Good afternoon everyone and thank you again for joining us as we round out day one of the UBS Global Industrials and Transportation Conference. I'm Damian Karas, analyst on our electrical equipment and multi industry research team. We're pleased to welcome Gates Industrial Corporation for this fireside chat. Joining us from the Gates team, we have CEO Ivo Jurek. Now, before we get into the Q& A session, let me first turn it over to Ivo to kick things off.
Thank you, Damian. Let me just briefly share with you why I believe this is such an exciting time at Gates. We have put a great deal of energy and investment into transforming Gates over the past few years, building up the company's strong foundation throughout the challenging market environments of 2019 and 2020. We've continued to invest in the revitalization of our product portfolio, our manufacturing footprint and our focused growth initiatives. We are now starting to see these investments pay off with a meaningful contribution and acceleration of growth momentum. Early in my tenure here at Gates, we set about rebuilding our innovation capabilities and tasked our teams with revitalizing our entire product portfolio. This is well underway and not only opening up new opportunities, but also leading to improvements in sustainability for us as well as our customers.
We are seeing our new product vitality pick up throughout the company and we are excited about the progress. The economic momentum is building across most of our end markets and we believe we are in the early stage of industrial recovery. On top of this, a substantial above market growth is supported by improving economic conditions and the success we are seeing with our innovation investments and growth initiatives. We believe the business is well positioned to achieve our mid term growth targets from a profitability perspective. We have a terrific set of organic opportunities across our segments and ongoing Gates production system initiatives that support future margin expansion. We believe our recent investments in capacity, new products and restructuring all provide runway for us to achieve our midterm targets of 24% EBITDA margins.
Our cash flows have proven quite resilient and when combined with our improved profitability, we allowed ourselves to make significant progress to deliver the business with a near term goal of about three times net leverage. That is being squarely in our sights. This not only creates nice optionality for us to optimize capital allocation, but also it gives us the opportunity to have a good runway for future prosperity of the company. With that Damian, I'm happy to take some questions and move to Q& A.
Terrific. Thanks for that introduction, Ivo. Just a note for those of you listening in, if you have any questions, you can submit them on the webcast and I'll go ahead and ask them. Ivo, it's been quite the journey since the start of the COVID pandemic to today. I was wondering if you could maybe first reflect a bit. Is there anything that you've learned about your business over the past year that you'd say really stands out? Secondly, as you kind of see things today, where would you say Gates has the most room for improvement or any issues that are really front and center for you?
I think it's a great question, Damian. 2020 was very tough, obviously, but we've pivoted quickly to operate in a safe manner, putting the safety of our employee first and foremost. I think that it was critical throughout this pandemic. We also worked quite hard to ensure we were able to continue to support our customers, many of our customers which operate in essential industries. When we originally deployed our in-region-for-region manufacturing strategy, it was to shorten our supply chain and frankly operate in close proximity to our customers. During the pandemic, this strategy allowed us to flex better and serve our customers well around the globe. In return, we believe this positions us well with customers today as well as it did over the last 12-16 months to frankly drive improvements to our market share position.
Now, maybe to the second part of the question. How and how we can improve the business better, how we have altered our portfolio, maybe let me go back to that a little bit and address that question a little more. I always have to go back to 2018 when we went public first. We've talked about a significant additional opportunity to rationalize our footprint, revitalize our product portfolio, improve the efficiency of our business, and frankly improve the efficiency of our SG&A. Most importantly, we knew that we needed to improve the balance sheet that we were operating within. We really haven't changed the strategy. Even looking back to 2019, it's been all about operating our business better. We've been focused on the longer term, which I think has been important for us, and to drive innovation, execute on our targeted initiatives to deliver above market growth.
When I look back at the challenges that we faced in 2019 and 2020, we continue to make those investments in product development and all of those growth initiatives. That's been helping us to reposition our business and frankly juice up a little bit our growth rate. I think, you know, we have been, you know, we have been reporting some substantial growth certainly over the last couple of quarters. You know, during the time we also dramatically reduced our automotive OEM business and so from that 2018 to 2020, we reduced that OEM business by nearly $100 million, which is a pretty substantial sum of revenue for a company of our size. You know, we've decided maybe in 2017, 2018 time frame that we will only focus on hybrid and ultimately electric applications. We are doing that.
That offset, we targeted an offset of automotive revenue with industrial investments. And you know, frankly, we are seeing that with programs such as chain to belt, Industrial fluid power initiatives. I think that that's been paying nice dividend for our company.
Great. Yeah, no, absolutely. You've been putting up some pretty impressive growth numbers the last couple quarters. Really appreciate all that perspective. Maybe if we just honed in on the growth opportunity a little bit more. If I'm being honest, I think when most people see industrial belts and hoses, their initial response is less than exuberant. M aybe you could just talk about what has you really the most excited about the future. You know, whether you're talking about specific products, you've launched commercial initiatives, some of the secular trends, maybe just kind of lay out the, the growth case for Gates.
Damian, I think that one of the reasons that they're not excited about it is because they don't quite understand that everything they do there is probably a Gates in an application that our folks are using across maybe consumer all the way to industrial applications. Really coming back to the fundamentals of that question, look, we believe that innovation is the foundation that's driving our growth. Look, we are developing product that is differentiated. It is IP protected technology. You know, all of that is critical to driving future growth opportunities. This innovation, frankly, is opening doors to new markets and new applications that are, frankly, secular in nature, such as e-commerce driven logistics, food and beverage, pharma and chemical manufacturing, stationary manufacturing equipment, industrial automation, robotics, personal mobility. I can name many of those.
As you start reflecting on these applications, you actually start realizing that, gee, maybe I didn't really think that a robot will have Gates belt in it, did I? That's really kind of, I think, maybe that misnomer. Now, the increasing focus on ESG in the industrial world is frankly accelerating the demand for our products.
Why?
You know, it's because our products are clean, they are more efficient, they increase uptime, they reduce the need for maintenance. You know, that is a dialogue that makes it much easier for us to approach customers, you know, with applications such as converting industrial chains to clean Gates-manufactured, differentiated belts. We are seeing this in our results now. You know, markets have improved somewhat. You know, our sales of fluid power, as an example of the new products in fluid power in the most recent quarter, were up 90%. Our mobility business grew 80%. You know, we saw a very significant lift in our industrial chain to belt business as well. Those are huge markets and we are in very, very early stages of these initiatives.
While we may not see this level of growth every quarter, Damian, we do see a very steady long term opportunities for our business and that gives us confidence that we can deliver above market growth rate that we have committed to our shareholders.
Understood. I definitely want to ask you a little bit more about the chain conversion, but maybe just thinking a little bit about, you know, the market share gains that you're saying that you're achieving now that were a part of the growth that you're seeing is clearly macro driven. Was wondering if you could maybe share, you know, a tangible example or two of that, you know, evidence that you're seeing market share wins or a product success that you're having if you could maybe kind of years.
There has not been a quarter where we have not continuously talked about numerous design wins in very attractive end markets and applications. You know, every quarter we come out and we delineate with both of our products, product segments, you know, how and where we are winning. Frankly, there has not been a quarter where we have not seen a number of very exciting wins across both of these product subsegments from chain to belt to industrial fluid power to mobility and others. Right. Most recently we have talked about key design wins in health care, E scooters, industrial automation, stationary manufacturing, AG construction equipment, heavy duty EV trucks, to name a few.
All we need to do is just reflect over the last couple of quarters and you see a true spectrum of very exciting design wins that you know, now frankly are starting to turn into valuable revenue from our customers for our products. You know, as I look at the attribute that we have undertaken about the transformation that we have driven through this company and frankly that has differentiated our product performance. That is what is helping us penetrate this very diverse new set of applications, customers and frankly end markets.
Great. One question that I do get right when they look at your business is fragmented market and high level of profitability. You know, the question being kind of if you know there's some capital injection that comes in at some of your competitors, you know, would they be able to kind of, you know, catch up to you quickly? What are your thoughts on that?
Yeah, look, our advantage, frankly, the way that I think about our company is that we have two of scale product platforms, power transmission and fluid power. That in itself, Damian, drives incredible amount of focus and intimacy into applications and end markets. Frankly, that's what differentiates Gates from others. That level of understanding gives us the opportunity to drive innovation, to frankly drive applied material science into our product portfolio. I have spoken on numerous occasions about, we are focused on building out of scale material science capability and we have made significant investments over several years into that. We have built development of our own industrial process technologies. When you combine these two subsegments, that's what is giving you an opportunity to drive that innovation.
Now you know I, you know I respect our competitors but I also believe that, you know, we are in stages where we will continue to drive generational product development progress in our platforms. We won't stop where we are, you know, where we are today. We will continue to drive that innovation. Frankly, you know, that portfolio and you know I've spoken about the targets kind of over the midterm of 20%+ is what I believe is going to put us on a pedestal where we can remain. We can continue to drive high levels of profitability, we can continue to drive growth of our company and frankly we can enable. It is reducing the weight of their equipment, it is higher uptime, it is reduction of energy consumption and so on and so forth.
I feel actually quite good about where we sit competitively and I believe that, you know, as competitors at some point in time will catch up with us. We will have the next level of innovation that we'll be bringing into the marketplace.
Great. I want to come back to the chain to belt conversion. Maybe for those investors that are not as familiar with Gates, maybe you could just kind of begin by giving your perspective on the opportunity, what it means for you, how, and then I would have a few follow up questions on that.
Yeah, look, chain development is actually a very interesting opportunity for Gates. It's about an approximately $8 billion market that is presently served by industrial chain and Gates does not manufacture industrial chain. It is an opportunity that is secular in nature that we believe we are very differentiated from other competitors of ours. We are competing against NAV. We are seeing a real momentum that has built in those conversions from a pretty strong foundation that we have built over the last three years. Now that momentum is actually supported by increasing focus on ESG trends that are frankly front and center for manufacturers around the world. Our teams are very focused, they're really energized by the breadth and the momentum of design wins. We are delivering, you know, we're delivering them in end markets such as food and beverage farm.
Why is that happening? It is happening because we are driving elimination of safety hazards in those facilities. Because you are not using lubrication, you do not have to shut down the equipment to lubricate those drive mechanisms. You reduce energy consumption because our belts, our drive mechanism, is lighter and more efficient and frankly it gives you an opportunity to get most out of the industrial assets that are deployed. I think it is a really good value prop. We are seeing that adoption, by the way, both at OEMs where we are trying to stick, but we also see momentum in end user operators where we are converting industrial chain in existing installations.
You know, this is a business opportunity that is very secular in nature and we anticipate it will add to our growth for very many years to come because frankly we are very early in this opportunity. Maybe borrowing a baseball analogy, actually kind of feel like we are just putting our unis on, not even entering the playing field yet.
Wow, okay. No, that's great. That was, I think, chained about for a number of years since you've been public and you mentioned some good momentum now that you're seeing, but sounds like you think this is really a multi year, maybe even a kind of a multi decade type of way out.
Absolutely. Look, I would fall in the category of multi decades again. Look, it's about an $8 billion market and from where I sit, why couldn't we have 25% penetration, 30% penetration of that market? You know, can we get more? Yeah, we could, you know, but you know, 30%, $8 billion market. That said, that's a big opportunity, it will take time. In 2019, I said, look, we're kind of targeting $200 million of incremental revenue that we should be able to generate kind of by the 2023 time frame. We are well on the way to be able to generate that level of revenue or more by that period of time. If you say, hey look, these guys are probably going to get to, you know, $200 million-$250 million of revenue by 2023, the guy said it's $8 billion market size.
That's why I feel that, you know, we are just putting our unis on and we are seeing adoption to, you know, pick up. It's becoming much simpler to drive those conversions because people are starting to get it and they see the value and, you know, we drive for many years to come.
That makes sense. Now, you mentioned that you're seeing the conversions both on the first fit, new equipment as well as, I guess, some, you know, aftermarket, some retrofit, if you will. Maybe if you could talk a little bit about, I mean, obviously the aftermarket, the installed base is a much larger portion of the market in a given year than the new equipment market. Maybe you could give us a little bit your perspective on, I mean, kind of what is the difference in the adoption rate, different end markets, applications, what's the best way to think about the life cycle for your, you know, your, your product offering in, you know, the belts that. As we think about how the adoption curve might move.
Yeah. The adoption curves varies. Right. Let me give you a couple of different examples and, you know, I'll try to cover, you know, I think the spectrum of the questions that you have, you have posed to me, Damian, with this. Look, let me give a really easy example. Is the example an OEM adaption pursuing, right? You go in, you're not going to convert e-bike or an e-scooter or a motorcycle from a chain to belt unless you convert it at the design with the OEM. There you go. You target the OEM, you go in and you replace the drive mechanism. Whatever they commit to do, they all do. If they commit to your belt, they're going to drive a belt production. You can take a look at Harley-Davidson.
If you have Harley-Davidson, you will only get it with a Gates drive as an example.
Right.
There will be a really good example on OEM design adoption, belt not break. The belt will wear. At some point in time you will actually get to replace that belt. It just depends on your duty cycle. How often do you ride your motorcycle? Do you ride it every day to work? Do you ride it for pleasure? That will predetermine how often you will replace them. There is a huge infrastructure of industrial facilities that have been built out over the last 50, 100 years. In those facilities, just about every apparatus has a drive and that drive, generally speaking, has an industrial chain. What we are targeting is we have built a small organization of folks that are targeting very specific industries and going from certain target industries to go and convert manufacturers.
Most recently, and I believe I have spoken about that on my Q1 earnings call, we have converted a very large manufacturer of food products in one of their facility. One of the reasons that they have done it is, is frankly because they grew frustrated by the amount of lubrication they needed to do to their chain drive. They were looking for an opportunity to improve their uptime of operating that equipment. We went in and we have converted that one facility. They have 85 facilities in the United States. We will convert every one of those 85 facilities. You know, it's a food manufacturer that's manufacturing products that, you know, anybody that's got kids is probably using their, you know, their products and you know, how many of those facilities are out there.
That was one of their, you know, specific food product types. And you know, we see that, you know, that resonates with our customers. Uptime, efficiency, energy, energy conservation, they are all important. By the way, once we install it, depending upon your upcycle, you know, you will still replace those belts, but instead of shutting your facility once a week, you know, twice per week to lubricate, you may replace that belt once a year. That value prop is quite substantial.
Makes total sense, really appreciate all that color. You know, maybe we can move on to, I guess, kind of thinking about electric vehicles and the opportunity there. You know, it's something that you've characterized as being favorable long term to Gates and that, you know, you'll, I think you've estimated kind of about 20% or more content on EV as opposed to an ICE vehicle. I guess help us think a little bit about, since you primarily play in the aftermarket rather than the first fit market for EV, what that means for your business. Given that I think a lot of your product under the hood is sort of on maybe a seven-12 year kind of replacement cycle, if you will.
Should we be thinking that kind of EV is maybe in a decade is where it really becomes a robust opportunity for you, but maybe just help us walk through the thinking on that.
Yeah, clearly Damian, I think that you are thinking about it the right way. Look, we are in very early stages of the adoption of EVs as we all know. It's very exciting, but I think we all agree we are very early here yet. We are developing new products and we are expanding our product coverage to continue our leadership position in the automotive replacement market around the world in particular. As you said, Damian, the replacement channel business, you know, where, you know, our primary focus resides, generally targets vehicles that are seven to 12 years out. We still have quite a bit of time before those markets fully develop. That being said, we are seeing significantly larger content opportunity on electric vehicles with an emphasis on thermal management system.
As we all probably understand, thermal management is critical because you do not want to have a thermal runaway event with batteries or inverters and motors. It would just be a bad, very bad thing. We are very selectively participating today on the OEM side of the business in line with our long term strategy. We will participate, but only in line with how we are thinking about the need for our participation there. While we are very excited about the future opportunity for Gates here, we believe it will take some time to materialize as the adoption curves evolve. Maybe 10-15 years down the road, we ought to be realizing some really nice growth from electric vehicles.
Interesting. You are strategically being very selective in where you play in the OE market for EVs.
Absolutely.
Where you're playing in thermal management, how do you feel like you're performing? Are you sort of gaining, you know, what's your kind of market share that you're capturing in this very small market right now?
Look, we are very much focused on highway industrial applications. We've talked about a couple of, you know, reasonably good sized design wins there. We anticipate those will start ramping up pretty quickly in production. We have good presence on the leading EV manufacturer today. You know, we have nice products and nice presence there. We just try to make sure that we don't over commit ourselves, Damian. Again, we want to protect our long term aftermarket revenue stream which we believe is critical. Frankly, that's where we are most comfortable to operate within.
Okay, no, makes sense. I want to kind of switch over to the margins in the business. You alluded to earlier sort of this medium term target of 24% EBITDA margins. I guess just kind of looking where you're at today, right. If you compared it to, you know, 2018 prior peak in the business, looks like this year kind of you're projected to sort of be at the same level of sales and it looks like kind of a similar level of margin. Just wondering, kind of, you know, why is that? You know that you're sort of kind of flat margin over the three years. Anything that stands out and help us to think about, right. How are you going to get to those 24% sort of medium term target?
Is it all about volume or is there other stuff in the mix there that you kind of have in the hopper as well?
Yes. Look, you know, although I think we all would like to put COVID-19 completely behind us, you know, we are still, let's remind ourselves, we are still managing through impediments that are driven by it, whether or not it is labor shortages, it's material disruption. Frankly, let's also remind ourselves of geographic spots that are still here front and center, certainly in 2021. You know, we anticipated that, that is something that we're going to continue to deal with. If you recall back to our Q1 earnings call, we have varied guidance for 2021 and we feel very positively about how the year is developing. Now, you know, kind of coming back to how and where we will get to that 24%+ EBITDA margins, we are fully committed to that midterm target.
You know, we believe that, you know, we set the target in 2019 and we believe that we can deliver to that target within the same set period of time, which is frankly remarkable taking into account that we have gone through trade war induced recession followed by a pandemic. We feel quite well where we sit in. You know, how do we get there? Look, the healthier end markets are going to help, is a big volume. Our Gates production system improvements are driving incremental margin performance and our recent investment in capacity and new products as well as restructuring is how you should think about getting to that 2024% plus in EBITDA margins. You know, we feel good about 21. We do feel that there are still impediments we need to manage through.
Frankly we feel quite good about being able to get to that 24% target that we have committed to our shareholders in 2019.
Right, yeah. I wanted to ask you what your expectation is for level of investment from here. I mean, is it you kind of have to sustain your current level investment or even increase it or do you have an opportunity to kind of, you know, put the brakes on that a little bit given you have been investing quite robustly the last several years and now a lot of that product is coming commercial to market and the, you know, restructuring and other operational initiatives you've taken?
Yeah, I would say that look, you know, the transformation that we were talking about is more or less behind us and we are not, you know, entering the phase of kind of continuous improvements and driving growth. That being said, you know, from a CapEx requirement, you know, our business is, you know, has started to stabilize kind of at a 3% of sales. We believe that, you know, that that's kind of a good CapEx investment. We believe that most of our large restructuring is behind us. We have the capacity in place that we believe is going to be supportive of driving organic growth and driving above market growth rate. Frankly, that is how we are thinking about the time frame that we have entered into the next two to three years. 3% of sales of CapEx.
This is still, you know, good amount of capital that you can deploy. And when you take into account about that, about 1% of CapEx is required for maintenance. You know, we still have 2% that we are guiding that we will be spending on organic initiatives. You know, frankly, those are really good high ROI ROIC projects and we believe that those are also projects that are the lowest risk projects. And so we feel that we are in a good place. Again, as you said, most of the significant investment behind us. We are well positioned to deliver the results that we have outlined that we can visualize.
Got it, got it. How about the supply chain issues? Maybe you can just kind of give us an update there. I think, you know, it sounded like first quarter, you've been managing them fairly well without, you know, a lot of hiccups. Just wondering if things have gotten, you know, any better, any worse. Has your visibility changed at all around that and also maybe just, you know, where you feel like you are being able to manage some of these inflationary pressures, which is an increasing investor concern right now.
Yeah, I mean, clearly can understand that sentiment. Look, as I said in my Q1 call, I'm very proud of our supply chain team and how that team and operating teams have responded to these global challenges we were seeing with the supply chain shortages, frankly, on a number of fronts. It wasn't one issue only, you know, it was multiple issues. Whether or not it was chemistry, steel, you know, precision steel, aluminum and so on, so forth, our team managed quite well and frankly, we continue to manage through these various supply chain disruptions, you know, in a reasonably, you know, good shape. We feel that the chemistry and the steel inputs are improving, but we certainly don't believe that they're going to go away until maybe the latter part of second half. We believe that these things are going to remain.
I think that what most folks do not quite understand is the impact that a Texas winter storm in February had on disruption in chemicals manufacturing. I think that we all kind of living through that. You know, when you combine that with the labor shortages and all the issues that, you know, the spectrum of manufacturers are dealing with, you know, I think that it is probably likely that is not going to work itself out certainly until the end of this year. You know, it has been very challenging, of course, for our team, I am sure for our competitors and our customers. We are managing through these impediments as well as is expected. You know, we anticipate that we should put that behind us as we exit 2021. Now, in respect to inflation, look, I think we are all dealing with elevated levels of inflation.
We, you know, we do have over 60% of our revenue that comes through distribution channel. We have an ability to, you know, reasonably rapidly put price increases in place. We have taken pretty proactive stance. At the beginning of the year, we raised prices, we are now seeing those prices flow through. We have been raising prices to OEMs. We have a number of contracts that have escalation clauses, so we have enacted those. Frankly, you know, we are going to customers that do not have the escalation clauses as well. Those are never easy conversations, but those are conversations that are very important to be had. You know, we believe that as we execute Q2 will be, you know, in a reasonably good shape to deal with, frankly, the escalation in inflation that we all see.
On the Q1 earnings call, I said that we believe that we will offset inflation, not just material inflation, but also logistics inflation, dollar for dollar. We believe that that remains to be the case.
That's all very helpful. We have a few minutes left here. I do want to ask you about capital allocation. You're going to be in a position here kind of for the first time since you've been public where, you know, you're delevering naturally pretty quickly. I think, you know, you're going to kind of get down to certainly under three times, about, maybe about two and a half times leverage by the end of the year. Could you give us a sense, what's capital allocation? What's a Gates acquisition going to look like? Have you been nurturing a pipeline the last few years? Are you just kind of starting to build that out today? Educate us on capital allocation.
Awesome. Look, first and foremost, our primary priority remains to deliver the balance sheet. Honestly, as you can imagine, a company like Gates that came in slightly higher, more elevated leverage into the public markets. That was an important parameter. We are going to get below three times. We're going to get there pretty quickly. As you said, we should be in a reasonably good shape exiting 2021. That being said, it does clearly open new avenues. With additional optionality going forward. We have significant organic growth opportunities that we continue to fund. First and foremost, we are not short on organic growth opportunities. Clearly M& A becomes another option for us to drive this growth. We're going to be very disciplined in our approach. We have a small team of people that we've put in place some time ago.
You know, it is not a new team. That team has been cultivating a pipeline of opportunities. Let's remind ourselves that we participate in very large, very fragmented markets. We have a good pipeline of opportunities out there. I think that what is extremely important for us is we are going to remain disciplined. We do not need to jump in and overreact to M& A because our balance sheet is improving. We have more than adequate amount of organic opportunities. When we find the right opportunity to go and acquire and acquire it at a fair valuation, we will do that to ensure that we drive the returns that we anticipate from those type of activities.
That's really helpful. I think we have time for one last question here. When I think about how a lot of multi industrial investors think and what's important to them, free cash flow. Free cash flow conversion is something that gets asked about quite a bit. Now your free cash flow conversion has had a tendency to whip around a bit so far in the early years. I'm wondering, is that just kind of a byproduct of the nature of your business or do you feel like there's things you can do to maybe drive more consistent free cash flow over time?
Yeah. Look, let me start with the fact that, you know, we have built a strategy that we believe was built around investment and repositioning the business. That strategy was enacted way before we went public. That necessitated, you know, significantly enlarging our operational footprint and giving ourselves an opportunity to become more efficient and ultimately drive that efficiency through to earnings. I believe that we are demonstrating that. You're right. We were consuming a little more cash than we were generating, you know, in the first couple of years post public exit or entrance, you know, 2021. Our guidance for cash conversion is at least 80%. You know, that takes into account a very robust growth that we are seeing across our business. We are supporting that growth with working capital.
I think that it's necessary and, you know, we are generating receivable and receivable will ultimately turn into cash flow. That being said, we do see an opportunity to continue to improve our capital efficiency over working capital efficiency over the midterm. We are focused on that. We think we can do better. Typically, our business is delivered at or above 100% free cash flow conversion. Frankly, that is the appropriate way to think about our business.
Okay, great. I think we have to leave it there. Unfortunately, we're short on time. Ivo, I want to thank you again for taking the time to talk with us today. Thanks to all those who tuned into the meeting. Have a great day, everybody.
Thank you.