Applied Industrial Technologies Inc (AIT) 2006 Q1 法說會逐字稿

Hello and welcome to the Applied Industrial Technologies first-quarter 2006 financial earnings conference call. (OPERATOR INSTRUCTIONS). Now I would like to introduce Mr. Richard Shaw, Applied's Vice President of Communications. Mr. Shaw, please go ahead, sir.

Thank you, Richard, and good afternoon, everyone. On behalf of Applied Industrial Technologies, I would like to thank you for joining our call this afternoon. Our earnings news release was issued this morning, and we also released today information on two new directors, as well as our dividend. You may retrieve these releases at www.applied.com. A replay of today's broadcast will be available for the next two weeks, and archived information is contained on our news release.

Before we begin, I would like to remind everyone that we will discuss Applied's business outlook during this conference call and make statements that are forward-looking. Applied intends that all forward-looking statements be subject to the Safe Harbor of the Private Securities Litigation Act of 1995. All forward-looking statements are based on current expectations regarding important risk factors, including trends in the industrial sector of the economy, the success of our various marketing strategies, and other risk factors identified in Applied's most recent periodic report and other filings made with the Securities and Exchange Commission.

Accordingly, actual results may differ materially from those expressed in the forward-looking statements, and the making of such statements should not be regarded as representation by Applied or any other person that the results expressed therein will be achieved. Applied assumes no obligation to publicly update or revise any forward-looking statements whether due to new information or events or otherwise.

This conference call is the copyrighted property of Applied Industrial Technologies. Any copying, rebroadcast, publication, posting, transcription or distribution of any portion of this call without Applied's express prior written consent is prohibited.

Our speakers today include David Pugh, Chairman and CEO of Applied, who will discuss our overall performance during the quarter. We will also hear from Mark Eisele, Vice President and Chief Financial Officer, who will discuss our financial performance in detail and Bill Purser, President and Chief Operating Officer, who will discuss operational activities. Dave Pugh will start us off. Dave?

Good afternoon, everyone. Our fiscal 2006 has gotten off to a good start. The first quarter was pretty solid from the standpoint of both sales and earnings. In fact, it was another record quarter in what is shaping up to be another record year. This was our 12th consecutive quarter of earnings per share increases of 25% or more, so we have had three uninterrupted years of compounded significant growth, the most important indicator of our performance.

When I take a look at it, also significant is the continued earnings leverage with a first-quarter sales increase in our net income. That's about four times the rate of our gain in sales. Particularly noteworthy in the first quarter is the operating margin of 6.3%, up from a very healthy 5.2% a year ago.

Now maintaining that margin level is going to be a tall order because we see more price increases on the horizon, but the increase is indicative of the improved earnings power of this Company as we continue to plow new ground in our quest for higher performance.

Our first quarter had a few challenges. Our business in the Southern states was interrupted by Katrina and Rita. We still have a couple of service centers that have physical limitations as a result. Our sales were at the low end of guidance. Bill is going to cover the details on this a little bit later. Our hopes are that some of the business disruption caused by the weather was simply postponed rather than lost. The question here that we are going to have a general equilibrium over time to replace the short-term losses or we can only see a partial equilibrium and have to accept that some of those losses are unrecoverable, and that is the crystal ball question only time is going to tell.

There are a few negatives that are being published about the economy for the remainder of the calendar year. So there is a little question mark there, but we continue to be very optimistic about our third and fourth quarters for sure. Whatever happens we are confident in our ability to adapt to whatever changes are out there.

So what you are going to here on today's conference call is fairly consistent with what you have heard in the previous quarters. We have a sense of gratification in our accomplishments, and we believe we are taking Applied to a whole new level of success in earnings power. But I guess all we can do is keep posting the numbers and let you decide that. With regard to results, I'm going to turn it over to to Mark and let him give you the details.

Thanks, Dave. Good afternoon, everyone. Let me provide some additional insight for our first-quarter performance. We're very pleased to achieve a first-quarter operating margin in excess of 6% for the first time in recent history which translated into earnings of $0.54 per share.

Sales for the first quarter ended at $443.2 million. This represents a 7.3% improvement over last year's first quarter. We had 64 selling days this quarter, which is the same number of days as the prior year. We believe that approximately 2 to 3 points of the sales increase percentage is due to the impacts of the Company passing along supplier price increases.

On a sales per day basis, the same-store sales increase for our United States service centers was 5.4% for the quarter -- a reduction from the 9.1% increase we experienced in our fourth quarter but against a tougher comparison. In addition, we believe the direct impact in the quarter from hurricanes Katrina and Rita were to reduce sales by approximately $1.5 million or .4% of sales.

We also saw our Canadian operations sales improve by 25% in the quarter, of which 14% related to our February 2005 acquisition of Groupe GLM in Québec; 9% related to currency translation from the strengthening of the Canadian dollar compared to the prior periods and 2% from volume mix and pricing. Our U.S. Fluid Power operations saw a sales increase of 7% in the quarter.

Finally, our Mexican and Puerto Rican operations had a combined sales increase of 22%. While this represents a slower -- while these represent slower rates of year-over-year sales increases than we experienced last year, all in all we saw continued growth across the board.

Also during the quarter our number of operating facilities was reduced by six to 434 locations. This primarily related to the merging of five service centers in the United States into other nearby service centers for operational efficiency purposes. Starting next quarter we will see an increase of nine locations due to the September 30th acquisition of Spencer Fluid Power.

Our gross profit percentage for the quarter was 27.6%. This is 110 basis points better than last year's first quarter and 70 basis points better than the fourth quarter of fiscal 2005. A major reason for this improvement relates to the traction gained from our gross margin initiatives in the U.S. service centers.

In addition, we experienced some rebate benefits in the quarter that related to purchases made during fiscal 2005. These were rebates on which we could not accrue benefits at June 30th due to all of the accounting requirements under Generally Accepted Accounting Principles not being met at that time. Therefore, in accordance with Generally Accepted Accounting Principles, these rebates were all recorded in the current quarter, which did boost the gross profit percentage in the quarter ended September 30th.

We believe our gross profit percentage in the September quarter is somewhat higher than what we expect on a go-forward run-rate in future quarters. We had previously stated that we expected the gross dollar amount of supplier rebates for all of fiscal 2006 to be slightly lower than fiscal 2005 as a percent of sales. While this did not occur in the first quarter due to my previous explanation, we believe rebates from suppliers will continue to be a challenge for the remainder of fiscal 2006.

Our selling, distribution and administrative expense rate of 21.3% of sales remains consistent with our rate over the last four quarters. The absolute increase in SD&A dollars was 7.4% compared to a sales increase of 7.3%. The SD&A increase primarily relates to additional compensation, incentives and benefits which are a direct result of our improved financial performance and to a lesser extent due to the GLM acquisition.

We also increased our provision for bad debt expenses in the quarter due to financial difficulties being experienced by some customers in the automotive parts industry. In addition, we had no gains on sales of property during the quarter, whereas last year we had gains of approximately $300,000. Our first-quarter operating margin increased to 6.3% compared to 5.2% in the prior year's first quarter and 5.6% in the fourth quarter of fiscal 2005. This achievement continues our upward trend in quarter over quarter operating margins. This trend is driven by the increase in sales, maintenance and expansion of gross margins and by limiting the growth of SD&A expenses.

Our annual effective tax rate for the quarter of 37.3% was slightly lower than we originally expected due to recording of benefits from federal refund claims filed during the quarter. We continue to believe that an effective rate of 37.5% is reasonable for the rest of the fiscal 2006. Our balance sheet continues to strengthen with shareholders equity exceeding $400 million. Our current ratio is 3 to 1. Our pretax return on assets grew to 15.6% for the quarter compared to 13.7% for all of fiscal 2005. Overall inventory balances increased $25.4 million for the quarter primarily due to $9.9 million from the Spencer Fluid Power acquisition, as well as from several small buying opportunities.

Accounts Receivable and days sales outstanding at 40.3 days remained competitive and in good shape. Cash flow from operations during the quarter is consistent with our results from the first quarter of last year and is driven by the increase in inventory we traditionally have in the first half of each fiscal year.

We provided financial guidance for the second quarter of fiscal 2006 in this morning's press release for sales increasing 8.9% to 11.3% to between $440 million to $450 million with earnings per share in the range of $0.43 to $0.49 per share.

Last year's earnings per share in the second quarter on a split adjusted basis was $0.33 per share. Therefore, our guidance is for an EPS increase of up to 48% on a sales increase of up to 11%. This guidance includes -- this guidance does include the projected results of operations for the Spencer Fluid Power acquisition. We expect this acquisition to be slightly accretive to earnings for the remainder of fiscal 2006. Based on our first-quarter results and taking into account the Spencer acquisition, we have increased our annual guidance for fiscal 2006 for sales to total between 1.85 billion to 1.89 billion with earnings per share in the $2.05 to $2.15 range.

That gives you some additional perspective on our first quarter. Now Bill Purser will comment on sales and operations.

Thanks, Mark. Good afternoon. Let me start by pressing expressing our continued sympathy and support for those who have suffered as a result of Hurricanes Katrina and Rita. This includes obviously some of our associates, customers and shareholders. While we have experienced what we feel to be short-term business disruption in Mississippi, Louisiana and Texas as a result of these storms, we are committed to helping the regions' industry rebuild.

Among our hurricane-related initiatives, we organize the donation of more than $100,000 of safety and work supplies for the relief effort. We shipped more than 25 pallets of supplies and equipment through a relief agency called Volunteer Mobile. Included in the shipment were leather gloves, flashlights, tools, environmental protection suits, breathing masks, safety glasses hand cleaner and more. The Company and our associates raised thousands of dollars for relief organizations such as the Red Cross, as well as funds to directly help Applied employees who were affected. I'm glad to report that all of our locations are up and running and providing much-needed products and service to our customers.

Now back to normal course business. I will start by telling you about Spencer Fluid Power. As Mark mentioned, this is a business with nine locations in the Western U.S. and sales of approximately 49 million over the past 12 months. Spencer is focused entirely on Fluid Power, which is a good growth business for us, and along with bearings and PT, it is one of our key business platforms.

The Spencer acquisition also strengthens our Fluid Power business in the Western U.S., and it also brings us additional marketing know-how in the mining and wood products industries, which as you are aware are both key industries for Applied. While acquisitions like Spencer or Groupe GLM in Québec, which we acquired in February, are not necessarily what we call big bangs in terms of sales volume, they are good examples of solid accretive actions that help us to continue to grow profitable sales and build market share.

Moving on to first-quarter sales, we once again saw widespread strength among our customer industry channels and geography. We are experiencing strong sales in industries such as industrial machinery and equipment, paper, lumber and wood products, fabricated metal and mining. This offset some weaknesses in primary metals, transportation equipment and textiles. Sales growth this quarter came in equal measure from our top 100 accounts, as well as from those small to medium-size customers that have been fueling our business in the past couple of years.

In terms of geography, business was good across the U.S., Canada, Puerto Rico and Mexico. I recently visited our locations in British Columbia and came away upbeat in regards to our opportunities. Our integration of the industrial equipment company in this market which we acquired in 2003 has been seamless in the eyes of our customers.

As we've shared in previous calls, this business year will be a year that we intend to invest more aggressively for business growth. I think you saw some of this investment show up in the first quarter SD&A.

As an example of where we are spending is our investment in our catalogs to increase awareness and gain a larger customer base. Speaking of which our Maintenance American and Fluid Power Connection catalogs both turned in improved performances in the first quarter with a sales increase of 7%.

We have also invested in the government sales group, adding dedicated sellers, as well as systems support for this new market opportunity. Our current sales are growing satisfactorily and are on track with our budget forecast.

Additionally we are investing in a new Canadian headquarters to keep pace with our growth in that market. Continued investment in facilities, people, training and incentives are absolutely critical for our Company if we are to maintain the momentum we have built and for us to achieve our forecasted sales and earnings performance for this business year.

Currently key industrial indices such as the MCU and PMI are holding up well; however, I do have some concerns about the state of consumer confidence and the direction of interest rates. These could end up stifling any industrial production gains.

As a result of that, I do expect some softness in customer demand in this current quarter. I do see improvement after the calendar turns.

One last notation on the operating front, our major bearing suppliers have already notified us of a new round of price increases between now and December. Although the round of price increases have been somewhat less frequent, they are still coming.

As you know, we have made great strides in our capability to pass through price increases to customers. But there still will be some lag time among our major accounts. I expect it will be reflected in our second and to some degree in our third-quarter gross margins.

So that's the operations overview, and now I will turn the call back over to Dave for closing comments.

Thanks, Bill. I guess I have to feel good that we have come out of the gate strongly in the 2006 year, allowing us to increase our annual guidance. This year is going to require an extraordinary level of vigilance due to the varied influences that could disrupt a currently strong economy. We remain alert and resourceful.

I hope you saw today that our Board increased our dividend by 25% to a quarterly rate of $0.15 per common share. They also indicated a confidence in our future by increasing the authorization of our share buyback program. In the area of corporate governance, I will call your attention to the fact that the shareholders today elected two new independent directors. Both of these are accomplished CEOs of big board companies -- John Meier, a CEO of Libby Inc., and Peter Wallace, a CEO of Robbins & Myers. I feel good that the quality and reputation of our Company has allowed us to attract this caliber of talent to our Board. I look forward to working with them and developing new ideas and directions for making Applied even stronger and more successful than we are today.

I want to thank you for your coming to this conference, and now we will open it up for questions.

(OPERATOR INSTRUCTIONS). Stephen Weiss (ph), Mindflow Capital Investments (ph).

Thank you very much, Dave. First of all, congratulations on a solid quarter.

Thank you.

A couple of things. How are you guys integrating customer pricing concessions through your supplier network as many distributors right now are looking at propagating this to suppliers if you had mastered this. Can you maybe give us a little detail on that?

Could you repeat that question? We had trouble hearing you.

No problem. Can you hear me okay? How are you guys going to be integrating customer pricing concessions through your supplier network as many distributors in your area are looking at propagating this to their suppliers, but few have been able to master that?

I mean if I understand that question you are asking about passing through the price increases to our --

How are you guys looking at still improving margins, looking at market baskets, being able to still work with your supplier network in the areas of not necessarily passing on price increases to your customer base, but still improving margins and looking at market baskets?

Good question. We began approximately almost 12 months ago now with some key initiatives within the Company that were aimed strictly at improving profits. Some were mixed initiatives, some were customer-based initiatives. Some were working moreso with suppliers and actually looking at reducing supplier base in an effort to get a better handle on where we needed to go from a margin standpoint.

I think one of the reasons that we have seen some gains in our gross profit is because of these initiatives that we have put in place. We will continue working on those. We think there is still an upside, and we will continue working those initiatives for the foreseeable future.

Right. Are market baskets real important to you, or were you just trying to add bundling of products to make your overall solution more valuable to your customer base rather than just increasing prices on certain materials on certain products?

I think the service aspect is certainly becoming stronger. The unbundling of services depends on what customer you are dealing with. We probably see more unbundling with larger accounts than we do medium and small accounts.

Looking at your supplier feedback, are a lot of them even though they really feel like they are being stretched right now in this economy, are a lot of them willing to work with you?

Yes. (multiple speakers)

And partner with you? What has been their feedback?

Our key suppliers are willing to work with us. They certainly are.

Okay. Congratulations on a good quarter. Good luck down the road.

Brent Rakers, Morgan Keegan Company. (technical difficulty). Holden Lewis, BB&T Capital Markets.

Can you give a little bit more color as to the size of the accrual that I guess you basically it would be better suited to be an '05 rather than '06 but slid into '06 anyway. Because obviously as we adjust our models, it sounds like that should be considered sort of an unusual item in terms of normalizing the gross margin. Can you give us some more color as to what the impact of that was?

This is Mark. What we can say is that when we get the conference call last quarter when we gave the original guidance for gross profit on a go-forward basis for fiscal '06, we stated that we were expecting gross profit in the range of 36.5% to maybe a little bit better. (multiple speakers) What did I say? 26.5%. I'm sorry. 26.5% or better. And obviously this quarter 27.6% was higher than that.

What we will say is that we continue to see some traction with the margin initiatives that Bill referred to so that we believe that for the remainder of fiscal '0 6 that the 26.5% might be a little bit better, but we really hesitate to try to quantify what the rebate impact was because we really have never provided that level of detail for competitive purposes.

Okay. And then can you give a sense also -- I mean I think we have all -- we go through this it seems the last couple of years -- but it seems like your guidance, which could be as low as $0.43, could be as high as $0.49, but again it seems like even the midpoint steps away from traditional seasonality in the business. Is there anything we should read into that in terms of expectations, or how should we view that?

Well, I think what we have from a seasonality perspective is obviously in the second quarter we have three fewer business days than in the first quarter, and so that has an impact on us. But we are still making a large step forward in -- we look at our guidance compared to the actual second quarter from a year ago as to leveraging the improvements on that. And that is what we look for as to having the quarter-over-quarter improvement from the prior years to make sure we are keeping our progress going that way.

Okay. All right. Thanks.

(OPERATOR INSTRUCTIONS). Jeff Hammond, KeyBanc Capital Markets.

I wanted to go back to the gross margin performance. If you could kind of help us with what exactly is working with regard to the initiatives, what specific initiatives are working? And then also to the impact of vendor price increases, I mean how much of a favorable impact did you see just by not having any price increases this quarter where that might abate as you get some of these vendor price increases towards the end of the year?

Well, Jeff, this is Bill. I will comment. I don't want to get specific on the margin initiatives. I think you understand the reasoning there. But we had five major initiatives that we began last November. And like I say, we feel like that some of the margin improvement has been a direct result of these initiatives. They involve things such as mix, evaluation of customers, and I'm giving you broad generalities, but I think you get the gist of where I am. It was several different things obviously within the five that we looked at in (technical difficulty)-- through the margin.

In regards to your comment on the price increases, we will be faced with the same situation, but not the rapidity that we had last year, in getting those through to our customer base. I think we have stressed that it is our intent to pass price increases through, not absorb them. But we still have the national accounts with contractual restrictions that we will have to review to see what impact that that is going to have as to whether we can get them through and, if not, when we can.

Okay. And I think a few quarters back, you had one issue of mix. Did you have some favorable mix this quarter, and is that sustainable? And then I guess on the issue of putting through price increases, there seemed to be one issue which was just simply timing of the national comps but another issue of kind of bolstering the systems. Is that more controllable as you resolved at this point?

Yes, I feel so, and that's good memory on your part. Those were two that went hand-in-hand. One was a system issue, and one was a timing issue. The timing issue still I don't have as much control over, but the system issue we do feel like we have got that under control now.

Okay. And then mix in the quarter relative to going forward on a normal mix?

You know, I was thinking about that as you made that comment. I don't think it was any different than our normal mix that I could put a finger on it. It was an unusual quarter for us, and we had across the board some specific customer changes that were a little hard to understand. But for the most part I cannot point to mix and say that yes, it was a mix issue.

If you will remember last year, we had an issue with I guess you could call it mix. We had a good deal of projects that came through at lower margins, but that is not the case here. There is not as many projects, but I would not call it a mix issue than I can put my hand on.

Okay. And then, Mark, two housekeeping items. If you could give us the breakdown between Fluid Power revenues and industrial? And then is there a way to quantify the bad debt that you had to take on in the SG&A line?

Yes, the grand total for Fluid Power versus industrial, it is around 16.5% Fluid Power and the rest industrial for the quarter. And from the perspective of the SD&A line for the additional bad debt expense, that is going to be the line item in the cash-flow statements, which I guess we show a condensed cash-flow statement on the press release. And that will show up in the 10-Q as we go forward when we show the amounts provided.

But I will say that the total amount of the increase that we recorded for that was less than a penny a share impact. So it was not huge, but it was something that we did deal with.

Adam Allman (ph), Midwest Research.

I was wondering, Mark, if you could talk about the progression of the year-over-year sales growth as we rolled through the quarter. Did we see any kind of noticeable change from the beginning of the quarter to the end of the quarter, and acceleration or deceleration of activity?

Yes, Adam, this is Bill. I referred a little bit to that in my previous comments when I said it was an unusual quarter. We had a fairly strong July, a very soft August, and then started seeing in September it ramping back up again and even moving into this month. So it was really kind of an odd month or odd quarter I should say for us, a very soft, soft August. And that is kind of a puzzlement. We think we have some answers, but for the most part September did come back and October is going well.

Was there any specific end markets that you could call out that really kind of fell off or MRO versus project-related activity?

No, it's more transportation -- was one of the markets that we saw down. The automotive sector, particularly the Midwest markets. That was probably the bigger drop-off. High-tech was down, but is starting to move a little bit. But that market was also down. And it was very spotty. It was almost customer specific across the quarter.

Adam, this is Dave. One of the things to remember is to take a look that we have a pretty tough comparison this quarter because first quarter of last year I believe we experienced about a 14.5% sales growth. So that was an exceptionally strong quarter last year. So the 7.3% this year is a little bit reflective of that.

Okay. And then how much to the top line growth did GLM and currency add this quarter?

Well, GLM added in grand total a little over 1%. It was probably about 1.2, 1.3% of the sales growth, and the currency amounts were maybe .5%. for the sales growth. But I would have to do the actual calculation, but that is approximately what they were.

(OPERATOR INSTRUCTIONS). It appears, gentlemen, we have no further questions. At this time I would like to turn it back to the speakers for any additional or closing remarks.

Okay, great. And let me just end up (inaudible) I appreciate the questions. Again, we feel like we have come out of the gate strong. We feel like we're going to provide another strong year, another record year. Because next quarter there's a little bit of a question mark as there are some influences out there that could be disruptive, and we will just wait and see how they go through. All the indicators lead us to believe our third and fourth quarters are going to be very strong, so looking forward to showing you some good numbers as we go down the road. Thanks, guys.

This does conclude today's conference call. You may disconnect at this time.