Welcome to the Fiscal 2021 First Quarter Earnings Call for Applied Industrial Technologies. My name is James, and I'll be your conference operator for today's call. [Operator Instructions] Please note that this conference is being recorded. I'd now like to turn the call over to Ryan Cieslak, Director of Investor Relations and Treasury. Ryan, you may begin.

Thanks, James, and good morning to everyone on the call. This morning, we issued our earnings release and supplemental investor deck detailing the first quarter results. Both of these documents are available in the Investor Relations section of applied.com. Before we begin, just a reminder, we'll discuss our business outlook and make forward-looking statements. All forward-looking statements are based on current expectations subject to certain risks, including the potential impact from COVID-19 as well as trends in sectors and geographies, success of our business strategy and other risk factors. 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, which are subject to the qualifications referenced in those documents. 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.

Thanks, Ryan, and good morning, everyone. On behalf of our entire team at Applied, we hope you and your families are healthy, safe and managing well. I'll start today with a business update, including how we continue to respond to the pandemic as well as progress with various internal initiatives and color on the external environment. Dave will follow with a summary of our financials and some specifics on our first quarter and outlook, and then I'll close with some final thoughts. Into early fiscal 2021, we're seeing a modest recovery gain momentum and are executing well. I'm encouraged by the start to the year and believe we are in a solid position to build off this positive momentum as we move forward. Our operations are functioning productively. Our supply chain and inventory levels are in a good position and we are responding effectively to customers' increasing requirements as an initial demand recovery appears to be underway. Throughout the past several quarters, we have quickly adapted to the evolving environment, including implementing new processes and ways to support our customer needs. A key part of our message to all our stakeholders during these evolving times is how Applied is stronger today than in prior cycles. This includes benefits from our expanded offerings, greater technical focus and a more diversified end market mix. We've also strengthened our marketing and sales efforts to showcase our comprehensive and leading technical offering and to further develop our cross-selling opportunity. We are increasingly critical to our customers as maintenance, production and efficiency requirements begin to ramp across their core operational infrastructure. These elements are providing near-term sales support and leave us increasingly constructive on our growth potential going forward. In addition, investments in systems, talent, analytics and operational processes in recent years are yielding additional…

Thanks, Neil. Before I begin, I will remind everyone that a supplemental investor deck recapping key financial performance and discussion points is available on our investor site for your additional reference. To provide more detail on our first quarter, consolidated sales decreased 12.7% over the prior year quarter. Acquisitions contributed 1.1% growth, partially offset by an unfavorable foreign currency impact of 0.4%. Netting these factors, sales decreased 13.4% on an organic basis with a like number of selling days year-over-year. Turning to sales performance by segment, as highlighted on Slides 6 and 7. Sales in our Service Center segment declined 14.9% year-over-year or 14.4% on organic basis. The decline reflects the ongoing impact from COVID-19, including reduced industrial production activity and customer facility restrictions which continues to impact MRO demand across our service center network. However, the 14% organic decline year-over-year represents an improvement from the 21% decline during last quarter. In addition, average daily sales rates were up more than 4% sequentially and above the normal seasonal progression. As Neil highlighted, we saw greater maintenance activity in break/fix demand. More customers are providing access into their facilities and releasing working capital spending following a slow pace during the summer months. Year-over-year declines remain greatest within Metals, Oil & Gas and Machinery end markets but were balanced by underlying improvement within Food & Beverage, Pulp & Paper, Aggregates, Forestry and Chemical Industries as well as ongoing growth in our Australian operations. Within our Fluid Power & Flow Control segment, sales decreased 7.4% over the prior year quarter with our August 2019 acquisition of Olympus Controls, contributing 3.8 points of growth on roughly half a quarter of remaining inorganic contribution. On an organic basis, segment sales declined 11.2%, reflecting lower demand across Industrial, Off-Highway Mobile and process-related end markets. This was…

Thanks, Dave. Overall, I'm encouraged by how we started the year. Our entire team has shown tremendous resiliency over the past several quarters which is driving improved performance into early fiscal 2021 and positions us to respond and capitalize on the recovery as it continues to unfold. We have proven the durability of our business model, strengthened our balance sheet and optimized our cost structure. We are leveraging our unique and differentiated industry position to be an industrial growth leader into the emerging recovery and in years to come. All of this is reflected in our first quarter results and provides further evidence of the positive path we're on. From our industry-leading technical MRO capabilities to our Engineered Solutions focus, multichannel cross-selling opportunity and expanding automation platform. We have multiple catalysts to expand our market potential and accelerate share gains in coming years, all while driving additional margin expansion. This is integrated into our long-term targets of $4.5 billion in sales and 11% EBITDA margins, which are well within our capability and provide the framework for accelerating earnings power and stakeholder returns long term. Once again, we thank you for your continued support and look forward to demonstrating the strength of our value proposition going forward. And with that, we'll open up the lines for questions.

[Operator Instructions] And our first question comes from the line of Adam Uhlman with Cleveland Research.

Congrats on the strong quarter. Yes, I wanted to start the discussion about the pace of demand through the quarter. It sounds as if the year-over-year declines moderated and eased as you got through September. Maybe you could correct me if I'm wrong, but then it sounds like it took another step down at the beginning of October, I guess. And anything that you would point out as certain industries that might have been more acutely weighing on that gradual recovery or anything else that sticks out to the choppiness of sales?

Yes. Adam, I'd say at this point, I don't know that I would point to really any industries. I think those that were contributing and running positive somewhat continued. The heavy industries would continue to have some choppiness or some challenge to it. I think it could be a function of we ended the September period, the quarter well. And there was just some natural easing as we started those first few days into October. And as we look at it, then we are encouraged as we continue to see that progress as we work through October kind of week by week seeing some of that sequential improvement, which would really include our Service Center segment but also the Fluid Power & Flow Control.

Okay. Got you. And then secondly, on the gross margin, I think, Dave, you said that you expect it to be relatively flattish here into the December quarter. I think historically, it's expanded a little bit sequentially from the September quarter. And I think with the local customer demand maybe starting to pick up a little bit it would have been stronger. I would have thought it would have been a little bit stronger I guess. Is there anything weighing on the margin or is that just a conservative base case at this point?

I'd say you call it the uncertainty in terms of what we see play out over the quarter. So typically, I don't think there's a strong increase sequentially as you move from our Q1 to our Q2. And just given the uncertainty, the choppiness of some of the activity and some of that inflationary impact that we're starting to see reading through, which did weigh on LIFO on the calc there, that had the -- standpoint of trying to provide guidance, I'd call it, consistent sequentially with Q1 results. We like the traction that we saw in Q1 with sequential improvement. And as we said, starting to see some of that local account mix coming back, but we continue to work some of the self-help initiatives there and the accretive product mix reading through. So we would hope some of that would continue into that Q2 to offset what we might see in terms of the additional LIFO headwinds.

Okay. Do you -- would you expect to see greater supplier incentives being offered in the December quarter for inventory purchases, I guess, relative to maybe a year ago? Or is it still kind of normal?

Typically, you might see that. I think the overall sentiment has been in some of the discussions that there's not as much appetite or need to drive that incremental volume given a year that had such uncertainty and maybe lackluster performance. So we find that many of our suppliers are not as attuned or running to a plan or something that was set 12 months ago and maybe a little less motivated to drive any kind of special deals on that front is the kind of the overall sentiment, I believe, that would see.

And our next question comes from the line of Chris Dankert with Longbow.

Dave, kind of wanted to go back to what you'd mentioned on SG&A, again, based on the decrementals, and I think just some of your comments. So we're looking at flattish sequentially to maybe up slightly into the second quarter. I just want to make sure I heard that correctly.

That's correct. Right. Just thinking about here again, some the investments still around growth, starting to see some of that further roll-off of the temporary cost actions as well as the impact of some of the medical and some of the things that provided favorability beyond discrete actions, travel, entertainment and things of that nature starting to read back through. So that would offset what really is a 2-day differential in terms of days. And which puts us at that flat to up slightly in terms of the SG&A progression as we move from Q1 to Q2.

Perfect. And I guess thinking bigger picture and longer term, you guys have done a lot in terms of investment in technology, but, I guess, are there any kind of blind spots or places that you do think you need to bolster or that could require some investment as we kind of come out of this downturn?

I think we've done a nice job of continuing to make those investments and being able to prioritize appropriately. We've got ongoing initiatives right now for warehouse management, software and automation that are continuing to be deployed. Work around further enhancements to .com, things of that nature that given that the big ERP investments are behind us, like where we've continued to prioritize those investments and thinking about Internet of Things and trying to get in front of some of that. So we've continued to fund those investments, striking a balance, obviously, with managing the near-term results that have not deprioritized some of those projects that we'll continue to set the business up for success as we come back out of this and continue to capitalize then on recovery going forward.

Got it. Got it. Glad to hear it. And just one last one, if I could. I guess thinking about ACS, how does that really kind of interplay with Olympus? Is there really a cross selling opportunity? Are they kind of in the same realm? Just any thoughts about how the portfolio is kind of coming together slowly here.

Yes. I think, Chris, the cross-sell opportunity really would be with the team and our legacy positions, industrials in our service center side of the network, obviously, right. We're all around that equipment and where discrete automation can be beneficial. We're seeing that with Olympus and the connection with Fluid Power customers or Service Center customers. We do think Olympus and ACS, there can be technology sharing as we work engineering projects can be cooperation and collaboration on that. And I think the companies bring a combination of expertise across some of the technology and applications, be it vision, be it robotics, mobile and collaborative, even communication products as customers look to expand their connectivity within their facility or connected to the Internet of things across multiple sites. So we think the businesses do help one another. And we think there's a big additive help that can occur with our Service Center industrial customers.

[Operator Instructions] Your next question comes from the line of Michael McGinn with Wells Fargo.

Neil, I was curious, has there been any early learnings from this downturn? And where you can structurally pull back, maybe not on labor, but certain processes that are not as important to driving profitable growth and share longer term?

I think we continue to look as we go through what's the balance of some of the temporary measures and actions that we take and when do those become a little bit more permanent or structural. And I would think it could be around geographies or access or points to certain market segments as we consider. I think there's been a kind of great learning as we've had in leveraging our technology investments that we've had, our go-to-market collaboration across our groups and how we are connecting with customers in newer ways with technology. And some of that as customers have become more open to that. But I think also, as we've gone through, it does reinforce the importance of being close to customers and having the ability to have a physical/virtual connection with them, to them as we go through. So I think that's going to stay important given the critical nature of the products. And then as customers have opened their facilities, I would say, we were one of the early ones in and given pretty bar out access. Obviously, our teams are following the safety guidelines, the protocols and procedures. But given the importance of our products and solutions that enable movement inside of these customers, it reinforces there. So I think in any time, when you go through something like this, there's learnings that we will translate and pull forward. And I think some of those play into as we grow into automation and how some of those technologies can help solve our customers' problems. And as customers have one more level of problems, that just further improves that return on investment around those technologies being adopted inside of their facilities. So there's a growing interest there.

Okay. Appreciate that. And then switching gears to the acquisition. I was curious ACS, what the level of cyclicality in that business has been? How they fared during the downturn, maybe from a revenue or margin standpoint relative to your -- the core Applied brand? Also, you have a $100 million per year acquisition target. I was just wondering, this is pretty small. Are there enough properties out there to fill that void for you guys?

Well, I'll start with the latter. From a pipeline standpoint, throughout, we remain active to our priorities. And I think my short answer to that would be yes. Now given the environment, you never perfectly control the timing. But we remain active around those priority areas around Fluid Power, Automation, Flow Control and also dialogue around our traditional Service Center segment as well. So those continue to go on. I think from an ACS performance, if you look back, they've demonstrated good growth. They have nice diversity in their end market segments that would include Life Science and some other technology segments as we think about the business going forward. There's already cross communication where we have common customers with our Service Center network where we have some presence where one of the groups can help one or the other with an introduction or work on a mutual opportunity. So they have demonstrated good growth throughout. If I look back historically from a margin profile, they would be above -- gross margin profile, they would be above the company fleet average. I'd say starting points, they would be from a profitability standpoint at kind of company average as we think about it going -- as we think about it today, but with the opportunity to contribute bigger and be better.

And our next question comes from the line of Steve Barger with KeyBanc Capital Markets.

Can you talk about competitive dynamics versus smaller private players right now? Or just what are you hearing in the channel about their health? And does that create any opportunities?

I don't know that I'm hearing too much on the overall health. I mean no doubt it's a challenging environment. You think about the operational requirements, the working capital requirements now that will be coming to go through. So in those regards, right, businesses are not easy. And so perhaps for some, depending on where they're at in the generational cycle can have them evaluate. I think overall, the space stays productive. I think there's good recognition of cost and cost to serve in doing it. And then I know from our standpoint, our broader capabilities are advantageous for us to be connecting with customers in these times. When we can address opportunities as we can address operating challenges or issues that they may have around Bearings and Power Transmission around Fluid Power, around Flow Control and now have even more Automation discussions, that's helpful for us as they -- customers perhaps more slowly open their facility to third parties.

So to the extent that your team has been able to get out there and prospect with this new broader set of capabilities, have there been conquests? Are you seeing any kind of measurable advancement of those -- of the ability to sell the portfolio?

We are seeing progress. And I mean, I think our potential is very notable. I'm encouraged, obviously, a bigger, stronger, more open macro helps all of that go faster. But I am encouraged. And it kind of success begets success. It opens eyes to the team and the momentum in the opportunity bill. So if I think about our sharing is higher, our quote activity is higher, the work along with that. And I think it shows more and more in the results as we go forward.

Any specifics about how you're using analytics to manage the business and to drive the sales force to make sure they're getting in front of the right customers?

The one we use it upfront as we think about attracting and recruiting use of analytics. We use analytics in development plans for associates as well. So those are kind of on the front end. And then we look at where we're at with customers and what's our position to the market potential and what's the position across categories. We're giving our selling teams greater tools from a sales portal standpoint that gives them kind of their own opportunity to drill down. We've had pretty good success and ability to provide that information on an ad hoc basis to push out. Now it's available for them to drill down real-time into the environment, and that's helped. We can also use that technology across the portal to load the leads in the cross-channel prospects that exist so that collaboration can go on pretty seamless across those groups right now. So that would be another area and we're going to continue to push ourselves. I think as we view the business and work our long-range strategy, we are consistent in saying, how do we help ourselves, what growth initiatives can we have and then build those into our plants. And so we don't have the big onetime investments to be making. Our view is we invest in ourselves as we go.

So as you think about this, it may be hard to measure because of the -- obviously, the pandemic over the last few quarters. But even as you think back to that or now that things are stabilizing, do you feel like you're outgrowing the market set itself however you measure that?

I think if we look at some of the other general industry surveys, if we look at some of the economic indicators, we do feel that. And -- but with that not satisfied, we're going to want to continue to work those out. We know in some regards, right, we don't have as much safety PPE as perhaps some others in a general space. Our participation in some of the other segments may create a little bit of headwind. I think about it totally how the Service Centers are performing and the trajectory they're on. We feel very good about that. I think the Fluid Power business and I think about how they performed in that sequential Q4 to Q1 and how I look at backlog building going on right now, both in technology and the industrial Off-Highway Mobile segment. Those are encouraging and I think that's got a little bit outperform going in it as well.

Got it and last one for me. Just as I think about putting the model together for 2Q, would I -- should I expect that Fluid Power has a lower rate of decline than the Service Center based distribution, similar to what we saw in the last couple of quarters?

We would call both of the kind of the set for data in Q2, kind of down mid-teens to low-teens -- excuse me, as you think about both Service Center and the Fluid Power & Flow Control segment.

Similar rates of change.

Similar rates. Yes.

And Steve, just keep in mind that the Fluid Power & Flow Control segment will have a more difficult comp in the second quarter versus the first quarter.

More of a comp issue.

Right. Well, and I guess I will squeeze in one more. 3Q itself is a fairly easy comp before you get to the trough quarter last year. Any view on whether revenue could be positive year-over-year in both 3Q and 4Q?

No. I think if we continued on these trends and had the kind of typical seasonality play out with what we see now, that would be a more of a high single digits type decline and then the return to growth in the fourth quarter as we sit here today and following those historical trends.

We are pleased, though, is the continued profitability of the Fluid Power & Flow Control segment. You look at EBITDA being up 40 basis points year-over-year on that lower volume. So it continues to show the value proposition and the -- having the importance of the technology that we bring there.

And our next question comes from the line of David Manthey with Baird.

First question is on these temporary cost actions in SG&A. When you exit the December quarter, what percentage of those temporary cost actions will have been reinstated? I'm not talking about variable costs that flex with volume but those specific pandemic related temporary cost actions you took.

Yes. I'd say, Dave, on that one, it'd be a little bit to be determined, right? We started easing some of those now or we did in the first quarter. We'll see as we develop in the second quarter. I would suspect we will have some additional ones of those potentially ease. Are we all the way out of it by the time we exit December? I think that's to be determined.

Okay. But based on that answer, is it right to assume that the low-teens -- low double-digits to low-teens decrementals, assuming 13% to 14% organic declines assumes that you're not 100% of those costs back?

Well, as we work through the quarter, we would not be 100% back then how we exit and go into the third we'll be looking at it. And like I said, that's to be determined.

Okay. So it's less than 100%, but it's certainly greater than 50% will be rolled back at that point. And I'm talking about exiting the period too, just to get a sort of run rate as we enter the new calendar year.

I'll stay where I'm at right now. But I appreciate your diligence on it.

All right. And then so looking back at the mini Industrial recession that we saw back in '15 and '16, it took a little while for your sales to reaccelerate. But within about 24 months or so, you exceeded the prior peak operating margin levels nicely. And I'm just thinking, as you look at the cycle we're in, currently a deeper trough than that one, but how do you think this cycle will be different than that one in terms of just how you emerge from it?

Well, I will say the same to be determined on the cycle, but as I think about us. We continue to be, in my mind, better and stronger. I think about our Fluid Power business is that way and what we're doing. Our participation broadly across Flow Control and those opportunities, our move into emerging provider of automation and all the opportunities that those bring. And then I think the systems that we have in place and how we continue to leverage those for performance and productivity. Those have been helpful for us I think at a talent level. We're at a higher level and that's helping us from an execution standpoint and what we're doing. So we performed well then. I think the business is just even in a stronger position to be more important to our customers and perform better than what the environment will give us. So -- to be determined on the cycle, our view is that we beat the general macros as we go through it. And we just got a lot more capability than we had been.

I'd add to that we continue to leverage that accretive margin mix as we see those sales redevelop and further strengthen and provides that opportunity to drive that operating margin and gross margin expansion.

Yes. I mean, our view, right, if you think Applied then on incremental -- our incrementals, maybe we're low teens. I think once we get running and we restore some of these temporary actions as that cycle really plays out over the period we think we're in a mid- to upper teens incremental than on the go-forward. And that kind of financially shows our view of the difference in the company and this capability.

Our next question comes from the line of Michael McGinn with Wells Fargo.

Just wanted to round out the discussion with freight. Some of your competitors have been talking about surge demand from e-commerce and -- just wondering if you can remind us where and how you're positioned and where higher costs would show up for you guys? And maybe any need to second source like some of your peers are doing?

I think for us, we continue to be in a good position on freight with our providers. You think about the nature of our products, our freight business is pretty attractive. It's high density. It's not very seasonal. So we're predictable as it goes across and that's valuable. So you think about our movement to our distribution centers and truckload and less than truckload, our use of dedicated carriers. And really our view of any partial changes have been manageable as we go through. So our view is we have a good understanding of it. We still have good management around it. And I don't see an adverse -- real adverse impact coming from it.

Okay. Great. I think earlier in the call, you mentioned working capital, maybe some need to build inventory in the second half of this year as you support those -- the growth needs of your customers. I was just wondering, you're at about 17% of sales right now versus closer to 19% historically. What is the level of structural improvement then as you've made investments in ERP? Some facility consolidations versus just the cyclical impact of lower sales?

The ERP investments, the use of the tools and the analytics there has certainly yielded the ability to better manage both the inventories that rationalize those during the most recent downturn. If you looked in the quarter, there has been a $24 million incremental reduction in operating inventories. So very pleased with that on a quarter where we started to see some of that volume come back, and we managed that with good contribution across both of the segments without adversely impacting service levels. So very pleased with analytics. So we use those same tools to be thoughtful and where we're adding back the inventory to respond to the ramping demand to better leverage that inventory investment as we move forward. Structurally though, I'd have to say, I like the work that we're doing, the continued benefit on the collections focus, particularly the shared services with the Service Center segment. Our administered kind of receivables there. We're at an all-time record, though, in terms of past due in the quarter across the aggregate business. It took over 90 days past due down another point sequentially. So we'll continue to work the structural actions as well on the collections to make sure that we're driving efficiencies there and once again, helping to mitigate what's going to naturally be an increase in new receivables as we start to see those volumes rebound. So to demonstrate on a $22 million sequential increase in sales in the quarter, we were flat in terms of receivables impact on working capital. So very pleased with the traction that we've also been able to demonstrated in that front. And here, again, that's a result of technology and that process focus that we put in place.

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

I just want to thank everyone for taking the time to join us today. We look forward to talking with many of you throughout the quarter.

Ladies and gentlemen, this does conclude today's conference call. Thank you for your participation. You may now disconnect.