Gates Industrial Corporation plc (NYSE:GTES) Q3 2023 Earnings Call Transcript

Gates Industrial Corporation plc (NYSE:GTES) Q3 2023 Earnings Call Transcript November 3, 2023

Gates Industrial Corporation plc beats earnings expectations. Reported EPS is $0.35, expectations were $0.32.

Operator: Ladies and gentlemen, good morning. My name is Abby, and I’ll be your conference operator today. At this time, I would like to welcome everyone to the Gates Industrial Corporation Third Quarter 2023 Earnings Call. [Operator Instructions]. And I will now turn the conference over to Rich Kwas, Vice President of Investor Relations. You may begin.

Rich Kwas : Good morning, and thank you for joining us on our third quarter 2023 earnings call. I’ll briefly cover our non-GAAP and forward-looking language before passing the call over to our CEO, Ivo Jurek, who will be followed by Brooks Mallard, our CFO. Before the market opened today, we published our third quarter 2023 results. A copy of the release is available on our website at investors gates.com. Our call this morning is being webcast and is accompanied by a slide presentation. On this call, we will refer to certain non-GAAP financial measures that we believe are useful in evaluating our performance. Reconciliations of historical non-GAAP financial measures are included in our earnings release and the slide presentation, each of which is available in the Investor Relations section of our website.

Please refer now to Slide 2 of the presentation, which provides a reminder that our remarks will include forward-looking statements within the meaning of the Private Securities Litigation Reform Act. These forward-looking statements are subject to risks that could cause actual results to be materially different from those expressed in or implied by such forward-looking statements. These risks include, among others, matters that we have described in our most recent annual report on Form 10-K and in our other filings we make with the SEC. We disclaim any obligation to update these forward-looking statements. During the balance of the quarter, we will be attending the Baird Global Industrial Conference in Chicago, and visiting investors in California, as well as internationally.

We look forward to meeting with many of you. With that out of the way, I’ll turn the call over to Ivo.

Ivo Jurek : Thank you, Rich. Good morning, and thank you for joining us today. Let’s begin on Slide 3 of the presentation. Our global teams executed well, delivering strong operating results, which translated to record revenues and adjusted earnings per share, for a third quarter. Core revenue performance year-over-year was consistent with our Q3 guidance midpoint, as automotive outperformed the industrial end markets. Our replacement channels posted positive growth year-over-year and largely offset declines in our first-fit channels. Regionally, EMEA and East Asia and India generated the strongest core growth. Demand in China was softer relative to our expectations when we last updated our outlook after the second quarter. Globally, our focus on replacement markets is providing top line growth support and mitigating the impact of spotty OEM demand trends.

Our book-to-bill remained at 1 in the quarter, and we continue to make progress reducing our past due backlog, and improving service levels to our global customers. Our adjusted EBITDA margin was 21.7% in the quarter, an increase of 110 basis points year-over-year despite less favorable channel and end market revenue mix. The expansion was fueled by a 330 basis point increase in our gross margin compared to the prior year period, partially offset by higher variable compensation costs. The supply chain environment was more stable relative to last year and benefited our performance, but several enterprise-wide initiatives involving supply chain and productivity, as well as our continued implementation of 80-20 best practices across the organization contributed to the gross margin expansion.

We are pleased with the improvement to our profitability, but are not satisfied, and intend to advance our various initiatives to drive incremental performance in the future. Q3 free cash flow was approximately $90 million and represented about 96% conversion of our adjusted net income. Our higher margin performance, coupled with stability in our trade working capital, contributed to the solid outcome. Seasonally speaking, this was a strong result and sets us well to achieve our guidance of 100% plus free cash flow conversion for the year. As a reminder, the fourth quarter is typically our strongest quarter for free cash flow generation. Our net leverage ratio finished the quarter at 2.6x, or 0.6 of a turn lower versus the prior year period.

Due to the third quarter outperformance, we are raising our 2023 adjusted EBITDA guidance to a midpoint of $730 million, an increase of $5 million from our prior guidance. Also, we have raised our adjusted EPS midpoint by $0.04, compared to our previous guidance. We are reiterating our full year guidance for core sales growth and free cash flow conversion. Please move to Slide 4. Third quarter total revenues were $873 million, with reported growth of 1.4% and core growth down just slightly year-over-year. Foreign currency changes contributed almost 2 percentage points to our overall growth versus the prior year period. In automotive, we experienced mid-single-digit core growth, both in the replacement and first-fit channels, and across almost all geographic regions.

The majority of our industrial end markets experienced decline globally, although energy and On-Highway were bright spots, growing mid-single digits, compared to the prior year period. Regionally, China industrial demand was weaker than expected. Broadly, our industrial replacement business held up better compared to our first-fit business. Globally, our replacement business increased low single digit year-over-year on a core basis, and provide a buffer against ongoing demand choppiness in the industrial OEM markets. Adjusted EBITDA was $189 million, and adjusted EBITDA margin was 21.7%, approximately 110 basis points higher than last year’s third quarter. Gross margin expanded 330 basis points year-over-year and was the driver of the improved adjusted EBITDA margin.

The gross margin increase was driven by a combination of price realization, a relatively stable supply chain environment and benefits from our enterprise-wide business initiatives. Of note, our adjusted EBITDA margin expansion included 170 basis points headwind from higher variable compensation expense. Adjusted earnings per share was $0.35, up 13% year-over-year. Relative to last year, higher operating income was the most important contributor. On Slide 5, we show our segment performance. In the Power Transmission segment, we generated revenues of $536 million and core growth of a little over 1% year-over-year. Currency was favorable by approximately 150 basis points. Automotive core growth was in the mid-single-digit range, with replacement growing slightly stronger than first-fit.

Our global industrial markets were mixed. Energy, On-Highway and construction revenues all increased, in the low double-digit range on a core basis. However, we experienced declines in Personal Mobility and Diversified Industrial. We believe the mobility business continues to work through industry-wide inventory destocking. We anticipate this dynamic to continue through the first half of 2024. Our design win activity in the personal mobility application space remains robust, and positions us to resume strong growth once the industry inventory overhang plays out. Our China industrial business was a bit softer than anticipated, declining approximately 10% versus the prior year period on a core basis. Overall, our transmission industrial replacement core revenues were more resilient than first-fit, declining low single digit year-over-year.

Despite the softening top line trends, we generated sizable margin expansion fueled by strengthening business performance in a more normalized supply chain environment. Our Fluid Power segment generated revenues of $337 million and core revenue declined about 3% year-over-year. Automotive core revenues increased mid-single digits with growth relatively similar across first-fit and replacement channels. Industrial revenues declined mid-single digits on a core basis. Energy and On-Highway realized positive growth, but that was more than offset by year-over-year decreases in agriculture and diversified industrials. Construction also declined slightly versus Q3 2022. Fluid Power segment adjusted EBITDA margins declined 70 basis points year-over-year, as higher variable compensation expense more than neutralize the benefits of gross margin expansion.

I will now pass the call over to Brooks for additional details on our results. Brooks?

Brooks Mallard : Thank you, Ivo. Starting on Slide 6, let’s review our core revenue details by region. Our core revenue performance in the third quarter was led by EMEA, which increased about 4%. In EMEA, automotive grew double digits, led by mid-teens growth in replacement. Our energy business grew more than 30%. Construction and on-highway were also solidly positive, delivering high single-digit core growth. These were offset by declines in Mobility, Diversified Industrial and Ag. North America core revenues decreased approximately 2% versus the prior year period. Automotive increased low single digits, and was accompanied by similar growth trends in On-Highway and Diversified Industrial. However, we experienced year-over-year headwinds in other verticals, most notably, in Personal Mobility and Agriculture, both of which declined double digits, consistent with our expectations.

Overall, the revenues from our replacement channels delivered stronger performance than the OEM-based channels. In China, overall demand was softer than expected. We realized positive contributions in the automotive replacement channel and the On-Highway end market, but experienced pressure in multiple industrial verticals. Industrial replacement revenues declined more than 20% year-over-year on a core basis. Industrial demand in China continues to be relatively weak, and we now expect our core revenues to be about flat with 2022. East Asia and India and South America core growth rates were nicely positive, both supported by good growth in automotive. Overall, our global replacement business delivered growth and helped mitigate slower demand trends in our industrial first-fit channels.

Turning to Slide 7. We bridge our year-over-year adjusted earnings per share performance. Improved operating performance driven by stronger gross margins benefited our results by approximately $0.04 per share. Net interest expense headwinds of $0.02 per share, were offset by reduced share count benefits of approximately the same amount. Overall, we were pleased with our ability to deliver solid year-over-year earnings growth in a challenging global demand environment. Shifting to Slide 8. We summarize our cash flow performance and balance sheet position. Our free cash flow for the second quarter was $90 million or 95.6% conversion of adjusted net income. Year-over-year margin expansion and moderating trade working capital trends versus the prior year period, supported the performance.

On a trailing 12-month basis, our free cash flow conversion is approximately 138%. Our net leverage ratio declined to 2.6x and a 0.6 turn decrease relative to the prior year period. In addition, we amended our 2029 term loan and reduced our spread by 50 basis points, which we estimate will generate approximately $3 million of annualized interest savings. Overall, we are pleased with our cash generation performance and its positive impact on our balance sheet. Our trailing 12-month return on invested capital increased 360 basis points year-over-year to 21.6%, largely driven by margin expansion and disciplined capital investment. Please turn to Slide 9 to review our updated 2023 guidance. At the midpoint, we are raising our full year adjusted EBITDA and adjusted earnings per share guidance to account for third quarter’s outperformance.

We have maintained our full year guidance for core revenue growth and free cash flow conversion. For the fourth quarter, we anticipate revenues to be in the range of $855 million to $885 million, which incorporates a core revenue decrease of a little over 4% year-over-year at the midpoint. Based on current business trends, we are tracking toward the lower half of the revenue dollar range. We expect to drive good profitability improvement in the fourth quarter, with adjusted EBITDA margins anticipated to increase in the range of 60 to 110 basis points year-over-year fueled by gross margin expansion, partially offset by higher SG&A. With that, I will turn it back over to Ivo.

Ivo Jurek : Thank you. On Slide 10, I’ll wrap up with a brief summary before taking your questions. We are pleased with our operating performance year-to-date, and intend to finish the year with another quarter of strong gross margin improvement, while dealing with softer demand. Year-to-date, through the third quarter, we have generated a 240 basis point year-over-year increase in gross margin, while experiencing mild volume pressure. The normalization of the supply chain environment this year, and our improving performance have translated to stronger margins. Moving forward, we are advancing our enterprise-wide supply chain initiatives to enhance our service, productivity levels and working capital efficiencies. Furthermore, we continue to evaluate restructuring projects that would optimize our operational footprint and organizational structure.

We intend to provide you with additional details on these opportunities in 2024. Second, we continue to reduce our net leverage ratio. We experienced a nice year-over-year decline in Q3 and are on track to further improve the ratio by year-end. Our year-end 2023 target of 2.5x represents a 0.3 turn reduction in our net leverage ratio relative to 2022, and includes the impact of returning $25 million to shareholders, via our share repurchase in May. We continue to generate surplus cash and see opportunities to reduce debt in near term. We believe we have multiple potential levers to create value for our shareholders over the next couple of years, and are highly focused on the opportunities available. Before moving to your questions, I want to take the opportunity to thank the 15,000 global Gates associates for their ongoing dedication and focus to serving our customers.

With that, I will now turn the call back over to the operator to begin the Q&A.

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Q&A Session

Operator: [Operator Instructions] We will take our first question from Andy Kaplowitz with Citi.

Andy Kaplowitz : Ivo, can you give us more color to how you’re thinking about industrial markets as you start to turn to ’24. I think you were early to call a destock this year in industrial. And maybe you could talk about where we are sort of in the channel. And I think you said that maybe destock can last in the first half of ’24. But could you elaborate on your thinking there? And could industrial turn positive in ’24?

Ivo Jurek: Yes. Thank you for your question, Andy. Look, we anticipated that the industrial activities are going to weaken throughout the year. And I think that it’s playing out the way that we’ve anticipated. I would say that what we didn’t anticipate is, a little bit weaker China, that certainly is playing itself out, but I also believe that China may be stabilizing as we exit ’23 after almost 2 years of underperformance. So our view is that the industrial markets, possibly should start seeing some degree of stability in the back half of ’24. But look, Andy, we just finished a terrific Q3, we are focused on execution on Q4 of this year, and we’ll certainly have a lot more to say about the markets and how we view those markets in ’24 on our next earnings call.

Andy Kaplowitz : Totally fair, Ivo. And to that point, maybe just a little more color in terms of Power Transmission margin and how you’re thinking about price versus cost moving forward, but also this is the highest margin you’ve seen in that segment in a couple of years. So maybe you can talk about how much impact these programs? You mentioned 80-20 supply chain initiatives. Any more color on how it’s helping you? I think you told us you’ll tell us more in ’24, but maybe a preview of that.

Brooks Mallard: Andy, we don’t get much into profitability by product line. But what we did say last year, if you remember, is that the Power Transmission product line was more impacted by some of the headwinds that we saw in the back half of 2022. And if you remember, we said we had about 200 to 250 basis points of headwinds that should correct themselves on the gross margin line as we move through 2023. And so if I break apart the gross margin side, and it’s probably a little bit heavier on the power transmission versus FP, because they were more impacted. You have this — at the midpoint of that 200, 250, about 225 bps of tailwinds from — really supply chain normalization that we’ve seen in the back half of ’23. Now that’s offset by about 125 to 175 bps of headwind on volume and mix.

So we’ve seen lower volumes, and we’ve seen lower mix, particularly on the industrial replacement side. And then I’d say offsetting that, the 80-20, some of the strategic pricing stuff that we’ve done, that’s about 150 to 200 bps of tailwind. And then you have productivity initiatives that were really just starting to see get started because of the supply chain normalization. That’s about 60 to 80 bps. And so you kind of roll all that up, and that gets you to the 300 to 350 bps of gross margin improvement that we’re seeing in the second half of 2023. So hopefully that kind of frames it up for you.

Operator: We will take our next question from Michael Halloran with Baird.

Unidentified Analyst: It’s Penn [indiscernible], on for Mike. Following up on Andy’s question there regarding some of the supply chain initiatives and regarding some of the relief from prior challenges, how much relief do you see ahead from the external environment on the supply chain? And then additionally, when we think about the internal actions, how much of this do you think about this being more typical course of business, ongoing productivity versus maybe more structural and proactive actions?

Ivo Jurek: Look, we believe that as we exit ’23, we have kind of been through the normalization of the supply chain. So, the second half of last year will be fully offset with the performance of kind of a normalized performance of the supply chain in 2023 exiting. So we believe that, that’s normalized. Look, we’ve spoken about our targets of 24% EBITDA, and we’ve kind of delineated how we’re going to get there through our own enterprise initiatives and 80-20 and kind of the ongoing productivity actions that we’re delineating, then we certainly believe that we are starting to demonstrate the validity of that plan, and we still believe that we have lots of opportunity to be able to deploy self-health, both, frankly, on more of the structural items as well as more on the ongoing productivity-based items.

So we’ll continue to provide you with the updates. We are very proud of our teams, have executed in the second half of this year, and we believe that, that positions us quite well for 2024.

Unidentified Analyst: Yes. Super helpful. Maybe if we switch gears and think more philosophically, as we get back to kind of below that 2.5x leverage level, how do you view M&A coming back into play over time? And, obviously, longer term, the company targets M&A contributions as part of the longer-term growth algorithm. How do you think about restarting that engine over time and where you’ll be looking to maybe over allocate some of your time and resources in terms of markets?

Ivo Jurek: Yes. Look, first and foremost, we are committed to get our leverage below 2x. We’ve made that commitment to all of our shareholders. We believe that we have a tremendous cash generation opportunities. The business is very, very capable of generating very robust cash flows that positions us well to reasonably quickly deliver to below 2x. Once we reach that level, we will have a very substantial capacity to deploy capital in a more strategic manner. We have a ton of opportunities in the pipeline. We are going to be extremely disciplined. We still have not seen a complete reality reset on valuations, and taking into account that we believe the biggest benefit that we can deliver for our shareholders is delivering the business, and potentially deploying capital to incremental share buybacks, we will be making all of those decisions.

But M&A is definitely starting to come more to a frame. We are very excited about it. We believe that, that’s going to be a big driver of future opportunity to drive growth, as well as profitability improvements, but we’ll be very, very disciplined.

Operator: We’ll take our next question from Damian Karas with UBS.

Damian Karas : So I know you’ve called out the Mobility destocking. Just wondering if you’re able to maybe quantify how much of an overall headwind the inventory destocking behaviors were in the third quarter, and thinking about your fourth quarter guidance. And really just — if there’s any way you could just give us a sense on kind of that sell-in activity versus kind of the sell-through demand, if you will.

Ivo Jurek: Yes. Look, so the overall, let me start with the overall, right? So the overall, we’ve indicated that our book-to-bill remains at 1. And that book-to-bill is embedded in our guidance for Q4. We did see rather substantial destocking as we have discussed from — about second quarter’s earnings call in the mobility — Personal Mobility space that continues to play itself out. There have been a very substantial overbuild of equipment that — our view is it’s going to take maybe to middle of next year to work itself out. But as you see, we are able to deliver a very strong performance despite some of the end market weaknesses in the very specific category. So we are very pleased with how our teams are delivering. We believe that we continue to outgrow the underlying market dynamics with our franchise, the products, the services that we deliver.