Yeah, he covers all the auto aftermarket guys, so a little overlap. Oh, there we go. All right. We are off and running here. Welcome to the Gates show, and very pleased to welcome two folks from Gates with us this afternoon. We have Ivo Jurek, who is the CEO. Rich looks after investor relations. We are going to run this as a bit of a fireside chat, I think. You do not have any slides to start with here. I will sort of kick things off. We will have a bit of a conversation, would love to have participation from anyone who is interested as well. We will make an opportunity for that. I think we are being webcast here today.
I was admonished this morning because I went through one of these sessions, and I did not ask the company if there were any updates that they wanted to talk about since it was a webcast presentation. With that having been learned, I will kick off that way. Is there anything you would like to update us around since this is a webcast conversation?
Thank you, Steve. I do not think that we have any meaningful update to what we have discussed on our second quarter earnings call. Our business continues to evolve meaningfully in line with our updated guidance. As a reminder for all, we have taken our guidance up by 100 basis points across board in revenue generation. So 5.5% core growth guidance for midpoint of Q3 and 6.5% core growth target for organic growth in Q4.
Right. Good. Okay, so that contrasts, if I am not mistaken, to about 1% growth in the first half. So obviously a nice inflection that you guys are seeing. How broad-based is that? What is driving it, and what gives you confidence in this fairly large increase in the second half?
Yeah. We have seen a very nice acceleration that frankly occurred in Q4 of last year. We went into Q1 with a well broadcasted ERP implementation that has occurred on our European business in February that has resulted in about 300 basis points core headwind in Q2 due to the ERP implementation.
Q1, sorry.
Sorry, Q1, which by the way, went flawlessly. It was executed well and as we exited Q1, we have begun to fully recover on the revenue targets that we have set up. While we had a small cost headwind in Q2 associated with the ERP, we have already delivered very nice core growth acceleration in Q2, and that acceleration order intake that resulted about 8%-9% organic core growth in terms of orders in Q2. The two or three secular drivers that we have in our business, personal mobility, which, as we have highlighted, has been growing in the mid-20s to about 30% compound annually. That continues to drive about a point of incremental growth for our business, accelerating revenue generation in our exposure in data centers with our data center enterprise initiative, and frankly, reasonably broad-based strength across our core business.
While there are still some businesses that yet need to inflect, we have highlighted that while ag has stopped generating negative deceleration, and we anticipate in the second half of this year, ag is going to start recovering. We certainly are seeing those trends, and I think the most recent announcement by major ag manufacturer would indicate that we have seen the bottom, and we should start seeing a recovery into 2027. While there are some puts and takes, in general, there is a broad strength. We have built a little bit of backlog in Q2, which generally speaking, as a short cycle book and ship business, we do not necessarily like to see, but that is just an indication of a reasonably strong end market demand environment.
Great. I think that ag producer is in the building actually, and has reiterated your outlook again. Talk a little bit in case people aren't intimately familiar with it in terms of the personal mobility opportunity.
Yeah. The personal mobility business, it's actually quite an interesting opportunity for us. In a nutshell, it is an opportunity where we are substituting a chain drive with a Gates engineered belt drive. It is much cleaner, much more efficient, much more elegant solution. From our vantage point, it is an opportunity where we are converting or competing against a non-traditional competitor. It is a story of penetration, and while we don't necessarily require the end market units to grow, for reference, there's about 180 million two-wheelers that get manufactured every year. It is a very broad-based, very large market opportunity. We have been very focused on paying attention to engineering a solution that is cost appropriate, that will get us to a much closer cost proximity of the chain drive in those two-wheeler applications.
With all the other benefits that I have highlighted that we deliver to the end user, we believe that we have a decades-long opportunity to take market share away from chain and continue to deliver a premium growth over the midterm in that business for us.
Are there other areas in end markets where there could be this similar substitution?
Yeah, absolutely. I think that what we have done in personal mobility is actually taking a very difficult set of applications that are very sensitive to certain market dynamics in terms of price versus benefit. And we have demonstrated that we can deliver a solution that is efficient and that we can start delivering broad market adaption of those solutions. If you think about another market opportunity for us, it's an industrial chain drive. There is about a $7 billion market opportunity that we view where the industrial chain resides today. And we have been working towards development of solutions that would be broadly adaptable for these industrial-type applications.
And we have announced recently that we'll have a CMD or Capital Markets Day on November 19, and we will be providing a pretty fulsome update on how we view that market, how we view that opportunity to continue to evolve for us. And while over the last three or so years, we have developed a very nice base of business, we believe that that's another opportunity similar to what we are seeing with the personal mobility that we can realize, again, nicely incremental, secular, supplemental organic growth over the midterm.
Okay, great. You mentioned the data center piece, so let's dig in there for a second. What do you do that's applicable to data centers, and how does that outlook for you?
Yeah. So interestingly enough for us, the data center opportunity resides in our core products of our core portfolio in Fluid Power. We manufacture fluid conveyance products, houses, couplings, and fittings. And we've manufactured electric water pumps for applications in electric propulsion that happen to be extremely unique in construction and very energy efficient and very space efficient, with very sizable throughput of liquids through those pumps. And so we manufacture for data centers, basically the end-to-end fluid cooling loop, pump house fittings that get adapted towards a manifold or a server rack or an on-chip liquid cooling directly in those server applications. So, core parts of our portfolio are specifically tailored for the data center application. Obviously, various set of specifications and certifications that are required to be complied with that we have now been able to secure.
We are working across the broad portfolio, broad spectrum of customers, from the server manufacturers and their ODM partners to hyperscalers, to infrastructure manufacturers, to the construction companies that build the buildings and facilitate the great spaces before you start actually getting into that white space for the IT equipment.
You've talked about, I think, the opportunity for between $100 million and $200 million of revenue from this end market by 2028. Are you happy that we're on track there? Could that even be conservative?
Yeah. So look, when we start talking about the $100 million - $200 million of market opportunity for us, the industry forecasts were that less than half of the data centers that will be coming out of the ground in the future will be liquid cooled. I would say that we all certainly view that being an extremely conservative estimate because frankly, everything that we see today that is going into that core AI-based infrastructure is liquid cooled. That also has expanded our TAM from about $1.5 billion to more than $2 billion just in the last 18 months. We believe that size of the market will continue to evolve and get larger. We've done a very good job, in our minds, in building pipelines of opportunities, building new customers. Those were all new applications for our company.
We've had to build our own front-end infrastructure to be able to actually understand how to address these type of customers, these type of opportunities. So we have done that. We have tailored specific solutions for those customers. We have discussed on our quarterly earnings calls that our business has been growing by hundreds of percent year-on-year from a small base. We've anticipated this year we'll deliver between $20 million and $30 million of revenue into that space. That will again grow pretty dramatically in 2027. I certainly feel that our pipeline, our business awards, and our opportunities that are in front of us should give us the opportunity to more than exceed that target that we have set for ourselves. Certainly towards the end of the decade, we see that those numbers should be more than conservative.
Okay. I guess if you had Analyst Day coming up, there might be an opportunity to update that.
Yeah, we will do that.
How about maybe let's switch topics a little bit. How much of your business, just remind us, goes through distribution these days, and what are you seeing in terms of distributor activity, stocking, et cetera?
Yeah. We're actually a very unique business because the channel partners or the distribution side of our business represent about 70% of our revenue, or 70%+ . That's a very unique composition of revenue generation. Certainly for the last two to three years, we have seen pretty subdued level of activity in our channel. We continue to see an improvements in the channel activities. We have not seen any rebounds in inventory rebalancing, any signs of restocking of inventories. The channel partners have remained being very disciplined. Ordering patterns are very much in line with their end user demand, so the sell-out is very balanced with the sell-in that they take from their partners like Gates and our competitors and such.
Is that the new normal? We hear that actually from a lot of different companies, that they are really not seeing much distributor stocking, and obviously in previous cycles, we would have expected some of that. Are they just going to run leaner from here on out, or are they just being careful and ultimately they will restock?
Yeah, Steve, if we kind of remind ourselves that we really haven't seen a pure industrial cycle since 2017, I am not quite sure what a new normal means, to be honest with you. Everything is a new normal for us in an industrial set of complexities that we all deal with. I do think that there will be a restocking. I think that the natural instincts are, as you see continuation of demand pull, the channel partners recognize that their value is in availability, and ultimately, if you don't have availability and if you depend on your OEM component supplier like Gates or any other partner that they may have to be in a position to on-demand supply, they will lose opportunities. My view is that as the cycle matures, they will restock their inventory.
Okay. All right. Hopefully we can look forward to that. Let's talk about auto aftermarket specifically a little bit here. You were able to actually add a pretty significant new distributor, I think it was last year. You've now anniversaried that, but you are still growing the business pretty nicely. What are the dynamics that you are seeing there?
Yeah. Look, first of all, I think that automotive aftermarket for our company is the most underappreciated gem in our portfolio. It is a terrific business. If I take a look at the last 26 years, that business has had one down year in 2009, and it was quite insignificant deceleration. It is a super stable business that provides durability to our portfolio. We like that business very much, and that business basically grows kind of low to mid-single digits throughout the cycle, net of any acquisition of market share or any market share gains. We have, over the last two to three years, grown that business very nicely, way in excess of that kind of a normalized rate trajectory. We do continue to see significant opportunities to grow that business. We have a very strong presence in Western world.
We have built number one market share position in products that we manufacture in China. We do believe that we have a similar opportunity in India. We see very nice growth rates in aftermarket in India. We have a very strong franchise in Latin America, and we still believe that there remain to be opportunities that we can execute on in market share gains in Western world. While that business is very durable with kind of the natural market dynamics, I do remind everybody that our business relies predominantly on do it for you professional mechanic service component. We only participate in opportunities on automobiles that are post auto warranty, so we do not really participate in the warranty period of time, so kind of that car park that is 7+ year of age.
This car park that has grown quite dramatically in the Western world is the oldest in history. Between Europe and North America, we are talking about 12 - 14 years of age, which is a very good sweet spot for our products. We only manufacture products that are mission critical, that require to be replaced when they need that replacement. So we have non-discretionary. We do not participate in discretionary. We have non-discretionary repair critical components, and that serves well for the long-term stability of this business.
I think, correct me if I am wrong, but I think the car park, even in China, is now getting older, right?
It is. It has approached a seven year sweet spot for us, and it has been a very good place to reside over the last certainly four, five, six years.
Okay, good. All right, so another kind of key part of the Gates story, in my opinion, is the margin trajectory, which has been very strong. Maybe just bring us up to speed on kind of what you've accomplished and where you think you can go from here.
Look, we've been able to deliver a very strong margin expansion during market downturn. We have demonstrated that over the last three years, we've been able to grow our margins over 300 basis points in a decelerating end market backdrop. That speaks to the resiliency of our franchise, the importance of our products, the criticality of our products, and frankly, the strategy that we have deployed in focusing on operational efficiency through enterprise initiatives. Our enterprise initiatives, to remind everybody, consisted of 80/20, where we have seen a very nice incremental benefit. 80/20, in our case, did not necessarily mean that we were trimming our portfolio. We were just focusing 80/20 on the productivity improvements.
We've been able to gain significant margin expansion through re-engineering our raw material composition deployed in construction of our products that we manufacture, and frankly, through footprint optimization projects that we have been executing through the last two to three years that delivered a significant benefit. So with that, we will be exiting the 2026 second half at kind of the 23.5%+ EBITDA margins, which puts us in a very, I think, unique category as an industrial company. And frankly, we have been able to deliver that without very significant benefit of volume.
Right.
Volumes were very muted in the last three years, and we have been able to drive that expansion very nicely. So we're very proud of where we sit, and we believe that we have more opportunity to be able to do more.
To your point on volume, how should we think about kind of normal incremental margin leverage as volume does start to come through?
Yeah. We tend to speak about our incremental margins kind of in a normalized run rate basis as kind of the 35%+ range. What we have indicated is that we believe that over the next three to four quarters, so kind of Q3 of 2026 through end of Q2 of 2027, we should be trafficking in that 40%-45% incrementals. You get more volume, you will start seeing better financial performance there. Then kind of in the second half of next year, again, get back to that normalized trend line of 35%+.
Is there more footprint consolidation ahead?
Look, I think that you continue to have opportunities as you evolve your franchise. But I do believe that footprint optimization is kind of a part of our ongoing algorithm that's going to be there. But I also believe that 80/20 continues to be part of our ongoing algorithm to continue to drive margin expansion. I also believe that AI-enabled back-end improvements will drive incremental margin expansion opportunities. Think optimization of distribution routes, optimization of real-time demand married to factory loading optimization, your asset utilization optimization driven by more complex algorithms balancing your CapEx utilization. I think those are opportunities that reside in front of us that should be nicely accretive to what we envisage is continuation of driving our margins more towards the upper end of that 24%+ trajectory.
And longer term, how do you view the two segments? Can they be margin equal, or is one of them sort of a better story?
Yeah. I think that if you look at our performance over the last couple of years, our margins on both of the segments were running plus or minus equal. We've had a little bit of a different performance last quarter, but it was predominantly driven by the fact that more of the footprint optimization was residing in Fluid Power, so it was slightly penalized with some of the costs that we were allocating, or that we were incurring, not allocating, incurring in footprint optimization on Fluid Power. But as we exit the year, you will see margins being more or less equal again. There is no real fundamental difference between those two product line segments and the margins that we are able to generate from those segments.
Okay, great. We've talked a little bit about footprint consolidation. What are some of the other tools in the box in terms of how you've been able to drive margin forward? I'm thinking about sourcing and design for manufacturing, whatever other tools. I don't want to put too many words in your mouth.
Yeah. Well, I think that I said a bunch of them in the prior segment, but certainly 80/20 is one of them. It is footprint optimization. It is raw material sourcing optimizations that we have done. We've done a very good job over the last three years where we've re-engineered materials. Frankly, there was an opportunity that was spurred upon us in the crisis when Russia invaded Ukraine, and we start seeing very significant raw material shortages. We felt that we needed to control the outcome of our destiny more effectively, and we realized that we had a lot more capabilities to be able to re-engineer some very complex and expensive polymers out of our raw material supply chain and commoditize them. Then go back and recompound those materials in our own factories.
We are basically, in essence, leveraging our own internal capability much more effectively through decompositioning some of the more complex raw materials that we were purchasing, and that gave us a very nice opportunity to drive further efficiency in our operational cost structure. Again, I spoke about it. I think that we will see some significant productivity through deployment of more sophisticated AI models into the factories, into the back end of your enterprise. I think that that's going to be very powerful as you move forward, as these models mature. They'll be very unique to individual companies. We are building our own, and I think that they'll be very incremental and very meaningful as we move towards the back end of this decade. We have a stated target of delivering about 20%+ of new product vitality index.
It is very well understood that the more new products that you launch, the greater the opportunity to have a better price-cost algorithm, so to speak. Generally speaking, newer products are more profitable than the older products. We are very much focused on relaunching a ton of our key product portfolio. I anticipate that there'll be a slew of new announcements over the next 12 months on innovation that we are launching. We're certainly doing an incredible job in the data center enterprise initiative space with innovation. That will position us not only to be sitting well on our ability to drive revenue growth, but also a profitable revenue growth. Our personal mobility is running very high NPI vitality. This is running the 70%, 80% new product innovation vitality.
That will continue as we're launching products to get into that broader penetration of that mid-market, mid-priced product portfolio offering. I would say that those are the key components of how we anticipate that we will continue the journey of driving margin expansion.
Okay. One question that I get a lot on the sort of price-cost side is there's a perception, I guess a bit of a misperception, that you're highly levered to oil prices, and yet obviously you've managed all that well. Just talk a little bit about that dynamic.
Yeah, look, I think that I would certainly like to know who is not levered to oil prices because oil prices translate into energy cost. I think that we all consume energy. Yes, there is some leverage, and there is correlation to oil prices, but you also have oil as a globalized commodity. Energy is a globalized commodity. You have to have a portfolio and a franchise quality that is capable of passing that inflation into the marketplace. We have been very effective in being able to do that. We have products that are essential. We do not manufacture products that are nice to have. Mission-critical products that go into harsh and hazardous applications, and generally speaking, the cost of our products is insignificant to the cost of the overall operating system.
It has not been super difficult to be able to be in a position where you can price for value that you provide.
Okay, great. Maybe we will take a second and see if anybody here wants to ask a question. I think there is one in the back row.
Yeah.
[Peanut gallery].
If you think about the aftermarket growth since maybe April of 2025, the contribution of units versus price, and what you see same-SKU price inflation looking like into 2027.
Yeah, look, we've actually been able to take quite a bit of market share during that period of time. We have signed up a major channel partner in the U.S., and that has delivered very significant unit growth for us. I would say that that unit growth was probably more significant than the price increases. But price is a component of the algorithm of growth, and we certainly anticipate that into 2027, we will still see a nice unit growth, and kind of balanced, maybe 2/3 units, 1/3 price into 2027.
Anyone else? No. Let's maybe switch and talk a little bit about capital deployment, and you made an acquisition earlier this year or are in the process of integrating another belts business. I think you've talked about opportunities for additional bolt-ons over time. How do you see that progressing?
Yeah, look, we've spent very focused effort on being able to get our balance sheet to be like a true best-in-class industrial company. Our balance sheet is we are about 1.8 x levered, and we certainly anticipate that we'll continue to see the leverage drop through the rest of this year, regardless of that small acquisition that we have made. I think that we've positioned our balance sheet to have optionality to play offense. We will play offense. We believe that we have many opportunities out there to build out of our reasonably robust pipeline to add to our portfolio. We certainly remain very focused on our strategy, our top-line strategy, execute on what we want to be. We certainly have desire to broaden our diversified industrial presence. We certainly understand well enough that there's an opportunity to consolidate the market.
It's still a highly fragmented market, despite the fact that three or four of the largest players, which Gates is one of, have a large share. If you combine three or four of the biggest players, we only have about 35% of the total market share. Again, remind everybody, Gates is number one, number two, and number three in everything that we do globally in terms of market share participation. So we do have an aspiration to be number one in market share in both of our product line segments. So, we feel that the opportunities are there. We're going to be very disciplined. We have an opportunity to deploy capital through share buybacks, as our shares are still rather inexpensive. We'll continue to do that opportunistically, but we will start leaning more towards M&A, as we move into the future here.
With these M&A opportunities, are you buying product, geography, I don't know, distributor relationships? What are the drivers?
I think that you can continue to add. Regardless of what's your position in the marketplace, and despite the fact that we feel that we have a very strong market presence and market brand recognition, we do believe that we can plug some more holes in our portfolio with our products. We would like to scale up some geographies in different product line segments. We can broaden our participation in power transmission and Fluid Power around the edges without necessarily starting a new so-called third leg. We don't necessarily target that as the primary desire to do M&A. So, we feel that we have an opportunity to broaden our geographic coverage as well as broaden our product portfolio. With that, you always gain an opportunity to do business with new customers and new channel partners that maybe you haven't done in the past.
Okay, great. Last chance for the room here. No? I'll ask one final one. I think you're re-domiciling the business to Bermuda, so I get questions about why that is important.
Yeah. Look, our biggest part of our business is in North America. We are an American company. We wanted to ensure that our shareholder rights are protected. As we start looking at some of the complexities of being a company that is operating on GAAP accounting principles and being domiciled in U.K. and having to file annual reports in IFRS, added complexities, added cost, added unnecessary filings, added audit fees. We looked at that and it says, "Look, this is a win-win for our shareholders." As vast majority of our shareholders are North American-based shareholders, we wanted to make sure that their rights are protected and frankly, looking always at efficiency. While it may not be massive amount of dollars in the big scheme of things, if you can reduce complexity, so 80/20, you will process out, right? Reduce complexity.
This was kind of an 80/20 process, reducing complexity and becoming more North America shareholder friendly.
Perfect.
Steve, I will just add it does add strategic flexibility for us over the long term to grow the business, so relative to where our position was in the U.K. So it does help on that longer term.
Okay, good. It gives you an amazing place to have an Analyst Day if you choose to do that, so. We are out of time. Thank you guys so much. Really appreciate the insights, and thank you all for your attention.
All right. Thank you.