Gates Industrial: Robust Margin With Plans For Market Extension (NYSE:GTES)

Dmytro Varavin Synopsis Gates Industrial Corporation plc (NYSE:GTES) focuses on highly engineered power transmission and fluid power solutions, serving customers across 130 countries. Over the past few years, its revenue growth rate has been decelerating. Despite flattish revenue growth, margins have been improving all along. They have also been capturing opportunities into data centre cooling, which allows them to leverage their technical expertise to provide solutions for growing demand in data centres. With the rising infrastructure building activity outside of the U.S., GTES would be able to capitalise on the rising demand for heavy-duty equipment with their international operations. I would recommend giving GTES a buy rating, given its strong potential upside. Historical Financial Analysis Author’s Chart Since FY21, GTES’ year-over-year revenue growth has declined. FY23’s total revenue increased from $3.55 billion to $3.57 billion, reflecting a 0.45% growth with its core revenue growth at 0.7%. The slight increase in revenue growth is due to pricing efforts, partially offset by lower volume. Automotive, energy, construction, and on-highway segments reported solid core growth, but a decline in personal mobility and diversified industrial segments negated these gains. Automotive replacement sales significantly contribute to the core sales growth, with the majority of this growth occurring in EMEA, China, and South America. Sales for the industrial market have fallen by 3.2% year-over-year. FY21’s significantly high growth rate of 24.4% is largely due to the significant impact of the pandemic, primarily driven by a rebound in industrial demand. Author’s Chart Moving on to the profitability margins, it appears that adjusted EBITDA and adjusted net income have remained consistently robust over the years. There has been an improvement in margins in FY23 compared to the prior year. Gross profit margins have increased by 2.9%, driven by strong commercial and operational execution. The adjusted EBITDA margin improved by 1.8%. FY23’s increase in profitability was a key driver for their ~20% growth in adjusted EPS, from $1.14 to $1.36. FY22’s profitability margins were in decline due to inflationary pressures and the absorption of fixed costs due to supply chain inefficiency. Overall, GTES has exited FY23 on a high note with good momentum, driving further expansion in profitability margin for FY24 as they focus on material cost reduction and productivity enhancement. First Quarter Earnings Analysis As reported on May 1, GTES 1Q24’s net sales fell by 3.9% year-over-year from $897.7 million to $862.6 million, missing estimates by $2.74 million. This includes declining core sales by 3.6% and 0.3% due to unfavourable FX impacts. Automotive replacement channel core sales have increased slightly, while its first-fits channel is experiencing double-digit declines. There are significant declines arising from Personal Mobility and Agriculture end-markets which are partially offset by growth in Automotive and On-highway end-markets. Despite a decrease in revenue, GTES has demonstrated operational efficiency with expanding margins. Adjusted EBITDA has grown by 3.3% year-over-year, from $174.5 million to $195.6 million. Higher adjusted EBITDA margin from 19.4% to 22.7% due to the firm’s restructuring initiatives that have positively impacted manufacturing performance, offsetting the weaker volume. Adjusted net income per dilute share has increased from $0.25 to $0.31, reflecting a year-over-year growth of 23.4%. Segment Revenue Author’s Chart GTES is a global manufacturer of engineered power transmissions and fluid power solutions. Its products are sold in over 130 countries, with 51% of FY23 sales outside of North America. Its business can be segregated into two segments: Power Transmissions and Fluid Power. Power transmission accounts for 61%, while Fluid Power accounts for the remaining 39% of FY23 net sales. GTES’s solutions are used across multiple end-markets, such as automotive replacement, the first-fit end market, industrial on-highway and off-highway applications, diversified industrial, energy & resources and personal mobility. GTES provides a wide range of products in the replacement channel and specified components to original equipment manufacturers. 64% of FY23 net sales are derived from the replacement channel. GTES caters to a large customer base with equipment that adheres to their maintenance cycle. The remaining 36% of GTES works with original equipment manufacturers, also known as first-fit customers. Market Extension Towards Data Centers Cooling The firm has mentioned opportunities in data centre cooling, seeing it as an emerging and significant opportunity to drive incremental growth for the next three- to four years. In addition, GTES has partnered with CoolIT Systems, a leader in liquid cooling technology, to develop liquid cooling solutions catered to AI and high-performance computing. With GTES’s extensive expertise in thermal management applications and their existing portfolio, it is able to participate in data centre cooling with their electric water pumps and fluid conveyance solutions. At the moment, they are in the process of launching their fully refreshed liquid conveyance that is targeted towards data centre applications, specifically hyperscale data centers. Data centre infrastructures are built with greater power density to enable AI, resulting in energy-intensive GPUs and TPUs generating a significant amount of heat, necessitating the use of advanced environmental control systems such as liquid cooling solutions, which GTES can offer. Further Growth Outside of North America While nearly half of GTES’s net revenue is derived from North America, GTES’s products are also sold in Europe, the Middle East, Africa, Greater China, East Asia, and India. GTES has a strong presence across these regions, and they should capitalize on ongoing opportunities across these regions. In Europe, GTES’s personal mobility business would be strategically positioned for the growing demand for electric two-wheelers. For East Asia and India, infrastructure investment as a proportion of GDP is anticipated to rise in India through 2028. In comparison to five years ago, the government’s investment in infrastructure has more than tripled to over $132 billion for FY25. Modi has planned for spending of 143 trillion rupees to upgrade ports, railways, roads, and many other infrastructures. With infrastructure builds ramping up in India, demand for heavy-duty equipment will follow. With GTES’s already strong presence there, these infrastructure build-outs presents a substantial growth opportunity for GTES throughout the next few years. Bloomberg Relative Valuation Model Author’s Relative Valuation GTES competes in a very fragmented market, facing competition in all of their markets and product categories. While there are numerous competitors in each of GTES’s markets and product offerings, none of the competitors can compete with GTES’s comprehensive range of product offerings, global presence, or end markets. In my relative valuation model, I will be comparing GTES against its peers in terms of growth outlook and profitability margins trailing twelve months [TTM]. For growth outlook, GTES has shown the weakest forward revenue growth rate of 1.39% and underperformed its peer’s median of 7.18% by a huge margin, representing 0.19x over the median. Moving onto profitability margins, GTES’s EBITDA margin is relatively higher among its peers, with an EBITDA margin TTM of 20.15%, which is 1.06x time over its peers’ median of 18.96%. Its net income margin TTM is at 6.97%, a slight underperformance against its peers’ median of 7.99%. Currently, GTES is trading at a forward P/E ratio of 11.74x, while its peers’ median is trading higher at 17.91x. Despite a relatively robust EBTIDA margin TTM in comparison to its peers, GTES underperformed in terms of growth outlook and net income margin TTM. I argue that it is fair for GTES to be trading at a lower P/E ratio. Based on management guidance, GTES has raised their adjusted EBITDA guidance for FY24 from $725–805 million to a range of $745–805 million, given its strong margin expansion in this quarter. FY24 market revenue estimate is at $3.53 billion, while its EPS is at $1.40. For FY25, the market revenue estimate is at $3.70 billion, while its EPS is expected to be at $1.66. Market estimates are justified given the growth catalysts that I have discussed earlier. Applying my target P/E of 11.74x to its 2025 EPS estimate, my 2025 target price is at $19.49, reflecting an 18% upside potential. Risks & Conclusions A significant share of GTES’s revenue is outside of the US, with ~51% being derived from EMEA, China, East Asia & India, and South America. GTES also sources its materials from China, India, and Eastern Europe, making its operation susceptible to economic and political volatility. The availability of raw materials has fluctuated during the Russia-Ukraine conflict. This event has resulted in the suspension of Russia’s operation, leading to restructuring expenses and a decrease in sales of ~2%. In addition, the ongoing uncertainty surrounding the current trade tensions with China remains a threat to GTES’s future performance. As of today, GTES has a strong competitive advantage with its global presence and product availability. With its steps taken to enter the evolving data centre cooling market and expanding opportunities outside of the U.S., I would recommend a buy rating for GTES given its strong potential upside.

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