Q3 2021 Applied Industrial Technologies Inc Earnings Call
Welcome to the fiscal 2021 third quarter earnings call for applied Industrial technologies. My name is Cheryl 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.
Wish to ask a question at that time, Please press star one on your telephone keypad.
Fear to asking the question Mitch your handset to ensure the best audio quality. Please.
Please note that this conference is being recorded I will now turn the call over to Ryan <unk> director of Investor Relations and Treasury, why and you may begin.
Okay. Thanks, Cheryl and good morning to everyone on the call hope you're all doing well. This morning, we issued our earnings release and supplemental investor deck detailing our third quarter results.
Both of these documents are available and the Investor Relations section of applied dotcom.
Before we begin just a reminder, I will discuss our business outlook and make forward looking statements. All forward looking statements are based on current expectations subject to certain risks, including the potential impact from the COVID-19, pandemic as well as trends and sectors and geographies and the success of our business strategy and other risk factors.
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.
In addition, the conference call will use non-GAAP financial measures, which are subject to the qualifications referenced and those documents.
Our speakers today include Neil Schrimsher applied as President and Chief Executive Officer, as well as Dave Welch, Our Chief Financial Officer with that I'll turn it over to Neil.
Thanks, Ryan and good morning, everyone. We appreciate you joining us and hope you're doing well I'll start today with some perspective on our third quarter results current industry conditions, and our position going forward, Dave will follow with a summary of our most recent quarter performance as well as some.
It takes on our forward outlook, and then I'll close with some final thoughts.
Overall, we had a strong third quarter that highlight solid execution on.
And a number of positive trends developing across the business I want to recognize the entire applied team. They are the foundation of the strong results you see materializing across our company today.
Perseverance and operational focus over the past year reflects our one applied culture.
And puts us in a great spot entering a period of significant potential for the company.
As it relates to the quarter's performance I want to emphasize four key points that stand out.
First we saw a sustained recovery and demand that accelerated into March.
Lee our technical and solutions focused value proposition is driving incremental growth opportunities.
And third we are managing supply chain and channel dynamics very well.
And our final key point, we are benefiting from a leaner cost structure.
With regard to the broader demand recovery on.
Underlying trends improved across the business as the quarter progressed, driving daily sales above normal seasonal patterns and our expectations combined.
Combined with the initial lapping a prior year pandemic related weakness sales returned to modest year over year growth following double digit declines over the past three quarters.
Trends were strongest in March and have sustained positive momentum into the early part of our fiscal fourth quarter with organic sales through the first 19 days of April up approximately 10% over the prior year.
Consistent with the last quarter were seeing greater break fix and recurring maintenance activity across our service center customer base as production continues to ramp and capacity comes back online.
The rebound and activity is currently greatest among larger strategic accounts. So we're seeing encouraging signs across local accounts as well.
Demand across our fluid power and flow control segment is also building with orders and backlog up sequentially and year over year during the quarter.
When looking across our customer end markets areas, such as food and beverage aggregates technology.
Number and wood chemicals.
Chemicals, and pulp and paper remain the strongest.
And we are seeing improved order momentum across heavy industries, including metals mining and machinery, where sequential sales trends improved from last quarter.
Given the break fix intensity and related service requirements of these heavier industries. The improvement is a favorable development.
We're also seeing greater growth opportunities tied to various secular trends and our technical position.
And our service Center segment, we believe our local presence and scale and service capabilities are increasingly valuable post the pandemic as customers address their increasing production and labor requirements, while adhering to new facility protocols and mitigating supply chain risk.
And our fluid power and flow control segment, we continued to see strong demand tailwind tied to five G infrastructure cloud computing and other growing technologies, including providing solutions across the semiconductor manufacturing channel.
Customers are proactively investing in solutions that optimize the productivity safety and efficiency of their production infrastructure and equipment.
This is driving demand for our leading fluid power service and engineered solutions capabilities as well as encouraging organic growth and backlog across our expanding automation business focused on machine vision robotics and digital solutions, our automation team is making.
Solid early progress connecting their premier engineering and application expertise across our growing footprint and legacy customer base.
Overall, the current demand backdrop and forward indicators, Inc.
<unk> commentary from our sales teams is encouraging and leaves us optimistic on the near term outlook.
That said inherent risk and uncertainties still exist as the recovery remains early.
Following and an unprecedented downturn.
We're keeping a close eye on emerging supply chain constraints across the industrial sector.
While consistent with typical early cycle dynamics lead times are extending across certain product categories.
A greater number of suppliers are highlighting component delays as broader production capacity and logistics and catch up to the demand recovery.
The direct impact to our operations and performance has been modest to date.
However, we expect a tighter industrial supply chain to persist as industry capacity and labor are just following the pandemic.
We believe our strong industry position and local presence sourcing capabilities and strategic supplier relationships put us in a solid spot to manage these dynamics well and meet our customers critical supply chain needs.
In addition to encouraging top line performance, the improving demand environment combined with our strong channel execution drove gross margin expansion during the third quarter.
And we're seeing greater number of suppliers announced price increases in recent months to date supplier price increases align with our broader early cycle expectations, though the backdrop remains fluid as suppliers deal with higher raw material and supply chain cost.
We have and established track record of effectively managing supplier inflation through the cycle.
This reflects our industry position.
Exposure to break fix activity.
And engineered solutions and systems mix as well as ongoing self help gross margin opportunities.
We remained highly focused on and our requirements as well as leveraging our channel position as we look to optimize with our suppliers and serve customers growth and supply chain initiatives.
Our third quarter results also reflect the emerging benefits from a leaner cost structure following business rationalization and recent years.
And operational efficiencies gained from processes systems and talent across the organization.
Combined with our cost discipline, and we grew adjusted EBITDA firmly above the rate of sales growth and expanded margins in the quarter, while growth requirements will influence our operating cost trajectory going forward and third quarter results are encouraging and.
<unk> insight into our operational leverage and EBITDA margin expansion potential as the demand recovery continues to unfold.
And then lastly, our balance sheet is and a very solid position.
Following record cash generation year to date.
We believe our margin expansion potential and ongoing working capital on initiatives will allow us to drive stronger cash conversion through the cycle relative to history.
Enhancing our ability to accelerate growth and enhance stakeholder returns and our M&A pipeline remains active and our primary focus for capital deployment as we look to further expand our automation and fluid power and flow control offerings.
At this time I'll turn the call over to day for additional detail on our financial results and outlook.
Thanks, Neil before I begin and reminder, regarding the availability of the supplemental investor deck, which is posted to our investor site each quarter for your additional reference as we discuss our most recent quarter performance.
Now turning to our results for the quarter consolidated sales increased one 2% over the prior year quarter.
Acquisitions contributed 1.8 points of growth and.
Foreign currency increased quarter sales by <unk>, 6%.
This was partially offset by one less selling day over the prior year period, which negatively impacted sales by one 6%.
Net of these factors sales increased 24% on an organic daily basis.
Average daily sales rates increased over 8% sequentially on an organic basis versus the prior quarter, which was higher than normal seasonal trends.
Excluding some weather related disruption during February underlying sales activity strengthened sequentially as the quarter progressed, including accelerating trends during March.
Sales performance was relatively consistent across both segments as highlighted on slides six and seven.
Sales and our service center segment increased 4% year over year on an organic daily basis, when excluding the impact from foreign currency and one less selling day and a quarter.
And this represents a notable improvement from the double digit declines in recent quarters and partially reflects easier comparisons as we begin to lap the onset of the pandemic and March.
The segment's average daily sales rate has now improved over 18% from the fiscal 'twenty June quarter.
Underlying demand improvement was broad based during the quarter, though and markets such as food and beverage aggregates pulp and paper lumber and Forest Street and chemicals, we made most productive right now.
As Neil mentioned, we are also seeing improved sequential trends from heavier and industries, while growth across our international operations has provided additional support.
Within our fluid power and flow control segment sales increased four 5% over the prior year quarter with our recent acquisitions of Acs and Gibson and engineering contributing 5.9 points of growth.
On an organic daily basis segment sales increased 2%.
And that benefited from favorable demand within technology life Sciences, and chemical end markets as well as improving trends across off highway and mobile applications.
This benefit was partially offset by ongoing year over year declines across certain industrial and process related end markets, albeit unapproved rate.
We are seeing greater demand for our fluid power solutions tied to electronic control integration equipment optimization and robotic automation.
In addition demand across our emerging automation platform is showing positive momentum with related organic sales orders and backlog all growing during the quarter.
Moving now to gross margin performance as highlighted on slide page eight of the deck gross margin of 29, 4% improved 43 basis points year over year or 29 basis points, when excluding non cash LIFO expense of <unk> $8 million and the quarter and $2 million in there.
Prior year quarter.
On a sequential basis gross margins improved over 50 basis points.
The improvement primarily reflects strong channel execution and effective price cost management, the improving demand environment and the benefit of ongoing internal initiatives.
Turning to our operating cost on an adjusted basis, selling and distribution and administrative expenses declined 3.4% year over year or approximately 6% when excluding incremental operating costs associated with our Acs and Gibbs and engineering and acquisitions.
Adjusted SG&A excludes $2 $6 million of non routine income recorded in the third quarter on fiscal 'twenty, 'twenty, one and $3 $9 million of non routine expense and the prior year quarter.
The year over year decline, primarily reflects our team's ongoing discipline and controlling costs as well as the benefit of a leaner cost structure following business rationalization and executed over the past several years.
Another key driver of SG&A productivity is the efficiency gains we continue to realize from operational excellence initiatives.
Each of our shared services model and technology investments, while T and E bad debt and amortization expenses were also lower year over year.
These dynamics more than offset the elimination during the quarter of various temporary cost actions, which we had implemented at this time last year and response to the band damage.
Overall, our strong cost control combined with improving sales and gross margin drove favorable operating leverage and the quarter.
And as a result, adjusted EBITDA grew over 14% year over year, and 27% sequentially. While adjusted EBITDA margin was 10, 3% up 119 basis points over the prior year.
On a GAAP basis, we reported earnings per share of $1.42, which includes the previously referenced non routine income.
On a non-GAAP adjusted basis, excluding these items, we reported earnings per share of $1.37, which compared to $1.02 and the prior year quarter.
Our adjusted tax rate during the quarter of 18% was below prior year levels of 23, 3% and our guidance of 23% to 25%.
The adjusted tax rate during the quarter include several discrete benefits related to income tax credits and stock option exercises.
Excluding this benefit as we move into our fourth quarter, we believe a tax rate of 23% isn't as appropriate assumption near term.
Moving to our cash flow performance and liquidity and cash generated from operating activities. During the third quarter was $44 $1 million, while free cash flow totaled $43 million.
Spite emerging growth and related working capital investment cash.
Cash flow and the quarter exceeded our expectations, primarily reflecting ongoing benefits from our operating working capital management initiatives, including cross functional inventory planning and enhanced collection standard work and leverage of our shared services model all supported with recent investments and technology.
Year to date, we have generated record free cash of $191 million, which is up 25% from prior year levels and represents 150% of adjusted net income.
Given the strong cash flow performance and the quarter. We ended March with approximately $304 million of cash on hand net.
Leverage stood at 1.9 times adjusted EBITDA at quarter end below the prior year level of 2.5 times and the fiscal 'twenty, one second quarter level of two one times and.
In addition, our revolver remains undrawn with approximately $250 million of capacity and an additional $250 million accordion option.
Combined with incremental capacity on our recently expanded a our securitization facility and uncommitted private placement shelf facility, our liquidity remains strong.
This provides flexibility to fund incremental working capital requirements and coming quarters as customer demand continues to improve as well as to pursue strategic M&A.
And other growth initiatives and pay down additional debt where appropriate.
In addition, given our improved outlook and solid liquidity position, we will look to deploy excess cash through opportunistic share buybacks and dividends as the cycle recovery continues to unfold.
Transitioning now to our outlook based on month to date trends in April and assuming normal sequential patterns. We would expect on physical fourth quarter, 2021 and organic sales to increase by 12% to 13% on a year over year basis.
This includes an assumption of double digit to low teen organic growth and our service center segment and high single digit to low double digit organic growth and our fluid power and flow control segment.
As a reminder, we will be fully lapping prior weakness from the pandemic, which resulted in a 18.4% organic sales decline and last year's fiscal fourth quarter.
In addition, this direction is meant to provide a starting framework on how fourth quarter sales could shape up if trends followed normal seasonality going forward.
While year to date and sales trends have exceeded normal seasonality as the recovery has unfolded. We believe a prudent approach remains warranted as we continue to recover from an unprecedented downturn.
In addition, as Neil highlighted earlier, we remain mindful of increasing supply chain constraints across the industrial sector, which could influence the cadence and trajectory and industrial activity and near term.
Based on the 12% to 13% organic sales growth assumption, we believe a low double digit to mid teen incremental margin is at an appropriate benchmark to use for our fourth quarter.
This assumes gross margin moderates slightly on a sequential basis into the fourth quarter, but continued to expand year over year.
The sequential moderation primarily reflects considerations around service center segment mix and sales from larger strategic accounts continue to recover at a faster pace as compared to local accounts near term as well as slightly higher LIFO expense.
We remain focused on our internal margin initiatives and deploying countermeasures, including pricing actions in response to increasing supplier inflation.
As it relates to operating expense, we expect SG&A to increase sequentially, reflecting higher incentive compensation additional growth related investments and the ongoing normalization of medical cost.
We also have one additional payroll day and our fiscal fourth quarter. This year versus on a recent third quarter. We continued to take a balanced approach to managing our operating cost.
Our expense and margin execution year to date is encouraging and provide strong indication of our potential going forward, including our target of mid to high teens incremental margins on average over an up cycle.
That said keep in mind that our incremental margins could vary over the next several quarters and into fiscal 2020 two as we look to support our growth initiatives and we face the ongoing normalization of medical merit and selling related expenses.
Lastly from a cash flow perspective, we expect free cash to moderate into the fourth quarter as a our levels cyclical build and we have plenty of inventory and a greater pace and support of our growth opportunities and the recovery.
We remain confident and our cash generation potential and reiterate our normalized annual free cash target of at least 100% of net income over a cycle.
With that I will now turn the call back over to Neil for some final comments.
Thanks, Dave as we close out fiscal 2021, I'm encouraged by what I see developing across our company our.
And our value proposition technical industry focus and expansion into emerging industrial solutions provides a clear path for favorable growth going forward.
We have the most comprehensive portfolio and technical surface service capabilities Premier engineered solution expertise and greatest track record of consistency and commitment to this vital space.
Our local presence and ongoing talent and investment provides further support to this foundation.
Now more than ever these attributes are critical for our suppliers and customers as they accelerate growth investments and solidify supply chains ahead of a potential extended up cycle.
Emerging signs of re shoring and investment and U S. Industrial infrastructure are promising and could represent notable tailwind for our business if they fully materialize.
And our expanding automation footprint is presenting new growth opportunities and faster growing and higher margin industrial applications.
And lastly, our cross selling initiative remains in the early innings, but is gaining momentum with related business wins, increasing and broader teams engaged.
Considering our embedded customer base and addressable market exceeding 70 billion and growing we believe this initiative represents a significant opportunity that should expand our share across both legacy and emerging market verticals and coming years.
Combined with our self help margin initiatives and strong balance sheet, we have great potential to accelerate our earnings power and.
Stakeholder returns long.
So once again, we thank you for your continued support and with that we'll open up the lines for your questions.
Thank you we will now begin the question and answer session. If you would like to ask a question. Please pick up your handset press Star and then the number one on your telephone keypad and keep you would like to withdraw your question from the queue press the pound key.
Pause for just a moment to compile the Q&A roster.
And our first question comes from Michael Mcginn from Wells Fargo. Please go ahead. Your line is open.
Hey, good morning, everybody and great quarter.
It's Mike.
I just want to go back to the acquisitions I think in the release you mentioned.
They added 15, but you were expecting maybe at the onset of guidance like 11% to 13, so that's like a 25% Delta were.
And now I'm just trying to square is that like were you expecting some declines and those businesses and that 25% isn't necessarily the pace of growth.
Can you talk about how fast some of your new automation players are growing at the moment.
Yeah, Michael I would say you know I think and we'd talk collectively the run rate on the businesses prior were around a $100 million.
In the expectations, maybe and the 10 to 11 eight <unk> for the two most recent additions Acs and Gibson and they.
And there we're seeing they are seeing the benefits of greater entrance back into customers to implement projects and have those commission. So we're seeing that come through as an encouraging sign and then we continue to work then they're cross opportunities with <unk>.
Customers, So hey, if I look back at the at the businesses and the space. It has the capability and in normal times to be at a high single digit maybe double digit area and the side, obviously and this we're gonna be looking for opportunities to further accelerate but a little bit better than our.
<unk>, which I think is a sign of won the performance and two things opening back up and some of those industry positions and customer base.
Okay and then my.
Second question on relates to you mentioned some of the you know as we enter this recovery some of the working capital considerations and <unk>.
Interested in and some of the people considerations and you have a you know a.
A decent team of I guess I would call on spec engineers supporting that fluid power segment, what what is the capacity within that team there are deemed forcing yourself, adding more people or consolidating into a center of excellence for.
Those spec engineering and <unk>.
And here's I guess I would call them.
Right so both.
And <unk> application Engineers, and then some engineering support that goes on as we configure.
Configure and build the build the systems and so I'd say our deployment model is both we will have local engineers inside of those operations.
And our facilities, but we also have centralized teams and expertise to help and use good engineering tools and software that that can help us meet surging demands across and kind of share work across facilities or cross engineering areas of expertise. So we feel like we are and a.
Good position right now we continued to be active we will recruit will be on campus to make quality additions to the team, but we feel like we are in a good spot right now and the team's excited as they get to engineer and be involved in more customer.
And <unk> more product applications and more technology opportunities.
Thanks, I appreciate the time.
Okay.
Thank you and again, if you would like to ask a question. Please press star one on your telephone handset.
And our next question comes from David Manthey from Baird. Please go ahead. Your line is open.
Thank you hi, good morning, guys.
Good morning.
So and.
First off just as we tracked what constitutes normal sequential patterns on a consolidated basis is typical seasonality believe about it sort of down low single and the first quarter up low single second quarter up mid single third quarter and then.
Flattish and the fourth quarter or is that a decent template to use as we gauge this going forward.
That that would be.
Okay Alright.
Alright.
<unk>.
Yeah.
And then.
In the U S. P. F. C segment could you parse out trends youre seeing and hydraulics versus flow control any disparity between those two.
That's a that segment yes.
Yeah, and I don't know, if there's a great disparities and it.
And our hydraulics business has had the benefit of.
Of continued work of connecting electronics to solutions, and and and for construction off highway mobile applications, So, perhaps a little stronger than flow control, but we were encouraged by the progress in the quarter and seeing orders and.
And backlog increase there there is the chemical refinery segment that was maybe more late cycle and this recovery and that is a portion of that flow control business, but the team is also doing a nice job and its focus and its diversification on space of hygienic food and beverage personal care.
Are pharma and some of those others and so that diversification is also helping on.
The full control business.
Okay and that makes sense.
And then when the pandemic started I seem to remember the theory was that some of these process industries just unplugged.
Unplugged and walked away and that there would be some sort of a.
Greater level of service center sales as they crank production back up and have you seen any sort of restart type of sales or are the accelerating sales youre seeing on the service center side, just mainly break fix and kind of routine production related sales.
And if there's any way of visibility into that.
I think especially and discussions with the team and with customers we're seeing.
You know greater break fix activity as capacity and production ramps, but also the and the work on the team's on projects to be ahead. I think there is a good recognition and seeing trends come through if you were idled for a longer period of time or took down normally continuous operating.
Equipment, you were experiencing a few more issues. So I think now the work is going on when do they plan a downtime to administer some of these projects.
But you're right, it's a ramping environment and so it's a little harder for some of those customers to say I want to plan for these cycles. So we're seeing perhaps some rolling projects. Some smaller projects until they can feel like they can get to a point for a little bit of extended shutdown and I think with that those.
Wont be multiple weeks, they've maybe parts of weeks and weekends that we'll see that activity go on.
Okay. Thanks, a lot Neil I appreciate it.
Thanks.
Thank you.
This time I'm, showing we have no further questions.
Now I'll turn the call back to Mr growth sure.
Alright, thanks, very much so what a busy earnings time, and I can tell and hopefully a clean straightforward quarter and a positive view on the on the outlook. We do look forward to connecting with many of you as we go throughout the quarter. So thank you for taking the time and and joining us today.
Thank you ladies and gentlemen, this concludes today's conference.
And now disconnect.
Yeah.
[music].