
In fact, probably prefers to put Gates hydraulic hose when they refit and go through one of the four or five lifetime refits of hydraulics on a combine harvester or something like that. Ultimately, it's our brand reputation that we sell uptime, and we sell uptime in a situation where the cost of the product is de minimis in relation to the cost of downtime. We like being on the OE, and admittedly, those margins are lower than the aftermarket, but we also do not take very low OE business because we do not have to. Margin is very product by product, region by region. If we do not have to be, we are not trying to buy aftermarket business because we do not have to be on the OE to get the aftermarket business.
In terms of pricing, it's been very strong recently. Obviously, a portion of that is to combat the inflationary environment. Can you just discuss price costs heading into 2019 and how you think about the phasing of that margin?
We anticipate, first of all, price cost was, I'll say, very favorable in 2018. I think we led the market up appropriately. We did experience raw material inflation, and we priced ahead and above that. We would anticipate it's a little bit our philosophy of pricing that our brand and aftermarket position positions us well to price. We believe we should price to offset raw material inflation, and we would anticipate doing that again in 2019. We do not think it's as inflationary of an environment, and likewise, it will not be as rich of a price environment that we saw in 2018, but we will be price cost favorable.
Shifting to balance sheet and cash flow, cash flow conversion is guided above 80% this year, step up YoY . What are the big drivers of that improvement?
First of all, we're just getting back to structurally where the business should run. I'd say that guidance was greater than 80%, which is where the business should run. Our longer-term target stated of 100% of our adjusted net income aligns with past performance. One, we put a lot of capital into the business, a lot of CapEx in the last year. We see that stepping down from $180 million in 2018 to about $150 million in 2019, on its way back to a more normalized level that we see at kind of 3% or a little over 3% of sales. Also, we had core growth in 2018 of 5.9%. We had total growth of 10%. We run a very high working capital requirement, probably a little too high.
That working capital requirement, about 25% of sales, meant we had to provide a lot of cash associated with that 10% growth. Obviously, the growth rate will moderate a little bit this year, so we will not have that big requirement. I think if we are a little more efficient as a working capital as a percent of sales, that will offset the increase of working capital associated with growth. Those should come closer to netting this year versus being a big negative last year. We have the decline in CapEx, which gets us right back towards where we should be running, frankly.
Okay. Maybe we could just shift to the automated response questions quickly. First question is, do you currently own this stock? Big opportunity.
Future buyers.
Number two, what is your general bias for the stock today? Okay. No negatives, but no shareholders. Number three, through cycle EPS? Okay. Number four, what should Gates do with excess cash on the balance sheet? Bolt-on M&A, dividends, debt pay down. A lot of requests here. Number five, for 2019 earnings, where should Gates trade on PE multiple? Okay. Number six, if you do not own the stock, as a lot of people in this room do not, what is the biggest barrier? Core growth. Okay. Got it. Just a couple of closing questions for me. Sticking with the balance sheet, what is the right—I mean, debt has come down quite a bit. What is the right balance sheet leverage ratio for you guys?
It's tough to say. Depends on future opportunities. We see three times net debt at three times leverage is an important demarcation point that we will be at in 2019 towards the end. We remind people that we started this journey at 7.25 times leverage at the beginning of the LBO, and pre-IPO proceeds were 5.1, and we've now subsequently deleveraged at 3.4 at the end of this last year. We feel the trajectory has been very good deleveraging, and we have line of sight to that first goal. Beyond that, we'll see. We have—Ivo mentioned we have very fragmented markets, which gives us an opportunity for structurally attractive M&A, probably as we gain more flexibility. After three times, it depends.
Okay. In terms of capital deployment in the form of M&A, can you just touch on the deals that you guys have done recently, and then what is the pipeline today for future acquisitions?
Given our leverage profile, we've really focused on bolt-on M&A that will accelerate organic strategy. A good example would be Rapro, a deal that we did recently, which was about 8.5% times EBITDA, but net of synergies, probably around more like 5.5% , which gives us good payback in the second year, and also maybe leverage neutrality in 18 months. It's a deal where we add a lot of value, and that's what we look for. There's a good pipeline of opportunities in these highly fragmented markets, but we have to be very selective and very disciplined, and we'll continue to do that. Our M&A flexibility will continue to increase as leverage comes down.
Okay. Since we have a lot of opportunity for shareholders in the room, what are people missing about Gates today? What's the final sale pitch?
I think that people underappreciate the diversity of our portfolio. I think that they do not appreciate the presence in the replacement markets and, frankly, the counterintuitive ability to generate and harvest our balance sheet during a downturn. We feel that we are a company that has not only a tremendous opportunity to grow in the future, but also has less of a downside during a recessionary market environment. We believe that people, as we mature as a public company—we have been public for one year—as we more mature as a public company and people start to appreciate the performance throughout the cycle, I think that we will get a lot better appreciation for the stock, and I think a lot more people will be interested in owning this equity.
Okay. Thank you both very much.
Thank you.
Absolutely. Appreciate it.