Gates Industrial Corporation plc (NYSE:GTES) Q4 2023 Earnings Call Transcript

Gates Industrial Corporation plc (NYSE:GTES) Q4 2023 Earnings Call Transcript February 8, 2024

Gates Industrial Corporation plc beats earnings expectations. Reported EPS is $0.39, expectations were $0.29. GTES isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Hello, and welcome to the Gates Industrial Corporation Q4 2023 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] I will now turn the call over to Rich Kwas, Vice President, Investor Relations. Please go ahead.

Richard Kwas: Good morning, and thank you for joining us on our fourth 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, will be followed by Brooks Mallard, our CFO. Before the market opened today, we published our fourth quarter 2023 results. A copy of the release is available on our website at investors.gates.com. Our call this morning is being webcast, 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’ve described in our most recent annual report on Form 10-K and other filings we make with the SEC. We disclaim any obligation to update these forward-looking statements. Before I turn it over to Ivo, we are hosting a Capital Markets Day on the afternoon of March 11 at the New York Stock Exchange. Instructions to RSVP will be sent next week, and we hope many of you can join us for an informative see.

I’ll now turn the call over to Ivo to review our results. Ivo?

Ivo Jurek: Thank you, Rich. Good morning, everyone, and thank you for joining us today. Let’s begin on Slide 3 of the presentation and review what we accomplished in 2023. I’m proud of what our Gates global teams achieved. Our team demonstrated resilience and fortitude through an uncertain macro environment and delivered strong margin expansion and cash conversion for the full year. Our global teams work diligently to service our customers and returned fill rates to pre-COVID performance levels progressively meeting our customers’ expectations across most of our product portfolio. Our team’s collective execution enabled us to deliver a 180 basis point year-over-year expansion in adjusted EBITDA margin. Importantly, the improvement was fueled by stronger commercial and operational execution, resulting in a 290 basis points increase in our gross margins.

We believe this outcome demonstrates the resilience and quality of the business as well as our team’s ability to manage through a challenging environment. The full year profitability increase was an important driver of our nearly 20% growth in adjusted EPS. Furthermore, our free cash flow conversion measured 110% and helped drive a 0.5 turn reduction in our net leverage ratio year-over-year while we returned $250 million of capital to shareholders via share repurchases in 2023. Our company-wide focused execution allowed us to surpass most of our initial financial guidance metrics for the year. We are in the relatively early stages of executing on our organically focused enterprise initiatives that we anticipate will be delivering performance benefits and enhancing shareholder returns over a multiyear horizon.

Over an extended time frame, our business has demonstrated an ability to deliver strong profitability and cash flow generation. We are now focused on elevating the enterprise growth and enhancing profitability while staying focused on improving shareholder returns. I look forward to sharing more details on these topics at our upcoming Capital Markets Day. Turning to Slide 4 and our fourth quarter highlights. Top line performance was about as expected. The demand environment remained choppy in the fourth quarter, and our end markets followed on recent trends as automotive outplaced industrial. Recall, we faced a difficult growth comparison from the year ago period, where we were able to accelerate the conversion of past-due backlog, creating a bit of an anomaly in seasonality.

Broadly speaking, our business demand has returned to normal seasonality, which, in our view, is a positive development. Our book-to-bill ratio in the quarter remained above 1. On the profitability front, we recorded strong adjusted EBITDA dollars and delivered a significant year-over-year margin increase. We’ve generated $186 million of adjusted EBITDA, which translated to an adjusted EBITDA margin of 21.5% and represented a year-over-year expansion of 290 basis points. The increase in adjusted EBITDA margin was fueled by 440 basis points improvement in gross margins. The gross margin improvement was supported by benefits from our enterprise initiatives particularly in our supply chain. Our performance was strong, considering that volumes were down year-over-year and revenue mix was less favorable.

Our fourth quarter free cash flow was approximately $165 million, which was 158% conversion of our adjusted net income. Improved profitability and working capital management were the primary drivers behind the results. Our trade working capital as a percentage of sales decreased year-over-year, benefiting from improved cash collections as well as a normalized operating environment. The strong free cash flow performance helped us to lower our net debt to adjusted EBITDA ratio to 2.3 times, a 0.5 turn reduction compared to the prior year period. We continue to make solid progress towards achieving our target net leverage goal of under 2times. Moving to Slide 5. I Fourth quarter total revenues were $863 million down a little less than 5% year-over-year on a core basis against the backdrop of the prior year’s Q4 seasonality anomaly driven by an accelerated recovery in certain product lines in the prior year.

Total revenues were down about 3% year-over-year, inclusive of favorable foreign currency effects. Automotive increased low single digits on a core basis. The majority of our industrial end markets realized year-over-year declines globally, while energy and On-Highway continued to post positive core growth versus the prior year period. At the channel level, demand in industrial first it declined double digits, impacted by softness in North America, EMEA and South America. In China, Industrial First Fit core revenue grew double digit year-over-year after experiencing general weakness over the past few quarters. Global industrial replacement channel core revenues declined low single digits versus the prior year period on normalization of lead times and associated channel inventories.

Adjusted EBITDA was $186 million, and adjusted EBITDA margin was 21.5%. Gross margin exceeded 39% in the fourth quarter. The year-over-year gross margin expansion was partially offset by higher SG&A spending. Overall, we are pleased with the improvement in profitability made in 2023 as we continue to advance our enterprise initiatives. Adjusted earnings per share was $0.39, up 56% year-over-year. Relative to last year, higher operating income contributed $0.07 a share augmented by lower interest and tax expense and reduced share count. On Slide 6, let’s review our segment results. In the Power Transmission segment, we generated revenues of $533 million. Core revenues were down about 5% year-over-year against the prior year comp backdrop. Currency contributed about 100 basis points of growth to our revenues.

In Automotive, core revenue growth was in the low-single digits with first-fit and replacement generating similar growth. Industrial end markets were mixed. Energy and construction both grew in the mid- to high single-digit range. And On-Highway grew low single digits compared to Q4 2022. The growth was more than offset by a decrease in diversified industrial, agriculture and anticipated weakness in personal mobility. Personal Mobility market continues to work through excess inventory, and we expect a couple more quarters of weakness before growth reaccelerates. Our design win activity in this space increased about 20% in 2023 over prior year, and we are optimistic about delivering on our anticipated midterm growth prospects. Core growth in China industrial business was about flat, an improvement relative to last quarter.

Global industrial replacement revenues stayed resilient in this segment, declining low single digits year-over-year and faring better than the first in market. The segment operating performance was strong and margin increased significantly year-over-year. Additionally, our enterprise initiatives are yielding benefits, including supply chain efficiencies as well as initial commercial traction from the first phase of 80/20. Our Fluid Power segment produced revenues of $331 million. On a core basis, revenues fell about 5% year-over-year. Foreign currency contributed almost 2 percentage points of growth to our year-over-year performance. Automotive core revenues decreased low single digits compared to Q4 2022. Industrial end markets experienced a mid-single-digit decline.

Modest growth in energy was more than neutralized by softness in other end markets, most notably agriculture and diversified industrial. Relative to segment’s overall core performance, industrial replacement outperformed, while industrial first-fit was a bit weaker. Fluid Power segment adjusted EBITDA margin increased 190 basis points versus the prior year on the heels of cost management and benefits from our enterprise initiatives. We remain focused on footprint optimization within the Fluid Power segment. We are in process of completing projects in South America and India that further expand our in-region-for-region manufacturing strategy. We anticipate these projects will result in lower fulfillment costs and increased throughput of our high-velocity hydraulics and industrial hose product lines.

We’ll share more details about the enterprise footprint optimization strategy in March at our Capital Markets Day. I will now pass the call over to Brooks for further comments on our results. Brooks?

Brooks Mallard: Thank you, Ivo. I’ll begin on Slide 7 and discuss our core revenue performance by region, starting with a brief overview. Regionally, we experienced mid-single digit declines in North America and EMEA, the two regions most impacted by the highlighted difficult year-over-year comparisons. While down slightly versus prior year, our China business exceeded our revised expectations. We realized positive core growth in South America. In North America, we experienced similar year-over-year percentage declines in automotive and industrial. Trends in EMEA were more divergent with high-single digit growth in automotive countered by an approximately 20% year-over-year decrease in industrial. In both North America and EMEA, the replacement channels performed better than first-fit.

China core revenues declined slightly year-over-year. Automotive increased mid-single digits and On-Highway revenues expanded over 40% versus the prior year period, augmented by a favorable comparison. Diversified Industrial remains solid, declining high teens compared to last year’s fourth quarter. In general, we started to experience more demand stability in China as we exited the year. South America grew mid-single digits, benefiting from relative strength in automotive, energy and on-highway, while East Asia’s revenues were relatively flat with the prior year on a core basis. Shifting to Slide 8, we show the adjusted earnings per share bridge to last year’s fourth quarter. Of note, this quarter’s adjusted earnings per share was a fourth quarter high for the company.

Relative to last year, stronger operating performance contributed approximately $0.07 in earnings per share. Lower tax and interest expense were modest tailwinds. I — the contribution from other primarily reflects the benefit of a reduced share count. Moving to Slide 9 and cash flow results and our balance sheet. Our free cash flow for the fourth quarter was $165 million or 158% conversion of adjusted net income. Q4 was our highest free cash flow quarter for 2023 consistent with normal seasonality. Strong margin performance and effective management of trade working capital supported the robust conversion. We delivered 110% free cash flow conversion on adjusted net income in 2023, underscoring the strong cash-generating capabilities of the business.

Our net leverage ratio declined to 2.3 times from 2.8 times in Q4 of 2022. We have authorized a new stock repurchase plan of up to $100 million. Given our strong cash position at the end of 2023, we intend to pay down a portion of our debt by the end of the first quarter. As our cash generation builds this year, we will look to apply it to further debt payment. Our trailing 12-month return on invested capital increased 300 basis points year-over-year to 23%, our highest level since the end of 2018. We continue to make progress toward achieving our midterm goal of 25%. Moving now to Slide 10 and our full year 2024 guidance and views on the first quarter. For 2024, we are initiating guidance for core revenues to be in the range of down 3% to up 1% relative to 2023.

Within that framework, we have factored in lower rates of pricing as inflation abates, a slower first half demand environment and improving trends in the second half. There are pockets of inventory destocking and demand softness that we expect to impact our 2024 core growth. Looking at our end market revenue exposure, we expect about half of our end markets to be down year-over-year in 2024. We anticipate demand trends to improve in the second half, but have taken a pragmatic view as we begin the year. Our initial 2024 adjusted EBITDA guidance is in the range of $725 million to $785 million. At the midpoint, this guidance implies about a 30 basis point year-over-year increase in adjusted EBITDA margin. Our adjusted earnings per share guidance is in the range of $1.28 per share to $1.43 per share.

We anticipate our free cash flow to exceed 90% of our adjusted net income in 2024 after we delivered 110% conversion in 2023. For the first quarter, we anticipate total revenues to be in the range of $840 million to $880 million and core revenues to be down about 5% year-over-year at the midpoint. Foreign currency is estimated to be a slight tailwind in Q1. For the first quarter, we expect our adjusted EBITDA margin to increase in the range of 40 basis points to 80 basis points compared to Q1 of 2023. On Slide 11, we show a year-over-year walk to our adjusted 2024 earnings per share midpoint. We expect the impact from that slight core revenue decline and headwind from nonoperating items will be fully offset by benefits from our enterprise initiatives.

With that, I will turn it back over to Ivo.

Ivo Jurek: Thanks, Brooks. On Slide 12, I will offer a brief summary before taking your questions. We had a strong finish to 2023 and I’m proud of our team for their perseverance and ability to perform in an uneven economic environment. We were able to deliver a nice margin improvement while encountering choppy demand conditions, benefiting from a mix of internal initiatives and the normalization of the underlying operating environment. In a substantial way, our operations have returned to pre-COVID levels. In 2023, our team was able to showcase the underlying strength of our business model, which we intend to build upon moving forward. As we enter 2024, we are mindful of the underlying macro risks, but we believe there are many opportunities as well.

We are taking a pragmatic approach to 2024, viewing the front half of the year has been more challenging due to normalization of business conditions, followed a gradually improving business environment in second half. While we cannot control the timing of improvement in broad-based business activity, we are firmly in control of improving our business operations for the long term. As such, we continue to build momentum of our enterprise initiatives in the areas of productivity, footprint optimization and 80/20. Moreover, we are thoughtful about making further investments in our business. As the business environment evolves, our priority is to stay close to our customers at the commercial front end as well as maintain tight operational proximity to optimize service levels and fill rates of our comprehensive portfolio of highly engineered mission-critical products.

We are making investments in innovation, material science and process engineering to improve the competitive position of our portfolio while equipping our people with better analytics and empowering them to ramp up the execution of our growth initiatives. We are focused on being good stewards for all of our stakeholders, investors, the communities we operate in and our employees. On that note, most recently Newsweek recognized Gates as one of America’s greatest workplaces for diversity for the second year in a row. Before I take your questions, I would like to extend my gratitude to the nearly 15,000 Gates employees globally for their hard work and accomplishments in 2023. And finally, as a reminder, our upcoming Capital Markets Day is scheduled for March 11 in New York, where we look forward to sharing more about our enterprise initiatives and business priorities.

With that, I’ll turn the call back to the operator to begin the Q&A.

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Q&A Session

Operator: Thank you. [Operator Instructions] Your first question comes from the line of Nigel Coe with Wolfe Research. Your line is open.

Nigel Coe: Thanks. Good morning, everyone.

Ivo Jurek: Good morning, Nigel.

Nigel Coe: Really good margin execution and cash flow production, so congratulations on that. Maybe just fill in the gaps. I think Brooks, you mentioned half of the end markets expected to be down in ’24. So I’d be curious why you’re seeing the down end markets. And then any thoughts on sort of the impact of inventory adjustments during the quarter, the sell-in versus sell-out dynamic?

Ivo Jurek: Yeah. Good morning, Nigel. Let me take this. Look, I think we have put in the appendix a view of the anticipated 2024 end market conditions. And we feel kind of predominantly — we see predominantly that the industrial On-Highway and the industrial Off-Highway will be more challenged in ’24 than it was in ’23. Obviously, ag has been challenged for a while, internationally in the second half of the year in the U.S. as well. We’ve managed to quite well, but we anticipate in ’24 that’s going to remain weak globally. On-Highway and had a terrific run of a couple of years, and it’s more or less just normalizing in terms of demand, but we are seeing some strength in China in On-Highway as well, and that has been quite negative for a while.

So some puts and takes in there. And then on diversified industrial, diversified industry has been quite weak. I mean, where or not it is logistics and distribution automation, the kind of discrete automation, it’s been quite choppy over the last year, and we certainly don’t anticipate that improving until sometimes into the back half of the year. So we’ve taken a reasonably muted view of that end market, but there are some positives as well. I mean the automotive replacement market, end market remains quite robust. The market dynamics are quite strong. The aged car park continues to grow, aged carpark in China continues to grow. So the underlying demand drivers remain positive. And then obviously, energy and resources, so oil and gas, mining and such, we remain quite optimistic about the underlying conditions of the market.

Maybe on the last one on Personal Mobility, the underlying market is actually reasonably okay. You still see a very significant amount of new design wins coming to fore front particularly as in some of the developing economies, you start seeing electrification of the personal mobility gets stronger. And we have — we’ve had a very strong amount of design wins. But the underlying largest — I mean, the broadest exposure that we have presently is in the bike market and that has been dealing with post-COVID in kind of an overhang of inventory. And that we believe is going to work itself out as well kind of in the front end of the year and sometimes as you are exiting other parts of Q2, maybe in the middle of Q3, we believe that we should start seeing that overhang to start dissipating and the market should start growing for us as well.

So puts and takes, not a fantastic backdrop, but we are managing quite well. And we believe that we are well positioned to deliver what would be presented in our guidance for 2024.

Nigel Coe: Thanks, Ivo. That’s great. And then, I guess my follow-up question is on the margin bridge on Slide 11, the $0.07 from enterprise initiatives. And you provided a little bit of color in terms of some of the cost initiatives. I just wondered if maybe you could just build that out in terms of kind of what’s driving that $0.07 and any sort of cost to achieve that we should think of as well.

Brooks Mallard: Yeah. Hey, Nigel. This is Brook. This is being driven entirely by gross margin improvement, right? And so if you remember, right, I’m going to give a little history we talked about — since COVID, we talked about the challenges related to the polymers and the resins and getting those and those were challenged because there were governments that were trying to get their hands on them for different reasons. And then there were other people that were getting out of the business and stuff like that. So it’s a little bit of a challenge in terms of getting some of the raw materials that we needed, and that caused us some operational efficiencies and some gross margin headwinds, and as we work through those and we’ve stacked the enterprise initiatives on top of them, we’ve really seen our gross margins progressively come back through 2023, quite in line with what our expectations were.

And so if you think about the fourth quarter, the normalization piece was probably about 250 bps of gross margin tailwind. We probably had between volume and mix, a couple of hundred basis points of gross margin headwind, and then the balance, which is about 400 basis points really comes from our enterprise initiatives around productivity, material cost out, freight cost out and 80/20, some of the strategic pricing stuff that we’ve done. And so just a combination of things that have happened over the course of 2023 that have helped drive those gross margins in the direction that we want to.

Operator: Your next question comes from the line of Julian Mitchell with Barclays Capital. Your line is open.

Julian Mitchell: Hi. Good morning. Maybe just wanted to look at the seasonality. So you’ve got some commentary on Slide 10 about the half and so on. So I just wondered any sense of kind of how much of the EBITDA or the earnings we should expect in the first half as a proportion of the year? And sort of related to that, perhaps, I think you’d mentioned more muted price assumptions, which is very understandable. So just within the core sales guide, what is the price tailwind versus last year?