Applied Industrial Technologies, Inc.

2021 First Quarter Earnings Call for Applied Industrial Technologies. My name is James, and I'll be your conference 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. If you wish to ask a question at that time, please press star 1 on your telephone keypad. Prior to asking a question, lift your handset to ensure the best audio quality. Please note that this conference is being recorded. I'd now like to turn the call over to Ryan Fieslak, Director of Investor Relations and Treasury. Ryan, you may begin.

Thanks, James, and good morning to everyone on the call. This morning, we issued our earnings release and supplemental investor deck detailing the first quarter results. Both of these documents are available in the investor relations section of apply.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 certain risks, including the potential impact from COVID-19, as well as trends in sectors and geographies, 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 in those documents. Our speakers today include Neil Scrimshaw, Applied's President and Chief Executive Officer, and Dave Wells, our Chief Financial Officer. With that, I'll turn it over to Neil.

Thanks, Ryan, and good morning, everyone. On behalf of our entire team at Applied, we hope you and your families are healthy, safe, and managing well. I'll start today with a business update, including how we continue to respond to the pandemic, as well as progress with various internal initiatives and color on the external environment. Dave will follow with a summary of our financials and some specifics on our first quarter and outlook, and then I'll close with some final thoughts. In the early fiscal 2021, we're seeing a modest recovery gain momentum and are executing well. I'm encouraged by the start to the year and believe we are in a solid position to build off this positive momentum as we move forward. Our operations are functioning productively. Our supply chain and inventory levels are in a good position. and we are responding effectively to customers' increasing requirements as an initial demand recovery appears to be underway. Throughout the past several quarters, we have quickly adapted to the evolving environment, including implementing new processes and ways to support our customer needs. A key part of our message to all our stakeholders during these evolving times is how applied is stronger today than in prior cycles. This includes benefits from our expanded offerings, greater technical focus, and a more diversified in-market mix. We've also strengthened our marketing and sales efforts to showcase our comprehensive and leading technical offering and to further develop our cross-selling opportunity. We are increasingly critical to our customers as maintenance, production, and efficiency requirements begin to ramp across their core operational infrastructure. These elements are providing near-term sales support and leave us increasingly constructive on our growth potential going forward. In addition, investments in systems, talent, analytics, and operational processes in recent years are yielding additional benefits in the current environment. We quickly aligned our cost structure and once again are demonstrating our operational discipline and the resilience of our operating model. This is highlighted by better than expected decremental margins in the quarter, as well as ongoing strengthening of our balance sheet following strong cash generation performance and a nearly 30% reduction in net debt levels over the prior year. Our capabilities and company-specific opportunities, combined with the improving outlook, positions us to be a growth leader with increasing earnings power entering the next phase of recovery in the industrial economy. This is demonstrated by our recent tuck-in acquisition of advanced control solutions earlier this month. ACS represents the next step in expanding our automation offering, which is further differentiating our value proposition, diversifying our in-market mix, and enhancing our growth profile to include next-generation industrial solutions. We welcome ACS to apply it and look forward to leveraging their innovative technology and capabilities as we continue to execute on this growth opportunity. As it relates to the broader demand environment, underlying trends remain below prior year levels during our first quarter as business activity continued to adjust to the ongoing pandemic. That said, customer order activity improved sequentially through the quarter, and we continue to gain traction with our internal growth initiatives. As a result, the year-over-year organic sales decline of 13.4% in the quarter improved notably from the 18.4% decline last quarter. Year-over-year organic sales declines improved each month and sequential trends in daily sales rates seasonally strong. We're starting to see greater maintenance activity and break-fix requirements with customers increasing access to their facilities and expanding equipment utilization as production gradually ramps back up, including at smaller local accounts. Feedback from our sales leaders suggest order sizes are increasing, customer inventory levels are being replenished, and maintenance projects are getting authorized as businesses increase activity, and new safety protocols support a productive path forward. In addition, we saw several industry verticals return back to growth during the quarter with 10 of our top 30 verticals up year over year versus only two last quarter. Areas such as food and beverage, aggregates, technology, chemicals, and transportation were all showing positive momentum. And while weakness remains greatest across heavy industries such as machinery, metals, and oil and gas, demand within these verticals appears to be stabilizing and improving slightly. We view these dynamics as a positive sign for the industrial economy and demand for our critical products and solutions. That said, the pace of in-market improvement remains gradual and at times inconsistent. Organic sales through our first 18 business days of October are down by a mid-teens percent over the prior year. We saw some easing in sales early in the month following a strong end to our fiscal first quarter. Sales trends have improved each week in October with order momentum increasing sequentially across both our segments month to date. However, it's important to note that visibility remains limited ahead of the seasonally slower winter months as customers continue to manage through an uncertain macro and pandemic outlook near term. Additionally, customer purchasing discipline can be more restrained around any given election cycle. As we've shown in recent quarters, we know how to manage and execute in this still uncertain business environment and will remain prudent in our cost focus and capital deployment near term while focusing on our self-help growth opportunities. Overall, we're seeing signs that reinforce our view that the worst is behind us and a recovery is starting to gain traction. This bodes well for when we enter the seasonally stronger second half of our fiscal year as comparisons become easier and we continue to execute on our internal growth initiatives. At this time, I'll turn the call over to Dave for additional detail on our financial results and outlook.

Thanks, Neal. Before I begin, I will remind everyone that a supplemental investor deck recapping key financial performance and discussion points is available on our investor site for your additional reference. To provide more detail on our first quarter, consolidated sales decreased 12.7% over the prior year quarter. Acquisitions contributed 1.1% growth, partially offset by an unfavorable foreign currency impact of 0.4%. Netting these factors, sales decreased 13.4% on an organic basis with a like number of selling days year-over-year. Turning to sales performance by segment, as highlighted on slides six and seven, sales in our service center segment declined 14.9% year-over-year, or 14.4% on organic basis. The decline reflects the ongoing impact from COVID-19, including reduced industrial production activity and customer facility restrictions, which continues to impact MRO demand across our service center network. However, the 14% organic decline year-over-year represents an improvement from the 21% decline during last quarter. In addition, average daily sales rates were up more than 4% sequentially and above the normal seasonal progression. As Neal highlighted, we saw greater maintenance activity and break-fix demand. More customers are providing access into their facilities and releasing working capital spending following a slow pace during the summer months. Year-over-year declines remained greatest within metals, oil and gas, and machinery end markets, but were balanced by underlying improvement within food and beverage, pulp and paper, aggregates, forestry, and chemical industries, as well as ongoing growth in Australian operations. Within our fluid power and flow control segment, sales decreased 7.4% over the prior year quarter, with our August 2019 acquisition of Olympus Controls contributing 3.8 points of growth on roughly half a quarter of remaining inorganic contribution. On an organic basis, segment sales declined 11.2%, reflecting lower demand across industrial, off-highway mobile, and process-related end markets. This was partially offset by sales growth within technology, life sciences, food and beverage, and chemical end markets during the quarter, as well as ongoing traction with our cross-selling initiatives and firm sales activity across our emerging automation platform. Moving to margin performance, as highlighted on page 8 of the deck, Gross margin of 28.9% declined approximately 50 basis points year-over-year or 40 basis points when excluding non-cash LIFO expense of $1.1 million in the quarter and $0.4 million in the prior year quarter. Year-over-year declines primarily reflect unfavorable mix tied to sales declines across our local service center accounts, albeit more modest relative to last quarter, as well as more subdued pricing opportunities, given the softer demand environment. That said, on a sequential basis, gross margins improved 13 basis points or 17 basis points when excluding LIFO expense, and we're slightly ahead of our expectations. While we expect some of the volume-driven year-over-year headwinds to persist near term, we remain focused on driving annual gross margin expansion as demand levels normalize, reflecting benefits from our systems investments, the positive contribution of expansionary products, strategic growth driven by our technical service-oriented solutions, and initiatives to expand business across our local customer base. In addition, we are starting to see a slightly greater level of supplier price increase announcements, which, combined with firming demand, could provide some positive momentum for pricing contribution and margin expansion into the second half of our fiscal year. Turning to our operating costs, selling, distribution, and administrative expenses declined 13.4% year-over-year or approximately 15% when excluding incremental operating costs associated with our Olympus Controls acquisition. Both of these figures exclude $1.5 million of non-routine costs in the prior year quarter. The year-over-year decline reflects the ongoing benefit from various actions we've taken in recent quarters to align expenses with lower demand. This includes a mix of both structural and temporary cost actions as we continue to assess the environment. And while we have begun to roll back some of the temporary actions, our team continues to demonstrate great discipline in controlling costs and identifying internal opportunities. Combined with improving sales trends during the quarter, we reported a 9.5% decremental margin on operating income during our recent fiscal first quarter, which exceeded our expectations and highlights the adaptability and durability of our operating model. Going forward, we will remain prudent and disciplined in maintaining our cost structure as we continue to gradually roll off temporary cost actions to align with our recent performance, a more constructive outlook, and our growth initiatives. EBITDA in the quarter was $67.6 million, down 13.6% compared to adjusted EBITDA of $78.2 million in the prior year quarter, while EBITDA margin was 9%, down a modest 10 basis points over the prior year, despite the double-digit sales decline. We reported net income of $34.8 million, or 89 cents per share, down from adjusted net income of $39.9 million, or $1.02 per share, in the prior year quarter. Moving to our cash flow performance and liquidity during the first quarter, cash generated from operating activities was $81.8 million, while free cash flow was $78.2 million, or approximately 225% of net income. This was up from $50 million and $45 million, respectively, as compared to the prior year quarter and represents record first quarter cash generation. The strong cash performance during the quarter reflects ongoing contribution from our working capital initiatives, as well as the countercyclical cash profile of our business model. Given the strong cash flow performance in the quarter, we ended September with over $271 million of cash on hand, with approximately 75% of that unrestricted U.S.-held cash. Of note, this is after utilizing $62 million of cash during the quarter to pay down debt. We have now paid down over $200 million of debt since early 2018, including over $80 million the past year. Our net debt is down nearly 30% over the prior year and net leverage stood at 2.1 times adjusted even at a quarter end below the prior year quarter level of 2.3 times and the prior year level of 2.6 times. Additionally, our revolver remained undrawn with approximately $250 million of capacity and an additional $250 million accordion option. combined with incremental capacity on our uncommitted private shelf facility, our liquidity is ample and our balance sheet is strong, entering what appears to be an emerging recovery. This provides flexibility to fund incremental working capital requirements in coming quarters as customer demand continues to improve, as well as opportunistically pursue strategic M&A aligned with our growth initiatives. Our M&A focus near-term remains on smaller bolt-on targets that align with our growth priorities, including additional automation and fluid power opportunities. Transitioning now to our outlook, as noted in our press release, we continue to refrain from providing formal full-year fiscal 2021 financial guidance due to the uncertainty around the ongoing impact of the COVID-19 pandemic. Visibility remains limited on how customers will proceed with operations into the seasonally slower winter months. That said, to provide some directional views near term, based on month-to-day trends in October and assuming normal sequential patterns in daily sales rates for the balance of the quarter, we would expect fiscal second quarter 2021 sales to decline 13% to 14% organically on a year-to-year basis. This includes an assumption of low T north gain declines in both our service center segment and fluid power and flow control segments. Again, this direction is meant to provide a starting framework on how second quarter sales could shape up if trends follow normal seasonality over the next two months. If customers reduce underlying production activity or extend seasonal plant shutdowns, this could drive organic declines that are greater than the 13% to 14% assumption. On the other hand, if we see ongoing improvement in underlying industrial activity and further traction with our internal growth initiatives, organic declines could be better than the 13% to 14% assumption. In addition, we expect our recent acquisition of ACS to contribute approximately $6 million in sales during our fiscal second quarter. Based on the 13% to 14% organic sales decline, we believe a low double digit to low key decremental margin is an appropriate benchmark to use for our second quarter. This assumes gross margins are relatively stable sequentially with first quarter levels as well as the ongoing gradual rollback of temporary cost actions. As indicated, we will continue to take a mindful and balanced approach to our operating costs going forward, including ongoing focus on internal opportunities and margin initiatives, which we expect to provide balance to our cost trajectory moving forward We are encouraged by our cost and margin execution year-to-date, which is providing the flexibility to further roll back temporary cost actions as we take an offensive approach to an emerging recovery and our strategic growth targets. We also note an effective tax rate of 23 to 25% is still an appropriate assumption year-term. Lastly, from a cash flow perspective, we would expect moderation from first quarter levels sequentially for the balance of the year given potential greater working capital requirements as we look to support growth and the recovery as the year plays out. We remain confident in our cash generation potential over the cycle and reiterate our normalized annual free cash target of at least 100% of net income. With that, I will now turn the call back over to Neal for some final comments.

Thanks, Dave. Overall, I'm encouraged by how we started the year. Our entire team has shown tremendous resiliency over the past several quarters, which is driving improved performance in the early fiscal 2021 and positions us to respond and capitalize on the recovery as it continues to unfold. We have proven the durability of our business model, strengthened our balance sheet, and optimized our cost structure. We are leveraging our unique and differentiated industry position to be an industrial growth leader into the emerging recovery and in years to come. All of this is reflected in our first quarter results and provides further evidence of the positive path we're on. From our industry-leading technical MRO capabilities to our engineered solutions focus, multi-channeled cross-selling opportunity, and expanding automation platform. We have multiple catalysts to expand our market potential and accelerate share gains in coming years, all while driving additional margin expansion. This is integrated into our long-term targets of $4.5 billion in sales and 11% EBITDA margins, which are well within our capability and provide the framework for accelerating earnings power and stakeholder returns long-term. Once again, we thank you for your continued support and look forward to demonstrating the strength of our value proposition going forward. And with that, we'll open up the lines for questions.

Thank you. And we will now begin the question and answer session. If you'd like to ask a question, please pick up your handset, press star and then number one on your telephone keypad. If you'd like to withdraw your question from the queue, press the pound key. And we'll pause for a moment to compile the Q&A roster. And our first question comes from the line of Adam Allman with Cleveland Research. Go ahead, please. Your line is open.

Hi, guys. Good morning. Congrats on the strong quarter. Thanks, Adam. Yeah, I wanted to start the discussion about the pace of demand through the quarter. It sounds as if the year-over-year declines moderated and eased as you got through September. Maybe you could correct me if I'm wrong, but then it sounds like it took another step down at the beginning of October, I guess. Anything that you would point out as certain industries that might have been more acutely weighing on that gradual recovery or anything else that sticks out to the choppiness of sales?

Adam, I'd say at this point, I don't know that I would point to really any industries. I think those that were contributing and running positives somewhat continued. The heavy industries would continue to have some choppiness or some challenge to it. I think it could be a function of we ended the September period, the quarter well, and there was just some natural easing as we started those first few days into October. And as we look at it, then we are encouraged as we continue to see that progress as we work through October, kind of week by week, seeing some of that sequential improvement. which would really include our service center segment, but also the fluid power and flow control.

Okay. Gotcha. And then secondly, on the gross margin, I think, Dave, you said that you expected to be relatively flattish here into the December quarter. I think historically it's expanded a little bit sequentially from the September quarter and I think with the local customer demand maybe starting to pick up a little bit, it would have been stronger. I would have thought it would have been a little bit stronger, I guess. Is there anything weighing on the margin, or is that just a conservative base case at this point?

I'd call it the uncertainty in terms of what we see play out over the quarter. Typically, I don't think there's a strong increase sequentially as you move from our Q1 to our Q2. And just, you know, given the uncertainty, the choppiness of some of the activity and, you know, some of that inflationary impact that we're starting to see reading through, which did weigh on LIFO on the calc there. I thought, you know, from the standpoint of, you know, trying to provide guidance, I'd call it, you know, consistent sequentially with Q1 results. We like the traction that we saw in Q1 with sequential improvement. As we said, starting to see some of that local account mix coming back, but we continue to work some of the self-help initiatives there and the accretive product mix reading through. So we would hope some of that would continue into Q2 to offset what we might see in terms of the additional LIFO headwinds.

Okay. Would you expect to see greater supplier incentives being offered in the December quarter for

inventory purchases i guess relative to maybe a year ago or is it still kind of normal typically you might see that i think the the overall sentiment has been in some of the discussions that you know there's not as much appetite or need to grab that incremental volume given a year that had such uncertainty and maybe lackluster performance so uh you know we find that many of our suppliers are not as as attuned or running to a plan or something that was set 12 months ago and maybe a little less motivated to grab any kind of special deals on that front is kind of the overall sentiment I believe that we would see. Great. Thank you.

And our next question comes from the line of Chris Dankert with Longbow. Go ahead, please. Your line is open.

Hey, morning, everyone. Dave, I kind of wanted to go back to what you'd mentioned on SG&A, again, based on the decrementals, and I think just some of your comments. So we're looking at, you know, flattish sequentially to maybe up slightly into the second quarter. I just want to make sure I heard that correctly.

That's correct. Right, just thinking about here again some of the investments still around growth, starting to see some of that, you know, further roll off of the temporary cost actions as well as the impact of – Some of the medical and some of the things that provided favorability beyond the street actions, travel, entertainment, things of that nature, starting to read back through. So that would offset what really is a two-day differential in terms of days. And we put that flat up slightly in terms of the SDNA progression as we move from Q1 to Q2.

Perfect. Thanks for confirming that. I guess thinking bigger picture and longer term, you guys have done a lot in terms of investment and technology, but I guess are there any kind of blind spots or places that you do think you need to bolster or that could require some investment as we kind of come out of this downturn?

I think we've done a nice job of continuing to make those investments and being able to prioritize appropriately. We've got ongoing initiatives right now for you know, warehouse management software and automation that are continuing to be deployed, work around, you know, further enhancements to .com, things of that nature that, you know, given that the big ERP investments are, you know, behind us, you know, like where we've continued to prioritize those investments and thinking about Internet things and trying to get in front of some of that. So, you know, we've continued to fund those investments, striking a balance, obviously, with, you know, managing the near-term results that have not deprioritized some of those projects that will continue to set the business up for success as we come back out of this and continue to capitalize on our recovery going forward.

I'm glad to hear it. And just one last one, if I could, I guess, thinking about ACS, how does that really kind of interplay with Olympus? Is there really a cross-selling opportunity? Are they kind of in the same realm? Just let me talk about how the portfolio is kind of coming together slowly here.

I think, Chris, the cross-sell opportunity really would be with the team and our legacy positions for industrials in our service center side of the network. Obviously, we're all around that equipment and where discrete automation can be beneficial. We're seeing that with Olympus and the connection with fluid power customers or service center customers. We do think Olympus and ACS, there can be technology sharing as we work. Engineering projects can be cooperation and collaboration on that. And I think the companies bring a combination of expertise across some of the technology and applications, be it vision, technology, be it robotics, mobile, and collaborative, even communication products as customers look to expand their connectivity within their facility or connected to the Internet of Things across multiple sites. So we think the businesses do help one another, and we think there's a big additive help that can occur with our service center industrial customers.

Perfect. Well, thanks so much for the detail, guys, and congrats again on the quarter.

Thank you, Chris.

And again, as a reminder, if you'd like to ask a question, please pick up your handset and press star, followed by the number one on your telephone keypad. And if you'd like to withdraw the question, please press the pound key. Your next question comes from the line of Michael McGinn with Wells Fargo. Go ahead, please. Your line is open.

Morning, everyone. Thanks for the time. All right, Mike. Neil, I was curious, have there been any early learnings from this downturn and where you can structurally pull back, maybe not on labor, but certain processes that are not as important to driving profitable growth and share longer term?

I think we continue to look as we go through what's the balance of some of the temporary measures and actions that we take and when do those become a little bit more permanent or structural. And I would think it could be around geographies or access or points to certain market segments as we consider. I think there's been a kind of great learning as we've had in leveraging our technology investments that we've had, our go-to-market collaboration across our groups, and how we are connecting with customers in newer ways with technology. And some of that is customers have become more open to that. But I think also as we've gone through, it does reinforce the importance of being close to customers and having a the ability to have a physical slash virtual connection with them to them as we go through so i think that's going to stay important given the critical nature of the products and then as customers have opened their facilities I would say we're one of the early ones in and getting pretty borrowed access. Obviously, our teams are following the safety guidelines, the protocols, and procedures. But given the importance of our products and solutions that enable movement, inside of these customers, it reinforces there. So I think in any time when you go through something like this, there's learnings that we will translate and pull forward. And I think some of those play into and would grow into automation and how some of those technologies can help solve our customers' problems. And as customers have one more level of problems, that just further improves that return on investment

uh around those technologies being adopted inside of their facilities so there's a growing interest there okay appreciate that and then um switching gears to the acquisition was curious um acs what the level of cyclicality in that business has been how they fared during the downturn maybe from a revenue or margin standpoint relative to your the core applied brand Also, you have a $100 million per year acquisition target. I was just wondering, this is pretty small. Are there enough properties out there to fill that void for you guys?

I'll start with the latter. You know, from a pipeline standpoint, you know, throughout, we remain active to our priorities. And I think my short answer to that would be yes. Now, hey, given the environment, you never perfectly control the timing. But we remain active. around those priority areas around fluid power, automation, flow control, and also dialogue around our traditional service center segment as well. So those continue to go on. I think from an ACS performance, if you look back, they've demonstrated a good growth. They have nice diversity in their in-market segments that would include life science and some other technology segments as we think about the business going forward. There's already cross-communication where we have common customers with our service center network where we have some presence where one of the groups can help one of the other with an introduction or work on a mutual opportunity. So they have demonstrated that. good growth throughout. If I look back historically from a margin profile, they would be above, gross margin profile, they'd be above the company fleet average. I'd say starting points, they'll be from a profitability standpoint at kind of company average as we think about it today, but with opportunity to contribute bigger and be better.

Appreciate it. I'll pass it along.

Our next question comes from the line of Steve Barger with KeyBank Capital Markets. Go ahead, please. Your line is open.

Good morning, guys. Good morning. Can you talk about competitive dynamics versus smaller private players right now? Or just what are you hearing in the channel about their health, and does that create any opportunities?

I don't know that I'm hearing, you know, too much on the overall health. I mean, no doubt it's a challenging environment. You know, you think about the operational requirements, the working capital requirements now that will be coming to go through. In those regards, businesses are not easy, and so perhaps for some, depending on where they're at in the generational cycle, can have them evaluate. I think overall the space stays productive. I think there's good recognition of cost and cost to serve in doing it. And then I know from our standpoint, Our broader capabilities are advantageous for us to be connecting with customers in these times. When we can address opportunities, we can address operating challenges or issues that they may have around bearings and power transmission. around fluid power, around flow control, and now have even more automation discussions. That's helpful for us as customers perhaps more slowly open their facility to third parties.

So to the extent that your team has been able to get out there and prospect, With this new broader set of capabilities, have there been conquests? Are you seeing any kind of measurable advancement of the ability to sell the portfolio?

we are seeing progress. I think our potential is very notable. I'm encouraged. Obviously, a bigger, stronger, more open macro helps all of that go faster. I am encouraged. Success begets success. It opens eyes to the team and the momentum and the opportunity builds. If I think about Our sharing is higher, our quote activity is higher, the work along with that, and I think it shows more and more in the results as we go forward.

Any specifics about how you're using analytics to manage the business and to drive the sales force to make sure they're getting in front of the right customers?

You know, one, we use it, you know, up front as we think about attracting and recruiting use of analytics. We use analytics and development plans for associates as well. So those are kind of on the front end. And then we look at where we're at with customers and what's our position to the market potential and what's the position across categories. We're giving our selling teams greater tools from a sales portal standpoint. that gives them kind of the their own opportunity to to drill down we've had pretty good success and ability to provide that information on an ad hoc basis to push out now it's available for them to to drill down uh real time into the environment and that's helped we can also use that technology across the portal to uh load the leads and the cross-channel prospects that exist so that collaboration can go on pretty seamless across those groups right now. So that would be another area. And we're going to continue to push ourselves. I think as we view the business and work our long-range strategy, we are consistent in saying, how do we help ourselves? What growth initiatives can we have? and then build those into our plans. And so we don't have the big one-time investments to be making. Our view is we invest in ourselves as we go.

So as you think about this, it may be hard to measure because of the, you know, obviously the pandemic over the last few quarters. But even as you think back to that or now that things are stabilizing, do you feel like you're outgrowing the market set itself, however you measure that?

I think if we look at some of the other general industry surveys, if we look at some of the economic indicators, We do feel that. But with that not satisfied, we're going to want to continue to work those out. We know in some regards we don't have as much safety PPE as perhaps some others in a general space. Our participation in some of the other segments may create a little bit of headwind. I think about it. totally how the service centers are performing and the trajectory they're on. We feel very good about that. I think the fluid power business, and I think about how they've performed in that sequential Q4 to Q1, and how I look at backlog building going on right now, both in technology and the industrial off-highway mobile segment. Those are encouraging, and I think that's got a little bit of outperform going in it as well.

Got it. And last one for me. Just as I think about putting the model together for 2Q, should I expect that fluid power has a lower rate of decline than service center-based distribution, similar to what we saw the last couple of quarters?

We would call both of the set for data in Q2 kind of down mid-teens. to no teens, I'm sorry, excuse me, as you think about both the service center and fluid power flow control segment.

Similar rates of change. Yeah, and Steve, just keep in mind that the fluid power and flow control segment will have a more difficult comp in the second quarter versus the first quarter. More of a comp issue.

Right. Well, and I guess I will squeeze in one more. 3Q itself is a fairly easy comp before you get to the trough quarter last year. Any view on whether revenue could be positive year over year in both 3Q and 4Q?

No, I think if we continued on these trends and had the kind of typical seasonality play out, you know, with what we see now, that would be a more high single digits type decline. And then the return to growth, in the fourth quarter, you know, as we'd sit here today and following those historical trends.

Great. Thank you.

Well, actually, that was the continued profitability of our flow control segment. You look at EBITDA being at 40 basis points year over year, you know, that lower volume. So it continues to show the value proposition and the importance of the technology that we bring there.

Right.

And our next question comes from the line of David Manthe with Baird. Go ahead, please. Your line is open.

Thank you. Good morning, guys. First question is on these temporary cost actions in SD&A. When you exit the December quarter, what percentage of those temporary cost actions will have been reinstated? I'm not talking about variable costs that flex with volume, but those specific costs. related temporary cost actions you took.

Yeah, I'd say, Dave, on that one, there'd be a little bit to be determined, right? We started easing some of those now, or we did in the first quarter. We'll see as we develop in the second quarter. I would suspect we will have some additional ones of those potentially eased. Are we all the way out of it by the time we exit December? I think that's to be determined.

Okay. But based on that answer, is it right to assume that the low teams, low double digits to low teams, decrementals, assuming 13% to 14% organic declines, assumes that you're not 100% of those costs back?

Well, as we work through the quarter, we would not be 100% back. Then how we exit and go into the third, you know, we'll be looking at it. And like I said, that's to be determined.

Okay. So it's less than 100, but it's certainly greater than 50 will be rolled back at that point. And I'm talking about exiting the period, too, just to get a sort of run rate as we enter the new calendar year.

I'll stay where I'm at right now. But I appreciate your diligence on it.

All right. Well, thanks for that. And then so looking back at the mini industrial recession that we saw back in 15 and 16, it took a little while for your sales to reaccelerate, but Within about 24 months or so, you exceeded the prior peak operating margin levels nicely. And I'm just thinking, as you look at the cycle we're in, currently a deeper trough than that one. But how do you think this cycle will be different than that one in terms of just how you emerge from it?

Well, you know, I'll say the same. To be determined on the cycle, but I think about us. You know, we continue to be, in my mind, better and stronger. I think about our fluid power business is that way and what we're doing, our participation broadly across flow control and those opportunities. our move into merging provider of automation and all the opportunities that those bring. And then I think the systems that we have in place and how we continue to leverage those for performance and productivity, those have been helpful for us. I think at a talent level, we're at a higher level, and that's helping us from an execution standpoint in what we're doing. So You know, we performed well then. I think the business is just even in a stronger position to be more important to our customers and perform better than what the environment will give us. So to be determined on the cycle, our view is that we beat the general macros as we go through it, and we just got a lot more capability than we had then.

Yeah, I'd add, too, that we continue to leverage that, you know, accretive margin mix as we, you know, see those sales redevelop and, you know, further strengthen and, you know, provide that opportunity to drive that operating margin and gross margin expansion.

Yeah, I mean, our view, right, if you think quite then on incremental, our incrementals maybe were low teams. I think... Once we get running and we restore some of these temporary actions, as that cycle really plays out over the period, we think we're in a mid-to-upper teams incremental then on the go forward. And that kind of financially shows our view of the difference in the company and its capability.

Got it.

All right, guys. Thank you.

Our next question comes from the line of Michael McGinn with Wells Fargo. Go ahead, please. Your line is open.

Hey, guys. Thanks for the follow-up. Just wanted to round out the discussion with Freight. Some of your competitors have been talking about surge demand from e-commerce. And just wondering if you could remind us where and how you're positioned and where higher costs would show up for you guys and maybe any need to second source like some of your peers are doing?

I think for us, we continue to be in a good position on freight with our providers. You think about the nature of our products, you know, our freight, our business is pretty attractive. It's high density. It's not very seasonal. So we're pretty predictable as it goes across, that's valuable. So you think about our movement to our distribution centers and truckload and less than truckload, our use of dedicated carriers, and really our view of any parcel changes have been manageable as we go through. So our view is we have a good understanding of it. We still have good management around it, and I don't see an adverse, real adverse impact coming from it.

Okay, great. I think earlier in the call, you mentioned working capital, maybe some need to build inventory in the second half of this year as you support the growth needs of your customers. I was wondering, you're at about 17% of sales right now versus closer to 19% historically. What is the level of structural improvement then as you've made investments in ERP, some facility consolidations versus just the cyclical impact of lower sales?

The ERP investments, the use of the tools and the analytics there has certainly yielded the ability to better manage both the inventories and rationalize those during the most recent downturn. If you look in the quarter, there's been a $24 million incremental reduction in operating inventories. So very pleased with that on a quarter where we started to see some of that volume come back. And we've managed that with with good contribution across both of the segments without adversely impacting service levels. So very pleased with the analytics. So we used those same tools to be thoughtful in where we're adding back inventory to respond to the ramping demand to better leverage that inventory investment as we move forward. Structurally, though, I'd also say I like the work that we're doing, the continued benefit on the collections focus, particularly the shared services with the service center segment, our administered receivables there. We're on an all-time record, though, in terms of past due in the quarter across the aggregate business segment. took our over 90-day past due down another point sequentially. So, you know, we'll continue to work the structural actions as well on the collections to make sure that we're driving efficiencies there and, once again, helping to mitigate what's going to naturally be an increase in new receivables as we start to see those volumes rebound. So just to illustrate on a $22 million sequential increase in sales in the quarter, we were flat in terms of receivables impact on working capital. So very pleased with the traction that we've also been able to demonstrate on that front. Here again, that's a result of technology and that process focus that we put in place. Got it. Appreciate it.

At this time, I'm showing we have no further questions. I'll now turn the call over to Mr. Scrimshaw for any closing remarks.

I just want to thank everyone for taking the time to join us today. We look forward to talking with many of you throughout the quarter.

Ladies and gentlemen, this does conclude today's conference call. Thank you for your participation. You may now disconnect.