speaker
Liz
Conference Call Operator

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 followed by the number one on your telephone keypad. Prior to asking a question, lift your hands up 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 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.

speaker
Ryan Cieslak
Director of Investor Relations and Treasury

Okay, thanks, Liz, and good morning to everyone on the call. This morning, we issued our earnings release and supplemental investor deck detailing our second quarter results. Both documents are available in the investor relations section of applied.com. Before we begin, just a reminder that we'll discuss our business outlook and make forward-looking statements. All forward-looking statements are based on current expectations subject to certain risks and uncertainties, including those that are detailed in our SEC filings. 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 President and Chief Executive Officer, and Dave Wells, our Chief Financial Officer. With that, I'll turn it over to Neil.

speaker
Neil Scrimshaw
President and Chief Executive Officer

Thanks, Ryan, and good morning, everyone. We appreciate you joining us. I'll begin today with perspective on our second quarter results and current industry conditions, followed by some thoughts on the recent acquisition of Hydrodyne and expectations going forward. They will then provide additional financial detail on the quarter's performance and updated outlook. And I'll then close with some final thoughts. Overall, we had a productive second quarter that highlights the operational resiliency and self-help opportunities of our differentiated industry position and strategy. We grew earnings and expanded margins over the prior year in an environment where demand remained soft and sales declined slightly. We also made progress in positioning the company for stronger growth moving forward. This includes ongoing investment in our sales tools and operational systems and technical talent, the building of business funnels, which is driving stronger orders, as well as the announcing and closing of our strategic acquisition of Hydrodyne, which I'll discuss in more detail in a moment. As it relates to the quarter's results, both EBITDA and EPS exceeded our expectations, increasing approximately 3% and 7% over the prior year, respectively. We benefited from strong gross margin performance and cost controls. While low FIFO expense contributed to margin performance in the quarter, both gross margins and EBITDA margins still expanded nicely over the prior year when excluding the change in LIFO expense. The positive performance was primarily driven by channel execution and ongoing margin initiatives across various areas of our business, as well as variable expense adjustments and cost control inherent to our model and operational discipline. Margin improvement was led by our engineered solution segment, where EBITDA margins expanded 115 basis points over the prior year and exceeded 16% for the first time. Our engineered solution segment EBITDA margin has expanded over 450 basis points the past five years. We're making solid progress with our internal initiatives and operational enhancements. as we continue to scale this strategic area of our business. The segment's margin expansion highlights the strong market position and value proposition we have across our portfolio of fluid power, flow control, and automation solutions, and should enhance our mixed tailwind and overall margin expansion potential moving forward as segment sales begin to reaccelerate. As it relates to top line trends, average daily sales declined 3.4% over the prior year, which was in line with the guidance we provided in October of down mid-single to low single digits. We continue to operate within a muted in-market backdrop with customers conservatively managing MRO spending and delaying capital investments. Underlying demand improved slightly following the slow start to October but moderated and was below normal seasonal patterns during December. Most of December's weakness was concentrated later in the month and in our view was primarily tied to the timing of holidays this year with Christmas and New Year's falling midweek as well as extended customer plan idling and deferred maintenance activity within our service center segment. We estimate softer sales during the last two weeks of December negatively impacted the quarter's overall organic sales growth by approximately 100 basis points. When looking at our top 30 in markets, 11 were positive year over year in the second quarter, which is below the 13 reported last quarter. In markets that were up year over year included chemicals, food and beverage, pulp and paper, and technology. This was offset by declines primarily in machinery, transportation, aggregates, fabricated metals, oil and gas, and mining in markets. Mixed in-market demand has continued in the early part of our fiscal third quarter as customers are settling into the new year. and continue to operate at a gradual pace. Of note, January sales are currently trending down a mid-single-digit percent year over year on an organic basis. We believe ongoing macro policy and interest rate uncertainty remain headwinds. Weather has played a role across the southern U.S. region over the past month as well. That said, we do not view January sales as indicative of how the third quarter and the balance of the year could play out based on several directionally positive trends taking shape. Of note, various industrial macro data points are showing some signs of improvement. The new orders component of the ISM index was in expansionary territory in November and December. Bookings across our service center network are improving following a slow end to December, while feedback and sentiment among customers are more positive post the election. Our service center segment is well positioned as in-market demand re-accelerates. with approximately 50% of our service center business tied to technical break-fix situations across critical industrial processes, systems, and infrastructure. We believe demand for our service center products and technical support could ramp quickly and broadly over the next year as customers reengage production and catch up on required technical MRO activity. This will be particularly evident across heavy manufacturing, machinery, mining, metals, and aggregate markets, given their break-fix intensive nature and deferred maintenance in recent periods. In addition, a lighter regulatory agenda with the new U.S. administration represents a potential incremental new tailwind in many of our legacy end markets across our service center operations as well as within our flow control network. Combined, we estimate these break-fix intensive and more regulated markets represent about 40% to 50% of our total sales today. In addition, order momentum and business funnels are building across the technology vertical, which represents approximately 15% of our engineered solution segment and 5% of our overall sales. We're beginning to see stronger demand across the semiconductor sector and related spending on wafer fab equipment following the demand headwind we experienced in this sector over the past several years. Stronger customer activity across the technology vertical is encouraging and a potentially strong growth tailwind moving forward. We also continue to see positive momentum developing across our automation business, with orders strengthening year to date as various secular tailwinds continue to positively influence demand. These dynamics are driving ongoing adoption of collaborative and mobile robots, machine vision, and IoT solutions. Our strong application and engineering capabilities, along with an expanded footprint and facility capacity, will further supplement our potential in this high growth area of our business as discrete automation investments re-accelerate in coming quarters and demand for aftermarket and service support starts to emerge. On another encouraging note, order trends are beginning to stabilize and improve slightly across fluid power industrial and mobile OEM customers. If you recall, this has been a primary area of sales weakness for us over the past year. During the second quarter, reduced sales from industrial and mobile OEM fluid power customers negatively impacted our consolidated organic year-over-year sales growth rate by approximately 150 basis points. However, related orders from these customers were up 9% sequentially from the first quarter. and relatively unchanged year-over-year during December. Combined with more normalized OEM inventory levels following recent destocking and much easier comparisons, we expect the year-over-year sales trend and related impact in this area of our business to improve moving forward. This includes potentially re-emerging as a growth tailwind in coming quarters considering secular demand, and required investments developing across fluid power systems, as well as ongoing strategic investments we are making into this more specialized and highly technical area of industrial distribution. Of note, we are extremely excited about the growth and operational momentum we expect to build following the completion of our Hydrodyne acquisition at the end of December. Based in Dallas, Texas, Hydrodyne is one of the largest U.S. distributors focused on fluid power and motion control systems with advanced service capabilities and product offerings in hydraulics, pneumatics, electromechanical, instrumentation, filtration, and fluid conveyance. The addition of Hydrodyne aligns extremely well with our strategy With anticipated sales of $260 million and EBITDA of $30 million in the first year of ownership, Hydrodyne strengthens our number of one fluid power position by extending our footprint across the southern U.S., where they operate with a team of nearly 500 associates out of 33 locations. Hydrodyne also brings strong technical capabilities that complement our current fluid power service and solution portfolio, with approximately 30% of sales tied to repair, engineering and design, system fabrication, hose assemblies, and other value-added solutions. Our combined technical capabilities and access to premier fluid power, motion, flow control, and automation technologies present a powerful value proposition for our customers that will accelerate cross-selling and market penetration. This includes enhancing our collective efforts to serve the rapid pace of innovation developing across fluid power systems. Our strategy and teams are aligned to support thousands of specialized OEMs and industrial manufacturers, engineer, design, and integrate these advanced features into their mobile and industrial equipment with world-class technologies from top fluid power suppliers. The strength of our combined technical teams and footprint will also allow us to more effectively and broadly capture growth opportunities developing across emerging end markets and commercial applications. We provide more detail around Hydrodyne acquisition in slides five and six of our second quarter earnings presentation. And Dave will cover off on some of the key financial considerations, including our initial accretion expectations. In summary, we're very excited to welcome Hydrodyne and their capabilities to the applied platform. Overall, I'm encouraged by the progress we are making with our strategy, including the ongoing build-out of our engineered solution segment. Following the Hydrodyne acquisition, the segment is now approaching 40% of overall sales compared to 15% 10 years ago. The strategic expansion of this segment has further differentiated our industry position and strengthened our competitive moat. We've established and fortified our leading market positions, building and serving critical motion, power, and control systems across nearly every industrial vertical. It's created a unique and potentially significant cross-selling opportunity throughout our legacy embedded customer base, while increasing exposure to faster growing end markets and secular tailwinds. It's also expanding our addressable market and allowing us to evolve and enhance our competitive position as the industrial sector and related systems advance with new age processes and technologies. Combined with a positive margin profile and ongoing operational enhancements, we expect our engineered solution segment to be a strong and differentiated driver of earnings growth and returns going forward. Lastly, I'm encouraged by the ongoing capital deployment opportunities with our industry position, balance sheet, and cash flow generation continue to support. Year to date, we've deployed over $380 million in capital focused on enhancing our growth position and shareholder returns. This compares to $251 million of capital deployed for all of fiscal 2024. While partially reflecting our recent Hydrodyne acquisition, we also continue to return capital to share buybacks, including deploying $30 million on share repurchases year to date. In addition, we announced this morning a 24% increase in our quarterly dividend. The increase is in line with our expectation for greater dividend growth as we align annual increases with normalized earnings growth, including the strong earnings and cash generation achieved in recent years. Our capital allocation priorities remain unchanged and highly focused on organic investments and M&A. However, our broader capital deployment trends year to date showcase the multiple opportunities and ways we can deploy capital to optimize shareholder returns as we continue to scale our business and achieve our strategic goals. Moving forward, our balance sheet and financial capacity remain extremely well positioned to continue to support M&A and other capital deployment opportunities. We have ongoing scope for additional buybacks for the remainder of fiscal 2025 based on our current financial capacity and the intrinsic value we see across our company long-term. In addition, our M&A pipeline and related due diligence remains active across both segments, with a primary focus on bolt-on and midsize targets, where we can create significant shareholder value. At this time, I'll turn the call over to Dave for additional detail on our financial results and outlook.

speaker
Dave Wells
Chief Financial Officer

Thanks, Neal. Just another reminder before I begin. As in prior quarters, we have posted a supplemental investor presentation to our investor site for your additional reference. This quarterly presentation provides a more detailed recap of our second quarter results, updated guidance, and details on our recent acquisition of Hydrodyne. Turning now to our financial performance in the quarter, consolidated sales decreased 0.4% over the prior year quarter. Acquisitions contributed 190 basis points, while the difference in selling days had a positive 160 basis point impact. This was partially offset by a negative 50 basis point impact from foreign currency translation. Vetting these factors, sales decreased 3.4% on an organic daily basis. As it relates to pricing, we estimate the contribution of product pricing on year-over-year sales growth was slightly less than 100 basis points for the quarter and largely in line with our expectations. Turning now to sales performance by segment, as highlighted on slides 9 and 10 of the presentation, sales in our service center segment declined 1.9% year-over-year on an organic daily basis. This excludes a positive 30 basis point impact from acquisitions, a positive 160 basis point impact from the difference in selling days, and a negative 70 basis point impact from foreign currency translation. The organic sales decline was primarily driven by reduced MRO spending, lower capital maintenance project activity, extended customer plant idling, and the timing of holidays in the month of December. The impact from weaker sales in late December was most pronounced across our service center operations. This followed more stable trends in October and November, where segment sales were relatively unchanged year-to-year. Growth in national accounts during the quarter was more than offset by weaker sales from local accounts. Segment EBITDA increased 1.4% over the prior year, while segment EBITDA margin of 13.4% improved nearly 30 basis points year-over-year. Within our engineer solutions segment, sales increased 0.4% over the prior year quarter, with acquisitions contributing 5.1 percentage points of growth, and the impact from one extra selling day, providing an additional 160 basis points of growth. On an organic daily basis, segment sales decreased 6.3% year over year. The decline was primarily driven by ongoing sales weakness across fluid power OEM customers, mostly reflecting reduced demand across mobile fluid power markets. This was partially balanced by more stable trends across industrial in-plant applications as well as improving demand in technology-related fluid power and markets. Meanwhile, sales within our automation operations declined by a high single-digit percentage year-over-year on an organic daily basis. This is consistent with last quarter and primarily reflects or headwinds from customers continuing to delay spending in response to macro uncertainty. Software fluid power and automation sales were partially offset by ongoing growth across our flow control operations. where average daily sales increased 2% year-over-year and over 4% sequentially, reflecting firm project activity on process infrastructure. In addition, despite the sales decline in the quarter, segment EBITDA increased 8% over the prior year, while segment EBITDA margin of 16.3% expanded 115 basis points from prior year levels. the performance primarily reflects strong gross margin expansion tied to our internal initiatives and value proposition, more favorable mix, and to a lesser extent, lower LIFO expense, as well as contributions from ongoing operational enhancements as we continue to execute our engineered solution strategy. Moving to consolidate gross margin performance, as highlighted on page 11 of the deck, gross margin of 30.6% increased 114 basis points compared to the prior year level of 29.4%. During the quarter, we recognized LIFO expense of $0.7 million compared to $3.4 million in the prior year quarter. This net LIFO tailwind had a favorable 25 basis point year-to-year impact on gross margins. Excluding this impact, we still generated solid gross margin expansion in the quarter despite ongoing mixed headwinds tied to lower sales across our engineered solution segment and local accounts. Underlying performance reflects the strong channel execution, our engineered solution segment performance, and the benefits of ongoing margin initiatives. As it relates to our operating costs, selling, distribution, and administrative expenses increased 2.3% compared to prior year levels. SD&A expense was 19.3% of sales during the quarter, reflecting an increase of 51 basis points from the prior year quarter. On organic constant currency basis, SD&A expense was up 0.3% over the prior year period, but down over 1% when adjusting for the extra payroll day in the quarter. Our team did a nice job controlling costs in the quarter against the muted demand backdrop, while managing inflationary pressures in order to continue to balance and sustain critical investments for growth. We also benefited from ongoing efficiency gains and reduced variable expense on lower sales, which helped balance higher administrative and occupancy costs. In particular, the quarter included approximately $1.5 million of due diligence and transaction related expenses related to the Hydrodyne acquisition. Overall, positive gross margin performance coupled with the benefit of spend initiatives resulted in reported EBITDA increasing 3.3% year-over-year, while EBITDA margin of 12.6% expanded 45 basis points from the prior level of 12.1%. Combined with greater interest income on higher average cash balances and a slightly reduced share count, we reported earnings per share of $2.39 which was up 6.7% from prior year adjusted EPS levels of $2.24. Of note, prior year adjusted EPS excludes a pre-tax $3 million or $0.08 per share deferred tax evaluation allowance benefit. Moving now to our cash flow performance, cash generated from operating activities during the second quarter was $95.1 million, while free cash flow totaled $89.9 million, representing conversion of 96% relative to net income. Year-to-date, we have generated approximately $212 million of free cash flow, which is up 34% year-over-year and represents conversion of 114% relative to net income. Our cash flow growth so far this year primarily reflects more modest working capital investment compared to prior year, as well as ongoing progress with internal initiatives and our enhanced margin profile. Turning now to our acquisition of Hydrodyne, as Neal mentioned, we were extremely excited about this transaction. It represents another notable milestone for Applied and our overall value proposition to customers, suppliers, and all stakeholders. Not only does the acquisition fit extremely well with our M&A priorities and return-based capital deployment strategy, Hydrodyne's local customer-centric culture and operational caliber aligns well with our operating framework, which will provide a strong foundation on which to build positive momentum early on. As it relates to some of the financial considerations of the deal, the purchase price of $276 million was funded with cash on hand, representing a transaction multiple of 9.1 times enterprise value to forward EBITDA before anticipated synergies. We expect the transaction to generate approximately $260 million in sales and $30 million in EBITDA, as well as be accretive to EPS for approximately 15 cents within the first 12 months of ownership. The EPS accretion estimate is net of projected acquisition and tangible amortization expense of over $11 million in the first year, or 22 cents per share, as well as reduced interest income on lower cash balances after funding the transaction. In addition, these assumptions are before anticipated synergies tied to cross-selling, leveraging complementary solutions, harmonizing technical capabilities and systems, and driving operational efficiencies across the combined operating platforms. We expect synergies to begin to develop in fiscal 2025, but be more meaningful in fiscal 2026 and 2027. Based on our initial projections, we are targeting net synergies of $5 million to $10 million within the first three years of ownership. Of additional note, following the transaction, our balance sheet remains strong, with pro forma net leverage increasing to a modest 0.5 times and approximately $1.5 billion of balance sheet capacity remaining. Turning out our outlook, as indicated in today's press release, and detailed on page 14 of our presentation, we're raising full year fiscal 2025 guidance to reflect our stronger second quarter earnings performance and estimated initial contribution from our acquisition of Hydrodyne. We now project EPS in the range of $9.65 to $10.05 based on sales growth of 1% to 3% and EBITDA margins of 12.2% to 12.4%. Previously, our guidance assumed EPS of $9.25 to $10, sales growth of down 2.5 to up 2.5%, and EBITDA margins of 12.1 to 12.3%. Our updated guidance assumes full-year fiscal 2025 sales decline organically by 3% to 1% on an average daily basis, compared to our prior assumption of down 4% to up 1%. We are now assuming year-over-year organic sales trends improve more gradually in the second half of fiscal 2025. We believe this is reasonable given ongoing uncertainty tied to macro policy and interest rates, which could continue to restrain customer capital spending and production growth near term. We are also taking into account the slower start to early third quarter organic sales trends, which as noted earlier, are trending down by a mid single-digit percentage over the prior year in January. The midpoint of guidance now assumes average organic sales decline by a slow single-digit percent year-over-year in the second half of fiscal 2025, including mid-single to low single-digit declines in the third quarter, followed by a return to modest growth in the fourth quarter. We're projecting M&A generated sales, including Hydrodyne, to contribute 600 to 700 basis points of year-over-year sales growth in the second half of the year, partially offset by ongoing foreign currency transactions and translation headwinds. Overall, while we remain constructive on our setup moving forward, considering easier prior year comparisons, improving demand indicators, and sustained benefits from our internal initiatives, we believe a balanced approach to our near-term outlook remains appropriate to any more definitive signs of a positive inflection in underlying industrial activity. Lastly, from a margin perspective, we expect third quarter gross margins to decline sequentially to around 30%. This assumes a more normalized level of gross margin execution relative to our strong second quarter performance, as well as slightly higher LIFO expense. Combined with ongoing inflationary headwinds, anticipated growth investments, our annual merit increase, which was effective January 1st, and initial integration costs, mixed considerations from our Hydrodyne acquisition, we expect third quarter EBITDA margins to moderate sequentially to 12 to 12.2%. Those still expand year over year. Lastly, our updated guidance assumes initial EPS accretion from Hydrodyne is modest in the third quarter as we begin integration and align initiatives within a muted end market backdrop. We expect accretion to begin to ramp in the fourth quarter and end of fiscal 2026 as initial synergies are achieved and end markets begin to recover. With that, I will now turn the call back over to Neil for some final comments.

speaker
Neil Scrimshaw
President and Chief Executive Officer

So to wrap up, I'm proud of the applied team and our performance through the first half of fiscal 2025. We're delivering on our commitments and making strong progress toward our interim financial objectives of $5.5 billion of revenue and 13% EBITDA margins. Near term, we believe the underlying demand environment could remain muted and somewhat choppy pending a more defined direction on macro policies post the election. As our second quarter results show, we have the ongoing self-help opportunities to manage and perform well if demand remains sluggish near term. That said, as we look forward and consider our industry position, we continue to believe we are close to entering a very favorable growth period at applied. We feel good about the positive demand signals developing, including stronger order trends across our higher margin engineered solution segment. Investments over the past several years should optimize our organic growth potential as end markets begin to recover. This includes recent facility expansions to optimize our service capabilities across the technology vertical and our automation operations. A recent board meeting was held at one of these facilities where we saw firsthand the growth potential of our expanded capacity and technical market position, as well as some of the building customer activity beginning to develop. We also believe break-fix activity should accelerate across our service center network into the spring and summer as production schedules ramp back up. This could drive more heightened technical MRO and capital spending as customers reengage initiatives to modernize equipment and expand production facilities now with the election behind us and as additional transparency develops on U.S. trade policies and interest rates. Our technical domain expertise and access to core industrial equipment puts us in a leading position to help customers manage through these operational requirements. Lastly, we're in a strong position to benefit from ongoing industry consolidation over the next several years, considering the high fragmentation and technical requirements associated with our industry segment. We believe the drivers of consolidation are higher today. Customer supply chain focus has intensified, They are potentially facing one of the more favorable U.S. manufacturing backdrops in decades, while also managing through limited technical labor availability and greater mandates to eliminate operational risk. Accelerating innovation and significance of motion, power, and control systems are increasing service requirements, including access to new production solutions and system repairs. Combined with structurally higher inflation, we believe these considerations could accelerate consolidation across sector both organically and through M&A as customers and suppliers increase business with larger, more capable distributors. The value of our scale, technical service, engineering capabilities, strategic supplier relationships, and available balance sheet capacity has never been stronger in our marketplace. Overall, we look forward to fully capturing this growth potential through the remainder of fiscal 2025 and years to come. As always, we thank you for your continued support. With that, we'll open up the lines for your questions.

speaker
Liz
Conference Call Operator

Thank you. We will now begin the question and answer session. If you would like to ask a question, please pick up your handset, press star, followed by the number one on your telephone keypad. If you would like to withdraw your question from the queue, press star one again. 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. Your first question comes from the line of David Matthews with Bird. Please go ahead.

speaker
David Matthews
Bird

Thank you. Good morning, everyone. Good morning. The first question is, in the second quarter, excluding rebates and the LIFO tailwind, you improved core gross margin by about 80 base points year over year. And on one of the slides, you mentioned execution. Yes, segment and initiatives. I'm wondering if you can further refine the sources and the sustainability of that improvement.

speaker
Neil Scrimshaw
President and Chief Executive Officer

Yes, I can start, David. I would say in the energy segment, good performance. We got benefit from mix. Scale is coming through for us into that side, and so we think just overall good execution as the team looks to appropriately price to the value of the systems and solutions that we have. So positive in point of sale there, but also benefit in the technical nature of the products and solutions mix, as well as some of the customer side in that. I think as Dave pointed out, we did get some supplier benefit into the side. I would say roughly 10 to 20 basis points of that. that could have been or that was tied to achieving a higher tier into that side. So it came through into this quarter. We would not look for that to replicate necessarily in the third quarter. And that really points us to saying gross margins are more low 30s percent in the third quarter and the rest of the back half. But we did get, you know, another 10 to 15 basis points of just good continued execution across the business as well.

speaker
Dave Wells
Chief Financial Officer

You're getting your point, Dave. Stripping out that unusual, you know, support, vendor support in the LIFO, you know, which combined, again, 10 to 20 basis points on the vendor support, 25 basis points in the LIFO, solid underlying performance. About 50 basis points of that did come out of the engineering solution segment. You know, combination is a new indicated mix. I mean, a big piece of that reading through is So we said we were up, you know, 2%, you know, year-over-year in terms of our flow control, you know, shipments up 4% sequentially. That is one of our richer, you know, gross margin performing businesses, as well as just, you know, kind of here again, pricing for the value and some of the favorability we're seeing coming out of that segment. But beyond that, you know, proud to see the 5 to 15 basis points improvement in the service center side of the business. So really getting in all cylinders there with the continued work around operational efficiencies. pricing in both pieces of the equation and really maximizing the general benefit and the market position that we do hold.

speaker
David Matthews
Bird

Okay, thanks for the detail there. And second, Dave, maybe you could talk about depreciation and amortization due to the acquisition of Hydrodyne separately, just what is the step up there? And then also related to Hydrodyne, you mentioned today $5 to $10 million in synergies over the first three years. I'm wondering, number one, is that a run rate by the time you hit the end of three years? And then second, is that cost synergies, sales synergies, or both?

speaker
Dave Wells
Chief Financial Officer

Yeah, the majority, it's about, let me see, 70-30 mix in terms of sales synergies, cost synergies. We'll get those by virtue of benefits harmonization, you know, leverage of some of our, you know, licensing for, you know, both businesses, our legacy fluid power business and Hydrodyne on an Epicor product that we do have some very favorable, you know, licensing costs for. And then, you know, do anticipate, as I said, some obviously the sales synergies coming through as we continue to leverage and, you know, particularly, you know, given the underserved nature of that southeastern region that we've been looking to, you know, enhance our position and for so long as we targeted this acquisition, you know, seeing some of that come through. So combination of both the 22 cent impact in terms of depreciation, amortization expense, as we talked about stripping out, you know, specifically hydrodynes. Yeah.

speaker
Ryan Cieslak
Director of Investor Relations and Treasury

Yeah, maybe I'll take that 1 just as relates to depreciation day of an amortization into the back half. You know, we will step up to in total closer to 17Million per quarter. And so, including the intangible amortization as well as their depreciation about 3Million of incremental DNA or depreciation amortization per quarter in the back half of the year.

speaker
Neil Scrimshaw
President and Chief Executive Officer

Yeah, and Dave, I'd say then as we think about the synergies, as we break them out, we think the cost margin side is in that more 70 to 80 into that. Obviously, a scale helps us some in that. We think on the purchasing side, some of the indirect support. But with that said, we're excited about the additional sales synergy opportunities, and perhaps in that 20 to 30% range, that opens up to leverage the capabilities, strong service and repair and solutions in the geographies that can link with the service centers in, and then the acceleration that we think across those in-market segments. in electronic controls, perhaps electrification in time will open up some of the cell synergies as well. So overall, very excited about the strategic addition to us in a core focus area of fluid power and in an important geography.

speaker
David Matthews
Bird

I appreciate the detail. Thank you.

speaker
Liz
Conference Call Operator

And your next question comes from the line of Ken Neiman from KeyBank Capital Markets. Please go ahead.

speaker
Ken Neiman
KeyBank Capital Markets

Thank you. Morning, guys. Morning. You know, first, I just wanted to clarify, Neal, on the January trend, you know, trending down mid-single digits. You know, I think it makes sense that it's being impacted by some of the holiday timing that you saw in December. But I am curious if you have any color on what the weekly trends through the month or how the ADS trends have kind of shifted from the beginning of the month towards the end and whether or not we're back to pre-shutdown levels or when you expect us to get there.

speaker
Neil Scrimshaw
President and Chief Executive Officer

Sure. And so I would say, Ken, most of the drag in January was early in the month and I'd say probably the first couple of weeks down double digits. I would really say the last couple of weeks up low single digit. A few days to go here as we move through. So that would be the break. And so that builds part of our view that it's hard to extrapolate holidays in November, December, and the early start of January as the full indicator. So we're encouraged by the pickup over the last couple of weeks.

speaker
Ken Neiman
KeyBank Capital Markets

Right. That's very helpful. And then, Neal, you know, you're essentially at your 40-60 segment mix between the engineer solutions and service center businesses. Do you or the board have a sense of where you want that mix to ultimately go from here? And how do you envision the pace of that mix shift change from the growth that you've seen in the last five years?

speaker
Neil Scrimshaw
President and Chief Executive Officer

So I think we've got still great potential on both segments. You know, we talked about it, time to get to the perhaps the 60 service center, 40, approaching that. With that said, opportunities on both segments to organically grow, cross-sell opportunities that help both, as well as future M&As. Could I anticipate engineered solutions growing past 40% in time to 45 or 50, a good healthy balance across the business? Absolutely. But that will play out, and there will be, you know, continued opportunities for bolt-ons on the service center side. But if it stabilizes out at a future date at a good healthy 50-50 with both profitably growing, that will be a good spot for the company.

speaker
Ken Neiman
KeyBank Capital Markets

Yep, that's helpful. Maybe if I could just squeeze one more in here. You talked about the year-to-date engineered orders being up year-over-year, just driven by automation and tech. Just to clarify, is the expectation that the revenue growth in those subsectors flip positive here in the second half? And maybe just some color on where the automation business is run rating from a revenue perspective today.

speaker
Neil Scrimshaw
President and Chief Executive Officer

Yeah, so I'll start and work backwards. I'd say run rate of the automation businesses probably in that 240 type range around there on the side. We did touch on order rates encouraging automation in the high single-digit tech, double-digit in that front. But, you know, collectively good activity broadly in engineered solutions, maybe more low single digit uh with the uh the broader impact that we've had in fluid power and in the off highway mobile segment but as we talked in the remarks a little bit of an improvement there that we think could be uh encouraging um as it uh as it goes across uh as far as the conversion timing you know it really depends some of them are very you know quickly in conversion other that have a more technical nature or complexity in the build-out could be 120, perhaps more, days into the site in that technical conversion on the site. So it really depends on the application of that conversion or where it fits in with the customer and their overall project, which that can also cause some slotting or timing impacts as well.

speaker
Ryan Cieslak
Director of Investor Relations and Treasury

And then Ken, as you think about the guidance by segment from the top line perspective, I think there is, it relates to the down mid single to low single digits organically in the third quarter. We think the segments could probably trend around that in somewhat similar way this quarter. And then if you get into the fourth quarter, there's a path clearly given the order trends that we've seen in the engineered solution segment to start to see the segment grow a little bit above where we see the service center segment from that standpoint.

speaker
Ken Neiman
KeyBank Capital Markets

Very helpful. Appreciate the call, guys.

speaker
Liz
Conference Call Operator

Your next question comes from the line of Chris Dankirk with Loop Capital Markets. Please go ahead.

speaker
Chris Dankirk
Loop Capital Markets

Hey, morning, guys. Thanks for taking the questions. I guess, congrats to the quarter. We're looking at gross margin here. The delineation there was very helpful. I guess, anything to call out on the freight side? That was a tailwind in the quarter. How do we think about maybe freight going into the back half of fiscal 25 here?

speaker
Neil Scrimshaw
President and Chief Executive Officer

Chris, I'll start. I'd say nothing significant to call out. Teams continue to have a good focus and execution on freight. and we will continue that emphasis. We know the importance of it. So I don't think a material input in the quarter, nor a big change in expectations for the back half.

speaker
Dave Wells
Chief Financial Officer

Correct. We've talked about rates have gone up significantly. We do have some nice contractual pricing, and the team is very focused on freight recovery and, you know, Kind of matching that. So really not a mover for us either direction as we've seen some of the ebb and flow of this freight cost.

speaker
Chris Dankirk
Loop Capital Markets

Helpful. Thank you so much there. And then maybe to zoom out to 30,000 feet for a second. A lot of talk around changes to the USMCA. I know we've been hearing some better investment conversation from your metals customers. Anything else that you're hearing or trying to keep in mind around trade talks and kind of how customers are positioning themselves here?

speaker
Neil Scrimshaw
President and Chief Executive Officer

Yeah, so if we think about that, you know, we have very good business and operations in Canada, in Mexico. A large portion of that is that they're highly contained and serving customers and segments in. In Mexico, not only the service centers and fluid power, recent, you know, strong addition in automation with COPAR in that front. So, you know, to date, we think that's potentially lower impact. To be determined, the views on the views on tariffs and what that impacts can be in that front, or is it to get improvements on immigration and perhaps drugs and some other policies in that? But you know, to date our view is it will not have a significant impact in in US and in those countries. It can be adjustment. If I look back at. Trump policies, you know, 1.0, we're very effective at managing the tariffs and the impacts and the 232 and the various 301 lists into that. We still have that in our playbook, you know, if or when those tariffs develop, we'll know how to execute.

speaker
Chris Dankirk
Loop Capital Markets

Understood. Thanks so much, guys.

speaker
Liz
Conference Call Operator

Your next question comes from the line of Sabrina Abrams with Bank of America. Please go ahead.

speaker
Sabrina Abrams
Bank of America

Hey, good morning, guys. Morning. You talked about, I guess, pricing coming in a little under 100 bps this quarter. Just wanted to ask about the behavior you're seeing from suppliers on pricing. Do you feel you're caught up on price cost? Has pricing sort of normalized and just any signs of disinflation?

speaker
Neil Scrimshaw
President and Chief Executive Officer

um maybe color by product line would be helpful as well yeah so Sabrina I can start I would say really no signs of uh disinflation I would say the um the amount of increase you know the frequency and the rate are similar you know suppliers probably organize around a couple of buckets some will be you know now at a calendar year end and start and some others will operate more perhaps off their fiscal calendar, and there'll be a grouping of suppliers there. If you think about overall dynamics, there still would be inflationary inputs around labor. For many of our suppliers, there's inflationary inputs on general and administrative expenses, medical, healthcare, into those sides. And perhaps metals inputs can vary into the front, but What we are seeing is that the rate of increases have more normalized as we look back or think back all the way to the pandemic of being more once per year. And the size of the increases are more normalized. And of course, that's all dependent on or pre any tariff impact. And I think their suppliers are clearly aligned If tariffs develop on some of those items, they will come through as increases to the product prices, not any just auxiliary costs. And so it would result in inflation. But all that said, right now, to your point in the remarks, less than 100 basis points impact. If we that would be our current expectation for the back half of the fiscal year, you know, aside of any other significant policy change.

speaker
Dave Wells
Chief Financial Officer

I'd reiterate, call it normalized in terms of the pricing that we do continue to see. And, you know, really you might jump to the conclusion that the lower LIFO expense was a result of, you know, kind of lower price inputs. Really more of a function in this case of the, you know, reduction in operating inventories we've continued to achieve. Operating inventories sequentially continue to normalize in the quarter, down about 2.5% sequentially, or $18 million. So it took some of the pressure off the LIFO calc and lowered some of that expense in the quarter. But here again, I'd call it more normalized and that good, steady inflation that distributors like because we know how to take that, recover that, and pass it on.

speaker
Sabrina Abrams
Bank of America

Thank you. And then... We talked about this a little, but can you give color on why gross margins moderate Q over Q? I guess there's 10 to 20 bips from the supplier rebates that I think you said doesn't repeat, but there's a remaining 40, 50 bips of sequential moderation. And just like wondering if it's mixed, is it sourcing? Is the price cost? How should I think about the moderation?

speaker
Dave Wells
Chief Financial Officer

The combination of mix and then, you know, we did say the, we do assume, you know, slightly step up from what we saw in the most recent quarter in terms of LIFO. Just, you know, not expecting to reduce inventory levels further to that order of magnitude. So we'd see LIFO expense step back up. We've got in, you know, kind of around another million or so each quarter. So that's one of the biggest drivers. And, you know, just seeing some of that mix impact normalized would be the other factor as I look at the equation and the expectation for some of that normalizing in terms of the gross margin performance.

speaker
Liz
Conference Call Operator

Thank you. Your next question comes from the line of Brett Lindsey with Mizuho. Please go ahead.

speaker
Brett Lindsey
Mizuho

Hey, good morning. Thanks for the questions. First one just on the tariff situation. So obviously it's still a bit unclear on where those might land, but you did note additional policy transparency would certainly be good for demand. Just curious what you're hearing from customers in terms of potential pre-buy activity ahead of any tariff-related pricing and how that might work for the channels?

speaker
Neil Scrimshaw
President and Chief Executive Officer

Yeah, so let's say, Britt, for us, and given the supply base and that many of the products can either be domestically or North America produced in that area, right, we're low direct import some of our suppliers may have componentry to it to adjust in the time I do not see heightened pre-buy activity on on products I think most are taking the stance if or when they occur there'll be some notice period to do that perhaps there'll be some existing inventory in the channel and in customers are prepared to take it forward to the marketplace as well And so if there are tariffs, right, it can have an inflationary impact on that will need to pass all the way through the businesses, all the way through the channels and to the end users, the end consumers in that. And so I do not see a big move to get in front because there's not really the understanding or the clarity of what went on last time. Does that repeat or is it going to be different?

speaker
Dave Wells
Chief Financial Officer

I'd add, too, that we think about 50% of our service center business being break-fix and not really being able to anticipate what they do need. That's another dynamic that we just see as much stocking and destocking in this business as a result.

speaker
Brett Lindsey
Mizuho

Makes sense. And then just to follow up on M&A, so you noted a number of bolt-on and mid-size deals in the pipeline. Maybe just talk about the near-term actionability of the pipeline for hydrodyn size deals. And then if there's any constraints on management integration resources or anything to do a couple more of these chunkier mid-size deals and maybe what's behind it. Thanks a lot.

speaker
Neil Scrimshaw
President and Chief Executive Officer

Yeah, so I'd say, Brett, the business, the teams, clearly we have the operating capacity and the capability to do these across Our businesses, whether it be fluid power, flow control, and automations, as you can imagine, right, the teams start to turn in. The operating team's slightly different in those, as well as the service centers. You know, I said we can't perfectly control the timing on these as well. We did touch on business, the expectations, the requirements of customers to that side. I think it will cause more businesses to look and consider. And so we just plan on, like we are really at all periods, stay active to our priorities with those companies, with those prospects, and with those targets.

speaker
Brett Lindsey
Mizuho

Okay, great. Best of luck. Thank you.

speaker
Liz
Conference Call Operator

Final question comes from the line of Patrick Schuchert with Oppenheimer. Please go ahead.

speaker
Patrick Schuchert
Oppenheimer

Hey, guys, wondering if you could give us some background on the history you had with Hydrodyne leading up to the deal. You know, what most attracted you to it? Any incremental learnings and cross-selling potential or the technical capabilities you listed that you may have had in your first month of ownership as you get a better look under the hood?

speaker
Neil Scrimshaw
President and Chief Executive Officer

Yeah, so Patrick, I'd say one, a very good business that we've known for an extended period of time. From a geographic standpoint, it was not an area that we had from a fluid power company standpoint, really the reach and the participation. So it helps us very much there. I would say very similar from a value-added solutions approach into that, both in industrial, in market applications. as well as mobile on and off highway in the front. A lot of good service and repair capabilities, so we think given our service center participation across businesses, that can fulfill some of the service and repair needs of those customers effectively in those served geographies. So it's early. but a very good team, very good approach in doing it. We'll be smart about the business operation and the integration and how we go forward. We think we have good line of sight to margins that combine with the businesses around scale and cost on the margin side, as well as it will open up more synergy opportunities on the selling side for us over that time period. So, again, a very good strategic fit in the geography, a lot of capabilities fitting our engineered solutions build-out priority, especially around the fluid power side.

speaker
Patrick Schuchert
Oppenheimer

Okay, thanks for that. You guys mentioned ample capacity for more M&A, and, you know, Brett asked about the size, but I'm curious what the pipeline looks like now. regarding strategic focus areas? You guys prioritizing additional targets and fluid power, or would you view other product areas as more likely for excessive pursuits?

speaker
Neil Scrimshaw
President and Chief Executive Officer

So we would continue to have good prospects and targets in fluid power as well as flow control and automations a little more select, but opportunities on build out on the on the service center side with effective leverage at, you know, point five times now post acquisition. So we still have a ready capacity and capability to continue to be acquisitive in this. I mean, we we've said the business can clearly operate with two turns, two times leverage in an environment. And so obviously to talk about two, you got to get the one first in that front. So there's very good opportunities for us in that business has strong capacity and it'll be part of our continued build out as we get to the next level targets of the five billion in revenue and and 13% EBITDA margins. We will continue to grow organically as well as right acquisitions.

speaker
Patrick Schuchert
Oppenheimer

Okay, thanks. I'll pass it on.

speaker
Neil Scrimshaw
President and Chief Executive Officer

Thank you.

speaker
Liz
Conference Call Operator

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

speaker
Neil Scrimshaw
President and Chief Executive Officer

All right, simply I want to thank everyone for joining us today, and we look forward to talking with many of you throughout the quarter. Thank you.

speaker
Liz
Conference Call Operator

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

Disclaimer

This conference call transcript was computer generated and almost certianly contains errors. This transcript is provided for information purposes only.EarningsCall, LLC makes no representation about the accuracy of the aforementioned transcript, and you are cautioned not to place undue reliance on the information provided by the transcript.

-

-