Okay. Good afternoon, and thanks for joining us at the Wolf Transport Industrial Conference. We're going to kick off the afternoon session with Gates. Very pleased to have CEO Ivo Jurek with me to chat for the next half an hour on some of the key initiatives in place there. Ivo, I know you've got some more remarks, so let me hand over to you, and then we'll get into Q&A.
Sounds good. Thanks, Nigel. I'm delighted to be here. And real quick, look, I mean, I think that as we progress through 2022, we certainly are all aware of the complexities in the global economy and what the global economies are dealing with. That being said, we remain focused on our long-term strategy and continue to execute with a focus on meeting our customer demand and improving our service levels for our products. Look, when I look back since our IPO, we have been repositioning the company with focus on innovation and, frankly, opening new markets and opportunities for our products while improving our balance sheet. We're very pleased with the fact that we've made very significant progress on all three fronts.
Our innovation and new product introduction process is working and has not only significantly increased our NPI sales index and thus improved our competitive positioning of our company overall, but also has facilitated the opening of doors for new markets where we compete against non-traditional competitors like industrial chains deployed in mobility and in the industrial automation space, to mention a few. It has progressed so that we have reached a level of revenue generation in these new market opportunities that are significantly ahead of what we have anticipated when we introduced this opportunity in 2019 to our shareholders at that point in time. It is significantly ahead of the time. We are solving issues that we are dealing with on our recent earnings call vis-à-vis capacity constraints that maybe hold back a little bit our ability to supply the product to the demand that we see there.
We are continuing to position our customer demand, and we are focusing on the incremental opportunities that are out there. We are very pleased with our progress here. Lastly, since our IPO, we have continued to significantly improve our balance sheet. We are now in a position where we have optionality, and the optionality is such that we can focus further on reducing our gross debt. We can focus on returning capital back to our shareholders via buybacks or through M&A activities that will add some incremental technologies to our portfolio. While we certainly are cognizant and we believe that there will be impediments ahead of us, we are focused on managing through those impediments just as we have done through the time since we went public.
More importantly, we are focused on the long term to continue to drive strong returns for our shareholders and stakeholders that we have within our universe. With that, I'll now turn it back to you for some of the Q&A .
Thanks, Ivo. Yeah, I mean, you've had your fair share of headwinds since becoming a public company and tariffs, COVID, supply chain issues, and even the war in Europe. It hasn't been easy. I was going to kick off with just given the backdrop of potential slowdown, obviously, U.S. consumers deal with a lot of headwinds right now. Are you preparing for a slowdown and maybe taking some measures around that, or are you really preparing for a growth reacceleration? It certainly seems from your prepared remarks that you're really preparing for a growth reacceleration. Is that fair?
I think that it's fair. Look, we are also being pragmatic. We are focusing for both eventualities. Although we do have businesses where we've built a significant amount of backlog, and clearly our demand dramatically outstrips our ability to supply, particularly in some of these newer areas that are very exciting for us, and they'll be here for very, very many decades to come. We are also being cognizant that there will be some challenges, and we've got to be able to respond to those challenges. We're not trying to ignore one for the other, but we're trying to take a balanced approach so that we manage in a very strong execution on the short term, but we also focus on not giving ourselves impediments that we don't have to give ourselves for the long-term strategy execution that we are excited about.
To my mind, the key things are how solid and stable is the backlog? Can we count on that backlog even if we do go into a slower environment? That's the first issue for me. Then secondly, the ability to convert that backlog, i.e., the supply chain pressure points. Maybe you can just talk about the backlog stability. Through prior downturns, how stable has that backlog been? Have you seen cancellations? How solid is the backlog for the next 12 months?
Yes. First of all, I'll remind everybody that we are really not a backlog business. We are a book and ship business. Anytime we develop backlog, it actually is not something that makes me happy because it only states that our demand significantly outstrips our ability to supply. When I take a look back maybe three years, four years back, the backlog remained quite solid. We really never experienced cancellations, but we pretty quickly consumed that backlog when the economy went into a substantial slowdown. That being said, through April and May, we have continued to see very constructive order intake. Certainly over the midterm, we believe that we've sized up the impediments, and we believe that we are in a position to deliver what we've committed to the shareholders.
Okay. Maybe just market on the supply chain issues, Ivo. Obviously, China is a big sort of gating factor during the quarter, and obviously, you've embedded that into your framework. Just maybe talk about what you're seeing through April, May in terms of supply chain constraints and maybe more importantly, perhaps some of the resin capacity issues as well.
Yeah. I think that on our earnings call, I indicated that we have made significant progress with reducing dramatically the amount of headwinds that we have seen from supply chain, particularly from raw material availability. We are dealing with, we used to deal with maybe a dozen items week to week, but we've now really gotten down to maybe one or two items. We are making some progress in the specific resins that particularly go into automotive OEM applications in particular. We believe that in the second half, we will have that worked out as well. That's probably the one more meaningful remaining item vis-à-vis supply chain and raw material availability. The big issue for us in Q4 and Q1 was COVID.
Clearly, that has worked itself out, certainly in North America and Europe, but that is a rather significant impediment in China as we operate in the present quarter there.
Yeah. Obviously, labor was badly impacted by the COVID restrictions. Maybe just focus on the U.S. because that was obviously heavily impacted during Q4 and to some degree Q1. How is that trending? In terms of labor retention, the ability to hire and fill vacancies, what kinds of wage increases are you putting through to solve those problems?
We have seen the most significant wage increases, frankly, to be put in place kind of in Q4 of last year where we have re-indexed our cost structure. We have entered 2022 with basically the run rate that we believe is going to continue to make us a competitive and attractive employer, particularly in the manufacturing facilities and U.S. in particular. We still have some hotspots where here and there you have a distribution center that you're still struggling with getting workforce fully staffed, but the labor availability issues in North America in particular are significantly less onerous than they were in the second half of last year. We feel reasonably good where we sit today. It is not a massive impediment. It is certainly nowhere near what it was in 2021.
As we exited Q1, as I stated on the call, we felt that March was the first month where we kind of felt more normal, if there's such a thing, in North America operations specifically.
Yeah. Normal is not a word we use that much these days. That is good news. Obviously, you provided a lot of specificity around China in your sort of 2Q commentary. Just wondering, how is that playing out versus plan? I mean, in terms of your plants, supply chain, logistics, any help there would be appreciated.
Yeah. Look, we've, I think, taken a pretty pragmatic view of what we anticipate to see in China in the second quarter. So far, it has been playing more or less in line with how we have envisaged that the quarter is going to progress. We really did not count on dramatic improvement in the lockdowns of Shanghai. We looked at it more like what it was like in some of the Western economies when the economy shut down. We said basically it is going to take three months to reopen. That being said, all of our facilities are operational presently. We only have one facility that is, frankly, located inside of the Shanghai city proper that is operating at reduced capacity, but it is operating. The biggest impediment that I think we all are dealing with in China is inter-country logistics.
That is much more problematic than I think folks have envisaged and certainly us as well. We are solving that problem as well. We certainly believe that demand is holding okay. It's your ability to get raw materials into your factories and then ultimately get the finished goods to customers that are calling you, "Hey, where is my stuff? And how can we get the products from your warehouse to our facilities?" It's playing itself out more or less kind of how we've anticipated. It will be impacted quarter. It will be pretty dramatically impacted quarter, but not beyond what we have anticipated.
Okay. You think that, again, using the word normal, do you think 3Q might look a little bit more normal from a China perspective?
Oh, gosh, I wish that I had a crystal ball. I think that it really depends on what happens with potential infection rates in some of the bigger cities outside of Shanghai. Shanghai, I think, is going to be more normal in 3Q. Will that be an environment where they are not locking down some other cities? I think that that's everybody's guess, Nigel .
It feels like it's going to be two forward, one back, two forward, one back for a little while. That's fair. I do want to get on to some of the longer-term initiatives that you've referred to, things around innovation especially. Maybe just talk about Europe because you're very globally diversified, so you can give us some good perspective in terms of the geographies. Sounds like North America remains pretty strong. Europe is a big debate right now in terms of the inflationary impacts and potential slowdowns there. Are you seeing any worrying signs in Europe?
No. I would say that the biggest impediment that we have faced in Europe so far is the effect of reducing our presence in Russia in line with the sanctions. I would say that more or less the inflation that continues to ramp up is predominantly associated with escalation in energy costs. From a demand perspective, demand actually in the industrial applications has been rather strong, maybe a little bit to my surprise. We have built a very nice business in automotive replacement in Russia. When I take a look at some of the end markets, we will be dealing with some comps and some impacts with some of these decisions, particularly associated with the war in Q2. The underlying demand so far has remained reasonably solid. I think that we all are in the same boat.
We are all thinking, "Hey, can that remain at this level? Or is there the effect of inflation that will start rolling into potentially demand destruction?" So far, so good. We are very laser-focused on managing our European business particularly day to day.
We've heard some companies talking about some pushing to the right with the inflation. It doesn't sound like you've seen much of that, if I don't want to put words in your mouth.
Look, I think that the big issue in Europe, again, from an inflation perspective, is the escalation of energy costs. We are an industrial company. We consume quite a bit of energy. It is going to show up in inflation. That being said, we are being very proactive in pricing. That is something that I view customers as starting to understand a little more as to whether it is surcharges that you apply or, frankly, just raising prices to take that into account. I think inflation is going to remain, and it is going to be a headache for everybody. We are very focused on managing through and get to our stated objective to exit the year non-dilutive to our margin vis-à-vis inflation and raw material economics.
Okay. I do want to just make sure we understand the dynamics around this. Number one, on pricing, are we pretty much done with prices here? Would you expect to still roll through price increases over the balance of this year? In 1Q, obviously, margins were impacted by price costs, but that's more of the mathematical impact. I think on a dollar basis, you are fairly neutral. Would you expect to remain sort of, I think you've talked about, as you exited the year, being margin neutral on price costs. Is that fair?
That's fair. Look, I'll state it. We are continuing to deal with a very dynamic environment. Obviously, you layer in plans, and you believe that you have scoped it all in, and things change. We continue to offset inflation dollar for dollar with pricing. Coming back to your original question, "Hey, do you think that you're done with price?" I don't think that you will ever be done until you see inflation rolling over. What we are done with is we are done with not being quick on our feet. I think that we continue to be pretty proactive in adjusting pricing as needed to be. From where I sit today, Q1 inflation was a little bit higher, and we have taken additional pricing actions in Q1. Those will benefit us as the year progresses.
If inflation continues to roll in, it is inevitable that you will have to take prices. We are prepared for that. From everything that we see today, Nigel, we certainly believe that we can continue to reaffirm our commitment to deliver and exit the year being non-dilutive inflation price economics. We still anticipate that price economics is going to get to a level where we will not be taking a dilution to EBITDA margins at the end of the year.
Okay. That's great. We've never seen, generally speaking, industrial pricing is pretty solid through slowdowns or disinflationary periods. We've never seen, well, not for a long, long time, this scale of inflation. I'm just curious, what are your perspectives on that? Do you think that you can keep some of these price levels through maybe a rollback in resin prices?
Yeah. I think that that's an interesting question that I think that we all would like to have an absolutely crystal clear answer to. What I'll say is that over 65% of our business is in replacement channels. Generally speaking, you have probably a more significant likelihood that you will retain pricing on the products that go through channel. We anticipate that it's going to become more choppy with OEM pricing. Obviously, the OEMs have lots of pricing power. They are built to be able to bid these contracts. I think that everybody will have to make their own decision whether or not they are prepared to compress margins or whether they want to continue to generate a reasonable return. I think that's where the war is going to be fought.
Yep. Absolutely. Maybe we can talk about innovation, Ivo. It's easy to get sort of distracted from that. Maybe talk about new product vitality, how that's been trending, some of the investments you're making. Obviously, we spent a fair amount of time talking about industrial chain of belt. That's a very large TAM opportunity for Gates. Maybe talk about where we are in that process.
Yeah. Look, I mean, I think in a case, we've done many really good things with the business that help us to make dramatic progress in repositioning our franchise. I'll say that innovation is one of the things that is really uber successful. We set very substantial goals where we said, "Look, we want to more or less refresh our entire portfolio of products that we manufacture." We are touching just about every product line that we have vis-à-vis innovation and launching new, more innovative, more cost-competitive products into the marketplace. When I took over, and I think that kind of during the IPO price, we were talking about low single digits of NPI Vitality Index. Today, we are in teens. We have made a very dramatic progress with innovation. We are well on the way towards our stated objective of 20%+ of NPI Vitality.
We believe that we're going to get there over the next couple of years. That's doing really, really well. As you said, that's doing kind of a couple of things, right? Everybody's talking about, "Hey, will you be able to hold on to your pricing to protect your margins?" We kind of add another element. For us, the other element of gross margin improvement or expansion is being more competitive. That you get through innovation. That's kind of why we have been so hell-bent on driving the refresh of our portfolio. We believe that that's going to play a big role in our ability to maintain and expand our margins and normalize our margins as this process starts normalizing into the future vis-à-vis inflation. Now, coming back to the second part of your question, the industrial chain to belt initiative.
Look, that initiative is not only concentrated in diversified industrial and market. It is also in e-mobility or what we call personal mobility. We continue to see a very strong growth. There are lots of tailwinds that drive the adoption. As I said in my prepared remarks, we're actually so significantly ahead that we were running into capacity constraint in the products that go in the industrial chain to belt applications. I talked the last couple of quarters about adding specific capacity, adding capacity and repurposing some of the industrial equipment that we have. We are now in the process of launching the capacity to give ourselves an opportunity to continue to drive the growth forward. It is an opportunity that is a multi-decade opportunity for us.
We have a better technology, cleaner technology, more energy-efficient, and more quiet technology, which we believe that resonates really strongly with the end users. If I just take a look at industrial chain to belt, what did you do last quarter? Do you continue to drive the design wins that give you a line of sight on how that's going to evolve into the future? Absolutely. Look, we've converted a large multinational forest product manufacturer in the last quarter, a large pump applications in LNG facilities, all very relevant to what's happening today in the world. One of the world's largest manufacturers in cotton processing equipment in India, as an example, and a large manufacturer of lawn and garden equipment that has gone away from actually direct driving into a Gates belt-driven application. The opportunities are endless. The runway is very long.
Yes, it will take some time, but we are doing better than we anticipated. We believe that this is an opportunity that gives the company a more stable, more profitable, and long-term opportunity to continue to drive profitable products.
Good. That's great. Thanks for the detailed answer there, Ivo. Before I want to sort of wrap up on balance sheet and capital allocation, I do want to touch on the EV opportunity. I think you first started socializing maybe some of the content opportunities on EV platforms back in 2019. Obviously, we've seen a lot more launches since then. Just maybe talk about where you sit right now on the sort of the EV penetration curve.
Yeah. Look, I start always with kind of the boilerplate bullet that I think is essential. Our business in automotive is fundamentally focused on replacement channels. In automotive applications, that means vehicles that are 7- 12 years old. That is our mission statement. That business is 3x our OEM business. As we discussed EVs, yes, they are a great opportunity for Gates. We have a substantial content uplift in product lines that we are a leader, that we have a leadership position today, particularly in the thermal management and water costs. When you start thinking about that opportunity, right, look, there's about 600,000 EVs in the marketplace today that are in a sweet spot, right, out of all the populations. Again, the sweet spot is 7- 14-year vehicles. That 600,000 EVs is on a car park globally that's 1.4 billion in size.
Although we are very excited about that opportunity, Nigel, it will take quite some time to ramp up. We need more EVs to come to service and to use. We need those EVs to age so we can offer replacement components in the functions that we serve today. We have a large OEM pipeline, both in automotive and heavy-duty truck, but we are predominantly focusing on thermal management. We are focusing on steering and other accessory drive applications. We are happy with where we sit, but it will take time to scale up that opportunity that we have needed.
Okay. So you don't need to be on the OE platform with the OEM to participate in the aftermarket opportunity for EVs?
Absolutely. That is the case. We do not need to be in the OEM application.
Very clear. That's great.
We will be, but very selectively. We participate very selectively.
That's very clear.
We worked so hard to shrink our OEM business over the last five years.
Right. Finally, maybe in the couple of minutes we've got remaining, you talked about the balance sheet and the dramatic change in the balance sheet leverage since the IPO. You've got optionality on free cash flow here. The question I've got is, number one, when do we start to see conversion improving, i.e., these working capital pressures? When do you think those get behind us? I understand why that's been the case, but when do you see that happening? Where do you sit here on allocation? It seems like your stock price is a great investment right now. What's the pipeline for M&A looking like right here?
Yeah. Look, free cash conversion, we believe that we're going to be 90%+ in 2022. I think we stated it on our last earnings call. Maybe the natural question is, "Why aren't you 100%+ ?" Right? I think the issue is that with the dynamic of this particular year, we anticipate a stronger second half, and that will be a little bit of a headwind in terms of cash conversion, particularly on the receivable side. Look, inflation is driving higher pricing. It's also a little bit of a headwind in terms of receivables and inventory. We believe that it is all scoped and that that's going to get normalized. I don't think that our shareholders are going to be unhappy with 90%+ cash conversion as a measure of adjusted EBITDA.
On the capital allocation strategy, look, at this point in time, we anticipate to maintain a very balanced approach that provides for long-term value creation. I, by the way, agree with the share price. I think the stock is too cheap. Taking that into account, we believe that share repurchases have the highest risk-adjusted return for us. As you have seen recently, the board has been very supportive of that idea. We nearly completed the November of last year authorization to purchase over two years, about $200 million of our stock. That being said, we need to be very balanced. We also have an opportunity to reduce our gross debt for some shareholders. That is an important factor. We have plenty of cash to be able to do that.
We are also seeing some opportunities, and particularly both on M&A in technologies that we have an interest in. We will be very disciplined. We have an opportunity to deploy capital. We generate very strong cash flows. We will deploy cash to return that cash back to our shareholders, to the board of our shareholders.
Okay. Great. Thanks, Ivo. I think we're out of time. Any closing remarks?
I think that as you indicated, since 2018, when we became a public company, we've dealt with an endless stream of challenges. We are prepared for these challenges, but we continue to demonstrate that we become much stronger after every one of these specific set of challenges that are layered in front of us. We are ready for this one as well. The future of the company is terrific. The company is in very good shape. We have a terrific mission that we believe we can continue to execute on.
Ivo, that was great. Thanks for your time. Good luck out there. Thanks.
Thank you very much. Take care.