Welcome to the Fiscal 2020 Second Quarter Earnings Call for Applied Industrial Technologies. My name is Lindsay, and I’ll be your operator for today’s call. [Operator Instructions] 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.

Thank you, Lindsay, and good morning, everyone. 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 our website at applied.com. A replay of today’s broadcast will be available for the next two weeks. Before we begin, just a reminder that we’ll discuss our business outlook and make statements that are considered forward-looking. All forward-looking statements are based on current expectations that are subject to certain risks, including trends in sectors and geographies, the success of our business strategy and other risk factors provided in our press release, our most recent periodic report and other filings made with the SEC. These are available at the Investor Relations section of applied.com.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 explained in our press release and supplemental presentation, which are subject to the qualifications referenced in those documents. Today’s teleconference is available to the media and general public as well as to analysts and investors. Because the teleconference and its webcast are open to all constituents and prior notification has been widely and unselectively distributed, all content of the call will be considered fully disclosed. 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.

Thank you, Ryan, and good morning, everyone. We appreciate you joining us. I’ll begin with some brief thoughts, and then Dave will follow to review our financial results in more detail. Our second quarter was characterized by cost discipline, margin control and solid cash generation within a persistent soft end market backdrop. Execution in these areas is providing a path to deliver our earnings and cash commitments for the year and should support accretive growth once demand rebounds as well as capital deployment opportunities going forward.We also remain highly focused on accelerating our company-specific outgrowth potential regardless of the industrial cycle. As highlighted in recent quarters, our leading technical position and service capabilities across motion control, fluid power, flow control and now automation, puts us in a unique position to capture greater share organically as our customers outsource their technical MRO and production infrastructure needs. As well as through M&A as smaller players look to partner with a leading technical platform, given increasing service, operational and capital requirements. This trend should supplement a strong cross-selling opportunity here at Applied that remains in the early innings, and is focused on expanding the reach of our fluid power, flow control, consumables and automation solutions across our embedded service center network customer base.We also entered our second half of fiscal 2020 with a strong balance sheet, having reduced outstanding debt by $150 million over two years, post our acquisition of FCX, with net leverage down to our stated target of 2.5x. Combined with our cash generation trajectory, we have notable flexibility for additional deleveraging, acquisitions and pursuing other opportunities to enhance shareholder returns in the back half of our fiscal year. As it relates to the broader end market backdrop, as discussed in recent quarters and consistent with macroeconomic industrial reports, demand remains…

Thanks, Neil, and good morning, everyone. Before I begin, another reminder that a supplemental investor deck recapping key financial and performance talking points is available on our investors’ site. To summarize, we are managing effectively in a slow and uncertain end market environment with timely execution of our recent cost initiatives, continued solid gross margin performance and another positive quarter of cash generation. We expect cash generation momentum to continue into the second half of fiscal 2020, providing ample flexibility to pursue capital deployment opportunities. Overall, we believe we are well positioned in the current environment.Highlighting results for the quarter. Consolidated sales decreased 0.8% over the prior year quarter, excluding 3.2% growth contribution from acquisitions, sales declined 4% on an organic basis. Both selling days and foreign currency had a neutral impact this quarter. As previously highlighted, sustained weak demand across a number of key end markets remains the primary drag on sales.Looking at our results by segment as highlighted on Slide 6 and 7. Sales in our service center segment declined 2.3% year-over-year or 3.5% excluding a 1.2% incremental impact from acquisitions. Results reflect continued weak manufacturing activity and related MRO needs across our service center network as well as softer demand within our international operations in Canada and Mexico.Segment sales were unusually weak during the month of December. As mentioned earlier, we believe part of this reflects seasonal variations that occur around the holidays as customers take time off and adjust project and production schedules. Within our Fluid Power and Flow Control segment sales increased 2.7% over the prior year quarter with acquisitions adding 7.6% growth. This includes a full quarter of contribution from our August 2019 acquisition of Olympus Controls, and one remaining month of contribution from our November 2018 acquisition of Fluid Power sales.On an organic…

Thanks, Dave. Overall, while we’re executing largely to plan year-to-date, we remain prudent with our outlook given the backdrop of uncertainty in near-term industrial demand. We remain highly focused on our internal growth and margin initiatives, which in addition to potential benefits from trade resolution and ongoing cost opportunities, we see several levers that should support our earnings momentum in coming quarters if the current environment does not weaken further. Combined with our cash generation potential, we believe our position is strong, and we are eagerly moving forward to realize our full potential.With that, we’ll open up the lines for your questions.

Thank you. [Operator Instructions] Our first question comes from Chris Dankert with Longbow Research. Your line is open.

Hey, morning guys. Thanks for taking my questions. I guess first half we did talk about electronics briefly inside of fluid power, still a slight drag on the quarter. But going forward, just any comments on what backlog in that business looks like, maybe just backlog for total fluid power? Just any thoughts there would be really helpful.

So Chris, I’ll start. I think in the quarter, we did see some positive contribution. I think it still could be early to fully, call it, how it’s going to be in the second half, but did provide some balance to fluid power and Fluid Power and Flow Control, but we still see some pressure in the general industry segments and some of the mobile segments to date. So that leads to our view of combined, it would be down low single digits in the second half.

Got it, got it. That’s very helpful. Thanks guys. And then just if I could get your initial thoughts on the sale of Eaton’s Hydraulics business to Danfoss. I mean, I assume it’s probably a generally positive development, but just would love to hear how you’re thinking about that change.

Yes. I’d start with our view, right? I don’t think it’s a real surprise. As Eaton has continued to work their business portfolio, I think, the deal takes – will take some time. I think they’re talking about towards the end of the year. But I see positives in the business, especially as we think about it going forward. I think Danfoss has described it as a once in a lifetime opportunity with complementary product portfolios and the geographic footprint. And so I think for them, right, the industrial presence, the North American market is additive. Fluid conveyance is additive. And I think there’s opportunities then around mobile presence and potential technical add value capabilities that really exist in both businesses around electronics.

Got it. Got it. If I could just sneak one more in quick, and I’ll turn it over. Is the expectation for the year still for about a $7 million to $8 million LIFO headwind? I know most of that was supposed to be in the first half, it’s a little bit late here. Just any thoughts on LIFO for the year.

Yes. I mean, given the kind of continued trend there, we’re still calling it 6% to 7%, but that is down slightly from our $7 million to $8 million previous guidance on LIFO.

Perfect. Thanks so much guys. I’ll hop back in queue here.

You bet.

Our next question comes from David Manthey with Baird. Your line is now open.

Thank you. Good morning guys. Not to get too granular, but relative to the weakness you saw in January, I assume that you saw an incremental weakness around the midweek New Year’s Day holiday, similar to the Christmas midweek holiday. Have you seen any improvement relative to historical trends over the past couple of weeks? Or was the – has the weakness been more broad-based and continuing beyond just that first week of January?

So David, I’ll start. I’d say, I think it’s beyond just the early part, if I go back to December, we’re probably till the 20th, December 20th running mid-single digits decline. And then greater over the – from the 23rd on, right, and pulled that probably to a high single digits decline. And so coming into January, we haven’t seen the full snap back, bounce back. So that’s where to date, through these kind of 15 or so days, still mid-single digits. Now with that said, hey, the remaining seven days, we could see some movement in January, and we think that’s going to be more indicative than, obviously, to the third and perhaps to the back half of our fiscal years, but that’s what leads us to kind of our overall view around this uncertainty in our guidance right now.

Okay. Thank you. And relative to the 20 of your 30 end markets your industry verticals being down, do you have any insight in terms of how many of those are inflecting one way or another, meaning relative to the rate of change, do you track the number that are improving versus worsening in terms of the second derivative of growth?

Well, that can be a little noise in the numbers. We will look. And then you obviously look for materiality in the change. So, I think in the last period, we would have had eight positive or that’s 22 down. So a little bit of change in the overall segment. Some of those segments that would show positive trends still around food, we think about aggregate, rubber, plastics and paper. And then, on top of mind, I don’t get at this level, a lot of takeaways from big inflection changes that would lead us towards being – one, being more positive or one being more negative.

Okay, great. And then final question on SD&A. Clearly, you’re focused on day-to-day expense discipline. Have there been any additional cost actions taken since Q1 that would provide any step function benefits? And I believe you said that the Q1 cost actions would be fully in the run rate in Q2, just checking on that as well.

Largely in the Q2 run rate, but there is some slight incremental benefit, which to implement. On an absolute basis, we’re going to see a step-up just because of merit and the number of days in the back half. But will go to offset on a percentage of sales basis that back half step-up. So some modest incremental benefit and continue to evaluate across various businesses just given the economic conditions where it may warrant additional actions, and we have taken those, and we’ll continue to take those as appropriate.

Yes, David, I’d say, too, right? Hey, we remain focused on and in tune with the environment. We know how to operate in that. As I think about SD&A going forward in the third quarter, on an absolute basis, we’ll have cost actions read through, but it will be higher. We do our focal point, merit planning to start the year in January. So there will be some coming in there. There’s extra selling days in as we look forward, and obviously, M&A adds to that. So if we’re at the midpoint, our view from an SD&A standpoint we’re flat from a year-over-year standpoint in the third quarter.

Sounds good. Thanks very much guys.

You bet.

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

Hi, good morning everyone. Can we start with the comments about the local business being down a bit more than the national accounts? I guess, is that just a cyclical thing that you’re seeing there? Or could you maybe just expand your thoughts on what you’re seeing with the average customer count or average order sizes? Maybe just expand a bit more on that. And then any kind of efforts that you have of getting that business to pick up in the second half of the year. What kind of initiatives are underway?

Yes, Adam, my view of a lot of that local account was December and maybe start to January, but especially December, late December into that. And I think that has kind of a carryover influence of gross margins being flattish in that period. And we think about less activity going on in December and especially over those last couple of weeks. And so we continue to have very good activities across our business and participate in the local economy. And we have cross-sell opportunities with those. So, hey, we like our position. We like our focus in that segment and on that business. And so we think it’s more timing of year and some of those customers choosing to take that time out.

Okay. Got you. And then Dave, could you talk a little bit more about the free cash flow outlook for the year? Usually, the fourth quarter is a big source of pickup in cash. Do you expect that to happen again this year? And then remind me how much inventory you expect to pick up in the second half?

Sure. I think I am pleased with the sustained contraction across the year in terms of the cash generation, much more level-loaded this year. But absolutely, to your point, the back half does tend to be much seasonally stronger in terms of our cash flow generation profile. So we’ve made – and I think, very pleased with the progress we continue to make on reduction in past due receivables and collections. So, if you look at the overall reduction in AR year-over-year versus the decline in sales. Certainly, you can see that progress reading through.On the inventory side, we’ve still got work to do and that, as I pointed out, will be a tailwind in the back half of the year. I’m not going to hang a number on it at this point. But certainly, we’ve continued to make good progress when you look across the service center network in terms of sizing the inventories, commensurate with the – some of the demand profile that we’ve seen. But have seen a bit of a build that causes inventory still to be higher year-over-year and particularly in our Fluid Power and Flow Control business just given some project timing, project delays and still some supplier constraints that have impeded some shipments. So, some opportunity brew in both sides of the equation. But certainly, we’ll continue to move the needle there will be a tailwind, and that will help that stronger second half cash profile.

Okay. Thanks.

You bet.

Our next question comes from Joe Mondillo with Sidoti & Company. Your line is now open.

Hi, everyone. Good morning. Just wanted to clarify regarding the cost initiatives. David, did you say that most of the cost initiatives were in place in the first quarter, so the run rate that we saw in the second quarter should be sort of similar in the back half unless the environment changes at all? Is that correct?

It is marginal incremental benefit from a handful of those initiatives that we did not see the full benefit in the most recent quarter. And as I indicated, we continue to take actions in some of the more challenged businesses to size the cost appropriately. So, some modest incremental benefit as you think about that back half and that’s part of that offset once again to the focal point merits and the incremental selling days in the quarter.

All right, great. Thanks. And then also, just looking at the Fluid Power and Flow Control segment, could you just give us sort of the puts and takes, what’s going on there outside of the electronics business, which is really a small piece of the business? Just given sort of the OEM exposure that you have at fluid power and then with capacity utilization, I think, of – some of your customers probably coming down at flow control. Just curious what the puts and takes are going over the next – where the trends are going? Because I know sort of there was a comp sort of – tough comp that you’ve been going up against last couple of quarters. But now, we have some – I think, some organic negative trends that are going on in some of your end markets there. So, I’m just curious of how you’re thinking about that going forward.

So, we maybe, take it from a few angles. The – on the flow control side, right, we’ve had a large project that we comped against that will, for the most part, now be behind us in that area. There are some general headwinds around process related industries. But the team looking back and somewhat expectations looking forward in this macro, while we have opportunities, it could result in kind of a low single-digit. And then if we think about fluid power, we talk about some of the electronics and technical being able to contribute. We’ll see in the kind of coming months and quarters to the level. But to your point, there are industrials and some of those mobile OEs that are seeing slowness. Now with that, creates some opportunities for us to be with them working their products, working the designs, how we can grow our content, but that will contribute to us in future periods not necessarily in the quarter that we’re in or in the back half. So that kind of leads us to, we think, at our midpoint, there is a low single-digit headwind in the segment.

Okay, great. Thanks. And then just to touch on your guidance, just wondering what part of the business or what line item or margin, revenue, segment-wise, what was really the biggest cause that sort of took off the high end of the gains off the table?

Really, to sum it up, it was just a softer daily sales rates that we saw as indicated both in December, but then continuing into the month-to-date January that gave us pause and just given that uncertainty, the broad-based kind of market headwinds that we’ve seen, felt it appropriate to tug down that upper end just a bit in terms of relative to expectations.

Okay. And then just lastly, the tax rate was lower than I anticipated. I didn’t hear you mentioned anything in the prepared remarks, but I was just wondering what you expect, I guess, for maybe the back half of the year, for the whole year.

Yes. You bet. As opposed to the 25% to 26% we’ve previously guided, we did see some discretes that benefit us again in Q2. So, as we look at the back half, we will see some upward pressure on the back half rate. But as a result of the Q2 performance and favorability, would now call it 24% to 25% in terms of the overall full-year effective tax rate.

Okay. Thanks. Appreciate for taking my questions.

Yes.

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

Good morning, guys.

Good morning.

I wanted to go back to the broader environment. I think there’s a lot of expectation that there will be a recovery in calendar two half 2020. So, when you say subdued demand will persist, do you have any additional thoughts about duration and what you’re thinking about for catalyst to restart growth?

So, I mean, obviously, we think that continues for the half. And so for the start of what will be our new fiscal year, I don’t know that – we’re not fully into from a planning standpoint of those. Trade resolution obviously, has the opportunity to help and contribute to that potentially as we think about it going forward. Also, if there’s a broader infrastructure effort. But that’s probably not ahead of an election cycle that perhaps occurs after an election cycle.

So, you think the Phase 1 deal and maybe getting USMCA sign will provide enough clarity to get businesses looking to grow again? Or do you need something – or will they need something more specific?

I think it can start to help from a sentiment standpoint, but that’s not all into our guidance right now.

Yes. Are you – given the environment, are you seeing any change in multiple in the private market? Or do you expect that will happen as trailing 12-month EBITDA numbers start to come down?

I think for us, probably early, but from an M&A standpoint, right, we’re active, we’re busy, but on those read-throughs, it’s probably hard to say when they perfectly come through.

Yes. And just I guess philosophically, in recent quarters, we’ve seen private equity take out command distribution, another one made a strong run in Anixter in the electrical distribution space. Given where public market multiples are, do you think there will be more PE interest in public markets?

Hey, again, it’s probably better experts than I. Clearly, money is available. There’s interest in some of the spaces, multiples and in some of the segments. We think about Eaton. Those can be attractive in the side. But we have a disciplined approach as we think about it going forward. And working our targets going through. So I don’t know that it creates undue pressure for us in an M&A environment.

All right. Thanks.

[Operator Instructions] Our next question comes from Michael McGinn with Wells Fargo. Your line is now open.

Thanks. Sticking with the M&A theme. Can you give us an update on the underlying fundamentals of the robotics and automation market, specifically the growth rates you’re seeing within Olympus relative to your base business?

Well, I think, you can see in the quarter, that Olympus performed well. It continues to be, right, as they term it, right, where innovation meets automation. So, we’re excited about the product offerings that are available. Our work on key projects that exist today, broader engineered solutions and then that opportunity for us to expand that into some other markets or into – or with some other customers in that side. So the growth – or the interest in and the growth and the adoption continues to be at a good rate. So, we’re pleased with the performance in the quarter, and we think it can be a nice contributor for us in the business going forward.

Is it fair to say that, that growth rate, that nice growth rate is better than the service center and where fluid power is operating right now?

I’d say today in the cycle, yes, we would say that.

Okay. And then switching gears to gross margin, flat to up 10 bps, still sounds relatively positive. And you’ve never been the primary indicator for the trade war, given your limited direct exposure to China. But can you comment on how sticky this current run rate is, if we see a broader tariff roll back in subsequent conversations with customers on pricing?

For us, we think it continues to stick and stay. If I look at suppliers today, there’s still incoming price increases, they moderated from the past. But there will still be some of those coming through. And we will be taking them to the marketplace. And then for us, on margins, right, we’ll continue to work on point-of-sale, really just reducing variation around customer groups and product groups. And we think mix helps us going forward in those as well. As we provide more value content, more value-added solutions and projects to that helps us on the margin side. Over time, we think for a longer period, we still believe there’s the 10 to 20 basis point improvement.

Okay. And then if I can sneak one more in. On the international side of your business, you called out Canada and Mexico, but left out Australia. Was the Canada and East Coast comment more tied to general industrial or West Coast comment tied to natural resources? And then if you could just size Australia sales as a percent of total, that would be helpful.

Sure. So, I’d say Canada could be really across, right, some challenges in the western provinces, and that’s predominantly resource and resource connected, but also in some of those eastern provinces around the general industry activity. And so their participation in either metals, mining, machinery, process-related industries. There’s some commonality in there, maybe some uniqueness, but there’s some commonality across. And then from an Australian standpoint, less than 2% of the overall.

All right. Thanks a lot. I’ll pass along.

Okay.

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.

Thank you very much. And I just want to thank everyone for taking their time and joining us today, and we look forward to talking to many of you throughout the quarter.

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