Q3 2023 Applied Industrial Technologies Inc. Earnings Call
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Please note that this conference is being recorded I will now turn the call over to Ryan <unk> director of Investor Relations and Treasury Ryan you may begin.
Okay. Thanks, Frank and good morning to everyone on the call. This morning, we issued our earnings release and supplemental investor deck detailing our third quarter results.
Both of these documents are available in the Investor Relations section of applied Dot com.
Before we begin just a reminder, we will discuss our business outlook and make forward looking statements. All forward looking statements are based on current expectations and subject to certain risks and uncertainties, including those detailed in our SEC filings.
Actual results may differ materially from those expressed in the forward looking statements.
<unk> 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 in those documents.
Our speakers today include Neil Schrimsher applies President and Chief Executive Officer, and Dave Wells, Our Chief Financial Officer.
I'll turn it over to Neil.
Thanks, Ryan and good morning, everyone 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.
So overall, we had another solid quarter, demonstrating our industry position and operational focus we grew EBITDA by 29% and adjusted EPS by 36% on approximately 15% sales growth.
This is on top of similar levels of growth in the prior year period.
So very strong compounding growth in earnings power that we believe is top tier within our core marketplace.
Digging further into the results, we expanded both gross margins and EBITDA margins further.
Further enhanced our return on capital metrics and generated stronger cash flow both year over year and sequentially.
We did this against the backdrop of ongoing inflationary pressures and supply chain constraints.
As well as some moderation and broader market activity I want to thank our entire team for their ongoing efforts and focus on optimizing and positioning the company to achieve these results.
So a few key points to emphasize and provide more detail on in terms of underlying demand customer activity remained generally positive during the quarter feed.
Feedback from our teams on the ground continues to highlight a relatively productive marketplace.
Growth was strongest in many of our top industry verticals and across our larger national account base.
We're also capturing new business opportunities from our industry position and technical capabilities as customers address increased maintenance requirements.
Continue to work through backlogs.
Consolidate their spend across our comprehensive product and solution set.
We're seeing more and more examples of cross selling success, expanding wallet share with strategic accounts and engaging new local account relationships.
These are strong and sustainable self help growth tailwind that we look to build on into the future.
As expected, we did see broader market activity normalize some as the quarter progressed following a relatively busy production backdrop over the past several years.
Shipment activity tied to system assemblies and engineered solutions also moderated slightly following strong backlog conversion during December and January again, largely what we had anticipated.
Sales month to date in April are trending up a high single digit percent on an organic basis versus the prior year.
As reflected in our updated guidance, we remain mindful of ongoing macro headwinds that could weigh on near term market activity that said as we highlighted before we are favorably positioned to continue to outperform the broader market, reflecting our industry position and <unk>.
<unk> growth initiatives.
Part of this reflects our ability to capitalize on key secular growth trends gaining momentum across the north American industrial sector.
This includes greater infrastructure spending reassuring and aging and scares technical labor force and incremental growth from government stimulus spending.
We believe all of these dynamics are positively influencing our underlying growth today and could have an even greater impact into the future.
This is particularly true across our service center segment, which had another solid quarter with organic sales growth of 16% and strong incremental margins.
On a two year stack basis segment organic growth was up nearly 30% during the quarter while year to date segment operating margins are up nearly 240 basis points from an adjusted operating margin levels two years ago.
Reflecting on these results it's clear our service Center network is much stronger and more productive business today. Following a number of initiatives investments talent additions and process improvements made in recent years.
Similar to last quarter, we did see some slowing in select end markets during the quarter, such as metals and lumber and wood. However, overall booking levels remained relatively stable.
And in in markets that are slowing across our service Center network. The underlying trend is manageable to date and not indicative of a material correction.
In addition, many of our top industry verticals in the U S remained strong in the quarter with greater than 20% growth within food and beverage pulp and paper chemicals and mining.
We believe our service center customers remain focused on sustaining appropriate MRO activity on core production equipment in the current backdrop as they mitigate supply chain risk and positioned production capacity for growth in the years to come especially when.
<unk> potential re shoring infrastructure spending and increased capex requirements.
Within our engineered solutions segment, which includes our fluid power flow control and automation offerings, we had another solid quarter of double digit growth with organic sales up 13% from the prior year.
While moderating from the plus 20% growth we saw last quarter. This partially reflects more normalized shipment activity and backlog conversion. Following the strong trends we saw late last quarter.
We continue to see solid growth in our industrial and off highway mobile fluid power verticals.
Our technical solutions and engineering capabilities remain in high demand.
As Oems face required technology energy efficiency and safety enhancements for their systems and equipment.
Growth across our specialty flow control operations was also favorable in the quarter, reflecting steady MRO activity and maintenance project spending on process infrastructure and continued growth opportunities emerging from our customers de carbonization effort.
Underlying demand within our automation platform remains positive driven by strong secular tailwind and our expansion initiatives. This level of sales growth in the third quarter moderated from the over 20% growth we saw last quarter, so primarily reflecting shipment timing.
And ongoing supply chain constraints.
Year to date organic sales across our automation platform or up a healthy double digit level.
<unk> ongoing supply chain headwinds and we continue to see favorable growth in many of our core industry verticals and applications.
We remain very excited about the potential of our automation platform, including an active pipeline of strategic M&A opportunities that we expect to further scale and optimize our competitive position going forward.
In early April we announced the acquisition of advanced motion systems, which represents the sixth automation acquisition over the past four years.
With annual sales of around $10 million. The transaction is on the smaller end, but is a great accretive bolt on automation business that optimizes, our footprint in the upper northeast region with strong capabilities and machine vision motion control and related services.
We welcome Ams and look forward to leveraging their capabilities going forward.
In addition to our sales performance, we had another strong quarter of margin improvement both at the gross margin and EBITDA margin level.
We're managing ongoing inflationary pressures through channel execution and countermeasures.
Combined with our cost discipline and efficiency gains.
Grew EBITDA nearly twice the rate of sales growth and.
And expanded EBITDA margins sequentially and year over year.
Year to date EBITDA is nearly 60% higher on an adjusted basis than it was four years ago prior to the pandemic.
While some of that growth tied to the bolt on automation acquisitions, we've completed.
The core driver is organic execution from our team and enhancing our growth profile productivity business.
Business mix and cost structure in recent years.
The expansion of our underlying earnings power is a strong testament to our strategy commitment to operational excellence and industry position.
Lastly, we're in a strong position to take full advantage of our future organic growth and M&A opportunities moving forward our balance sheet has modest leverage currently and we expect stronger cash generation going forward as our working capital requirements moderate following heavy investment.
In recent years.
As it relates to M&A and capital deployment opportunities, we're holding firm to our return requirements and balancing broader macro dynamics.
Our top M&A priorities remain focused on automation fluid power and flow control, where we have an active pipeline.
We will also continue to evaluate options to strengthen our service center network where appropriate.
Through ongoing investments as well as select acquisition opportunities aimed at optimizing our market coverage talent and service capabilities.
In addition, we will continue to evaluate share buybacks and ongoing dividend growth as secondary options to deploy capital and drive returns.
At this time I will turn the call over to Dave for additional detail on our financial results and outlook.
Thanks, Neal and good morning, everyone first and as a reminder, that our quarterly supplemental investor presentation is available on our Investor site for your additional reference.
Turning now to details of our financial performance in the quarter consolidated sales increased 15, 4% over the prior year quarter.
Acquisitions contributed 70 basis points of growth, which was partially offset by a 30 basis point headwind from foreign currency translation.
The number of selling days in the quarter was consistent year over year.
Netting these factors sales increased 15% on organic basis.
As it relates to pricing, we estimate product pricing was around a mid single digit percent contributor to year over year sales growth in the quarter.
As a reminder, this assumption only reflects measurable topline contribution for price increases on SKU sold in both year over year periods.
Turning now to sales performance by segment as highlighted on slides six and seven of the presentation.
Sales in our service Center segment increased 16, 1% year over year on an organic basis, when excluding the impact of foreign currency.
Year over year sales growth was strongest across our large national accounts during the quarter, though we continue to see nice contribution from our smaller local accounts, albeit at a more modest pace as market activity normalizes against difficult comparisons.
We also continue to see solid fluid power aftermarket sales growth, reflecting strong execution and service support from our fluid power MRO specialists network.
Within our engineered solutions segment sales increased 15, 2% over the prior year quarter with acquisitions contributing two one points of growth.
On organic basis segment sales increased 13, 1% year over year.
Segment sales growth continues to be supported by strong performance and backlog levels across our fluid power division, including healthy activity within industrial and off highway mobile applications as well as sustained customer MRO and capex spending into process flow infrastructure.
This was partially offset by slower activity within fluid power technology verticals and ongoing inbound component delays impacting the timing of system shipments and backlog conversion.
Sales from automation operations were up by a mid single digit percent organically over the prior year period. This follows over 20% growth during the December quarter.
As previously noted automation growth in the quarter was partially impacted by ongoing supply chain constraints and shipment timing.
Moving to gross margin performance as highlighted on page eight of the deck gross margin of 29, 4% increased 13 basis points compared to the prior year level of 29, 3%.
During the quarter, we recognized LIFO expense of $8 2 million compared to $7 $4 million in the prior year quarter.
The net LIFO headwinds had an unfavorable <unk> seven basis point impact on gross margins during the quarter.
On a sequential basis gross margin improved 33 basis points during the quarter and was slightly ahead of our expectations.
We continue to manage broader inflationary dynamics well.
At the same time, we are benefiting from our gross margin initiatives, including enhanced analytics freight recovery internal execution, while favorable growth in our higher margin flow control operations is also providing support.
As it relates to our operating cost selling distribution and administrative expenses increased 7% on an organic constant currency basis compared to prior year levels.
SG&A expense was 18, 2% of sales during the quarter down from 19, 5% during the prior year quarter.
We continued to show strong execution and controlling costs in the current environment as we leverage our operational excellence initiatives shared services model and technology investments to help offset wage inflation required talent additions and medical cost inflation.
In addition, our ongoing air collection initiatives are helping control bad debt levels year to date.
Combined with double digit sales growth EBITDA increased 29% over prior year levels, while EBIT margins expanded 132 basis points over the prior year to 12, 4%.
This includes an unfavorable seven basis point year over year impact due to LIFO.
Combined with the reduced interest expense, we reported adjusted EPS of $2 38.
Representing a 36% increase from prior year EPS levels.
As highlighted in our press release adjusted EPS in the quarter excludes a net tax benefit up $3 $7 million, resulting from the release of a deferred tax valuation allowance within our Canadian operations.
Moving to our cash flow performance cash generated from operating activities. During the third quarter was $75 $2 billion, while free cash flow totaled $67 $2 million.
Compared to the prior year free cash increased nearly 39%, reflecting higher earnings and stabilizing working capital investment.
Year to date, we have generated over $143 million of free cash, which is up 17% from the prior year inclusive of greater working capital investment and Capex spend.
Looking ahead, we expect working capital investment to ease going forward, which should provide a path for stronger free cash generation during our fiscal fourth quarter and into fiscal 2024 pending the direction of broader macro dynamics and partially balanced by our ongoing growth initiatives and related investments.
<unk>.
From a balance sheet perspective, we ended March with approximately $182 million of cash on hand, and net leverage at slightly below one times EBITDA.
Our leverage remains below our normalized range of two to two five times, partially reflecting the significant EBIT growth we have experienced in recent years as well as ongoing debt reduction.
We also remained disciplined with our M&A approach focus on targets and valuation supporting our return requirements and strategic priorities.
Turning now to our outlook as indicated in todays press release and detailed on page 10 of our presentation. We are adjusting full year fiscal 2023 guidance, including tightening our sales guidance to the high end of the prior range and increasing guidance for EBIT margins and EPS.
Following our third quarter performance.
We now project full year fiscal 2023, adjusted EPS in the range of $8 40 to $8 60 per share based on a sales growth of 14% to 15% and EBIT margins of 11, 7% to 11, 8%.
Previously our guidance assumed EPS of $8 10 to $8 50 per share sales growth of 13% to 15% and EBIT margins of 11 five to 11, 7%.
The updated adjusted EPS guidance range excludes the $3 $7 million net tax benefit in the most recent quarter related to tax valuation allowance adjustment.
Our updated guidance implies a fiscal fourth quarter EPS range of $2 70.
$2 20.
On low to mid single digit sales growth over the prior year and 11, 6% EBIT margin at the midpoint.
Our fourth quarter sales growth guidance is relatively unchanged from our prior outlook provided in January and takes into consideration sales trends month to date in April broader economic uncertainty ongoing inflationary pressures moderate market activity near term and more modest pricing contribution.
We will face more difficult sales growth comparisons as well as the fourth quarter progresses.
With that I will now turn the call back over to Neil for some final comments.
Thanks, Dave as we prepare to close out fiscal 2023, I'm extremely proud of the progress we've made and excited about the significant opportunity that still lies ahead for our organization.
Our value proposition technical industry focus and expansion into emerging industrial solutions provides a clear path for favorable growth and strong returns going forward.
As we expected broader market activity is moderating slightly as the economy adjusts to higher interest rates tighter credit conditions and lingering uncertainty on many levels.
We continue to believe any near term slowdown within our core end markets will be transitional and shorten nature given positive tailwind underpinning the industrial sector, a greater focus on supply chain reliability and capacity investments in the wake of meaningful shocks.
Faced in recent years.
In addition, we had many self help levers building across our business today that support our growth trajectory beyond cycle conditions. This includes our exposure to secular tailwind tied to re shoring and investment in U S industrial infrastructure, which could represent notable tailwind.
Across our business for years to come.
We also anticipate benefits from our cross selling strategy.
Spansion into new market verticals, and a more diversified end market mix relative to prior cycles.
Additionally, we will continue to evaluate and develop new commercial solutions that fully leverage our technical capabilities and application expertise as legacy industrial infrastructure converges with new emerging technologies.
This includes greater growth opportunities around Iot telematics and electrification for fluid power systems as well as the ongoing build out of our automation platform.
Today our.
Automation offering is approaching $200 million of annualized sales and 15% of our engineered solutions segment and.
And we expect to further scale this platform going forward, both organically and through strategic acquisitions.
We expect strong secular and structural demand for these next generation industrial solutions, which should be nicely additive to our growth both near term and more meaningfully on a longer term basis.
Lastly, we see ongoing margin expansion over the long term, reflecting a diverse set of opportunities tied to mix tailwind and system investments.
Plus our competitive mode from the critical nature of our core product set application expertise and customized solutions.
Near term, we will remain diligent and ready to adjust if the environment slows our presents a more meaningful pullback.
As our historical track record shows we have the playbook to execute in any environment, while generating strong counter cyclical cash flow.
As always we thank you for your continued support and with that we'll open up the lines for your questions.
Thank you.
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We'll pause for just a moment to compile the Q&A roster.
Our first question comes from Chris Dankert with loop capital. Please proceed.
Hey, good morning, guys and congrats on the quarter here.
I guess first off.
I'm looking at gross margin typically we see kind of a seasonal step up into the fourth quarter I guess, given the impact of LIFO and freight and some of the other moving parts here should we see a typical seasonal move into the fourth quarter or just maybe you could walk us through just the impact of some of the moving parts in gross margin near term here.
The guide assumes a modest decline in gross margin sequentially very strong performance in the quarter. There were some some higher levels of vendor support and other things that contributed to that but very continued their strong continued execution performance on really all levers in terms of our margin initiatives. So we would expect that to.
Moderate a little bit like I said, we were up over 30 basis points sequentially. As we moved into Q3, so was expected, but the typical seasonality just a bit as a result of that Chris.
Okay perfect. That's really really helpful. Thank you.
And then have to happen to it.
Obviously, you're starting to look down the barrel at 24, I know, there's no guidance today, but just.
On a snapshot basis or are you kind of look at everything going on right. Now I mean would you expect to be able to hit growth given all these secular tailwind pushing behind that or just any comments maybe beyond the quarter at the end of the fiscal 'twenty three here.
Chris I'll start and obviously, we'll provide color when we get to August and Q4 results and the outlook I think for US as we think about outlook now when we're working our plans but.
We'll play model, our thing and to have a have a cautious approach to it given the uncertainty that's out there, but clearly clearly more to come.
Got it thanks, so much and I'll hop back in queue here.
Our next question comes from David <unk> with Baird. Please proceed.
Yes, hi, good morning, guys.
First question.
As you measure price and you think about that on the Skus that repeat this year versus last.
Do you think that that naturally underestimate the impact. The reason I mentioned is that I would think that your ability to price in and get installation and retain that not have competed away would be better.
Skus that are more rare in adult turn that frequently versus the ones that are more calm and any thoughts on that.
On that assumption.
Sure David.
Can start so.
You are correct.
We would go off the data that we have on the matched skus in the third that do over the period. Obviously, we have a lot of configured products are non standard products that don't match and that we do feel like with our gross margin performance in the business. We the team has done a very nice job at keeping.
Pace with that inflation that to think about it in the quarter, probably a price cost match.
Probably viewed neutral maybe slightly positive in the side, but.
We are intent on knowing especially in the engineered solutions side of our business and these build outs that we price accordingly to the value and the benefits that we're generating and so.
That's been our view in the in the past and that I think that will continue forward and we like that we have.
<unk> levers that can help us over an up cycle.
Gross margins and the things that we've done around point of sale and use of data and analytics there.
We feel like we benefit from mix both customer side as we saw both large accounts and local accounts, we're doing well.
More technical solutions in that so we think all of those.
Set up favorably for us for a gross margin standpoint over the up cycle.
Do think.
The amount of a supplier increases.
We do look forward there.
They will likely moderate there's still going to be increases, but I think from those that were multiple times a year.
They will settle back to more annual increases and lifts, but I feel like there could be there will be an <unk>.
Ongoing tail to this inflation, especially when considering.
Labor and kind of overhead expenses type things tied around medical and others.
Okay.
Yes, it seems that way.
Thanks for that Neil.
Second.
One of the factors that we've been hearing about is the share shift that's been driven by supply chain issues and this probably relates more to your service center business than that.
But when you think about the outgrowth that you've seen over the past couple of years.
Do you consider that maybe some of that was driven by availability and it could normalize as <unk>.
Supply chain has come back.
Well as I think about it I think it's.
From our products from our solutions.
Service set that we wrap around it I think the the.
The customer expectations have continued to grow I think <unk>.
Many are looking at how they consolidate their spend with fewer more capable providers.
I think the breadth of what they consider or what they need today expands.
Fans across our technical product range, and we're well set up for that.
So I don't look at that as.
Is it change going forward and as we think about industrial production.
Perhaps it was.
Slightly less than one obviously there has been inflation come in.
Two the business and to the marketplace. If PPI is at 6% to your point, we've had the opportunity to perform and outperform in that I don't think that setup for the marketplace and customer expectations given the other secular trends on re shoring the desire to do.
Do more technical work and integrate automate automation and how they optimize their facilities.
The need to outsource more based on a challenging technical labor environment, I think those set up very well for us for multiple years to come.
Okay.
Maybe one more just quickly.
Just looking through my old notes in our head that 75% of what you used to call flow control.
MRO and first off I'm, just wondering if I have that right in the first place and then in second.
When you think about the kind of the long tail aftermarket.
Any of the business you do in Es, primarily in that and that flow control area and then with the addition of.
Of automation I'm, just wondering has that changed the dynamic at all.
So you have it correct on the.
On the set up with.
Flow control being 75% MRO.
As automation comes into that segment, there's some flow piece into that but that business carries.
<unk> work and we will build a backlog were encouraged in the quarter. Good good order rate lighter on the volume out this quarter.
As we've talked about coming off a high second quarter in this and so we think the set up there is that high single digit double digit based on adoption rates around automation.
<unk> control being later cycle in some of the trends and needs and investments around infrastructure, we think that sets up well and then in our in our fluid power business right, where it carries.
Most of that backlog in the area.
It is still going at nice historical levels, perhaps two to three times that so we think that is favorable for us as we look forward.
Going into 'twenty four.
Okay, but as it relates to MRO and maybe there is something to be said for the age of the applications.
Is it safe to say that automation is a lower MRO component to it and flow control does maybe again because it's more.
Mature.
Yes, I would say much lower much lower than that.
Our our focus.
Focus our work is building out those systems and working with customers and so afterwards or their base MRO flow materials, but it would be much much lower.
Alright, thanks very much.
Ladies and gentlemen, as a reminder to ask a question. Please press one four on your telephone keypad.
Our next question comes from Ken Newman with Keybanc capital markets. Please proceed.
Hey, good morning, guys.
Hi.
Neil.
Curious I mean, I just wanted to touch back on the margin implied margin guidance for Q.
Yes, I think you mentioned some expectations for a moderating price maybe some more normalizing seasonality, but I just want to clarify is there anything else that we should kind of be aware of.
Particularly within the SG&A line here or.
Maybe the expectations from a LIFO headwind going forward.
No not really.
Guide assumes normalized levels that we've seen in the last couple of quarters of both inflationary impact and LIFO.
Yeah.
It's a function of the tougher comps and think about the relative sales growth that's going to put some pressure on the incremental margins. So we're calling the the guide would assume low double digit incrementals as a result of kind of the.
The continued inflationary impact that we're seeing as well as the lower relative volume leverage that we'll have in Q4 on a year over year basis. So nothing out of the ordinary though in terms of LIFO. Other margin assumptions are the one I alluded to in Chris' question.
Got it.
Still steady SG&A rates.
Keeping the focus on the operational controls there.
Right.
I guess to follow up on that.
I know you're not ready to guide to 2024, yet, but just listening to your commentary. It seems like you aren't seeing any evidence of a material slowdown yet.
You mentioned decrementals in the low double digit range in a typical down cycle and maybe thats, a little bit more conservatism, but if market conditions continue to hold in where they are.
How do you think about incremental margin the sales are up call. It low to mid single digit in this kind of environment.
All else equal.
So we're targeting that low double digit to mid single or mid double digit.
Mid teens margins Incrementals I think we've demonstrated historically the ability to.
Surpass that obviously, when we had that volume leverage.
As things start to subside, we'd see that pull back to like I said that mid teens rate, but you.
We're going to stay very focused on margin expansion and would expect to see ultimately LIFO start ease although that does have what's again a much longer tail on it given the range of demand that we do see in this business and Youll stay accountable on the SG&A side too.
Target those.
Mid teens.
Incrementals or decrementals, they go that direction, but.
Thanks, Ed.
Being prudent in terms of our thoughts around the.
The guide for Q4, just given the continued uncertainty that we're seeing.
Yes, and I'll just add right.
And you said it in the remarks, it clearly will be out more in August on <unk>.
24, but we.
We do believe we setup with all.
We think any slowdown in kind of core end markets would be more transitional shorten nature at this point.
And so we know theres many secular positive tailwind that are out there and I think our customers have a greater focus on supply chain and that reliability and how they continue to have their capacity to serve markets and so we think about this this cycle.
I know you do work around.
The IP industrial cycles.
So perhaps there is a pullback, but I mean this could look like something maybe thats more early two thousands or even prior to that that if there is a dip it could be relatively short in nature and set up another three to four year run on it on it going forward. So.
How all that plays out and it relates to the next fiscal year I mean, clearly we will be providing.
More detailed and more guidance, we think very spot on with what we are mining.
Around Q4, and very specifics and we'll look to be have more detail when we get to that August timeframe.
Right.
Maybe one more here.
Obviously, just thinking about the cycle and there has been market worried obviously about the tighter credit lending and maybe its broader impact on industrial activity.
Neil maybe could you talk a little bit about whether you're seeing a change in momentum in sales trends between your smaller and medium sized <unk> versus the national accounts I know you backed out pretty positively about that secular trend, which I imagine is more heavy on the national account side.
But I'd say good activity.
With with both and so if I think about it on our service Center side team has continues to have a good focus so no we would not see any.
Significant material trends, we've talked about our top industries many of them.
Running very well.
We talk about the top 30.
Those declining went to eight this quarter versus five but and those are really in the the lower tail of that number kind of the lower 10% of that.
So I mean, they were cognizant, we're aware we'll be prudent we will be mindful, we know we can.
Quickly react if needed.
But to date, we can still remain encouraged about the.
Market that's there.
Okay. Good.
Sure.
Thank you.
At this time I'm showing we have no further questions I will now turn the call over to Mr. Scripture for any closing remarks.
I just want to thank everyone for joining us today, and we look forward to talking with many of you throughout the rest of the quarter. Thanks a lot.
Ladies and gentlemen that does conclude today's conference you may now disconnect have a great day everyone.
Yeah.