Applied Industrial Technologies, Inc.
Q1 2017 Earnings Call Transcript

Published: 29 Apr 2017

[Operator:]

Welcome to the Fiscal 2017 Third Quarter Earnings Call for Applied Industrial Technologies. My name is Tommy, and I'll be your operator for today's call. At this time, all participants are now in a listen-only mode. Later, we’ll conduct a question-and-answer session. Please note that this conference is being recorded. I will now turn the call over to Julie Kho. Julie, you may begin.

[Julie Kho:]

Thank you, Tommy, and good morning, everyone. Our earnings release was issued this morning before the market opened. If you haven't received it, you could retrieve it from our website at applied.com. A replay of today's broadcast will be available for the next two 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 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 statement, 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 Mark Eisele, our Chief Financial Officer. I will now turn the call over to Neil.

[Neil Schrimsher:]

Thank you, Julie, and good morning, everyone. We appreciate you joining us today. I will start by providing a recap from our news release this morning. Our sales for the third quarter of fiscal year 2017 were $679.3 million, an increase of 7.3% compared with $633.2 million in the same period a year-ago. Net income for the quarter was $29.5 million or $0.75 per share compared with a net loss of $44.7 million or $1.14 per share in the third quarter of fiscal 2016. As you may recall, our third quarter of fiscal 2016 was largely influenced by a non-cash goodwill impairment charge and a 7 million restructuring expense. Our current year third quarter results reflect a solid quarter with continued sales per day improvements across our core operations, and ongoing operational excellence activities throughout the business. Entering the fourth quarter of our fiscal year, we are increasing our sales and earnings per share guidance. We expect fourth-quarter sales to increase 6% to 8% over the prior year quarter and earnings per share for our final quarter to be in the range of $0.68 to $0.78 per share. These results and full year EPS expectations of $2.74 to $2.84 per share, higher than our previous guidance range of $2.50 to $2.60 per share. We are pleased with our recent acquisition of Sentinel Fluid Controls, a distributor of hydraulic and lubrication components, systems and solutions. The addition of Sentinel complements and enhances the applied fluid power and network of companies, which lead the industry in innovative fluid power technology and engineered system solutions. Acquisitions remain an integral part of our overall growth strategy, and we continue to develop an active pipeline of opportunities that align with our strategies, extending our business reach, enhancing our capabilities and expanding with new and current customers to benefit all Applied stakeholders. At this time, I'll turn the call over to Mark for more detail on our financial results.

[Mark Eisele:]

Thank, Neil. Good morning, everyone. I'll provide some additional insight regarding our third quarter fiscal 2017 financial performance. Our sales per day rate during the quarter was $10.61 million, 6.5% ahead of the prior year quarter and 6.5% greater than our rate in the December quarter. We had 64 selling days in the March 2017 quarter compared to 63.5 days in the March 2016 quarter. This resulted in a 0.6% tailwind when comparing sales in the current quarter versus the prior year quarter. Acquisitions had a positive impact on sales of 0.4% during the quarter, and foreign currency impacts increased sales by 0.1%. Excluding the effects of these items, our organic operations experienced a 6% sales increase in sales per day compared to the prior year. In addition, we believe the impact of vendor price increases was minimal during the quarter. Our product mix during the quarter was 29.5% fluid power products and 70.5% industrial products. Third quarter sales in our service center-based distribution segment increased $30.8 million or 5.9%. Acquisitions added $1.3 million or 0.3% and foreign currency fluctuations increased sales 0.1%. Excluding acquisitions and currency translation, organic operations in the service center-based distribution segment experienced a 5.5% increase in sales, which is a 4.7% increase in sales per day. Turning to our operations that sell to upstream oil and gas customers, after eight quarters of year-over-year sales declines, we experienced a 51% increase in sales in the March quarter compared to the prior year quarter. From a run rate perspective, we saw an 18.8% increase in sales compared to our December 2016 quarter. We have now seen three consecutive quarters where our sales per day rates have increased. For the fourth quarter, we expect stable sales per day run rate to upstream oil and gas customers compared to the March 2017 quarter. Our fluid power businesses segment experienced a sales increase of $15.3 million in the third quarter or 14% year-over-year. Acquisitions added 1.1% and foreign currency translation decreased sales by a little less than 0.1%. Excluding the impact of acquisitions and currency translation, the fluid power businesses segment operations saw a sales increase of 13%, which includes a 0.8% increase due to the one half additional sales day included in the quarter. Our fluid power businesses in the US and Mexico both experienced double-digit percentage sales increases in the quarter. From a geographic perspective, sales in the quarter for our U.S. operations were up 7.1% compared to the prior year quarter, including a positive impact from acquisitions of 0.2%. Our overall Canadian operations experienced a sales increase of $5 million or 8.2% with the positive impact from acquisitions of $1.3 million or 2.2% and a positive foreign currency translation impact during the quarter of 4.0%. Canadian organic operations experienced a 2% increase in sales, of which 1.6% relates to one additional selling day in Canada during the quarter. Consolidated sales from our other country operations, which include Mexico, Australia and New Zealand increased $2.8 million or 8.3% year-over-year. This consisted of a sales increase in local currency of 14.1%, which benefited 3.3% from two additional selling days during the quarter in these countries, and a negative foreign currency translation impact of 5.8% in the quarter. The local currency sales increase in the quarter relates to both our Mexican and Australian operations. Our gross profit percentage for the quarter was 28.1%. while this is 50 basis points higher than our prior year amount, it is 10 basis points below the prior year quarter once you remove the impact of the associated restructuring charges from fiscal 2016 results. Our selling, distribution and administrative expenses on an absolute basis increased $2.3 million or 1.6% when compared to the same quarter in the prior year. Additional SD&A from businesses acquired added $0.8 million or 0.6% of SD&A, and changes in foreign currency rates had the effect of increasing SD&A in the quarter by $0.4 million. We expect fourth quarter SD&A to be relatively similar on a sequential basis. The effective income tax rate was 32.0% for the quarter. This is lower by 2.9% due to $1.3 million of tax benefits from discrete items from excess tax benefits resulting from exercises of stock options during the quarter. Year-to-date, our effective tax rate is 32.9%. We expect our effective tax rate for fourth quarter operations to be in the range of 34.0% to 35.0%. Our consolidated balance sheet remained strong with shareholders' equity of $705.9 million and a conservative debt to total capitalization ratio of 31%. Our after-tax return on assets for the quarter was 9.0%, which brings our year-to-date rate up to 8.3%. Inventory at March 2017 decreased from December by $4.3 million. This decrease reflects operational inventory reductions of $11.8 million, offset by $7.5 million of inventory increases due to foreign currency translation and acquisitions. As we look towards our June fiscal year-end, we expect additional operational inventory decreases in the $5 million to $10 million range. Cash generated from operating activities was $32.8 million for the quarter and $78.5 million year-to-date. This compares to $57.5 million for the quarter and $91.3 million year-to-date in 2016. year-over-year change in cash provided from operations relates entirely to the rise in accounts receivable resulting from our 7.3% sales increase in the quarter. We continue to expect cash provided from operating activities for all of fiscal 2017 to be in a similar range compared to what we accomplished in fiscal 2016. Now, I'll turn the call back to Neil for some final comments.

[Neil Schrimsher:]

Thanks Mark. In summary, we are pleased with the return to growth and the ongoing progress in executing our strategy. 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 2018. With that, we’ll open up the lines now for your questions.

[Operator:]

Thank you. [Operator Instructions] And we will proceed with our first question on the line Adam Uhlman with Cleveland Research. Please go right ahead.

[Adam Uhlman:]

Hi all. Good morning.

[Neil Schrimsher:]

Good morning.

[Mark Eisele:]

Good morning Adam.

[Adam Uhlman:]

I was wondering if we could start with the sales trends that we saw in the quarter, it seems like you saw a pretty meaningful acceleration in demand by month, I was wondering if you could maybe flush that out for us, and then, related to that maybe the trend that you are seeing here so far in April?

[Neil Schrimsher:]

Okay, sure. So Adam, I would say the sales per day trends really improved throughout the prior quarter of January to February, February onto March. April is running positive year-over-year, really in the projected sales range. It is down from the month of March with a couple of days to go, but I would say somewhat as expected considering holiday timing, spring break season so forth.

[Adam Uhlman:]

Okay, got you. And then, has there been any change in project activity that you have seen larger order sizes, anything along those lines that maybe surprised you or different from the prior trend?

[Neil Schrimsher:]

No real big project breaks as we go through, as we think about the margin, we saw some good performance with some larger customers. We did see some project. So we think that has got a customer mix in our margin line. We think about our margins going forward into fourth quarter we think it is a return to really first half performance, not what was in Q3. So we are in those reviews and discussions with the team. Fluid power performed well in the quarter, but really we expect that to continue. If I look at their April order trends, their backlog and their activity, we expect that going forward.

[Adam Uhlman:]

Okay, thank you.

[Operator:]

Thank you very much. And we will get to our next question on the line from David Stratton from Great Lakes Review. Please go right ahead.

[David Stratton:]

Good morning. Thank you for taking the questions. when we look at the energy end markets, can you kind of breakout where you are seeing – where that 51% came from, whether it is broad-based or are there specific end markets where you are seeing a turnaround?

[Neil Schrimsher:]

I would say in this case, broad-based across our groups. If you think about upstream and upstream in drilling, we saw year-over-year performance in participating sequentially. Also upstream in our businesses and our presence on the production side did well. So really in every one of those US plays, a little bit better, but the greatest activity in West Texas in particular that Permian basin. In Canada, we have got less rig activity going on right now. I think it is below 100 operational rigs. So if you think about it from February until now, down a meaningful number, but it is the seasonal aspect of operating in Canada. So with the spring fall going on there is just less operational rigs. That will continue through the spring thaw, really through the end of May. Roads will solidify and activity will pick back up there as well, but we are pleased that it is on really all aspects of upstream for us in many of the markets that we have a good position in.

[David Stratton:]

And then looking out, are these changes, as far as you can tell here to stay, or is this a one-time thing?

[Neil Schrimsher:]

I may have to ask you on those forecasts, but so we know where price of oil is at, inventory level was down a little bit. So I think this level of activity can stay for a period of time and we will know how to operate. Obviously if it gets better, we will do better, and if it gets challenging we know how to operate at that level as well. So, I think our look forward is in the near-term it is more at this level, and we will see how the broader economy develops.

[David Stratton:]

Great, thank you. And then can you just really quick touch on the 30 industries you check?

[Neil Schrimsher:]

Sure. So in the past quarter we would have had 18 of those industries showing increases. So, oil and gas, and petroleum refining would have been a couple of those. Machinery OEMs, industries connected around construction, cement, aggregate, building materials, food would have been in that group and obviously a few others. So, I think in total count, more were up this time period. So encouraging as well.

[David Stratton:]

All right. Well, thank you very much.

[Neil Schrimsher:]

Okay.

[Operator:]

Thank you. And we will proceed to our next question on the line from Steve Barger with KeyBanc Capital Markets. Please go right ahead.

[Neil Schrimsher:]

Hi Steve.

[Operator:]

[Operator Instructions]

[Ryan Cieslak:]

Hi, good morning guys. This is Ryan on the phone for Steve. How is everything going?

[Neil Schrimsher:]

Good Ryan.

[Ryan Cieslak:]

Good, good. Thinking into 2018, if we start to see this mid-single-digit growth, how should we think about incremental contribution margins going forward?

[Neil Schrimsher:]

Well, I will start a little bit on kind of where were in our planning process right now. So, for us to be determined what it is going to look like on the volume side, but we will be working through that. We have said that we expect that we can continue to lever very well when we demonstrate growth into the business. So, for us, it is early for us to be calling fiscal ’18 as we go through this planning cycle.

[Mark Eisele:]

But I think like Neil said, Ryan, the highlight here is, we do believe that positive organic sales increases lever very well to our bottom line, and I believe that is exactly what we showed on our third quarter results today. And so we continue to have positive results, on a sales top line going forward, and we should continue to see nice leveraging.

[Ryan Cieslak:]

Got you. And then, where there any product lines that kind of stuck out to you guys during the quarter where you saw some good growth come from?

[Neil Schrimsher:]

I think really good broad-based performance in our core products. We are focused on making progress in our expansionary products, leveraging kind of all of our channels to market, our service center based, our applied.com, working well with the service centers with our vendor managed inventory specialist to grow Class C consumables, and then obviously fluid power did well. I think there our focus especially with the service centers around the energy-saving products of fluid power. So where we can help customers lower their operating cost and really have a nice sustainability impact for them as well. And then I think in the fluid power companies business, it is just combining technology, electronics, software to traditional hydraulics to help those mobile and industrial OEM customers.

[Ryan Cieslak:]

Okay, good. And then just thinking about your service vendor segment, I mean how do you guys view Amazon business as a competitor, and how do you feel about them longer-term in this space?

[Neil Schrimsher:]

Them as in those products, or?

[Ryan Cieslak:]

Yes, within the products you are selling with service center distribution segment.

[Neil Schrimsher:]

Maybe if you are just asking specifically around those fluid power companies. We love the space. We are doing very well, and order trends are good, backlog is productive. So we are working very closely with those mobile and industrial OEMs to really grow our content help improve their products and solutions. And then on the industrial side, we have got a lot of service and repair capability that we can connect to those industrial customers to help solve their needs, just like we do on the bearing and power transmission side.

[Ryan Cieslak:]

All right. Thank you guys.

[Operator:]

Thank you. [Operator Instructions] And we will get to our next question on the line from Chris Dankert with Longbow. Please go right ahead.

[Chris Dankert:]

Good morning guys. Thanks for taking my question. I guess last quarter you were calling out the expectation is about a 4% increase in SD&A, back half versus first half, it looks like with the improved end demand, you guys have accelerated that a bit. Now of course, it is a 6% to 7% increase versus the first half, I guess, how do we think about SD&A in the first half of the year, and then have you seen any labor tightness trying to bring more salesmen onboard?

[Neil Schrimsher:]

Let me start with that from the overall SD&A perspective, and then we can dive into actual sales rep activity. When we moved into the second half of the year, we did have merit increases for associates at the beginning of January with our improved performance. We do have compensation incentives that are doing better, which is a good thing from that perspective. They are tied with our improved performance and so that is impacting SD&A, because we do have a nice blend of base compensation versus incentive compensation that flexes up and down with performance. So those are the primary trends and so your initial thought that gee, sales increased drove a little bit higher SD&A increase is true, and that really primarily related to the incentives perspective. We are still running on an overall total headcount, about 125 fewer people if you exclude the acquisitions than we had a year ago at this point in time. And so that continues to help us when we manage our SG&A headcount.

[Mark Eisele:]

And so, as we think about it going forward and as we are in our planning cycle, we will remain disciplined on our SD&A. we like always will be looking for the opportunities for the right ads and the investments. Our preference on those will be forward facing customer facing resources, and we will be looking at just right productivity initiatives that help us operate productively, effectively in that we can handle higher rates of volume, higher level of transactions with similar insight and support staffing levels.

[Chris Dankert:]

Got you, thanks guys. Just maybe comment to reduce inventory, I guess given the better demand trend, is that a matter of really levering the SAP investment in some of the efficiency initiates, because I guess I would have expected maybe, not to say restocking, but an up tick in working capital given the improving demand?

[Neil Schrimsher:]

I would start and I would say we continue to look to connect and work with our suppliers, who in many instances have their own continuous improvement initiatives, work their cycle times to how we can take excess or days or speed up in that cycle to improve inventory levels and so, it gives us the opportunity in some cases to stock less or be more productive on high volume, high turning items, and we can use some of those dollars in lower moving items that can be key to our customer when they really need them. So, part of this is our focus and our effort and our coordination with suppliers, and then I think a little is a natural move down from December calendar year-end activities. And we knew we had the opportunity if we would have second half improvements and that is what we are seeing coming even with some higher increased sales levels.

[Mark Eisele:]

and I will just add onto that as well. When we think about our inventory turnover, our inventory turnover rates using a FIFO perspective, we see opportunities for improvement. The reason we see those opportunities is exactly what Neil was talking about about how we are managing the supply chain internally as well as with our suppliers to enhance those. When we see the opportunity to improve turnover through the sales increase percentages that we are experiencing, we look back and see what inventory turnovers we had several years ago. And we had inventory turnover levels of around 4.5 turns on a FIFO basis, and we are right now a little under 4. So some of this is recapturing some of those turns that we had in the past.

[Chris Dankert:]

Got you. That is very helpful. Thanks guys.

[Operator:]

Thank you very much. I will proceed to our next question on the line from Garo Norian with Palisade Capital Management. Please go right ahead.

[Garo Norian:]

Hi guys. Just following up on the inventory question. Are you guys working I guess closer with the buyers, maybe giving them better visibility into the sell through, is that part of the improvement?

[Neil Schrimsher:]

I would say it is a lot of how we can work on delivery times in that we receive and take it through our facilities, our distribution centers more productively, and then on in turn to our service centers. So, it is much less on in customer transaction and those type visibilities, of just looking at where the handoffs occur, and that we are doing them faster.

[Garo Norian:]

Got it. And are the prices from suppliers starting to reflect kind of some of those raw material increases that have been moving through the system, or where does pricing kind of stand?

[Neil Schrimsher:]

I would say from an year to date standpoint, we haven't seen so much. We are seeing increases from suppliers. So I think as we work through calendar 2017, we will see a few more supplier increases, and likely have some moderate inflation as we go forward. As we look back at the results and the impact prices it has not been so large, but we think going forward in that time period; it will start to show up more.

[Garo Norian:]

Got it, and then, I know we are early on on seeing improvements in the business from the end markets from our top line perspective, but are there any needs or potential needs for locations, any kinds of reversals of some of the consolidating activity that you had to do over the last couple of years?

[Neil Schrimsher:]

No, as we think about our locations, one we have kind of over 470 service centers, and 65 plus fluid power service and repair. I mean, we like our number, but we will continue to evaluate. We think it is important to be close to customers, having our account managers that can go into the facilities, help them lower, owning and operating cost, especially in brake-fix MRO, we think it is important to be close to customers. So really our prior moves were really how would we combine some locations, strengthen them, maybe combine the number of resources that we would have in the facility. So, even as we work through those we did not pull back from markets. As I think about our business activity now and planning going forward, we will likely have some combinations that we will be making in facilities and markets, which will help our productivity, and we will be evaluating markets that we should be increasing our presence in.

[Garo Norian:]

Great, thank you.

[Operator:]

Thank you very much. And at this time, I'm showing we have no further questions. I'll now turn the call over to Mr. Schrimsher for any closing remarks.

[Neil Schrimsher:]

I just want to take the opportunity to thank everyone for joining us today, and we look forward to seeing many of you throughout the current quarter. thank you very much.

[Operator:]

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