Gates Industrial Can Be More Than A Short-Cycle Recovery Story

Summary

• Gates offers broad exposure to the auto and short-cycle industrial recovery, with additional upside from R&D-driven efforts to gain share, including replacing chains with belts in multiple industrial power applications.
• Gates generates the bulk of its sales from products where it is among the share leaders and aftermarket revenue is a significant part of the business.
• Margins are not exceptional and leverage is high, but management has been focusing on increasing its R&D productivity and the share of revenue generated by new products.
• While the long-term return potential doesn't look exceptional, the shares do look relatively undervalued on above-average short-cycle sensitivity.

With close to half of its revenue coming from auto end-markets and the remainder from largely short-cycle markets, Gates Industrial Corporation (NYSE:GTES) should be well-placed for a strong recovery in 2021. To that end, management has already guided for revenue growth of 9% to 14%, with healthy EBITDA margins, as those markets come back to life.

What the company can do above and beyond cyclical recovery leverage will be a key factor in the longer-term returns for shareholders. Management has already produced some tangible benefits from its investments and reinvestments into materials research, and the opportunities to drive improved new product development and gain share in existing markets is real, but the company will also need to couple that with improved margins and reduced leverage.

I can’t call Gates a compelling idea on a long-term basis, but the stock does look more undervalued on a shorter-term margin/return-driven approach. The biggest risk I see there is that the market moves on from short-cycle names – something that has happened around this point in prior cycles, but those prior cycles didn’t involve a recovery from a global pandemic coupled with significant stimulus efforts.

Powering Back Up

Gates generates about two-thirds of its revenue from its Power Transmission business, a business largely based on providing various kinds of belts used in stationary drives, mobile heavy equipment, autos, and light personal vehicles (bikes, ATVs, etc.). A little less than half of this business is “first fit” (meaning it goes on original equipment), while the remainder is from aftermarket sales that aren’t quite as volatile.

Gates is one of those companies that focuses on products that aren’t individually all that expensive (many of its products cost in the hundreds of dollars or less), but are nevertheless mission-critical. Couple that with strong engineering capabilities that has led to products with demonstrated performance quality and customers aren’t as likely to switch away from Gates to save a few dollars – more than 40% of the company’s sales (company-wide) come from products where they have #1 share and more than 80% of sales come from products with top-three market share.

With end-market recoveries across a range of markets including autos, heavy equipment (agriculture, construction, and mining), industrial automation, and so on, Gates should be looking at improving volume growth for at least the next year or two. On top of that are ongoing share growth opportunities driven by new product development.

One such example is a long-term “chain to belt” transition opportunity that management has sized at over $17B. Belts have 3x to 4x longer useful lives than chains in power transmission applications, they’re more efficient, and they’re safer. This is a multi-year opportunity, and some markets will likely never switch over (or not in a timeframe within my forecasting window), but it’s a meaningful opportunity to produce growth above and beyond the underlying cycle.

Fluid Power Offers A Similar Story

While Gates’s Fluid Power business has some important differences, including modestly lower aftermarket leverage and lower market share, it too is a short-cycle cyclical business with a materials science/product innovation share growth kicker.

Hoses, tubes, and fittings are used in a wide range of industries and product types, and again these are products that individually don’t cost a lot but carry high costs for failure. Gates typically has low single-digit market share in most of its target markets, but has been developing new products like premium high-pressure hoses to expand its addressable opportunities.

One small caution I’d note is this – both Eaton (ETN) and Parker-Hannifin (PH) have been deprioritizing their hydraulics businesses. Eaton is selling its Hydraulics business to Danfoss, while Parker has been prioritizing other areas of the business for growth reinvestment. This is a mixed development in my view. On one hand, less competition from well-run rivals is a potential opportunity for Gates. On the other hand, when well-regarded companies are trying to reduce their exposure to a market, it’s reasonable to contemplate why that may be.

EVs Should Be No Worse Than A Wash

With over 45% of sales coming from the auto market, the combustion engine to EV transition is relevant here. First, I think it’s important to point out that more than half of auto sales are aftermarket sales, and those will fade more slowly. Second, while xEVs will change the make-up of the business, the net impact looks pretty manageable.

Gates currently generates about $145 to $205 of content on cars with international combustion engines, with around $80-$120 from Power Transmission and $65-$85 from Fluid Power. With xEVs, the overall content isn’t too much different (around $140 to $190), but the split flips to $80-$110 for Fluid Power and $60-$80 Power Transmission. Although Power Transmission is a more profitable business for Gates overall, I don’t think the ICE-EV transition will be all that problematic for the business.

A couple of other points are worth mentioning. First, Gates has had content on all models from Tesla (TSLA). Second, the biggest opportunity for Gates would be in hybrids (opportunities for actual content growth), but at this point it doesn’t look as though many OEMs are all that interested in hybrids as opposed to BEVs.

The Outlook

There are some other issues here to consider. First, the leverage is quite high at over 3x the sell-side average EBITDA estimate for 2021. That’s not as problematic going into a recovery cycle, but it is a concern and it will limit the company’s flexibility on M&A.

Second, Blackstone (BX) owns 85% of the shares and will eventually look to sell down that stake.

I would also note that Gates’s financial numbers are not exceptional. Low-to-mid teens operating margins are nothing particularly special, and I’m only looking for around 250bp of EBITDA margin improvement from 2019 to 2023. With that, neither the ROIC nor the ROA are particularly impressive either. These aren’t end-all be-all metrics, but valuations for industrial stocks do tend to correlate with margins and returns.

I like the leverage Gates has to this short-cycle recovery, and I also like more company-specific growth opportunities like the chain-to-belt replacement opportunity and the opportunity to use enhanced new product development (management is targeting an improvement in its vitality index, or the measure of revenue contributions from new products, to 25%-plus from 10%) to drive share growth in existing markets and enter new markets.

I’m looking for pandemic-adjusted long-term revenue growth of around 3.5%, which does imply growth above the underlying economic cycles, and I could see another 100bp of outgrowth on better execution. I’m looking for margins to improve to drive FCF margins into the low double-digits relatively soon, but I think mid-teens FCF margins will be a tough target to reach. Even still, that’s enough to support mid-single-digit FCF growth.

The Bottom Line

Based on those assumptions, the long-term total annualized return potential from Gates isn’t so exceptional. Interestingly, though, the shares do look more undervalued on a shorter-term margin-driven EV/EBITDA basis (even though the margins aren’t exceptional), with upside to around $19.

I believe this may be a byproduct of the market getting a little more cautious with names seen as early-cycle plays. Time will tell whether this cycle plays out like past cycles, but I do think Gates could have some near-term outperformance potential on the strength of the recoveries in its served markets.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[falconcraig]

$19 was the IPO price in January of 2018...ho hum..