Applied Industrial Technologies, Inc.

Welcome to the fiscal 2022 first quarter earnings call for applied industrial technologies. My name is Shelby 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. 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 will now turn the call over to Ryan Cieslak, Director of Investor Relations and Treasury. Ryan, you may begin.

Thanks, Shelby, and good morning to everyone on the call. This morning, we issued our earnings release and supplemental investor deck detailing our 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 the COVID-19 pandemic, as well as trends in sectors and geographies, 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 in those documents. Our speakers today include Neal Scrimcher, Applied President and Chief Executive Officer, and Dave Wells, our Chief Financial Officer. With that, I'll turn it over to Neal.

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 first quarter results, current industry conditions, and company-specific opportunities. Dave will follow with more specific detail on the quarter's performance and provide some additional color on our outlook and guidance. And then I'll close with some final thoughts. In the early fiscal 2022, we are executing well and making progress on our strategic initiatives. We reported record first quarter sales, EBITDA, and earnings per share. as well as another strong quarter of cash generation despite greater working capital investment year to date. As widely evident across the industrial sector, inflationary pressures and supply chain constraints are presenting challenges as industrial production and broader economic activity continues to recover. Nonetheless, we are in a strong position to handle these conditions and believe the current backdrop is reinforcing our value proposition and long-term growth opportunity. As it relates to the quarter and our views going forward, I want to emphasize a few key points that continue to drive our performance. First, underlying demand remains positive. Second, our industry position, operational capabilities, and internal growth initiatives are supporting results. And third, we continue to benefit from efficiency gains and effective channel execution. In terms of underlying demand, trends remain favorable across both our segments during the quarter. Industrial supply chain constraints are having some impact on the timing of demand flowing through to sales, though solid execution and our favorable industry position still drove an over 16% organic increase in sales versus prior year levels and stronger growth on a two-year stack basis relative to recent quarters. This positive momentum has continued into our fiscal second quarter with organic sales month to date in October up by a mid-teens percent over the prior year. As it relates to customer and market, Trends during the quarter were strongest across technology, chemicals, lumber and wood, pulp and paper, and aggregate verticals. In addition, we continue to see stronger order and sales momentum across heavy industries, including industrial machinery, metals, and mining, providing incremental support to our sales growth into early fiscal 2022. Forward demand indicators also remain largely positive. Working activity across our service center network is holding up well, despite sector-wide supply chain pressures. We believe this partially reflects the diversity of our customer mix, as well as sustained MRO demand as customers catch up on required maintenance activity, provide greater facility access, and continue to gradually release capital spending. Our ability to provide strong technical and local support, inventory availability, and supply chain solutions places our service center network in a solid position to address our customers' evolving needs near term while helping them prepare and execute growing production requirements over the intermediate to long term. In our fluid power and flow control segment, we continue to see strong demand from the technology sector. This includes areas tied to 5G infrastructure and cloud computing, as well as direct solutions we are providing to semiconductor manufacturing. Customer indications and related outlooks across the technology and market remain robust, reflecting various secular tailwinds and production expectations. continue with an ongoing recovery in longer and later cycle markets such as industrial OE and process flow, we believe the underlying demand backdrop across our fluid power and flow control operations remains favorable. In addition, we're seeing strong growth indications across our expanding automation platform. The current tight labor market combined with evolving production considerations post the pandemic is driving greater customer interactions and related order momentum for our automation solutions. We remain focused on expanding our automation reach and capabilities, both organically and through additional M&A. During the quarter, we announced the tuck-in acquisition of RR Flutie Company, a regional provider of advanced automation solutions in the US Midwest. The transaction further optimizes our footprint and strategy across next generation technologies, including machine vision and robotics. We welcome RR40 to apply and look forward to leveraging their capabilities going forward. Overall, the demand environment remains positive and we're seeing ongoing contribution from our internal growth initiatives. That said, we expect supply chain constraints to persist across the industrial sector near term. Lead times remain extended across certain product categories, driving component delays and an increase in fulfillment timing. We saw greater evidence of this across both our segments during the quarter. Our teams are effectively managing through these issues to date as reflected by our first quarter results. as well as our ability to increase operational inventory levels in the U.S. by 6% during the quarter. Our products are primarily sourced across North America, limiting our direct exposure to international freight and supply chain dynamics. Our technical scale, local presence, and supplier relationships are key competitive advantages in the current backdrop, providing a strong platform to gain share as the cycle continues to unfold. The broader supply chain backdrop is also increasing inflationary pressures across our business, both through the products we sell and the expense we incur to support our competitive position and growth initiatives. We saw ongoing supplier price increases develop during the quarter with indications of additional increases in coming quarters. Our price actions, strong channel execution, and benefits from productivity gains are helping offset current inflationary headwinds as reflected by solid EBITDA growth and EBITDA margin expansion during our first quarter. We continue to take appropriate actions to offset these headwinds. Overall, we are encouraged by our ongoing execution. First quarter results highlight the strength of our position and company-specific earnings potential despite broader challenges industry-wide, and reinforce our ability to progress towards both near-term and long-term objectives in any operational environment. Combined with the strong balance sheet, increasing order momentum exiting the quarter, and greater signs of secular growth tailwinds across our business, we remain positive on our potential going forward. Now at this time, I'll turn the call over to Dave for additional detail on our financial results and outlook. Thanks, Neal.

Just another reminder before I begin. Consistent with prior quarters, we have posted a quarterly supplemental investor presentation to our investor site. This will serve as an additional reference for you as we discuss our most recent quarter performance and outlook. Turning now to our results for the quarter, consolidated sales increased 19.2% over the prior year quarter. Acquisitions contributed 2.1 percentage points of growth, and foreign currency drove a favorable 80 basis point increase. The number of selling days in the quarter was consistent year over year. In any of these factors, sales increased 16.3% on an organic basis. On a two-year stack basis, the organic change was positive in the quarter and strengthened from fiscal 21 fourth quarter trends. As it relates to pricing, we estimate the contribution of product pricing on year-over-year sales growth was around 140 to 180 basis points in the quarter. As a reminder, this assumption only reflects measurable top-line contribution from price increases on SKUs sold in both periods year-over-year. Looking at sales performance across our segments, as highlighted on slides 6 and 7 of the presentation, Sales in our service center segment increased 15.9% year-over-year on an organic basis when excluding the impact from foreign currency. On a two-year stack basis, segment organic sales were up nearly 2%, an improvement from fiscal 21 fourth quarter trends. And markets such as lumber and forestry, pulp and paper, chemicals, aggregates, and food and beverage had the strongest growth on a two-year stack basis during the quarter, while primary metals, machinery, and mining are showing greater improvement both year-over-year and sequentially. In addition to solid sales performance in our U.S. service center operations, we saw favorable growth across our international operations, which contributed to the segment's top-line performance in the quarter. Within our fluid power and flow control segment, sales increased 24% over the prior year quarter, with acquisitions contributing 6.6 points of growth. On an organic basis, segment sales increased 17.4% year-over-year and 6% on a two-year stacked basis. Segment sales continue to benefit from strong demand within technology and markets as well as across life sciences, chemical, and agricultural land markets. Sales trends within primary metals and refined land markets also improved nicely during the quarter partially offset by moderating trends across certain transportation verticals. By business unit segment growth was strongest across fluid power and automation. In addition, demand across our later and longer cycle flow control operations continues to improve with customer quote activity and order momentum building through the quarter. Extended supplier lead times and inbound component delays had some effect on segment sales growth during the quarter though the overall impact remains limited and manageable to date. Moving to gross margin performance, as highlighted on page 8 of the deck, gross margin of 28.6% declined 22 basis points year-over-year. During the quarter, we recognized LIFO expense of $3.6 million compared to $1.1 million of expense in the prior year quarter and a $3.7 million LIFO benefit in our fiscal 21 fourth quarter. The net LIFO headwind had an unfavorable 25 basis point year-to-year impact on gross margins during the quarter. LIFO expense was higher than expected during the quarter reflecting supplier product inflation and a greater level of strategic inventory expansion year-to-date. Excluding the impact of LIFO, gross margins were relatively unchanged year-to-year and up sequentially reflecting strong channel execution pricing actions, and ongoing progress with internal margin initiatives. Turning to our operating costs, selling, distribution, and administrative expenses increased 10.6% year-over-year, or approximately 7% on an organic constant currency basis. SD&A expense was 20.3% of sales during the quarter, down from 21.9% in the prior year quarter. We had another solid quarter of SD&A expense control, reflecting our linear cost structure following business rationalization taken in recent years, as well as benefits from our operational excellence initiatives, shared services model, and technology investments. These dynamics are helping mitigate the impact from inflationary pressures, higher employee related expenses, lapping of prior year temporary cost action, and normalizing medical expense. combined with improving sales and effective price-cost management, EBITDA grew 31% year-over-year, while EBITDA margin of 9.9% was up 89 basis points over the prior year. Including reduced interest expense and a slightly lower tax rate, reported earnings per share of $1.36 was up 52% from the prior year. Moving to our cash flow performance and liquidity, Cash generated from operating activities during the first quarter was $48.6 million, while free cash flow totaled $45 million, or 85% of net income. We had a strong quarter of cash generation considering greater working capital investment year to date, including a strategic inventory bill during the quarter to support growth and address supply chain constraints. We continued to benefit from our working capital initiatives and solid execution across our business. Our cash performance and outlook continues to support capital deployment opportunities. During the quarter, we deployed a total of $36 million on shared buybacks, debt reduction, dividends, and acquisitions. With regards to shared buybacks, we repurchased nearly 77,000 shares for approximately $6.5 million. We ended September with just over $247 million of cash on hand and net leverage at 1.7 times adjusted EBITDA, which is below the prior level of 2.1 times and the fiscal 21 fourth quarter level of 1.8 times. Our revolver remains undrawn with approximately $250 million of capacity and an additional $250 million accordion option. Combined with incremental capacity on our AR securitization facility and uncommitted private shelf facility, our liquidity remains strong. Turning now to our outlook, as indicated in today's press release and detailed on page 10 of our presentation, we are maintaining our full-year fiscal 2022 guidance established in mid-August. This includes EPS in the range of $5 to $5.40 per share based on sales growth of 8% to 10% including a 7% to 9% organic growth assumption, as well as EBITDA margins of 9.7% to 9.9%. We are encouraged by our year-to-date operational performance and remain focused on our growth, margin, and working capital initiatives. Combined with our favorable industry position, ongoing order momentum, and forward demand indications, our fundamental outlook and underlying earnings potential remain firmly intact. That said, as previously highlighted, LIFO expense year-to-date is running higher than our initial expectations. Assuming fiscal Q1 LIFO expense levels of $3.6 million sustained for the balance of the year, this would result in LIFO expense representing an approximate 40 basis point year-to-year headwind on EBITDA margins compared to our initial expectation of 20 to 30 basis points. Combined with ongoing uncertainty from the industrial supply chain and inflationary pressures, we currently view the midpoint of EPS guidance as most reasonable from a directional standpoint, pending additional insight into how the year progresses. In addition, based on month-to-date sales trends in October and considering slightly more difficult comparisons in coming months, we currently project fiscal second-core organic sales to grow by a low double-digit to low teen percentage over the prior year quarter. We expect gross margins will be down slightly on a sequential basis during the second quarter, assuming a similar level of LIFO expense as the first quarter. This would be directionally in line with normal seasonal trends. Further, we expect SD&A expense will be flat to up slightly on a sequential basis compared to first quarter levels of approximately $181 million. Lastly, from a cash flow perspective, we continue to expect free cash flow to be lower year-over-year in fiscal 2022 compared to fiscal 2021 as AR levels continue to cyclically build and we replenish inventory. That said, we are encouraged by our first quarter cash flow performance and continue to drive working capital initiatives as a partial offset across our business. With that, I'll now turn the call back over to Neil for some final comments.

Thanks, Dave. Overall, we are encouraged by how we started the year and what we see entering our fiscal second quarter. Order momentum remains firm across our businesses. Our fluid power backlog is at record levels. And we are effectively building inventory to support our growth opportunities. Our increased exposure to technology and markets is driving greater participation in secular growth tailwinds while our later cycle flow control business is seeing increased activity across key market verticals. We're also making great progress in building our automation platform, including organically as customer and supplier relationships continue to develop and broaden across new industry verticals and within our legacy in markets. Customer outlooks on underlying demand and capital spending remain largely favorable over the intermediate term, and we're on track to achieve our initial guidance provided in mid August. As is common across the industry right now, we're dealing with inflationary pressures, supply chain constraints and lingering COVID related impacts. As our historical track record and first quarter results show, we know how to execute in any environment. In addition, I believe our strategy on ongoing initiatives will prove out further in this environment as the industrial economy continues to evolve both cyclically and structurally. The breadth and availability of our products combined with our leading technical solutions and localized support is a significant competitive advantage right now. We look to leverage these capabilities across our expanded addressable market during these dynamic times and in years to come. At the same time, our balance sheet and liquidity provide strong support to pursue strategic M&A opportunities. We maintain a disciplined approach to M&A and are actively evaluating opportunities primarily across key priority areas of fluid power, flow control, and automation. there remains significant potential to further scale our leading technical industry position across these areas. We're eager to demonstrate what we're fully capable of in the years ahead as we continue to leverage our position as the leading technical distributor and solutions provider across critical industrial infrastructure. Once again, we thank you for your continued support, and with that, we'll open up the lines for questions.

Thank you. 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 the number one on your telephone keypad. If you would like to withdraw your question from the queue, press the pound key. We'll pause for just a moment to compile the Q&A roster. Your first question is from David Manthe of Bayard.

Thank you. Good morning, everybody. First off, could you tell us how many of your 30 industries would be up on a two-year stack basis?

So we talked on like year-to-date in the quarter, 25 up. On a two-year stack basis, we would have 17 up, which I think is relatively similar to last quarter. If we think about strongest growth compared to 2019, Those would include chemicals, lumber and wood, technology, aggregates, and then paper and allied products, with really all of those being 20% up compared to 2019 levels.

Okay. And then RR Flutie, what approximately revenue is in EBITDA there, Neal?

So we'd say similar size, uh, of recent acquisitions on the run rate. And so collectively for the total business now, right in the quarter organically, we were up 20%. And then as we think about with polluting run rate of the business now, 120 million in total on the automation side. So a very good addition for us there in the Midwest.

Okay. It seems to be coming together. And then finally, on the second quarter SDNA outlook for flat to up slightly, normal seasonal would be more like flat to down. Could you just talk about the factors that are driving that OpEx outlook?

A couple things come into play there, David. You do have full quarter fluidity reading through million to million five is going to be an impact. Also, you know, even though we've got three less selling days sequentially and less selling day year over year, we have the same number of payroll days both year per year and sequentially. So that does play in, you know, not quite the typical seasonal trend you would see there. So combination of the additional M&A related SCNA as well as just the like payroll days is where the factor that comes into play there.

Perfect. Thanks a lot, guys.

You bet. Your next question is from Adam Ullman of Cleveland Research.

Hey guys, good morning. Good morning. I wanted to start on, it looks like you had some strategic inventory buys this quarter, and that's really helping deliver some good results. I'm wondering if you would expect any more into year end, and then Davey had mentioned some thoughts on working capital being somewhat of a headwind this year. Any thoughts on just how you would think about inventories? as we think about trends into June?

So, Adam, I'll start. We will continue our interaction with our leading suppliers across the product categories to manage through the supply chain headwinds and have right inventories for our customers, both higher velocity types, but also doing the advanced planning of some of those that are going to have extended lead times and how we stay in front of those to really insulate, protect our customers, and continue to serve.

So in addition to that, Adam, I think the thing you'll see is some additional increase in inventory levels. Just thinking about the strongest backlog position we've seen across the project-oriented nature of our business, fluid power, flow control, automation now. So you'll see temporary increases as well just related to those projects flushing through. would anticipate working capital continue to be a headwind for that. As indicated in the script, we'll continue to mitigate that with some of the work that's ongoing across inventory planning, the cross-functional activities we have going on there that would yield the results for us, and would still indicate kind of in line with our initial expectations, 80 to 85% of free cash flow, so slightly lower in terms of our free cash as presented income. as a result of that working capital investment, but making the right tradeoffs to protect service levels there and some of that just coming with the sheer growth that we're seeing in the business as we move forward.

Okay. And then with the fluid power backlog at record highs, I guess, do you have any concern about the price levels that you have in that backlog relative to product costs moving up quite a bit, or is that not a concern? Do you think you can price for those higher levels?

I would say not a big concern. Some of that is on order and so we will expect deliveries of that and for extended items in the backlog is the requirement to look at the pricing that that will go out. And so it has not been an issue for us as we look back and we don't expect that to be an issue going forward.

Okay, gotcha. Matt, for me, I might have missed it, but could you share what you're seeing across your oil and gas operations and how you expect demand from that market to unfold over the next, call it like six to nine months?

So we're seeing improved activity in that segment for us. Overall, it's still today around 3%. of our sales, but we are seeing increased activity and the team's done a nice job of positioning to the market and the demand in that, and so we're operating and serving well. Great, thanks.

Your next question is from Chris Dankert of Loop Capital.

Hey, good morning guys. Thanks for taking my question here. I guess looking at the sales guide for the year, not taking that up at this point, just given what we've seen first quarter, what you're seeing into October and kind of your expectations there, it seems like we're kind of calling for below seasonal growth in the back half. Is that just taking a conservative cut given the volatility out there right now, or is there any reason to believe things are going to slow in the back half here?

Well, you know, I just think on the start, really after a couple of months where we established guidance, you know, it's early. To your point, there's a few moving pieces and some uncertainty around supply chain and inflation, and clearly LIFO is running higher than we expected, right? When we established guidance, you know, that was inclusive of maybe 20 to 30, and it's running a little bit more than that right now. So if I think that goes in. If we think about the range of our assumptions, really kind of the low end of the guidance assumes a sequential pattern that's slightly below normal. And then the high end of the guidance assumes a sequential pattern that are really relatively in line. And so today we think it's appropriate to maintain guidance. To Dave's comments, we talk about maybe an orientation toward the midpoint of that. But as the year unfolds, we still see a path for something that can be greater than that midpoint, but it's still early at this stage.

Got it. No, that makes complete sense. Thanks for the color there. And I guess given the impact of LIFO here, it's still reasonable to assume we can hit kind of a flattish gross margin for the year, or is kind of the expectation now there'll be a little bit of a softening just given that headwind?

The cooperation excluding LIFO, certainly you'll see some modest improvement. That was really embedded in the underlying assumptions, which did include a 20 to 30 basis point headwind from LIFO. Here again, with what we saw, the stronger LIFO expense in Q1, If we see that continue, it is, you know, 40, 45 basis point, you know, headwind that we'll be working to offset there. So good underlying traction from the initiatives, pricing, you know, other offsets in terms of margin initiatives, you know, that could put pressure just depending on, you know, the sustained impact of that life of expense. But underneath that, you'll continue to see, I think, you know, positive trends in terms of our gross margin performance.

So as we think about it for the quarter, Just look ahead, maybe a little sequential decline in that side in the quarter. And then, hey, the back half, right, to be determined. But as we work to go forward then with pricing actions and our own internal margin initiatives, you know, we'll be talking more about that as we get through second quarter and talk about the back half of the upcoming fiscal year.

Got it. Got it. And then I'm going to sneak one more in here quick. I know we're building off a small base, but just can you share what the organic growth was in that automation business this quarter?

So in the quarter, the organic growth of automation was 20% in the quarter. So we'll work and keep growing the base with new customers served and then bringing those solutions and technology to our legacy customer base.

Got it. Thanks so much, guys, and best of luck.

As a reminder, if you would like to ask a question, please press star 1. Your next question is from Michael McGinn of Wells Fargo.

Hey, morning, everyone. Can you comment on some of the mitigating supply chain actions and levers you have to pull if things get worse from here? whether it be ports, freight types, stocking methodologies, and does second sourcing have any impact on supplier rebates, or are you having to second source right now?

I'd say for that last point, I mean, we continue to work with leading suppliers and best brands as we go forward in that. So no real impact work or effort going on there. Our products are predominantly North American produced. They could have some long-distance components that would go into that, but we continue to work with suppliers to have that awareness and visibility. So we do not anticipate any pivot or difference in the strategy. We look to stay engaged, be nimble with working with those suppliers. We productively built inventory in that, and we look to stay connected with our customers and working with our suppliers to do that in this coming quarter. And as it likely continues on into the start of calendar 2022, we'll do the same. But it's not a big differentiation or deviation in our strategy and our work.

Got it. And sorry if I missed this. Last part, I think price contributed 80 to 100 bps. Is there an update to that number on what it had? What was the benefit in FQ1?

You would talk to that being 140 to 180 basis point benefit. Here again, that's where you've got the same skew match year-over-year, which I'll just remind you is less than a third of the business. Think about the variability of the demand that we see.

Got it. Appreciate the time.

Your final question is from Steve Barger of KeyBank Capital Markets.

Hey, thanks. Good morning, guys. Just starting with the 2Q guide, I know you have one left selling day this quarter, but with negative 10% comps for both segments from last year, do you expect double-digit organic growth in each segment for 2Q? We would.

We would see, you know, kind of expect both contributions or contribution out of both segments, Steve. So, We'd expect to see that here again, really both segments, the low double-digit, potentially low teens.

And Neil, a couple of times you've mentioned inflation and supply chain as challenges. In general, do you see those issues as a risk to your business outlook or an opportunity given your inventory position and your vendor relationships?

Well, we know our responsibilities and requirements, so we feel confident that we can execute through it. I believe good, steady inflation can be a positive for the environment and distribution. Now, the size of some of these are rather large, and so we'll continue to manage appropriately. It is the environment and we're committed to executing in it and representing our suppliers well and serving our customers.

And I think you mentioned this, but just to confirm, you're not seeing signs of demand destruction from price or parts availability or anything else so far?

No, we're not. I just point to the quarter and the results that we have, the growing orders and the backlog. And I think also the positive signs underneath as mid to later cycle segments continue to grow. As that progresses and what I view in second quarter or back half, that will be very positive developments for us.

Got it. And with basically every company complaining about labor shortages, this seems like the best environment maybe ever to sell automated solutions. So I guess first, We've heard lead times are expanding for some automation products. Are you getting all the parts and products you need to be able to sell those solutions?

My short answer is going to be yes. It's the same approach and techniques as we have the orders coming in to plan out the bill of materials and the requirements. Lead times may extend a little bit. We saw early on. access into some of the facilities at times could have slowed. That's really opened back up. And so solutions around machine tending, vision systems, robotics, we continue to see that. And we, like across our other parts of the business, will be engaged with our suppliers to deliver those solutions.

Are you worried about an increasingly competitive environment for that part of the portfolio, just given these secular trends? and do you have the footprint in Salesforce you need to make sure you're winning more than your fair share of new business?

We really like our footprint, and we're going to be focused on continuing to grow it organically and perhaps inorganically. We're active in that, but I like our lineup, and it is still a – fragmented space. And so really our competition at the customer level, we're engaged with the customers. We have a longstanding embedded know-how at these customers across many, many of these segments. And now we're just expanding what we can bring to them to help them solve problems around discrete automation. So I think it sets up very well for us.

Understood. Thanks.

I'm showing we have no further questions. I will now turn the call back to Mr. Scrimshaw 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 quarter. Thanks a lot.

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