Yahoo Finance Applied Industrial Technologies, Inc. (NYSE:AIT) Q3 2024 Earnings Call Transcript
Applied Industrial Technologies, Inc. (NYSE:AIT) Q3 2024 Earnings Call Transcript April 25, 2024
Applied Industrial Technologies, Inc. beats earnings expectations. Reported EPS is $2.48, expectations were $2.4. Applied Industrial Technologies, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).
Operator: Welcome to the Fiscal 2024 Third Quarter Earnings Call for Applied Industrial Technologies. My name is Rochelle and I'll be your operator for today's call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] Please note that this conference is being recorded. I will now turn the call over to Ryan Cieslak, Director of Investor Relations and Treasury. Ryan, you may begin.
Ryan Cieslak: Okay. Thanks Rochelle, and good morning to everyone on the call. This morning we issued our earnings release and supplemental investor deck detailing our second quarter results. Both of these documents are available in the Investor Relations section of applied.com. Before we begin, just a reminder, we'll discuss our business outlook and make forward-looking statements. All forward-looking statements are based on current expectations subject to the certain risks and uncertainties, including those detailed in our SEC filings. 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.
In addition, the conference call will use non-GAAP financial measures, which are subject to the qualifications referenced in those documents. Our speakers today include Neil Schrimsher, Applied's President and Chief Executive Officer; and Dave Wells, our Chief Financial Officer. With that, I'll turn it over to Neil.
Neil Schrimsher: Thanks, Ryan, and good morning, everyone. We appreciate you joining us. As usual, I'll begin with some perspective and highlights on the key drivers of our results, including an update on industry conditions as well as expectations going forward. Dave will follow with more detail on the quarter's financials and provide additional color on our outlook and guidance, and then I'll close with some final thoughts. Overall, our third quarter results reflect our strong industry position and ongoing progress with our internal growth initiatives against a mixed and evolving end market backdrop. There are a couple of puts and takes I want to walk through. First, sales exceeded our expectations during the quarter and returned to modest year-over-year organic growth.
The year-over-year trend improved each month through the quarter. While partially reflecting easy comparisons, reported sales also benefited from solid performance across our core service center segment where steady break fix activity, sales process initiatives and secular growth tailwinds continue to drive positive momentum. This was partially offset by ongoing modest sales declines within our Engineered Solutions segment. Set by ongoing modest sales declines within our Engineered Solutions segment. While the decline was slightly greater than expected, we're seeing several encouraging developments, including stabilizing technology vertical headwinds, strengthening process flow orders. In addition, our automation platform is also developing significant growth opportunities that we expect to start billing in the quarters ahead.
All of this indicates that fiscal third 2024 will represent the trough in the segment's year-over-year sales performance. Combined with improving short cycle macro demand indicators in recent months and potential incremental tailwinds tied to infrastructure spending, reshoring and our cross-selling efforts, we are positioning the business to accelerate organic growth in coming quarters and progress towards our long-term growth objectives. This growth positioning and the modest sales growth backdrop near term resulted in some expense deleveraging during the quarter. Our Applied team continues to execute and control cost effectively as reflected in operating expense up less than 2% year to date. This is inclusive of slightly higher support cost and our annual merit increase that went into effect January 1 and despite some prior year expense favorability.
In addition, we remain on track to achieve record cash generation this year, which will provide additional capacity for capital deployment opportunities. Our priorities remain unchanged with a primary focus on optimizing growth and operating capabilities through both organic investments and inorganic acquisitions. Secondarily, we look to return cash to our shareholders through opportunistic share buybacks, while continuing to support consistent annual increases in our ordinary dividend and managing our balance sheet commitments. Over the past 5 years, we've deployed over $900 million in capital towards these areas. As it relates to acquisitions, we have significant potential based on an active pipeline and our industry position. We remain focused on our return framework and opportunities that stand to enhance our organic growth, margin profile and competitive position long term.
Considering the fragmented markets we compete in as well as increasing technical and operating requirements across our industry, we believe M&A activity could increase over the next several years. On that note, as indicated in our press release this morning, I'm pleased to announce a definitive agreement to acquire Grupo Kopar, a provider of emerging automation technologies and engineered solutions primarily across Mexico. This acquisition will extend our automation footprint with the addition of 16 locations across Mexico as well as Costa Rica and Texas. Kopar has strong alignment with our strategy, focused on high value robotics, machine vision and IoT applications, and they will provide a diverse portfolio of established customers across food and beverage, automotive, light manufacturing, electronics and pharmaceutical end markets.
The acquisition will add approximately 200 new associates and is expected to generate annual sales over $60 million in the first year with accretive contributions to both gross margins and EBITDA margins. We expect the acquisition to close in the coming weeks, and we look forward to welcoming Kopar to Applied and leveraging their capabilities going forward. As it relates to the underlying demand environment, overall dynamics remain mixed but generally stable. Demand within our core technical MRO operations has been resilient, including solid demand across our U.S. service center and flow control operations, where sales increased organically by a mid- to high single digit percent during the quarter, including strong activity during the month of March.
We believe steady capacity utilization and heightened technical MRO requirements on critical production infrastructure remain key tailwinds. This has been further supported by an increased focus on energy efficiency and service coverage. That said, end market dynamics within these MRO areas of our business are bifurcated to some degree. In addition, demand remains more muted across the OEM channel including reduced shipment activity for off highway mobile fluid power components and systems within our Engineered Solutions segment. We believe this partially reflects ongoing recalibration across various mobile end markets as supply chains stabilize and higher interest rates balance more capital-intensive machinery production. As such, we saw slightly more mix trends out of our top 30 end markets during the quarter, where 15 generated positive growth year over year compared to 18 last quarter.
Growth was most favorable across food and beverage, primary metals, utilities, mining, lumber and wood verticals during the quarter, offset by declines such as machinery, energy, pulp and paper and fabricated metals. As it relates to the solid performance within our Service Center segment, we continue to see strong growth across larger national accounts and fluid power aftermarket sales. We also began to see some improving growth out of our local customer accounts during the quarter, partially reflecting demand for our conveyance and shop services. In general, technical break fix activity remains resilient across many of our key service center markets. We believe our service center customers remain focused on sustaining appropriate MRO activity on core equipment as they position and refresh production capacity for growth in years to come, especially when considering aged industrial production assets across the U.S. and an increase in focus on energy efficiencies.
Our technical domain expertise and access to core industrial equipment puts us in a leading position to help customers manage through these operational requirements, particularly as they struggle with finding skilled labor. In addition, our sales initiatives continue to drive new growth We're leveraging technology investments to streamline processes and digitally enhance capabilities and business intelligence. Our service center teams are going to market today as key consultants to our customers' most important capital equipment, making our relationships and interactions increasingly strategic and less transactional. This is driving increased account penetration and account openings as well as expanding opportunities to cross sell our technical solutions, including new industrial technologies tied to robotics and IoT.
Overall, our service center team is executing at a high level and remains in a strong growth position moving forward. Within our Engineered Solutions segment, MRO activity and capital spending on process infrastructure remains positive across our flow control operations. Consistent with prior quarters, flow control is benefiting from new business tied to customers' de carbonization and energy transition efforts. This includes technical support for the configuration, assembly and testing of process systems used in carbon capture, utilization and storage as well as producing alternative fuel sources. Combined with internal business development and solid sales execution, we saw flow control booking activity gain momentum during the third with related orders up by a high teen percent both year over year and sequentially.
In addition, demand and order activity for stationary fluid power systems across industrial focused end markets remains relatively firm. We believe this partially reflects the many positive secular tailwinds across the U.S. manufacturing base, including investments focused on updating and expanding industrial production infrastructure and aging manufacturing equipment. This includes enhancing efficiency and lifecycle of hydraulic systems and power units, filtration systems and hydraulic presses and is reflected in positive fluid power sales growth within metals, mining and rubber industries during the quarter. That said, these trends were more than offset by reduced activity for off highway mobile OEM components and systems within fluid power and to a lesser degree ongoing organic sales declines within our automation operations as expected.
We believe the lower number of operating days and holiday timing in March had some impact on the completion and timing of engineered solutions in these more technical and assembly heavy areas of our business. Nonetheless, underlying demand and backlog conversion from mobile OEM fluid power customers was mixed in the quarter, partially reflecting more balanced production activity across various machinery end markets. Overall, while the sales backdrop within our engineered solutions segment remains bifurcated near term, we are constructive on the segment's potential into fiscal 2025. Of note, the year over year headwind tied to technology vertical has stabilized and could emerge as a positive growth catalyst in coming quarters as comparisons continue to ease and demand within this key end market recovers.
Early leading indicators have been directionally positive across the semiconductor space in recent months. In addition, we are favorably positioned to benefit from the ongoing secular growth across data center infrastructure including providing various fluid conveyance, flow control and robotic solutions for server cooling, material handling and technical maintenance. We also note that customer interest in our automation operations remains positive with our sales funnel and presales engineering activity remaining active. We have meaningful growth opportunities developing in automation given the scale, service and engineering capabilities we are developing around advanced technology such as smart vision and mobile robots as well as the market access our service center network provides.
Combined with the building order activity, cross flow control and easing comparisons, we look forward to seeing a rebound in segment growth in coming quarters. At this time, I'll turn the call over to Dave for additional detail on our financial results and outlook.
Dave Wells: Thanks, Neil. Just a reminder before I begin. As in prior quarters, we have posted a quarterly supplemental investor presentation to our investor site. This is for your additional reference as we recap our most recent quarter performance and updated guidance. Turning now to details on our financial performance in the quarter, consolidated sales increased 1.3% over the prior year quarter. Acquisitions contributed 120 basis points and foreign currency translation had a positive 20 basis point impact, while the difference in selling days had a negative 80 basis point impact. Netting these factors, sales increased 0.7% year-over-year on an organic daily basis and approximately 16% on a two-year stack basis. As it relates to pricing, we estimate the contribution of product pricing on year-over-year sales growth was in the low single digits for the quarter and relatively unchanged from last quarter.
Turning now to sales performance by segment. As highlighted on Slide 7 and 8 of the presentation, sales in our Service Centers segment increased 2.6% year over year on an organic daily basis when excluding a 1.5% positive impact from acquisitions and a 30-basis point positive impact from foreign currency translation. On a sequential basis, segment sales per day increased 4% from fiscal second quarter, only slightly below normal seasonal patterns and an improvement from relative trends in recent quarters. Growth in the quarter was strongest across our U.S. service center network led by solid contributions from strategic accounts as well as improving growth among local accounts. This was partially offset by more muted sales trends across our international operations.
Within our Engineered Solutions segment, sales decreased 3.6% over the prior year quarter. This includes a positive 40 basis points of growth from acquisitions. On an organic daily basis, accounting for one less selling day in this year's quarter, segment sales decreased 3.2% year-over-year. Stronger growth across process flow control markets was more than offset by lower fluid power sales against a difficult prior year comparison as well as ongoing sales declines within our automation operations. That said, both fluid power and automation sales were unchanged sequentially and as mentioned earlier were likely adversely impacted by more muted system shipments due to the calendar shift and holiday timing during March. In addition, contribution from the technology vertical remained subdued during the quarter, though the year over year headwind abated relative to recent quarters, reflecting easier comparisons and demand stabilization.
Moving to gross margin performance. As highlighted on page 9 of the deck, gross margin of 29.5% increased 8 basis points compared to the prior year level of 29.4%. During the quarter, we recognized LIFO expense of $4.8 million compared to $8.2 million in the prior year quarter. This net LIFO tailwind had a favorable 30 basis point year-over-year impact on gross margins. Third quarter LIFO expense was, however, up sequentially and slightly higher than our expectations. In addition, we estimate gross margins in the quarter include approximately 10 basis points of unfavorable mix compared to prior year levels. This primarily reflects lower engineered solutions segment sales as well as strong national account sales growth and a lesser mix of automation engineered solutions compared to the prior year.
Overall, we continue to manage broader inflationary dynamics well through our ongoing initiatives, including enhanced analytics, freight expense management and channel execution. As it relates to our operating costs, selling, distribution and administrative expenses increased 5. 3% compared to prior year levels. SG&A expense was 18.9% of sales during the quarter, up from 18.2% during the prior year quarter. On an organic constant currency basis, SG&A expense was up approximately 3% over the prior year period. We saw slightly greater than expected expense deleveraging in the quarter given muted sales growth combined with higher employee costs, professional fees and investments tied to a growth and supporting our constructive outlook. In addition, year over year SG&A expense comparisons were impacted by some cost favorability in the prior year period relating to strong AR collection performance and related provisioning reversals.
We continue to manage costs well as we balance expense controls against our growth initiatives and outlook, as well as face ongoing inflationary pressures. Overall, slightly greater than expected engineered solutions sales declines combined with unfavorable expense absorption, mix and difficult prior year comparisons resulted in reported EBITDA declining 3.3% year-over-year during the quarter, while EBITDA margin of 11.8% decreased 56 basis points year-over-year. We view the year-over-year declines in EBITDA and EBITDA margin as a transitory near-term dynamic and largely isolated to the third quarter, particularly when considering prior year comparisons. On a year-to-date basis, we note EBITDA has increased 4% compared to a 2% sales increase, while EBITDA margins are up approximately 20 basis points year to date.
We also continue to reflect benefit from lower net interest expense, which was down nearly $5 million from the prior year and primarily reflects reduced debt levels and greater interest income from higher cash balances and investment yields. Combined with a lower tax rate relative to prior year levels, reported earnings per share of $2.48 was up 4% from the prior year adjusted EPS levels. Moving to our cash flow performance. Cash generated from operating activities during the third quarter was $84,200,000 while free cash flow totaled $76.7 million or 79% of net income and was up 14% from the prior year level. Year to date, we have generated nearly $235 million of free cash, which is up 64% from the prior year, reflecting sustained earnings growth, our enhanced margin profile and ongoing progress on working capital initiatives.
From a balance sheet perspective, we ended March with approximately $457 million of cash on hand and net leverage at 0.3x EBITDA, which is below the prior year level of 0.9x and unchanged from last quarter. Our balance sheet is in a solid position to support our capital deployment initiatives moving forward, as well as enhance returns for all stakeholders. During the Q3, we repurchased approximately 100,000 shares for $18 million. This brings our year-to-date total on share repurchases to $29 million. Turning now to our outlook. As indicated in today's press release and detailed on page 12 of our presentation, we are updating full year fiscal 2024 guidance to reflect third quarter performance and our fourth quarter expectations. Specifically, we now project adjusted EPS in the range of $9.55 dollars to $9.70 based on sales growth of 1.5% to 2.5% including a 0.5% to 1.5% organic growth assumption as well as EBITDA margins of 12% to 12.1%.
Previously, our guidance assumed EPS of $9.35 to $9.70 sales growth of 1% to 3% and EBITDA margins of 12.1% to 12.3%. The updated adjusted EPS guidance range excludes the $3 million net tax benefit realized in fiscal 2024 second quarter related to the tax valuation allowance adjustment. Our updated guidance implies a fiscal fourth quarter EPS range of $2.44 to $2.59 and an organic sales per day range of down 1% to up 2% year over year and EBITDA margins of 12% to 12.4%. Our fourth quarter sales guidance takes into consideration organic sales month to date in April, which are down by a low single digit percent year over year combined with ongoing economic uncertainty. In addition, we expect year over year sales declines to persist in our engineered solutions segment during the fourth quarter reflecting softer fluid power OEM demand and uncertainty around the timing and magnitude of recovery across the technology vertical.
Overall, while we remain constructive on our setup moving forward, considering easier prior year comparisons, favorable trends within our shorter cycle service center operations and sustained benefits from our internal initiatives, we believe it remains prudent to take a balanced approach to our near-term outlook pending more definitive and broader signs of a positive inflection in macro and industry conditions. Lastly, from a margin perspective, we expect fourth quarter gross margins to be flat to up slightly sequentially, inclusive of ongoing mix headwinds near term. We also expect ongoing expense deleveraging near term based on our fourth quarter sales outlook and growth positioning go to a lesser degree than in the third quarter and balanced by cost controls and reduced professional fees.
Combined with lower LIFO expense compared to the prior year and easier comparisons, we expect year over year EBITDA trends to show improvement from third quarter performance. With that, I'll now turn the call back over to Neil for some final comments.
Neil Schrimsher: Thanks, Dave. As we prepare to close out fiscal 2024, I'm proud of the ongoing progress we're making to strengthen our industry position, customer experience and growth potential. This is evident in our year-to-date performance where we have sustained year-over-year organic sales growth against difficult high teen growth comparison during a period of sub-fifty PMI readings, declines in industrial production and notable technology vertical headwinds. We've also expanded margins and sustained earnings growth year to date while strengthening our cash generation to record levels. These results clearly show the traction of our strategy and internal initiatives are having, including diversifying our end market mix, gaining exposure to sustainable noncyclical growth tailwinds and enhancing our operational capabilities.
As we look ahead to fiscal 2025, I remain constructive on the outlook for our company and the potential for sustained above market sales and earnings growth. While we are cognizant of various crosscurrents that remain, we are encouraged by recent improvements in various industrial macro indicators that correlate with our business. This includes the ISM PMI above 50 during March, including the production sub index at its highest level in nearly two years. In addition, durable goods orders are showing improvement and federal stimulus for infrastructure build out is starting to flow at a greater rate. We're also uniquely positioned to benefit from many secular and structural tailwinds continuing to play out across North American manufacturing and industrial sectors.
Our technical domain expertise within industrial facilities across North America, including local MRO and engineering support on critical capital equipment is increasingly vital as customers manage through an aging skilled labor force along with continuing requirements tied to reshoring and U.S. infrastructure investments, both of which are expected to gain momentum moving forward. We see additional support levels from energy security and supply chain hardening. In addition, our strategic positioning and capabilities in areas of pneumatic automation, fluid conveyance and robotics have expanded our addressable market and organic growth profile across the technology sector, which we believe could reemerge as a meaningful earnings tailwind giving ongoing and critical build out of semiconductor manufacturing and data center infrastructure.
Combined with our balance sheet capacity, we expect to make ongoing progress in fiscal 2025 to move towards our intermediate objectives of $5.5 billion in sales and 13% EBITDA margins, while also developing the next step in Applied's evolution and long-term potential. I want to recognize our entire Applied team. They're the foundation of our performance and evolution. Their perseverance and customer focus and operational focus provide a strong position to accelerate our potential moving forward. As always, we thank you for your continued support. And with that, we'll open up the lines for your questions.
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