Gates Industrial Corporation PLC (GTES) 2018 Q3 法說會逐字稿

Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the Gates Industrial Corporation Q3 2018 Earnings Call. (Operator Instructions)

I will now turn the call over to Bill Waelke, Head of Investor Relations. You may begin your conference.

Thanks for joining us on our third quarter 2018 earnings call. I'll briefly cover our non-GAAP and forward-looking language before turning things over to Ivo, who's on the call today along with our CFO, David Naemura.

After the market closed this afternoon, we published our third 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. Ivo?

Good afternoon, everybody. I appreciate you joining us to discuss our third quarter 2018 results. Let me start with a summary of some key results. I'll begin on Slide 3 of our presentation. We are pleased to report another strong quarter of performance. We generated revenues of $828 million, which represents a record third quarter revenue level for Gates. Our total revenue growth was 8.9% over the prior year quarter, driven by accelerating core growth of 7.2% and a contribution from acquisitions of 3.9%. This was offset partially by a foreign currency translation headwind of 2.2%.

The demand environment remained supportive across many of the end markets that we serve and right in line with our expectations. We saw continued strength in our industrial end markets and experienced a good demand environment in our automotive business, particularly in China and due to our significant aftermarket presence globally.

North America delivered strong core revenue growth in the quarter of 11%, driven by strength in nearly all industrial end markets as well as another quarter of outperformance in the automotive aftermarket.

In Europe, our industrial end markets were favorable across both the replacement and first-fit channels. This offset softer automotive first-fit sales, which were primarily a result of planned ramp-downs of OEM projects and the expected delays stemming from new emissions testing requirements.

Our business in emerging economies continued to perform well in the third quarter with growth across all of our end markets, including strong growth in our replacement channels. With respect to China in particular, we are very pleased with our third quarter core revenue growth of just under 10%. This growth was achieved with share gains and strong performance in our replacement business and came on top of a 30% core growth in the third quarter of last year. Additionally, this performance came despite the fact that we have had to deprioritize certain China sales to satisfy large global industrial OEs in this capacity-constrained hydraulic environment.

While our China automotive first-fit revenue demonstrated solid growth in Q3, our full year guidance has contemplated a slowdown of these sales in Q4 due to comparison against Q4 in 2017, which along with Q4 of 2016 included very high demand driven by tax incentives on smaller engine vehicles. We believe that we remain well positioned in China with a pipeline of programs at both industrial and automotive OEs as well as a strong position in replacement channels, including the rapidly developing automotive aftermarket.

Our Q3 adjusted EBITDA of $181 million represents a record third quarter results for Gates. At 21.9% of sales, our adjusted EBITDA margin reflects 30 basis points of expansion over the prior year Q3. Excluding acquisitions, adjusted EBITDA margin expanded by 50 basis points. In Q3, we continued to invest in the business. In September, the second of our 3 planned increments of manufacturing capacity came online according to plan, and commercial shipments from that facility have begun.

Our strong execution from the first half of 2018 continued in Q3. I am proud of the Gates team for delivering record results, all while operating many production facilities at full utilization, successfully executing the simultaneous addition of new capacity on 3 continents and integrating our acquisitions in different regions of the world.

We have also maintained positive price/cost in an inflationary environment as we said that we would. This execution drove solid results across our segments, which I will now cover in more detail.

Turning to Slide 4, beginning with Power Transmission. Our Power Transmission segment delivered total revenue growth of 2.5% and core revenue growth of 4.7% in third quarter. We grew revenues across nearly all of our end markets with particular strength in the general industrial and heavy-duty truck end markets. We also saw another quarter of very strong performance in our automotive replacement business globally.

Our trend of emerging economies outperforming developed markets continued in the quarter. In China, Power Transmission core revenue growth was almost 10% in the third quarter, driven by strength in our replacement business.

During the quarter, we continued to add to our chain-to-belt organizational capabilities with resources aligned around targeting both first-fit and replacement opportunities with the key verticals we have mentioned. We had key wins during the quarter in pulp and paper, with lumber and agriculture applications as well as in personal mobility applications where we had both e-bike and e-scooter wins in China.

We also recently announced the introduction of a new platform of Micro-V belts. This new platform of belts will scale to appropriate performance in a range of applications and provide advancements in performance, energy efficiency and manufacturability.

This new platform of belts is made possible by our material science and process engineering capabilities. Our first targeted application will be a new Micro-V belt set of products specifically designed for the aftermarket segment in emerging market countries.

The Power Transmission adjusted EBITDA margin expanded by 30 basis points in Q3 compared to the prior year. This margin expansion was achieved despite some headwinds from emerging market FX.

On Slide 5, our Fluid Power segment achieved another quarter of strong growth, with total revenue increasing by 21% compared to prior year quarter. On a core basis, third quarter revenue growth was 12%, with core revenue growth of 17% in hydraulics, which is our largest Fluid Power product category.

Industrial end market demand drove broad-based regional growth, with mobile hydraulics markets having the strongest performance. As our newly launched MXT hydraulic hose family gains adoption in the field, we are hearing consistent feedback that the value proposition is resonating with both first-fit and replacement customers. Reduced weight and improved flexibility as well as lower inventory requirements due to fewer hose construction types are attributes that really do differentiate this innovative new product from our competitors.

In fact, [as I mentioned] earlier, our new hydraulic plant in Mexico came online in Q3. As the plant continues to ramp up into next year, it will not only alleviate some of our existing capacity constraints but will also support market share gain opportunities from our Fluid Power initiatives.

The last stage of our current hydraulics capacity expansion, the new plant at our existing campus in Poland, remains on track to come online later in Q4 with its full production ramp into mid-2019. Our Fluid Power revenue growth, along with procurement actions and pricing, contributed to an improved adjusted EBITDA margin. When excluding acquisitions, the year-over-year expansion in segment margin was 100 basis points. As previously discussed, the Q3 positive margin drivers more than offset both start-up costs from the new plants as well as significant inefficiencies from running at full utilization. These costs will continue to be incurred in Q4 and abate as we exit 2018. David will discuss this in more detail in his remarks.

Our recent acquisitions in Fluid Power segment are progressing well, and we continue to see operational efficiencies gains from the implementation of the Gates Operating System. Overall, our recent acquisitions are meeting expectations and are on track to deliver the planned synergies.

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

Thanks, Ivo. I will now cover our Q3 financial performance beginning on Slide 6, where as Ivo mentioned, you can see the record third quarter results that we delivered for revenue and adjusted EBITDA. Core revenue growth was 7.2% in the quarter while acquisitions contributed an additional 3.9% and foreign currency was a headwind of 2.2%, resulting in total revenue growth of 8.9%. The core revenue growth reflects continued strong demand in our industrial end markets across both of our segments, particularly in our replacement business. We saw continued strong demand for mobile applications, particularly in the construction and agriculture end markets. We also saw broad-based demand in our General Industrial business. Finally, our oil and gas business performed well driven in part by leveraging technology gained through the Techflow acquisition.

We also experienced strong growth in our automotive replacement channel, which grew by nearly 7% globally, a function of very strong growth in emerging markets, particularly in China where we continue to expand our leading product coverage and our distribution base throughout the country. Overall, emerging market core revenue growth was approximately 9% in total for the third quarter.

Price/cost was favorable in Q3, consistent with the year-to-date trend, and we expect it to remain favorable for the full year. Our adjusted EBITDA of $181 million was an increase of $17 million or 10.4% over the prior year quarter. Our adjusted EBITDA margin was 21.9%, an improvement of 30 basis points over the prior year Q3. Excluding the impact of acquisitions, our adjusted EBITDA margin was 22.1%, an increase of 50 basis points over the prior year Q3.

We delivered this strong adjusted EBITDA performance while managing the new plant start-up costs as well as costs related to capacity-driven inefficiencies and initiatives to maximize output in a strong Fluid Power demand environment.

We grew adjusted net income to $0.30 per share on a diluted basis compared to $0.23 per share in the prior year quarter, which was the result of better operating performance, a lower effective tax rate and reduced interest expense. The diluted weighted average share count in the third quarter was approximately 298 million, 17% higher than the diluted weighted average share count of approximately 255 million in the prior year period. Our GAAP effective tax rate in Q3 was 10%, and we believe that our full year effective rate will now be in the teens with an underlying operational rate still in the mid to low 20s.

Slide 7 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 revenue, excluding acquisitions for comparability purposes, improved 160 basis points compared to Q3 of last year, reflecting continued progress in improving our working capital efficiency.

Our free cash flow for the last 12-month period reflects the higher spend on the Fluid Power capacity expansions, which will taper off in 2019. Adjusting for this provides a more like-for-like comparison of our free cash flow. We have also continued to build working capital to support our growth, particularly in the Fluid Power segment. Although we have continued to drive improvements in our working capital efficiency as a percentage of last 12 months sales, we have also had to provide working capital in support of our sales growth of 13.1% year-to-date and 14% for the last 12-month period compared to the same prior year period.

Within our elevated CapEx spending, underlying maintenance CapEx continues to be in line with our historic range of approximately 1.5% of net sales.

On leverage, we ended Q3 with a net leverage ratio of 3.6x, reflecting our commitment to deleveraging the business while investing in both organic and inorganic growth.

Moving to Slide 8. We are pleased with our performance in the quarter, a result of our team's focus on execution in a very

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as an update on some of the second half costs that we previously discussed.

In Q3, we were impacted by new plant start-up costs as well as inefficiencies from running some of our plants at full capacity. In addition, we also incurred expenses from actions we began taking to maximize output in certain facilities where we are constrained, including certain distribution capacity. These actions will allow us to continue to grow in an efficient manner and will further position us well for 2019 but are a near-term expense impact.

We anticipate that we will continue to experience all of these impacts through the fourth quarter but that these items will abate as we progress into next year. Nonetheless, we are maintaining our previous guidance for full year 2018 as unchanged.

With that, I will now hand it back to Ivo.

Thanks, Dave. We are encouraged by the solid results we delivered in the third quarter. I'm proud of the work of the Gates team globally and their delivery of record results, all while navigating a higher cost environment, operating production facilities at full utilization, successfully executing with simultaneous addition of new capacity on 3 continents and integrating 3 acquisitions in different regions of the world.

Our team performed well and in line with our plans despite the challenges we faced in the quarter. We remain focused on execution. Our key organic initiatives and product launches remain on track and are gaining momentum. New product innovation is accelerating in pace while leveraging our industrial technology and material science capabilities.

VAV initiatives on existing products, productivity improvements and footprint optimizations are significant priorities. We have always talked about shifting our improvement focus from planned productivity efforts, which have yielded great results to VAVE and the introduction of new products. We are seeing that happen with the introduction of our MXT hose family and next-generation Micro-V belt platform. Both of these are very innovative products, and we have series of additional new product launches that will be happening in the coming quarters as a part of refreshing of our product portfolio. In addition to our organic initiatives, we also continue to maintain an active pipeline of acquisition opportunities to accelerate future growth.

In closing, I would like to thank the global Gates team for their commitment and performance in delivering another outstanding set of results this quarter. We will now turn the call back over to the operator to open up the Q&A. Operator?

(Operator Instructions) Your first question comes from Jamie Cook from Crédit Suisse.

I just -- a couple of questions. If you could, given the macro concerns that are out there, could you provide any color in terms of during the quarter or into October where you saw trends decelerate or, on the flip side, accelerate just given some of the macro concerns that are out there, either by end market or by geography?

Jamie, thank you. Look, the quarter has developed very much in line with our expectation and maybe a little bit stronger, to be honest with you, with China auto. We have expected that we will start seeing deceleration in Q3, and that's really not occurred yet. But as I stated earlier, our expectation is that you will start seeing abating not necessarily because of significant drop in demand, but primarily because of the significant growth numbers that we have printed in Q4 in '16 and '17. I would say that maybe year OE, it's pretty well documented that, that's kind of slowed down because of the new emission testing standards. But the rest of it was pretty much in line with what our expectation was and maybe a little bit stronger on the industrial side. That's probably the best color I can give you at this point in time.

Okay. And can you just talk about how you're feeling about your ability to meet demand and whether freight or supply chain disruptions have had any impact in the quarter or going forward?

Yes. Look, I'll start with the fact that we were a little bit surprised that we didn't see any abatement of the very high-pressure hydraulic product lines. We anticipated that we now start seeing a little more of a normalization of growth rates, and the growth rates continued to stay strong. We're taking market share basically in most of the regions. Capacity is very tight. We have actually had to make some tough calls on shifting some production capacity from one region to another. China comes to mind where we have, frankly, de-committed some volume because they needed to service some of the larger OEMs. But we are trying to be very proactive and take decisions. And we took some decisions in Q3 where we started repositioning some of our capacity to ensure that we position ourselves well as we exit Q4 into '19. So it's very tight out there. There's not a ton of available capacity in the supply chain, and we feel pretty good about where we sit and what '19 may bring.

Your next question comes from Andrew Kaplowitz from Citigroup.

Ivo, last quarter, I think you said global auto replacement demand grew 8%; this quarter, 7%. I think last quarter you said you were seeing double-digit replacement growth in China. It seems like that you're still kind of seeing that or at least you saw that in Q3. You didn't expect -- you did mention expected slowdown in China auto first-fit, I guess, mostly based on comps. But could you give us more perspective on what kind of visibility you might have into '19, particularly in the global auto replacement market? You can talk about the first-fit also. But I guess, my particular emphasis will be in China, what you see there.

Thanks, Andy. That's a great question, actually. Yes. I would say that in Q3, we've seen the same trends as we've seen in Q2 with our auto replacement market, again, very, very solid growth. China's still about low double digits and developed markets still growing very, very strongly. So we feel very positive about the trend line that we see. And as we explained, I think, on our last call, I had mentioned that we see -- the headwind that we have experienced in the prior years from the drop in car registrations in 2009 to abate, and that should become tailwind as we move into 2019. So we feel quite constructively about the AR market globally in 2019. We feel very well -- very good about the AR market in -- auto replacement in China. We've been building our presence there and that car park -- that aged car park in China is growing pretty handsomely. So I think that, that's going to be a very strong position for us. In the auto first-fit, we probably shared it with you all in the call. Look, we're very selective in what business we take. We have decided some time ago during our strategy development that we want to stay relevant. We don't necessarily want to be a broad market participant, and this is playing out the way that we've expected. So the mix is helping us out. But we are very constructive on the AR market and not overly concerned about what's happening in the first-fit registrations.

And Dave, your incremental margin, actually, it looks modestly better in Q3 than in Q2 overall despite what was supposed to be an increase in start-up costs and inefficiencies that you did talk about. Is it mix toward aftermarket that's helping you? Maybe it's the premium products that you mentioned. I know you talked about price versus cost. So you're covering costs, but are you more than covering costs? And how much in the way of start-up costs and/or inefficiency did you end up seeing in Q3?

Yes. So Andy, you're right. I think it was partially some of the premium sales which helped mix things up, but also price. We talked about price/cost being positive. And it was well positive, and that's obviously very helpful from a fall-through perspective. As far as the costs that we incurred, they're right in line from a start-up cost perspective. We talked about $4 million to $6 million in the second half of the year. I think we're on track for that. I think the other cost, the inefficiencies that we've talked about continued to be there as well. As we were trying to explain, it will continue in the fourth. And then frankly, as Ivo mentioned, we entered some new activities to reposition some of our footprint to continue to help facilitate growth that was both on the Fluid Power manufacturing side and also from a distribution perspective to enable more capacity. And with or without its cost, and that will be a Q3 and a Q4 cost as well, but I think we've -- not huge numbers, but they all kind of add up, to your point. And that's what's resulted in the negative margin from a gross margin perspective year-over-year even excluding the impact of the acquisitions.

Your next question comes from Steven Winoker from UBS.

Just maybe just spending a little more time on those questions. Can you actually give us or quantify, if you add them all together, what that impact was that you expect to go through to Q4 on all of those actions and inefficiencies, et cetera? Sort of what should we be thinking about and how much of an abatement maybe in basis points or some -- just a little more kind of aggregate view of all of that, that you're fighting?

Yes, I'd say it's probably

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points of gross margin in the third and that probably increases at the gross margin level to almost 100 basis points in the fourth as we continue to take these actions to quantify it. As you've noted, we've contemplated most of it, and I think we've increased it a little bit. But I think it's still kind of within the realm of what we'd expected, but we wanted to share an update and let you know that we're continuing to do these things.

Okay. And can you maybe just go back to price/cost and the thinking around what you are seeing in terms of China and tariffs? I know you've covered it before a little bit. But maybe kind of revisit it in light of what we're seeing coming this January and the degree to which that is or is not a risk.

Yes. No, it's great. We're aided by obviously our in region, for region strategy. And although in these times of supply constraint, we'd probably move a few more things cross-borders than we otherwise would. As we look forward in the beginning of January, we think -- we don't think our exposure is any greater than, really, what we've talked about before. So we've talked about $10 million to $15 million in previous calls, and we think that's still relevant. There's a handful of things that we'll be bringing in from China. We continue to think that the broader impacts on inflation are probably more what we'll see. But our strategy remains to price for that, and we've priced ahead. We think we've been a market leader in price, and we continue to believe we're well positioned into '19 as we were in 2018.

And through any kind of professional and other channels, there's no delay impact that you have on that -- on pricing when you decide to, as you said, price ahead if you decide you need more -- some other folks may have a longer delay?

Steve, there's always a lag, and it depends on channel and it depends on region, honestly. But this is -- that's kind of built into our thinking, and I think that's been there all along. We've continued to stay ahead of it, and I think we will continue to do that.

Your next question comes from Jerry Revich from Goldman Sachs.

This is Ben Burud on for Jerry. Could you guys please provide some color on where lead times are currently, where you're seeing them going in Fluid Power?

Well, it depends on -- it honestly depends on the products. We're most constrained at the highest level of our hydraulics portfolio. In other words, kind of the highest pressure applications. And lead times are definitely coming down as we bring new capacity on, as we do the things we've talked about doing in the second half. But we're not a backlog business. We don't operate a backlog. We operate book shift. Admittedly, we're not satisfying all the demands that we see out there. But what was once being measured in kind of multiple months, I think we're now starting to measure in kind of the 4- to 6 week-ish-type lead times and reducing.

Understood. And also could you provide an update on the timing of the production ramp of the 2 new facilities you've added?

Yes. So in Q3, we've basically been able to quite progressively ramp up our incremental capacity in China. That capacity is now running nearly in 2 shifts of -- sometimes end of -- middle of November, we should be running full 2 shifts in China. In Mexico, the expectation is that we will exit Q4 kind of on that 2-shift ramp-up of this facility. We have been able to prequalify most of our product lines in Poland, but we are still in full product qualification. And we expect that we will be exiting kind of at a quasi 1-shift production ramp-up Q4 and getting to that full 1 shift early in Q1 of 2019. And so kind of towards the end of Q1 of '19, we should be in a very, very reasonable run rate on all 3 facilities.

Your next question comes from Jeff Hammond from KeyBanc Capital Markets.

Just got a few cleanup items. One, just you -- getting into the fourth quarter, you kind of left the EBITDA range. Any kind of biases around tightening that towards the high end or low end?

Well, no. We thought it was an okay range size. There is a lot of uncertainty aside from some of the cost actions I talked about. There's emerging market currencies, which actually, as you've all noted, negatively impacted us in the third quarter. So we thought the range was an okay size and decided to leave it.

Okay. And then you talked about all the start-up costs, and I think Steve asked the question on, kind of, moving into the 4Q. But is there a way to kind of add those up in terms of how big of an impact that is in '18 all-in? And I mean, what would go away into '19?

Yes. I think '18, we're talking about kind of $14 million to $16 million maybe at the top end. I think those will, for the most part, decline pretty quickly in 2019 as we get the new capacity up to speed. We'll still see a little bit of start-up costs. I think as we stop operating at really full, full capacity on some of our other Fluid Power plants, we won't have as many expediting costs. We won't have as much kind of premium freight and expensive temp labor and things like that, that are really a drag right now. And then the repositioning work we talked about, which is actually reasonably expensive, are things that will be done in the first quarter. So things should come down reasonably well.

Okay, great. And then just finally, on cash flow, clearly good growth. And you need to invest in working capital, and you've got a lot of moving pieces. But how should we think about working capital into 4Q? And as you get some of these plants up and running, what's the opportunity to really drive some of the extended working capital out of the system?

Yes. So generally speaking, I think as we think for year-end, we'll be hitting our lower -- low point of working capital for the year. Our working capital is rather seasonal. We continue to look to improve working capital as a percent of sales over the prior year. Historically kind of talked about 50 basis points. I think we'll do better than that. We've been running better than that year-to-date. So I think we'll be better than that for year-end. And next year, we look to improve again. We'll target inventory at a reasonable level next year. We think there's still good opportunity there. As we get the plants up and running, we'll -- I don't think that's going to materially hurt or help our working capital position. But clearly, we'll look to improve and we'll be targeting more improvement in inventory in the coming year.

Your next question comes from Julian Mitchell from Barclays.

Maybe a first question just on the Fluid Power incremental margins. I guess, this year, because of some well-discussed items that's running at about 20%; last year, it was, I think, just under 20%. So when we think about 2019, should we think about a big step-up in the incremental margin? Or is there something in the business that you think means that this sort of 20 percentage plus rate is -- that you've seen in the last 2 years is a useful sort of go-forward placeholder?

The primary impact in 2Q '18 has been the addition of Atlas. So when we look at Fluid Power, just for -- using the third quarter as an example, the incrementals would have been, I think, about -- it would have been -- excluding the acquisition, it would have been about 35%, which I think is a little more indicative of the business. So the impact of Atlas, which we'll be able to expand but has been brought in as a reasonably low margin business and will provide us the opportunity to grow EBITDA dollars in the future, is muting that. So we think when run well, on a core basis, the business is kind of in that mid-30s and maybe in kind of the low to mid-30s. And I think Fluid Power should resemble that in kind of normalized times.

I see. And maybe, Dave, just remind us sort of how quickly you think those acquisition or acquired margins can step up in the next couple of years.

So at the end of the third quarter, Atlas becomes core to us. So now we'll be comparing against result that include Atlas. Part of the challenges we have had in -- Atlas has played out like we thought it would. But honestly, with the demand on Fluid Power, we haven't been able to do some of the things we've wanted to do there. So I think we will get above average in dollar growth out of our Atlas investment. But it has a reasonably low jumping-off point. So I think -- I don't think it's going to be too dramatic because it's not that big a business, but I think it will be accretive to our EBITDA dollar growth in 2019.

And then just my follow-up would be around the cash flow. Understood that CapEx is very inflated this year and also that within the operating cash flow, that was down in the 9-month period because of working capital. When you think about those 2 items, the working capital and the CapEx for next year, do you think as a result of changes in them, the free cash conversion should step up dramatically?

Yes, I do. I don't know if it gets all the way back to the 100% level that we target. We're going to work our way back with normalized CapEx level over the next few years. But as a percent of sales, that will improve year-over-year. And again, I think we'll be able to drive some working capital efficiency -- additional working capital efficiency next year as well. So we should see help from both those components.

Your next question comes from Charley Brady from SunTrust Robinson Humphrey.

I wonder if you can just -- on the commentary about deprioritizing production in certain regions and moving stuff, like go to China to somewhere else. If you can kind of comment on that a little bit in terms of, is there any way you can quantify potentially what the lost -- I guess, lost sales, for lack of a better term, would have been? And once this capacity comes online, you can now bring in that -- the work that you couldn't have otherwise done. I'm just trying to get a sense of if I look at the core growth rate, which is obviously already is pretty good, how much better could that be? And if we're going to '19 and we've got more capacity, that gives a little more gas relative to what you might have seen in 2018, assuming the demand levels stay where they are.

Yes. Look, so this comment was primarily made around the China consumption. We frankly couldn't satisfy all demand in China. We would prefer to step away from how much it was because the demand is so constrained and we just need to support the global OE customers, first and foremost, in some of the outlying regions. Look, the best way to characterize it is that industrial demand in particular, the highest pressure of hydraulic products remain robust. And we are being very proactive in trying to ensure that we free up as much capacity as we can and that, frankly, what we've tried to do in Q3 and Q4 and I think that Dave outlined some of the incremental costs that we have undertaken to be able to increase further our output in those most premium products that we manufacture. We remain very bullish, and our expectation is that we are well positioned and we are positioning ourselves better for 2019.

Great. And just you referenced some of the project wins on the chain-to-belt conversion in the slides, in your prepared remarks. Can you give a little more color on that as far as maybe sizing it or kind of when is that coming into revenue as far as ramping on those projects?

Sure. So look, we are converting some of these projects into revenue over next couple of quarters. So we expect that the new wins will start contributing to revenue kind of Q2 of next year and ramp up from there. We will provide you with much better clarity on our visibility and our expectation with chain-to-belt during our Investor Day in late February of next year. As we've said, we are very bullish on this secular opportunity. It is playing the way that we have expected. We're making investments. We are building out organizational capability. It requires a little different go-to-market approach in some of these applications. And we remain very optimistic about what this has to offer for us over the long term.

Your next question comes from Deane Dray from RBC Capital Markets.

2019 has come up several times in Q&A this afternoon and would be curious if just based upon the trends that you've seen, the backlog, kind of visibility, is it fair to say you're still on this growth track of roughly IP plus 2 or 3 percentage points? And what would be kind of the bias of where you see it playing out today?

Look, Deane, I want to stay away from 2019 too much. But generally speaking, I think we see markets that continue to be supportive. And we've talked about our kind of IP plus business model. We have no reason to think right now that we wouldn't be in that realm next year. There's going to be puts and takes. But we've got new NPIs that we're bringing to market, a bunch of other initiatives. And we're not holding back on the things that we think we need to do for next year, like these costs in the second half, like the capital investments we've made. So we continue to position ourselves and we remain reasonably bullish. You want to add something, Ivo?

Well, I think that you said it well. I think that, Deane, I would say that we are quite optimistic actually about what we are doing. We continue to stay on our thesis that we have shared with everybody during our IPO process and markets support it, so we feel that we are in a good place.

Yes. And then just, Dave, you had said on the new products, maybe you can spend a moment or, Ivo, on this Micro-V belt. Just the way you described it, is -- can you talk about the size of the addressable market, what specific applications and does it cannibalize any of your previous models or versions of industrial belts?

Sure, Deane. Let me take that for a bit here. Look, it moves into a very large market, first and foremost, and we expect that this platform is going to give us an opportunity to kind of do 3 different things. Number one, the first launch that's occurring as we speak is a launch that's going to give us an opportunity to go after some of these markets that we have historically not gone after in the emerging countries. And that's kind of a $200 million, $300 million marketplace. So we are quite excited about that. And we expect that, that's going to be really accretive to us over the midterm. We are also expecting that we will start replacing some of our existing product lines with a better quality product that gives our customer a better energy efficiency in these applications. And frankly, it makes it a lot easier for us to manufacture these. So this is a really good platform that should be very accretive, both from new opportunities that are out there as well as with refreshing our existing product line.

(Operator Instructions) The next question comes from Sawyer Rice from Morgan Stanley.

Could you just maybe update us on how you're thinking about the balance of organic versus inorganic investments here and particularly how you're seeing the size of the M&A pipeline?

Sure. I think we will stick to what we have said. And we remain -- there remains an opportunity. I think the pipeline is pretty robust. We continue to target bolt-ons. There's always a large pipeline. There's always 2 or 3 things that are of interest, but we're going to remain reasonably opportunistic and balance our inorganic opportunities with continuing to deleverage the business. So if we look to 2019, I think 2019 might be similar to what we saw in 2018 and '17. We've done 3 deals over 2 years of kind of a bolt-on size. And I'm not guessing that's what will happen next year. We can do no deals. We can do a couple of deals. But I think past behavior here is kind of reasonably indicative of how we expect things to develop.

Okay. And then maybe just following up on the tariffs question from earlier. That range that you gave, that contemplates the 25% step-up in January? And then maybe if you could give us a framework of how to think about -- you've done a good job mitigating with your in region, for region strategy. But any -- what percentage of your kind of supply chain that is from China is not currently tariffed, just so we have a framework for a potential List 4?

Yes. That does contemplate the 25% as an annualized number. And we really have just a very few discrete set of items from the products we produce and would bring in. We have a handful of raw material inputs that we would anticipate tariff-based inflation on. But our in region, for region strategy is really the key here. We don't produce in China for the U.S. market with the exception of a product or 2. And so it's really that, that's the play here. And for the U.S. market, we're producing domestically in the United States or, in some cases, in Mexico as well. So that's the situation.

There are no further questions at this time. I will turn the call back over to the presenters.

Thank you very much for joining us for our results call in Q3. We look forward to speaking with you when we're going to be updating our Q4 performance in January. Thank you.

This concludes today's conference call. You may now disconnect.