Applied Industrial Technologies, Inc (NYSE:AIT) Q1 2020 Earnings Conference Call October 30, 2019 10:00 AM ET

Company Participants

Ryan Cieslak – Director of Investor Relations and Treasury
Neil Schrimsher – President and Chief Executive Officer
Dave Wells – Chief Financial Officer

Conference Call Participants

Chris Dankert – Longbow Research
Adam Uhlman – Cleveland
Joe Mondillo – Sidoti & Co
Ken Newman – KeyBanc Capital
Michael McGinn – Wells Fargo Securities

Operator

Welcome to the Fiscal 2020 First Quarter Earnings Call for Applied Industrial Technologies. My name is Mariama, and I’ll be your operator for today’s call. [Operator Instructions] Please note that this conference is being recorded.

I will now turn the call over to Ryan Cieslak, Director of Investor Relations and Treasury. Ryan, you may begin.

Ryan Cieslak

Thank you, Mariama, and good morning, everyone. This morning, we issued our earnings release and supplemental investor deck detailing our first quarter results. Both of these documents are available in the Investor Relations section of our website at applied.com. A replay of today’s broadcast will be available for the next two weeks.

Before we begin, just a reminder that we’ll discuss our business outlook and make statements that are considered forward-looking. All forward-looking statements are based on current expectations that are subject to certain risks, including trends in sectors and geographies, the success of our business strategy and other risk factors provided in our press release, our most recent periodic report and other filings made with the SEC. These are available at the Investor Relations section of applied.com.

Actual results may differ materially from those expressed in the forward-looking statements. The company undertakes no obligation to update publicly or revise any forward-looking statement. In addition, the conference call will use non-GAAP financial measures explained in our press release and supplemental presentation, which are subject to the qualifications referenced in those documents.

Today’s teleconference is available to the media and general public as well as to analysts and investors. Because the teleconference and its webcast are open to all constituents and prior notification has been widely and unselectively distributed, all content of the call will be considered fully disclosed. Our speakers today include Neil Schrimsher, Applied’s President and Chief Executive Officer; and Dave Wells, our Chief Financial Officer.

With that, I’ll turn it over to Neil.

Neil Schrimsher

Thank you, Ryan. Good morning, everyone. We appreciate you joining us. I’ll begin with some brief thoughts, then Dave will follow to review our financial results in more detail. First, I want to thank all our associates for their hard work to start our fiscal year. Their ongoing effort is apparent in several key areas that will enhance our industry position and future earnings potential.

Several company-specific trends during the quarter highlight this. Of note, our gross margin expanded year-over-year, while cash generation was seasonally strong with free cash up notably from a year ago. In addition, consistent with our company’s track record of operational discipline, we are proactively adjusting to the slower demand environment.

We are seeing sustained benefits from ongoing productivity initiatives and effectively executed more direct cost actions during the quarter. Benefits from our ongoing cost focus and Q1 actions will ramp into our second quarter results and support delivery of our fiscal 2020 guidance. As discussed last quarter and consistent with macroeconomic industrial reports, demand is subdued with a greater number of our end markets contracting year-over-year during the first quarter.

Declines were most notable within metals, mining, oil and gas, process and transportation-related industries. Customers are producing and spending less given macro uncertainty around trade policy and a more modest pace to capital project activity. That said, while end market uncertainty remains, our sales trends are running in line with our guidance assumptions provided in mid-August and in several areas are showing signs of stabilization. Year-over-year organic sales trends were consistent through the quarter, and declines moderated into October. And trends should also benefit from easier comparisons going forward.

Our focus is positioning the company for more robust growth as we believe our opportunity is meaningful. Simply put, we are integral to the motion, power and control of industrial infrastructure and equipment, which, today, is increasingly complex, requires comprehensive solutions and support and demands adapting to emerging technologies and labor shortages.

We believe our technical product portfolio, service capabilities and engineered solutions are leading the industry, and our strategy and investments are focused on embedding this value more deeply across our customers' direct production and supply chain functions. This includes investing into adjacencies that further address our customers' technical needs while building an additional moat around our value proposition.

Our 2018 acquisition of FCX and their leading flow control capabilities is an example of this, which we expect to drive additional revenue synergy opportunities over the next several years. Our recent acquisition of Olympus Controls is another example. They’re off to a solid start and showing promising growth potential tied to their premier automation solutions. We expect greater contribution from these strategic growth areas over the intermediate to long term as we deploy return-enhancing solutions across our extensive installed customer base. This, in turn, gets us more technically tied to the customers' direct operations and creates a significant incremental aftermarket opportunity supported by our extensive and localized MRO service in our network. So throughout Applied, we are excited about our potential.

And now at this time, I’ll turn the call over to Dave for additional detail on our financial results.

Dave Wells

Thanks, Neil, and good morning, everyone. Before I begin, another reminder that a supplemental investor deck recapping key financial and performance talking points is available on our Investors site. To summarize the first quarter, while we faced slower end market demand, sales were in line with our expectations and we effectively managed through the softer demand environment. We are sustaining gross margin enhancement, generating significant free cash flow and initiated cost actions that will favorably impact earnings going forward.

Overall, we believe that we are well positioned to deliver on our fiscal 2020 and long-term commitments. To provide more detail, consolidated sales decreased 0.9% over the prior year quarter. Acquisitions contributed 2.8% growth, with an extra selling day in the quarter generating a 1.6% positive impact. This benefit was partially offset by unfavorable foreign currency impact of 0.1%.

Netting these factors, sales decreased 5.2% on an organic daily basis, reflecting, as previously highlighted, slower demand across a number of key end markets. In addition, year-over-year trends continue to be impacted by the wind-down of a large prior year flow control project, with this quarter representing our most difficult comparison. Looking at the results by segment. As highlighted on Slides six and seven, sales in our Service Center segment were essentially flat year-over-year but down 3.5% on an organic daily basis.

First quarter results reflected slower manufacturing activity and related MRO needs across our U.S. Service Center network as well as weaker demand across our Canadian operations and oil and gas end markets. Comparisons also remain somewhat difficult with the prior year first quarter up over 7% on an organic daily basis.

On a two-year stack basis, segment sales were up 4% with the trend relatively stable through the quarter. Within our Fluid Power and Flow Control segment, sales decreased 2.8% over the prior year quarter. Excluding the impact of acquisitions and selling days, segment sales declined 9% on an organic daily basis. First quarter results reflected slowing activity across our industrial OEM customer base as well as weaker flow control sales, which were primarily tied to the year-over-year drag from the large project previously referenced.

On a positive note, overall segment sales were in line with to slightly above our expectations, with year-over-year declines moderating as the quarter progressed. This was partially driven by easing technology market headwinds, where our backlog and order activity continues to improve.

Moving on now to margin performance as highlighted on Page eight of the deck. Reported gross margin of 29.4% was up 23 basis points year-over-year and 21 basis points sequentially. Results include a non-cash LIFO charge during the quarter of just under $400,000, which compared favorably to the prior year LIFO expense.

Excluding LIFO, our gross margin still increased 8 basis points year-over-year, reflecting ongoing execution of our pricing and other margin expansion initiatives, coupled with the continued mix benefit from expansionary products and value-added services.

Turning to our operating cost. On a reported basis, selling, distribution and administrative expenses were up 2.6% year-over-year, but down 2.4% on an organic per day basis when adjusting out the impact of acquisitions, foreign currency and non-routine severance expenses in the quarter. Our SD&A was elevated as a percent of sales during the quarter, which we had expected given an extra payroll day, some integration-focused investments made in recently acquired businesses and the phasing of various cost actions in response to softer demand.

Benefits from these actions favorably impacted SD&A later in the quarter and will ramp to full run rate benefit in our second quarter. As such, we expect SD&A to ease as a percent of sales for the balance of fiscal 2020. Reported EPS for the quarter was $1 per share, inclusive of approximately $0.02 of non-routine severance expense resulting from the previously mentioned cost actions. Excluding this incremental expense, non-GAAP adjusted EPS was $1.02 per share. Cash generated from operating activities was $15 million, while free cash flow was $45.1 million or approximately 113% of adjusted net income and over 5x higher than prior year. We had solid cash generation in the first quarter, which, if you recall, is typically our weakest quarter for free cash generation. We are continuing to make good progress in our working capital initiatives in a slower demand environment.

This includes ongoing traction from our shared services and other collection initiatives, and we expect additional tailwinds near term as we continue to optimize inventory levels. We remain confident in our free cash flow potential for the full year, which will support our capital allocation strategy focused on reducing outstanding debt, funding accretive tuck-in M&A opportunities and opportunistically buying back shares. We used cash on-hand to fund our purchase of Olympus Controls during the quarter, and we also paid down $5 million of outstanding debt. Our debt is down nearly $110 million since financing the acquisition of FCX, with net leverage still at 2.6x EBITDA at quarter end, below the prior year period of 3.1x.

Transitioning now to our outlook. As noted in our press release, we are reaffirming our guidance for fiscal 2020, including a sales range of down 2% to up 2% or down 5% to down 1% on an organic per day basis as well as earnings per share in the range of $4.20 to $4.50 per share. We also reaffirm our free cash flow outlook of $200 million to $220 million, which represents a 30% increase over fiscal 2020 at the midpoint.

Our guidance continues to take into account the backdrop of uncertainty in near-term industrial demand. However, we are executing the plan year-to-date and remain focused on internal growth and margin initiatives as well as our long-term strategy. Combined with recent stabilization in sales trends and benefit of first quarter cost actions, we look to gain additional traction in the coming quarters. With that, I will now turn the call back over to Neil for some final comments.

Neil Schrimsher

Thanks, Dave. Overall, while end market demand remain soft, we know how to execute and navigate through it. We’re starting our second quarter with some positive momentum, which we will look to build on. We delivered a track record of margin enhancement, quickly delevered our balance sheet post our FCX acquisition and are in position to generate record free cash flow this year to drive further shareholder returns. We believe our value proposition and growth opportunity ahead is strong and differentiated and puts us in position to adapt and capture emerging secular growth tailwinds long term.

After starting out as a bearing distributor nearly 97 years ago, we are now designing, engineering, assembling and automating critical areas of the industrial supply chain and broader economy while providing unmatched technical aftermarket and MRO support through our localized Service Center network and comprehensive product set. I want to thank our customers, associates and shareholders for their continued support. We are confident in the value we will unlock going forward. With that, we’ll open up the lines for your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from Chris Dankert with Longbow Research. Your line is open.

Chris Dankert

Congrats on a nice quarter here. I guess, starting off, you highlight the cost-out actions taken in the quarter. What is kind of the run rate there? It sounds like it was more than just kind of pulling back on discretionary spending. Maybe just a little bit more illumination on the cost-out actions.

Neil Schrimsher

So I think, overall, right, there’s quite plenty in the materials that could guide you in towards what we view as SD&A. But as we think about it, it will be lower in the second quarter sequentially. As we think about it though, year-over-year, it will be up acquisitions-related. So we won’t go into every detail around it. But perhaps to help shortcut productivity move for you, we would think around 21.5% for SD&A in the second quarter, plus or minus 20 basis points around that with the actions.

Dave Wells

It’s down sequentially, Chris. But here again, had just a 1.5 months of Olympus in this quarter. So you’ll see that run rate kick in here in Q2.

Chris Dankert

Got it. Got it. That’s really, really helpful, guys. And then just as I’m going to the deck, which, by the way, thank you for the update there, you mentioned that electronics inside of Fluid Power sees an improvement. Any directionality as far as bigger than a breadbasket how much improvement we’re seeing in electronics today?

Neil Schrimsher

I think, hey, overall, we can be pleased with some of the progress. I mean the overall market still has some slight declines in that. We just think we’re growing our content and involvement, especially with midsized OEMs, as we work with them on the equipment and the functionality that they can increase in that. So we feel like we’re gaining in content and gaining in participation, but we are participating in a slower macro market overall.

Chris Dankert

Got it. Maybe that’s my final question before I hop back in queue. Just any comment on fluid power backlog in totality?

Dave Wells

I’d say backlog, overall, we’re speaking specifically to electronics, the components there, pretty stable in terms of the sequential look at backlog across the overall Fluid Power and Flow Control business.

Neil Schrimsher

And we continue to obviously work with customers on the projects and what’s going to release and will yet get extended out for a little bit in the period as well. So we see some development in the backlog, but will it perfectly come out in the next quarter or the third quarter? Probably not that full transparency.

Chris Dankert

Got it, thank you so much guys.

Operator

You next question comes from Adam Uhlman with Cleveland. Your line is open.

Adam Uhlman

Yes. I was wondering if you could expand a little bit more on outside of the electronics market, where I think you mentioned that the orders are picking up a bit. What other end markets are you seeing kind of less worse trends that are helping moderate the sales declines here going into October? Or is that more of like a comparison issue or maybe a stabilization of certain markets? I’m just wondering if there’s any green shoots out there that you’re seeing.

Neil Schrimsher

I think that’s more of a stabilization and maybe a sequential. We think about our 30 industries, and this quarter, we would have had eight positives. So sequentially, we’re down from a sequential standpoint, I think, 18 in the last period. I think those where you still see maybe a little stronger activity or continuing would be around aggregate, food, which is – always has pretty good activity, maybe in the rubber, plastics area of that. And then obviously, the larger ones on the other side, we called those out earlier, metals, mining, oil and gas and some of the transportation, process segments.

Adam Uhlman

Okay. Got you. And then I was wondering if you could tell us what price realization was this quarter and how you’re thinking about that through the rest of the year. And then somewhat related to that, how should we be thinking about the cadence of gross margin as we go through the year?

Neil Schrimsher

We think price contributed maybe less than 100 basis points on the top line. Our view continues around margins that for the year, we’d have the 10 to 20 basis points opportunity for improvement as we work our way through the year. So that’s our view and expectations.

Operator

Your next question comes from Joe Mondillo with Sidoti & Co. Your line is open.

Joe Mondillo

Just wondering what the sort of trajectory of your business that you’re sort of viewing things. We’ve seen a lot of the macro data as well as micro data just looking at all these companies in the industrial sector. Growth’s slowing over the last several quarters. It seems like the data or the earnings for a lot of investor companies have been mixed so far, but it seems like there is a continuing slowing. I’m just wondering sort of – it seems like maybe there’s some stabilization within your business, especially at fluid power. But I’m just wondering how you’re sort of viewing things in terms of just the overall environment.

Neil Schrimsher

I think some macro things to consider still would be the production index. We think in fluid power, durable goods, which I believe is running down mid-single digits. So perhaps, in the kind of the core segment of fluid power, we might be slightly better than that right now. But we think those trends continue. We recognized them when we established initial guidance in the mid-August time frame, and those still shape our views today. And there could be a case for the low end. There might be some improvements in the back half for the higher end, but our real belief, sitting here today, still is anchored around the midpoint of the ranges.

Joe Mondillo

Okay. And then it sounds like the backlog at fluid power, flow control, it seems like you’re sort of describing it as stabilizing. I’m just curious, on the fluid power side of things, are things sort of continuing to weaken there just based on sort of some of the markets and customers that you deal with?

Neil Schrimsher

Yes. I think it’s varied, right? You’ll see the larger producers with their numbers and trends. And obviously, they also have an aftermarket but some larger OE participation. That’s not our participation. It would be more the midsized and smaller OEs and then the industrial aftermarket in that. And so I think, for us, we feel like we’re in a similar environment. Obviously, we’re continuing to work hard and engage where we can be involved.

And projects in engineering and design creates us the opportunities for aftermarket service and repair. What we don’t know perfectly is when every one of those opportunities will release as they go into the demand environment. And so that’s where we say with the backlog and some of the other ones, we feel like we’ve still just got to work our way through it as we get through this quarter and probably turn into the new calendar year.

Joe Mondillo

Okay. Then last question from me. I’m not sure if I missed this in your prepared commentary, but what are sort of some of the strongest markets or businesses that you’re seeing within the overall company?

Neil Schrimsher

Yes. I think those that – where we’d continue to see activity. Around the aggregate segment, I think food and probably rubber and plastics would be the ones that would be showing kind of continued positives in that side.

Joe Mondillo

Okay. Perfect, thanks a lot. Appreciate it.

Operator

[Operator Instructions] Your next question comes from Steve Barger with KeyBanc Capital. Your line is open.

Ken Newman

Good morning guys. This is Ken Newman on for Steve. Thanks for taking my questions. The free cash flow this quarter was very good, especially on a conversion basis relative to net income. Just curious, you talked about traction in the working capital initiatives amid a slower environment. Can you just talk about how much of that was from an internal initiative versus just inventories kind of clearing off the balance sheet? And any commentary you have on what you foresee for – from a destocking perspective in customers' inventories at this point of the cycle?

Dave Wells

Yes. Here again, we’re not suspect to a great deal of stocking, destocking nor do we see a lot of that in our business in terms of kind of the inventory that we would hold. But we did talk as we ended last year about seeing on a modest excess inventory position that we continue to work down. Some of that effort was actually offset with some project and the impact of some pushout in the Fluid Power, Flow Control segment. So we did see, even with the stronger cash flow performance, a slight build obviously on the inventory side. So the real benefit was driven by the continued work that we see around collections.

So we’ve certainly got some leverage from lower volumes but outpaced that in terms of performance, like the traction that we continued to show there. So we’ll continue to work those initiatives as we move forward as well as continue to work on some of that inventory build, burning through that. It will be a bit of a modest tailwind for us as we think about the out quarters. So it helps to firm up here again given the seasonally stronger start and the kind of the guidance of $200 million, $220 million that we put out there on free cash for the year.

Ken Newman

Right. Makes sense. Okay. And my follow-up question here is just on the M&A pipeline. Obviously, I think, in your deck, you mentioned that it still remains a high priority for you going forward. Just trying to get a better sense of how does the pipeline look if you want to provide any detail at this point. And how do you think about an ideal candidate in terms of deal size or product offering, especially in a challenging demand environment like the one that we’re seeing today?

Neil Schrimsher

I’d say our M&A priorities remain consistent across our product segments. And so that would be bearings and power transmission, it would be fluid power, it would be flow control. Now we add into that – we’ll look at automation in time as we go through and then perhaps some other general consumables. So our priorities stay the same. We work hard to know best prospects and targets and maintain a relationship as we go. You never can perfectly control the timing in any part of the economic cycle or environment.

And there’s kind of all sizes of candidates that would be in there. If you look back, on a revenue basis, maybe the average has been around less than $30 million, which would be some additions, bolt-ons, tuck-ins around some. But obviously, if you look back at history, there’s been larger ones as well. It would be hard to perfectly characterize everything in the pipeline.

Ken Newman

That’s helpful. Thank you guys.

Operator

Your next question comes from Michael McGinn with Wells Fargo Securities. Your line is open.

Michael McGinn

Hi, good morning everybody. Just wondering if I could sneak one in on gross margin, going back to that. Just – you mentioned OEM a little weaker. I was wondering to get a little sense of how much of the gross margin improvement was kind of the aftermarket fluidics, that benefiting it versus your own structural actions. What kind of mix is embedded within the current quarter and then going forward?

Neil Schrimsher

Yes. We think, just on margin, we continue to work our view of all aspects of margin and obviously use systems and tools around point of sale just to reduce variation, make better smarter decisions, stay balanced in customer mix in both with the local accounts and larger accounts. We do get benefit as we expand our products and service offering in the product mix contribution side of those. So that can and our expectation will continue to contribute to the business going forward. So I think a thing that has helped us not only this quarter but in past quarters is that we have a broad approach to working those initiatives and efforts, and that builds our confidence we can continue to do that as we look going out.

Michael McGinn

Great. And then if I could just add – get a finer point on the SG&A commentary. Historically, in a year where you haven’t done – or you haven’t been an as acquisition-heavy, your SG&A ramped on an absolute dollar perspective throughout the year. It sounds like maybe your – that cadence is changed this year. Is my assumption right there?

Dave Wells

It is. I mean it is really driven by the – here again, you’ll see an offset to the full quarter of Olympus really driven by the impact of the cost actions that we rolled out that provided very, very modest benefit in Q1. So you will see that ramp, as we discussed, into Q2 and continue to read through those benefit for the balance of the year.

Michael McGinn

Okay. And then just lastly, if I could touch base on the M&A side. You guys moved discipline M&A down in the deck on Slide 11, but it still sounds like it’s a focus for you. In the past, FCX increased your TAM in certain markets. I think chemical is one. Is there an area that you’d like to highlight that you’re – past initiatives, you’re building – you think you’re building scale or current verticals where you think you still have some work to do?

Neil Schrimsher

Well, we like that our targeted addressable market continues to expand and grow. It’s probably getting closer to $70 billion as we do some things and think about the business expansion geographically within our served markets. We could build a path that it could easily get to $80 billion in that side. And we continue to think market back to industrial customers, how do we broaden our capabilities to their requirements?

And I still believe there is fundamental drivers that customers are looking to consolidate their spend with few or more capable suppliers, and they’re also getting challenged as they deal with the kind of a technical labor expertise gap. And they’re needing some qualified providers to do that. And so that’s what really drives our focus, our efforts in not only bearings and power transmission but fluid power and flow control and automation because we think all of those are linked to industrial production and the broader industrial supply chain.

Michael McGinn

All right, appreciate the color.

Operator

At this time, I’m showing we have no further questions. I will now turn the call over to Mr. Schrimsher for any closing remark.

Neil Schrimsher

I just simply want to thank everyone for joining us on the call, and we look forward to seeing many of you throughout this quarter. Thank you.

Operator

Thank you, ladies and gentlemen. This concludes today’s conference. Thank you for participating. You may now disconnect.