We'll start dialing in still, but we're really excited to have Gates with us today. I think, Ivo, this is probably about a year almost since you went public or down to that anniversary here. So Ivo Jurek joined the Gates Corporation in May 2015. You've spent your entire career in the industrials area, both U.S. and internationally. David Namura has served as CFO since March of 2015. Prior to Gates, Dave was at Danaher, which I know none of you guys have ever heard of. I'm just kidding, Danaher, if you're listening. Anyway, we're really happy to have you guys here today. I'll just start off with kind of a softball for you guys. You had 3.5% growth in the quarter in Q4, which was a little slower than it's been. Still pretty good, obviously.
We know you have a pretty strong industrial business, very solid auto replacement business. Just kind of go over some of the trends that you saw, like a kind of update. I mean, you just reported, so I'm sure not much has changed. Any sort of update that you'd give on the markets?
Yeah. We like the softball, so I'm not going to be.
They're not all going to be softballs, Ivo.
I'm not going to be using the baseball analogy in here, but look, 3.5% core growth in Q4, very strong industrial performance still, high single-digits growth in Q4, but impacted by our first-fit presence in automotive markets, particularly in Europe and in China. It was kind of a tale of two stories there, if you would. One is that in Europe, we have anticipated some declines in our performance because we simply have decided that we will not renew some of these programs that we were on historically. As we said during the IPO, we really don't feel that we need to be a large market, full market participant in the automotive first-fit business in the industrial world to continue to drive actually our presence forward in the automotive replacement market. We have consciously decided to take fewer programs in Europe.
We were impacted by about 50% greater decline, primarily driven by that change of the emission laws in Europe. That impact was a little bigger than what we had anticipated in Q4, and it was a little bit, frankly, a little bit longer lasting than I think all of us anticipated. In Q3, when I go back to that earnings call that we had at that time, we said, "Hey, look, China, we've had some really heady numbers in China in automotive first-fit." We thought that we were going to see some comparative declines to growth rates, but China came in a little bit worse than what we had anticipated. Frankly, it was a little bit broader than just the automotive first-fit business in China. I think we have seen some declines in sales, particularly to export-oriented machine builders.
That came in a little bit worse. All in, it was a pretty solid performance taking into account the level of exposure that we've had in the auto first-fit business in those two markets.
You guided to 3-5% growth for the year for 2019. I think the question I get is, how much contingency have you factored into your guide for Europe continuing to sort of be, especially in the auto first-fit market, weak for at least the first half of the year? The issues you mentioned in China, whether it's first-fit auto or whether it's the exporters, how much cushion do you have if those businesses get worse while all the other businesses are okay?
Yeah. Let me start maybe with answering the question a little bit differently, and then I'll try to come back to your specific set of questions. Look, when we think about how Gates should perform, Gates has a very high degree of correlation to global industrial production. When we were thinking about our guidance, we said, "Hey, look, we don't anticipate that the markets are going to be as good as they were in 2018," and they're still reasonably good, but we didn't think that they're going to be as good as in 2018. We started with the assumption that those markets are going to be a little bit weaker.
When you come back to Gates, we say, "Hey, look, Gates kind of performs global industrial production plus 2-3% incrementally of growth driven by some of the large initiatives that we have for the company." Now coming back to your specific question about 2019, we said, "Hey, look, global industrial production is going to be probably down slightly from 2018." We were pretty pragmatic about where we felt the markets are going to be and how much help we're going to get from the markets. We assume that we're going to have some help from pricing. I mean, we've had very strong performance in price material economics in 2018. We have a number of carry-through of pricing initiatives going into 2019. We have installed new capacity globally in fluid power.
We've launched a whole bunch of new products, highly innovative, highly differentiated. They're just the beginning of what we are going to continue to do through 2019 and beyond. We feel reasonably positive that we have a good opportunity to deliver that midpoint of our guidance, taking into account what's going to happen in the markets. By the way, we've counted on the auto first-fit business to be kind of down for the year, not really forecasting any significant recovering. Of course, back half of the year is going to get a little easier from the comps.
Ivo, this is the thing that I do not think some investors get, is that I just want to clarify what you just said. It seems like what you are saying is that market outgrowth, call it 2-3%, plus pricing, call it 1-2%, is basically your whole forecast of, and again, you are assuming basically flat or no global industrial production growth. You think you can do 3-5% in that environment. Is that fair?
It's fair. Look, and again, I think that the markets are opaque, right? So it's hard to predict what's going to happen tomorrow, obviously, but we feel reasonably constructive that we can outgrow the market to the degree that we have forecasted.
Maybe you can talk about this outgrowth a little more, right? When you and I first met, you talked about you wanting to make it more material science when you came in. It does seem like this new product revolution has continued to increase. Maybe the first question is, is 2019 a bigger new product year than 2018? Is 2020 still a bigger product year than 2019? You get that question. The other side of the question is around capacity, right? You have basically added China, Mexico, Poland now. By the second half of this year, basically, you are all up and running in these places. How much extra growth do you get just from the capacity additions, assuming you fill them at least somewhat?
Yeah. Lots of questions in there.
Yes. We have lots of time, so.
Hopefully, I can hit them all, but starting with the capacity first. In terms of capacity, as you said, we have three new plants that came online. I'll brag a little bit in here for a second, right? Industrial companies, generally speaking, have a difficulty ramping up one new capacity project at a time. We have done three in the second half of last year in three different geographies, and we've done that really well. When you think about the capacity additions, more specifically, we have fully capacitized our existing plant in China. That plant is up and running from about August of last year. We have added capacity in our plant in our campus in Mexico. That capacity has started to ramp up in Q4 and should be in a very nice runway trajectory in Q1.
Our Polish plant started commercial shipments in Q4. Our expectation is that as we progress through 2019, we're going to be at a steady-state run rate from that capacity addition. What we have done is, with the exception of China, we have capacitized only about half of those two new facilities. We have more runway to further increase capacity if we see fit to do that. If you think about how much capacity we added, we've kind of added if we sold it all out, and although it would be a nice problem to have, we hope that we don't sell it out in the first year or two years, we've added about $150-$200 million of incremental revenue-type capacity. That's kind of on that last question first.
Coming back to that innovation cycle, look, when we came to Gates, Dave and I in 2015, we had the opportunity to walk straight into an industrial recession that it seems like we all kind of forget about. When we started to manage this business, started to get our arms around it, and we're experiencing this recession, we said, "Hey, look, we need to do something differently to be able to get this business back on a trajectory and a model that we have had." We started with driving productivity improvements across our factories. We said, "Hey, we start with productivity improvements. Then we go in and we focus on VAVE." The third piece, the third leg of that story would be the innovation. It kind of played out the way that we've anticipated.
The VAVE jump-started our innovation, and that's when we started saying, "Hey, look, we got lots of opportunity on the material science side. We got lots of opportunity, frankly, on dramatically changing the industrial processes that are used to build these products. That will not only help us to build better products, but also it's going to help us to create the next layer of competitive mode around the products that we manufacture for our customers." The third leg was, "Hey, using lever on material science and developing kind of the physics-based technologies." Those started to launch in the middle of the second half of 2018.
Frankly, our anticipation is that over the next three to five years, we'll completely turn our portfolio through innovation around and start mixing the portfolio towards a better mix of profitability as well as so much more highly competitive that will allow us to enter new markets, particularly on the fluid power side. We've represented that those are multi-billion dollar opportunities that we have through the innovation that we anticipate to launch and that we have started to launch in late 2018.
Ivo, when I hear that Mexico and Poland are half utilized, I want to think about margin dilution. Then I look at your Q4, and you add 50% incrementals in fluid power with a bunch of startup costs. Maybe this is how to get Dave involved. Talk about the margin potential. First of all, why did you—your guidance was pretty conservative Q4 around margin. I thought you did a really good job versus it. What was supposed to be your higher cost quarter? How did you sort of persevere through that? As you go into 2019 here, if your two bigger factors are sitting half utilized, is it that they're just so much more efficient? You had mentioned sort of shutting down a Turkish facility.
Is that part of this, that even though you've got incremental capacity, you just have much more efficient production when it comes down to it?
For Q4, the business tends to run in kind of the 30-ish to low 30s incrementals on a core basis. What you saw on a core basis in Q4 was 50%. If you kind of did the math, we would have anticipated kind of more high 30s in the environment we've been running because we've been reasonably price-cost favorable, and that's been kind of mixing up the incrementals. If you will, if there's 15 points of difference in there, it's $4 million-$5 million. That is really driven by just, frankly, a few things going better than we thought at year-end. It's a little bit the law of small numbers.
I think what we saw was some of those costs that we continue to field around startup and other kind of footprint optimization, smaller footprint optimization moves we're making, and frankly, some continued inefficiencies at running at full capacity that were offset by some other things that kind of went our way or were not as bad as we would have thought. As we look into the year, we will get some improvement from relief against some of those costs we have been incurring over the course, particularly the second half of this year, and that will help next year. The plants, what we do is we build the building, right? We do not fit out the whole building with equipment. We are very judicious about being at 40% or 50% of that. It gives us room to expand as we go.
I think we'll still continue to incur some startup costs through the first half of the year. There's equipment still hitting the ground. We're not fully absorbing all of the overhead that we put in place. You've talked about this new capacity being $200 million of revenue. We're talking 8% of total revenue, a portion of which we're under-absorbing. There are plenty of other factors around VAVE projects coming online, as well as other efficiencies around footprint and other things we'll continue to drive that should offset that.
Dave, you reminded me you did have a bunch of, call it, I don't want to say transportation costs, but costs in terms of being at full capacity in fluid power or over full capacity in power. Those costs, are they more than the incremental savings that you or incremental headwind that you have from under-utilization? You see what I'm saying? If I look at the first half of the year, it seems like your incrementals should actually be a little better because you are lapping the bad stuff from the fully utilized, even though you've got a little bit of under-utilization in your new factories. I think that makes sense. Maybe it doesn't.
I think so. They compare against those costs of running at full utilization.
Yeah, that's what I mean.
Will be favorable in the second half of the year to some degree. In the first half of this year, we'll continue to have some startup costs that, frankly, are a little more in 2019 than there would have been in the first half of 2018. I think we get a little bit of a favorable compare in the back half of the year until the next thing happens, so.
Got it. You did allude to pricing, right, and favorable pricing. I mean, Gates is known as a premium brand in most of what you do, right? Maybe you can talk a little bit more about your ability to sort of stay ahead of the game. I think you guys were kind of early in the sort of raising prices and price cost conundrum that we all saw. If we do not go to 25% tariffs, does price cost become more of a tailwind as we go on over the next few quarters?
I do not think more of a tailwind. It was a good tailwind for us in 2018. We saw raw material inflation, and we were able to price for it. We were price-cost favorable. We think that normalizes a little bit as we head into 2019. We will still have some price. We will have some amount of raw material inflation. In our business, we think about our business as we are going to incur raw material inflation. It is our job to price for it. The combination of our brand and our aftermarket presence positions us well to do that. That is kind of how we think of pricing. I think we were successful in 2018 in a very fair way, probably accomplished, had good accomplishment on the price cost side.
Because we're all analysts and we want to know what's next before it happens, maybe you can talk about the March Analyst Day just in this sense in that you've talked about taking out this higher cost Turkey facility, and you mentioned sort of the one to two footprint rationalizations that you could do per year. Is that a topic that will come up more at this analyst day, or is it just sort of this is what we can do with our existing footprint? How much should we think about cost out as another leg for you guys over the next couple of years?
We did not anticipate kind of rolling out the broader vision, if you will, at the analyst day in a week. I think in a quarter or so, you will see us come back with a broader plan. I guess the one highlight I would make is that in early days, we got a lot of feedback that said, "This company's been through private equity ownership. All the cost is torn out." That is just not the case. I mean, there is a lot of rooftop consolidation opportunities and things that people may have assumed have happened but have not yet happened. We have been really focused to date on driving productivity into the footprint that we have.
As we move out of that stage, we'll be looking to more optimize that existing footprint based on not just the new capacity we've brought online, but also the productivity we've added to our existing capacity, which provides us some opportunity to not take capacity offline, but rather to deliver similar capacity within a smaller footprint. More to come. I think it probably isn't a venue for us to announce new actions, but we think there's a good runway of opportunities to continue to optimize over the next few years.
Okay. One more from me before I open it up to the audience. In China, again, it's a mixed market for you guys, right, because you've got auto replacement, pretty strong. Industrial replacement actually has been pretty strong, and that offsets some of the just industrial weed business and the auto first business, so auto first business. How should we think about that balancing act in the current environment, looking at this year and maybe next year? Are the businesses big enough in auto and industrial replacement to offset if the OE businesses continue to sort of slow down a little bit?
Look, I think that our auto first business in China is the largest component of our business today. The way that we think about China, first and foremost, China is the largest industrial economy in the world. It's not the largest economy, but the largest industrial economy in the world. We feel that we have a tremendous amount of opportunity to expand our presence in the industrial space. We see a terrific set of positive dynamics in the automotive replacement business. That business is growing two to three X the rate of any other business that we have in China. Whether or not we're going to see more bumps short term from a quarter to quarter, we do believe that the long-term trajectory for our business in China is very strong.
Frankly, we anticipated we're going to deliver positive core growth in China in 2019.
Any questions from the audience?
I guess, Ivo, back to your comments on industrial and the strength you saw. I think you called out ag, construction, and general industrial as all being strong. Could you disaggregate those a little bit for us? Maybe where are you seeing the most strength? Is it just pretty equal across those buckets? What gives you kind of confidence in the sustainability of those particular markets?
Yeah. I think on the call, we said that we have seen a reasonably good amount of strength, frankly, globally. I mean, it was better in North America than maybe elsewhere. In general, the industrial growth was reasonably good globally across the applications that we service.
have any commentary on those kind of different end markets?
My sense, I don't want to put myself out there on the record, but my sense is that 2019 was a really good year in these markets, right? Generally speaking, it feels like our end customers and users feel still reasonably positive. I think everybody's forecasting that they see reasonably good demand for their products. My sense is that you're going to start seeing normalization of the run rates of growth. I don't anticipate that you're going to see a negative core growth or negative growth in the end user machine equipment build-out rates.
Thank you. Just to follow up on that, specifically within the fluid power business, the largest player in that market put up flat to down orders in their second, so the calendar fourth quarter. I'm just curious, is there a mixed differential as you think about how your portfolio lines up versus Parkers? Maybe they're too conservative in their outlook. Maybe just kind of contrast your kind of geographic or product footprint and how it may differ.
Yeah. Look, I'm not necessarily going to compare myself to Gates to Parker. What I try to remind folks is that Parker is a really large company that's got a very significant number of different product lines, maybe hundreds of product lines. Gates has got two product lines. I think that we are a little more nimble, a little more focused on the end applications and markets and customers. We also have about 70% of our fluid power revenue that comes from the aftermarket. I think that that's a little richer aftermarket mix component versus some of the other competitors like Parker and some of the other guys. I think that that bodes better for us. We have an ability to drive revenue and maybe take a little more market share more effectively, I would say.
I would say that we also are very, very focused on innovation. I think that the new innovative products that are coming to the marketplace are going to continue to differentiate us from some of the larger, more general participants in the market, if that makes sense.
Ivo, I wanted to sort of dig in a little bit on the global auto aftermarket business because it's so important for you guys. The resiliency in places like China has been very strong. We understand the penetration business there that you have, but maybe give us a little more color on why it's been so strong for you guys, who you're taking share from, and sort of what is the longevity of the growth that you see?
That's a really interesting dynamic. Look, China, what we call the sweet spot of our applications, is kind of that 7-12-year-old car fleet. The China 7-12-year-old car fleet has been growing very dramatically over the last many years, right? I mean, it's been an unprecedented registration growth in China of new vehicles, and that's filtering through. By kind of 2020, that car fleet is going to become the largest car fleet in the world. That's really the good news, right? Where we have spent quite a bit of time, money, and resources over the last four or five years is on building out our product portfolio coverage. Today, we have what we represent as the leading portfolio coverage of the Chinese car park.
We have about 90% plus of portfolio coverage for the entire car fleet that's present in the Chinese marketplace today. Where it becomes interesting is that China, unlike the U.S. or Europe, does not have a very well-developed channel. Not only have we been developing the product portfolio coverage over the last five years or so, we have also been spending quite a bit of time and money on developing our channel presence and, frankly, our presence within the various markets that China offers. That investment has translated into, frankly, high double-digit growth rates that we expect that we will see for a pretty reasonable amount of time because of the dynamics of that car park.
I mean, we know about your share in the U.S. auto replacement market, but why hasn't any Western competition tried to compete with you in China as well?
Look, I think that many Western companies make a little bit of a miscalculation, right? When they go in and you're supposed to make an investment, you look and say, "Well, let me wait until that market develops, and then I'm going to invest." Our philosophy at Gates has been quite different. We felt that we want to drive the development of the marketplace because that entrenches us, and that gives us the opportunity to have a, frankly, unfair competitive advantage for the long term. That is what you really see in North America, where we have a very, very little automotive first-fit presence, but we are absolutely, by far, the largest market shareholder in the automotive aftermarket business. We view the same thing in China.
I think that by the time that the market is going to develop into very large numbers, it may be a little too late to start building out that coverage of products, which takes a significant amount of time. Secondarily, once you have the products, you have to have that China regional presence, which is not easy to do when you do not have a mature distribution footprint that has developed in that country.
Just finally on auto replacement, would you highlight any sort of recent trends in U.S. auto replacement? Because it's continued to be a very solid market for you. And it's a lot of it we know is from the car park sort of maturing after the 2009 recession. Anything else that's continued to lead to the solid results that you've had there?
I think the big issue is what you just said, right? We are seeing finally the negative turning to a positive. The 2009, 2010 car registrations have turned finally into positive tailwind. Look, the economy is really good. We all drive more than we have maybe driven 15 years ago. Gasoline is cheap, and the economy is doing really well. That is a mix of attributes that are very positive towards folks feeling good and wanting to repair their automobiles and wanting to get a job and driving to their job or driving to school, what have you. The dynamics in the developed markets are positive due to these factors. Of course, we talked about the dynamics in the emerging economies, which are very, very strong as well.
Dave, let me ask you about cash flow. Your long-term target is 100%. You want to do 80% plus in 2019. Obviously, cash conversion was lower. We asked you all those questions on the call in 2018. Maybe we could sort of go over it again in terms of we know you had to fund the 10% growth in working capital. We know you had to spend significant CapEx for these plants that you were putting online. Maybe talk about the conviction in 80% or more cash conversion in 2019, because I do think it's a pivotal year for you to generate cash.
Yeah, thanks. Andy, I think our conviction is high. I think our historical business model, in essence, reflects that level of performance. I think 2018 was the anomaly, and we're getting back to really kind of the structural nature of the business. We're talking about a 3%-5% core growth rate as opposed to the 10% actual growth rate total all up that we delivered last year, albeit only roughly 6% core. At roughly 25% of sales, we had to provide a lot of working capital associated with that. We hit a bit of an all-time high from a CapEx standpoint as we built out the new capacity. We think the capacity will come or, excuse me, the CapEx will come down from about $180 million to about $150 million. We need to drive more efficiency in working capital.
We tend to target 50 basis points a year. We think we'll target that again this year. I think on the lower growth rate, I think if you did all that math, you'd be somewhere over 80%. That's returning back towards our historical cash conversion levels as a percentage of our adjusted net income. From a CapEx perspective, we've always said that about 3% is about where this business should run. We kind of underinvested in 2016 or did not as we were working out our strategy. You saw us gain traction in 2017 and 2018, and 2018 being the highest percent of sales. You'll see us work back down towards that 3% level over the course of 2019 and 2020, bringing cash flow well back in line.
The math on leverage should be that if we're successful in doing this, we have a lot of conviction on our line of sight to be at three times leverage net debt at a leverage ratio of three times EBITDA by year-end or better, frankly, below three times.
Dave, what's the right level? Is it sort of that two, two and a half times that you want to target, or what?
Yeah, it's tough to say. I mean, one of the things about our markets is they're highly fragmented. They're good markets to compete in. They're also very good markets to acquire in. We have answered a lot of questions around M&A over the course of the last few years. I think we see M&A as an opportunity that, as we continue to reduce leverage, becomes more of an opportunity for us. I do not want to say we're heading all the way to two because we might get below three and decide to do a deal or two. It's tough to say. We do see three as an important demarcation point. We have always said we had a lot of conviction around achieving that level sooner than later. I think this is the year.
Dave Rivo, is it more likely that you do an industrial acquisition than an auto acquisition? Do you care?
I think that you can probably bet on more of an industrial acquisition than an auto acquisition.
Okay. Let me ask you about cyclicality in general, right? I mean, a lot of us, if we go back and look at your 2009 performance, it actually was reasonably good versus some of the other industrial companies that we cover. You have continued to sort of add to the portfolio over time. You obviously have 60% of the business is aftermarket. How do you think you perform in the next recession and why? Where does the next slowdown?
Going back to 2008, 2009, and 2010, what we saw was a couple of things. One, very V-shaped recovery for Gates. I think down big in 2009, driven by our OE markets, both industrial and automotive, and then a larger recovery on a core basis in 2010. In that 2009 downturn, our automotive aftermarket, which is a steadier part of our business, was actually flat or maybe even up 50 basis points. That helped us kind of work our way through what were more volatile times. I think that was the extreme. In 2015, again, we saw some volatility on the industrial side significantly in a lot of commodity-based markets like oil and gas and some others, where we offset some of that roughness with that kind of automotive aftermarket once again. I guess it depends on the nature of the downturn.
I think what we've seen is our larger concentration of automotive aftermarket offsetting some of the volatility that we will see come through, particularly in that 35% of the business that's more OE focus.
Okay. No Gates presentation would be the same without asking about chain to belt. Got to ask about chain to belt. It still seems like the early days. At the same time, you've been talking about it for a while. We know it's a huge opportunity. You've given more examples of growth aspects. When does it become a needle mover, you think, for you guys in terms of revenue? Is it as early as next year, 2021? When do you think it really will move the needle?
Andy, let me start with the fact that we today already generate around $200 million from what we call the chain to belt market opportunity. We already have a really nice baseline of the business. We have a very nice, strong pipeline of future opportunities that we are working on to continue to add to that revenue base. We try to stay away from characterizing how much more revenue we're going to generate. When we think about this opportunity, it's about an $8 billion total available market for Gates. We would not or we don't compete, generally speaking, with anybody that's in our space. Our traditional belt-type competitors can't touch that. We compete with a competing technology, the roller chain.
When we think about this opportunity, this $8 billion market, we say, "Hey, look, we kind of think about it in three streams." One is kind of an industrial set of applications, so heavy-duty industrial applications such as lumber mills and grain silos and aggregate manufacturing facilities as examples. There is a stream that we are focused on, which we call personal mobility. Anything from bicycles to motorcycles and scooters and electric scooters and so on and so forth, which is a pretty large opportunity, about $1 billion in size for us. We have a very nice presence there and continue to drive our revenue in that space annually. The third piece is something that we call the light industrial automation and thing conveyance or moving goods on conveyor systems in light industrial distribution, warehousing-type facilities as an example.
It is not the belt that is actually moving the packages or the product itself. It is that apparatus, that motor that is powering that set of rollers that will move that package or whatever that content is on that belt. That is a huge opportunity for us with a business that we have in our portfolio that is manufacturing products out of thermoplastic urethane and from urethane materials. We have about a $40 million-$50 million business there. We anticipate that we can tap into that billion-dollar opportunity very nicely. We feel that we have a much stronger conviction, I think, today, Andy, than we had a year ago. We have a nice base of products on which we can build off. As we discussed earlier, we have an incredible amount of innovation that we are directing into this opportunity in particular.
Our anticipation is that it's going to be quite meaningful addition of revenue over the next kind of one to three years' time frame.
Is it the most exciting thing in the portfolio now, or is there something else that you point to and say, "Bigger growth prospects?
Look, I think that the chain to belt is a prospect for the company for the next 100 years. I mean, that's kind of a highly secular, very important piece that we have to execute and something that's going to solidify our presence in the marketplace for a long time. We are also very excited about the opportunities that we have with the technology we are launching on an initiative that we call belt to belt. That's basically going after our competitors with differentiated technology, which is quite exciting. We are very excited and continue to be very excited about fluid power and hydraulics. I mean, we have a ton of new products that are going to be launched.
I think there'll be a bunch of new press releases that we're going to be issuing over the next couple of weeks with some new innovations that we are putting into the marketplace. As we do that, we continue to broaden the market opportunity for the products that we manufacture. Again, at the end of the day, we want to be the premium player across all markets. Many of the markets the company has not participated historically because we simply did not have the portfolio. I'm quite excited about prospects, long-term prospects for the company across those two product lines that we have in our portfolio today.
I think that's a good note, Daniel. Thank you, Ivo. Thank you, Dave. Appreciate it.
Thank you.