Applied Industrial Technologies, Inc. (AIT) Q3 2019 Earnings Report, Transcript and Summary

Welcome to the Fiscal 2019 Third Quarter Earnings Call for Applied Industrial Technologies. My name is Mariama, and I'll be your operator for today's call. At this time all participants are in a listen-only mode. Later, we will conduct a question-and-answer session [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.

Thanks, Mariama, and good morning, everyone. We appreciate you joining the call. I've been joined Applied about a month ago very excited for this new role and the many opportunities we believe we have here at Applied. It's been great to work with many of you in the investment community over the years, and I look forward to talking and meeting once again in the days ahead. So to get started this, morning we issued our earnings release and the supplemental investor deck. These documents are available at 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 during the call and make statements that are considered forward-looking. Our forward-looking statements, including those made during the question-and-answer portion, speak only as of the date hereof and are based on current expectations that are subject to certain risks. These include trends in sectors and geographies, the success of our business strategies 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, whether due to new information events or otherwise. In addition, the conference call we use non-GAAP financial measures explained in our press release and supplemental presentation, which are subject to the qualifications referenced in those documents. The teleconference is being made available to the media and the 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 distribute, all content of the call will be considered fully disclosed. Our speakers today include A - Neil Schrimsher, Applied's President and Chief Executive Officer; and Dave Wells, our Chief Financial Officer. With that I'll turn over to Neil.

Thank you, Ryan, and good morning everyone. We appreciate you joining us. I'm pleased to welcome Ryan to the call today, we're very happy to have him on the team and look forward to the contributions he will make both externally with the investment community and internally with our financial teams. I'll start today with a brief summary of the quarter then Dave will follow to review our financial results in more detail, and also cover our updated guidance. Our net sales for the third quarter grew 7% to $885.4 million from $827.7 million in the same quarter last year. Net income for the quarter was $16.5 million or $0.42 per share, compared to $36.6 million or $0.93 per share in the prior year. As referenced in our news release our reported results were impacted by a non-cash intangible impairment charge and related restructuring cost in our Canadian upstream oil and gas operations. Excluding these items non-GAAP adjusted EPS was $1.16, up 9.4% from the prior year on a comparable basis. Additionally, we recorded a non-cash LIFO charge in the quarter, due to continued inflationary headwinds, which is included in the adjusted results. Well, Dave will be adding more detail on the numbers shortly. Overall our performance this quarter was driven by three factors; solid growth in our Service Center segment; a focus on gross margin execution; and ongoing SD&A cost accountability and productivity. These factors are allowing us to sustain positive organic growth despite more difficult comparisons and drive ongoing margin expansion at various levels of the organization. The results partially reflect continuous improvement initiatives and ongoing opportunities here at Applied that remain early on and leave us well-positioned for the future regardless of the industrial cycle. We also remain positive on the long-term share gain potential and secular tailwinds within our Fluid Power and Flow Control businesses. That said, as discussed last quarter, softness in technology end markets, primarily electronic equipment and component manufacturers, as well as tougher comparisons are impacting Fluid Power growth at present. Also, we continue to face inflationary pressures as evidenced by the LIFO charge in the quarter. Aside from these variances we believe the industrial cycle remains firm, highlighted by above normal sequential growth in our service center segment, along with favorable order and backlog momentum in our Fluid Power and Flow Control segment as we exit the quarter. We continue to take appropriate business and cost actions in Western Canada and remained encouraged by the positive activity within our U.S. oil and gas markets, where our scaling position in key basins is contributing nicely to our multifaceted growth and differentiation. On that note, we're pleased to welcome the addition of MilRoc distribution and Woodward Steel to the Applied family of businesses in the quarter. Officially joining the company in early March, this business is an excellent strategic fit that complements and further diversifies our product and service offering to key U.S. oil and gas markets, primarily upstream in the Anadarko and Permian Basins. To provide a little more color, the business is a provider of oilfield focused products, namely pumps and valves and also offers equipment repair services. Additionally, the business is a full line steel supplier to oil and gas and agriculture industries, providing many custom services that include sowing, fabrication and forming. With a strong foundation and a history of service, value and timely delivery that are well aligned with Applied, we look forward to the synergies and growth we will realize together. At this time, I'll turn the call over to Dave for additional detail on our financial results.

Thanks, Neil, and good morning, everyone. I would also like to welcome Ryan and reiterate how pleased we are to have him on the team, as we work to continue to enhance our investor communications and outreach. Before, we move on to further details on financial results for the quarter another reminder that a supplemental investor deck recapping key financial and performance talking points was issued this morning and is available on our investors site. Starting first with top line, on a consolidated basis sales increased 7% over the prior year. Acquisitions generate 6.2% growth year-over-year, while foreign currency lowered sales by 0.7% and the difference in selling days was a negative 0.8% impact, as compared to prior year. Netting these factors, sales increased 2.3% on an organic daily basis. As previously mentioned and also highlighted on Slide five of the investor deck, growth in the most recent quarter was driven by our Service Center segment, where organic daily sales increased 6% year-over-year and roughly 5% sequentially. The sequential increase was seasonally strong reflecting generally healthy industrial MRO markets, improved price recovery, solid sales execution in US, as well as steady growth in our international operations and US oil and gas focused businesses. As Neil shared during March, we completed a small tuck-in acquisition, which added just under $4 million of sales or 60 basis points to segment growth for the one month of ownership in the quarter. Combined with adverse impact from foreign currency and fewer selling days total segment sales increased 4.9%. Growth rates were relatively consistent as the quarter progressed, while daily sales rates increased throughout the quarter. Moving now to our Fluid Power and Flow Control segment. Sales increased 12.6% over the prior year. Acquisitions added 21.1% reflecting one remaining month of inorganic contribution from the acquisition of FCX, which closed February 1st of last year, as well as a full quarter of contribution from our early November acquisition of Fluid Power sales. Excluding the impact of acquisitions and sowing days segment sales declined 7.5% on an organic daily basis. Sales per day were flat sequentially to the prior quarter in line with our expectations and guidance. As communicated last quarter, the organic decline primarily reflects lower demand in technology related end markets and tough comparisons following robust growth in this market during fiscal 2018, as well as the wind down of a large prior year FCX Flow Control project. This performance was consistent with our expectations, while organic growth on a two-year stacked basis of 10% improved slightly from last quarter highlighting stabilization. I would also point out that our backlog in Fluid Power and Flow Control continues to expand a positive sign for these longer cycle businesses going forward. Looking at a geographic cut of sales performance in the quarter, sales in the US were, up over 8% year-over-year or nearly 2% on an organic daily basis. Sales from our businesses outside of the US were, down slightly on a reported basis, but increased by just over 4.5% when excluding the impact from foreign currency and selling days. Moving on to margin performance, as highlighted on Page six of the deck, we reported gross margins of 28.9% were unchanged year-over-year and sequentially. Latest reported results, however, include a 41 basis point non-cash LIFO inventory charge, which was higher than our expectations and reflective of an ongoing inflationary environment. On an adjusted basis, our core gross margins increased 38 basis points year-over-year, and nearly 20 basis points organically. Solid underlying gross margin performance, which was masked by the non-cash LIFO charge in the quarter reflects the 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 3.5%, but down 1.5% year-over-year, when adjusting out the impact of acquisitions, as well as non-recurring restructuring charges in the quarter, which drove nearly one point of the reported increase. Restructuring actions were primarily focused on our Canadian upstream oil and gas operations in response to ongoing industrywide weaker demand in that geography and included charges for severance and facility exit cost. Lower adjusted year-over-year spend reflects the benefit of productivity initiatives, leverage of systems investments and our ongoing diligence in controlling spend. Overall, our gross margin and cost execution in the quarter highlights various self-help opportunities we remain focused on regardless of cycle dynamics. Solid underlying operational performance in the quarter was further masked, however by a $31.6 million non-cash intangible impairment charge for certain long-lived intangible assets. These assets were related to the company's reliance upstream oil and gas operations in Canada with the impairment attributed to the continued decline in the oil and gas industry in Western Canada. The resulting $23.1 million after tax impact on net income coupled with a related $3.8 million valuation allowance against certain deferred Canadian tax assets generate a combined $0.70 adverse impact on current quarter earnings per share. Even with the incremental 38 basis points of LIFO charge year-over-year and excluding non-cash impairment and restructuring charges fall through to pre-tax income, an incremental volume was nearly 18% in the quarter. Reported EPS for the quarter was $0.42 per share on a GAAP basis or $1.16 per share on a non-GAAP adjusted basis, when excluding the net impact of the impairment and restructuring charges previously discussed. This represents over 9% growth year-over-year on a comparable adjusted basis adjusting out the adverse impact of the $0.13 per share non-recurring FCX transaction cost incurred in the prior year quarter. Cash generated from operating activities was $11.6 million for the quarter, which was below the prior year period and expectations, primarily as a result of delayed inventory burn. Year-to-date, we have generated over $77 million in operating cash flow, which is up over 60% compared to the prior year. Traction from our shared services and other collection initiatives continues to be a bright spot with another eight point reduction in past due accounts receivable realized in the quarter. Our capital allocation strategy continues to focus on reducing outstanding debt and funding accretive tuck-in M&A opportunities. Net leverage was under 2.9 times EBITDA at quarter end below the prior year period of 3.3 times EBITDA. We had a slight draw on our revolving credit line in the most recent quarter to support our recent acquisition and additionally funded $11 million of opportunistic share buybacks, totaling just over 192,000 shares during the quarter under our current authorization. Transitioning now to our updated outlook. We reaffirm the midpoint of our fiscal 2019 earnings per share guidance on a non-GAAP adjusted basis, while tightening the range to between $4.50 to $4.60 per share, as we approach year end. Our updated outlook now assumes a sales increase of 14% to 15%, which includes an organic sales increase of between 3% and 4%. This implies a fourth quarter fiscal 2019 earnings per share range between $1.11 to $1.21. Consistent with the most recent quarter, and our earlier guidance by segment, we are targeting fourth quarter organic daily sales rates increasing mid single-digits in our Service Center segment with a 4% to 7% decline in our Fluid Power and Flow Control segment giving continued tech driven softness and tough prior year comps. Lastly, we are revising our free cash flow guidance for the full year to between $105 million to $125 million to reflect the delayed benefit of inventory conversion and resulting softer third quarter fiscal 2019 cash flow. As we look forward to our June fiscal year-end and into fiscal 2020, we expect operational inventory levels to decrease to more normalized levels as we burn off excess investment in inventories made over the past year to protect service levels and in response to rapidly inflationary increases. Additionally, we anticipate further benefits from ongoing working capital management initiatives, which will maximize cash flow into fiscal fourth quarter 2019 and 2020. Our free cash generation capabilities remain strong and a hallmark of our model with our optimized margin profile providing additional tailwinds in years to come. As such, based on current demand and inflation dynamics, we anticipate free cash flow in fiscal 2020 to exceed $200 million. This will support our commitment to maintain our track record of consistent dividend payments and regular increases, while continuing to pay down debt and invest in acquisition growth opportunities going forward. With that I will now turn the call back over to Neil for some final comments.

Thanks, Dave. As we enter the last quarter of fiscal 2019 and progressed through year three of the industrial up cycle, we remain encouraged by what we've accomplished over the past three years; including generated compound annual EBITDA growth of nearly 20%, roughly a 100 basis points of gross margin improvement and a 150 basis points of EBITDA margin expansion. We've exceeded prior peak sales and margins and we still have much more room to grow in realizing our full potential. With our annual planning process under way, we look forward to building on this momentum with strong execution through our fourth quarter we will deliver our commitments and provide successful finish to the fiscal year, setting the stage for the next level of growth in fiscal 2020. We're excited for what's to come anchored around our industry-leading product offering, technical value-added capabilities and enhanced differentiation. With that we'll open up the lines for your questions.

Thank you. We will now begin the question-and-answer session [Operator Instructions]. Your first question comes from Adam Uhlman with Cleveland Research. Your line is open.

I just wondered if you could expand a bit more on what you're seeing in general business trends. And if you could talk about, you know, the organic sales growth rates as -- by month as we moved through the quarter and what you saw in April to-date?

So if we look back at the quarter, our sales per day increased each month on an absolute dollar basis and percentage wise improved January to February and again February to March, the greatest increase, January to February. The comparable is getting a little more, but the March increase was greater than the absolute total for the quarter as well. So I'd say, overall sales per day continued with positive developments. If we look forward at April right now, really somewhat as expected low single-digits, we've got a few days to go maybe a little bit of holiday timing impact with that, but it's at low single-digits right now.

Okay, and then for the guidance, it seems that you might have raised the outlook on organic growth, I think previously you're saying maybe 2% to 3% for the year and now 3% to 4%. Is that correct and kind of, where are you feeling better about the business?

So if we look at the performance in our Service Center business and year-over-year in the quarter and sequentially up to 5% we're seeing that, we alluded to it and in the comments backlog improving in the Flow Control and in Fluid Power, we'll be working to convert that into this fourth quarter. I think the guys in our businesses -- our global businesses in local currency performed well, some currency impact in that. So we will be focused on a strong close to this fiscal year.

Your next question comes from Steve Barger with KeyBanc Capital. Your line is open.

First question is on Fluid Power. So the negative 7% organic growth in the quarter. How much of that is the technology and electronics business and how do you see that segment playing out in 4Q and next year?

So out of those Fluid Power companies over half had growth in the quarter, we set the technology aside, we still had growth. Sequentially, we were flat overall with the movement. We think the fourth quarter in the technology segment is likely similar. We think that perhaps it can have some improvement. Long-term, we know with artificial intelligence, Internet of Things, other requirements, it's going to return to growth in that. We think we work through that this next quarter and we start to likely see some improvements as we would go into the first half of our next fiscal year. The rest of the businesses, I remained encouraged by what we are doing to bring electronic solutions into hydraulic applications especially from mobile OEMs. Now we're looking to further expand that, replicate that across applications and reach new customers in doing that. So I'm pleased with that continued momentum as well.

Are there any specific end-markets where you're seeing real success in the service offerings or the Fluid Power integrations that you'd call out?

I don't know that in single out anyone. I mean, there are construction applications, there are agricultural applications as they go across response vehicles. I think anywhere in that mobile environment and I'm also encouraged by the teaming that's going on for industrial applications and how we are leveraging our position whether it occur from bearings and power transmission with our Service Centers or even on the Flow Control side with FCX to identify and bring power units and other solutions from the fluid power side, that's additive and helpful. So we'll be working both the mobile side, as well as the industrial side, the Fluid Power as we go through the quarter and into the next fiscal year.

And then on the free cash flow guide you guys were very confident on the January call in the prior guidance. When did you start to see the issues around the late inventory burn-off. And is that inventory more on the Service Center side or Fluid Power?

That inventory does tend more to the Service Center side and you know here again we had said they've been working with the team, you know, some objectives as far as the inventory reduction trajectory that we just flagged in the quarter. You know, we had some additional impact coming off a strong Q2 in terms of some sales phasing here again a lot of that sales -- sequential sales increase was back-end loaded, and it did not have that phenomena as we close December and given the, kind of softer last couple of weeks of December that we saw. So that provide a bit of lift in Q2 on the either receivable side of the equation and as we continue unwind is kind of evenly split across the sales phase in inventory and payables story for Q3, as we continue to unwind the Q2 performance, we did have a bit of an artificially inflated payables position as we've, kind of, discover with some latest in ERP go lives in the FCX business, and you know embedded in that payables number is a contra receivable from our suppliers for some the incremental levels of rebates and vendor support that we're seeing in response to the stronger business conditions. So those three factors really played in to drive the quarter performance, unfortunately a lot of which does spill over into the full year projection. Just thinking about the trajectory we're seeing on inventory reduction and some additional headwinds that we see in Q4. So hoping to do better, continuing to drive like I said very pleased with the reduction in past due that we're seeing out of our initiatives around shared service collections here again eight points in the quarter, but some of that here again offset with those other factors I mentioned.

And last one from me. It's good to hear you say that you see the $200 million falling in 2020, but just given your mix and margin profile on a go forward basis. Wouldn't you have expected that anyway and more broadly? Is that a reasonable level to think about as you think about your strategic plan and moving toward those goals?

I think it actually is a reasonable level to think about as we move forward. There again I view this year is somewhat an anomaly with the inventory that we put on the shelf in response to both the service supply constraints that we saw in certain piece of the business. A lot of that in advance of some of the rapid increases -- inflationary increases we saw driven by tariffs, you know, for the most part. So you know, I would strip that as a bit of an anomaly, little bit disappointing in terms of our traction to gain some of that burned off. But I'd see that normalize as we continue to move through Q4 and round the quarter and the next year and get back to a more normalized cash flow trajectory where, you know, again we help ourselves with some of the initiatives that we have working in terms of past due reduction continuing to better manage the various inputs on the inventory side and continue some of the payables initiatives to help ourself there as well.

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

I guess first off, nice quarter as you know on the gross margin side of things even with that the LIFO being in there. I think based on your comments was pricing up about 3% in the quarter. Is that the right way to think about it?

Here again we did speak specifically to pricing. I think we've talked on prior calls, you know, we get a good pricing measure on about a third of that repetitive business year-over-year out of Service Center segment. So looking at kind of the mix of local accounts where we're doing very well in terms of pacing some of those inflationary increases, you know, continued improvement on the large account activity with some beginning of the year price increases that went through, I call it two to three across, you know, that piece of the business, which we think, you know, generally translates to more broadly across the business, but don't have the specific price metrics at play.

Thank you.

I think, overall the improvement in gross margin performance, if you strip out and look organically up about 20 basis points. Certainly does indicate some of that traction in terms of price realization, but also, you know, the continued benefit of some of the expansionary products and other mix benefit that we see there.

Yes, absolutely nice to see that, that gross margin moving higher here. And, kind of, drilling down that based on your prior comments and kind of what we are seeing in the guide here, it looks like 29.4% to 29.6% in the fourth quarter is kind of the tacit range you're looking at, is that the way to -- to be thinking about it?

Yes. We assume about 20% or 20 basis points, excuse me, sequential improvement in, you know, in gross margin as we move forward into Q4.

And then just last one for me. And sorry, if I missed it, but could you kind of give some highlights on the three markets and just, kind of, what's moving beside to electronics?

So we would have had 22 of the 30 positive, I think that's up sequentially from the prior quarter and so metals primary and fabricated aggregate oil and gas, metallic mining, those are all positive, rubber, plastic products, chemicals. Those demonstrating some weaker comparables, lumber wood products, obviously the computer electronic manufacturing we talked about, coal mining would be in that category as well.

Your next questions come from Michael McGinn with Wells Fargo. Your line is open.

Good morning, gentlemen. This is Mike on for Allison. I just want to ask a couple of questions about the ERP conversions with FCX. If my memory serves me right, your prior conversions were SIP, I just wanted to confirm that's a common platform you are moving toward?

I'll start and Dave, we actually operate that business and they were -- and continue on a P21 system. We find it's very good from a service and repair standpoint. So very similar to our Fluid Power business, that operates on that. So our Service Center business operate on one ERP platform system common and our Fluid Power and Flow Control really has one common one. And so in time, we'll continue to look within those businesses on migration as we acquire. We look at what's the appropriate time to do that. That was in FCX's history of doing that, and we'll look to continue that process as well.

Okay, either way, you have the muscle memory from prior ERP conversion, so can you talk about is that giving you confidence -- what the timeline for FCXs relative to your prior conversions and that gives you confidence in your working capital assumptions for 2020?

Yes. So to be clear FCX continues on their ERP platform, which is common with the vast majority of our Fluid Power in that operating side. So there is no system, there's no ERP conversion that would do. That would hold with the acquisitions that were made within FCX that were on versions of the same system coming in. So there is very little system conversion work going in, so that does build confidence on working capital and candidly other performance. I think we have an understanding and we demonstrate how to use the information and data to reduce variation on the pricing side. It helps us in shared service and centralization to do things on receivables. And the information helps us in managing payables also. So there's not a time conversion linked to any ERP's.

Just to further clarify hopefully this was really the conversion to P21 of the last couple of acquisitions that FCX had done, you know, prior to the acquisition of FCX by Applied. So entire footprint now in that P21 instance, which here is against a common platform that we use in our Fluid Power business.

And if I could just sneak one more in on capital allocation you talked about it on the call larger buyback this quarter small bolt-on time, but there are some larger opportunities out there specifically from one competitor, who has been pretty vocable their -- shopping their business. Can you just give us a sense of where you guys are acquisition wise I think prior to Q3 you said, you thought the oil and gas market was kind of right sized here. Do you still think that now and what -- what do you expect going forward?

Yeah, I'd say maybe for your earlier one probably best that you asked the specific or the related questions to a particular company, but they -- from our side, I believe we've continue to be clear on our M&A priorities. In bearings and power transmission, we're interested in specific opportunities, further strengthen geographies, fill a specific market gap or void, really versus a large property that, that may present some synergy, but undoubtedly comes with dis-synergies from overlap of locations, customers and associates or employees. We have inputs and priority around Fluid Power, expanding our value-added geographic reach around hydraulics and pneumatics, both for OE and MRO applications. We have our priority around the engineered process Flow Control, extending the geographic reach in the US, perhaps in time in North America and across those product ranges. We just look at that business we know in pumps and valves and instrumentation, filtration there's opportunities for us. We've talked about customers wanting to have an increased desire to consolidate their spin, do business with few or more capable suppliers. That leads us to look at maintenance supplies and solutions, but there we've done more things organically of extending those products into our distribution centers, hiring vendor managed inventory specialists, but we could look there from an acquisition standpoint. It would be added to the business. In oil and gas, it's 10% of our business, I think that's market weight and there I like the move that we've made now into Anadarko, it's one that we've looked at. We think that's important. If we think about our Permian presence we're very pleased with that. It will continue to grow those businesses will, as we have opportunity as takeaway capacity constraints are dealt with in that side. But part of that demand field will come from Anadarko in time, so that seven plus locations that we have in that deposit and that scoop/stack play will be beneficial for us. And I would say lastly on the M&A side, we'll continue to look at right adjacencies that are important to our industrial customers and would be well represented around our technical capability around products and value-added services and solutions. So though there are priorities that we're working on and that -- those priorities are reflective in our M&A pipeline and candidly how I spend my time.

Your next question comes from Scott Blumenthal with Emerald Advisers. Your line is open.

Neil, can you or have you disclosed a backlog number. I did get the percentage sequential improvement. And can you talk about how much of the Fluid Power and Flow Control segment is driven by backlog or may come out of backlog in any one quarter?

So we haven't on an absolute number in doing it. We talk about in those businesses value-added services and projects approaching 30% of that business, so a lot of that backlog would be around those projects. Sometimes there's naturally flow business in a brief period that get caught up in that backlog. So we're happy to share it in its overall and talk about its trends, but we don't go into the specific numbers.

And then I guess the second part of my question. How much of the quarterly or annual sales do you believe are driven out of that backlog?

Coming into a quarter, we would expect about 30% of those sales to be derived from that backlog position that we would be seeing coming into the quarter.

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

Okay. I just want to thank everyone for joining us today. We look forward to talking and seeing many of you as we move throughout this coming quarter.

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