Good day, ladies and gentlemen, and welcome to the Gates Industrial Corporation Q4 2018 Earnings Conference Call. Currently at this time, all participants are in a listen-only mode. Later, we will conduct the question-and-answer session, and instructions will follow at that time. [Operator Instructions] Also as a reminder, this conference call is being recorded. At this time, I'd like to turn the call over to your host Bill Waelke. Please go ahead.

Thanks, Wilhelm, and thank you everyone for joining us on our fourth quarter 2018 earnings call. I'll briefly cover our non-GAAP and forward-looking language before passing the call over to Ivo, who's here today along with our CFO, David Naemura. After the market closed this afternoon, we published our fourth 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. On this call, we will refer to certain non-GAAP financial measures that we believe are useful in evaluating our performance. A reconciliation of these non-GAAP financial measures is 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 and answers 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 or implied by such forward-looking statements. These risks include among others matters that we have described in our annual report on Form 10-K and in other filings we make with the SEC. We disclaim any obligation to update these forward-looking statements which may not be updated until our next quarterly earnings call if at all. With that, I'll turn things over to Ivo.

Good afternoon, everyone. Thank you for joining us to discuss our fourth quarter 2018 results. Let me start with a summary of the key highlights from the quarter beginning on slide 3 of our presentation. We are pleased to report another strong quarter of performance. We generated revenues of $792 million, which represents a record fourth quarter for Gates. Our core revenue growth was 3.5% over the prior year, which was partially offset by foreign currency translation headwind of 3%. During the fourth quarter, we experienced solid growth from our industrial end markets. We believe that our broad portfolio of high-performing products and the global footprint are allowing us to supplement market growth with share gains which have been seen with particular outperformance in our hydraulics product line. In total, our industrial sales grew 7.7%. We also had a strong performance in the automotive replacement channel particularly in emerging markets where we continue to build out our distribution base and market-leading product coverage. Our automotive aftermarket channel grew 7.3% globally including double-digit growth in emerging markets. This growth in industrial end markets and automotive replacement channel more than offset the significant revenue decline of 12.7% in our automotive first-fit channel which was concentrated in China and Europe. We had anticipated a large portion of this decline when entering the quarter, but some of it was more significant than we have thought. I will touch more on this in our regional commentary next. North America, which is our largest individual region delivered strong core revenue growth in the quarter at over 8%, driven by strength at nearly all industrial end markets, as well as another quarter of outperformance in the automotive replacement channel. In Europe, we experienced strong demand across industrial end markets, particularly at first-fit customers. This growth was offset…

Thanks Ivo. I will now cover our financial performance beginning on slide 8 where as Ivo mentioned you can see the record fourth quarter results in revenue, adjusted EBITDA and adjusted EBITDA margin. Core revenue growth was 3.5% in the quarter, while acquisitions contributed only an additional 70 basis points of growth with Atlas having gone core at the end of the prior quarter. Foreign currency was a headwind of 3% resulting in total revenue growth of 1.3%. The core revenue growth reflects continued strong demand in our industrial end markets where we had growth of nearly 8%. The construction and agriculture end markets were supportive, particularly as it relates to mobile hydraulic Fluid Power applications and we saw broad-based demand in our general industrial business. Further, our automotive replacement channel grew over 7% globally with double-digit growth in emerging markets, particularly China. The core growth in these channels was partially offset by a 12.7% decline globally in our automotive first fit channel, driven by declines in EMEA and China, as Ivo discussed. Aside from these specific challenges in automotive first fit, the business environment remained healthy with the rest of the company experiencing 7.5% core growth in Q4. Price cost was again favorable in Q4, consistent with the trend we've experienced throughout the year. Our adjusted EBITDA of $186 million was an increase of $13 million or 7.4% over the prior year quarter. Our adjusted EBITDA margin was 23.5%, a significant increase over the prior year Q4 and reflective of what turned out to be very high fall through in the quarter. On a core basis our incrementals were about 50%, which is about 15 points higher than we would have expected to see. This was a function of continued favorable price cost and favorable mix resulting from the…

Thanks David. We delivered solid results in 2018, our first year as a public company. The Gates team executed well globally and as a result, we delivered record results in a dynamic environment while effectively executing a number of large initiatives. The diversity of our business model served us well. Our industrial end markets and replacement channels remained supportive which allowed us to deliver solid core growth of 5.9%, despite the headwinds from certain auto first-fit markets. I would like to thank our global Gates team and congratulate them on their performance in delivering our upward realized guidance, despite the challenges we faced in the second half and particularly in the first -- fourth quarter. We demonstrated the ability not only to maintain positive price cost economics, but also to continue expand our adjusted EBITDA growth and incremental margins, particularly when adjusting for the impacts of FX and acquisitions. Focused execution remains our top priority. In 2018, we dedicated a significant amount of capital to large strategic initiatives which will serve us as a foundation for growth in 2019 and beyond. New product introductions are moving forward at an accelerated pace and will support our growth targets and reinforce our position as value-adding partner to our global customers. Despite significant investment in the business in 2018, we continued our path of deleveraging and we have a line of sight to being below three times leverage by the end of the year. The regions and end markets where we have the majority of our business are performing well. Our outlook for 2019 reflects solid core growth and margin expansion as well as significant improvement in free cash flow conversion. Moving forward a conversion rate that is more representative of our business model. We are excited both by the progress we have made and the opportunities that remain ahead and we look forward to demonstrating the merits of our business in the coming years. With that, we will now turn the call back over to the operator to open up the Q&A.

Thank you sir. [Operator Instructions] Our first question comes from Andrew Kaplowitz from Citi. Please go ahead.

Good evening, guys. It’s Alan Fleming on for Andy.

Good evening.

Ivo let us start on the auto replacement. Can you talk about your visibility here on that side of the business? I mean last quarter I think auto replacement demand was up 7%. It was up another 7% this quarter. Obviously, it looks like the U.S. or North America is hanging in there and China is quite strong. Is there any reason why you can't continue to deliver kind of this mid-single-digit type growth on the global auto replacement demand in 2019? And do you see these trends kind of holding steady?

Look at this point in time we feel pretty constructive about what's happening with the automotive replacement business. As we've discussed we are doing quite well in China where we continue to build out our portfolio, build out our presence with channel partners. North America and Europe continue to have a supportive market dynamic, particularly driven by the 2009, 2010 decline of car registrations and the fact that the sweet spot for our demand is in that seven to 11 years which we finally turned that leaf over of the declines from 2009. So, although we will not provide additional guidance to that level, we feel reasonably positive about where we sit with the auto replacement business that we have.

Okay. And flipping over to China and the industrial demand your comments there about maybe seeing some pressure from export-related demand. Is it possible that China industrial gets worse before it gets better in 2019? And what kind of uncertainty or risk have you factored into the guidance for the possibility that we don't get a U.S./China trade deal and demand could deteriorate further?

Look, I think that we've tried to highlight some of the risks that we see. I would tell you that we probably see more uncertainty with the exporters and particularly not buying, not building inventory because they don't want to be stuck with any products in case that the trade conflict doesn't get resolved over the next three to six months. But outside of that I think that we are being pretty realistic about what that market environment looks like. And we're really not counting on any significant rebound in Q1 in particular. And I think that we have taken that into account for -- in our guidance for 2019.

Okay. I'll leave it there. Thanks, guys.

Thank you.

Thank you. Our next question comes from Jeff Hammond from KeyBanc Capital Markets. Please go ahead.

Hey, good afternoon, guys.

Hi, Jeff.

Hi, Jeff.

Hey. So, just on auto first-fit I just -- maybe if you can bifurcate the level of weakness in 4Q in China and Europe, and then how you see those playing out? I think you mentioned China weakness but are you seeing Europe stabilizing?

Sure. Let me start with the fact that Europe and China are two largest automotive first-fit businesses as we have indicated in the past. And frankly one of the things that kind of a nuance for us is that in Q4 in particular that quarter is more heavily weighted as an automotive first-fit quarter due to the regular seasonality. So when you think about our Q4 results they're kind of disproportionately impacted by the China and Europe weakness in Q4 Well, in Europe we've counted on good amount of that decline particularly because we have the visibility on the programs that are rolling off and that is aligning to our strategy that we have communicated from basically the time that we hit the IPO road show. We thought that we want to be very selective in how many programs we're going to take. So I think about half of that decline being planned. The emissions testing standards that were implemented had a larger impact than what we initially thought. And we really anticipated that that's going to get resolved as we entered the fourth quarter and -- or exit the fourth quarter and we really have -- still seeing a reasonably good impact of that emissions testing process being deployed. And that's how we think about the auto decline in Europe. So reasonably weak and again half planned, half maybe little less expected. For China, we came through a very tough compare as we mentioned on the Q3 earnings call. And the market frankly was softer -- a little bit softer than what we have anticipated not -- again not just in the auto first-fit business but also in the industrial sales as we have highlighted in our prepared remarks. It is worth noting though that we are seeing healthy double-digit growth in replacement channels for both the automotive and industrial end markets. So look we feel that we are set up pretty nicely to weather the current automotive first-fit weakness and frankly the trade war headwinds. And look as David noted, we believe that we see some further deceleration in China particularly in Q1 and this current environment frankly is contemplated in our guidance. So that's kind of how we feel about auto.

Okay, great. And then, just can you talk about order rates in the Fluid Power business? Clearly, top line was strong, but I think some of your peers showed some deceleration. Just talk about order momentum in that business.

Look, we don't provide guidance on order rates, because frankly we don't really track order rates. So as we said, we're not a backlog business. We have book and ship business. But what we have seen in kind of exiting the year is what we have seen at the beginning of this year and that's probably where I would leave it at.

Okay. And then, just on the 3% to 5% core, do you expect both segments -- I know, you don't give segment guidance, but do you expect both segments to be in that 3% to 5% range?

We would expect Fluid Power to be higher than Power Transmission consistent with how we have run the last few years. Maybe not as exaggerated as we've seen in the last kind of year-and-a-half, but we would expect that the growth to be higher.

Okay. Thanks, guys.

Thanks, Jeff.

Thank you. Our next question comes from Julian Mitchell from Barclays. Please go ahead.

Hi. Good evening.

Good evening, Julian.

Good evening. Maybe just the first question around the free cash flow. I guess you have that base free cash flow of sort of 130-ish in 2018. Is it right that you're guiding for sort of 300-plus in 2019? And if that's correct and then maybe flesh out some of the moving parts. I guess CapEx is dropping $30 million or so year-on-year, but what are you expecting around working capital? For example, does that become an actual cash -- a big cash inflow in 2019?

Julian, I think, the $300 million, you're kind of in the zone. I think we have shown us returning to conversion levels, kind of consistent with how we've historically operated. Big pieces are going to be EBITDA dollar growth. Secondly, on the working capital side, we run at a pretty high percentage of revenues. We look to improve that year-over-year, but the bigger drivers are revenues. So with 10% revenue growth last year, we provided a lot of working capital dollars. That will obviously be lower this year. And then the other component would be from reduction to you point of around $30 million in CapEx. So I think that would get you close.

Thanks. And related to that, the CapEx in 2020, does that return to a sort of normalized level at that point?

Yes. We've always said the business should run around 3% of sales plus or minus. And actually, I think, what you see is us walking our way back towards that and I think we'll continue to cut down a little bit, as a percent of sales in 2020 from 2019.

Thank you. And my second question really around the organic sales guide the 3% to 5% sort of core assumption. Is the right way to think about that, you're at the bottom end of that range in Q1, which steps down a little bit from Q4, because you're assuming China maybe gets a little bit worse. And then you're at the top end plus of that range in the second half of the year. Is that the right way that you're modeling it?

Yes. I think directionally that makes sense. I think we see the second half a little stronger than the first half. And with the China weakness coming out of the year, that's quite directionally right, Julian.

Great. Thank you very much.

Thank you.

Thank you. Our next question comes from Deane Dray from RBC Capital Markets. Please go ahead.

Thank you, good afternoon everyone.

Hi Dean.

I just want to circle back on auto first-fit. Does the headwinds you saw this quarter change your appetite in any way, your exposure to first-fit auto? You're growing so many other markets faster and I know you turned down more business in auto first-fit than you actually take, but is there any change in your appetite here based upon the quarter?

Deane, I don't think that we've -- we are changing the perspective on the auto business. I think that we are being consistent with what we said. We're going to be -- we are continuing to be very, very selective in what business we take. I think as we've recently released an announcement out there on several really interesting new technologies that we believe will offer a highly differentiated performance for auto first-fit customers that should allow us to take business at very nice premium margins to kind of more of the -- more what the historical business has been and continue to support the automotive replacement business as we go forward. But we don't really feel that we want to be taking it out of auto first-fit business. And as you very correctly stated our interest is continue to outperform in industrial and continue the evolution of our portfolio heavily weighted towards that industrial set of applications.

That's real helpful. And then on Fluid Power, you've talked in the past several quarters about this global capacity shortage. And you've brought capacity on pretty smoothly here. Is there still that shortage? Because now you're also talking about the ability to go after some of your underperforming plants and I presume some of that is in Fluid Power. But just where is the equilibrium right now in capacity and demand in Fluid Power?

Look we've brought a significant amount of capacity on-stream. And so we see several of our product lines to come more towards that equilibrium. We do still have some product lines that are constrained and we expect that, that's going continue certainly throughout the first half of the year. We continue to not necessarily add capacity, but get more productive with the existing set of assets that we have to release some of those constraints and assist our customers with their needs to build their products. But we are -- we feel that we're in a lot better shape exiting 2018 and entering 2019 capacity-wise.

Got it. Yes. Go ahead David.

Well you asked about the footprint. I would say you're right about that that would provide us a few opportunities probably on Fluid Power side as we get more into it.

Good. And then just I might have missed it in the 2019 guidance, but can you comment on tax? And was there anything unusual about those discrete tax items in the fourth quarter?

The fourth quarter was -- there were a host of new rates that dropped in the fourth quarter and they gave us line of sight to utilizations for foreign tax credits that we previously didn't have line of sight to so that resulted in some VA releases in the fourth quarter. For next year, I think kind of a more normalized tax rate of -- effective tax rate of around 25% and maybe 20% -- 25%, 27% on a cash tax basis.

Thanks guys.

Thanks Deane.

Thank you. Our next question comes from Jerry Revich from Goldman Sachs. Please go ahead.

Hi, good afternoon, and good evening, everyone.

Hi, Jerry.

I'm wondering, if you could talk about the manufacturing footprint plan a bit more. So let's say on the Fluid Power side of demand call it about flat over the course of 2019. To what extent, do you have an opportunity to accelerate that rationalization program? And can you talk about what the longer-term opportunities are moving towards that larger scale campuses as you mentioned as they eventually over time displace some of the smaller locations? What are the unit economics of improvement there?

Look, we will not be making any announcements on this call about footprint rationalization, but as you mentioned we do have some opportunities particularly driven sort of productivity improvements sort of the deployment of our Gates Operating System. We did scale up those campuses so that gives us some opportunities to look at some future plant consolidations. Look I think that the Turkish plant is a really good example, right? We had a subscale facility. We opened up a regional facility that's of scale and we flowed the demand into the new facility. There are many others that we will pursue over the next few years. And when we are ready, we will make an announcement on what those are.

Thank you.

Our next question comes from Josh Pokrzywinski from Morgan Stanley. Please go ahead.

Hi, good evening, guys.

Hi, Josh.

Just a first question. Ivo, you talked a little bit about some reluctance from some of your customers to take on inventory ahead of trade resolution or not really knowing the state of play there. Maybe comment more broadly on what you're seeing in inventory? Was there anyone who is on the other side of it who is perhaps pre-buying ahead of tariff? Just trying to understand where they may be ebb and flow with the channel. I guess any commentary across the different end markets and geographies would be helpful.

Yeah. So Josh, my comment was particularly directed towards the inventory not being taken up by the export-oriented manufacturers in China that was the comment that I was making. We – kind of the more general comment, we really don't see any significant build out in channel inventory. I'd probably say that, we haven't really seen any, but there may have been some that we have not been able to visualize. So we think that in Fluid Power the inventories are reasonably lean. On Power Transmission, we again did not see any pre-buys either. So I would not be in a good position to be able to give you any outside of this commentary on any trade-related pre-buys associated with our products.

Got it. That's helpful. And then just following up on the free cash flow and working capital question from earlier, Dave, if I understand it right it does sound like inventory is perhaps a little bit of a benefit at least directional benefit to 2019 on that 80% conversion. Does that mean normalized conversion is then below 80% or as CapEx comes down it kind of offsets that pull down of inventory? I'm just trying to conceptualize what the right rate is if we normalize everything going forward.

Yeah. I would say, what we consistently said Josh is that we're looking for kind of 50 basis points of improvement when we look at net working capital dollars as a percent of last 12 months sales. And we didn't see that this last year and that was really a function of some decisions we made around places we're going to build some inventory versus strategic actions as well as some continued inefficiencies associated with some of our fluid power activities. So -- and that includes having more hose on the water coming from China to the U.S. as we try to fulfill some of the higher demand to some customers here. But having said that, we think we'll get back to reducing that and then be a little more efficient and then the overall dollars won't grow as much as we did in the prior year as a result of the lower sales growth in 2019 as related to 2018. So all of those things, we believe are additive to this idea of getting back to over 80%, which is where we feel the business model should deliver free cash flow conversion in relation to adjusted net income. And I think to the earlier point the math would imply a significant step-up in free cash flow generation.

Right. So just I mean just to be clear on it short of getting -- giving 2020 free cash flow guidance, which I understand is absurd that number should be higher than 80% than the out-year as some of the mechanical items shift. I just want to make sure I'm not missing anything.

No. I think that's fair.

Okay. Perfect. Thanks for the call.

Thank you.

Thank you. Our next question comes from Jerry Revich from Goldman Sachs. Please go ahead.

Yeah, thank you. Can you hear me now?

Yes Jerry. We can. Sorry about that.

Okay, perfect. Thank you. No, it's probably on my side. So, Ivo, I just wanted to better understand the cost savings that you folks are going to achieve let's say on this Turkey example or another example of switching from a smaller facility towards the new campus approach. Can you just flesh out the opportunity set and what's the ultimate margin opportunity that that creates as we think about what the business will look like in next cycle?

Yeah. I think – Jerry, it's Dave. Using Turkey as an example, we think Turkey will provide net a couple of million dollars of savings per year. We can produce maybe a little more effectively but also we're able to eliminate some indirect and overhead. But that's an example of a very small footprint item probably our smallest. The way we've discussed internally and again I want to stop short of announcing anything here because we're still working on it. We think there's a good opportunity to average one or two a year for the next few years, and we probably look at those different regionally. And I think the idea would be now that we've got capacity at scale at sites in some of our other larger plants, Ivo alluded to productivity, which is enabling us to then further consolidate some activities. We'll look at how we can benefit to a rooftop of two. You'll add to that?

Yeah. And what I would add maybe, Jerry, is that we also as I think we have said on a couple of these calls is we are working on tremendous amount of new technology as well as new manufacturing technology, which should give us the opportunity to further drive productivity improvements to meet for additional manufacturing footprint and so on and so forth. So, we feel that there will be some good opportunities to drive further productivity.

And then, Jerry, regarding how that impacts the model, I'd say for us we look at -- like a payback of a Turkey opportunity would be very short probably a year, but most things are going to be in that one to two-year payback period. And they're reasonably decent scale and take time to execute, so that's why they would happen slowly over time, but that gives us the opportunity to drive a little bit of incremental gross margin. And frankly, we would use it to probably -- not necessarily drop through the bottom-line but go fund more go-to-market and R&D activities as we continue to kind of expand EBITDA margins in the mid-20s here.

Okay. And on the Fluid Power outlook for this year are there any meaningful discrete customer wins or any program tailwinds that we should be thinking about as we overlay what the demand looks like versus how it might look for you guys?

I would say that we continue to build a ton of opportunities in Fluid Power, Jerry. Again, frankly, that's an opportunity to be kind of getting to my soapbox about we build this Fluid Power capacity not necessarily to consolidate other sites. We build that Fluid Power capacity to be able to take more market share away. It's a giant market. We are a large player in that market, but we still have a reasonably small market share when taking into an account the regional presence and footprint. So, we're working on a significant amount of new opportunities, particularly in the regions that we're adding the capacity. So, we feel reasonably constructive about our opportunities in 2019 and beyond with Fluid Power.

I appreciate the discussion. Thanks.

Thank you.

Thank you.

Thank you. This concludes the Q&A session. At this time, I'd like to turn call over to Bill Waelke for closing remarks. Please go ahead.

All right. We appreciate everyone joining this afternoon and the interest in Gates. As many of you are aware the team here is always available to assist with any follow-up questions. We look forward to updating you after the first quarter. Thanks everyone. Have a good evening.

Thank you.

Thank you, ladies and gentlemen, for attending today's conference. This concludes the program. You may all disconnect. Good day.