Earnings Call Transcript - GTES Q3 2025

Operator, Operator

Ladies and gentlemen, thank you for being here. My name is Krista, and I will be your conference operator today. I would like to welcome everyone to the Gates Industrial Corporation Third Quarter 2025 Earnings Conference Call. I now turn the conference over to Rich Kwas, Vice President of Investor Relations. Rich, the floor is yours.

Rich Kwas, Vice President of Investor Relations

Greetings, and thank you for joining us on our third quarter 2025 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 2025 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've described in our most recent annual report on Form 10-K and in other filings we make with the SEC, including our Q2 quarterly report on Form 10-Q that was filed in July of 2025. We disclaim any obligation to update these forward-looking statements. 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 and look forward to meeting many of you. Before we start, please note all comparisons are against the prior year period unless stated otherwise. And now I'll turn the call over to Ivo.

Ivo Jurek, CEO

Thank you, Rich. Good morning, everyone, and thank you for joining our call today. Let's begin on Slide 3 of the presentation. Gates posted solid third quarter results with positive core revenue growth of almost 2% on the macro industrial demand conditions that remain subdued. Our replacement channel grew low single digits, supported by mid-single-digit growth in automotive replacement. Our OEM sales were relatively flat. At the end market level, industrial was mixed. Globally, Off-Highway realized positive growth with stabilizing demand in construction, offsetting incremental weakness in North American and European agriculture. Commercial On-Highway declined mid-single digits, impacted by decreasing production rates in North America. Personal Mobility generated another strong quarter of growth, exceeding 20% year-on-year. Our adjusted EBITDA margin increased nicely year-over-year to 22.9%. We generated record adjusted EBITDA dollars and margin for a third quarter. Our net leverage ratio declined to 2.0x, a 0.4x reduction compared to last year's third quarter. With that, we are on pace to reduce our net leverage to under 2x by year-end. We have updated our 2025 guidance, raising our adjusted EPS midpoint to $1.50 per share. We have maintained our full year 2025 adjusted EBITDA midpoint of $780 million, while slightly lowering our core sales growth outlook at the midpoint. Brooks will provide more color and comments about our updated guidance assumptions later in the presentation. Additionally, our Board recently approved a new $300 million share repurchase authorization that will expire at the end of 2026. The new authorization replaces the prior authorization, which had over $100 million remaining. On Slide 4, we have heard from a number of you on the call that you would like to see an update on what is occurring in the end markets. So we have laid out an updated view of our underlying end markets and how they have progressed during 2025. Coming into the year, we did not anticipate a broad macro recovery, but we have continued to see uneven end market performance since we set our initial expectations for the year in February. We did, however, enter the year with some expectations that the PMIs could begin to recover in the second half of 2025. That has not emerged to date. Industrial Off-Highway demand trends have continued to languish and softened a bit relative to our expectation during the third quarter in certain geographies on reduced build rates and dealer inventory destock. Additionally, in the On-Highway end market, the North American commercial truck production levels deteriorated as the third quarter evolved. Despite some of these near-term headwinds, we are still outperforming our underlying markets and believe that many of our challenged end markets are troughing or are close to troughing. Our Automotive Replacement and Personal Mobility business continues to grow nicely, while our data center opportunity set continues to expand. As such, we are optimistic that demand in the majority of our end markets will be more stable to improving at some point in 2026. Please turn to Slide 5. Third quarter total sales were $856 million, which translated to core growth of 1.7%. Total revenues grew 3% and benefited from favorable foreign currency. As I have highlighted earlier, the end market performance was mixed in the quarter. Personal Mobility continued to trend nicely higher with its year-over-year growth rate accelerating compared to the second quarter. Off-Highway grew mid-single digits with growth in construction and agriculture globally. However, agriculture declined incrementally in both North America and Europe. Diversified Industrial and Energy were both down slightly and On-Highway demand was soft. Automotive grew low single digits with solid growth in auto replacement more than offset a slight decline in auto OEM. Our key growth verticals, Personal Mobility and Auto Replacement contributed to the performance. Our revenues from data center also continue to increase, although from a small base. And we see the liquid cooling opportunity in early stages of more broad-based adoption. Adjusted EBITDA was $196 million with adjusted EBITDA margin coming in at 22.9%, an increase of 90 basis points and represented a record third quarter margin rate for the company. Our adjusted earnings per share was $0.39, an increase of approximately 18% year-over-year. Operating performance contributed $0.02, while a lower tax rate and consolidated mix of other items each contributed $0.02. We believe we are effectively managing the enterprise across all aspects. On Slide 6, we will review our segment highlights. In the Power Transmission segment, we generated revenues of $533 million in the quarter and core growth of 2.3%. Most industrial end markets realized growth. Personal Mobility continues to be a strong contributor with growth exceeding 20% in the quarter. At a channel level, replacement grew with automotive and industrial channel core growth each growing low single digits. OEM sales also grew low single digits with industrial sales growth more than offsetting a decrease in automotive. We continue to invest in our strategic sales initiatives and innovation to help drive potential outgrowth in the future. Our mobility opportunity pipeline is staying robust. In the Fluid Power segment, our sales were $322 million, representing core growth of just under 1%. Many of our key end markets in Fluid Power continued to experience various levels of demand pressure, but our teams have held their own. Commercial On-Highway sales decreased mid-teens as industry inventories are elevated. Off-Highway grew with positive construction trends offsetting a low single-digit decline in agriculture. The agriculture performance year-over-year was worse, impacted by incremental OEM production cuts to better align our customers' inventory levels heading into the year-end. We believe the underlying agriculture market is troughing and should be better positioned for recovery sometimes in 2026. Replacement demand was strong, driven by double-digit growth in Automotive Replacement globally with broad-based growth across regions. Industrial OEM sales declined mid-single digits on a core basis, driven by soft demand trends in agriculture and commercial truck. Our data center opportunity pipeline exceeds $150 million and design-in activities remain robust. With respect to profitability, both segments expanded adjusted EBITDA margins at a similar rate. I will now pass the call over to Brooks for further comments on our results.

Brooks Mallard, CFO

Thank you, Ivo. I'll begin on Slide 7 and review our core sales performance by region. The majority of our geographic regions generated core growth in the quarter, highlighted by EMEA's return to growth. In North America, core sales were about flat. The incremental demand weakness experienced in Agriculture and Commercial On-Highway during the quarter was primarily concentrated within the North American region and led to a low double-digit decline in industrial OEM sales. Industrial Replacement sales were also down slightly. Industrial was offset by growth in automotive as Automotive Replacement sales increased high single digits, supported by year-over-year growth contribution from our new channel partner. Automotive OEM sales grew low single digits. In EMEA, core sales grew 2.6%. Industrial end markets were mixed. Construction returned to growth and more than offset weak demand in agriculture. On-Highway grew while energy and diversified industrial saw declines. Personal Mobility was very strong, growing almost 75%. At the channel level, OEM sales grew high single digits, supported by Construction, On-Highway and Mobility, partially offset by lower automotive OEM. Sales into replacement channels increased slightly. East Asia and India posted approximately 5% core growth. Most industrial end markets grew. Automotive OEM sales decreased slightly, which was more than offset by high teens growth in Automotive Replacement. China core sales expanded 6% year-over-year with growth across all channels and most end markets. South America core sales declined low to mid-single digits. On Slide 8, we show the key components of our year-over-year change in adjusted earnings per share. Operating performance contributed approximately $0.02 per share, driven by core growth and higher adjusted EBITDA margin. A lower tax rate contributed $0.02 per share. Other items, including lower interest expense, lower share count, and other income together generated about $0.02 per share. Slide 9 provides a summary of our cash flow performance and balance sheet metrics. Our free cash flow was $73 million and represented 73% conversion to adjusted net income. Our restructuring cash outflows have increased, which impacted our free cash flow conversion. Our net leverage ratio declined to 2.0x at the end of the third quarter, which was an improvement on a year-over-year and sequential basis. During the quarter, we paid down $100 million of gross debt. We expect our net leverage to be under 2x at calendar year-end 2025. Our trailing 12-month return on invested capital was 21.6%, an improvement sequentially as improved operating performance helped offset the impact from internal investments in high-return projects. On Slide 10, we provide our updated 2025 guidance. We have trimmed our core revenue growth midpoint to 1% and narrowed the range from 0.5% to 1.5% to reflect current macro conditions for the balance of the year. In addition, we have maintained our $780 million adjusted EBITDA midpoint and narrowed the range to $770 million to $790 million. We have raised our adjusted earnings per share guidance to the range of $1.48 per share to $1.52 per share, the upper half of our previous range. The $1.50 per share midpoint reflects a $0.02 per share increase relative to our prior guidance. Our guidance for capital expenditures is unchanged. We have lowered our free cash flow conversion outlook to a range of 80% to 90% from 90% plus as a result of increased restructuring cash outlays as part of our footprint optimization and restructuring initiatives. Turning to Slide 11. We want to provide an update on our ongoing restructuring plans as well as the strategic system conversion that we have been working on and that we expect to be complete by the middle of 2026. Beginning late in Q4 2025 and finishing by the end of Q2 2026, we expect to close multiple factories, complete a labor realignment and go live with an ERP conversion for most of our European footprint. As we complete these activities, we will be focused on providing continuity and service for our customers and our affected team members. We expect to incur additional costs and other one-time operational impacts from these projects in the first half of 2026. From a financial perspective, we anticipate an unfavorable year-over-year impact of 100 to 200 basis points to our adjusted EBITDA margin in the first quarter and a more modest unfavorable effect in the second quarter, ranging from 25 to 75 basis points year-over-year. In the second half of 2026, as we look towards completion of these various projects, we expect operations to normalize and realize favorable impact to our adjusted EBITDA margin from our restructuring activities of 75 to 125 basis points year-over-year. Excluding volume considerations, we expect our footprint optimization, restructuring, and material cost-out activities to generate 0 to 25 basis points overall adjusted EBITDA margin improvement year-over-year for the full year 2026. We anticipate being at a 23.5% adjusted EBITDA run rate in the second half of 2026 in a volume-neutral environment. As I said, we have not taken volume impacts into this analysis and plan to update those assumptions as well as provide further insight into our restructuring activities when we initiate our formal 2026 guidance in conjunction with our Q4 earnings call in February. I will now turn the call back over to Ivo.

Ivo Jurek, CEO

Thank you, Brooks. Moving to Slide 12. This is our illustrative update on our walk towards the midterm stated adjusted EBITDA margin target of 24.5%. In 2025, we have experienced a highly fluid business environment and continuation of prolonged negative PMI prints, resulting in constrained volume performance. With that as a backdrop, we now anticipate completing our initial phase of the committed footprint optimization projects by mid-2026 and still expect that those projects will achieve 100 basis points of savings from the footprint optimization program exiting 2026. Coupled with our ongoing focus on material cost savings and 80/20, we estimate that our adjusted EBITDA margin will be nearing 24% on a run rate basis exiting next year. Most importantly, this does not assume any margin benefit from a potential broad volume recovery in our industrial end markets. While the end market volatility has not been supportive, we are very pleased with our execution and performance to date. We believe the prospects for incremental improvement over the midterm are positive, especially as the end market conditions begin to potentially inflect. With that, let me summarize our views on Slide 13. We believe we have executed well, delivering solid results given the lackluster demand environment we have encountered throughout this year. We generated record third quarter adjusted EBITDA margin rate and achieved our highest quarterly core growth rate since Q2 2023. For the year, we are on target to deliver adjusted EBITDA margin expansion and earnings growth in a muted demand backdrop. We continue to make progress with our Personal Mobility and data center strategic initiatives and believe we will encounter a better industrial demand landscape in 2026. We continue to adjust our structural cost base, and we expect our savings to begin to compound during the second half of '26 and anticipate our adjusted EBITDA margin rate to be approaching near 24% exiting next year. With that as a baseline level, we would expect any volume improvement to be additive to our margin performance. Lastly, we believe we now possess a strong balance sheet that can be utilized to support various potentially value-creating capital deployment options. Our Board recently approved a new $300 million share repurchase authorization. Separately, debt reduction continues to be an option. We just repaid $100 million of debt during the third quarter. And of course, at this juncture, our ability to execute bolt-on M&A transactions is increasing as we move towards our midterm financial leverage target. Before taking your questions, I want to thank the approximately 14,000 global Gates associates for their diligence and commitment supporting our customer needs. With that, I will now turn the call back over to the operator for Q&A.

Operator, Operator

Your first question comes from the line of Nigel Coe with Wolfe Research.

Nigel Coe, Analyst

I wanted to clarify some questions regarding Slide 12. The 24% for 2027 should be considered more of a baseline. If we continue to operate at the current level, 24% represents where you can expect margins, and increased volume could provide some growth. I want to confirm that this is accurate. Additionally, I would like to discuss the costs you mentioned for the first half of the year and the benefits you anticipate from the ERP implementation.

Ivo Jurek, CEO

Thank you, Nigel. I will address the first part of your question and then hand it over to Brooks regarding the ERP aspects and other cost-related inquiries. Referring to Slide 12, the margin walk was designed to help you understand the impact of the temporary costs associated with restarting our restructuring program. This program aims to significantly enhance our cost structure. However, it does not indicate our growth forecast for 2026. Essentially, this serves as a foundational minimum. We do anticipate growth in 2026. The margin impact presented does not include any advantages from revenue growth because we haven't provided updated guidance for 2026 yet. As you know, we will offer that update after our Q4 fiscal year, in January. We are optimistic that many of our end markets are at or near their lowest points, and as I mentioned in my remarks, we believe they will improve in 2026. Additionally, we are enthusiastic about our strategic revenue generation initiatives for next year, which we expect will positively contribute to our growth in 2026. With that, Brooks, please take the second part of the question.

Brooks Mallard, CFO

We anticipate various one-time costs associated with the restructuring and headcount realignment. This includes additional freight and expediting costs, along with expenses for redundant labor and productivity as we handle relocations, which is common in our operations. As Ivo mentioned, it's important to remember that a key reason for these footprint optimization efforts is to foster our future growth. While we expect cost benefits, more significantly, we will gain additional capacity in both machinery and labor, allowing us to scale effectively. Regarding our ERP systems, we are transitioning from an outdated system to a new one that will enhance our warehouse and overall business management capabilities. However, we have not incorporated these anticipated benefits into our forecasts. We aim to improve our efficiencies and support our strategic goals through the ERP implementation, but we believe it will take the first half of the year to get everything properly aligned. Thus, we wanted to be open about the costs and impacts related to these activities.

Nigel Coe, Analyst

Yes, we definitely appreciate that. Just wanted to double-click on growth. You mentioned growth about 4x or 5x there. What kind of tailwinds or visibility do you have right now on some of the structural growth vectors like data center, Personal Mobility? I'm guessing you're going to have some price carryforward for next year. But more importantly, when you talk about the bottoming in some of these Off-Highway, On-Highway markets, how much visibility do you have on production schedules for your OEM partners? And do you have any visibility on maybe kind of a turn in production for those end markets?

Ivo Jurek, CEO

Yes, sure. Thank you for that great question, Nigel. I remain very optimistic about some of our growth areas like Personal Mobility, liquid cooling, and data centers. Regarding Personal Mobility, in our last call, we projected growth over the next three years. However, I want to remind everyone that growth isn’t always linear. Overall, we expect Personal Mobility to grow approximately 30% annually between 2025 and 2028, though there will be fluctuations, with growth rates ranging from 22% to 35%. Our confidence comes from the design wins we've discussed in previous calls. The destock period post-COVID has happened, leading to a strong acceleration in our growth trajectory, which we expect to continue for the next couple of years. We have also highlighted the accelerated adoption of liquid cooling. While I’m not providing a detailed revenue forecast for 2026 today, I anticipate sharing more details in our next call. There’s significant activity in this area, with an increasing need for cooling in our projects. We are observing substantial growth in design-in activity across our customer base, which bodes well for the next one to three years. We plan to offer more concrete financial details related to this growth in upcoming quarters. In our Automotive Replacement market, although we don’t typically frame it as a growth driver, we have seen substantial growth recently, contributing stability to our revenue. We expect this trend to continue into 2026, 2027, and 2028, with plenty of growth potential remaining in that 2% to 3% range for this more mature market segment. Looking at our traditional end markets, we believe the auto original equipment business is stabilizing, and we expect additive growth rates in North America and ultimately in Europe by 2026. The markets are stabilizing following recent announcements, and there’s a growing optimism in this sector. We are also seeing some positive developments in commercial construction, while agriculture faced challenges that worsened in the third quarter. Despite some promising core growth in agriculture, the overall situation is gradually improving, and we think the worst is behind us. Finally, the diversified industrial market has shown signs of bottoming out, and we anticipate it becoming more beneficial in 2026. I want to clarify that we’re not avoiding the idea of organic growth for 2026; on the contrary, we are quite optimistic. However, we want to provide visibility into some structural cost adjustments we are making in the first half of the year. We're working on resetting our cost structure to become more competitive and support our anticipated growth rate, which we feel positive about.

Operator, Operator

Your next question comes from the line of Deane Dray with RBC Capital Markets.

Deane Dray, Analyst

I wanted to revisit Slide 12. I understand that you've presented this as a margin walk, but could you provide some details about the restructuring? Specifically, how many plants are involved, their locations, the anticipated headcount reduction, the investment amount, and the expected payback timeline? While I realize you're addressing it as a margin, it would be beneficial to have this additional information as well. If there are restrictions, particularly regarding overseas operations and works councils, starting with that information would still be helpful.

Brooks Mallard, CFO

Yes. The situation is quite complex because it involves a restructuring primarily focused on North America and EMEA. We are closing multiple factories, which will impact hundreds of employees. The payback typically takes one to two years, depending on severance costs, relocation expenses, and necessary investments. Regarding the headwinds, we are anticipating a $30 million to $35 million one-time impact for the first half of 2026, which includes system conversion costs. Additionally, our increased capital expenditure in recent years has contributed to this investment, with around $20 million spent last year and another $20 million this year. This context helps explain the one to two-year payback timeframe, influenced by the timing of project implementation and when savings are realized. We expect to complete the initial phase of restructuring by the end of the second half of 2026, resulting in tangible benefits during that period. Moreover, we are actively pursuing additional projects and allocating funds that haven’t yet been reflected in our regular financials. In the latter half of this year, we anticipate around $10 million in savings, which will carry over into the first half of 2027. This represents half of the expected $40 million in total savings, and we are continuing to work on the other half, with details to be disclosed over the coming year. I hope this provides clarity on how these efforts are progressing.

Deane Dray, Analyst

Yes, it really did. I appreciate that additional information. As a follow-up, I would like you to explain the impact of tariffs on pricing. Do you anticipate any decrease in volume due to demand destruction, and what is the overall status of tariffs?

Brooks Mallard, CFO

So let me take the cost piece, and I'll let Ivo talk about the volume piece. So from a cost basis, we're okay in terms of the total EBITDA impact. What I would say, though, as you look at some of the gross margin dilution in the back half of 2025, and that will fall through to EBITDA dilution. We're probably seeing 30 to 40 bps of dilution because we're not getting anything in terms of bottom line add from the tariffs, right? We're just kind of holding our own and making sure that we don't cost ourselves money. So the impact from a profitability perspective is kind of 30 to 40 bps, $0 from a total EBITDA dollars perspective. And then I'll pass it over to Ivo to talk about the volume piece.

Ivo Jurek, CEO

Yes, Deane, I think that I would describe this more as a short-term transitory challenge rather than volume destruction. There seems to be some impact on agriculture, particularly due to the increasingly difficult trade environment for farmers. This is related to the delayed recovery we have observed in the agriculture sector overall. As I mentioned earlier, agriculture in Q3 was slightly worse than we expected at the beginning of the quarter. However, we believe that this market will start to normalize as we move into 2026, and we anticipate it will become a bit less negative during that year. Around that time, we are also noting more stabilization in the auto industry, and forecasts for production output from carmakers may become more positive. Some of these temporary challenges appear to be diminishing, and as we approach 2026, we expect a more stable environment.

Operator, Operator

Your next question comes from the line of Julian Mitchell with Barclays.

Julian Mitchell, Analyst

Maybe just the first question, trying to drill into perhaps a little bit the sort of exit rate from 2025. Just looking at the fourth quarter, for example, you mentioned Ivo was sort of firming of the industrial environment in the prepared material. But I think the revenue guide seems to embed sort of fairly normal seasonality for the fourth quarter. Just wondered if you could clarify that? And then similarly on kind of the EBITDA rate in the fourth quarter, often down sequentially. I think this time, it's sort of flat to up. Just wondered if there was anything to call out there in terms of enterprise initiative benefits or mix or something.

Ivo Jurek, CEO

Yes, Julian, you described it accurately. If we consider our Q4 revenue, it reflects the exit rate from Q3, adjusted for typical seasonal patterns. There's nothing unusual about it. I wouldn't say we've anticipated any additional recoveries. We're certainly cautious regarding agriculture, but based on the current situation, I don't expect any noticeable changes in Q4, especially since many end markets and customers have faced some tough times this year. I haven't seen anyone positioning themselves for 2026, which is somewhat reassuring. It indicates that the focus is shifting more towards 2026, and we're definitely hearing a more optimistic perspective about that year in certain segments of our business. With that said regarding demand, I'll let Brooks discuss the EBITDA for Q4.

Brooks Mallard, CFO

From a Q4 perspective, we're observing some progress with our initiatives related to material costs. However, this is somewhat offset by the impact of tariffs and the usual seasonal trends expected in Q4. We're generally pleased with our inventory levels in terms of service and readiness for activities in Q1. We are not significantly increasing inventories as we approach the year's end. Overall, there are factors that are beneficial and others that we are managing to ensure we achieve year-over-year EBITDA growth, but there isn’t anything structurally different as we wrap up the year.

Ivo Jurek, CEO

But Julian, we are also executing rather well, right? I mean we had 18% EPS growth in Q3, record level of margins in a reasonably muted end market environment. So I think that the organization is doing a good job in managing during some of these challenging times and frankly, delivering differentiated operating results.

Julian Mitchell, Analyst

Great. And then just one quick follow-up on the sort of cash conversion. I think you walked down the guide a bit there. There's some higher cash restructuring. Should we expect much improvement in conversion next year? Or no, because of the EMEA and North America restructuring charges will sort of weigh on next year?

Brooks Mallard, CFO

Yes, we need to examine that. I believe the primary factor impacting us in 2025 is the restructuring charges, which will affect adjusted EBITDA and adjusted net income, but will also flow through free cash flow. Additionally, we expect higher capital expenditures. While we will continue to invest in CapEx, I think it will begin to decrease slightly in 2026. We may encounter some minor challenges related to the cash out from restructuring compared to how it affects adjusted net income, but these should be less significant than this year. We have identified the headwinds, and they will be reflected in our financial numbers and cash flow. This won't significantly impact the overall cash conversion since they will be recorded in both areas. We will provide updates on this and clarify it when we revise our guidance for 2026. Essentially, it’s included in one metric, but not in the other, leading to a slight imbalance that we need to highlight in our cash conversion.

Operator, Operator

Your next question comes from the line of Jeff Hammond with KeyBanc Capital Markets.

Jeffrey Hammond, Analyst

Appreciate all the color. So just to kind of put a bow on this noise around margins and the margin bridge because I think that the message is getting confused that next year is a transition year and maybe your long-term target is getting pushed out. It seems like to me, you had said to get to your margin target, you needed 100 to 150 basis points from volume, and that hasn't played out. And it seems like you've maybe outperformed on internal execution, material savings and the volume has been the whole, but maybe just level set me on that.

Ivo Jurek, CEO

I think you expressed it well, Jeff. We’re actually meeting our midterm targets without any assistance from the current macro environment, which feels encouraging given how challenging it is to operate in such poor PMI conditions. It's crucial for us to convey to the market that the company is performing effectively. We genuinely believe that there will be a shift in volume. We all recognize that predicting shifts in macroeconomics is difficult due to the many variables related to trade and industrial policies, as well as global market behavior. However, we should expect that after 36 months of negative PMI, we might soon see a turnaround. When that happens, it will certainly add to what we've outlined in our presentation. Yes, I believe our stock is undervalued. It is trading at a valuation that does not reflect the company’s performance. We plan to proceed with buybacks, as the Board has authorized $300 million for that purpose, and we will utilize those funds. The company is also generating significant free cash flow, allowing us to pursue all potential capital deployment strategies. We have paid down some debt and will strategically buy back our stock. We are also optimistic about our balance sheet improving towards below the 2x leverage we see as a benchmark. I hope to avoid discussing leverage in the future. We believe we can use all three capital deployment strategies, with a stronger focus on bolt-on mergers and acquisitions.

Operator, Operator

Your next question comes from the line of Andy Kaplowitz with Citigroup.

Andrew Kaplowitz, Analyst

You've been talking about accelerating footprint optimization and doing 80/20 since your Investor Day 1.5 years ago. But obviously, your growth since then has been somewhat slow. So I'm just trying to figure out if you're accelerating or enhancing any of your restructuring plans versus when you updated us at that Investor Day. And then maybe can you update us on how 80/20 is impacting Gates as you go into '26 and beyond? If you do organically grow, can you do core incrementals over 40%?

Ivo Jurek, CEO

Yes. I want to be fully transparent. As Liberation Day approached in April, we took a moment to assess the new mercantile regime and rethink our overall operating structure. We've been in this region for a long time, so we felt it was important to understand the current landscape. After we became more comfortable with what we observed and how we were organized, we concluded that our original plan was indeed the right approach. As Brooks mentioned, we need to ensure access to labor that allows us to adapt to these cycles. We believe we're on the brink of an up cycle, so we need to be well-positioned to support the anticipated growth in the near future. We are executing our original plan, and nothing has significantly changed regarding our footprint optimization and restructuring efforts. We are in very good shape, and this pause has validated that our plan was correct. We're moving forward now. Regarding the 80/20 initiative, we have achieved material cost reductions and improved operational focus, which have allowed us to exceed our expectations outlined during our Capital Markets Day in 2023 and still meet our midterm targets even without growth. This is a strong tool for us. We believe we are just in the early stages, and if we look at companies like ITW that have utilized this strategy for over a decade and continue to see margin expansion, we see similar potential for ourselves. We expect to utilize 80/20 as a key factor in enhancing our profitability and growing our business through strategic growth channels. We believe we can successfully achieve both objectives, and 80/20 will be very beneficial for us. Additionally, if we set aside the restructuring benefits noted, we still believe that in a normalized growth environment, which we expect around 2026 and beyond, we should generate incremental growth of 30% to 35% beyond the benefits described previously. Yes, I believe North America has faced the most challenges due to agricultural market exposure, which has slightly deteriorated. It wasn't a significant amount of revenue, but it has been less supportive than we expected. Other markets are performing reasonably well. The automotive sector has seen strong growth, particularly in automotive replacement in North America, and our industrial replacement market is also expanding. Overall, the situation is not bad; it's in line with our expectations, aside from the agricultural challenges. South America faced difficulties in the last quarter, but that follows an extraordinary period of growth over the past six quarters, and we expect it to enter a growth phase as we move from 2025 into 2026. Europe has been slightly surprising, showing better performance than we anticipated with positive core growth, though the auto markets remain weak. Our AR business is thriving, especially in the commercial construction and mobility sectors, and our industrial replacement business is stabilizing and showing some improvement in Q3. In China, automotive and industrial replacement sectors are performing adequately, consistent with our previous observations. East Asia and India are also growing well, notably in the automotive replacement sector. India appears to be on a promising growth trajectory as its economy develops, potentially becoming a viable alternative to China in the midterm. In summary, we are generally more optimistic than pessimistic and anticipate that 2026 will show more positive results than what was suggested in today's release.

Operator, Operator

Your next question comes from the line of Tomo Sano with JPMorgan.

Tomohiko Sano, Analyst

I'd like to ask about the data centers. And of the $322 million in Fluid Power revenue this quarter, how much was related to data center sales? And what are your expectations for 2025 data center revenue and the conversions of your $150 million plus pipeline in 2026, please?

Ivo Jurek, CEO

Yes. We are not going to provide specific details on the revenue flows since it's still a relatively small, but growing, segment for us, starting from a very low base. Therefore, I don't think it's worthwhile to discuss the sizing at this moment. The revenue is in the millions, not in the tens of millions yet. Our design-in activities are very active, with a considerable number of new customers engaging with us on new design-in opportunities. We plan to share more information in January or early February during our Q4 earnings call. We remain optimistic that the data center growth as a sector will increase significantly. We believe that achieving between $80 million to $200 million, or $100 million to $200 million by 2028, is an attainable intermediate target over the next two to three years. Additionally, we will be attending the Supercompute show in St. Louis in about two weeks, and we invite anyone interested to come talk to us about our new products and innovations, as well as to learn more about our technology initiatives.

Tomohiko Sano, Analyst

And a follow-up on pricing perspective. Could you talk about how effective you have been in passing through cost inflation in Q3? And what is your pricing strategy for 2026, please?

Brooks Mallard, CFO

Yes, we have always been effective at managing pricing in response to inflation. When new tariffs were introduced, we successfully adjusted our pricing to account for those changes, although we faced some challenges in Asia where operational adjustments were necessary. We have committed to covering material and utility inflation annually through our pricing strategy. With the implementation of our 80/20 approach, we have added a value-based pricing strategy, allowing us to be competitive on certain products while also being able to set prices for unique items based on the value we provide. Overall, we will continue to use pricing to address our material and utility inflation.

Operator, Operator

That concludes our question-and-answer session. I will now turn the conference back over to Rich for closing comments.

Rich Kwas, Vice President of Investor Relations

All right. Thanks, everyone, for joining. If you have any further questions, feel free to reach out. Otherwise, have a great rest of the week. Take care.

Operator, Operator

Ladies and gentlemen, this does conclude today's conference call. Thank you for your participation, and you may now disconnect.