Earnings Call Transcript - GTES Q1 2021

Operator, Operator

Good day and thank you for standing by. Welcome to Gates Industrial Corporation Q1 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Bill Waelke. Please go ahead.

Bill Waelke, Speaker

Thank you, everyone, for joining us this morning. 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 first quarter results. A copy of the release is available on our website at investors.gates.com. Today's call is being webcast and is accompanied by a slide presentation.

Ivo Jurek, CEO

Thank you, Bill. Good morning all and thank you for joining us on our first quarter earnings call. Before I jump into more of the details, let me begin with a few high-level thoughts on the quarter outlined on our Slide 3. We delivered another quarter of above-market growth, achieving a record level of quarterly revenue combined with strong operational execution. Our business is off to an excellent start to the year. Economic momentum is building across most of our end markets, resulting in solid performance for the quarter that significantly exceeded our original guidance and the updated expectations we provided at the beginning of April. Our substantial above-market growth is evidence of the accelerating success we have seen with our innovation investments and growth initiatives, which are delivering solid share gains. We saw continued strength across the business as well as outstanding momentum in orders as we exited the quarter. The exit from the pandemic and the resulting steady economic recovery we are seeing today have created several transitory headwinds, from the rise in inflation and tight raw material supply conditions to labor market scarcity and availability of logistics capacity. Operationally, our teams are agile and proactive, successfully navigating these complexities as well as lingering COVID-induced inefficiencies to drive productivity initiatives that contributed to our significant year-over-year margin expansion. As a result of our strong start to the year and the trends we are currently seeing in our end markets, we are raising our full-year guidance, which Brooks will cover later in the presentation.

Brooks Mallard, CFO

Thank you, Ivo. Now moving on to Slide 6 where we're continuing to show the regional breakdown of our revenue performance. We delivered strong double-digit core growth across all our regions, with China and emerging markets in total significantly outperforming. Growth in China lapped the worst of the impact from the COVID shutdown last year and was driven by strength across the board. From an end market perspective, we experienced the most significant growth in China in diversified industrial and automotive replacement applications, with both up approximately 100% year-over-year.

Ivo Jurek, CEO

Thank you, Brooks. Moving now to the summary on Slide 9 and a few key takeaways I would like to leave you with. We believe our business is positioned to deliver sustainable above-market growth. The investments we have been making over the past several years are accelerating our growth in the market today. We are expanding margins through productivity improvements. Our strong operational execution is focused on supporting the large increase in volumes and delivering strong incremental margins against a challenging operational backdrop. We are positioned to manage through the current operating environment complexities. We remain focused on execution throughout 2020 and kept our regional supply chains open to accommodate demand recovery, which we are now experiencing. We leaned heavily on the Gates production system tools for demand and supply planning early in the recovery, which is now enabling us to better navigate supply chain issues. And our in-region, for-region business model and the investments we've made in our manufacturing infrastructure will assist us in managing through the present set of global challenges. Finally, we continue to generate solid cash flow and are deleveraging the business ahead of our plan, which provides more optionality around future capital allocation. I would like to conclude by thanking the Gates teams globally for their continued perseverance and focus in delivering an outstanding quarter.

Damian Karas, Analyst

So I wanted to ask you about recent trends. Obviously, you mentioned order momentum through the quarter and you provided some nice second quarter guidance. But Ivo, maybe you could just give us an update since the end of the quarter, the trends you've been seeing across regions and thinking about the different end markets you plan.

Ivo Jurek, CEO

Thank you for your question, Damian. Yes, I mean, we certainly saw very broadly positive demand trends throughout Q1 as I've outlined in my prepared remarks. What we have seen in April, particularly in order rates, certainly reflects the continuation of the same trend and we've contemplated that, obviously, in our updated guide. It's been quite broad across, frankly, all of the regions so we continue to see that strength regionally. And frankly, we continue to see the strength in both of our reported segments. But I do want to note as well that we will be dealing with some incremental headwinds, frankly, associated with labor availability in the United States specifically and the decelerating auto OEM demand as our customers are facing more challenging supply chain issues on their end and I think that the well-reported issues in India associated with COVID. So although I'll reiterate the demand is very strong, we also want to make sure that we would be remiss if we did not bring forward some of the incremental concerns that are out there in the marketplace.

Damian Karas, Analyst

Got it, that makes sense. And you stated that you haven't seen any evidence of significant restocking taking place. I know you don't necessarily have great visibility into this, but what's your sense on where inventory levels currently are? Would you say kind of normal or below normal for this level of demand?

Ivo Jurek, CEO

I mean, I think that we have actually a reasonably good visibility, particularly in North America and ultimately in Europe as well. And based upon the point-of-sale data that we track very closely, we have not seen — we certainly don't believe that we have seen any significant restocking that is occurring in the channel. Look, the macro data that's out there indicated inventories are quite low. Certainly, that's been reported by some of the large end users. The commentary from our large OEM customers suggests that the inventory remains very low and that they are struggling to build inventory to support their own underlying demand patterns. So I believe that the strength that we are seeing with orders and the business overall is driven by significant underlying demand fundamentals and not necessarily artificial order patterns.

Jeff Hammond, Analyst

A couple of questions. One, the North America growth is a little lower, and I'm just wondering how much that is just kind of comp dynamics versus anything else. And then just on, you mentioned the first-fit kind of continuing to outpace or outpacing in the first quarter. Is that what you're seeing in order rates? And maybe just give us, I mean, obviously, the incrementals are very good but what's kind of the mix headwind as you think about that?

Ivo Jurek, CEO

Jeff, the first-fit is indeed outpacing and it has outpaced a little bit in Q1, but it's going to be more pronounced in Q2 in particular as in Q2 of last year, the vast majority of the OEMs started to shut down their production, and they certainly see more favorable performance in Q2 of '20 with our replacement channels than we have seen with the OEM channel. So if you think about Q2 comps, I think that you're going to see a much more substantial rebalance of first-fit being stronger in terms of growth and, frankly, in terms of mix than the replacement channels. That being said, I mean, obviously, we are reporting extremely strong growth year-over-year, nearly 55%, so I think that brings in itself sort of challenges to be able to support that. In North America, we have had a very strong performance over the last quarter—last couple of quarters. We continue to see very strong growth in North America, and it's more driven by our ability to fulfill those orders than demand growth, Jeff. So I think that as we balance our ability to support all of our customers, we are prioritizing making sure that our customers do get the products that they have ordered. And I wouldn't necessarily be looking at the North America growth rate that still, frankly, was actually quite terrific with low teens performance year-over-year. And I think that the overall demand environment remains very strong there as well.

Jeff Hammond, Analyst

Okay, great. And then good color on the outgrowth, I'm just wondering how much is just purely what you think is coming from differentiated product and some of the new product initiatives versus your ability to kind of fulfill demand versus your competitors in the near term.

Ivo Jurek, CEO

Yes. Thank you, thank you for that question. Look, my sense is that we have kept our operations going quite well through the pandemic. And I think that some of the outperformance that we are seeing is especially with the fact that we've been a reliable channel partner for our customers globally. So probably some of it is more of a market share gain through reliability of supply, and my sense is that, that's more of a permanent reset to market share. On the new products, look, over the last couple of years, I have been speaking on these earnings calls about a very substantial amount of design wins that we've had across broad-based, very attractive end markets for us and end markets that we've prioritized to continue to drive longer-term secular growth for our business. And with the more constructive end markets out there, we are starting to see that now show up in our numbers. And we believe that we will continue to deliver a very nice outgrowth to the market recovery well into the future. So we're very constructive about what we have been able to accomplish and now seeing that actually showing up in the P&L.

Deane Dray, Analyst

I was hoping we'd get some more color on your update that you'll be price/cost positive for the year. Take us through both sides of the equation. What kind of price increases did you see in the quarter? What kind of pricing are you planning to put through? And then some more color on the supply chain side, labor has come up a couple of different times. Do you have unfilled positions? And anything about the raws, like the highlight in the industry about natural rubber being in short supply, some of it because of stockpiling, but just both sides of the equation, if you could.

Brooks Mallard, CFO

So on the price side, a lot of our pricing announcements went out in Q1 and really became effective at the end of Q1 and into Q2. So from that—and that's kind of our normal cycle. We were able to pull some of those forward so we're able to get a little bit more price in Q1, but the balance of it will come for the full year. And as we see additional inflationary pressures come out, both on the material side and on the logistics side, we're looking at additional price increases to make sure the dollar-for-dollar that we're offsetting the inflationary pressures we see. When you think about our full—kind of our full-year guidance and what we've given, what I would say is, without getting into specifics on price and everything, when you look at our incrementals, we're going to see about 300 bps of dilution overall on our incrementals that we would normally see, just because you're getting price and inflationary dollars offset dollar-to-dollar but you're not getting any flow-through on that additional revenue. So that's how I would lay it out. In terms of supply, we've been able to manage through material supply constraints pretty well overall. Of course, there's a little bit of cost associated with that as you expedite things, you move things around. Probably the bigger issue that we've been dealing with and Ivo alluded to this earlier is labor availability in the U.S. And so that's kind of the one that we're managing through right now, probably the biggest one that we're dealing with. Ivo, I don't know if you have any additional color on that.

Ivo Jurek, CEO

Yes, I think that's well said. I think the way that I would bring that maybe to the part of the question that you have had, the biggest inflation that we have frankly seen has been in metals and in chemical components, resin, carbon black. And on the chemicals side, we've seen—we've been particularly hit with, frankly, the Texas storm in February that has driven more havoc into the supply chain. But we certainly believe that that's going to start normalizing in the second half of the year as all of those facilities will get back up and operational. So we think that we are well-positioned. We certainly believe that we were forward-leaning with taking pricing announcements into the market, and we continue to be very focused on ensuring that the business will continue to demonstrate the strength of our brands and our ability, frankly, on the top of that strength, to offset any inflation in raw materials with pricing.

Deane Dray, Analyst

That's really helpful. And as Brooks in his answer, when you said dollar-for-dollar on the price increases to the inflation, I was also to ask about what happens because you do get some margin dilution there and he already sized it. So I appreciate the precision and the answer there and it's perfectly understandable. All right. So second question for me is on the growth in belt from chain, this conversion hitting 50% in the quarter, was this more of—are we reaching this critical mass, this momentum now? Is that meaningful? Was it just—is it an easier comp? I want to just get a perspective on how meaningful this because it is a big jump here and we have been waiting for it. I just want to make sure that we have it in context.

Ivo Jurek, CEO

Yes. Thank you for the question, Deane. Look, we have been highlighting for a while since we introduced this initiative today is a very significant available market out there for alternative power transmission technologies such as chains, gearboxes, and cables. That's the fundamental out there. Our products have significant value proposition that we have discussed, look, reduced maintenance, they're more quiet, they're safer, they are lightweight, they are more efficient. And when you combine that with everybody's desire to focus now more on ESG initiatives, that's kind of a sweet spot for us to drive these conversions and maybe even accelerate them. With respect to the progress and coming back to the heart of your question, there are several secular drivers out there increased automation not only to improve operational efficiency but also to help address challenges that we all are seeing around the world's availability of labor. Look, e-commerce is accelerating demand for warehousing and logistics. And that is a real sweet spot for supporting some of these underlying trends in this market. If you layer in the product introductions on top of what we have been able to do simply with the design wins, we have been talking about some of these design wins for a couple of years now. That is what is driving the acceleration of this initiative. And frankly, it's not from a small base. It's from a reasonably good base that we have been able to build on. Again, I don't anticipate that we will see 50% incrementals in terms of growth every quarter. But certainly, the long-term opportunity for our business is very robust with this initiative. And frankly, that's what's going to help us to deliver our stated goal to deliver growth well above the base of the industrial market growth rate.

Julian Mitchell, Analyst

And thanks for the context on chain-to-belt just now. Maybe just looking at the guidance for the second half of the year, just wanted to better understand what's informing that revenue guidance in particular. I think it's implying sort of sales are down mid-single digits-plus half-on-half, up maybe mid-high single digits year-on-year in the second half. Doesn't seem like you are seeing kind of excess ordering or pull forwards in the first half. So maybe help clarify what's behind that second half assumption? Is it something to do with what's going on among auto OEMs? As when we look back historically, there isn't an obvious kind of seasonal pattern for Gates revenue-wise, first half, second half.

Ivo Jurek, CEO

Good set of items, Julian. Thank you for the question. Let me kind of start with, we are certainly anticipating that we will see more seasonally normalized year in 2021. And frankly, I can't even believe that we are asking about normalized seasonality, which I think is a good thing. But I also believe that we are in very early stages of the market recovery, and there is a terrific macroeconomic backdrop to what we see presently. We are seeing very positive trends in the end markets across all the regions that we participate in the channels. And as I said, there's really no evidence of restocking that is recurring in the face of some of the COVID challenges that I think most are still are facing, us included. We are seeing acceleration of sales-related growth due to our initiatives, and we certainly anticipate that those will continue throughout 2021 and beyond. The orders have been very robust. Of course, there have been challenges but we continue to navigate through those challenges quite well, and we anticipate that we will manage all of these challenges throughout 2021. Coming back to your auto question, look, what we have embedded in our guidance, Julian is, frankly, a deceleration in automotive OEM business because I certainly do not believe that we will break through all of the semiconductor challenges that the car companies are dealing with in 2021. I think that they will get better but I don't anticipate that they're going to get all solved in 2021. And I think that, that end market is going to probably become the end market that is most challenged in 2021. I think I hit everything you had an interest in.

Eitan Buchbinder, Analyst

This is Eitan Buchbinder on for Andy. So it's encouraging to see a recovery in Fluid Power progressing during the quarter. Can you discuss what your percentage of capacity utilization was for the segment? And given recently added capacity, how much room for further margin expansion is there as utilization improves?

Ivo Jurek, CEO

Thank you for the question. Look, the capacity utilization is very quickly rising. I think that we're still bringing up all of the capacity that we have put in place during 2018, early 2019 timeframe. So we feel good about where we sit in terms of capacity utilization and how much room we have available. In terms of margins, again, we're not going to provide a specific guide on reportable segments, but we certainly do believe that we have room to run and certainly an opportunity to continue to drive further expansion from what we have reported today. I would also remind you that we have increased our midpoint of EBITDA margin for the year by 90 bps at the midpoint. And we've certainly embedded our opportunity to further expand Fluid Power margins in that. Yes, we are not a backlog business, but I will say that we have increased our backlog in Q1. There's certainly incremental visibility to what we would normally have. And I would again point you back to our prepared remarks. Order rates have been very strong. We have applications that certainly in the early cycle as well as the mid-cycle and the latter cycle businesses such as oil and gas and some of the industrial automation businesses that they are starting to ramp up in earnest. And we feel quite optimistic about what we see in terms of the market recovery momentum, across—frankly, across the globe. Now that being said, again as I mentioned, there are some headwinds, certain regions like India, Southeast Asia, we've got to pay more attention to those regions as well as what I said about the automotive OEM business that we anticipate is going to continue to face challenges for the remainder of the year. But despite those challenges, we've taken our midpoint of our guidance of over $200 million.

Bill Waelke, Speaker

All right. Thank you, everyone, for your interest in Gates. As always, the team here is available for any follow-up questions, and we look forward to providing our next update on the second quarter. Have a good day.

Operator, Operator

Ladies and gentlemen, that concludes today's conference call. Thank you for participating. You may now disconnect.