Applied Industrial Technologies Inc (AIT) 2018 Q3 法說會逐字稿

Welcome to the Fiscal 2018 Third Quarter Earnings Call for Applied Industrial Technologies. My name is Virgil, 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, Virgil, and good morning, everyone. Our 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. Also, a supplemental investor deck detailing latest quarter results is available for reference on the Investor Relations portion of our website.

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 will 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 at 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 addition, the conference call includes the use of non-GAAP financial measures. These measures are explained in our press release and in the supplemental presentation material and are subject to the qualifications referenced in those documents. 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 will begin with a brief recap of our results.

Our net sales for the third quarter grew 21.8% to $827.7 million, from $679.3 million in the same quarter a year ago. Net income for the quarter increased 24.1% to $36.6 million from $29.5 million. And earnings per share rose 24% to $0.93 per share, compared with $0.75 per share in the prior year quarter.

Our strong third quarter results reflect broad-based execution across our business groups, along with the expected 2-month contributions from the recent acquisition of FCX Performance. While less than 90 days since closing, I could not be more pleased or excited about the efforts to date. I want to thank the FCX team members and Applied associates for their energy, engagement and focus to serving our customers and contributing to our overall business performance. Throughout our business, we had significant opportunities for growth, with both our product offering and expanding value-added capabilities that further enhance our differentiation as the technical MRO distribution leader. Now with a closer look at our financial performance for the quarter, here is Dave.

Thanks, Neil, and good morning, everyone. I'll begin with further details on our most recent quarter financial performance and then move on to some additional color and our updated fiscal year 2018 outlook.

Starting with the top line, as Neil mentioned, for the quarter ended March 2018, sales increased 21.8% over the prior year quarter. This was comprised of a 6.7% organic increase coupled with an 80 basis point benefit from foreign currency exchange and 15.3% acquisition-related increase. Year-over-year comparative performance also included a 1% dilutive impact attributed to 1/2 less selling day in the quarter.

Excluding the 2 months of FCX Performance acquisition impact, sales per day increased 4.7% sequentially and 7.9% year-over-year.

Third quarter sales in our Service Center Based Distribution segment increased $27.4 million or 4.8%. Acquisitions within this segment increased sales by $0.9 million or 20 basis points, and foreign currency fluctuations increased sales by 1%.

Excluding the impact of acquisitions and currency translation, sales increased by $20.9 million or 3.6%, driven by a 4.4% core operational increase, which was partially offset by a 0.8% headwind due to the 1/2 less selling day in this year's quarter.

Moving to our Fluid Power and Flow Control segment. Third quarter sales increased $121 million or 114.6% as compared to prior year. Acquisitions within this segment generated $103 million of this increase or 97.6% year-over-year segment growth.

Excluding the impact of acquisitions, sales increased $18 million or 17%, driven by a core operational increase of 18.7%. Again, core operational performance was partially offset by a 1.7% decrease attributed to the differential in selling days.

From a geographic perspective, sales in the quarter for our U.S. operations were up 24.7%, with acquisitions driving an increase of 18%. Excluding acquisition impact, sales from U.S. operations increased by $38.2 million or 6.7%, comprised of 7.7% organic growth, offset by a 1% decrease due to the 1/2 less selling day in the quarter.

Sales from our businesses outside of the United States, which increased 6.8% versus the prior year quarter, represented a balance of the increase over prior year sales.

Moving on to gross margins. Our gross profit percentage for the quarter was 28.9%, up 85 basis points year-over-year. Excluding the benefit from the FCX acquisition, gross profit margin for the core business was 28.4%. This represents a 30 basis point year-over-year and 15 basis point sequential improvement, as a result of traction realized from various margin improvement initiatives.

Additionally, 2 months of FCX's acquisition results drove another 56 basis points of margin expansion year-over-year.

Our selling, distribution and administrative expenses on an absolute basis increased $38 million or 26.1% when compared to the same quarter in the prior year. Acquired businesses accounted for $32.7 million or 22.5% of the year-over-year growth, including $5.7 million in onetime acquisition cost and $4.2 million of intangibles amortization related to the FCX acquisition. Changes in foreign currency rates increased SG&A in the quarter by $1.3 million or 0.9% compared to the prior year quarter.

Excluding the impact of acquisitions and currency translation, SG&A increased only $4 million or 2.7% year-over-year for the quarter, driven primarily by the impact of annual merit increases and higher performance-based incentives.

Excluding the impact of acquisitions, average headcount in the quarter was down 15 positions year-over-year, reflecting continued leverage of systems investments and productivity initiatives.

Resulting EBITDA for the quarter was $72.3 million or 8.7% of sales. This included the adverse impact of $5.7 million of the total $6.7 million in onetime transaction cost, associated with the FCX acquisition, which were recorded in SG&A.

The effective income tax rate was 26.1% for the quarter, which was lower than we guided, primarily as a result of a 120 basis point or $1.3 million benefit recognized from discrete tax adjustments. We now expect our fourth quarter effective tax rate to be in the range of 33% to 34% of pretax earnings, as we complete the final remeasurement of certain deferred taxes from the blended 28% fiscal year 2018 rate to the go-forward 21% U.S. statutory rate.

Our consolidated balance sheet remains strong with shareholders' equity of $806 million. Following the culmination of the FCX Performance transaction and borrowing to fund the acquisition, our capital allocation priorities remain focused on delevering and continuing to deliver shareholder value by maintaining our track record of consistent dividend payments. As such, there was no share repurchase activity in the quarter.

Additionally, we extinguished $25 million of the initial $112.5 million revolver draw, taken as we executed our new credit facility January 31, to fund the FCX Performance acquisition.

Cash generated from operating activities was $26.7 million for the quarter, $6.1 million lower than the prior year quarter. Year-over-year build of accounts receivable within the quarter reflected improved collections performance and past due reduction, but was still a $7.5 million headwind as a result of incremental volumes.

As we look forward to our June fiscal year-end, we expect operational inventory levels to decrease by $20 million. Additionally, we expect to recognize further benefits from our collections and payables working capital management initiatives currently ongoing to maximize our fourth quarter cash flow.

Regarding our full year outlook, as referenced in today's earnings release, we raised our fiscal year 2018 earnings guidance to a range of $3.51 to $3.61 per share on a sales increase of 17.5% to 18.5%. Excluding the benefit of the FCX Performance acquisition, this assumes a sales increase of between 8.1% to 8.6% for the year, based on continued positive near-term industrial market outlook and further traction from our strategic growth initiatives. Additionally, our full year EPS guidance includes $0.12 in onetime transaction-related cash cost associated with the FCX acquisition as well as $0.19 incremental noncash amortization. With that, I will now turn the call back over to Neil for some final closing comments.

Thanks, Dave. In summary, we are pleased with our overall performance and accomplishments today. However, we're not satisfied. We know there is more work to be done to realize our full potential. With our annual planning process underway, we look forward to building on this momentum, generating a strong finish to the fiscal year, delivering on our commitments and setting the stage for the next level of growth in fiscal 2019. As we continue to celebrate Applied's 95 years of leadership in distribution, we're ever more energized and excited about our business potential, growth prospects and providing benefits for all our stakeholders.

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

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

Can we start with FCX and the updated earnings guidance for the year for that business? I guess, could you expand a bit on what you're seeing on the top line and the margin performance? And then secondly, related to that, do you think that your initial earnings accretion estimate of $0.10 to $0.20 for next year is still a reasonable target? Or has that gone up as well?

I'll start and maybe let Dave come in, especially as we think about it going into next year. The business is performing very well for the first couple of months that we have and we feel good about it coming into the coming quarter. Obviously, we get 1 more month so we think, in the guidance, right, our total sales are going to be in upper 20s to maybe 30% from a growth standpoint. And we think FCX continues at its 2-month rate, that there's some projects in that first couple of months. Maybe there will be a little bit of seasonality but our thinking is, it continues at that rate and then core Applied is in the upper single-digit rate, perhaps more than 7% and somewhere above the 8% on the ranges of the guidance. So that's our expectations that we have. And then from the margin standpoint, we know the added month of FCX, right? It will be accretive to our margins overall. So total margins probably improve 40 to maybe 70-or-so basis points in that. We believe the core, while it has some opportunities, we know we will be getting some LIFO expense that will be coming into the fourth quarter as well. So we'll have continuous improvement initiatives, but it may be closer to its number that was in the third quarter with some work underway to make it a little bit better.

Yes, we are seeing some upside, Adam, in the fiscal '18 guidance in terms of some volume benefit, about $0.03 volume benefit as well as about $0.08 benefit from lower amortization expense versus our initial assumptions. Thinking about the full year '19 guidance, we have not updated, obviously, the '19 guidance, but you could expect some of that amortization benefit to flow through to the full year impact there.

Okay. And then just a follow-up. How big is the expected LIFO expense that you're going to see next quarter?

We've not got a good estimate on that at this point, Adam. But it could be 10 to 20 basis point headwind.

Your next question comes from Ryan Cieslak from Northcoast Research.

This is Avi on for Ryan. Can you guys just discuss some of the pricing dynamics in the quarter in terms of how much that contributed to top line growth? And how, if any, impacted on gross margins as it relates to price cost spreads and your ability to pass that through? I think going forward, the indication from suppliers is that it relates to additional price increases.

Sure. So I would say, overall, if we look at the gross margin improvements that we had, including on legacy business, the 30 basis points year-over-year and the 15 basis points sequentially, we feel like we did good work addressing or managing inflation that was coming at us. We remind ourselves, and maybe it's not obvious to everyone, as we think about price volume as it relates to sales, about less than 1/3 of our SKUs, our product sold, are repeatable to the prior year quarter, so where you can get a true absolute price metric. 2/3 are unique, either based on their sales frequency, their value-added configuration or assemblies of other products. So you don't get a perfect match to that. So if I think about it from a sales standpoint and what it may have contributed, I think price could have been more than 1%, maybe not 2% in that. If I think about it from the supplier side and what is coming, that's probably more in the 3% to 4% range. So we would expect in time that to work through, but is still more on the -- we get the price measurement clearly on about 1/3 of our SKUs that we sell on a quarterly basis. And then on the others, we feel like we're doing a nice job recognizing that cost that we would see and reflecting it in those sales as well.

Yes, I just here again point to the year-over-year benefit that we saw in margins, continuing to work the price, the vendor support as well as some of the margin initiatives to offset the inflationary impact we're seeing. Plus we have some LIFO headwinds that we did see in this quarter as well.

That's very helpful. And just second question, if I may. With growth moving significantly higher in the last several quarters, do you feel like your supply chain is well equipped? Or is there enough capacity and pinch points to support the level of growth you're realizing what's out maybe having to increase your level of SG&A investment going forward?

I'll start. I believe we're in a very good position. We think about the systems and the technology investments that we're having, those are yielding benefit, speed, efficiency, productivity for us. And so we really look for our staffing actions to be around forward-facing resources with, perhaps, less requirements or freeing up time for those that were just doing a back office functionality. So we feel we're in a very good position, as we look at the SG&A rate of what it was in the quarter, it helps provide nice leverage on that volume. And we feel that's our potential looking forward as well.

And clearly, again, we saw that in the quarter with SG&A being up only 2.7%, average headcount being down year-over-year, despite the higher volumes.

(Operator Instructions) Your next question comes from Jason Rodgers from Great Lakes Review.

I just want to make sure I understand the expected tax rate. What are you projecting for the fourth quarter?

Fourth quarter will be back to 33% to 34% effective tax rate, as we go through the final remeasurement. Here again, we're on the blended tax rate since we straddle the tax act change at 28% this year. That will step down to 21% as we exit our fiscal year and move into fiscal '19. And the final remeasurement, there's that cost that spiked then in Q4. As we round the corner, obviously, then we're looking at a 23% to 25% ongoing effective tax rate as we move forward in fiscal '19.

All right. And if you could comment on the industry performance in the quarter as well as the performance of the oil and gas markets and the expectation for the oil and gas for the fourth quarter.

Okay. So our sales performance in the top 30 industries, we would've had 21 with increases. Positives around oil and gas, so we'll get to that. I think primary metals, machinery OEMs, aggregates, chemicals are doing well. Food and others that are either close to or demonstrating encouraging trends on oil and gas, if we think about it on a sales-per-day basis sequentially, it would have improved 10%. It's predominantly in the upstream, drilling and ongoing production. The U.S. is faring better in many areas, but especially the Permian basin. Many will say Permian output is going to approach 3 million barrels a day in May. Looking out over a longer-term horizon, some say that will go to, by 2023, to 4 million barrels a day. So that's encouraging. There's more pipelines that's connecting the Permian that are being built to either Corpus or Houston. So that's also good for those businesses located there, including FCX and [Eed]. So that's driving a lot of that activity. And looking forward, we would expect that performance to continue. So in the quarter, it's probably a teens-type year-over-year improvement.

And then if I could just squeeze one more in. Performance in April, how are sales tracking?

As we think about month-to-date, April is as expected. Year-over-year, it's upper single digits comparison. So good activity going on. If we look at the quarter point to March, a very similar with a few days ago, maybe slightly down. But I think it's going to be in a good rate in comparison sequentially and set up well from a year-over-year standpoint.

Your next question comes from Chris Dankert from Longbow Research.

I guess, first off, just thinking about, you said [agg] from the heavy equipment stuff doing better. Looking at fluid power, I guess, what's the backlog like in that business right now? And kind of just any commentary on health in fluid power specifically.

So our fluid power performance continues to be strong. I think plus 13 backlog from a year-over-year basis, plus 20% sequentially in the quarter it grew. So that's productive. And the teams continue to do a nice job, connecting technology to the designs and offering and helping mobile and industrial OEMs improve their products and offerings with features and benefits. So businesses are performing well. And then on the MRO side, we're just active with industrials, helping them either with machine control, energy savings around pneumatics. So that side of our business has been positive as well. And then we think about it, take one step going forward, the natural link with process controls is very positive and should aid the business as we move into future quarters as well.

Got it, that's really helpful. And then I just want to make sure I heard the comment correctly. So going forward, it sounds like deleveraging is going to be a focus here. So it's fair to assume that interest expense is going to be lower than just what the headline would -- I'm just trying to look at 2019, if you can give us a commentary that's great. But less than $40 million interest expense seems like a fair range?

Yes, as we work through delevering, that would be an expectation for sure to continue to mitigate the interest expense as we move through fiscal '19.

Got it, got it. And then just one more, if I could. Looking at the balance sheet, it seems like FCX is operating at a very lean basis on inventory days. I guess, is there any kind of best practice gains we realized there on integration? And maybe I'm wrong, but if you just look at the numbers, it seems like they were doing really, really well on an inventory basis.

I think, here again, they had a slightly different business model, thinking about the MRO nature there and the engineered components. It might akin more to our fluid power versus the industrial distribution piece of the business here. But I think we'll continue to share best practices and leverage here again, since we're on the same systems, there's operational excellence initiatives to try to leverage the inventory benefits across both pieces of the business.

Your next question comes from Steve Barger from KeyBanc Capital Markets.

I got on the call a little bit late so let me know if this has been covered. But as we -- after we made the adjustments in the quarter, we got an incremental margin of 11%. Is that how we should think about that level for the next few quarters until FCX anniversaries? And then going forward after that, how should we think about incrementals, assuming we stay in a rising volume environment?

We still expect incrementals to be -- so 11%. 11% includes the impact of onetime cost if you strip those out.

We adjusted for those and went to [105].

Okay. We would expect, obviously, FCX mixing this up, we talked about $0.14 to $0.15 fall-through expectation on the incremental dollar. We would expect that to continue to edge up, as we roll in the complete benefit of the FCX acquisition.

Okay. And so you would expect, even in 4Q and in the first half of '18 -- sorry '19, to be able to outperform that level?

Correct.

Okay. I just got off a machinery OEM call. People are very concerned about order sustainability and cycle longevity and I know you're further down the supply chain. But curious about your view of the cycle in the back half calendar '18 or even in to next year. Just based on what you're seeing, contextually, from prior cycles or what you're hearing from customers?

Well we kicked off our annual planning process. And so we're working it bottoms up right now and we'll be having sessions with the teams and the business units in the coming days and weeks. But I think most are positive on their outlook as we go through the rest of calendar '18 and really going into '19. And know there will be some economists and others that will talk about perhaps '19 in the back half could have a little bit of softening. And I say to that, right, to be determined. But if we look out over the horizon and our order rate and our backlog was relevant in some of those business, the activity that's going on in shops right now are at good, high levels. So I think that's what we continue to see through '18 and we would expect it to carry through a good portion of '19. After that, I guess, to be determined.

Sure. As you think about your machinery OEM customers, do you have more exposure to dirt or aerial or traditional construction equipment? Any sense of that?

To me, it's a nice, blended mix across, I don't know, 7 or 8 of those segments and including others that could in some cleaner industries that are doing that as well. So it's a nice blend.

And for the OEMs, pretty broad-based demand ramp that you're seeing. Any outliers one way or the other?

No. Really no outliers. And a portion of it is technology-driven. More and more electronic capabilities coming in, those being desired to come into products. So that is very encouraging. And then now with FCX, we think we have an extended opportunity to increase those from a value-added service standpoint, right? Today, they'll work on pump skids, valve stands, providing component and repair services that get actuated by something we're doing today in either hydraulics or pneumatics. So that will be a nice combination on the service side that can provide some additional work.

Yes. It's a good segue into my next question. And I know it's really early for this, but as you're getting into the FCX integration, any new things you've learned since we did the call? Opportunities you've uncovered in terms of cross-selling, getting more involved in selling value-added services or just the broad product line?

I'd say we are extremely encouraged and excited about all of them. I don't know that we learned anything new in categories as you have the opportunity to get more in specifics, clearly, there is learning. We probably have up to 18 work streams established, teams identified on them, building action plans around them, with a focus on hey, what can we do to help ourselves in the very near term? What are good midterm plans and how do we pursue them? And what will even be a little longer term, later term as we think in that synergy horizon. So we are encouraged about those, and we have in our mind, the right focus. The teams are delivering on their core responsibilities, while also seeking the additional opportunities that would either enhance competitiveness and cost or enhance the opportunities for sales and the margin.

Right, okay. That's a good answer. One more and I'll get back in the queue. Are there any specific types of products where you're seeing greater inflation? Or can you talk about dynamics in bearings versus hydraulics versus less highly engineered products, just any context?

Yes. I think it's -- I would say in general, they're pretty similar, as they would go across. I think as suppliers are trying to, perhaps, move away from either older technology or slower moving products to promote new products or some SKU consolidation, they will put more increases on truly older legacy products to help encourage that migration. So we see that and we help our customers work through and sort through that transition in adopting or translating to some of those new products. But I don't think a great deal. And probably a little bit of thought comes up around tariffs, but there's really been kind of low, no activity to date to be determined how it plays out. But also, I think, if it occurs on those products, it's going to come through in the form of on the products on price, which is that mechanism we know how to handle, right? It is not going to come in as an additional item on the invoice, which makes it more challenging for everyone to handle on that side. And then the other side, as the potential of some of those tariffs in those industries, we could see the early signs of maybe some added activity, right? Hiring, staffing, shifting capacity. So if there's more activity on that from the customer side, at least in an early period of time, that can or will contribute to the volume side of it, which can be positive.

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

I just had a few housekeeping items. What's the current debt-to-EBITDA? And how much of the debt is fixed?

So we're at about 3.6% gross debt-to-EBITDA. 3.3% on a net basis. About 17% of that (inaudible) that we're working towards fixing a greater portion of that with some interest rate hedging, as we move forward here.

And what's the cash flow target, if you have one, to end fiscal '18?

Targeting $140 million to $150 million. We've got -- here again, part of the story is, the great backlog build we've seen in fluid power, up $25 million in backlog there has been a bit of a headwind for us. But still working through inventory reductions, as we work through some of the pre-buy activity and made some nice traction this quarter in terms of about 2.4% reduction in our past due collections as well as some payables extension initiatives that will continue to contribute here in the Q4.

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 for joining us today, and we will look forward to seeing many of you as we move into the quarter.

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