Applied Industrial Technologies Inc (AIT) Q2 2021 Earnings Call Transcript

Welcome to the Fiscal 2021 Second Quarter Earnings Call for Applied Industrial Technologies. My name is Mariama, and I'll be your operator for today's call. 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, Mariama, 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 of these documents are available in the Investor Relations' section of applied.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.

Thanks Ryan, and good morning, everyone. We appreciate you joining us and hope your new year is starting well. I'll begin today with some perspective on our second quarter results, current industry conditions, and our position going forward. Dave will follow with a summary of our financials and some specifics on our second quarter and outlook, and then I'll close with some final thoughts. We're pleased to report a solid and productive quarter for Applied, along with positive momentum building as we enter the second half of our fiscal year. Our team executed extremely well during the second quarter and we saw a sustained sequential improvement in customer demand following the initial recovery highlighted last quarter. We are leveraging our industry position and generating incremental traction from our strategic growth initiatives. These include addressing early cycle customer technical MRO needs, as well as playing a vital role in supporting efficiency and performance initiatives across their critical industrial infrastructure. We believe these customer initiatives will be increasingly relevant, giving a greater focus on operational risk management and supply chain considerations. We are capturing these initial tailwinds while remaining disciplined with controlling costs as sales continue to recover. Cost accountability and execution have always been key to our culture and remain integral to our operational focus going forward. This is supplemented by operating efficiencies gained from optimizing processes, systems, and talent across the organization in recent years. While additional expense restoration will occur in the second half of our fiscal year, we expect these counter elements to provide further balance to our cost trajectory in the near-term and support our long-term EBITDA margin expansion potential as the demand recovery continues to unfold and we leverage our operational network. I'm also encouraged by the strong cash generation we continue to see across the business. Year-to-date, free cash is up over 60% from prior-year levels and over 200% of adjusted net income. While influenced by the counter-cyclical nature of our model, cash flow is ahead of our expectations and up meaningfully from prior-year levels. This highlights the progress we continue to make with regard to expanding our market position while optimizing our margin profile and working capital management.

Thanks Neil. Just another reminder before I begin, regarding the availability of the quarterly supplemental investor deck, recapping key performance and discussion points, which has been posted to our investors' site for your additional reference.

Thanks Dave. Approximately three quarters ago, during the initial weeks of the pandemic, I stated my belief that Applied has never been in a better position to manage through the current environment and exit the pandemic-driven downturn in an even stronger position. Our performance since then provides strong confirmation of this belief, the tremendous team we have at Applied, and the earnings potential that lies ahead. This includes record cash generation and a 30% reduction in our net debt, our strong cost execution supporting relatively stable EBITDA margins despite the meaningful end market slowdown. During this time, we also completed two acquisitions, supplementing our long-term growth profile while advancing other key growth initiatives, including optimizing our cross-selling opportunities and strategic end-market positioning. We are delivering on our requirements and commitments while moving the organization toward our longer-term next milestone financial objectives of $4.5 billion of revenue and 11% EBITDA margins. We remain cognizant of ongoing end-market uncertainty, but we're eager to demonstrate what we're fully capable of in the years ahead as we continue to leverage our differentiated industry 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 your questions.

Your first question comes from David Manthey with Baird. Your line is open.

So could you outline the automation outlook as we enter calendar 2021 here with Olympus, AVS, and Gibson? What I'm wondering is, can you now approach the market differently with the expanded geographic coverage that you have?

I believe we can approach the market fully, and so work that would go on now as we look across these businesses, we can share best practices that go on in technology or sales engineers. We can look at support and perhaps development work from an applications engineering standpoint to start across the group. And then as we have opportunities that can exist in some of the geographies, we can leverage some back-office infrastructure that would start. So it's early to be doing that, and so each of the groups will be working with their current customer base, their current pipeline of opportunities, but we are broadening the effort to say where can we connect this automation to what would have been legacy service in our customers for additional growth opportunities.

Yes, that's helpful, Neil. And on that last point, my second question is, have you begun the process of cross-selling and have the legacy Applied salespeople been trained to at least be knowledgeable in automation and robotics so they can pull in the experts? Or how is that going, and can you give us a timeline regarding where we are and where we're going in that prospect?

I would say, while early, we are raising that awareness of our account managers and selling teams regarding what is available when they are inside facilities, where to look for opportunities, how to start the dialogue, and then providing support with automation-capable individuals to help connect the dots. We have projects, we have early results in the pipeline across that customer base, and we have growing interest in that capability. You can imagine more in the West, started in the Southeast, and we're just getting started in that Northeast and Mid-Atlantic, but now with that growing footprint and capability, that can occur with customers that have sites and facilities across the geography.

Your next question comes from Adam Uhlman with Cleveland Research. Your line is open.

I wanted to start with a question around cash flow. I'm wondering what you're going to do with all this cash you're generating. I guess inventory working capital sounds like that's a source here over the next year or so. Could you maybe dimension how you're thinking about inventory additions as business levels start to pick up? And related to that, steel prices have jumped quite a bit. I'm sure supplier price increases are starting to come through. Is there any opportunity to buy ahead of that? Was that an opportunity here in the December quarter or could you do a little bit before then to mitigate the impact of higher material costs?

Sure. I mean, we're going to continue to evaluate, and I think we have a very good cross-functional process put in place to evaluate the trade-offs between the investment in inventory tied to net working capital and leveraging those pre-buy opportunities. So we'll see that continue into the back half of the year, that's due to great results as you look at our cash flow year-to-date, with the working capital efficiency being the key driver of the overdrive that we have seen. That said, we'll be mindful about what we put back on the shelf going to peak the rate of demand and while protecting our customer base against outages and where it makes sense despite the advance of potential increases. Historically, we've done a very good job of matching and managing that price cost inflation. We see that trend continuing to move forward as we continue to leverage the inventory position and systems in place. So back to the original question, we'll see some build in working capital as we resolve this year, volume impact on accounts receivable even though we continue to do a nice job of reducing our past due position, down another 5 points year-over-year across the business. But then continue to leverage that cash flow; strategic M&A will continue to evaluate other growth opportunities to drive shareholder value.

And Adam, I would add that if we look back at our second quarter, I think price was kind of a modest contribution, I think it's very similar in the third quarter. While the input cost of steel and other commodities start to go up, it is an input for many of our suppliers, who would still be processing them through. We do see increased frequency of price increases coming; many of them may have announced periods to allow orderly implementation. I think there will be greater activity there in the announcements before it's coming through in results, but I'm not sure it's much of a change in the third quarter. It may be an impact, a little more into the fourth, and obviously, as we get into next fiscal year. To today's point, we've got a good track record and history of managing that price cost inflation as we go forward, but I do think there will be a modest ramping as we think about it through the end of this fiscal year.

Thank you, that's very helpful. And my second question is really on oil and gas. It sounds like you did some more restructuring of your footprint there, but I'm wondering if you're seeing any green shoots in that industry at all?

We talked about some of the heavier industries perhaps getting some of those oil and gas opportunities. I mean, we did the evaluation, and as we look, the outlook led us to making adjustments to service centers that participate more in that oil and gas sector and reducing the number. Obviously and unfortunately, that impacts individuals, but we have an opportunity to redeploy some of those resources to other growth initiatives. So I would say it's quite early to see many green shoots in oil and gas. We will have a presence and should participate from a Permian standpoint and from an Anadarko standpoint, but from a percentage of our business, it's less than 5% today, and I expect that it stays at that level over a period of time.

Your next question comes from Chris Dankert with Longbow Research. Your line is open.

I guess just thinking about the opportunity for preventative maintenance and software revenue, any sense for what inning we're in there with customers? Is it still really early days? What's the additional opportunity with some of those preventative maintenance stuff? Ultimately, do you think adding some of that software revenue can be margin-accretive for you guys? Just any thoughts there would be great.

I would say it is still early. Our approach with Applied, Internet of Things, and how we connect, we are working very well with our leading manufacturers and targeting specific customers. Most customer approaches are concentrated on facility or specific areas of the facility, proving out success, harnessing the data available from equipment, and using that for predictive maintenance or perhaps for broader remote monitoring across multiple sites, especially with less travel and physical presence that they're having in their own facility. I think that is early. We are having success, and as we do, we can replicate that with our customer in the facility and across their landscape. We believe it is a great opportunity; it’s very early innings. We are excited about it. So we're participating, and we think it ramps over a period of time.

I guess just a quick follow-up on that. Is this an offering you guys are kind of leading with, or is it at the moment, preventative maintenance more of a customer pull thing where they're requesting it?

We are leading with the enabling technologies that help in their discrete automation opportunities. Some of it may be predictive maintenance, but in many places, it's using vision products to help with quality inspection or perhaps manage out physical labor that was previously doing it. The use of collaborative robots helps from a labor density standpoint during this time and provides ongoing productivity in there. The data connection ones are now to say we've had sensor-embedded products for a long period of time that customers want to connect and understand operations. I think there are many elements to it; it's not just technology and monitoring for preventative maintenance.

That makes sense, thanks for that. And then I guess just the last one from me. We've talked a lot about automation, but we haven't heard a ton about linear motion. Just any comments on how the growth's progressing there? Any additional focus on M&A, or is the focus shifting more to automation? Just any comment on linear would be great.

Overall, our priorities are active across, as Dave touched on, some in automation, which has been the most recent couple in that. We continue to focus on and be busy from a fluid power standpoint, and we will look at how we selectively add to our capabilities and footprint, whether that's in flow control or the service center. For us, linear motion, depending on size, can be part of those segments in the industry. It has the opportunity to contribute as we move forward, but there is a big focus on fluid power, automation, and flow control.

Your next question comes from Steve Barger with KeyBanc Capital Markets. Your line is open.

I'm just going to stick with the growth initiatives. Now that you have the footprint on the West Coast, Southeast, and Northeast, are you looking for further geographic coverage in the Midwest, or can you do that here? As you learn more, do you have the ability to organically create a business unit, or do you need to do that by acquisition?

I think we'll continue to look at companies and organizations that would provide additive benefits and capabilities, so even while we're in those geographies, perhaps, there is another way to further augment. As we grow in scale and start to leverage back shared capabilities of the technology, application engineers, greater amounts of sales engineers, and some of the virtual selling capabilities that exist today, we feel like we can grow in geographies leveraging footprint and capabilities that we have. So it could be a mix as we go through, and we're going to continue to be active and busy as we evaluate that. But as we grow, we're opening up the ability to build on what we have and leverage existing Applied resources in the service center selling side, as well as in fluid power and flow control.

As you think about automation, robotics, fluid power, flow control, can you tell us what percentage of revenue that is right now and what that growth rate is? Or what do you expect it to be relative to the rest of the business?

I don't know if I have it top of mind or at hand on the percent of revenue. I know we are having success in this environment. While it's new to us, the things that are coming into the pipeline and as we move these projects along, our team is working hard to commission and implement what they have in that side. So it's probably early to start comparing on the growth sides. As we march through fewer declines in sales and start to return to growth likely as we think about our fourth quarter and beyond, I expect this area to contribute at that rate and greater than that rate to be part of the pulling effort.

Just as it relates to the size, do you think about the acquisitions that have been made specifically over the last 16 months? We talked about the size of Olympus Controls; we initially did it around $45 million to $50 million of revenue. The last two that we did with ACS and Gibson are about half that size in terms of revenue. So as you do get to an idea of what those three acquisitions represent on an annual basis, that will start to give a better view. Additionally, there are a number of offerings and capabilities that we have within our fluid power business and across our service center network where there is certainly automation tied to it. So when you kind of mine that on top of that, that will certainly be incremental as well. But it is still probably a lower percentage of the business today, with the view that it continues to ramp as we build out the network both organically and through acquisitions.

No, that's great detail. I guess what I was really trying to get at is if you look at that call it $90 million to $100 million in revenue, whether it's historically or on a go-forward basis, and I know it's tough to compare over the last year. Is that part of the business growing faster than the fluid power segment itself, and how additive is that to the organization? Is that also accretive to the fluid power segment?

I think it can grow at that rate higher. We've talked from an accretive standpoint today. I'm more at the company average, but the potential is to be above that. That's our view and what we'll be working towards.

Got it. That just leads into my last question. Free cash flow has been outstanding, as you noted. You talked about cash conversion moderating in your return to growth, which is understandable. But as you think about mix and growth initiatives, is that creating sustainable changes to the cash flow profile through cycles?

If you look back, we're at higher peaks now and we think we have continued to improve and mix up our ability from a cash generation standpoint. We do things internally with shared services and approach, leveraging technology, and we think our effective use of inventory and management in that side. We do expect it to moderate, but we expect to perform at a higher level than over time. We think working capital as a percent of sales can reach 20%.

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

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

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