Hi, good afternoon. I'm Morgan Stanley's Electrical Equipment and Multi-Industry Analyst, Josh Pokrzywinski. Thanks for joining us for day two of our Laguna Conference, virtual this year of course. Of course, we'll make it up to you next year. I promise, and it might just be me, but I promise that we'll be out there. Joining me for our next fireside chat, Ivo Jurek, CEO of Gates. Good to see you as always. Thanks for taking the time. Before we get into Q&A here, though, I do have a quick disclosure statement to read just as a reminder. For any questions about our research disclosures, please see our disclosure website at morganstanley.com/researchdisclosures. For all other questions, please reach out through Morgan Stanley sales coverage. With that, Ivo, thanks for making the time. Good to see you as always.
Maybe just to jump right into it, maybe get us an update of what you're seeing out there in the world. I think we'll probably spend a good amount of time on supply chain. Certainly been topical this week, but maybe kind of set the table high level of what you're seeing out there in your markets.
Yeah, look, nice to see you, Josh. Thank you for the invitation. We're all looking forward to having an opportunity to be together in Laguna next year, hopefully. Look, the overall environment for our products remains very robust, not so dissimilar to what we have spoken about on our Q2 earnings call. Last couple of quarters, we have mentioned that our book-to-bill ratio remains well above one. I would say that the sentiment remains the same. As you indicated, the biggest challenges that we are all dealing with presently are supply chain disruptions, logistics availability, and frankly, the availability of direct labor in the United States in particular. That, I think, pretty much sums it up of what we are all dealing with today.
Got it. Yeah, I think certainly common observation around the supply chain side. How would you compare that to kind of the pricing environment and your ability to keep up with that here in the medium term? Is that something that is going to get more acute before it gets better, or do you feel like the pricing environment sort of kept pace?
Yeah, so look, given our very strong brand, the large replacement channel presence, kind of the predominant dynamics for our business, and the portfolio of mission-critical products, the business has, generally speaking, and historically responded well to an inflationary environment. We certainly, this year, we were very early in bringing price increases to the market, frankly, to offset inflation that we have seen already in early Q1. We have remained price material economics positive in the first half of the year. Maybe coming back to our most recent earnings call, we have indicated that we did not see or we did not anticipate inflation to ease. However, we still expect that price cost will be positive for the full year.
Based on our track record of delivering price cost every year since we became a public company, we have demonstrated the ability to manage through inflationary pressures, and we believe that we'll be able to do that well into the future.
Got it. Obviously, every supply chain and kind of timing of purchases looks a little different. Spot prices do not always kind of tell the tale, as it were. Are you sort of living at spot rates in the business today, or will that inflation kind of continue out over the next couple of quarters just as hedges and contracted purchases and things like that reset?
Yeah, look, we do not necessarily want to speculate about what input costs will do well into the future. I mean, presently, we are all dealing with reasonably significant inflation out there. Again, the dynamics of our business are such that we have a significant presence in the replacement channel. We have a very well-demonstrated ability to manage through market conditions, inflationary, deflationary. We have an ability to react to economics on kind of a 60-day to 90-day basis in terms of reacting to inflation or deflation that we see. The biggest issues, again, we are seeing is freight. I would say that almost the material attribute of inflation is maybe getting within what we would expect, but the freight inflation is still with us. I think that we will need to deal with that well into the future.
Got it. Maybe pivoting over to the demand side, something that really stands out is the strength in your general industrial markets. I know we talk a lot about auto, probably too much on the first fit side, but general industrial has sort of led the way out. Do you think you're gaining share there? If so, what do you think is really driving that? Does that affect how you view investment priorities or M&A and kind of other strategic imperatives going forward, just given the success you've had?
Look, we have been and we remain very focused on growing our diversified industrial business, which frankly is also the maturity where our chain-to-belt initiatives are focused. We are seeing very positive secular momentum in industrial automation, particularly in warehousing and logistics applications with the acceleration of e-commerce. Frankly, precision motion control applications such as robotics. Those are all really nice general industrial applications that we believe in long-term opportunity for growth for our products. The design wins that we have mentioned over the past couple of years are now turning into revenues, resulting in very nice growth that we have been demonstrating. We are confident that we have been gaining share on that basis. Lastly, I would say that we have prioritized growth in general industrial applications since we became a public company.
We will continue to direct our investment priorities there well into the future as well.
Got it. I know one topic that's come up a lot over the past two to three quarters has been inventory replenishment, which is probably overblown on the way out as being this massive tailwind. It's probably helped a bit, is sort of my suspicion. Where do you think we are today on overall channel health and inventory levels? Is there still some to go? Have we gone backwards with kind of the recent tightness? What's the state of play there today?
I think that's a good question, Josh. I think everybody's got a great deal of interest. When we talk about inventory levels, specifically from a company's perspective, we're talking about channels. We are frankly referring to the replacement channels of our business. That's where our largest part of our business participation is at. That's also where we have the best visibility. We have frankly not seen any signs of tangible inventory restock in our replacement channels today. Based on the point of sale data that I refer to when I speak about inventory rebalancing and the end user demand, which is very broadly supportive, the channel inventories remain quite low when compared to the demand levels that our distribution channel partners see. On our last two earnings calls, we've talked about our book-to-bill ratio, as I mentioned earlier on this call.
Our book-to-bill remains nicely above one. That is an indication of the demand outstripping our ability to supply, especially for a business like ours that does not typically build backlog. If and when a meaningful restocking happens in the future, frankly, we will have to stay focused on supporting our customers' needs, just as we are doing today. It is hard for me to see that that is going to occur anytime before 2022.
Got it. I want to pick up on something you just mentioned on chain-to-belt earlier when discussing diversified industrial. What do you think of as kind of the big applications that have yet to convert? I know some of this stuff is specified in over time, and the winds come in advance of the revenue sometimes by quite a bit of time. How do you think about that over the next couple of years in terms of the incremental growth from what you can see today?
Let me remind everybody that we believe that this is a really nice secular opportunity that is quite sizable. It is over $8 billion market size. We believe that we are at very early stages of capitalizing on the opportunity. We have talked about numerous design wins in chain-to-belt over the past few years. I have been pretty upfront about where we are winning. Those design wins today are turning into billable revenue, which we have been highlighting over the last couple of quarters. We see very strong growth from that initiative. While we do not anticipate, certainly, the type of elevated growth rates that we have been reporting over the last quarter, in every quarter, this is a large, steady, secular, long-term opportunity for our business that will support our growth well into the future.
We are quite focused on particularly diversified industrial applications, as we discussed a couple of moments ago, particularly across logistics, distribution, and light industrial applications such as food, beverage, pharma, to be listing a couple of these areas that are of great deal of interest for us. We are targeting applications where, frankly, uptime, cleanliness are key priorities for the end users, with belt offering the biggest set of value proposition benefits when compared to those chains. We are also discussing the expectation that over $200 million of revenue is a target that we believe we can deliver in our diversified industrial end markets. A large portion of that is going to come from this chain-to-belt initiative that we spoke about.
Again, as I said, frankly, considering the size of that market opportunity, we are just getting started, and we are very excited about it.
Now, the real question is, when is my road bike going to have a belt on it rather than having to deal with this chain?
Road bike, that may be a little while. I'm hoping that maybe you can buy yourself a nice e-bike to help pedaling uphill. You can get a good one with the Gates Carbon Drive support.
I'll keep that in mind. I only got seven years where the knees left, so I don't have infinite runway to wait for that. Shifting over to the auto side. You've sort of been deliberately migrating or managing down some of the OE exposure over the past couple of years here, being much more selective in the bidding process. I think at the same time, though, you've also seen OEMs really shift their own focus to the EV side. How has that selectivity and OEM reprioritization gone? Are you finding more content on the EVs? Is it just sort of a lack of interest in the broader OE? Kind of doesn't matter what technology they're using. Sort of talk about your own strategy and what you see on the customer side and how you think that plays out here.
Yeah, lots of really good points in there, Josh. Let me start with reminding everybody that we are predominantly focused on the replacement channel in automotive. We are focused on build-out of our EV product coverage on vehicles that are in operation. Before it becomes a meaningful portion of the 7-12-year-old fleet, that certainly is going to take some time. We have been very intentionally, as you said, reducing our automotive OEM participation from about 15% to 10% since our IPO. The 10% was in the first half of 2021. That was the most recent quarter that we had reported. We certainly demonstrated that we do not need the OEM business to drive growth in the replacement portion of our franchise.
Generally speaking, we are seeing much larger content opportunities on electric vehicles, with the emphasis for us being in a thermal management system. This shift from IC to EV is, frankly, a substantially net positive for Gates as it relates to the total dollar content. For example, a mechanical water pump on an IC car is selling for about $10-$15 a unit, while the electric water pump on the electric application runs north of $100. Very substantial growth there. It is a similar situation on the thermal management hose assemblies, with content growing from $15-$30 on ICE towards trending towards $100-$200 on an EV application. To put a point to it, a couple of quarters ago, I've highlighted a design win on an electric platform with roughly $600 of content per vehicle.
That is a really good example of the potential we have with the electrification on a pass car or a heavy-duty application. As you can see, we are quite excited about electrification, but it is still, for us, a much longer-term opportunity as we want to be truly a large player as we are today in the aftermarket part of that business.
Understood. Just for comparison for folks on the line, what is that $600? What would that translate to in a more typical ICE application for you?
It would typically trend somewhere between $50-$100.
Got it. Order of magnitude, more than 10x.
Absolutely. I think that that's what we've tried to demonstrate to our shareholder base and potential shareholder base. We are really quite excited about the opportunity. We're in the business today, so it isn't like we've got to cross some technology schism to be able to participate here.
Got it. Maybe just shifting over to the fluid power strategy. I mean, chain-to-belt is sort of a pretty clear differentiator on the PT side. What do you see as driving margins and growth once IP returns to normalized levels for the fluid power side of the house? Anything that you're doing specifically or anything in some of those markets that you're particularly focused on?
Okay. Let me start with what I said on the second quarter earnings call. We view our fluid power business as still being a bit later in recovery relative to power transmission. We think that power transmission is a little bit ahead. That also is supported by the growth rate in PT versus FP. The key part on what we are delivering with our new product innovation is differentiated level of performance to end user. That, in general, translates into share gains. We have seen good evidence of that over the last year or so as well. Many of our new products use advanced construction, which drives improvement in factory operations. Frankly, it supports our competitive positioning. Again, that comes back to that market share gains that we have been reporting.
This innovation also gives us the opportunity to drive product that enables portfolio simplification, which, frankly, is quite big when you take into account the amount of SKUs that we manufacture that we have been historically speaking about. That, frankly, drives further operational efficiencies. Look, as an example, our new fluid power innovation is allowing us to cover an even broader set of applications with 50% or fewer hose SKUs. That enables growth. That enables ease of doing business, not just for us, but also for our channel partners. That builds not only an opportunity to drive revenue generation, take market share, but it also, frankly, gives us an opportunity to be much easier to do business with. That is what I would summarize as the key set of fundamentals around driving growth and perhaps profitability improvements in fluid power.
Got it. Is there a strong interplay today amongst the two businesses where customers truly are purchasers of both? I guess I'm sort of leaving distribution in the aftermarket aside. The distributor seems like they could logically carry both. OE content-wise, the showing up with both product lines, are you finding that gives you an advantage when you bid on these platforms?
Yeah. Look, it's much easier to talk to the same customer. Let's make no mistake. Generally speaking, it resides in two different purchasing organizations on the power transmission versus fluid power side. It does help you that you are a credible player with one or the other product portfolio. I wouldn't say that it gives you a dramatic advantage because you have those two product lines. It, by some default, gives you the right to get more market share. I think that you've got to be focused on both. You've got to be focused on driving innovation and outsourcing your competitors. Maybe the benefit just is around the fact that you have a credibility with these large accounts in these pretty critical application sets.
Got it. Just shifting over to Asia and maybe diving into the aftermarket model there, particularly in China. Obviously, the case count there has gone up, and you've seen more lockdowns. Any evidence of that in your business, whether on demand side or kind of customer responses, lead times, anything that would sort of relate back to what you're seeing at kind of the macro or COVID level in Asia?
Yeah. I think there's a lot that we are all reading about what's happening in Asia. Asia has been pretty hard hit over the last 18 months with COVID. It almost seems like they're just going from one shutdown to another. We are very fortunate that all of our operations in Asia have not been impacted, certainly in the last 60 days. We are in countries that are open, they are operational. Frankly, the demand that we see remains very much in line with our second-half guidance.
Got it. Understood. Just thinking about kind of the medium-term incremental margin outlook, you guys have seen a nice snapback here thus far in the recovery. Demand certainly seems like it's strong. You're staying on top of price cost, generally speaking. How should we think about kind of that migration over the next couple of years in that backdrop? Can we still sustain these 30% + incremental margins? Or are there other investments or something else that starts to normalize that?
Yeah, Josh, we've certainly committed to our shareholder base that we believe we can deliver incremental margins during the upcycle in the mid-30s. Nothing is telling us today that we can't do that. We certainly have been doing a solid effort here on the inflation management. We believe that despite the fact that it is very difficult, it is front and center in everything that we do. We are able to manage through it. We will continue to remain very vigilant in controlling what's within our control. Fundamentally, our business is positioned to be able to deliver the mid-30s incrementals over the midterm.
Got it. Last question. With the balance sheet improving here quite a bit in recent years, how should we think about the framework for capital allocation? Clearly, two lines of business that are doing fairly well. Do you think about bolt-ons for M&A? Anything else on allocation that's sort of rising to the top here as that becomes more actionable?
Yeah. As you know, Josh, you and I had this conversation many times. My priority continues to be deleveraging of the business from where we came from to where we sit today. We are moving forward towards the long-term target of net leverage kind of below two times, two times. The stronger balance sheet that we have today does provide us with additional optionality, as you have highlighted, with respect to further capital allocation. We remain very excited about opportunities that we have to invest organically. We believe in the organic growth as probably the lowest cost, highest return growth. Clearly, M&A now becomes a much better option for us as well. We are participating in highly fragmented end markets.
That gives you the opportunity to go out and do some more bolt-on type acquisitions that we certainly have a very good pipeline of opportunities with. We also have other means to look at potential deployment of our cash, whether or not it is potentially repurchasing some shares or potentially issuing dividend. All of those attributes are on the table for us. We will review all of them. We will make sure that we do what makes sense for our shareholders and for the business over the long term. The optionality, from where I sit, is nice to have at this point in time.
Excellent. Thanks for participating today, Ivo. Good to see you as always. Hope to do it in person next year. In the meantime, take care. Be well. Thanks a lot.
Thank you very much.