Gates Industrial Corp plc Q3 FY2024 Earnings Call

Thank you for standing by. My name is Briana, and I will be your conference operator today. I would like to welcome everyone to the Gates Industrial Corporation Q3 2024 Earnings Call. Please note that this call is being recorded. At this time, all participants are in a listen-only mode. After the speakers’ remarks, there will be a question-and-answer session. I will now turn the conference over to Rich Kwas, VP, Investor Relations. Please go ahead, sir.

Good evening, and thank you for joining us on our third quarter 2024 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 2024 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 other filings we make with the SEC. We disclaim any obligation to update these forward-looking statements. Later this quarter, we will be attending the Baird Global Industrial Conference, the UBS Global Industrials and Transportation Conference and the Goldman Sachs Industrials and Materials Conference. We look forward to meeting with many of you. Before we start, please note all comparisons are against the prior year period unless stated otherwise. Now, I'll turn the call over to Ivo.

Thank you, Rich. Good morning, everyone. We'll begin on Slide 3. In the third quarter, our team continued to execute well and delivered solid profitability improvement while encountering soft demand in certain industrial end markets. We experienced about a 4% decline on a core basis, primarily driven by weaker demand in the agriculture, construction, and personal mobility markets. Total replacement sales increased 1%, led by modest growth in automotive replacement, while sales to OEMs declined in the low double-digit range. Book-to-bill is slightly above 1. We generated a 30 basis points increase in adjusted EBITDA margins. The improvement was fueled by a 110 basis point increase in our gross margin. Gross margin benefited from ongoing advancement of our various enterprise initiatives, which include pricing actions and productivity. In addition, channel mix was favorable. These factors more than offset the impact of volume weakness during the quarter. Our net leverage ratio declined to 2.4 times from 2.6 times in the year-ago period, supported by a lower debt balance and improved profitability. During the quarter, we returned capital to shareholders via a $125 million share repurchase. We have updated our 2024 guidance, raising our adjusted EPS midpoint to $1.35. We have maintained our full year 2024 adjusted EBITDA midpoint of $755 million and narrowed that range. Brooks will touch a bit more on our guidance later in the presentation. So now please turn to Slide 4. In the third quarter, we produced sales of $831 million, which was a 3.8% decrease on a core basis. Replacement sales grew slightly. We continue to see durable demand trends in our global automotive replacement business. OEM sales decreased primarily due to lower demand in agriculture, construction, and personal mobility. Our key Asian geographies in South America generated core sales growth, a bright spot in the quarter. Adjusted EBITDA was approximately $183 million, which translated to a 22% margin, an increase of approximately 30 basis points. The improvement was led by a 110 basis point increase in gross margin driven by efficiencies from our enterprise initiatives as well as an increased mix of replacement sales, which carries higher margins compared to the off-fleet average. SG&A was higher due to increased spending associated with investments in our strategic initiatives and unfavorable effects. We believe we are making appropriate SG&A investments to improve the enterprise growth algorithm for the long term. Adjusted earnings per share was $0.33, which was 8% lower versus the year prior. Operating income was approximately $0.83 headwind, which was impacted by the lower core sales performance. We managed our operations well in the weaker environment. The year-over-year decline in adjusted EBITDA compared to the year-over-year decline in sales measured 16% and better-than-normal performance, aided by our execution on company-wide enterprise initiatives. On Slide 5, we'll review our segment performance. In the Power Transmission segment, we generated sales of $513 million, which represented an approximate 3% decrease on a core basis. The replacement channel was up year-over-year, backed by modest growth in automotive replacement. OEM demand remained under pressure with both industrial and automotive experiencing declines in the low double-digit range. Broadly, we saw declines across our end markets in Power Transmission, diversified industrial, and automotive, benefiting from good replacement activity. These were the most resilient markets as both posted low single-digit decreases in core sales. Agricultural and construction demand remained muted. Personal mobility remained a headwind for growth, but the sales base has stabilized and inventories at the mobility manufacturers are trending lower. We expect inventory levels to normalize by year-end and believe the business is well positioned for growth in 2025. Power Transmission adjusted EBITDA margin expanded 30 basis points. Gross margin expansion drove the increase, led by contributions from our enterprise initiatives as well as favorable channel mix, partially offset by lower volumes. In the Fluid Power segment, our sales were $317 million. On a core basis, sales decreased just under 5%. The replacement business grew modestly, led by automotive replacement, which grew mid-single digits. Industrial replacement core sales performance was relatively flat. Industrial OEM sales declined mid-teens on a core basis, driven by continued demand pressure in agriculture and construction. Despite lower volumes, Fluid Power EBITDA margins expanded 20 basis points due to the progress with our enterprise initiatives and a higher replacement sales mix. Additionally, as part of our footprint optimization initiative announced in March at our Capital Markets Day, we have commenced projects that will predominantly impact our Fluid Power business and should be a nice contributor to profitability in 2025 and beyond, all else equal. I will now pass the call over to Brooks for further comments on our results.

Thank you, Ivo. I'll begin on Slide 6 and discuss our core sales performance by region. Our key Asian geographies and South America grew, but that was more than offset by demand weakness in North America and EMEA. In North America, core sales declined approximately 6%, driven by weaker OEM trends. Industrial OEM channel sales were down double digits, with the agriculture and construction end markets most impactful to our performance, followed by mobility. We also experienced weakness in automotive OEM with sales down mid-single digits. North American replacement channel sales remained resilient, bolstered by low single-digit growth in automotive replacement and flat sales performance in industrial replacement. In EMEA, core sales fell just over 6%. Overall, macroeconomic pressure impacted the region's top-line performance. Both industrial OEM and replacement core sales were down double digits, driven by declines in energy, construction, and diversified industrial. Automotive OEM sales were down double digits, which was mostly offset by mid-single digit growth in automotive replacement. China core sales grew modestly and benefited from strength in the industrial end markets, which expanded double digits. Construction, diversified, and personal mobility were significant contributors. The growth was partially offset by a high single-digit decline in automotive, driven by OEM demand softness. Automotive replacement declined slightly. South America and East Asia and India both posted low low-single-digit growth in core sales. Automotive outperformed industrial in both regions, with industrial OEM sales down modestly. Replacement channels outperformed OEM channels. On slide 7, we lay out the key drivers of the year-over-year change in adjusted earnings per share. Operating performance represented a $0.03 per share headwind driven by the year-over-year core sales decline. Favorable interest expense and other items, including a lower share count offset a higher adjusted effective tax rate. Slide 8 provides an overview of our cash flow performance and balance sheet metrics for the third quarter. Our free cash flow was $88 million, which represented 101% conversion to adjusted net income. Trade working capital increased due to higher inventories and a higher mix of automotive replacement receivables. We built incremental inventory to support the new automotive replacement business we announced last quarter. In addition, while industrial market activity currently remains subdued in our most important geographies, we believe we are nearing a trough. Given our short cycle demand characteristics, we are positioning the business to capitalize on a potential recovery and support superior customer service levels. Our net leverage ratio was 2.4 times at the end of the quarter, representing a 0.2 times improvement compared to last year. The combination of a lower debt balance and improved profitability contributed to the results. We are well positioned to deliver our 2026 target of one to two times net debt to adjusted EBITDA. As a reminder, as a result of our recent debt refinancing, we have no debt maturities until 2029. Our trailing 12-month return on invested capital was 22.3%, a 70 basis point increase and supported by the increase in adjusted EBITDA margin. Shifting to our updated 2024 guidance on slide 9. We have increased our adjusted earnings per share guidance and narrowed our adjusted EBITDA guidance range while reiterating the midpoint. We believe our full year 2024 core growth will be in the range of minus 4% to minus 3%, which is in the lower half of our prior guidance range. We have narrowed our adjusted EBITDA guidance to a range of $745 million to $765 million. The $755 million midpoint is consistent with prior guidance. We have increased our adjusted earnings per share range to $1.33 per share to $1.37 per share, a $0.03 increase at the midpoint. Our guidance for capital expenditures and free cash flow conversion remains unchanged. On slide 10, we show our updated earnings per share walk for 2024. From left to right, we project about a $0.01 per share benefit from operating income, which is offset by higher interest expense. Our lower tax rate and share count contributed $0.03 of adjusted earnings per share benefit. Turning to slide 11. We wanted to provide a brief update on our footprint optimization plan. Last quarter, we discussed achieving $40 million of annualized savings over a multi-year period with savings beginning to accrue next year. To date, we have announced three closures of subscale facilities, which are all expected to be completed by year-end. The footprint optimization plan is a global initiative and other rooftop consolidations are poised to enter the execution stage. Savings are expected to build over the course of 2025 and 2026. As a reminder, we anticipate achieving 40% of the full savings run rate as we exit 2025 and intend to be at the full savings level on a run rate basis by the end of 2026. In aggregate, we believe the footprint optimization plan can contribute over 100 basis points to our adjusted EBITDA margin at maturity, which is at the high end of the range we communicated at our Capital Markets Day in March. Now, I will turn it back over to Ivo for his closing remarks.

Thank you, Brooks. On Slide 12, I'll provide some key thoughts before we take your questions. First, our global Gates team is executing well and we are delivering higher profit margins in a soft demand environment. Our team is effectively managing the operating variables that can be controlled in a challenging environment and produced a record Q3 gross margin for Gates since we became a public company. In 2024, we are on track to generate over 100 basis points of adjusted EBITDA margin improvement with our core sales on pace to decline low to mid-single digits. Second, we are positioned to drive meaningful returns for our shareholders over the next few years. Since 2016, on a core basis, our sales have grown at a 4% compound annual growth rate. We have multiple strategic growth initiatives in place including driving a change in the way personal mobility devices are designed and built, developing new fluid conveyance technologies that offer more efficient cooling solutions for hyperscale data centers as well as further increasing our relevance with existing customers and securing new customers in the automotive and industrial replacement channels. As the industrial market stabilizes, we believe we are well-positioned to drive attractive core revenue growth over the mid-term. In addition, we believe the ongoing execution of our enterprise initiatives should enable us to deliver average incremental margins on the growth we anticipate to achieve. We are making incremental investments across the enterprise to position the company to deliver high organic growth and experience more organizational efficiencies over the next decade. Finally, our balance sheet position continues to show steady improvement, and we anticipate having more avenues available to deploy capital over the mid-term. We intend to be opportunistic, yet prudent in deploying our excess free cash flows. Before taking your questions, I want to extend my appreciation to the almost 15,000 global Gates associates for their hard work and determination in achieving our enterprise priorities and satisfying our customers' expectations. With that, I will now turn the call back over to the operator for Q&A.

Our first question comes from Jeff Hammond with KeyBanc. Please go ahead.

Hey good morning guys. Great execution on the decrementals. It seems like a lot of the restructuring savings come in '25, '26, maybe just talk about what you're doing in the near term to mitigate the decremental headwind here in the short-term soft period.

Yes. Thank you, Jeff. Look, we have a ton on our plates associated with our enterprise initiatives. So obviously, front-to-back 80/20 execution is what we are focused on, and I think we have fast-spoken on the last couple of calls about our focus on material cost reductions, optimized pricing through '20 and factory productivity. And I think that that's what's a bit unique about this cycle than maybe in a previous cycle. We feel pretty good where we sit and we continue to execute. Our teams execute well, and we are managing to extend our gross margins in a somewhat negative demand backdrop.

Okay. Great. And then, it seems like your peers are putting up some pretty challenging numbers in China and Asia and you guys kind of bucked the trend. And so that really stood out. I'm just wondering, what you think you're doing there? Is it share gain? Is it kind of where you play that's driving that meaningful outgrowth?

Yes, Jeff, thank you. I'm very proud of what our China team has been able to execute. We've spoken for a while that we have had a pretty significant focus in region, for region. So that our business is really more dependent on the local macro environment than as demonstrated, that's not been necessarily great. It's been challenging for some time. But we did see some green shoots in industrial end markets in Q3. Our team has been focused on expanding our market share, expanding our presence across various applications in the industrial space, just as much as in the automotive replacement side of our business, and they have executed really well. And while we don't see any benefits yet from the stimulus that the Chinese government is indicating that they will deploy, we feel pretty good about where we sit. The growth has been returning, and we anticipate that we're going to have kind of a mid-single-digit growth rate for the full year 2024 in China. So the team has done a really good job.

Okay. Appreciate it.

Our next question comes from Nigel Coe with Wolfe Research.

Thanks. Good morning, everyone. There's a lot happening this morning, and I want to ensure that the message on Page 11 is completely clear. Are you indicating that by 2026, or regarding your guidance of 25.5%, you are referring to the high end of your medium-term EBITDA margin target?

Yeah. So I would say at the end of 2026 compared to 2024 that we will be at that $40 million run rate of savings or 100 basis points, a little bit over 100 basis points that we had committed to on the last call as we move forward. So it will hit incrementally as we move through 2025 and 2026 as we execute on the different projects. The different optimization plans. But if you look at it over a two-year period, by then is when you should see that 100-plus basis points of incremental EBITDA margin improvement.

Okay. But not necessarily 25.5%. That's somewhat volume-dependent. Okay. I understand that. Okay. Okay. And then on the 4Q kind of buildup, I think that at the midpoint, you're seeing a slight pickup, I think, maybe 1% or so on revenues at the midpoint. The margin stepping down a fair amount. So we got revenue stable to slightly up, margin down, I think, maybe 100 basis points plus quarter-over-quarter. So I just want to understand those dynamics a little bit better.

That's primarily due to the automotive replacement business we mentioned in the last earnings call. We have been providing some lift credits as we secure inventory for that segment. The challenges are more significant than we anticipated because we're fast-tracking the shipping for this business. Most of this is occurring in the fourth quarter, where we expect the bulk of those credits to take place. Year-over-year, this represents about a 75 to 80 basis points headwind in EBITDA margin. This is a one-time issue as we ramp up inventory for our new automotive replacement customers in the latter half of the year.

And Nigel, I want to quickly comment on revenues. For the full year, consider that there is close to a 1% headwind from foreign exchange. This will help in understanding the core sales growth implications for the fourth quarter. I just want to ensure everyone has this information for their modeling.

Thanks, Rich. I just wanted to clarify the share count part of the bridge. I understand you don't break out checkout, but it would include the third quarter buyback, which won't be affected by what Blackstone does in the next couple of months.

That's correct.

Yeah. Okay. Thank you. Thank you very much.

Our next question comes from Damian Karas with UBS.

Hey, good morning, everyone.

Hey, Damian.

Brooks, you mentioned that you think you're getting close to a low point and are beginning to prepare for a recovery. Can you share more about what you're observing and hearing that supports this perspective? If that is true, how do you think it will affect the growth range for the business in 2025?

There's been quite a few quarters of negative PMI and declining volumes, especially in the industrial sector. As we've progressed through the year, we've focused on a couple of key aspects. One is labor availability, ensuring we can run our factories efficiently, and the other is positioning our inventory to provide excellent customer service and be ready for an eventual turnaround. We believe we will reach the end of this negative PMI phase, and we want to be prepared for that shift. While we can't pinpoint exactly when it will happen, we anticipate certain parts of the business, like mobility, may see a recovery sooner, possibly in 2025, while the timing for industrial remains uncertain. Our goal is to be ready to serve our customers and capitalize on the upcoming upcycle.

I see. That makes sense. And then regarding the footprint optimization, are there any further details you can share around the facilities, like where they're located, any particular concentration in end market or product? And what's your confidence that you can maintain market share should we see a return to growth sooner rather than later with less facility capacity out there?

Yes. So we try to play a little bit close to the vest on the location. It's primarily in the fluid power segment that we're seeing the footprint optimization activities so far. And remember, as we talked about, we're not taking capacity out of our operational footprint, right? We are, in fact, making sure we have the same or more operational capacity and/or labor availability as we move through these footprint optimization plans. That's key for us. And if you remember, Ivo and I both talked about labor availability being one of the biggest drivers as we move through this footprint optimization plan. So we actually feel better about where we stand from a capacity perspective as we move through the cycle. And we thought we thought through all of that as about how we optimize our footprint moving forward.

Understood. Thanks, guys. Best of luck.

Thanks.

Our next question comes from Julian Mitchell with Barclays.

Hi. Good morning. I suppose just want to sort of double-check because you're talking about inventories being high because of expected sort of demand inflection, but you're not seeing that inflection yet. And when I look at the inventories to, say, trailing 12-month sales, I think they're at 21% in September and inventories are up low double-digit year-on-year. Pre-COVID your inventory to sales was 15%. So just want to understand, should we expect for the medium-term, your inventory sales runs at sort of 20% plus, and that's a kind of sustainable go-forward rate from here?

Yes, Julian, that's a great question. There are a couple of points to consider. First, we've mentioned that we're planning to take on additional customers into 2025. Brooks has highlighted the ramp-up happening in Q4 with those new accounts. We've also adjusted some of our inventory to manage the initial orders and the ongoing setups that customers expect. On another note, historically we have struggled to fully leverage the business opportunities available to us, which has led to a significant backlog. Analyzing our business data, we see that PMIs have been negative for over 24 months. While we are not predicting an immediate shift in the PMI cycle, we feel we are closer to that turning point than we anticipated at the start of 2024. As we consider our strategy, we want to ensure we're well-positioned for the next upcycle. We plan to maintain a slightly higher inventory level to capture more market share, and we have several initiatives in place to meet our free cash flow goals for our analysts and shareholders. This outlines our current thinking.

That's really helpful. Thanks, Ivo. Just to follow up on your point regarding cash flow, I see that year-to-date you have about a 40% conversion of adjusted net. In Q4, does this imply that there will be some sort of non-inventory working capital liquidation that will bring you closer to the 90% for the full year? Additionally, as we consider cash uses moving forward, should we expect that buybacks will still be the primary focus for at least the next year, given the current stock valuation?

Looking back at our last four fourth quarters, we are on track to meet our 90% cash conversion goal, which aligns with our historical performance. The business usually generates a substantial amount of cash in Q4 due to seasonal factors. As mentioned, we expect some inventory to be released as we ship automotive replacement products, leading to typical seasonal cash inflows from receivables and inventory reduction. We are confident about our cash conversion outlook. Regarding capital allocation, we need to reduce our gross debt below $2 billion. We still have the ability to buy back stock, and as our stock price increases and our valuation improves, pursuing acquisitions will become more favorable for us. Mergers and acquisitions will definitely be part of our strategy as we consider capital allocation through 2025.

But we will be very thoughtful about embracing alternatives. And as you said, Julian, stocks are way too cheap based on the financial metrics and the performance that we have delivered, and we believe that it's in the best of shareholders' interest to deploy capital in buying back our shares.

That’s great. Thank you.

Our next question comes from Deane Dray with RBC.

Thank you. Good morning, everyone.

Good morning.

Good morning.

I wanted to clarify Julian's question about inventories. Regarding the increase, how much of it was related to the new auto replacement account and how much was due to positioning ahead of demand to ensure fill rates and service levels? If you could separate those two, that would be helpful.

Yes. I mean I would say the inventory positioning for the new business is probably in the $10 million to $15 million range. And then the balance is us working through optimizing our inventory using the 80/20 tools, thinking about when the inflection might come, what those demand signals that might look like, and then how we make sure we take full advantage of the up cycle when it comes.

Okay. That's good. And then can you talk about contributions from new products and any update? I know it's still small, but any update on the data center initiatives.

Yes, sure. So we continue to track towards the 20% of new product vitality index, Deane. So we're very much on track to reach the level that we have committed kind of in that 2018, 2019 timeframe. So that's making really good progress. And as we anticipate the inflection in personal mobility, we will continue to see a nice contribution from those sales into the NPI vitality in addition to our fluid conveyance side of our business. I would say that maybe on the data centers, in September, we've announced the launch of a new Data Master Data Center Cooling House that we anticipate will start shipping this quarter in Q4. It's a product line that is very specifically designed towards data center application. It does have better maybe increased compactness for the application, allowing a much more efficient assembly and routing in a very tight footprint in those data centers. And there are also features of very specialty compounded type materials that ensure cleanliness throughout the system, limiting any contamination opportunities and downtime to engineering and deploying our material science into this product line. So it will be more on the new product side of the data centers. And then we are working very closely with partner CoolIT on a number of applications on our water pumps. We are also expanding the portfolio of these water pumps from about 100 watts up to 4 kilowatts, and we have a number of new accounts that we are working on design-ins with globally and frankly, predominantly between North America and Asia. So that's proceeding quite well. Again, it's very early on. And while there's lots of interest and lots of discussion about companies that are booking kind of new business, lots of the new businesses are coming on the chip side. And then on the infrastructure side, there are some customers that have a longer cycle infrastructure-type build. And our products are more consumable that go into these types of applications, so we anticipated our stacking is going to be more on the latter part of that project cycle. So we're very excited about what we are doing. The opportunities are quite nice out there, and we have substantially scaled up the reach of the type of customers that we are dealing with, both from the hardware side all the way through the infrastructure side.

That’s a great update. Thank you.

Thanks, Deane.

Our next question comes from Mike Halloran with Baird.

Hey, morning everyone.

Good morning.

One, just as you think about the stressed end markets that you're seeing today, are you at the point where you're starting to see sequential stability in those markets? Or is there still a deterioration? And I suppose more broadly, when you think about the cumulative portfolio at this point? Is this just more stable at softer levels? Or is it more variable than that by end market, if I'm just thinking about it on a sequential basis?

Yes. The main idea behind our thesis regarding Gates is that our significant presence in the replacement market should provide better stability as we navigate through these cycles, and I believe we are witnessing that. The replacement markets have shown considerable improvement and are slightly up despite a larger revenue base. In contrast, the first-fit segment of our business, which is smaller, has faced significant challenges due to the negative end market conditions, particularly in off-highway sectors. Additionally, while there's been some impact on the personal mobility market, we are beginning to see signs of stability. Inventories in the personal mobility channels are stabilizing well, and we expect that as we transition from Q4 into 2025, this sector will start to accelerate and return to historical growth rates. We are optimistic about this not only because we excel in these applications but also because of numerous new design-ins we have implemented over the past few years. Looking at more traditional markets, our industrial replacement market showed much more positive behavior in Q3. Although it hasn't entered a growth phase, it has stabilized, remaining flat, which is encouraging. The automotive replacement side of our business is performing well after two years of strong growth. We also discussed the new account in AR in North America, which will significantly contribute positively in 2025. The replacement market is functioning as we anticipated when we took the company public, providing more stability, and I believe this is a positive indicator for the future. Additionally, despite a couple of years of negative core growth, we have successfully improved our gross margins and EBITDA margins over the last 24 months. We feel confident about the potential of this business as we gain operational leverage from increased revenues.

Yeah, makes sense. And a follow-up, just I certainly understand the answer to Julian's question earlier about buyback prioritization. As you think about the shift to M&A over the next few years here, how aggressively are you working on the cultivation today? Do you feel like you have the right team in place? And then what kind of opportunities are you seeing out there when you look at things that are coming your way or that you're working on?

Look, we have a good team, small team, but a good team. Our first priority was to repair our balance sheet or get our balance sheet to a point where we can start thinking about deploying excess free cash flow into incremental M&A. While that was happening, we were not inactive. We are active out there. We are cultivating relationships. We have pipelines of opportunities where we've participated in a number of discussions. But at this point in time, again, our stock is cheap. And I probably get more rewarded by generating rewards for our shareholders by buying back stock than deploying and trying to buy companies at a much higher multiple than we trade. But I think that as we rerate and as things start to normalize, we continue to execute. We have a tremendous platform that can deliver truly accretive organic growth rates over the next three, four, five years. And so we believe that we have low risk of ramping up, scaling up our business. We are deploying SG&A towards those opportunities. We have done a good job of balancing our capital deployment across our factories. So we are well positioned to deliver on nice organic growth rates as the market starts to stabilize. And I don't think that, that's a year out, that's probably a lot closer than that.

Thanks, Ivo.

Our next question comes from Jerry Revich with Goldman Sachs.

Hi, this is Clay on for Jerry. Just one question for me. How has price cost trended throughout the year as material costs have slowed? And then how does this inform how we think about pricing for next year? Thanks.

Our pricing strategy consists of two key components. We have consistently demonstrated strong pricing power and will continue to address material freight inflation with appropriate pricing adjustments. The second aspect is the 80/20 pricing initiative, which has contributed positively, though not dramatically, as we progress through 2024. We have yet to fully implement the 80/20 model across all regions and product lines, and there's still potential for further benefits from it. Regardless of inflation trends, we are confident in our ability to adjust our prices accordingly to protect our margins, regardless of the inflationary pressures we face.

Thanks. I appreciate it.

Our next question comes from Nigel Coe with Wolfe Research.

Yes, I've got another question. So, I just wanted to come back to the data center opportunity. I mean, I know it's very small right now, but when you compare to Parker Hannifin has sized the TAM at potentially $2 billion by 2028, I'm just wondering if that's kind of the scope of the market you see as well. Just there any thoughts there would be helpful.

Yes, Nigel, I think during our Capital Market Day, I've talked about kind of $1 billion, $1.5 billion. So, we're in a very similar vicinity as what Parker has outlined. They may have some other products there. But for us between our houses, couplings, and water pumps, we believe that that's plus or minus a similar number.

Okay. And then just a quick one on the return to growth because it seems that you are seeing a bottom in the market, and I think any sort of reasonable view on seasonality as we go from Q4 to Q1, has you growing in Q1 2021? Just want to make sure that's not out of whack with your thoughts.

We are not ready to discuss 2025 just yet. However, looking at the typical seasonality from the past few years, it's expected that growth will resume when transitioning from Q4 to Q1. In our next call, we will provide our guidance for 2025, including our outlook on volumes, margins, and other factors. Assuming normal seasonality, it would be reasonable to expect a return to growth.

Okay, fair enough. Thanks, guys.

Our next question comes from David Raso with Evercore ISI.

Hi. Thank you. Sorry, I've been on a lot of calls, so if this was answered, I apologize. The agricultural construction and personal mobility softness, is there any sign of a bottoming in those particular markets sort of dovetailing on the prior question about trying to think of resumption of organic growth? Are those businesses a big part of that? Or is that something that we don't yet really know when the bottom is on those markets?

Yes, Dave. Good morning. Thank you for your question. I think I mentioned earlier that we definitely believe personal mobility is stabilizing. While it may still be slightly negative in Q4, inventory levels at our customers are bottoming out and normalizing. We expect personal mobility to resume growth in 2025. However, agriculture and commercial construction are still showing a reasonably negative trend. My sense is that there may be more challenges ahead in those sectors over the next couple of quarters before we start to see stability.

And anything on construction in particular?

No, I would say that construction is kind of similar to agriculture. It's reasonably negative globally. I think that you're probably not going to see any stability into maybe the latter part of next year.

Lastly, regarding the plant closures, is there a reason we can't accelerate some of them? I understand the difficulty in executing this, especially while trying to serve customers, but unless you believe the market is going to improve significantly, it seems like it would be worth considering.

We have announced three facility closures that will occur in the second half of 2024 and are set to be completed by the end of this year. Our policy is to inform you when we are implementing these changes. As we begin to execute, we anticipate more actions into 2025, and when we are prepared to clarify the impacts, we will provide an update. We have included additional details in our presentation on page 11, and we are on track to execute these plans.

And of what's been announced, how much are those already accounting for part of the $40 million in full savings? Just so I can get a scope of how many maybe more need to be executed to get to $40 million.

Yes. I think we need to be careful with the details we provide about our rollout based on the timing. By the end of 2026, we expect to achieve $40 million in incremental EBITDA margin, which represents an increase of over 100 basis points. The distribution of this is approximately 40% in 2025 and 60% in 2026. As we implement these changes and begin to see savings, we will be more selective in reporting our progress. For now, we will stick to this general overview and provide updates as we advance through the various phases of our footprint optimization.

And David, that's at run rate for 2025 and 2026. So the 40% gets you to a number, but that's run rate, not realized savings in 2025.

No, I appreciate it's not 16 for the full year. It's a run rate in 16 by the time you exit.

By the end of 2025, correct. Yes.

Helpful. Thank you so much.

Yes.

Thanks David.

Our next question comes from Andrew Kaplowitz with Citi.

Hey. Good morning, guys.

Hey, good morning.

Ivo, I think you started Diversified Industrial is one of your most resilient end markets in power transmission, which I think is kind of the opposite of what you were seeing earlier in the year. So maybe you can give us more color on what's going on there overall.

Yes, we are beginning to observe some stability, especially in the replacement channels. People still need to repair their equipment and may have postponed some maintenance. While maintenance can be deferred, inventories have been significantly reduced. Although we do not expect a notable rebound in inventories in the short term, we believe we have reached the lowest point of the demand disruption experienced over the past couple of years. The Diversified Industrial end market was essentially flat compared to last year, which represents the best performance we have had in several quarters.

Ivo, the auto OEMs have become a smaller part of your business and it remains somewhat unpredictable. However, it seems that the replacement segment is stable and potentially robust. Is this benefiting from the volatility in the auto OEM sector? And do you have good visibility for the global auto replacement business as we head into 2025?

Look, we are very constructive on the global auto replacement business from a couple of different venues. One is that we are taking market share, which is always nicely accretive to our business. And two, if you take a look at the underlying market dynamics, the car fleets continue to age. People are driving. The unemployment is very healthy, both in the developed world as well as reasonably healthy in the developing world. We manufacture products that are not discretionary. If something breaks that we manufacture, it's not nice to have. You will have to replace it. And so that gives us a more optimistic view that that market continues to be reasonably accretive to what we do in 2025.

And Brooks, you probably already talked about that, but just sort of my own edification, I got on late is that, I know you spoke about some start-up costs last quarter as you ramped up some customer wins, but those costs just lower than you expected in Q3, can you flush out what you saw?

No, I would say they're lower in Q3. I think we've accelerated some of those lifts and shipments related to the new business we've won. So we are expecting more headwinds than we initially anticipated. Most of those headwinds will come in Q4. There was an earlier question about year-over-year margin impact, and we saw about a 70 to 80 basis points margin impact year-over-year from that accelerated activity with the new replacement customer. Overall, I think it's positive. We're moving faster, performing better, and getting the product on the shelf where it belongs. I believe we will have a good footprint as we move into next year.

Appreciate it, guys.

Thanks, Andy.

We have no further questions at this time. I will now turn it back over to Rich Kwas for any closing remarks.

Thanks, everyone, for participating. If you have any follow-up questions, please feel free to reach out. And have a great rest of the week. Take care.

This concludes today's conference. You may now disconnect.