Applied Industrial Technologies Inc (AIT) 2008 Q1 法說會逐字稿

Hello and welcome to the Applied Industrial Technologies first quarter 2008 financial earnings conference call. All lines will be in a listen only mode until the formal question-and-answer session. At that time, instructions will be given. At the request of Applied Industrial Technologies, today's conference call is being recorded. If you should have any objection, you may disconnect at this time.

I would like to introduce Mr.Richard Shaw, Applied Vice President of Communication and Learning. Mr. Shaw you may begin.

Thank you Clarissa and good afternoon. On behalf of Applied Industrial Technologies I'd like to thank everyone for joining us today for our first quarter fiscal 2008 call. We released our earnings this morning before the market opened and should you need a copy, you can retrieve it by visiting our website at applied.com. A replay of today's broadcast will be available for the next two weeks and the archive information is contained in 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, except as required by law. This conference call is the copyrighted property of Applied Industrial Technologies and 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'll also hear from Mark Eisele, Vice President and Chief Financial Officer, who will discuss our financial performance in detail. Bill Purser and Ben Mondics, our Executive Vice President and Chief Operating Officer, who will discuss operational activity. Dave Pugh will start us off.

Thanks, Rick. And good afternoon, everyone. It's nice to have an attentive audience. Until this past Sunday in Cleveland, if you weren't talking about the Indians, nobody was listening. A response to good numbers was limited to internal celebrations and really the first quarter numbers are worthy of note in my estimation. If I may quote our Corporate Vice President of quality as she started last week's officers' meeting when she said, there's nothing extraordinary about these numbers, they are good and they continue to show improvement. That's the kind of mind-set I like in our key leaders.

As we said in our news release this morning, we are off to a good start on what we expect to be another good year. For our first quarter, we saw the earnings improve by 19% on sales growth of a little over 5%, continuing our trend of year-over-year double-digit earnings per share increases. The earnings leverage on this moderate growth was a little slower than we anticipated for the quarter. Correspondingly, we've raised our annual earnings guidance. Considering the continued slope of the housing market at its related industries, we were really pleased with our ability to offset the significant declines in some of the segments where we've been traditionally strong. We've stayed on course with our plans to change the longer-term profile of our customer base by targeting anticyclical markets. Government sales are a key opponent of this strategy and the double-digit increase this quarter shows that that investment is paying off.

Looking ahead, we see a positive, though moderating manufacturing climate in general. Uncertainties created by the housing market should be mitigated by other opportunities for us. We continue to exhibit the ability to manage our cost structure to a growth rate well below that of our sales growth. As our SD&A as a percent of sales this quarter dropped below the 20% mark. This discipline in handling these costs is vital during slowing market conditions. Managing all of our processes to a proper balance helped us to record a 7.6% operating margin, exceeding the 7% mark for the second consecutive quarter and improving nicely on last year's 6.8%. It's a direct result of solid plans by our Management and effective implementation by our associates.

The margin management's going to continue to be a challenge as the market slows, but we are showing good resolve in not accepting the premise that prices have to fall in this type of an environment. Asset management will also continue to remain under close scrutiny as the markets shift. Inventories did rise this quarter, a little bit of a seasonal norm, and we're forecast to have these inventories rise again next quarter. The year end projections for inventories, though, are where we want them to be. Receivables are trending downward. Our return on invested capital continues to be better than the industry norm. Cash generation for the quarter was excellent. It keeps our balance sheet in good shape to support all of our strategic efforts. We are pursuing acquisitions for expansion, and no, we can't add details to that comment at this time. Our Board has authorized an appropriate stock repurchase plan when we feel that's the best use of our cash.

To summarize, I would say that the operations are solid enough to provide us with a degree of confidence and the markets are uncertain enough to keep us from becoming complacent. And that's a good blend. We have good processes and a sense of urgency to keep them that way. In just a bit I'll be back to wrap things up before we take questions. Right now I'm going to hand it over to Mark to provide a few more details about the financials.

Thanks, Dave. Good afternoon, everyone. Let me provide some additional insight for our first quarter financial performance. We were very pleased to achieve first quarter earnings of $0.56 per share. Sales for the first quarter ended at $518.5 million. This represents a 5.3% improvement over last year's first quarter. We had 63 selling days this quarter, which was the same as last year.

For the quarter U.S. service center sales were up 6.4% while sales at our U.S. fluid power businesses were down just under 1%. For the U.S. service centers, we estimate that approximately 1% of their increase relates to the impact of passing along supplier price increases on our sales. Sales in our Canadian operations increased by 1.9% in the quarter. This results from a 5.7% increase due to currency translation, partially offset by a 3.8% decrease from volume, mix and pricing. We have begun to see a topline slowdown in our Canadian operations, primarily driven by declines in the lumber and wood products area due to the declining housing markets, along with the strengthening of the Canadian dollar, which is having a negative impact on products Canada is exporting to the U.S. Our Mexican and Puerto Rican operations had combined sales decreases of 2.5%.

During the quarter our number of operating facilities increased by four locations to 449 due to the opening of service center locations to support new, national contract agreements. Our product mix during the quarter was 19.6% fluid power products and 80.4% industrial products. Our gross profit percentage for the quarter was 27.4%, slightly above the guidance we provided for fiscal 2008 of 27.3%. This 27.4% margin is the same as last year's first quarter and 50 basis points higher than the June 2007quarter. Our selling, distribution and administrative expense as a percent of sales was 19.8% for the quarter. This rate is approximately 90 basis points lower than the first quarter of fiscal 2007 and slightly lower than our go-forward run rate expectations for the remainder of fiscal 2008, as we plan to continue to add resources for our government and other growth programs throughout the fiscal year.

The absolute dollar increase in SG&A for the quarter was only 1.1% compared to a sales increase of 5.3%. We continue to see benefits from our overall focus on productivity improvements and cost controls. In addition, gains on sale of three locations lowered our SG&A expenses on a one-time basis by $750,000 in the first quarter.

Our first quarter operating margin increased to 7.6% compared to 6.8% in the prior year's first quarter. This represents the second consecutive quarter that our operating margin surpassed the 7% level and is a continuation of our upward trend in operating margins. The effective tax rate for the quarter was 36.8% compared to 35.6% in the first quarter last year. The prior year tax rate was unusually low due to favorable resolution of certain state tax matters. We anticipate our tax rate for the year to be in the 36.5% to 37.0% range. Our balance sheet remains solid with shareholder's equity at over $470 million and a current ratio of 2.7 to 1. This ratio remains slightly below prior year levels due to the classification of $50 million of debt as a current liability. We plan to pay off that debt upon maturity in December 2007. Our pretax return on assets rose to 19.6% for the quarter compared to 18.1% for the prior year quarter.

Our September 2007 inventory balance was slightly higher than June 30th's level, primarily due to the increase in certain products to maintain timely service levels for our new national contracts. We do anticipate a seasonal increase in inventories during our second quarter. This increase is then expected to flow through our system in our third and fourth quarters so that inventory levels at June year end should be close to our prior year levels. Accounts receivable and days sales outstanding of approximately 40 days remain competitive, but are not currently at our internal targets. Cash provided from operations for the quarter was a solid $28.9 million compared to $16.1 million in the prior quarter.

We have affirmed our annual financial sales guidance for fiscal 2008 in this morning's press release to between approximately $2.1 billion to $2.18 billion, but have increased our earnings per share guidance to the range of $2.05 to $2.20 per share. Therefore, our guidance for all of fiscal 2008 is for an EPS increase of up to 14% on a sales increase of up to 8%. Now Bill Purser and Ben Mondics will comment on sales and operations. Bill?

Thanks Mark, and good afternoon everyone. It's a pleasure to be with you this afternoon, as it has been for so many quarterly calls over the past seven years. My transition to retirement is nearly complete and Ben is well prepared to move ahead without my guidance. However, I plan on being here for any questions you might have during the Q&A. That said, let me turn our operational comments over the Ben. Ben?

Thanks, Bill, for your continued support, and I too am pleased with our first quarter performance. As an overview of our performance by industry, six SIC codes saw strong, double-digit growth during the quarter while another six saw some level of moderating growth compared to last year's first quarter. The metal mining, primary metals and amusement services industries showed exceptional growth. We also saw strong growth with food and beverage products, transportation equipment, and stone, clay, glass and concrete products. A number of other industries did achieve moderate growth. These would include fabricated metal products, rubber and plastic products, petroleum refining, coal mining, printing and publishing, and electric, gas and sanitary services. The declines we have been seeing in lumber and wood products slowed, as did nonmetallic mineral mining and electric and electronic equipment manufacturing. Paper and Allied products were down only slightly.

We made excellent progress this quarter with our government sales efforts. We're continuing to ramp up our resources in this area and our steadfast focus has been rewarded with double-digit growth. We see this progress continuing and we're well on our way to our expected growth levels in this area for fiscal 2008. I'm pleased to say that we were named once again to the information week 500 list of Leading Information Technology Companies in the U.S. For 2007, Applied ranked number 21 out of 500 firms, our highest ranking to date since debuting on the list in 2000.

In our last teleconference, we announced the launch of our new, 1100 page Applied branded catalog, published to coincide with the beginning of our fiscal year. After three months on the street, we are seeing the fruits of our labor with double-digit growth over last year's first quarter. S portion of this growth is due to the additional SKUs we have incorporated into the new book, which combines the best of the Applied Maintenance America and Fluid Power Connection catalogs. The new book contains more than 10,000 new and expanded products and was developed in direct response to requests from customers to provide a one-stop source for the most widely used name brand MRO parts that we supply.

To summarize, although we have seen moderating growth in a few industries, we are still confident that we will meet our topline growth estimates. Manufacturing activity continues to show steady growth, due in part to capital spending activity, increased exports and reasonable inventory levels. All-in-all, we're looking for continued strong performance over the next three quarters. I will now turn the call over the Dave for closing comments.

Thanks, Mark and Ben, Bill. Again, we're off to a good start. And we're feeling confident but cautious about the remainder of the fiscal year. We're going to keep a close eye on our operating fundamentals and the effective execution of a well-balanced strategy by both the Management team and the associates. We feel that we have the resources and the resolve to create a good portion of our future, and we have the scale and the skill to mold the rest from what the market offers. I feel that good things lie ahead. I want to thank you again for your interest in Applied and we will now get to your questions. Operator, please open the lines and we'll get started.

Thank you. (OPERATOR INSTRUCTIONS) We'll go first to Matt Duncan with Stephens, Inc.

Good afternoon, guys, and congrats on a nice quarter.

Hey thanks, Matt.

The first question I've got is on this SD&A expense as a percent of sales. Mark I know you said that it was below kind of what you think your expectation is is that will be on a go forward basis. Can you by any chance quantify for us kind of what you guys are expecting in your guidance in terms of SD&A as a percent of sales going forward?

Yes Matt, I think what we-- at the last conference call in August, we talked a little bit about the expectations for the SD&A as a percent of sales. I don't recall what that was specifically here and I don't have that information in front of me. I do say though that we had the one issue this quarter where we had some gains on sale of properties which reduced our SD&A expenses by about I guess 20 basis points or thereabout, which is a one time deal. We do not have in our plans any other gains on the sales of property, just like we didn't have in the plan this quarter the gains on the sales of property that actually happened. So that helped dampen the SD&A expense for this quarter right now. And some of the other thoughts that we've talked about is that we are ramping up some of the investments we're having for the government sales and other growth initiatives. And those are not fully ramped up at this point in time. So we do expect the run rate to be a little bit higher in the future quarters, but it's tough for me to quantify that right now.

Fair enough. I know you guys typically don't talk about month-to-month sales trends, but I guess some other distributors have on recent conference calls. And with some concerns out there about where we're going in terms of how good the growth is going to be for the economy in '08, I'm wondering if though you could provide us with sort of a look in the month-to-month trend in the quarter and if not maybe just give us some commentary about what you guys see in terms of growth for the economy for the next year.

This is Ben, and I guess through the quarter, on a month-to-month basis our sales were at the relatively the same rate throughout the quarter. And I think going forward for the rest of the fiscal, we're looking to be within the range that we've given in that 5% to 8% range.

Okay. On the government business, can you quantify for us what those sales were this quarter?

We don't have those numbers right in front of us right now for that. I mean as you recall, we talked about our rates of increase last year for fiscal '07 versus '06 and we are still planning on having a major improvement again with the government sales for fiscal '08 as well.

Okay. And then last thing here and I'll jump back if queue, and Dave you alluded to this a little bit on the acquisition pipeline. It's been a little while since you guys made one. You're now sitting on about $145 million in cash, very little debt, your debt to LTM EBITDA ratio is about 0.5 times. Can you tell us a little bit about what that pipeline looks like, I don't know if there's any more detail you can give us and then kind of what your planned uses for cash are?

Not only do we have the cash, Matt, but the fact that the market might be showing signs of moderating makes folks a little more interested in coming to the table. So we do see a pretty good pipeline out there right now, feel good about our ability to close some of these and we will be moving ahead with that and that will probably be our primary use of cash. And to the extent that any of that slows down, we can always-- we have the authorization and the ability to go back and repurchase our shares. We'll continue to watch the dividend and make sure that our payout on dividends are in line with our targeted rate.

Okay. Thanks a lot guys, and congrats again on a nice quarter.

Sure thing.

Thank you.

Our next question comes from Jeff Hammond with KeyBanc Capital Markets.

Hi. Good afternoon, guys.

Hey, Jeff.

Hey, I guess your sales rate this quarter was kind of at the low end of the range, I mean is there something -- I guess taking into account the midpoint being kind of 6.5, is there something that you're seeing out there that would suggest an uptick in the growth rate, or does this seem like a stable run rate?

This is Ben and just a few comments. I think we mentioned the breakout from the U.S. and Canada, Mexico and also the fluid power and we've been -- historically, we've -- the Canadian and Mexican operations as well as fluid power have done much better than they have been and we would expect that we will see improvement in those segments as we continue on throughout the year. Relatively stable overall, but a couple of those areas where we've been weak, we would expect some improvement.

Sorry, I jumped on the call late, there was a technical issue. Did you mention why those markets would have been weaker in the first quarter?

Well, Jeff, we talked a little bit about Canada about the weakening and the-- our sales in that market there relating to lumber/wood products slowing down with the housing market as well as with the currency, it's impacting the Canadian exports into the U.S. also.

Okay.

And Jeff, some of the, some of the fluid power business has been impacted by a reduction in requirements for mobile equipment in the housing industry and in the construction area, but as I may have mentioned earlier, we're not going to accept these as excuses. If the cheese moves, we're going to move with it and we're going to find things to offset it.

Right, it just seems like the commentary from the fluid power OEMs and then just looking at currency and the housing situation, that those issues would persist.

Could be, but you can either let them persist or go do something else.

Right, okay. Did you say that the lumber market was less negative this quarter than previous quarters, or it was just one of the negative SIC codes?

We did say it was less negative, that's correct.

Okay. And then just maybe to ask the government sales question a different way, I think on the last call you articulated you've kind of been on a run rate of $25 million to $50 million. You were hoping to get another incremental $25 million in sales. Is that the run rate you saw in the quarter and is that still a good kind of growth rate to think about for '08?

We're not changing those previous comments that we had, so--.

Okay, perfect. And then on the 5-- and maybe you touched on this in the prepared remarks, but the $0.05 at the top end, is that upside that you got from this quarter or where are you kind of seeing that? At the gross margin line or better SG&A or--?

For--

Just that raising the guidance on the high end by a $0.05, what's kind of the underlying reason, clearly on the cost given that the sales rate hasn't changed?

I think looking at it from an overall basis, our results for this quarter and our perception of what's going to happen for the rest of the year causes us to look at that on an overall basis. And we wanted to move up the top end a bit because we think that as we forecast into the future that good things are happening and we're working our plan and we think we'll still be able to deliver the plan and I think a little bit of this-- it's a little bit of everything. We have a good rate with our gross profit percentage. I think our SD&A expense rate was good for the quarter and that's the balancing act we have on investing in our business to invest in the growth to get the sales.

Jeff, just as a comment I made in my opening statements, the leverage that we saw in the first quarter was a little stronger than we had anticipated for the first quarter. For the remainder of the year, the numbers we're seeing remains pretty much where we put the plan in place to begin with. The fact that we did not raise the lower end of our range indicates that there is some uncertainty out there with regard to whether the housing has bottomed out, but right now as we see it we feel comfortable about raising the upper end guidance and all we've done is just widen the range a little bit.

Okay great. And then I guess final question, you mentioned that maybe valuations are getting a little bit better and I just noticed that you hadn't been in buying stock lately. It just seems like given your balance sheet and free cash flow that you would have room to do both.

That's a valid assumption.

Yes.

Okay, or is there something in the pipeline of size that would preclude you from buying back stock on a short-term basis?

You're crossing the line, Jeff. You know we're not going to add too much commentary to the fact that we're just -- we are in the acquisition market, so--.

Okay, thanks, guys.

Thanks.

Our next question comes from Brent Rakers with Morgan Keegan.

Good afternoon. Dave I guess I'm that vain hopefully I don't cross the line either, but could you remind us a little bit again about what your real targeted M&A strategy is? My understanding was it was still focusing on kind of some infill stuff, geographically Eastern Canada, maybe some fluid power acquisitions. Have you broadened the scope at all of that?

Well you nailed it right on the button, Brent, and that's exactly the list that we're still working on.

Okay, okay great. And then skipping to a housekeeping question, did you disclose the number of employees at quarter end?

We have not. We will have that in our 10Q and our expectations are to file the 10Q by the end of this week, and I would tell it to you right now, Brent, but I don't happen to have a draft of it with me.

Okay. I'm guessing based on what July was, which you reported in the K, pretty close to flat year-over-year. I was hoping you could maybe talk about what that target is. I know you talk about hiring additional sales people on the government side and growing SG&A. Is there a mind set at all to try to hold that employee number constant? Meaning, can you pare back on maybe some consolidation, some other employees or some support personnel that maybe you can leverage so you can maybe neutralize the net affect of adding the government employees?

Let me touch a little bit on that and maybe Ben can add some more color. I believe our employee count is down at the September quarter versus the June quarter and I don't have the exact number with me, but it is down from that. And of course, we're looking at both of those other perspectives that we've talked about, about redeploying resources as we get more efficient in our core day-to-day businesses. We can redeploy some resources to these more profitable growth areas as well as then hire additional folks into those profitable growth areas too to continue to work on them.

Yeah this is Ben. I'll add a little color to that in that we do not have any plans to reduce the number of people, but it continues to be a challenge in the marketplace to find good, qualified people. So that's an ongoing challenge for our field Management to ramp up and get those people in place.

Brent, let me just add the final flavor to this is, (inaudible) and looked at-- honestly, we're probably disappointed in the number of people that are out there right now because we had planned to move more people into that government sales business a little bit faster, but they are a limited breed and we're not going to put just anyone out there. So yes it may take us a little bit more time to get the type of talent we need in that area adjusted good in the general sales arena.

And Dave, on that government line, is there any willingness to shift strategy a little bit more? I believe you've been primarily hiring, producing existing government personnel. Any thoughts to changing the training program, maybe going for a little bit younger guy or newer entries maybe that are not existing producers?

To the extent that we can have the trainers on board, yes. We can do that. But I want to make sure that our nucleus has the ability to bring people up quickly as we bring just raw talent into that field.

And then last question on the government side, at least, in terms of the targets for this year, presumably you said double-digit growth in the quarter and you talked a little bit around the numbers. You're still on track for the guidance. I'm assuming that there were no surprises in the quarter in terms of government revenue?

None at all. And we expect to move very well in that business this year. We're very comfortable with the numbers that are out there.

And Dave is that conditional upon future hires or do you believe you get to those targets with the people you have already?

I think we're going to make -- we're going to -- almost going to tell you, we're going to will this into existence, but if there are any obstacles in our way, we are committed to getting the obstacles out of the way.

Great, okay. And then just a couple more questions. On the pricing side, it seems like -- and again, I guess correct me if I'm wrong, first, was there a price increase from vendors that went into affect at the start of this quarter?

There was one large bearing manufacturer that had a price increase around August, beginning of August.

And Mark, did that pressure short term gross margins to any degree because of the timing on passing that to national accounts?

They always do. I mean with the way our contracts work with customers, we do have firm pricing for certain amounts of time until we can roll these price increases through. So, yes. Any price increase for the national contracts sometimes do have a delayed impact into passing that along through the margins.

All right. And then I guess a related question. It seems like a number of these bearing guys are talking about their pricing pressures and they're looking to pass pricing on. Are you seeing other announced price increases and then what kind of price assumption do you think is appropriate to use for the December quarter?

We recently received another notification from other large bearing manufacturer that had a-- they're going to have a price increase right around January 1 and --

The increases for our second quarter are the normal ones we see typically this time of year. Nothing out of the ordinary.

Okay. And then just last question and I'll get back in the queue. In terms of the gross margin, I guess I was under a misunderstanding. I thought the original gross margin guidance was for levels comparable to last year and I thought that was 27.2 and now I guess you're running a little bit above that. Anything unusual in the gross margins or is this kind of a new higher level that we -- you would expect to be able to extrapolate or at least hold or maybe even improve throughout the year?

I think we're still viewing our gross margin percentages to be similar to what we did last year. So I mean 5 or 10 basis points are-- that's just normal variability.

Great. Thanks a lot.

Sure.

Greg Halter with Great Lakes Review.

Congratulations on the good results and thanks for taking my questions.

Thanks, Greg.

One on your capital spending, I think it was only $1.5 million or $6 million for the quarter and I know you also had the proceeds from the sales of -- property sales of $1 million. I wondered if you could provide us some guidance on what you expect going forward for the full year on a net to capital spending basis?

Well, I think, Greg, our projection on capital expenditures is anywhere in the $8 million to $10 million range for the whole year and I think that's consistent with what we talked about last quarter in our projections. We do not have any future sales of properties in our plan for the remainder of the year. That's not to say that some will or won't happen, but there's nothing in the pipeline right now.

Okay. And relative to the M&A area, I know you guys have been pretty -- or more than pretty disciplined, very disciplined on what you pay and I just wanted to get your commentary on whether or not you're changing your views on that or whether the market is coming more towards you?

Greg, we've always been receptive to being more aggressive where the strategic fit is there. And that's just common negotiating practice. What we're seeing right now is that there was so much of the industry in our field out there is in privately held companies that felt the real pain of the last recession and we had kind of projected that at the first sign of a moderation of markets this time that people didn't want to ride it all the way down like they did in 2000. So we expected the market to open up to us a bit when the economic programs started to falter a tad. So this is pretty much what we had projected. And so we're seeing more opportunity. We have not changed our internal hurdle rates for expectations, but if we see really good ones out there, we can be as aggressive as the next guy.

Okay, great. Thank you.

Thank you. Clarissa is that it?

Yes I'm sorry, this concludes the question-and-answer session. At this time, Mr. Pugh, I'd like to turn the call back over to you for any additional or closing remarks.

Great thank you very much. And again, thanks for your participation today, good questions and just glad you could join us for a celebration of a solid quarter. I would like to say good-bye to Bill Purser because this will be his last time on the conversations with you. He's done a tremendous job for us and we have a great replacement for him in Ben. So keep watching and we'll be talking to you again in January. Thank you very much.

This does conclude today's conference. We appreciate your participation. You may now disconnect.