RRX - Gates Industrial Playing Catch-Up With Sentiment After Supply Issues Undermined 2022

Summary

• Gates beat fourth quarter expectations with 16% organic revenue growth, but weakening end-market demand has management expecting no volume growth in 2023.
• Supply chain issues hit the company hard in 2022, but margin, free cash flow, and return leverage have been lackluster for some time and need to improve.
• Valuation is undemanding up through the high-teens, and there's more upside available if management can unlock more margin leverage.

Supply chain pressures were an issue for most industrial companies in 2022, but not many seemed to struggle as much with them as Gates Industrial ( GTES ), and these challenges (including lost or deferred revenue and weaker margins) have definitely impacted valuation. While the industrial sector has done alright since my last update on Gates (beating the S&P 500 by around 9%) and several industrials in Gates’ peer group have done even better, including Parker-Hannifin ( PH ) and Regal Rexnord ( RRX ), Gates has lost about 15% of its value.

Worthwhile addressable markets aren’t the issue for Gates, as there are still credible opportunities in chain-to-belt transitions in many industrial markets, personal mobility (e-bikes/e-scooters), and EVs, management has to rebuild credibility with the Street. It also doesn’t help that a significant part of the company’s end-market mix is likely to see weaker demand trends in 2023, with Gates management itself looking for no volume growth in guidance. Valuation is undemanding, though, and with weak sentiment and lower expectations, Gates could have a better setup to performance from here.

Catch-Up Demand Drives Stronger Reported Results

Gates’s fourth quarter will look strange at first blush, as 16% organic growth from a company with significant short-cycle exposure would seem to be an anomaly at this point in the cycle. The “but” is that supply chain issues kept a lot of orders in the backlog, and as these supply chain pressures have eased, Gates could generate some above-average quarterly results.

Revenue rose 16% in organic terms, beating by about 4%, with Power Transmission up 15% (a 5% beat) and Fluid Power up 18% (a 3.5% beat). Gross margin declined 40bp year over year and 190bp quarter over quarter to 34.9%, and that was close to two points lower than the Street expected. EBITDA rose 19%, beating by close to 5%, with margin up 150bp to 18.6%; Power Transmission EBITDA rose 7% (beating by more than 7%), with margin up 10bp to 18.4%, while Fluid Power EBITDA rose 44% (inline), with margin up 380bp to 18.8%.

Guidance was relatively healthy versus expectations, with “low-to-mid single-digit” core revenue basically in line with the Street, but EBITDA of 700M to 750M about 4% ahead of the Street at the midpoint.

Strong Demand Across Multiple Markets

Gates management pointed out strong demand in the quarter from off-highway (about 20% of revenue), energy (around 5% of revenue), personal mobility (4% of revenue), and auto aftermarket (30% of revenue).

None of this is surprising relative to other reports from industrials for this quarter; off-highway remains strong as companies deliver out of strong backlogs, while energy remains one of the stronger markets heading into 2023. Personal mobility is a little more Gates-specific (it’s not a big market for most other industrials), and a strong auto aftermarket is consistent with reports from companies like Dover ( DOV ) and Illinois Tool Works ( ITW ).

Likewise, management’s call for flat volume performance in 2023 is perhaps a little more conservative than the guidance from some peers, but is broadly consistent with flat to low single-digit guidance from the sector as a whole.

Auto aftermarket is likely to slow now that inventory levels have largely been replenished and auto traffic is basically back to normal. Off-highway and trucks will be interesting markets to follow; the businesses should be strong in the first half as companies deliver on robust backlogs delayed by supply issues in FY’22, but demand and orders should decline pretty noticeably later in the year. Energy is likely to remain strong throughout the year, and I see growth opportunities in personal mobility.

Gates’ biggest challenge is likely to be in the “general industrial” catch-all that accounts for around 20% of sales. Warehouse automation has slowed markedly, and overall automation demand has also slowed as companies are pausing capacity expansion and retrofit plans until they have more visibility on their own end-user demand situations. While “chain to belt” conversion is still a significant long-term opportunity for Gates, and one that I think will accelerate in 2024, I don’t see it as such a significant near-term driver.

Margin Leverage Is A Bigger Concern Than Growth

I’m not really concerned about Gates not having enough growing addressable market opportunities. Chain-to-belt will last for years, and I do still expect more investment in automation across a range of end-markets like biopharma, food/beverage, general manufacturing, and semiconductors, as well as in warehouse automation. I also continue to believe there are worthwhile opportunities for the company in personal mobility (electric bikes and scooters) and EVs (water pumps and thermal management systems).

Where I’d like to see better execution is on margins. While the pandemic and the supply chain crunch that followed are certainly valid excuses for margin disruption, Gates hadn’t really been showing much EBITDA margin momentum before then. Along those lines, the company doesn’t have particularly exceptional profit margins (EBITDA or operating margin), and metrics like ROIC, ROA, and ROTA are actually pretty mediocre compared to quality industrials.

Given that Gates is the market leader in a large percentage of its business (around 40% of product revenue is from products where Gates is #1 and over 80% is from products where Gates is #3 or better) and has been actively working to improve its vitality index, I would like to see better incremental margins and improvements in those return metrics. Along those lines, Gates’ long-term trailing free cash flow margins are, at best, quite ordinary.

The Outlook

The biggest downside I see with Gates is that the company and stock are an “is what it is” situation and there’s just not that much incremental leverage to margins, FCF, ROIC, and so on. At best, that would make for a cyclical stock that investors could trade, but wouldn’t really argue for a long-term holding.

I’m only looking for around 3% to 4% long-term revenue growth, and I think the company should be able to reach that without much difficulty if their estimates of the chain-to-belt and e-mobility market opportunities are reasonably accurate. I’m looking for about 6% FCF growth, with margins improving from the high single-digits into the low double-digits. I don’t think my assumptions are especially ambitious, but sustained double-digit FCF margins haven’t been achieved before.

If Gates can hit those long-term targets, the shares should trade in the high teens. Likewise, using my 12-month operating margin, ROIC, and ROA assumptions, Gates should be able to support a forward EBITDA multiple of around 10x, which again drives a high-teens fair value.

The Bottom Line

Gates shares have been stronger of late, outperforming the industrial group over the last three months by more than 10%. With supply chain pressures easing, maybe we’ll see more of the true underlying performance, though that will be tempered by a weaker short-cycle market in 2023. On balance, I think an undemanding valuation can support further gains, but I would need to see more improvement before really thinking of this as any kind of core holding.

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