Gates Industrial (GTES): Potential Synergies And Future FCF Generation Makes Me a Buyer

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Currently investing in the new electric mobility revolution, and serving home fitness applications, Gates Industrial (GTES) will most likely experience revenue growth in the coming years. I appreciate that management promised M&A acceleration and internationalization efforts. Putting everything together, future free cash flow implies a valuation that is significantly higher than what the market is currently discounting. Despite supply chain risks and impairment risks, I am a buyer of shares.

Gates Industrial

Gates Industrial is a manufacturer of transmission and fluid power solutions. In both business segments, the company appears to target a massive market, which, management believes, could be larger than $63 billion. Given the current market share reported, I believe that there is significant room for business growth:

Investors Presentation

Investors Presentation

Investors Presentation

Investors Presentation

The company’s business model is quite diversified because Gates targets clients from different industries. It means that the company’s revenue will most likely be stable. If one sector does not perform, Gates may sell in other industries, so revenue volatility wouldn’t affect much:

Our products are used in applications across numerous end markets, including off-highway end markets such as construction and agriculture, on-highway end markets such as transportation, diversified industrial, energy, automotive, consumer products and many others. Source: Annual Report

Our net sales have historically been, and remain, highly correlated with industrial activity and utilization, and not with any single end market given the diversification of our business and high exposure to replacement markets. Source: Annual Report

I also appreciate quite a bit the fact that Gates Industrial reports a lot of recurrent revenue. The company’s most relevant business comes from replacement channels, which offers not only recurrent revenue, but also high margin figures:

The majority of our net sales came from replacement channels, which provide high-margin, recurring revenue streams and are driven by attractive market trends. Source: Annual Report

Approximately 64% of our net sales were generated from replacement channels and 36% from first-fit channels globally. Source: Annual Report

With that, in my view, the most appealing feature about Gates is the company’s growth opportunities in the new electric mobility revolution and home fitness applications. If management invests sufficiently in these growing sectors, in the next five to six years, I would be expecting revenue growth to trend north.

Future Guidance Appears Quite Optimistic

I need to mention the mid-term targets delivered in the most recent quarterly report. I appreciate that management is giving a lot of details about its future expectation. The company expects to achieve sales of $4 billion, adjusted EBITDA margin of 24%, and net leverage around 2x. These fantastic figures will be supported by an acceleration in the number of mergers and acquisitions, expansion of earnings, and transformation of the product portfolio.

Investors Presentation

Investors Presentation

My Base Case Scenario Includes Internationalization And More Recurrent Revenue

Under my base case scenario, I expect that the company will continue to benefit from the recurrent revenue coming from the replacement channel. I appreciate the company’s recurrent revenue because making free cash flow estimates is easier.

Besides, I would also expect certain internationalization efforts. In my opinion, with know-how acquired in North America, management will most likely be able to report sales growth in Europe, Asia, and South America. Notice that there is significant room for improvement because in the last annual report, North America was responsible for close to 50% of the total amount of sales:

Annual Report

Annual Report

The company expects to obtain 2% to 3% sales growth from new installed capacity, geographic expansion, and new products. If we also include M&A growth, management believes that the company could grow 5%-8% above market growth:

Investors Presentation

Investors Presentation

Even with the previous assumptions of the management, I would stay very conservative. I assumed 6%-8% sales growth from 2022 to 2028. It means that we would reach $4 billion by 2024, and 2028 sales would equal $5 billion. I also included net income of $362-$548 million.

My Figures

My Figures

With depreciation and amortization of $251-$396 million and changes in working capital of -$130 million, I obtained FCF of $0.776-$1.36 billion. The net present value with a WACC of 7% would be equal to $5.37 billion. The current market capitalization is equal to $4-$5 billion, so I would say that the company does look undervalued:

My Figures

My Figures

Ycharts

Ycharts

If we want to be extremely conservative, I believe that we could be using an exit multiple of 9x. Keep in mind that in the past, Gates Industrial Corporation traded at close to 8x-18x:

Ycharts

Ycharts

If we use an exit multiple of 9x, and assume 540 million in cash, debt of $2.74 billion, and 291 million shares, the implied stock price would be equal to $37.6. Hence, I believe that the current valuation of $11-$21 appears quite cheap. I will be buying shares:

My Figures

My Figures

My Best Case Scenario Would Also Include New Innovations

Already with more than 2,400 patents, Gates Industrial continues to invest a considerable amount of money in new products. I am quite optimistic about future products and the results from the company’s R&D efforts. Under this case scenario, I will expect that new innovations will most likely lead to sales growth:

Applied R&D is important to our businesses and integral to our leading market positions. We have engineering teams in the U.S., Canada, the U.K., Germany, Spain, Poland, Turkey, Japan, China, Brazil, India, Mexico, Korea and Thailand that focus on the introduction of new and improved products with a particular emphasis on energy efficiency, safety, the application of technology to reduce unit and operating costs and improving services to our customers. Source: Annual Report

In this scenario, I assumed net sales of 10% and an EBITDA margin of 23%, which implied 2028 EBITDA of $1.505 billion. The company’s EBT/Sales would stay at 10%, and 2028 net income would equal $635 million:

My Figures

My Figures

With the previous assumptions, I believe that the WACC would be significantly lower than that in the previous case scenario, so I used a WACC of 5%. Keep in mind that traders would buy more shares when management reports 10% sales growth.

If we also include capital expenditures of $100 million, which management promised in the last report, the free cash flow would stand at $900 million and $1.650 billion. Finally, if we assume an exit multiple of 15x, $540 million in cash, and debt of $2.7 billion, the implied stock price would equal $75.5. Under this case scenario, the upside potential appears quite significant:

My Figures

My Figures

Balance Sheet Analysis: Significant Amount Of Goodwill

As of October 2, 2021, Gates reported $540 million in cash, which, in my view, management will be able to use for acquisition of new targets. The total amount of goodwill is massive, which stands at $2.07 billion, and represents a beneficial opportunity for growth. In my view, if management has calculated the valuation of targets correctly and expected synergies are true, free cash flow will most likely grow. Finally, with $1.6 billion in intangible assets, in my view, the company owns a lot of accumulated know-how, which will help management maintain market share in existing markets.

With respect to the company’s financial obligations, I wouldn’t worry much. As of October 2, 2021, the company reports debt worth $2.54 billion, lease liabilities worth $118 million, and post-retirement benefit obligations worth $131 million. If we assume that Gates will soon report $4 billion in sales and an EBITDA margin of 24%, in my view, the company will most likely reduce its debt levels soon.

Impairment Risk And Supply Chain Risks

Among the different risks, in this case, I am concerned about the goodwill impairment risk. Take into account that goodwill and intangibles comprise more than 51% of the total amount of assets. Let’s consider some numbers to understand the magnitude of the risk. If accountants decide to reduce goodwill and intangible assets by 20%, the reduction in the total amount of assets could be reduced by 10%. If the assets per share decline by 10%, I am sure that the stock price would decline accordingly.

I would also highlight that Gates Industrial Corporation is especially vulnerable to supply chain risks and negotiations with key suppliers. In the last annual report, the company clearly reported that it suffered delays and production limitations. In the worst case scenario, I would expect a significant decrease in the company’s free cash flow. As a result, the company’s fair price may decline significantly:

A significant disruption in service within our operations, among our key suppliers and supply chains, or other third parties. We have experienced instances of suppliers temporarily closing operations, delaying order fulfillment or limiting production. Continued disruptions, shipping delays or insolvency of key vendors in our supply chain could make it difficult or more costly for us to obtain the raw materials or other inputs we need for our operations. Source: Annual Report

Conclusion

Currently investing in the new electric mobility revolution, and with products serving home fitness applications, Gates will most likely experience revenue growth. I am quite optimistic about the company’s accumulated goodwill and the promises about M&A acceleration. If the company acquires more targets, and synergies are not lower than expected, I would be expecting free cash flow growth. With all, yes I see some risks coming from impairment of intangible assets and supply chain risks. However, in my opinion, the current valuation is not at all justified. Future free cash flow justifies higher price marks, so I am a buyer of shares.

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