Applied Industrial Technologies, Inc.

Welcome to the fiscal 2023 first quarter earnings call for applied industrial technologies. My name is Bridget and I will 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 one followed by four on your telephone keypad. Prior to asking a question, lift your handset to ensure the best audio quality. If at any time during the conference call you need to reach an operator, please press star zero. Please note that this conference is being recorded. I will now turn the call over to Mr. Ryan Cieslak, Director of Investor Relations and Treasury. Ryan, you may begin.

Okay, thanks, Bridget, and good morning to everyone on the call. This morning we issued our earnings release and investor presentation 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, which are based on current expectations subject to certain risks and uncertainties, including those detailed in our SEC filings. Actual results may differ materially from these expectations. The company undertakes no obligation to update publicly or revise any forward-looking statement. In addition, the conference call will use certain non-GAAP financial measures, which are subject to qualifications referenced in those documents. Our speakers today include Neal Scrimshaw, Applied's 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. I'll start today with some perspective on our first quarter results, including an update on current industry conditions and our performance, as well as our expectations going forward. Dave will follow with more specific detail on the quarter's financials and provide additional color on our outlook and guidance, which we raised this morning. And I'll then close with some final thoughts. So overall, we had a solid start to fiscal 2023. Sales, EBITDA, and EPS all hit record first quarter levels with respective growth of 19%, 34%, and 45% over prior year levels. Demand remained strong during the quarter. We continue to benefit from our industry position and internal growth initiatives. This is driving new growth opportunities across both our segments. We're also doing an excellent job of managing inflation and controlling costs. This consistent performance is supporting robust operating leverage, helping further expand our margin profile and resulting in meaningful earnings growth despite more difficult comparisons. I want to thank our entire team for their ongoing effort and focus on optimizing and positioning applied to achieve these results. So several key points to highlight in more detail. First, as it relates to underlying demand, customer order and spending activity remained healthy through the quarter and exceeded our initial expectations. We saw some normalization in sequential trends following robust levels in recent quarters. However, bookings and order trends remain firm and highlight a productive and steady demand environment. as customers work through record backlogs, reinforce supply chains and equipment across their production base, and make required maintenance and growth investments. Our diversified in-market base is providing further support. Positive underlying demand and sales growth have continued into the early part of our fiscal second quarter with organic sales month-to-date in October, approximately 20% over the prior year. Within our service center segment, organic sales growth was above 20% for the second straight quarter. This is on top of 16% in the prior year period, so very positive trends. Segment orders and booking rates remain firm through the quarter, and we continue to see encouraging order patterns into October. Break-fix MRO activity remains steady at healthy levels within most of our core end markets. In addition, we believe the level of growth sustaining across our service center network partially reflects various secular growth tailwinds and supply chain requirements facing the U.S. manufacturing sector today. Our scale, local and consistent service capabilities, and technical knowledge of motion and control products and solutions are driving greater growth opportunities across both legacy and emerging end markets as these tailwinds persist. We also continue to benefit from sales process initiatives and ongoing pricing actions, as well as increased traction from our cross-selling efforts. Earlier this month, our broader U.S. Service Center leadership team gathered in Cleveland for the first time in three years. The excitement and energy surrounding our core business today is meaningful, and our teams are making significant progress, deploying a number of strategic actions designed to further catalyze our growth and margin profile long-term. Sales growth also remains solid in our engineered solutions segment, which, as indicated in our press release this morning, is the new name of our former fluid power and flow control segment. As we continue to strategically expand this segment, including the scope and capabilities of our fluid power, flow control, and automation businesses, we believe the new name aligns better with our core value proposition and leading technical capabilities across these higher engineered products and solutions. These specific elements are integral to the solid growth we're seeing across this segment. Of note, engineered solution segment organic sales growth of 18% accelerated from 14% last quarter. Growth in the segment continues to benefit from firm demand across longer cycle industrial OE, off-highway mobile, and process flow verticals. Our fluid power team continues to see healthy demand across many of our leading engineered solutions. from customized manifolds and industrial power units to pneumatic automation systems and advanced solutions tied to IoT, telematics, and the electrification of fluid power systems. In addition, MRO activity and capital spending on process infrastructure remains positive in our core flow control in markets. with incremental support from new business tied to our customers' decarbonization efforts. We also continue to see healthy order growth and backlog across our automation platform. Our automation growth strategy and value proposition is gaining further traction across the market as customers manage through structural labor constraints and evolving production considerations in the post-pandemic industrial economy. 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. Overall, the momentum sustaining across engineered solution segment is encouraging, particularly when considering ongoing supply chain constraints and component delays. which are impacting the timing of system builds and shipments. Our industry position and supplier relationships provide the ability to manage through these ongoing constraints near term, and we continue to work with our suppliers to optimize component availability going forward. In addition to sustained top line momentum, we had another strong quarter managing inflationary pressures through channel execution and additional countermeasures. Combined with our cost discipline and efficiency gains, we grew EBITDA nearly twice the rate of sales growth and expanded EBITDA margins year over year for the eighth straight quarter, while EPS grew nearly two and a half times the rate of sales during the quarter. So really solid flow through once again with strong contribution from both segments. At this time, I'll turn the call over to Dave for additional detail on our financial results and outlook. Thanks, Neal.

First, just another reminder that our quarterly supplemental investor presentation is available on our investor site for your additional reference. I will start by reiterating Neal's comments on the solid quarter and the ongoing execution by our team. It's great to see the momentum. So now for a few more details on the quarter. consolidated sales increased 19.1% over the prior year quarter. Acquisitions contributed 20 basis points of growth, which was offset by a 50 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 19.4% on organic basis. As it relates to pricing, we estimate the contribution of product pricing on year over year sales growth was approximately 500 basis points in the quarter, consistent with last quarter. As a reminder, this assumption only reflects measurable top line contribution from price increases on SKUs sold in both year-over-year periods. Turning now to sales performance by segment, as highlighted on slide six and seven of the presentation, sales in our service center segment increased 20.3% year-over-year on an organic basis when excluding the impact of foreign currency. Growth remains broad-based across our core end markets, but what's strongest was in food and beverage, mining, metals, pulp and paper, energy, aggregates, and lumber and wood. Within our engineered solution segment, sales increased 18.4% over the prior year quarter, with acquisitions contributing 60 basis points of growth. On an organic basis, segment sales increased 17.8% year-over-year, and over 35% on a two-year stack basis. Segment sales growth is being supported by strong water rates and backlog across our fluid power division, sustained customer MRO and CapEx spending in process flow infrastructure, and ongoing healthy demand for our next generation automation solutions. By end market, segment demand during the quarter was strongest within metals, mining, agriculture, chemicals, technology, food and beverage, and machinery. Extended supplier lead times and inbound component delays continued to weigh on segment sales growth during the quarter, but the overall impact remains limited to date. Moving to our gross margin performance, as highlighted on page 8 of the deck, gross margin of 28.9% increased 24 basis points compared to the prior year level of 28.6%. During the quarter, we recognized LIFO expense of $9.1 million compared to $3.6 million in the prior year quarter. The net LIFO headwind had an unfavorable 52 basis point year-over-year impact on gross margins during the quarter and reflects supplier product inflation and ongoing inventory expansion year-to-date. Overall, underlying gross margin trends were in line with our expectations during the quarter. Our team continues to respond well to macroinflationary dynamics with broad-based channel execution, pricing actions, and ongoing margin countermeasures. As it relates to our operating costs, selling, distribution, and administrative expenses increased 11% on an organic constant currency basis compared to prior year levels. SD&A expense was 18.8% of sales during the quarter, down from 20.3% during the prior year quarter. Despite ongoing inflationary headwinds, including higher employee related expenses, our teams are doing a great job of controlling costs in the current environment as we leverage our operational excellence initiatives, shared services model, and technology investments. Overall, our solid sales growth, gross margin management, and cost leverage drove a 34.2% increase in EBITDA over prior year levels. In addition, even a margin of 11.2% increased 125 basis points compared to prior year levels. This includes an unfavorable 52 basis point year-over-year impact due to LIFO. Lastly, reported earnings per share of $1.97 was up 45% from prior year earnings per share levels. Moving to our cash flow performance, Cash generated from operating activities during the first quarter was $25.9 million, while free cash flow totaled $20.4 million. As a reminder, the first quarter is typically our lowest cash generation quarter from a seasonal perspective. Ongoing demand momentum and sales mix were other influencing factors on working capital during the quarter. Looking ahead, we expect easing working capital trends as the year progresses. including some benefit from the conversion of work in process tied to our engineered solution segment, as well as continued benefits from our working capital initiatives. From a balance sheet perspective, we ended September with approximately $148 million of cash on hand and net leverage at 1.1 times EBITDA, which is below the prior year level of 1.7 times adjusted EBITDA. Our revolver currently has approximately $490 million of available capacity and an additional $500 million accordion option. We also have incremental capacity on our AR securitization facility and uncommitted private cell facility. Turning now to our outlook, as indicated in today's press release and detailed on page 10 of our presentation, we are raising full-year fiscal 2023 guidance to reflect the strong first quarter performance and increased assumptions for the first half of the year. We now project EPS in the range of $6.90 to $7.55 per share based on sales growth of 5% to 9%, including a 6% to 10% organic growth assumption, as well as EBITDA margins of 10.9% to 11.2%. Previously, our guidance assumed EPS of $6.65 to $7.30 per share sales growth of 3% to 7%, and EBITDA margins up 10.8% to 11.1%. Our sales outlook continues to take into consideration broader economic uncertainty, as well as ongoing inflationary and supply chain pressures. We are also mindful of the potential of some moderation and normalization of order rates driven by the slower industrial activity and growth as the year continues to play out. We have incorporated these assumptions into our updated guidance, particularly within the second half of our fiscal year. In addition, based on month-to-date sales trends in October and our near-term outlook, we currently project fiscal second quarter organic sales to grow by a low to mid-teen percentage over the prior year quarter. Please note that sales comparisons are more difficult as the second quarter progresses, especially as we comp against the strong sales growth we saw last December. In addition, we expect potentially more subdued scheduled maintenance activity into the seasonally slower late fall and winter months of this year as customers manage calendar year-end budget spending in an uncertain environment. Lastly, based on our low to mid-TNORC index sales growth assumption, we expect second quarter gross margins to be relatively unchanged compared to first quarter levels and SD&A expense down slightly on a sequential basis. With that, I'll now turn the call back over to Neil for some final comments.

Thanks, Dave. So to wrap up and summarize, we feel good about the sustained momentum we are seeing in the early part of our fiscal 2023 year. The performance is providing strong evidence of the favorable position we have as structural and secular tailwinds persist across the industrial sector. From critical break-fix MRO support at a local level to an expanding portfolio of emerging technologies and specialized engineering solutions. We believe our capabilities and strategy are significant as customers reconfigure and reinforce supply chains in support of their own growth strategies long term. The underlying fundamental backdrop is further supported by increasing evidence of reshoring and localizing production back to North America. This is evident when considering U.S. manufacturing capacity utilization was at a 22-year high in September. At the same time, U.S. manufacturing infrastructure is aged, and our customers' technical service and support requirements are increasing. We believe this backdrop could present an extended period of structurally higher break-fix MRO activity, as well as ongoing investment in the refreshing and expanding industrial production infrastructure and capacity across North America. This will require strong channel partners with leading technical capabilities, next generation solutions, strategic supplier relationships, and industry leading talent. Our strategy and growth initiatives are strongly aligned with these trends and requirements. As Dave mentioned, we remain cognizant of the uncertain economic backdrop near term, including the potential impact of higher interest rates on business investment globally. While potentially slowing demand industry-wide in coming quarters, we believe our industry position, diversified in-market mix, and notable self-help opportunities can continue to drive above-market growth going forward. In addition, as we've shown in the past, our business model and operating discipline provides the playbook and flexibility to easily adjust, if need be, while simultaneously generating significant cash flow. And lastly, our balance sheet and liquidity provide strong support for ongoing organic investment and pursuit of strategic M&A opportunities in the current environment. So overall, it's great to see how the year started, and we remain very focused on what's ahead as we progress towards our next milestone of $5 billion in revenue and 12% EBITDA margins. Once again, we thank you for your continued support, and with that, we'll open up the lines for your questions.

Thank you. We will now begin the question and answer session. If you would like to ask a question, please pick up your handset, press one followed by four on your telephone keypad. If you would like to withdraw your registration from the queue, please press the one followed by the three. As a reminder, if at any time you need to reach an operator, please press star zero. We'll pause for just a moment to compile the Q&A roster. And our first question comes from the line of Chris Dankert of Loop Capital. Please proceed with your question.

Hey, morning, everyone. I guess first off, just a very genuine congratulations to you and the whole team over there at Plymouth. You guys should be very proud of this result here. So kudos. I guess first question, you know, thinking about the guide, I mean, incredible, you know, one cue. If I'm reading kind of the tea leaves you gave on two cue correctly, are we assuming kind of midpoint of the guide organic growth drops, you know, to flat in the back half of the year? Am I reading that correctly? And just how do we think about how you're the shape of the year, I guess, baked into guidance today?

Yeah, the guide, you know, at the midpoint would imply, you know, flat to up modestly second half organic growth, you know, based on that uncertainty out there. So, you know, if, clear vision, obviously, of the backlog position through the second quarter. So just be prudent in terms of that uncertainty that's still out there as we think about the macro and that outlook for the back half of the year at this point.

Got it. Understood. And then just to kind of move down the line a bit to, you know, SG&A and EBITDA margin, impressive execution in the first quarter here. But, you know, typically, or at least in the past, in the recent several years here, first quarter EBITDA margin has been kind of the lowest of the year. Is it fair to say that, again, based on guidance, we're thinking kind of an inverse shape, just again, kind of 1Q is a high watermark given the level of growth we've seen here?

We did suggest here again, second quarter, consistent with the first quarter. The big factor is the LIFO headwinds continuing to weigh on us. You think about, once again, the random demand in this business as some of those parts hit the radar in terms of remeasurement. So we're going to see a longer tail on that. Still seeing some of those economic increases come through. So just being cognizant of that continued LIFO headwind as we think about the guide here and how that plays out. We'd expect that to ease, obviously, as we move across the year. So could point to a little bit of an upside then, as you think about, from the current rates. But Q2, consistent with Q1, as we have it pegged right now.

Just to follow up on that, I guess, forgive me if I've missed it, but is current LIFO expected to be like a $20 million drag on the year right now?

No, it could be upwards of $30 million right now, is the way we're calling it.

Got it. Got it. Thanks so much for the color. And again, congrats on the core guys.

Thanks, Chris.

And our next question comes from the line of David Mancy of Baird. Please proceed with your question.

Thank you. Good morning, everyone. Thanks for renaming the engineered solution segment. That'll save us all a lot of trouble going forward. Dave, on your second quarter comments regarding gross margin being unchanged, I didn't catch it. Were you referring to the year over year or quarter to quarter?

It's actually from Q1.

Got it. Okay. And then I hate to get too granular here. You beat the street by what looks like 36 cents. I don't know exactly what your outlook was, but you raised the guide at the midpoint by 25 cents. I assume we shouldn't read anything into that given the October strength. Or if you could just talk about it, are there any leading indicators that are more troublesome today than what you saw 75 or 80 days ago? Or am I just reading too much into that?

Yeah, I would say, David, not anymore. We're just trying to be mindful of, hey, the various cross-currents and things we read that our customers read as well. But our dialogue with our teams, with our customers continues to remain constructive. We're pleased with the solid start thus far in the quarter. We know that comparables get a little stronger as we go through, and especially if we think back to last December. And then after that, you know, we've got it potentially being relatively flat. As we think about broader market, is it going to slow a little bit? I think we could build a case that the general market could, but we are definitely working on how we perform above market and take advantage of our own growth initiatives, plus our position for what we feel are very unique, very strong, secular trends that I don't think our business has seen or experienced quite some time or if forever.

Yeah, okay, thanks. We do appreciate that conservatism. Oh, here, just a couple more so I can slide in here. So first on the strength and off-highway mobile, you've been seeing that for some time now. Is there an infrastructure demand pull there? And are you seeing any other kind of these, you know, programmatic kind of government spending pull forward of demand in any of your business segments? And then second, Neil, just, and then I'll hop off. Automation, could you talk about what industries you're having the most success in automation or applications? Thank you.

Sure. So if I think about fluid power and off-highway mobile, I don't think there's anything unique in driving it from general market conditions. I think we are growing in the segment as we expand our solutions and capabilities, as we bring electronic controls in as we expand the offering and capabilities that many of these midsize OEMs are introducing new features on their equipment and participating in a good marketplace to pull those through. So we feel like we're growing and broadening our solution set with them and collectively we're both doing well in the market. And then on the automation side, it's really the full range. If I think about the cross-sell potential, given our embedded position and very important capital equipment with the service centers across those segments, whether they be food and beverage, machinery, paper, more automation solutions are coming in. We think about robotics and machine tending and how that's helped. or material movement with mobile robots inside of plants and facilities. That's helping with labor bottlenecks that can exist for our customers. And then vision systems are really increasing output and the quality control around consumer goods and packaging and other industries. So we feel like many of these industrial segments are about 30, 35% penetrated with automation solutions. You know, we're not naive. It doesn't go to 100, but we feel like it materially steps up from here, and we plan to fully participate.

That all sounds great. Thanks a lot, guys. Congrats. Thank you.

And again, as a reminder, to register questions, please press the 1 followed by the 4 on your telephone. Our next question comes from the line of Ken Newman of KeyBank Capital Markets. Please proceed with your question.

Hey, good morning, guys. Congrats on the quarter. Could you just expand a little bit on what you're expecting in terms of industry consolidation in the back half? I'm curious how much you think or you're assuming you're going to outperform the industry.

Yeah, so we would look probably for the first half, we think market conditions, industrial production could be up mid-single digit. And then as we think about the back half, there could be a potential that there's a decline of mid-single digit in that side. So that's forming some of our views on the general market conditions and the guide. But with that, we feel like we were well positioned, our locations, our service capabilities, our broadening, expanding engineered solutions to perform very, very well.

Understood. For my follow-up, there was a large acquisition announced this morning between two of your larger suppliers. I'm not sure if you've gotten to take a look at that, but I'm curious if you have any initial color on just how much product overlap there is between Altra and Regal Rex Nord and whether we should think about this as a net positive impact for you going forward.

I did get to see it come across and exchange some congratulatory notes. We obviously know both suppliers and the businesses. I assume it will take a little bit of time for the regulatory review and approval, but we see it as positives. Again, strong position with both as it goes through. I think as they take out those extended solutions, we would view that as additive. So no adverse opinion on it from our side.

Okay. One more if I could just squeeze it in. And I'm sorry if I missed this, but did you quantify how much the automation business was up organically in the quarter? And curious if you could just give us an update on where run rate annualized sales are.

Sure. So I'd say the growth rate was similar to what we saw last quarter, kind of that mid-single digit up organically. With that, order rates and backlog did grow. So as we mentioned in the comments, the segment has experienced some backlog or delays of certain components that have held up systems in going out. We continue to see that. Our September number was very strong. in doing it, so our expectations are that the segment will continue to perform and perhaps outperform what will be the overall blended conditions for the business as we think about it going forward. So encourage continued to work, and it is one that we will look at making the appropriate organic and inorganic investments to grow. But even with that, still up north of $150 million in terms of annualized run rate at this point.

Understood. And then is there, sorry, maybe just the M&A pipeline within that business. I know you talked positively about it being active. Any color there? And how do you think about capital deployment amid higher macro uncertainty?

Yeah, so overall, I mean, obviously, we continue to do a nice job with our financial position, and our priorities remain Where we can make organic investments in the business, we will do. The M&A acquisitions or opportunities that we have in these times, we're busy to our priorities that we've talked about in the past. So those would remain our big ones. And then obviously, hey, we'll still always be committed to the dividend, and then share repurchase will be a view more opportunistically look.

Understood. Thanks for the time.

Thank you.

And we do have a follow-up question from the line of David Bante of Baird. Please proceed with your question.

Yeah, quick follow-up here. Could you remind us the differences of the company in terms of mix and business in general relative to 2015 and 2016, we saw a retrench in IP of about a mid-single-digit amount back then. And, of course, that was accompanied by oil rolling over hard in 2014 and 2015. But could you just remind us the key differences of the business makeup today versus then?

Yeah. So I don't have it all compared to that. But against that time, you know, David, we've clearly grown fluid power flow control and now automation on the side, so as engineered solutions, you know, approaches, you know, 30, 33% of the business. We expect in time, we look down the road, the company mix could be, would be 60 to 40 and perhaps even further out, 50-50, with a strong focus on growing both. I've been very impressed with service center performance. in the time, and many of those secular trends benefiting. So in that time period, we think we had managed decrementals well then, and we're continuing to demonstrate that capability if we have that type pullback that we can manage decrementals just like we've expanded our incrementals going forward.

And certainly much less oil and gas exposure, double ditched at that time, David, you know, kind of less than 4% now at this point.

Yeah, that's what I thought. I just would add to, you know, the exposure that we have around areas like food and beverage aggregates, the greater exposure there today, you know, as well as, you know, there's a category that we talk about around general industry. I think, as you know, that captures anything that's, you know, 4% or less of the business and a much larger percentage of the business today. than in prior cycles as well. So the diversification of the end markets is a notable element of applied today, certainly relative to prior cycles.

Got it. Thanks for the time, guys.

Thank you.

Thank you. At this time, I'm showing we have no further questions.

I will now turn the call over to Mr. Scrimshaw for any closing remarks.

Hey, I simply want to thank everyone for joining us today and we look forward to seeing many of you throughout the quarter.

Thank you.

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