Applied Industrial Technologies, Inc. — Form 10-Q
Reporting period: Fiscal second quarter and six months ended December 31, 2018 (fiscal 2019). Financial statements are unaudited; amounts below are in U.S. dollars unless indicated.
Business context and results
Applied distributes industrial products and provides engineering, systems integration, and inventory-management services. It operated 606 facilities across North America, Australia, New Zealand, and Singapore. The January 2018 acquisition of FCX Performance materially expanded the Fluid Power & Flow Control segment.
| Metric | Three months ended Dec. 31, 2018 | Six months ended Dec. 31, 2018 |
|---|---|---|
| Net sales | $840.0 million; +25.9% | $1,704.6 million; +26.5% |
| Gross profit / margin | $242.9 million / 28.9% | $494.7 million / 29.0% |
| Operating income / margin | $61.0 million / 7.3% | $127.3 million / 7.5% |
| Net income | $38.7 million; +25.1% | $87.7 million; +35.5% |
| Diluted EPS | $0.99, versus $0.79 | $2.23, versus $1.65 |
| Net interest expense | $9.6 million | $20.1 million |
Quarterly sales growth included $142.2 million from acquisitions and was reduced by $4.7 million of foreign-currency translation. Excluding acquisitions and currency, sales rose 5.3%, including 3.7% organic growth and one additional selling day. For the six-month period, comparable sales growth was 5.9%, including 5.1% organic growth and one additional selling day.
Material changes and operating drivers
- Quarterly Service Center Based Distribution sales increased 6.1%; organic growth, excluding currency and the extra selling day, was 5.3%. Fluid Power & Flow Control sales more than doubled largely due to acquisitions; excluding acquisitions, sales declined 2.7% in the quarter and 0.4% for six months, reflecting softness and project delays in technology-related fluid power markets.
- Gross margin increased 0.7 percentage points in both the quarter and six-month period. Acquisitions contributed approximately 0.9 percentage points, partly offset by higher LIFO expense.
- SD&A rose 28.4% in the quarter and 30.2% for six months; as a share of sales it increased to 21.7% and 21.6%, respectively. Acquisition costs, including FCX intangible amortization, were a major contributor.
- The six-month effective tax rate fell to 17.7% from 31.9%. Management attributed the decrease mainly to the Tax Cuts and Jobs Act; its net benefit was $18.1 million for six months and $6.0 million for the quarter. This benefited reported earnings growth.
Cash flow, debt, and liquidity
- Six-month operating cash flow was $65.6 million, versus $21.2 million a year earlier. Investing used $13.4 million, including $6.9 million for acquisitions and $7.1 million for property purchases. Financing used $25.9 million, including $23.3 million in dividends. Cash increased $25.7 million to $79.8 million.
- At December 31, 2018, working capital was $688.0 million and the current ratio was 2.7, versus 2.4 at June 30, 2018. Management said cash, operating cash flow, and available borrowing capacity should fund normal operating needs, dividends, acquisitions, and investment.
- Management reported $969.7 million of outstanding borrowings, versus $966.1 million at June 30, 2018. Debt included a $623.4 million term loan at 4.31%, $175.0 million drawn under a receivables securitization facility at 3.22%, and $170.0 million of fixed-rate notes. The revolving facility had no borrowings and $245.3 million of unused availability, net of letters of credit; a further $50.0 million was available under the shelf facility.
- Debt covenants require net indebtedness below 4.25 times consolidated EBITDA under the most restrictive test. The company reported leverage below 3.0 times and compliance with all covenants.
Outlook, accounting, and risks
- Management expects a fiscal 2019 full-year effective tax rate of 21%–23%. It expected year-end inventory turnover to be similar to or slightly better than the December 31 level of 4.2.
- Management cited improving U.S. industrial production and capacity utilization, while noting a late-December sales slowdown and weakness/project delays in certain technology-related fluid power businesses. The PMI remained above 50 in December but declined from September.
- ASC 606 was adopted July 1, 2018; the transition increased opening retained earnings by $3.4 million. Its reported six-month impact versus the prior accounting basis was $4.3 million of sales and $0.7 million of net income. Segment reporting was also revised to align with management’s current structure.
- The company anticipated a material balance-sheet impact from lease accounting adoption through new right-of-use assets and lease liabilities; the amount was not yet determined. The interim statements were reviewed by Deloitte, which reported no material modifications were needed; this was a review, not an audit.
- Key disclosed risks include customer demand and economic conditions, pricing and supplier programs, receivable collection, acquisition integration and debt, foreign exchange, cybersecurity and information systems, goodwill impairment, tariffs and trade policy, and operational disruptions. Pending legal matters were not expected by management to have a material adverse effect. Management concluded disclosure controls were effective; FCX’s internal controls were excluded from the period-end evaluation.
Important facts for investors to verify
- How much of continued sales and earnings growth is organic versus acquisition-related, particularly in Fluid Power & Flow Control.
- Whether operating margins can hold as acquisition-related amortization, compensation costs, and other SD&A increase.
- The durability of earnings excluding the tax-law benefit, and the resulting full-year tax rate.
- Debt reduction, variable-rate interest exposure, and access to the receivables facility, whose availability depends on customer and receivable characteristics.
- The eventual balance-sheet and implementation effects of lease accounting, and progress integrating FCX and extending internal-control oversight.