Applied Industrial Technologies Inc (AIT) 2018 Q2 法說會逐字稿

Welcome to the Fiscal 2018 Second Quarter Earnings Call for Applied Industrial Technologies. My name is Christina, and I'll be your operator for today's call. (Operator Instructions) Please note that this conference is being recorded.

I will now turn the call over to Julie Kho. Julie, you may begin.

Thank you, Christina, and good morning, everyone. Our earnings release was issued this morning before the market opened. If you haven't received it, you can retrieve it from our website at applied.com. A replay of today's broadcast will be available for the next 2 weeks as noted in the press release.

Before we begin, I would like to remind everyone that we'll discuss Applied's business outlook during the conference call and make statements that are considered forward-looking. All forward-looking statements, including those made during the question-and-answer portion, speak only as of the date hereof and are based on current expectations that are subject to certain risks, including trends in various industry sectors and geographies, the success of our various business strategies and other risk factors provided in our press release and identified in Applied's most recent periodic report and other filings made with the SEC, which are available in the Investor Relations section of our website at applied.com.

Accordingly, 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 statements, whether due to new information or events or otherwise.

In compliance with SEC Regulation FD, this teleconference is being made available to the media and the general public as well as to analysts and investors. Because the teleconference and its webcast are open to all constituents and prior notification has been widely and unselectively disseminated, all content of the call will be considered fully disclosed.

Our speakers today include Neil Schrimsher, Applied's President and Chief Executive Officer; and Dave Wells, our Chief Financial Officer.

I will now turn the call over to Neil.

Thank you, Julie, and good morning, everyone. We appreciate you joining us. I'll begin with a brief recap of our results.

Our sales for the second quarter grew 9.7% to $667.2 million from $608.1 million in the same quarter a year ago. Net income for the quarter increased 28.5% to $31 million from $24.1 million. And earnings per share rose 29.5% to $0.79 per share compared to $0.61 per share in the prior year quarter.

Our second quarter results reflect broad-based execution across our business groups and a productive economic market environment. Overall, we're off to an exciting start to the calendar year and our fiscal year second half, celebrating 95 years of leadership in an industrial distribution and further strengthening our position with the definitive agreement to acquire specialty flow control provider, FCX Performance, Inc. Just yesterday, we were granted early termination of the Hart-Scott-Rodino waiting period with respect to the pending acquisition of FCX. We're pleased with this latest development and now expect to close the transaction on January 31, 2018.

Also today, we announced that our Board of Directors raised a quarterly cash dividend to $0.30 per common share, demonstrating our cash generation and commitment to increasing shareholder value. Now with a closer look at our financial performance for the quarter, here's Dave.

Thanks, Neil. Good morning, everyone. I'll now move on to provide some additional insights on our second quarter fiscal 2018 financial performance. Starting with top line, our daily sales rate improved 1.2% sequentially from the September quarter and was 9.7% higher than the prior year quarter. Acquisitions had a 0.9% positive impact on sales, and foreign currency translation provided a 0.8% benefit. The number of selling days in the quarter was consistent year-over-year.

Looking now at segment results. Second quarter sales in our Service Center-Based Distribution segment increased $41.3 million, or 8%. Acquisitions within this segment increased sales by $0.9 million, or 0.2%, and favorable foreign currency translation increased sales by $4.7 million, or 0.9%. Excluding the impact of acquisitions and currency translation, organic sales increased $35.7 million or 6.9%. The most recent quarter Service Center segment results benefited from positive growth in all businesses and geographies.

Sales from our U.S. Fluid Power Business segment increased by $17.8 million or 19% year-over-year. Acquisitions within this segment drove 5.1% of this sales increase. Excluding the impact of acquisitions, sales increased by $13 million or 13.9%.

From a geographic perspective, sales in the quarter for our U.S. operations were up 9.5%, including a positive impact from acquisitions of 0.9%. Excluding the impact of acquisitions, U.S. sales were up 8.6% organically. Sales from our Canadian operations increased 8.5% with favorable foreign currency translation, generating 5.2% of this increase. Consolidated sales from our other country operations, which include Mexico, Australia, New Zealand and Singapore, increased 14.2% compared to the same quarter in the prior year.

Acquisitions drove 2.3% of this increase and favorable foreign currency translation increased other country sales by 3.8%. Excluding the impact of acquisitions and currency translation, other country sales were up 8.1% compared to the same quarter in the prior year.

Our gross profit percentage for the quarter was 28.2%, 13 basis points lower year-over-year and flat sequentially. Inventory -- inflationary headwinds resulted in LIFO expense being recorded in the quarter compared to LIFO income in the prior year quarter. The year-over-year swing generated a 28 basis point adverse impact on gross margins. While this adverse impact was offset with price and benefits from other margin initiatives, sales mix in the quarter resulted in slightly lower year-over-year margins.

Selling, distribution and administrative expenses reflected nice volume leverage, totaling 21.2% of sales in the quarter as compared to 22.1% in the prior year quarter. SD&A increased $7 million, or 5.2%, with foreign currency exchange driving 80 basis points of this increase and acquisitions adding another 80 basis points. Excluding the impact of acquisitions and unfavorable currency translation, SD&A increased 3.6% during the quarter compared to the prior year quarter.

Despite average headcount for the quarter being down slightly year-over-year, the majority of this increased

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our employment cost, which were attributed to wage economics and performance-based incentives.

Quarter results also included $0.4 million of nonroutine transaction-related cost associated with the recently announced FCX Performance acquisition.

The effective income tax rate was 30.6% for the quarter compared to 32.7% for the quarter ended December 31, 2016. This generated a $0.02 earnings per share benefit year-over-year. The decrease in the effective tax rate is primarily due to the enactment of the U.S. Tax Cuts and Jobs Act, which reduces the company's U.S. federal corporate income tax rate from 35% to 21% effective January 1, 2018. This results in a blended U.S. statutory rate for the company's fiscal 2018, which was 28.06% for the quarter ended December 31, 2017.

In our fourth quarter, however, we expect our aggregate effective tax rate to return to a range of 34% to 34.5%, as we record expense related to the further remeasurement of certain deferred tax assets and liabilities from revised fiscal year 2018 28% rate to the 21% fiscal year 2019 U.S. statutory rate.

We expect our resulting full year effective tax rate for fiscal 2018 to be in the 31% to 32% range, and we expect our fiscal year 2019 effective tax rate to range from 23% to 24%.

Our consolidated balance sheet remains strong with shareholder's equity of $779 million. Our after-tax return on assets for the quarter was 9%. A sequential increase in inventory in December 2017 resulted from higher business volumes and the timing impact of inventory purchases related to the calendar year-end buying incentives and programs offered by certain strategic suppliers.

As we look forward to our June fiscal year-end, we expect operational inventory levels to decrease by $20 million to $30 million.

Cash generated from operating activities was $11.7 million for the quarter, $8 million higher than the prior year quarter, despite program-related inventory increases.

Year-to-date, cash generated from operating activities of $21.2 million compares to $45.7 million in the prior year period as a result of higher volume-driven receivable and inventory levels. As we work down calendar year-end program-related inventory purchases and recognize anticipated benefits of our working capital management initiatives currently ongoing, we are still targeting cash generation from operating activities for the fiscal 2018 to be in the range of $150 million to $160 million despite the impact of higher business volumes.

During the quarter, we also purchased 146,000 shares of treasury stock on the open market at an average cost of $61.84 per share for a total of $9 million.

Following the culmination of the FCX Performance transaction and borrowing to fund the acquisition, our capital allocation priorities will focus on delevering and continuing to deliver shareholder value by maintaining our track record of consistent dividend payments and increases.

Regarding our full year outlook. As referenced in today's earnings release, we raised the range on our fiscal year 2018 earnings guidance of between $3.10 and $3.20 per share to a range of $3.40 and $3.50 per share. This equates to a range of approximately $3.29 to $3.39 per share at the prior estimated 34% effective tax rate.

Despite tougher second half comps, our revised guidance assumes 6% to 7% sales growth for the year, given another solid quarter under our belts, the productive outlook for near-term industrial markets and continued traction generated from execution of our strategic priorities.

As noted in our release, we will provide further guidance to include the partial year impact to results from the acquisition of FCX Performance in conjunction with announcing the close of the transaction, which is now anticipated to take place on January 31, 2018.

With that, I will turn the call back over to Neil for some final comments.

Thanks, Dave. Through our business execution and strategic investments, we continue to strengthen our differentiated industrial distribution capabilities, including our critical core products offering, expanding value-added services, leadership in engineered fluid power solutions, growing geographic reach and channels to market. At 95 years, Applied is well positioned as the technical MRO distribution leader. And we're committed to generating profitable growth and enhancing value for all our stakeholders.

With that, we'll open up the lines for your questions.

(Operator Instructions) Your first question comes from Ryan Cieslak from Northcoast Research.

My first question, Neil, maybe you can just provide some detail how the quarter progressed with regard to the sales growth rate? And any color you can give on January so far? I know there's been some weather impact, it seems, like for some distributors, any color around that? And what you guys are thinking so far here, I guess, year-to-date?

Sure. On the sales per day trends in Q2, we know it improved overall around 120 basis points. Really, the development from October to November, we had improvements and really throughout most of November just right up until or between the holiday period. Then, month-to-date January has continued as expected, mid-single digits increase year-over-year off low single digits compared to kind of the December end. But again, not surprising, given the quarter end closing around December in that side. So for us, at this time of year, right, you get weather. And we're just working our way through it. We got good weather geographies in some of our markets too, and we'll look to make the most of those.

Okay. And then on pricing, Dave, if I heard you right, you said you are seeing supplier inflation come through. Maybe just talk a little bit about maybe the magnitude of that inflation that you're seeing right now? And have you been able to sort of pass that along successfully? And what type of benefit should we expect maybe on the top line from pricing and just larger inflation here going forward?

Sure. Again, I want to remind you about the variability of our kind of quarter-over-quarter, year-over-year SKU sales. It's really less than 1/4 of those that repeat year-over-year. But looking at the -- we do have a light match just to understand the impact of both the supplier price increases, and what we've been able to pass on in terms of that price -- we're seeing about kind of a low 3% in terms of inflationary impact, kind of 3% up in terms of the supplier price increases does seem to be starting to level off at this point in terms of what is being passed on to us. Here again, we work to pass those on and are largely offsetting those through a combination of pricing and work with our suppliers on supplier programs, et cetera, where we can't get that price immediately. So I'd say, kind of doing a good job in the business in offsetting that impact and seeing that inflationary impact starting to stabilize as we move through the quarter.

Okay, great. And then, I guess my last question, and I'll hop back in the queue. So the gross margin, sounds like there was some impact there from changes in LIFO and the way you're accounting there with regard to the inflation and certainly some of the mix impact as well. How do we think about the back half of the year now for gross margins in the context of some of the growth you're seeing there for those large accounts and pricing? And Neil, is the expectation that you still have the ability to see that? I think in the past, you talked about 20 to 30 basis points or so of margin improvement. That's still a good bogey once things settle out.

Yes, right. Yes, I'll start. And I would say we still have the objective to grow margin 20 to 30 basis points a year and clearly view we have the potential to do that. So flat sequentially as we move through. We understand, Dave talked about some of the rising inflation and given the LIFO treatment that came in. I think all in all, across our business groups, many good job of matching and passing through increases as we think about the point-of-sale side of it. And then, the mix that he alluded to or talked about a little bit, I think we just had nice growth with some larger accounts. We also had nice growth with all other accounts as they would go in that, just slightly higher in this quarter with a few of the larger accounts. And so going forward, team's got the right line of sight. We know we have opportunities around point-of-sale, reducing variation at customer groups and across product types. And we believe continued growth, customer mix can help us, also product mix can help us as we go through in that. So that's what we'd say, it is the right goal, it is the right objective for us to have. And then, I think about in some of our groups with value-added services, that margin potential exists there as well.

Your next question comes from Jason Rodgers from Great Lakes Review.

Could you talk about the oil and gas markets? And how much that contributed to the sales increase in the quarter? And what your outlook for that market is, going forward?

Sure. The oil and gas markets continue to be productive for us for the quarter. That did drive just over 1 point of our overall growth. We expect as we continue to see -- look across the next couple of quarters, continued productivity there, probably here again against the tougher comps settling out in kind of mid-teens increase year-over-year for the back half of the year, which is good drive within the oil and gas-focused service centers, a full year increase of about 20% to 25% year-over-year sales growth.

And I wonder if you could give an update on the 30 industry groups you track and the performance there for the quarter?

Sure. So the sales performance in the top 30, we had 20 industries with increases, make up a little bit from the last couple of quarters. Positives around oil and gas, also aggregate primary metals. So positives with machinery OEMs and also chemicals, kind of a bounce back. We had some softness in the last quarter, and I think that was more timing around hurricanes then. So we saw the positives of that coming in this quarter and also food.

And would you mind giving us an update on the efforts you talked about last quarter to improve receivable collections?

Sure. We've worked through, I think we alluded to last quarter, in the process of compiling and building out the shared services function for our U.S.-based receivables collections for the service centers. Completed within the quarter, the buildout of that organization really continuing to hone the standard work in terms of the -- we've had the interaction with the field and with the management team to successfully drive collections. So continue to hold around there on that front and expect to drive benefit as we move forward, as we work this consistent processes, utilize some of the new tools to drive efficiencies in the collections activities.

And then finally, would you mind repeating the expectation for the tax rate for 3Q and 4Q?

Sure. Q3 in isolation is going to be kind of 28% to 29% rate, given the 28% statutory effective tax rate for the balance of '18 -- our fiscal '18. Q4 in isolation will be in the range of 34% to 34.5%, given the further remeasurement then of our certain deferred tax sets and liabilities that will take place as we transition then from that 28% blended rate for this year to the 21% effective statutory rate for fiscal '19.

Your next question comes from Chris Dankert from Longbow Research.

I guess, to clarify first off, how do we think about FCX in terms of guidance? Is that baked in at this point? Or will that be kind of rolled in once the deal closes officially? And kind of any new thoughts on how we should think about for fiscal '19 at this point?

No new thoughts, kind of, beyond what we guided as we announced the transaction. Here again, what we will do is, upon announcing the close of the transaction as we indicated now, now anticipated for the 31st, we will provide updated guidance to include the FCX and the impacts on both fiscal '18 and any update in terms of our forward thoughts around the business. But no changes. We continue to work through the integration planning efforts in terms of our view on what that business will add in the next 12 months.

Got you. Got you. And then, just, Neil, any commentary on current bidding activity in addition to what the Fluid Power backlog looks like right now?

Continues to be very productive. I would say, looking back, there was a little acquisition impact in it, but it's at a high level. It's at a historically high, high level in that. So we feel good about that and the work going on across those Fluid Power groups of connecting with these mobile and OEM customers and the technical solutions that we're bringing to them. So...

We did grow backlog about 15% in the Fluid Power Business within the quarter. So continued strong order intake.

Perfect. And then just finally, if I could. Obviously, if it's -- no matter where you go with the just-in-time inventory environment now, but have you guys seen any restocking benefit given kind of how some of these industries have seen a step change in demand?

I don't know there is so much restocking as I think across industries right now. Activity is good. And so therefore, the product requirements and the services and the solutions to them are increasing at a good pace. So good activity going across, including in heavy industries, which can chew up mechanical parts or require them. And so I think that's good for the broader industrial economic environment.

(Operator Instructions) Your next question comes from Adam Uhlman from Cleveland Research.

I wanted to start with some of the gross margin commentary that you had. I guess, you'd mentioned that you took advantage of some purchasing programs, supplier incentives, that's -- I guess, that's pretty typical in December. But in an inflationary environment, I would think that, that should start to release potential gross margin benefit for Applied in the second half of the year. Do you think that's going to come through in the gross margin line over the next 2 quarters? Or is it too small to really move the needle?

I'll start, and Dave can come in. But I would say it contributes, but it contributes like it has in the past. And it really contributes when we have a rate of sale to go through and do that. So it'll start as a capitalized. And then when we have sale-like activity, it would get attached to those products and sales. So we will see benefit, but this has occurred in past years as well.

Okay.

No marked change from a prior year phenomenon you may have seen, Adam.

Got you. Okay. And then, to the discussion of the top 30 industries. What is declining year-over-year now for Applied? Where is kind of the pressure? And I guess, within that group, where do you feel better about, maybe the momentum is changing, and we could have more than 20 industries growing?

Yes, I think we could be close to more of them hitting growth. I think there's more around the 0 line, which sometimes can be -- perhaps there's noise in the classifications and what perfectly segments that they fall into. I think in this last one as we look at, maybe some of the -- either paper connected or wood industries could have been a little lighter. But again, not by big numbers. So if I think about it going forward, I think there is a good potential that it's going to be a higher than 20 number as we think about future quarters.

Okay. Got you. And then just quickly last on the FCX acquisition. I guess, you've already provided some numbers in terms of the dilution that's expected for the fiscal year as we absorb a lot of onetime costs. And it would seem as if a lot of those are noncash charges. And the accretion from the acquisition, I mean, just for the balance of the fiscal year to be over 10% cash, I guess, from the rough numbers we have. I'm just wondering, on a run-rate basis, how we should think about the cash contribution from the acquisition putting all the noncash charges aside?

You're right. I mean, the nature of the charges are such that they're more noncash weighted. I'd say the characteristics of the FCX business, in terms of cash generation, the cash profile, are very akin to that of Applied. So not at all capital intensive, nice conversion in terms of receivables and not significant impact in terms of inventory carrying. So I think you're going to see a very nice combination as we bring the businesses together. Here again, we'll get back with specific guidance as we make the announcement here at the end of the quarter, but expect to certainly tighten that range in terms of the magnitude even of the onetime costs versus what we are initially contemplating.

Your next question comes from Steve Barger from KeyBanc Capital.

Going back to the price cost considerations in the back half, incremental operating contribution margins have been about 15% in the past 2 quarters. Is that a good run rate we should be thinking about for the base business in the mid-single-digit growth environment?

Yes, yes, certainly what we'd be targeting in terms of we think about those incremental dollars and the follow-through that we would expect on those. So would not see any characteristics that would change that in the back half of the year.

Okay. And you've talked a little bit about FCX. But is it reasonable to think that incrementals there are higher than the base business, just given the higher gross margin, maybe the mix of businesses? Or is that not necessarily right?

It would tend to be higher than what we would see, just given the incremental gross margin profile in that business.

With volume trends picking up across a lot of industries now, can you talk about current inventory levels relative to demand? And are you seeing any hitches in the supply chain in terms of lead times pushing out for any types of products?

We feel good about our inventory levels. We stay close with really our key or all of our suppliers. And we know their service or their performance. And we both have high expectations that we're always on our game. But if we anticipate there's going to be issues or concerns on those sides, those will be ones that we'll look at, how do we productively deal with them early. I think it's also a benefit that we get -- as we think about how we have inventory across our large DC network then that would feed a corresponding amount of service centers. So there can be some adjustments that we make across some of those DCs as we link with suppliers. But we're working very hard with them on clear signals and then how we leverage the -- I guess, the productive pull-through of both businesses that we're focused on serving these customers.

Got it. And then, last one for me. When you look across the product lines, are you -- and this is an inflation-oriented question -- are you seeing bigger increases based on things with high steel content or things that are highly engineered? Just trying to get a sense from where the upstream pricing pressure is across those products.

I think on those maybe they all tend to still group together. I think the largest increases are on the ones that are more -- as far as we would like to view them more to become obsolete. And so some of that may be to drive that behavior, right, that they're either harder to make or they have replacement capabilities and other offerings. So older, legacy products can have a higher increase attached to them versus some of the others.

Your next question comes from Ryan Cieslak from North Coast Research.

Just one quick follow-up. I think the last quarter you talked about some incremental employee costs are rolling through in the back half of the year as well as some IT investments? Is there a way to maybe quantify what the incremental cost headwind will be here in the back half of the year?

You bet. Just a good reminder, Ryan, that, yes, we did have -- taking place January 1, the focus merit increases, which would increase kind of our employment cost an average of 3%. So given that, that's about 70% or so of our SD&A cost base, we expect an increase in the range of $3 million to $4 million as you look at the -- that impact from the merit and other inflationary increases as well as some of the IT spend that we discussed.

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.

I just want to thank everyone, again, for taking the time to join us, and we look forward to talking with many of you throughout the quarter.

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