Applied Industrial Technologies, Inc. (AIT) Earnings Call Transcript

Welcome to the fiscal 2026 Fourth Quarter Earnings Call for Applied Industrial Technologies. My name is Trevor, and I'll be your moderator for today's call. [Operator Instructions]. Please note that this conference is being recorded. I will now turn the call over to Ryan Cieslak, Vice President of Investor Relations and Treasury. Ryan, you may begin.

Okay. Thanks, Trevor, and good morning to everyone on the call. This morning, we issued our earnings release and supplemental investor deck detailing our fourth 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 and uncertainties, including those 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, we will use non-GAAP financial measures during the conference call, which are subject to the qualifications referenced in our SEC filings. Our speakers today include Neil Schrimsher, Applied's President and Chief Executive Officer; and Dave Wells, our Chief Financial Officer. With that, I'll turn it over to Neil.

Thanks, Ryan, and good morning, everyone. We appreciate you joining us. I'll begin today with perspective and highlights on our results, including an update on industry conditions and expectations going forward as well as provide an overview of our new intermediate financial targets. Dave will follow with more financial detail on the quarter's performance and provide additional color on our fiscal 2027 guidance. I'll then close with some final thoughts. So overall, we reported a solid finish to fiscal 2026 with record fourth quarter sales and earnings that exceeded our expectations. The quarter was underscored by organic sales growth of 10%, which was the strongest in more than 3 years and a notable improvement from the 6% growth we reported last quarter. We levered the stronger growth very well, expanding EBITDA margins by more than 60 basis points to over 13%, growing EBITDA by 16% and EPS by 13% compared to the prior year, which is inclusive of ongoing LIFO expense headwinds. In total, these are strong results to end the year that was both defining and pivotal on many fronts, including showing strong evidence of our operating durability as well as early signs of the significant growth potential taking shape across our business. I want to thank our Applied team for their ongoing execution. The focus drove another year of exceeding our commitments and creating meaningful value for our customers, suppliers and all stakeholders, further validating the power of our collective efforts and differentiated industry position. So several key points to highlight in more detail. First, underlying demand improved across both segments during the quarter. Trends strengthened through the end of the quarter with organic sales increasing over 10% year-over-year in June despite more difficult comparisons. The stronger sales growth was volume-driven, reflecting greater technical MRO and capital spending activity, combined with ongoing benefits from our internal sales initiatives and industry position. Strengthening underlying demand was apparent in year-over-year trends across our top 30 end markets, where 20 generated positive sales growth compared to 17 last quarter and 15 in the prior year quarter. Growth was strongest across metals, technology, utilities and energy, machinery, rubber and plastics and pulp and paper. This was partially offset by declines primarily in chemicals, lumber and wood and transportation. Sales growth during the quarter was led by our Engineered Solutions segment, which delivered 13% organic sales growth year-over-year, up from 9% last quarter. During the quarter, we saw stronger demand across legacy and emerging customer verticals as well as solid backlog conversion. Segment order trends also remained positive during the quarter, increasing by a double-digit percent year-over-year for the third straight quarter. Sales growth in the quarter was strongest in automation, where organic sales increased over 20% year-over-year. This was the strongest organic growth in over 4 years, underscoring the solid demand developing for our automation solutions as the adoption of robotics, machine vision and digital technologies ramps higher with more productive capital spending environment. Growth also strengthened across our industrial and mobile fluid power operations, where sales increased by a high single-digit percent over the prior year. Demand is improving across many of our legacy fluid power markets, including construction, metals and machinery. In addition, our engineering project funnel is expanding as OEM customers increasingly focus on upgrading fluid power systems and integrate new advanced features into their mobile equipment. Our fluid power performance is also benefiting from Hydradyne which, as you recall, we acquired 18 months ago. We've made tremendous progress across our synergy work streams and contribution from Hydradyne improved throughout fiscal 2026. Of note, the second half of fiscal 2026 Hydradyne sales increased by a double-digit percent year-over-year, while their EBITDA margins improved over 200 basis points. In addition, segment performance during the quarter benefited from strong technology vertical contribution, including favorable growth across the semiconductor space as well as new business continuing to develop around data centers. As a reminder, our technology vertical represents over 15% of our Engineered Solutions segment today with related participation across all 3 areas of the segment, including automation, fluid power and flow control. Our Service Center segment also had a solid quarter. Organic sales growth of 8% accelerated from 4% last quarter, with average daily sales up approximately 5% sequentially and ahead of normal seasonality for the second straight quarter. Greater brake fix and technical MRO activity continued to broaden throughout the quarter. Of note, 27 of our top 30 industry verticals were up year-over-year in our U.S. service center network during the fourth quarter with notable strength across metals, pulp and paper, rubber and plastics and utilities and energy. Growth was strongest across national strategic accounts where sales continue to benefit from our internal initiatives and One Applied value proposition. We also saw demand strengthen across small and midsized local accounts where sales increased by a high single-digit percent year-over-year during the quarter, providing further evidence of the recovery taking shape across the industrial sector. It's also worth noting the Service Center segment's performance throughout fiscal 2026. Despite more mixed end market demand to start the year, segment sales grew organically year-over-year every quarter in fiscal 2026. Total sales finished up nearly 6%, while EBITDA grew 8%, inclusive of greater LIFO expense. Looking at the segment's performance over the past 5 years, organic sales growth has averaged 8%, while EBITDA growth has averaged 13%. Overall, this is a notable performance that highlights a stronger and more durable growth profile that exists across our Service Center segment today reflecting benefits from internal initiatives as well as secular and structural tailwinds positively impacting our core market position. So overall, a solid quarter, highlighting continued positive top line momentum building across Applied. At the same time, our team remains focused on driving stronger returns as this more favorable growth backdrop continues to develop. We saw solid evidence of this during the quarter where we levered 10% sales growth into 16% EBITDA growth, representing incremental margins of over 19% or more than 22% when excluding LIFO expense. We also had a strong quarter of free cash generation, which increased 16% over the prior year. Free cash totaled $461 million in fiscal 2026, which was down modestly over the prior year despite greater working capital requirements to support growth in the back half of the year. Ongoing initiatives and system investments continue to optimize our working capital KPIs, including areas of accounts receivable and inventory management with net working capital as a percent of sales ending fiscal 2026 at a 6-year low. Moving forward, we remain well positioned to drive stronger earnings growth and solid cash generation with ongoing support from our internal initiatives and mix tailwinds. From a capital deployment standpoint, we had another year -- another productive year in fiscal 2026, deploying approximately $425 million on share buybacks, dividends, CapEx and M&A. Over the past 2 years, related capital deployment totaled just under $1 billion. In fiscal 2026, we were more active with share buybacks, repurchasing a total of 1.2 million shares for $317 million. We also increased our quarterly dividend by 11% and continues to invest in our technology platforms, distribution centers and growth capacity during the year. We expect to remain active with capital deployment in fiscal 2027 with nearly $2 billion of balance sheet capacity. As always, we will remain disciplined with a focus on deploying capital that enhances our scale, growth profile and competitive position going forward. M&A remains a top priority, and we continue to actively evaluate various targets across both our segments. Lastly, I'd like to take a moment to provide some initial thoughts on our fiscal 2027 outlook as well as our intermediate financial objectives, which we increased this morning. Dave will provide greater detail on our guidance assumptions. But overall, we enter fiscal 2027 with solid growth potential and operational momentum developing across both our segments. Positive sales momentum has continued into the first quarter with organic sales to date up approximately 7% compared to prior year levels. End market demand in aggregate, appears to be on solid footing with limited pockets of weakness or signs of slowing near term. Broader macro indicators, including ISM, industrial production and durable goods orders continue to trend favorably. In addition, following a more muted growth backdrop in fiscal 2026, we expect potentially greater contribution from higher-margin flow control sales in fiscal 2027 as MRO and project activity across process end markets improve following a greater level of deferred spending this past year, particularly in chemicals and refining verticals. We remain mindful of the evolving geopolitical backdrop and trade policy uncertainty, both of which could impact the cadence and trajectory of end market growth depending on how things develop. We will also face more difficult comparisons, most notably in the second half of the year following our recent strong performance. These considerations are contemplated in our initial fiscal 2027 guidance. Beyond critical and core end market dynamics, we expect ongoing positive contribution from our internal sales initiatives, including greater cross-selling momentum and benefits from sales productivity investments. We also expect structural and secular tailwinds to remain positive and potentially more impactful factors to our demand moving forward. Of note, our ongoing evolution has positioned Applied at the intersection of exciting and powerful growth trends tied to rising technical support at customer plants, industrial system upgrades, automation adoption, including physical AI integration and the build-out of critical infrastructure across both legacy and emerging customer verticals. Our related exposure to these trends is high, given our industry position supporting U.S. manufacturing and deep technical knowledge of our customers' facilities as well as greater scale we have today in areas of advanced automation and fluid power. Further, our balance sheet and cash generation provide meaningful capacity to further compound our growth through ongoing M&A. As I mentioned earlier, our pipeline remains active, and we believe M&A contribution could be more meaningful to our sales growth through fiscal 2027 and beyond as we further execute our strategy. The M&A backdrop is increasingly productive as targets face heightened competition, required operational investments and extended ownership life cycles. Our acquisition track record, including more than 18 transactions since 2018, combined with our leading technical solutions platform makes us a compelling home for the companies we are currently evaluating. So we see many catalysts and tailwinds supporting our ongoing growth across Applied as we enter the next phase of our evolution. At the same time, we have great potential to further expand our EBITDA margin profile moving forward. Our business model provides inherent operating leverage, and we continue to target mid to high-teen incremental EBITDA margins at mid-single-digit organic sales growth. The ongoing expansion of our Engineered Solutions segment and local account growth across our service centers provide durable and structural mix tailwinds that should intensify in a more favorable demand environment. We also see opportunities to further optimize our productivity and operating leverage through ongoing technology investments, expanding our shared services model and leveraging AI, while ongoing synergy progress across recent acquisitions, including Hydradyne provide further margin support. The opportunity ahead is exciting and one that has been built through compounding years of executing our strategy, committing to continuous improvement, leveraging our differentiated industry position and adhering to a disciplined approach to capital investment. From various organic investments and positioning made across our core Service Center segment to strategic moves into flow control and automation, our strategy has driven intentional transformation across our business to serve customers more completely, expand our market potential and strengthen our overall value proposition. Our historical performance provides strong evidence of the power of our strategy and potential. In the past 5 years, we've grown sales by 9%, EBITDA by 14%, EPS by 18% and free cash flow by 15% on a compounded annual basis. Over the same period, gross margins have expanded 120 basis points and EBITDA margins have expanded by over 260 basis points, while our return on capital metrics have improved notably. Considering these dynamics, we believe now is the opportune time to update our intermediate financial targets, including increasing our sales objective to $7 billion from $5.5 billion prior and increasing our EBITDA margin objective to 14% from 13% prior. We believe these objectives are well within the company's capability and can be achieved over the next 5 years depending on broader macro conditions, the cadence and scope of M&A and other factors. Overall, our team is now engaged and ready to execute on these next milestones, which we believe provides the framework for significant value creation for all stakeholders moving forward. At this time, I'll turn it over to Dave for additional detail on our results and outlook.

Thanks, Neil, and good morning to everyone joining today. 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. We hope that you will find this to be a useful resource as we recap our most recent quarter performance and initial fiscal 2027 guidance. Turning now to our financial performance in the quarter. Consolidated sales increased 10.4% over the prior year quarter. Acquisitions and foreign currency were a modest tailwind in the period, adding 30 and 40 basis points, respectively, of growth. The number of selling days in the quarter was consistent year-over-year. Netting these factors, sales increased 9.7% on an organic basis. As it relates to pricing, we estimate the contribution of product pricing to year-over-year sales growth was approximately 250 basis points in the quarter, which was above our guidance of 200 basis points. Netting this impact, we estimate volumes grew approximately 7% over the prior year, a nice acceleration from the March quarter volume growth of 3.5%. Moving to consolidated gross margin performance. As highlighted on Page 8 of the deck, gross margin of 30.4% was down 20 basis points compared to the prior year level. During the quarter, we recognized LIFO expense of $6.4 million compared to $2.9 million in the prior year quarter and $5.6 million last quarter. On a net basis, this resulted in an unfavorable 26 basis point year-over-year impact on gross margins. Excluding LIFO expense, gross margins were up modestly year-over-year, reflecting ongoing progress with our internal margin initiatives as well as price and channel execution. As it relates to our operating costs, selling, distribution and administrative expenses increased 5.1% compared to prior year levels. On an organic constant currency basis, SG&A expense was up 4.3% year-over-year. As a percentage of sales, SG&A expense improved 94 basis points year-over-year to 18.6%, highlighting strong operating leverage in the quarter and a solid improvement from trends last quarter. Our teams continue to remain disciplined on spend while also focusing on various efficiency initiatives tied to technology investments, shared services and sales productivity tools. This helped offset continuing inflationary headwinds, higher incentives and ongoing growth investment in the business during the quarter. Overall, stronger organic sales growth, combined with steady gross margin performance and solid cost leverage resulted in reported EBITDA increasing 16.1% over the prior year. This is inclusive of greater LIFO expense year-over-year, which negatively impacted EBITDA growth by 2.3 percentage points compared to the prior year quarter. Reported EBITDA margin of 13.1% was up 64 basis points from the prior year level with year-over-year LIFO headwinds negatively impacting EBITDA margin by 26 basis points. EBITDA margins exceeded our fourth quarter guidance range of 12.6% to 12.8%, primarily reflecting more favorable cost leverage on stronger sales growth in the quarter. Reported earnings per share of $3.17 increased 13.2% from prior year EPS of $2.80. On a year-over-year basis, EPS was impacted by a higher tax rate and net interest expense, partially offset by a lower diluted share count. Turning now to our performance by business segment. As highlighted on Slides 9 and 10 of the presentation, sales in our Service Center segment increased 7.9% year-over-year on an organic basis. This excludes 50 basis points of contribution from acquisitions and a positive 60 basis point impact from foreign currency translation. Improved organic sales growth was primarily driven by stronger volume growth across our U.S. Service Center operations, reflecting more favorable end market demand and benefits from our internal sales initiatives and to a lesser extent, improved volume growth across our international operations. Segment EBITDA increased 16.3% over the prior year while segment EBITDA margin of 14.5% expanded 91 basis points. This year-over-year improvement primarily reflects favorable operating leverage on stronger sales growth, combined with solid channel execution and cost control, which more than offset ongoing inflationary headwinds, including greater LIFO expense compared to the prior year level. Within our Engineered Solutions segment, sales increased 12.9% over the prior year quarter on an organic basis. The year-over-year increase was primarily driven by double-digit growth across our automation and fluid power operations, reflecting solid backlog conversion, improving end market demand and positive technology vertical contribution. This was partially offset by muted sales growth across our flow control operations, primarily reflecting a more difficult prior year comparison, coupled with softer MRO activity across various process end markets during the quarter. Segment EBITDA increased 15.8% over the prior year or approximately 19% when excluding LIFO expense. In addition, segment EBITDA margin of 15.1% expanded 38 basis points from prior year levels, inclusive of a 44 basis point year-over-year LIFO headwind. The strong EBITDA growth and EBITDA margin performance in the quarter primarily reflects solid underlying incremental margins on more robust sales growth, combined with ongoing cost accountability, partially offset by muted flow control sales growth in the quarter. Moving to our cash flow performance. Cash generated from operating activities during the fourth quarter was $165 million, while free cash flow totaled $159.7 million, representing conversion of approximately 135% relative to net income. Compared to the prior year fourth quarter, free cash was up nearly 16%, reflecting stronger earnings and ongoing benefits from our working capital initiatives. From a balance sheet perspective, we ended June with approximately $127 million of cash on hand and net leverage at 0.2x EBITDA. Our current revolving credit agreement has approximately $826 million of available capacity and an additional $800 million accordion option. Combined with incremental capacity under our AR securitization facility, we have significant financial capacity to support our capital deployment initiatives moving forward, including accretive M&A, dividend growth and share buybacks. During the fourth quarter, we repurchased over 265,000 shares for $81 million. Turning now to our outlook, which is detailed on Page 13 of the presentation. We are establishing full year fiscal 2027 guidance, including EPS in the range of $11.65 to $12.15 based on sales growth of 4% to 6.5% and EBITDA margins of 12.5% to 12.8%. Our outlook takes into consideration ongoing economic uncertainty tied to current geopolitical and trade policy dynamics as well as lingering inflationary pressures. At the midpoint of guidance, we assume stronger organic sales growth in the first half of the year based on current underlying market conditions followed by more modest growth rates in the back half of the year, reflecting more difficult comparisons as well as more muted market growth assumptions, pending greater clarity on how macro and trade policy dynamics develop later in the year. While we are positive on current demand conditions and our market position entering fiscal 2027, we believe a prudent approach to our market growth rate assumptions remains warranted at this time considering the inherent risk and dynamic nature of current geopolitical and trade policy dynamics, which in totality represent a still somewhat unprecedented operating backdrop. Guidance also assumes 150 to 200 basis points of year-over-year sales contribution from pricing. Guidance does not assume contribution from future acquisitions or share buybacks. In addition, based on quarter-to-date sales trends through mid-August and our near-term outlook, we currently project fiscal first quarter organic sales to increase by 6% to 8% versus the prior year quarter. Our guidance also assumes fiscal first quarter EBITDA margins within the range of 12.3% to 12.4%. From a margin and cost perspective, guidance assumes ongoing inflationary pressures and growth investments as well as higher LIFO expense in fiscal 2027 versus 2026. That said, we expect the year-over-year increase in LIFO expense to be more modest in fiscal 2027 following the notable increase we saw in fiscal 2026, combined with more balanced supplier price increases relative to last year. In addition, the midpoint of our full year guidance assumes incremental EBITDA margins that are within our targeted range of mid- to high teens. Lastly, we expect free cash generation to remain strong in fiscal 2027, but to potentially trend lower year-over-year, reflecting greater working capital investment to support our growth opportunities. In addition, we expect ongoing organic investments supporting our strategy and technology investments with capital expenditures targeted in the $35 million to $40 million range for fiscal 2027. With that, I will now turn the call back over to Neil for some final comments.

So as we begin fiscal 2027, we are encouraged by the ongoing positive sales momentum. The recovery taking shape across the industrial sector appears durable near term, with customers operating at higher production levels and increasing capital spending in support of a growing manufacturing backdrop across North America, including clear secular tailwinds, gaining traction. Our initial guidance for fiscal 2027 incorporates a steady and favorable growth backdrop in the first half of the year, and a more prudent assumptions in the back half as we take into consideration the short-cycle nature of our business, more difficult comparisons and limited visibility in how current trade policy and geopolitical dynamics might develop as the year progresses. That said, current market conditions and sustained order momentum leave us positively biased, and we continue to have many self-help opportunities to positively influence our performance above and beyond underlying market growth. In addition, as highlighted by the increase to our intermediate financial objectives, we enter fiscal 2027 with the strongest market position in Applied's history and with strategic initiatives that present a path to deliver meaningful earnings growth over the next 5 years. Overall, our track record highlights the power of our strategy and value creation potential, and we're extremely motivated and engaged based on what we believe lies ahead. With that, we'll open up the lines for your questions.

[Operator Instructions] Our first question comes from the line of Christopher Glynn with Oppenheimer.

Just kind of curiosity question for us, the CapEx is almost 50% higher than the average of the past several years. Just curious if anything particularly is causing that or just keeping up with growth?

Yes. We're coming off a year. It's not a capital-intensive business, as you know, Chris, but see some opportunities that are in flight, both in terms of some organic investment to further our footprint across some of the automation business, for example, some technology, further technology investments. No big heavy single hitters there, but just some organic investment continue to focus on both efficiencies and organic growth opportunities in the business. So stepping up as part of our capital deployment, that CapEx a bit to see some of those opportunities that we see in front of us.

Great. Makes sense. And so it's nice to see the environment more enabling to show off the virility of the business model. And in that vein, you talked about some initiatives taking hold. Curious, in automation, are those key applications? I know they have plenty of runway, but anything really standing out among the vision, digitization, robotics? And are there any new categories you want to feature there that might roll into the fold near term? And also in the initiatives bucket, you talked about increasing cross-selling momentum. So maybe go into that of a bit.

Sure. I can start, Chris. So I think first, across automation, they are active and continue to participate in technology. So if you think about semi wafer fab equipment and data center, that's good. But also food and beverage, we're doing more with productized solutions that can help in robotics and autonomous mobile robots through facilities as well as vision systems in and around consumer packaging and goods. And we're also helping with some solutions around strategic inventory management where vigilant systems can play into there. So we think the setup and the industry outlooks around robotics and collaborative robots is strong for years ahead. I think we're finding really good applications and developing those on the vision side. We'll continue to look at what else is important in rounding out. I mean we've got good digital solutions, user interface. We're helping customers as they think about AI, putting things in place in their facilities that help that with robotics and vision and get returns for them in that front. So we think we have a good mix. We'll continue to evaluate on that front. And then, just broader initiatives, I think, across the group on cross-selling. I'm still encouraged with the team's engagement on that, good pipeline of opportunities. We're seeing increased number of customers looking to us as we know their operating facilities so well that we can help them with advancements in fluid power systems, robotics and vision, and we're even seeing more opportunity around services and repair and pumps and valves with our flow control business.

Great. And if I could sneak in a final one. I understand the mid to high teens incremental margin, long-term framework. You did put up a 22% underlying in the quarter. You had maybe 3 years of kind of flattish end market environment. You're clearly out of that right now. But is there an opportunity where that could stay in the 20% range like you had underlying in the fourth quarter?

Well...

Go ahead.

You've seen that potential, obviously, as you know, the guidance does assume some slightly higher LIFO expense on a year-over-year basis. We finished '26 at $21.5 million. Guidance assumes $24 million to $28 million. So I'd say the biggest wildcard, to your point, Chris, would be LIFO expense and what that does in terms of the P&L. If you strip that away, nice performance. We've shown the ability to, all things being equal, deliver 20-plus percent EBITDA incrementals. But that potential is there. I think that's the biggest wildcard in my mind because the team has done a nice job, as you saw in the most recent quarter of continuing to grow that underlying gross margin profile and control SG&A.

Our next question comes from the line of David Manthey with Baird. Our next question comes from the line of Ken Newman with KeyBanc Capital Markets.

Nice quarter. Maybe for my first question here, it was nice to see a pretty solid order growth of, I think you said 20% year-over-year in your automation business this quarter. Neil, curious if you expect any kind of impact from this recent FCC ban on foreign robotics imports. I'm assuming it's pretty low, but maybe can you remind us how much of the automation business is exposed to products impacted by the ban? And curious if that provides either a catalyst for pricing or share gains just relative to the new automation project integration?

Yes. I'd say to date, the assessment is, it is pretty low into that front. Business, to your point, continues to operate very well. Incoming orders are strong. Our work on applications in those targeted verticals as well as some cross-selling opportunity remains good. So at this point, I think it's smaller.

Okay. That's helpful. I also was geared towards your comment, Neil, on M&A potentially driving some stronger contributions to revenue growth this year. I know it's not included in your guidance, but maybe any color just on what you're seeing in the change in activity in the M&A pipeline. I'm curious if there's a way to kind of frame up what some of these targets could look like from a revenue or a margin perspective, if that's something you can talk to.

Yes, it'd be harder to put it to specific revenues in that. We continue to be active. And if you think about things like Hydradyne and midsized potential in naturally across both segments of the business, there can be some smaller bolt-ons and then there are perhaps a few larger properties that I think we will either evaluate or look at coming to market over a period. Do those impact into '27 or not really to be determined. But I think it is a good a good environment from an M&A standpoint. We continue to operate with clear priorities and evaluate things that can be additive to our Engineered Solutions across fluid power, flow control and automation as well as augment our Service Center presence and performance into that. So good activity in front. We're a believer in helping ourselves as we go through that. So we know what priorities matter. We know good prospects, good targets. And so those dialogues and exchanges continue.

Our next question comes from the line of Andrew Obin with Bank of America.

Can you hear me?