Applied Industrial - Earnings Call - Q1 2020

Transcript

Speaker 0

Welcome to the Fiscal twenty twenty First 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. 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.

Speaker 1

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 apply.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 Scrimsher, Applied's President and Chief Executive Officer, and Dave Wells, our Chief Financial Officer. With that, I'll turn it over to Neil.

Speaker 2

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 twenty twenty 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 SCX 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 customer's direct operations and creates a significant incremental aftermarket opportunity supported by our extensive and localized MRO service center network.

Speaker 3

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. 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 twenty twenty 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 noncash 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 eight 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 costs. 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 and 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 and A later in the quarter, and will ramp to full run rate benefit in our second quarter. As such, we expect SD and A to ease as a percent of sales for the balance of fiscal twenty twenty. Reported EPS for the quarter was $1 per share, inclusive of approximately $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 $50,000,000 while free cash flow was $45,100,000 or approximately 113% of adjusted net income and over five times 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 on 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 and 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 $5,000,000 of outstanding debt.

Our debt is down nearly $110,000,000 since financing the acquisition of FCX, with net leverage still at 2.6 times EBITDA at quarter end, below the prior year period of 3.1 times. Transitioning now to our outlook. As noted in our press release, we are reaffirming our guidance for fiscal twenty twenty, 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 $4.2 to $4.5 per share. We also reaffirm our free cash flow outlook of $200,000,000 to $220,000,000 which represents a 30% increase over fiscal twenty nineteen at the midpoint. Our guidance continues to take into account the backdrop of uncertainty in near term industrial demand.

However, we are executing to 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.

Speaker 2

Thanks, Dave. Overall, while end market demand remains 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 ninety seven 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.

Speaker 0

Thank you. We will now Will Your first question comes from Chris Dankert with Longbow Research. Your line is open.

Speaker 4

Hi, good morning guys. Thanks for taking my question and congrats on a nice quarter here. I guess starting off, you you highlighted the cost out actions taken in the quarter. You know, what is kind of the

Speaker 3

run rate there? It sounds like

Speaker 4

it was more than just kind of pulling back on discretionary spending, maybe just a little bit more illumination on the cost out actions.

Speaker 2

I think overall, there's probably plenty in the materials that could guide you in towards what we view as SD and 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. 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 and A in the second quarter, plus or minus 20 basis points around that with the actions.

Speaker 3

So down sequentially, Chris, but here again had just a month and a half of Olympus in this quarter. So you'll see that run rate kick in here in Q2.

Speaker 4

Got it. Got it. That's really, really helpful, guys. Thank you. And then just as I'm going through the deck, which by the way, thank you for the update there, you mentioned that electronics inside of Fluid Power is seeing some improvement.

Any directionality as far as bigger than a breadbasket, how much improvement we're seeing in electronics today?

Speaker 2

Think, Kate, 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 midsize 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 maybe we are participating in a slower macro market overall.

Speaker 4

It. Got it. A little drag in

Speaker 3

the quarter, but a positive in terms of backlog build in the quarter.

Speaker 4

Got it. Maybe that's my final question before I hop back in queue. Just any comment on Fluid Power backlog in totality?

Speaker 3

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 flow control business.

Speaker 2

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

Speaker 4

Got it. Got it. Thanks so much, guys.

Speaker 0

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

Speaker 5

Hi, guys. Good morning. Congrats on the strong quarter. Thanks, Adam. Hey, I was wondering if you could expand a little bit more on outside of the electronics markets, I think you mentioned that the orders 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 yet.

Speaker 2

Yeah, I think that's more of a stabilization and maybe a sequential. We think about our 30 industries in this quarter we would have had eight positives. Sequentially or 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 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, mining, oil and gas, and some of the transportation process segments.

Speaker 5

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?

Speaker 2

Yeah, we think price contributed maybe less than 100 basis points on the top line. Our view continues around margins. 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.

Speaker 5

Great. Thank you very much.

Speaker 0

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

Speaker 6

Hi. Good morning, guys.

Speaker 7

Good morning.

Speaker 6

Just, just wondering what the sort of trajectory of your business that you 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 slowing over the last several quarters. It seemed like the data or the earnings for a lot of industrial companies has 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?

Speaker 2

I think some macro things to consider still will 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 timeframe.

Those still shape our views today. 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 is still anchored around the midpoint of the ranges.

Speaker 6

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, you know, there just, you know, based on sort of some of the markets and customers that you deal with?

Speaker 2

Yeah, I think it's varied, right? And you'll see the larger producers with their numbers and trends in it. Obviously they also have an aftermarket but some large OE participation. That's not our participation. It would be more the mid size 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 in projects in engineering and design, creates us 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.

Speaker 6

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

Speaker 2

Yeah, 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, you know, kind of continued positives in that side.

Speaker 6

Okay. Perfect. Thanks a lot. Appreciate it.

Speaker 0

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

Speaker 8

Hey, good morning, guys. This is Ken Newman on for Steve. Thanks for taking my questions.

Speaker 7

Good morning, Ken.

Speaker 8

Good 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 the slower environment.

Speaker 5

Can you

Speaker 8

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 in the cycle?

Speaker 3

Here again, we're not suspect to a great deal of stocking, destocking nor do we see a lot of that in business 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 push out 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 certainly got some leverage from lower volumes, outpaced that in terms of performance, like the traction that we continue 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. There will be a bit of a modest tailwind for us as we think about the out quarters. It helps to firm up here again, given the seasonally stronger start, and the kind of the guidance of 200,000,000 to $220,000,000 that we put out there on free cash for the year.

Speaker 8

Right. Makes sense. Okay. And my follow-up question here is just on the M and A pipeline. Obviously, I think in in your your deck, you mentioned that it still remains a a high priority for you going forward.

Just trying to get a better sense of, you know, how does the pipeline look, if you wanna 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?

Speaker 2

I'd say our M and A priorities remain consistent across our product segments. That would be bearings and power transmission, fluid power, 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. There's kind of all sizes of candidates that would be in there. You look back on a revenue basis, maybe the average has been around less than $30,000,000 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'd be hard to perfectly characterize everything in the pipeline.

Speaker 7

That's helpful. Thank you, guys.

Speaker 2

Okay.

Speaker 0

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

Speaker 7

Hi. Good morning, everybody. I was 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?

Speaker 2

We think just on margin, we continue to work our view of all aspects of margin. Obviously, use systems and tools around point of sale just to reduce variation, make better, smarter decisions. Stay balanced in customer mix both with 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.

Speaker 7

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

Speaker 3

Yeah, it is. It's 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 So you'll really see that ramp, as we discussed, into Q2 and continue to read through as benefit for the balance of the year. Okay.

Speaker 7

And then just lastly, if I could touch base on the M and A side. You guys moved disciplined M and 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 Chemicals won. Is there an area that you'd like to highlight that your past initiatives, you think you're building scale or current verticals where you think you still have some work to do?

Speaker 2

We like that our targeted addressable market continues to expand and grow. It's probably getting closer to $70,000,000,000 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 $80,000,000,000 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's fundamental drivers that customers are looking to consolidate their spend with fewer, more capable suppliers.

And they're also getting challenged as they deal with kind of a technical labor expertise gap. And they're needing some qualified providers to do that. 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.

Speaker 7

All right. Appreciate the color. Great quarter. Thanks, Mike.

Speaker 0

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.

Speaker 2

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.

Speaker 0

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