Business context and reporting period
Applied Industrial Technologies distributes industrial products and provides engineering, systems integration, and related services to MRO and OEM customers. This Form 10-Q covers the three months ended September 30, 2018—the first quarter of fiscal 2019, although the request metadata labels it “2018 Q1.” The interim financial statements are unaudited; Deloitte performed a review, not an audit.
Financial performance
Amounts below are in millions of dollars except per-share data and percentages.
| Metric | Quarter ended Sep. 30, 2018 | Prior-year quarter | Change |
|---|---|---|---|
| Net sales | $864.5 | $680.7 | +27.0% |
| Gross profit | $251.9 | $192.4 | +30.9% |
| Operating income | $66.3 | $51.8 | +28.0% |
| Net income | $48.9 | $33.7 | +45.1% |
| Diluted EPS | $1.24 | $0.86 | +44.2% |
| Operating cash flow | $11.8 | $9.4 | +$2.4 |
Gross margin was 29.1% versus 28.3%; operating margin was 7.7% versus 7.6%; and net margin was 5.7% versus 5.0%. The FCX acquisition added $146.5 million of sales. Excluding acquisitions, currency effects, and ASC 606 adoption, sales grew 6.9% organically. Management attributed organic growth primarily to improved industrial activity; it also noted that FCX favorably affected gross margin by 96 basis points, partly offset by higher LIFO expense.
Operating cash flow was modest relative to net income, reflecting higher working-capital investment to support increased sales. Investing cash outflow was $3.1 million, including $3.2 million of property purchases. Financing cash outflow was $6.9 million; cash increased $2.3 million to $56.4 million.
Balance sheet, debt, and liquidity
At September 30, 2018, cash was $56.4 million, current assets $1,089.1 million, and current liabilities $394.2 million. Working capital was $694.9 million and the current ratio was 2.8, compared with 2.4 at June 30, 2018. Shareholders’ equity was $870.8 million, up from $815.0 million at fiscal year-end.
Management reported $974.6 million of outstanding borrowings, compared with $966.1 million at June 30. Debt included $628.3 million outstanding on the term loan, $175.0 million under a newly established receivables securitization facility, and $170.0 million of private shelf notes. The term loan’s variable rate was 4.25%; the securitization borrowing rate was 2.08%. The company had $245.4 million available under its revolving facility, net of letters of credit, and $50.0 million available under the shelf facility. It was in compliance with debt covenants; the most restrictive limit was net indebtedness below 4.25 times EBITDA, and reported indebtedness was below 3.0 times EBITDA.
Material changes, outlook, and risks
- FCX acquisition: Acquired in January 2018 for total consideration of $781.8 million; it contributed $146.5 million of current-quarter sales and $11.6 million of operating income. Purchase accounting remained preliminary.
- Tax effects: The effective tax rate fell to 12.8% from 33.1%, including a $12.1 million net benefit associated with the Tax Cuts and Jobs Act. Management expected a 24.0%–25.0% full-year fiscal 2019 tax rate; accounting for certain tax-law effects was not complete.
- ASC 606: Adopted July 1, 2018 using the modified retrospective method, increasing opening retained earnings by $3.4 million net of tax. Adoption reduced reported quarterly sales by $3.3 million, operating income by $0.7 million, and net income by $0.5 million.
- Management outlook: Management expected cash, operating cash flow, and available borrowing capacity to fund normal working capital, dividends, acquisitions, investment, and potential share purchases. It expected year-end inventory turnover to be similar to or slightly better than 4.1.
- Risks and contingencies: Variable-rate debt creates interest-rate exposure; receivables-facility availability depends on customer credit ratings, concentration, and receivable characteristics. Management cited economic and customer-demand conditions, product costs and availability, competition, foreign currency, acquisition integration, information-system security, tariffs and trade policy, and possible goodwill impairment among material risks. Pending legal matters were not expected by management to have a material adverse effect.
- Accounting change ahead: The company anticipated a material balance-sheet impact from adopting the new lease standard through recognition of right-of-use assets and lease liabilities; the financial impact had not yet been determined.
Important facts for investors to verify
- How much of sales growth and margin performance is sustainable organically, separate from FCX and tax benefits?
- Whether FCX integration and preliminary purchase accounting change reported results, amortization, or impairment exposure.
- Working-capital conversion and operating cash flow relative to earnings as sales expand.
- Debt paydown, variable interest costs, covenant headroom, and continued access to the receivables facility.
- The final fiscal 2019 tax rate and the balance-sheet effects of lease-standard adoption.