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Gates Industrial Corporation plc  (NYSE:GTES)
Q4 2018 Earnings Conference Call
Feb. 12, 2019, 5:00 p.m. ET

Contents:

Prepared Remarks:

Operator

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 a 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, to Bill Waelke. Please go ahead.

Bill Waelke -- Vice President, Investor Relations

Thanks, Dan. 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 is 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 as 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 two 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 made 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.

Ivo Jurek -- Chief Executive Officer

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 the slide three 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 a 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 in a global footprint 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 had 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 a 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 by the significant weakness in automotive first-fit, resulting from a substantial planned ramp down of OEM projects that was further compounded by the market disruption from the WLTP emissions testing requirements. This has been little longer lasting and more impactful than we anticipated at first.

In China, we experienced mixed results. With double-digit growth across our replacement channels, which was offset by a decline in our automotive first-fit business. Automotive first-fit faced a very difficult compare as we have mentioned in our last earnings call and ultimately was still a bit weaker and in the quarter that we have originally anticipated. Our revenue in industrial end markets in China was impacted by slowing of sales to export-oriented customers, a function, we believe, of the ongoing trade dispute. Despite these headwinds, our Industrial business overall did grow modestly in China. Our automotive replacement channel continue to grow there in high-teens, a direct result of the significant growth in the aged car park, a dynamic that we expect to continue to assist our sales growth in that market for many years to come.

Now, turning to EBITDA. Our Q4 adjusted EBITDA of $186 million represents a record fourth quarter results for Gates. At 23.5% of sales, our adjusted EBITDA margin reflects 140 basis points of expansion over the prior year Q4.

Q4, sort of, final increment of our new fluid power capacity come online according to plan. Our new manufacturing facility in Poland is now producing in volume and commercial shipments have begun. Additionally, our focus on revitalizing our innovation capabilities resulted in further introduction of differentiated new products that offer customers compelling value and provide us with additional opportunities to drive future growth.

Finally, one of our unrelenting areas of focus is deleveraging the business. We made additional progress in this area during the quarter, reducing our net leverage to 3.4 times, while significantly investing in the business. David will cover this in more detail momentarily.

Moving to slide four. Our $3.35 billion in 2018 net sales represents a record for the company. Underlying our core revenue growth of nearly 6% was broad-based demand, driven by strength in our industrial end markets and strong sales in both the industrial and automotive replacement channels. This growth more than offset the mid single-digit decline in our automotive first-fit business for the year.

FX translation, despite becoming a meaningful headwind in the second half of the year, contributed 60 basis points to our full year revenue growth. Our revenue growth helped to deliver full year adjusted EBITDA of $756 million and an adjusted EBITDA margin of 22.6%, representing expansion of 60 basis points over the prior year and in line with the guidance we provided.

Our improved operating performance in combination with reduced interest expense and a lower effective tax rate contributed to our adjusted earnings-per-share growth of over 50%, which was delivered on a significantly higher weighted average share base.

In summary, we executed well in 2018. I'm proud of the Gates team for delivering record results in what was a complex environment, both from a macro perspective and a Gates-specific perspective, as we successfully undertook several major initiatives while managing through dynamic markets. The macro environments affected our segments differently in the year, which I will now cover in more detail.

Turning to slide five, and beginning with power transmission. Our power transmission segment experienced a revenue decline of 4.4% in the quarter, driven by negative FX impact and a core revenue decline of 1%. Revenue from industrial end markets as well as our automotive replacement channel grew high single digits in Q4 on a core basis. This growth was offset by a low double-digit decline in our power transmission automotive first-fit business, associated with a previously mentioned weakness in Europe and China.

Outside of our automotive first-fit business, our power transmission revenue grew approximately 4% on a core basis.

For the full year, total power transmission segment revenue grew 4.5%, consisting of 3.6% core growth and a small favorable impact from FX. Our power transmission revenues had notable growth in the energy and construction end markets as well as in the automotive replacement channel, particularly in North America.

In China, the segment experienced double-digit growth in sales to customers in the replacement channels. Outside of the automotive first-fit business, our power transmission revenue grew at a strong annual rate of nearly 7% on a core basis.

With respect to our chain-to-belt growth initiatives, we continue to refine our organizational capabilities and commercial approach globally. We had key wins during the quarter in wide range of applications, including personal mobility, automated storage and retrieval systems and material handling systems. We plan to provide greater insight into our midterm plan during the upcoming Investors Day in New York, later this month.

The power transmission segment adjusted EBITDA margins expanded by 90 basis points in Q4 compared to the prior year period, despite lower volume and FX headwinds. For the full year, the power transmission adjusted EBITDA margins expanded by 70 basis points, due largely to our revenue growth, favorable mix and positive price cost dynamics.

Turning to slide six. Our fluid power segment achieved another quarter of strong growth with total revenue increasing by 12.2% compared to the prior year quarter. On a core basis, fourth quarter revenue growth was 12.3%, including core revenue growth of 16% in our hydraulics product line with growth from acquisitions of 2.1% and FX headwind of 2.2%.

Industrial end markets demand drove broad-based growth across nearly all of our regions with the agriculture, general industrial and construction markets having the strongest performance, particularly in our largest region, North America. The segment achieved double-digit growth in both the first-fit and replacement channels with a replacement channel is growing at a slightly higher rate.

For the full year, fluid power total revenue growth was up 21% compared to 2017, consisting of approximately 10.5% growth in both core revenue and from acquisitions with negligible FX impact. We had double-digit core revenue growth across nearly all industrial end markets and in nearly all regions with our overall fluid power business in South America having the highest core growth rate at nearly 20%. The growth of our first-fit business outpaced that of replacement channels for the full year with double-digit growth in all regions.

As I mentioned earlier, our new hydraulic facility at our existing campus in Poland came online in Q4. As the plant continues to ramp up through the first part of 2019, it will support existing demand as well as market share gain opportunities in Europe where this is our first fluid power facility of scale on the continent. Concurrent with the opening of this new plant in Q4, we also announced the closure of sub-scale fluid power facility in Turkey. Our fluid power volume growth along with favorable price cost contributed to adjusted EBITDA margin expansion in both the fourth quarter and full year of 220 basis points and 70 basis points, respectively.

Now turning to slide seven. This is a summary overview of our 2018 core revenue growth by region. We experienced solid core revenue growth across most of our regions, led by South America, we saw double-digit growth in automotive replacement channel, as well as double-digit fluid power growth in all end markets.

Core growth in North America was also led by fluid power with double-digit growth in most end markets and a strong performance in the automotive replacement channel. Despite the Q4 weakness in automotive first-fit, China delivered 7% core revenue growth for the year. This growth was led by fluid power and a strong power transmission performance in automotive replacement channel in particular.

In the EMEA region, solid fluid power core revenue growth in industrial end markets and power transmission growth in the automotive replacement channel offset the significant automotive first-fit second half weakness.

Within our East Asia and India region, we had strong growth of 17% in India, where we experienced double-digit industrial growth, most notably in the construction and heavy-duty truck end markets. This growth offset a slight core revenue decline in East Asia, where among some other challenges certain industrial channels were constrained as we directed available fluid power capacity toward other regions.

Before I hand it over to David, I would like to touch on the topic of footprint consolidation opportunities. As we have operated Gates over the past few years, we have improved operations significantly but have not engaged in many site optimization or rooftop consolidation projects. Although our recent plant expansions have been based around campus concepts in China, Mexico and Poland, we still have significant number of facilities and belief that we have opportunity to optimize our overall footprint. We talked earlier about closing our sub-scale Turkey hose plant now that we have the Poland plant online. This is one example and we believe that we will have additional opportunities for self-help and we are actively looking at what activities we may want to undertake in the coming few years.

With that, I will now turn it over to David for some additional details on the financials.

David Naemura -- Chief Financial Officer

Thanks, Ivo. I will now cover our financial performance beginning on slide eight, 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 decline in our automotive first-fit business as well as some favorable items hitting on what amounted to a lower net revenue growth quarter exaggerating the fall through.

We grew adjusted net income to $0.36 per share on a diluted basis compared to $0.16 per share in the prior year quarter, which was the result of better operating performance and lower effective tax rate and reduced interest expense on higher weighted average share count. The diluted weighted average share count in Q4 was approximately 295 million shares, almost 17% higher than the diluted weighted average share count of approximately 252 million in the prior year period as a result of shares issued during the IPO.

The effective tax rate factored into the Q4 adjusted net income was approximately 9%, which reflected an ongoing rate in the low-20s reduced by some additional discrete tax benefits in the quarter.

Turning to slide nine to address our full year financial performance. Full year revenue growth was 10.1% with core growth of 5.9%. Acquisitions contributed 3.5% as we realized a small benefit and we realized a small benefit from FX. Core growth was strong in our industrial channels as well as in our automotive replacement channel, which grew just under 7% for the full year.

Automotive first-fit declined 4.6% for the full year, due to the second half decline mostly occurring in Q4, some of which we had planned for and part of which came in lower than expected. Overall, our global replacement channels had core revenue growth of 6.9% and our first-fit channels had core growth of 4.2%, driven by the continued strength in industrial first-fit sales, which grew 12.9% with continued strong growth in hydraulic applications.

Our revenue growth translates through to EBITDA growth and margin expansion as EBITDA dollars grew 13% and EBITDA margin expanded 60 basis points. Price costs continued to be managed well throughout the year and we were able to stand up our new capacity as planned. We incurred new plant start-up costs and managed through a number of other capacity related challenges. We believe that the full-year EBITDA reflects very solid execution in this environment.

Our adjusted EPS grew by over 50%, primarily as a result of the increase in adjusted EBITDA and lower interest expense resulting from the lower debt balance in the year.

Slide 10 provides detail on key cash flow items and our focus on continued deleveraging of the business. Our trade net working capital as a percentage of revenues was flat from the prior year, where we would typically be expecting about 50 basis points of improvement. We experienced inventory build in a number of areas that offset other improvements within the year. These inventory builds were associates in part with certain strategic increases and other activities associated with fulfilling fluid power demand and should moderate this year. The overall increase in working capital dollars is associated with the overall 10.1% revenue growth rate for the year.

Our free cash flow reflects the higher CapEx spend on the fluid power capacity expansions as well as the increase of working capital associated with our growth.

We will talk about our outlook in a moment, but we would anticipate these items to improve in 2019 and our conversion percentage to move back toward historical levels.

On leverage, we ended the year with a net leverage ratio of 3.4 times, reflecting our continued commitment to deleverage the business while still investing in growth.

Moving to our outlook, on slide 11, for 2019, our current outlook for core growth is a range of 3% to 5% with higher growth in the second half of the year. Underlying this growth rate is continued growth in our industrial markets as well as in our replacement channels, partially offset by some further decline in automotive first-fit. In China, we are anticipating a weaker first half, particularly Q1, which we believe will reflect further deceleration from Q4. For the full year, however, we are still expecting growth in China as a result of our replacement channel exposure and the opportunities we have to expand our fluid power business.

Our outlook for adjusted EBITDA is $775 million to $805 million, which reflects some impact from an FX headwind for the year based on current rates. Capital expenditures are expected to decrease to approximately $150 million, a decline from just over $180 million in 2018. And, as I noted earlier, we would anticipate our free cash flow conversion increasing to over 80% in 2019.

Our growth in earnings combined with the higher conversion rate would imply significant increase in our free cash flow in 2019. Based on the -- our current outlook, we also anticipate that we will be below 3 times net leverage by the end of 2019, barring any larger M&A, which is not foreseen at this time.

With that, I will now turn it back over to Ivo.

Ivo Jurek -- Chief Executive Officer

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 on a number of large initiatives. The diversity of our business model served us well. Our industrial end markets and replacement channels remain supportive, which allowed us to deliver solid core growth of 5.9%, despite the headwinds from certain other first-fit markets.

I would like to thank our global Gates team and congratulate them on their performance in delivering our upward revised guidance, despite the challenges we faced in the second half and particularly in the fourth quarter.

We demonstrated the ability not only to maintain positive price cost economics, but also to continue expand our adjusted EBITDA margin. We generated solid 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 investments in the business in 2018, we continued our path of deleveraging and we have a line of sight of being below 3 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.

Questions and Answers:

Operator

Thank you, sir. (Operator Instructions) Our first question comes from Andrew Kaplowitz from Citi. Please go ahead.

Daniel Yu -- Citi -- Analyst

Hi. Good evening, guys, This is Dan standing on for Andy.

Ivo Jurek -- Chief Executive Officer

Hi. Good evening.

Daniel Yu -- Citi -- Analyst

Ivo, I want to 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 US 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 '19 and do you see these trends kind of holding steady?

Ivo Jurek -- Chief Executive Officer

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, built out our presence with channel partners. North America and Europe continue to have a supportive market dynamics, particularly driven by 2009, 2010 decline of car registrations, and the fact that the sweet spot for our demand is in that 7 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 other replacement business that we have.

Daniel Yu -- Citi -- Analyst

Okay. And flipping over to China, in 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 US-China trade deal and demand could deteriorate further?

Ivo Jurek -- Chief Executive Officer

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, in 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 kind of over to 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 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.

Daniel Yu -- Citi -- Analyst

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

Ivo Jurek -- Chief Executive Officer

Thank you.

Operator

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

Jeff Hammond -- KeyBanc Capital Markets -- Analyst

Hey, good afternoon, guys.

Ivo Jurek -- Chief Executive Officer

Hi, Jeff.

David Naemura -- Chief Financial Officer

Hi, Jeff.

Jeff Hammond -- KeyBanc Capital Markets -- Analyst

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?

Ivo Jurek -- Chief Executive Officer

Sure. Let me start with the fact that Europe and China are our two largest automotive first-fit businesses as we have indicated in the past, and frankly one of the things that's kind of nuance for us is that, in Q4, in particular, that quarter is more heavily weighted as an automotive first big quarter due to the regular seasonality. So, when you think about our Q4 results, they 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 there are visibility on the programs that are rolling off and that debt 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 are going to take, so kind of 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've really anticipated that that's going to get resolved as we kind of entered the fourth quarter or exit the fourth quarter and we really have -- still seeing reasonably good impact of that emissions testing process being deployed. And that's kind of how we think about the other decline in Europe. So reasonably weak and again have plan -- have maybe a 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, again not just in the out of first-fit business but actually 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 have 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.

Jeff Hammond -- KeyBanc Capital Markets -- Analyst

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?

Ivo Jurek -- Chief Executive Officer

Look, we don't provide guidance on order rates, because frankly we don't really track order rates. As we said, we are not a backlog business, we are 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.

Jeff Hammond -- KeyBanc Capital Markets -- Analyst

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?

David Naemura -- Chief Financial Officer

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 last, kind of, year and a half, but we would expect that peak growth to be higher.

Jeff Hammond -- KeyBanc Capital Markets -- Analyst

Okay. Thanks, guys.

David Naemura -- Chief Financial Officer

Thanks, Jeff.

Operator

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

Julian Mitchell -- Barclays -- Analyst

Hi. Good evening.

Ivo Jurek -- Chief Executive Officer

Good evening, Julian.

Julian Mitchell -- Barclays -- Analyst

Maybe just a first question around the free cash flow. I guess, you have that base free cash flow, sort of, 130-ish in '18. Is it right that you are guiding for sort of 300 plus in 2019 in terms of -- if that's correct, then maybe flush out some of the moving parts? I guess, CapEx is dropping 30 million or so year-on-year, what are you expecting around working capital, for example? Does that become an actual cash, a big cash inflow in '19?

David Naemura -- Chief Financial Officer

Julian. I think, 300, you're kind of in the zone. I think, we chose 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 revenue. 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 your point of around $30 million in CapEx. So, I think that would get you close.

Julian Mitchell -- Barclays -- Analyst

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

David Naemura -- Chief Financial Officer

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

Julian Mitchell -- Barclays -- Analyst

Thank you. Then 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 make -- steps down a little bit from Q4, because you are assuming China, maybe, just a little bit worse and then you 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?

David Naemura -- Chief Financial Officer

Yeah, 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 probably directionally right, Julian.

Julian Mitchell -- Barclays -- Analyst

Great. Thank you very much.

David Naemura -- Chief Financial Officer

Thank you.

Operator

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

Deane Dray -- RBC Capital Markets -- Analyst

Thank you. Good afternoon, everyone.

Ivo Jurek -- Chief Executive Officer

Hi, Deane.

David Naemura -- Chief Financial Officer

Hi, Deane.

Deane Dray -- RBC Capital Markets -- Analyst

Hey. Just want to circle back on auto first-fit. And does that -- does the headwinds you saw this quarter change your appetite in any way, I think, 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?

Ivo Jurek -- Chief Executive Officer

Dean, I don't think that we are changing the perspective on the auto business. I think that we have been consistent with what we said. We are going to be continued 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 or auto first-fit customers that should allow us to take business at very nice premium margins to kind of more -- 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 a ton of auto first-fit business and as you have very correctly stated, our interest is continue to outperform in industrial and continue the evolution of our portfolio heavily weighted toward that industrial set of applications.

Deane Dray -- RBC Capital Markets -- Analyst

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 the year underperforming plants and I presume some of that's in fluid power, but just where is the equilibrium right now and in capacity and demand on fluid power?

Ivo Jurek -- Chief Executive Officer

Look, we've brought a significant amount of capacity on-stream. And so, we see several of our product lines to come more toward that equilibrium. We do still have some product lines that are constrained and we expect that that's going to continue as certainly throughout the first half of the year. We continue to not necessarily add capacity, but get more productive with existing set of assets that we have to relieve 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.

Deane Dray -- RBC Capital Markets -- Analyst

Got it. Yeah, go ahead, Dave.

David Naemura -- Chief Financial Officer

Well, you asked about the footprint. I would say, you're right about that, that they would provide us few opportunities, probably on the fluid power side as we get more into it.

Deane Dray -- RBC Capital Markets -- Analyst

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?

David Naemura -- Chief Financial Officer

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

Deane Dray -- RBC Capital Markets -- Analyst

Got it. Thanks, guys.

David Naemura -- Chief Financial Officer

Thanks, Deane.

Operator

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

Jerry Revich -- Goldman Sachs -- Analyst

Hi. Good afternoon and good evening, everyone.

Ivo Jurek -- Chief Executive Officer

Hi, Jerry.

Jerry Revich -- Goldman Sachs -- Analyst

I'm wondering if you can talk about the manufacturing footprint plan a bit more. So let's say on the fluid power side of demands, call it, flat over the course of '19, 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 toward the larger scale campuses as you mentioned those -- they eventually over time displace some of the smaller locations. What are the unit economics of improvement there?

Ivo Jurek -- Chief Executive Officer

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 through the productivity improvements should the deployment of our Gates operating system. We did scale up those campuses. So that gives us some opportunities to look at some future plan consolidations. Look, I think that the Turkish plant is a really good example, right. We had a sub-scale facility, we opened up the regional facility that's off-scale and we've pulled 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.

Operator

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

Joshua Pokrzywinski -- Morgan Stanley -- Analyst

Hi. Good evening, guys.

David Naemura -- Chief Financial Officer

Hi, Josh.

Joshua Pokrzywinski -- Morgan Stanley -- Analyst

Just a first question. 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 any one who is on the other side of it, who is perhaps pre-buying ahead of tariff. Just trying to understand where there may be ebb and flow in the channel? I guess, any commentary across the different end markets of geographies would be helpful?

Ivo Jurek -- Chief Executive Officer

So, Josh, my comment was particularly directed toward the inventory not being taken up by the export-oriented manufacturers in China, that was the comment I was making. We -- kind of the more general comment, we really don't see any significant build-out in inventory -- 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.

Joshua Pokrzywinski -- Morgan Stanley -- Analyst

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

David Naemura -- Chief Financial Officer

Yeah. I'd say, what we've 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 month 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 for some 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 US as we tried 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 lower sales growth for 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 to 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.

Joshua Pokrzywinski -- Morgan Stanley -- Analyst

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 (ph), that number should be higher around 80, then the out-year as some of the mechanical items yet, I just want to make sure I'm not missing anything.

David Naemura -- Chief Financial Officer

No, I think that's fair.

Joshua Pokrzywinski -- Morgan Stanley -- Analyst

Okay. Perfect. Thanks for the call.

David Naemura -- Chief Financial Officer

Thank you.

Operator

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

Jerry Revich -- Goldman Sachs -- Analyst

Yeah. Thank you. Can you hear me now?

Ivo Jurek -- Chief Executive Officer

Yes, Jerry. Sorry about that.

Jerry Revich -- Goldman Sachs -- Analyst

Okay. perfect. Thank you. Though it's probably on my side. So, Ivo, I just wanted to better understand the cost savings that you folks are going to achieve what -- on this Turkey example or another example of switching from a smaller facility toward the new campus approach. And can you just flesh out the opportunity set and what's the ultimate margin opportunity that creates as we think about what the business growth will look like in the next cycle?

David Naemura -- Chief Financial Officer

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 want to stop short of announcing anything here, because we're still working on it. We think there is a good opportunity to average one or two a year for the next few years and we'd probably look at those different regionally and I think the idea would be now that we've got capacity outscaled certain sites and some other larger plants, Ivo alluded to productivity, which is enabling us to then further consolidate some activities. We will look at how we can benefit to a rooftop of two.

Ivo Jurek -- Chief Executive Officer

Yeah, and what I would add, maybe, Jerry, is that, we also -- as I think we have said on couple of these calls as 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 need for additional manufacturing footprint and so on and so forth. So, we feel that there'll be some good opportunities to drive further productivity.

David Naemura -- Chief Financial Officer

And, 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 kind of that one to two-year payback period and they're reasonably decent scale and take time to execute, so that's why they would happens slowly over time. But that gives us the opportunity to drive a little bit of incremental gross margin that frankly we would use to probably not necessarily drop through to the bottom line, we go fund more go-to-market and R&D activities as we continue to kind of expand EBITDA margins into the mid-20s here.

Jerry Revich -- Goldman Sachs -- Analyst

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 a demand looks like versus how it might look for Gates?

Ivo Jurek -- Chief Executive Officer

I would say that we continue to build a ton of opportunities in fluid power, Jerry. Again, frankly that's an opportunity to me kind of get in my soapbox about we've built this fluid power capacity not necessarily to consolidate our sites, we've 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 are adding the capacity, so we feel reasonably constructive about our opportunities in 2019 and beyond with fluid power.

Jerry Revich -- Goldman Sachs -- Analyst

I appreciate the discussion. Thanks.

Ivo Jurek -- Chief Executive Officer

Thank you.

David Naemura -- Chief Financial Officer

Thank you.

Operator

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

Bill Waelke -- Vice President, Investor Relations

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 shoot any follow-up questions. We look forward to updating you after the first quarter. Thanks. Everyone, have a good evening.

Ivo Jurek -- Chief Executive Officer

Thank you.

Operator

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

Duration: 55 minutes

Call participants:

Bill Waelke -- Vice President, Investor Relations

Ivo Jurek -- Chief Executive Officer

David Naemura -- Chief Financial Officer

Daniel Yu -- Citi -- Analyst

Jeff Hammond -- KeyBanc Capital Markets -- Analyst

Julian Mitchell -- Barclays -- Analyst

Deane Dray -- RBC Capital Markets -- Analyst

Jerry Revich -- Goldman Sachs -- Analyst

Joshua Pokrzywinski -- Morgan Stanley -- Analyst

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