Good morning, and thanks for joining us again at the Wolfe Transportation Industrial conference. We're continuing with Gates, and I'm very, very pleased to welcome CEO Ivo Jurek. We'll get into the Q&A session in a moment, but before I do that, I'll introduce myself. My name is Nigel Coe. I'm the firm's multi-industry analyst, and today is May the 27th. We have a lot of topics to cover, Ivo, but I thought maybe it'd be a good opportunity to maybe just talk us through what you're seeing since you reported a very strong 1Q, how you're looking to 2Q and beyond.
Thank you, Nigel. Good morning. Look, clearly we see a very strong momentum continue to build in our end market after the most recent downturn that we've just exited. Let's remind ourselves of the fact that we've just exited that downturn. Part of what has been changing since the beginning of the year for us is that we reported very strong first three months of results. Frankly, we have continued to see increasing order rates exiting Q1 with our book to bill well above one. There is a very strong underlying momentum that has built. For us, look, we have repositioned our company over the past several years, and we are now seeing also the benefits over and above that market momentum from the investments that we have made in our growth initiatives, in innovation, new product introduction.
Frankly, that's been what has given us somewhat of a higher degree of confidence, taking into account that this is a short cycle, short visibility business, as you know. It has given us a little more confidence, taking into account that momentum that we continue to see. When you combine that with the fact that we do not see any restocking, or certainly we have not seen any unusual customer behavior today, with inventories continuing to remain reasonably low in some end markets like the industrial channel side, we see inventory position almost being at all-time low where we sit today. That all bodes well for what we believe is the midterm future. Look, that being said, we also see a very strong underlying end market demand. We do not believe that this is some artificial behavior.
When I talk to our customers, and I talk to many of our major accounts quite frequently, they see a very strong fundamental demand in their end markets. That is really good. We also are seeing some real challenges that everybody is dealing with. Whether or not those are challenges associated with material availability, that is quite a headwind for everybody. That brings a little bit of a dampening effect on the momentum that everybody sees, but that underlying demand is not going to go away. It just perhaps is going to be pushed a little bit into the future. Look, coming back to our company and where we sit, I believe that we have managed quite well through these shortages.
We have leaned forward kind of at the end of Q3 of last year where everybody was still to a degree staring at an abyss, but we felt that we are seeing positive turns and that we needed to preposition ourselves. When I talked to our OEM customers, they already started seeing semiconductor shortages in Q3 and Q4 of last year. It became a big issue in Q1, but it did not quite sneak up on us as much as maybe on some of the end markets that you have seen throughout the Q1 reporting season. Maybe the last thing that I would say on this point is that, look, I think that you from the industrial side and from the analyst side, you understand this well, Nigel. The industrial companies have not had great 15 years looking backwards, right?
I think that we are perhaps in an early innings of a real sustained industrial upcycle. I am really excited about it. I think that Gates is well positioned. We have done a lot with this company over the last six years, and I believe that we are going to benefit from the underlying fundamental strength that we see in the end markets today.
I appreciate the thoughtful and detailed response there. I want to get into some of the secular and structural growth drivers that you've got, but I do want to stick with the cycle because I think you raised a very good point. You haven't had a lot of help since you became a public company in 2018. 2018, we had sort of high yield market meltdown. We had 2019, very tough for short cycle markets, automotive end markets, etc. In 2020, we had COVID. You have had three rough years. Generally speaking, you're right, since the GFC, we've had very weak industrial end markets. You sound pretty confident we're in for a sustained recovery here. Again, just going back to your comments, what gives you that confidence? What gives you the confidence that this is a three, four, five-year recovery?
Look, a lot is happening in fundamentally, a lot is happening in our end markets. You can go in and you can talk to somebody like John Deere, right? They have almost an 18-month visibility for demand of their products. I mean, it's always hard to say, is it a fundamental visibility that is different from the past? In my six years, I really don't hear customers to be that forward-looking with that much sustained visibility. Nigel, there's also some really interesting secular trends that are happening. Look, we all talk about the Amazon impact, right? There is a peripheral benefit from the Amazon impact for our business. Not just that it opens a different channel, it also drives consumption of heavy-duty trucks, medium-duty trucks that the goods need to be delivered from manufacturers to the Amazon warehouse.
Whether or not you use an airplane or FedEx, UPS, USPS, not to leave anybody out there, they all use industrial devices to move goods. That is really good for our business. As these warehouses get built out, again, whether or not it is a large distribution center that is built by Walmart or Amazon, they need industrial automation. Industrial automation is a big driver of our industrial products like power transmission belts as well as hydraulic hoses. I can just go on and on and on. What is happening with electrification of personal mobility? That is a secular trend leaning into recovering consumer confidence. Those are all fundamentals that, frankly, as you pointed out very astutely, frankly, in my six years as CEO of Gates, I really have not seen that.
I have seen the vast majority of my time at the company dealing with some natural or unnatural headwind that came our way. I remain very bullish. I remain very optimistic about what's happening in these markets. Look, there are going to be different starts, of course. That always happens. I think fundamentally, I'm much more optimistic than maybe I have been in five or six years. I'm really excited that the demand for our product is going to be there for an extended period of time. The innovation that we have done and the refocus on benefiting from secular tailwinds, ESG, reduction of power consumption, elimination of hazards in factories. Look, we are front and center of that process. Whether it's robotics or it is a heavy-duty truck, you will find Gates' products with a large content in all of those applications.
Very exciting time for us.
Absolutely. When CEOs are confident, they tend to invest, they tend to hire, spend on innovation. You're not in a point at this point where you can go out and do lots of acquisitions. That tends to be another kind of function as well. What are you doing in terms of hiring and organically investing? Are you stepping up investment spending here?
Look, we have hired a very substantial amount of folks since we bottomed out in Q2 of 2021. Look, we had to. I mean, you certainly saw the reported numbers. We've generated a record level of revenue for the corporation in its 110-year history. We couldn't do anything other than hire people. Also, let me remind you, we have been kind of maybe out of cycle with our investment. We've put our investment in that, frankly, did not make me look very smart in 2019, right? These investments are long-term investments. They take time to be put in the ground. We've put three new factories between 2018 and end of 2019. We are benefiting from the investment today. We have great cash flows. They give us opportunities. Cash flow gives us an opportunity to invest in organic initiatives. We have a huge runway in organic initiatives.
We have put the major investments behind us, but we still invest about 3% of our revenue in CapEx. About 1% goes into maintenance and 2% goes into things like high returns generating organic initiatives. We are investing in those to support ourselves. As you said, look, we got balance sheet flexibility. We are going to be reaching two to three times net leverage in 2021, taking into account midpoint of our guide for 2021. We feel really good where we sit. This company is a high-quality asset with high recurring cash flows generation. We got opportunities to do what we need to do, whether or not it is organic or inorganic.
Okay. We spent a lot of time talking about the cycle. We view as when cycles are expanding, you typically will have formats. Obviously, when cycles are downturning, you'll tend to have a format. We are in a good position right now. Can we talk about maybe some of your organic initiatives? One would be chain to belt kind of transition. The second one would be sort of EV content mix-up. Maybe just talk about industrial chain to belt. I think you talked about the growth last quarter, if I'm not mistaken, about 50% growth in industrial chain to belt. How do you see this transitioning over the next two or three years?
Sure. I mean, terrific question. Thank you for asking it, actually, because we are very excited about this opportunity. Look, over the past several years, I have been consistently talking about a really nice set of chain to belt design wins in attractive, large end markets and applications. Let's remind ourselves that what we are doing in chain to belt and the opportunity for Gates is, frankly, adjacency to our core. This isn't something that we have done in the past. As you said, this is maybe an $8 billion market opportunity for us where we believe we are the only differentiated Gates belt provider that has the opportunity to replace roller chain. Frankly, look, there hasn't been a quarter over the last eight quarters or so that we haven't talked about some exciting design wins.
We are seeing accelerated momentum from this very great foundation that we have built over the last several years, supported by a new and renewed focus on ESG that is, frankly, front and center now for industrial manufacturers, not like us, but all of our partners that we do business with. Our teams are very focused. They're really energized by the breadth and the momentum of the design wins that we are delivering. They're in very attractive end markets for us, markets that we have not always had a great presence in food and beverage, right? I mean, we all need to buy food and we consume Coca-Cola, beer, whatever, it's your drink of choice. Pharmaceuticals, logistics, and warehousing that I have spoken about, and industrial automation to name some of these examples where we are able to penetrate.
We are able to do that both in new applications and convert existing applications. Think about it as brownfield, greenfield type design wins. Look, the margins are very strong in those applications. They are above fleet average that we generate. This is something that we believe we can continue to drive well into the future. We are in an early inning. This is what gives us the opportunity to drive our growth well above that Global Industrial PMI that we kind of like to benchmark ourselves to. We feel that we are very well positioned. Now, every quarter is not going to be a 50% core growth quarter, but we think that this is an opportunity that's going to give us some legs well into the future.
Are you confident that customers are receptive to this transition?
Absolutely. Look, we offer incredible benefit. We give them energy consumption reduction. We give them substantial improvement in uptime. We eliminate hazards from these factories. I'll tell you an example. I've spoken with our team that has brought in an incredible blue chip customer design win in food processing, something that all of us are purchasing from that food manufacturer today. They consume one gallon of grease a day to be able to grease their chain that is powering that manufacturing equipment. We've eliminated all of that. Yeah, it is a grease that is used. It's a food-grade grease. It is very expensive, by the way. We eliminated any need for that. There are some real tangible benefits. As people, all of us are focused on sustainability. We want to drive energy consumption reduction. We want to make a safer environment.
Look, grease is dangerous. Number one source of accidents in industrial facilities is slips and falls, right? You put grease on, it has a tendency to spill on the floor. You are an employee, an associate, you walk around, you fall, and you hit your head. Not a good thing. Our products, people now believe it, see it, and they are very excited about the benefit that they get.
Okay. Great. The other one I want to touch on, Ivo, was the EV opportunity. I know Gates has really migrated the portfolio away from its legacy automotive backgrounds to first fits down to about 10%, 10%-11% of sales right now. EV content opportunity is much higher given the cooling requirements and heat management requirements for an EV power unit. What are you seeing today in terms of build wins in EV? Is that content uplift story playing out? Are you seeing that in your catalogs?
Yeah, sure. Let me kind of start from a little different angle if I can, Nigel, because I think what is not really well understood is when folks take a look at our organic growth performance over the last three years as a public company, they look at it and say, "Hey, look, you kind of a little bit underperformed that growth curve." What is very little understood is we actually feel really good about how we have performed vis-à-vis growth when you take into account that since the IPO, we have reduced our automotive and in a focused manner, we have reduced our automotive OEM participation from about 18% of our total revenue at the IPO to about 10% of revenue today. That has not necessarily dampened our growth dramatically. It is a significant reduction of exposure to an end market.
We have done that in a very focused and strategic manner. I want to remind ourselves of that when people take a look at comps, right? That being said, look, we have very early innings of that shift to that electric propulsion. We are developing very differentiated products from electric water pumps and various number of ranges from 50 W to 1.4 kW to give ourselves an opportunity to have a coverage not just on passenger vehicles, but as well take the opportunity as heavy-duty truck manufacturers are coming and moving in that direction in small steps. I have spoken about an opportunity, Nigel, I think on my Q4 earnings call with a heavy-duty truck OEMs, leading truck manufacturer, global truck manufacturer that, frankly, is starting a production in a very near-term future. The content on that truck for us is over $600.
I can tell you, I have no $600 content today on a heavy-duty truck with the present products that we manufacture in diesel application. Nowhere near that. We see that opportunity being tangible. We are there. We are winning those opportunities. I will tell you, this is something that's going to take time. This is something that is early innings of a shift in propulsion. We are focused on not only building the new technology that we can support our OEM customers with, we are also very much focused on building out that vehicles in operation content for cars that are on the street today. As you know, we are predominantly automotive replacement-focused company in the auto space. We are really not that focused on the OEM piece. In that space, our sweet spot is something that is 7 years -11 years in age.
We believe that even with electrics, that will be the sweet spot for our cars. Maybe not 7 years-11 years, maybe 5 years-10 years as we see these vehicles shift. We have a leading coverage of vehicles in operation, and we are in a very good position. We believe that as the time is going to move forward towards those shifts, we are going to be there. We see that as a tangible opportunity for our company, and we are very confident that it will be a net benefit for our franchise.
Great. Thanks, Ivo. You mentioned earlier on that maybe investing $160 million in CapEx back in 2018 perhaps was not the smartest move in hindsight. With that said, you now have a lot of capacity to absorb. Where I want to go with this is really, as we come back up on the volume curve, are you confident that as you absorb the excess capacity, incremental margins can be very attractive here, even with inflationary pressures and even with some investment spending? Do you think 40% incremental margins can be sustained here?
Absolutely. Look, when I speak about our incremental margins, we kind of have a number of levers, right? One lever is just improving absorption in these facilities, but it also gives us the opportunity to drive incremental growth and support those customers, which is a very big benefit. As the capacity gets absorbed, you get benefit. We have a second lever that is innovation. Innovation of new products gives us pretty significant improvement in our cost of goods manufactured. We do not put a different label and call it a new product. I mean, we are revolutionizing the industry where we participate. Generally speaking, that gives us the opportunity to make these products more cost-effective. The third attribute is price. Our franchise is we are top three market shareholder globally in the two product line segments that we participate across about 80% of everything that we do.
It gives us a reasonable amount of confidence that we can offset inflation. If you pull it all together, our guidance was for 40% + in incremental margins in the second half of the year. That takes into account the very significantly elevated volumes that we've guided and the dilution that we see, obviously, from offsetting inflation with price, but not necessarily getting a margin accretion. We offset the inflation dollar for dollar, but we get a bit of a dilution into the incrementals on that incremental revenue. Taking all of those factors into account, we still feel comfortable with 40% + in the second half. We will not get 40% + incrementals day in, day out.
We believe that the sustained level of restructuring that we have driven and the opportunities that we have with the innovation that we are putting in the marketplace, our sustained incremental margin should reside in that 35%-40%. We feel quite good about that neighborhood. Look, we are a high-growth margin business, as you know. We ought to be levering up in that 35%-40% to, frankly, reward our customers and to deliver the gains that we believe we can deliver over time.
Right. Price and power, maybe to comment on that, to touch on some of the price and actions you've taken, customer receptivity, I'm sure the channel is happy to pass along price. What about the OEM channels?
Yeah. We have a number of OEMs with contracts where we have escalator clauses in so that the conversation becomes obviously a lot easier because you can see it in inflation of steel, aluminum, carbon black, name it. It's out there. That's not an incredibly difficult conversation. It's never an easy conversation. I'm not going to tell you that it's easy, but it is much easier. Frankly, there's also a supply and demand set of issues. Customers have been much more reasonable than in the past cycles. Although you never want to reach out and have these significant discussions with them, I think that folks actually understand that the inflation is real. By the way, they see it in everything that they do. They see it in inflation of labor. They see it in purchasing steel for their own products.
I do not think that you are coming in there, you are an outlier, and they are saying, "Well, gee, nobody has talked to me about inflation. What is going on with you?" Again, not an easy conversation, but it is not one that they do not anticipate. You look at results, many of our end users, end customers, they themselves are raising prices, right? I mean, inflation is here, and we will manage through it. We are well equipped. We have a strong pricing team. Frankly, we feel that we need to get compensated for the mission-critical products that we offer to the marketplace and our customers.
Fantastic. We've got two or three minutes remaining. If anyone's got any questions in the audience, please feel free to pass those along. I've got two more to debate with you, Ivo. One would be free cash conversion. Three of the four years, if we take out, if we X out that CapEx investment cycle, you've converted at or above 100% free cash conversion. With a sort of tepid demand environment, working capital as a portion of sales is definitely towards the high end of our coverage. What is the opportunity to really optimize trade working capital and in particular inventories as volumes pick back up again?
Yeah. Look, in general, the profile of the business is such that the free cash flow conversion profile for our business has been at 100%, as you noted. Nothing really has changed from our commitment to continue to convert at that rate. When you take a look at 2021 in our guide for free cash conversion of about 80%+, look, we have a very substantial growth that we are seeing across our business, which, frankly, we have to support with working capital. That is actually not a bad thing because the working capital is actually a certainty that you have that will turn into cash. It is just somewhat delayed as you are building up to support that volume. We expect working capital is going to improve throughout the year, particularly as the receivables are being collected.
Look, I mean, we believe that the opportunity to continue to drive an improvement. I mean, our Gates operating system is focused on driving improvement to inventory turns. We are developing new products that give us an opportunity to simplify our supply chains, that give us an opportunity to buy more raw materials from larger accounts and manage our payables more effectively. We believe that we still have work to do. Our working capital, certainly on the incremental revenues, should be meaningfully below 25% as a percent of sales. We think that there's an opportunity, but we also believe that in a sustainable way, 100% cash conversion of that income is certainly what we anticipate to deliver year in, year out, with the exception of maybe a dislocated year like this where we have such a huge growth.
That's understandable. It does sound like there's a pathway to more work capital efficiency as we get deeper into this recovery.
Absolutely.
My final question, Ivo, is really on the balance sheets. Based on EBITDA recovery and free cash production, debt reduction, your leverage ratios are going to come down pretty dramatically based on our model over the next 12 months-18 months. Do you see scope to transition towards capital allocation as opposed to delevering over the next 12 months-18 months? Right now, if you had the choice, given where your multiple is right now, would you be buying back stock as opposed to acquisitions?
I think it's a great question, Nigel. My view is that tremendous opportunity to look at where we get the best benefit to generate returns for our shareholders. That's what we will do. Look, my job, first and foremost, was to deliver the balance sheet. I think there was a significant skepticism about how fast we can get there. We will get below three times, at three times at the end of Q2 of this year, we will dramatically deliver over the next 12 months-18 months, as you have pointed out. That gives us that opportunity. Whether or not it is a buyback, it is more accelerated M&A. Look, we are going to be very focused on not overpaying for assets. We don't need the M&A to accelerate our growth.
We have a tremendous amount of organic opportunities, and we will use that cash to do the right thing for our shareholders.
Okay. Ivo, very clear. That was a great discussion. Thanks for that. We're out of time. We're going to be kicking off again in five minutes with JCI . I hope you can join us for that. Again, Ivo, thanks for being here. Thanks for supporting us. We'll catch up soon. Thank you very much.
Thank you very much.