GTES - Gates Industrial: Current Trends Point To A Rising Share Price

2023-05-09 21:06:53 ET

Summary

• Despite the cybersecurity incident in early February of this year, there were many encouraging trends in Q1.
• Both segments reported core growth and margins increased to the upside.
• The balance sheet continues to get stronger due to sustained cash-flow generation.

Intro

We wrote about Gates Industrial Corporation plc ( GTES ) in July of last year (prevailing share price of $10.88) when we stated that GTES stock was a buy on a confirmed bottom. Not long after this commentary, shares managed to print a convincing bottom (through a MACD crossover as well as a sustained move above $12 a share) and finally gain traction to the upside. Although earnings were not growing at the time, when one delved down into Gates' fundamentals, it was evident that the company had plenty of near-term catalysts which had the potential to return the company to strong growth rates once more.

For one, revenue growth at the time (Post fiscal 2022 Q1 earnings) in both segments (Power Transmission & Fluid Power) was on an upward curve. Furthermore, the growing backlog at the time was a sign of optimism especially when one considers how the company was investing heavily in areas where demand was well above-average.

Fast forward roughly 10 months and shares now find themselves almost 30% up on that July'2022 price ($13.92 per share). Furthermore, given the solid Q1 -2023 report Gates announced just this past week, we believe there are more gains to come here for multiple reasons we delve into below.

Q1 Earnings

Firstly, given the cybersecurity incident which took place some weeks into the quarter (resulting in a temporary shutdown of significant activity worldwide), it was really encouraging to see Gates still have the capacity to report core positive growth in both its 'Power Transmission' segment as well as the 'Fluid Power' segment. Energy & construction markets powered growth in both segments where total sales came in at $897.7 million for the quarter. This number as mentioned would have been higher for the cybersecurity incident but we are now beginning to see the ramifications of solid growth in multiple end markets which can be clearly seen in Gates' financials.

Margin Growth

Gross margin in the first quarter came in at 36.27% compared to 34.13% in the same period of 12 months prior as the supply chain did not affect Gates' cost of revenues to the scale we have seen in previous quarters. Adjusted EBITDA margin also increased in Q1 (19.4%) as inflationary-led costs eased somewhat compared to the same period of 12 months prior. Although investors did not see the impact of this margin growth in Q1 on the bottom line (due to high taxation, elevated interest expense, and the ramifications of the cybersecurity incident), these trends over time will benefit the net earnings as we see below.

Forward Earnings Expectations

Below, we see the ramifications of rising margins and how they are expected to affect Gates' future annual earnings. While a 4%+ bottom-line growth rate is expected this year, consensus is predicting a much improved 15%+ growth rate in fiscal 2024 (EPS of $1.37). Suffice it to say, the benefit of strong expected bottom-line growth rates is that Gates' fiscal 2024 non-GAAP earnings multiple now comes in at a very attractive 10.20 (demonstrating undervaluation ). Many investors make the mistake of thinking that a rising share price automatically lends itself to the respective stock having a higher valuation. This though many times is not true, especially if growth expectations continue to accelerate much faster than the prevailing share price. Furthermore, a company's earnings are far more viable when positive cash flow is being generated as a result, which incidentally is also taking place now in Gates Industrial.

Cash-Flow

Gates generated $38 million of free cash flow in Q1 due to better-working capital & inventory management. With cash-flow generation expected to improve (forward p/c of 9.14), this is bullish with respect to the company being able to reward shareholders through buybacks (thus increasing EPS over time), debt destruction, or indeed more investment in high-growth areas. The second area (debt load) is crucial in that long-term debt came in at $2.44 billion at the end of Q1. Therefore, from a core value investment (Where profitability & valuation trends remain in sync), Gates' debt is the one outlier that must be controlled in an environment of rising interest rates. However, strong cash-flow generation usually leads to growing equity as the company has the opportunity to grow its asset base through the use of that invested cash. Therefore, to this effect, Gates' net-leverage ratio dropped to 2.7 in Q1 which was an encouraging trend all things remaining equal. Long holders will be hoping this trend can continue which will reduce that rather elevated interest expense on Gates' income statement over time.

Conclusion

To sum up, Gates Industrial's recent first-quarter earnings report gave plenty of room for encouragement. Although the revenue number slightly missed the mark, margins grew in the quarter with the company reaffirming its core top-line growth & adjusted EBITDA targets for fiscal 2023. We look forward to continued coverage.

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