Julie Kho Neil A. Schrimsher - Chief Executive Officer, President, Director and Member of Executive Committee Mark O. Eisele - Chief Financial Officer, Vice President and Treasurer.

John Anthony Baliotti - Janney Montgomery Scott LLC, Research Division Matt Duncan - Stephens Inc., Research Division Courtney Killion Gregory W. Halter - Great Lakes Review Anjali R. Voria - Wunderlich Securities Inc., Research Division.

Ladies and gentlemen, welcome to the Fiscal 2014 Second Quarter Earning Call for Applied Industrial Technologies. My name is Frank, and I will 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 Ms. Julie Kho. Ms. Kho, you may begin..

Thanks, Frank, and good morning, everyone. On behalf of Applied Industrial Technologies, thank you for joining us on our fiscal 2014 second quarter investor conference call. Our earnings release was issued this morning before the market opened. If you haven't received it, you can retrieve it from our website at applied.com.

A replay of today's broadcast will be available for the next 2 weeks, as noted in the press release. Before we begin, I would like to remind everyone that we'll discuss Applied's business outlook during the conference call and make statements that are considered forward-looking.

All forward-looking statements, including those made during the question-and-answer portion, speak only as of the date hereof and are based on current expectations that are subject to certain risks, including trends in the industrial sector of the economy, the success of our various business strategies and other risk factors identified in Applied's most recent periodic report and other filings made with the SEC, which are available at the Investor Relations section of our website at applied.com.

Accordingly, 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 statements whether due to new information or events or otherwise.

In compliance with SEC Regulation FD, this teleconference is being made available to the media and to the 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 disseminated, all content of the call will be considered fully disclosed. Our speakers today include Neil Schrimsher, Applied's President and Chief Executive Officer; and Mark Eisele, our Chief Financial Officer.

Neil, please go ahead..

Okay. Thank you, Julie, and good morning, everyone. To quickly recap the numbers from our release this morning, our sales for the second quarter were $581.9 million, down 1.3% from the prior year. Net income for the quarter was $25.9 million or $0.61 per share compared with $27 million or $0.64 per share in the prior-year quarter.

On the sales front, we continue to experience some weaker industrial demand in some key market segments, as well as negative impacts on reported sales from foreign currency translation. We did maintain a disciplined focus on our operating costs, while driving our continuous improvement initiatives across the business.

In the quarter, we continue to expand our Fluid Power sales, service and repair capabilities in domestic and international markets, with the Fluid Power segment revenues increasing 6.4%.

In Applied MSS, we remained active by completing facility and system consolidations and providing new sales order technology, including handheld devices and the My MSS intranet site for our vendor managed inventory specialist.

In addition, we completed planning on expansion of the MSS consumables MRO product offering into another Applied distribution center, and we're excited about our growth prospects with our existing customers and reaching new end-users. We also continue our ERP deployments across the U.S. service center network. Today, we have 317 locations in the U.S.

and Canada live on the system, and we will complete our U.S. deployments early in the fourth quarter of our fiscal year. Our teams have worked very hard preparing for the system transitions and throughout the phase go lives. We know ERP projects are a significant undertaking in investment, in time and in resources.

The business transformation provides our organization with a common enterprise platform with the system capabilities and consistent processes that will further enhance our service and our performance for years to come. On the acquisition front, we completed one acquisition at the end of the calendar year.

Texas Oilpatch Services, or TOPS, a distributor of bearings, oil seals, power transmission products and related replacement parts to the oilfield industry, and they're an excellent fit with Applied.

This further enhances our capabilities to serve upstream customers in the oil and gas market, and we're excited about the opportunities for broader energy market participation. In this morning's release, we also announced that the company's Board of Directors declared a $0.02 or 8.7% increase in the quarterly cash dividend to $0.25 per common share.

This is our fifth dividend increase since 2010, with a cumulative increase of 67% over this 5-year period. In the quarter, we became more active in share repurchases, resulting in the purchase of 226,100 shares of common stock for $10.8 million.

We are committed to generating increased shareholder value through the return of cash to our shareholders via attractive dividends and share repurchases, as well as through our business execution and strategic investments. Acquisitions are a key part of our strategy, and we expect to remain active in this area as we move through calendar 2014.

So with that, I'll turn the call over to Mark for additional detail on our financial results..

Thanks, Neil. Good morning, everyone. I'll provide some additional insight regarding our second quarter fiscal 2014 financial performance. Our sales per day rate during the quarter was $9.4 million or 1.3% below the prior-year quarter and 0.8% below our rate in the September quarter.

We had the same number of selling days in the December 2013 quarter compared to the prior year. Acquisitions had a positive impact on sales of 1.2% during the quarter, and foreign currency translation decreased sales by 1%. Therefore, overall core same-store operations experienced a 1.5% decrease in sales compared to the prior year.

In addition, we believe the impact of vendor price increases was minimal during the quarter. Our product mix during the quarter was 30% fluid power products and 70% industrial products. Second quarter sales in our Service Center-Based Distribution segment decreased $14.5 million or 3%.

Acquisitions had a positive impact to our Service Center-Based Distribution segment quarterly sales of 1.4%. The sales in our Fluid Power businesses segment increased $7 million or 6.4%, of which approximately 0.7% was due to acquisitions. From a geographic perspective, sales in the second quarter from our overall U.S.

operations were 0.2% higher compared to the prior-year quarter and experienced the positive impact of $6.8 million or 1.4% from acquisitions.

Our Canadian operations benefited from $0.5 million of sales from acquisitions during the quarter and experienced a combined sales decrease of $6.4 million or 8.6%, including an unfavorable currency translation impact of 5.8%.

Consolidated sales from our other country operations, which include Mexico, Australia and New Zealand, ended up with an overall increase -- an overall decrease of $2.4 million or 6.4%, which includes unfavorable foreign currency translation of 5.5%.

Our gross profit percentage for the quarter was 28.1%, 50 basis points above the prior year second quarter. This increase can be attributed to the positive impact of recent acquisitions, operating at gross margins above our traditional core business, as well as improved supplier support.

Our selling, distribution and administrative expenses as a percentage of sales was 21.2% for the quarter, 40 basis points above the prior year second quarter. On an absolute basis, SD&A increased $1.2 million in the quarter or 1%. Acquisitions added $4.2 million or 3.4% to our SD&A in the quarter.

Our core operational SD&A run rate was 2.5% lower on a year-over-year comparison, resulting from ongoing cost-containment actions. Our effective tax rate for the second quarter was 35.6% and is at 34.7% year-to-date. We still believe our tax rate for fiscal 2014 will be around 34.0% to 34.5% for the entire year.

Our consolidated balance sheet remains strong, with shareholders' equity of $773.5 million. Our after-tax return on assets, so far, in fiscal 2014 is 10%. As Neil mentioned earlier, we did complete our acquisition of Texas Oilpatch Services as of December 31, 2013.

On an annual run rate, sales of this organization are expected to be less than 1% of our consolidated sales. While being slightly accretive for fiscal 2015 and beyond, our bottom line results in fiscal 2014 will most likely be less than $0.01 accretive due to transaction costs.

Inventory at December 31 is above our June and September levels, primarily due to increases in our U.S. service center operations related to certain strategic supplier programs and stocking levels in connection with our continued ERP rollout throughout the U.S. service center network.

Ahead of go lives, we have accelerated purchases to minimize transactions between our legacy system and the new SAP system to ensure high levels of customer service. Lastly, our Texas Oilpatch Services acquisition added $3.2 million of inventory as of December 31.

As we stated in our previous conference call, we expect December 31, 2013, to be our high watermark for inventory balances. We expect a slight decrease in inventory levels at March 31, 2014, and a somewhat larger decrease as of June 30, 2014. Inventory levels at the June 30, 2014, could be lower than December levels by upwards of $20 million.

Cash generated from operations was $15.7 million for the quarter compared to $4.9 million in the prior-year quarter. We expect improved cash flows from operations over the remainder of the fiscal year.

We purchased 226,100 shares of stock in the open market during the December quarter, and we expect to remain active around the same level in executing stock buybacks throughout our fiscal year. Now I'll turn the call back to Neil for some final comments..

Thanks, Mark. So while we made progress on our initiatives in the quarter, we're not satisfied with our overall results. All across Applied, we have a great opportunity to improve our growth and profitability, organically, via acquisition and through our technology investments.

We see some signs of improvement and some key markets and the broader industrial economic indicators, which will be positive for our sales and business results as we move throughout 2014. So with that, we'll now open up the lines for your questions..

[Operator Instructions] Our first question comes from the line of John Baliotti from Janney Capital Markets..

Neil or Mark, you, guys, obviously did a good job in what you can control, what was within your control at the cost side and, obviously, a nice containment on the SD&A side and the cost of goods.

Give us a sense of how you feel about -- is that -- can you maintain that consistency throughout the year? Or do you think there's any kind of some fluctuations we would see in the next couple of quarters in those components?.

John, this is Mark. I think from our perspective, going forward, from an SD&A view, is we think we should be able to maintain the SD&A expenditures comparable to what we had in the prior year. So as you noticed this quarter, we were 1% difference in what we spent last year.

Our view, going forward, over the next couple of quarters, should be -- we should be in the same ballpark as what we've spent last year. So that's our view on our costs..

Okay. And just as the quarter unroll -- I mean, obviously, we've heard from a number of other companies and there is fluctuation in the pattern throughout the quarter.

Is there any kind of color that you got out of the quarter in terms of what either -- how it progressed? Or just in total, what kind of interaction you had with customers?.

Sure. So John, I would say, in the quarter, I think we saw some improvements as we moved through the quarter, but maybe, it's softened or waned a little bit in kind of the mid- to late December. I don't know if that's holidays or calendar timing or what, but we had positives in our U.S. Fluid Power business, encouraging throughout.

And if I kind of look at the January, I'd say the starts, similar to the second quarter overall, kind of the customer sentiment when I'm out. I think they remain kind of steady, cautiously optimistic, as they're rooting for these economic metrics to translate into additional activity. I think on their fronts, many of them are doing well.

They've got cash. They're making investments. Some of their best can be investing in their own business and their operations. They're planning for the future.

So some of those bigger swings, they may be looking to time those investments, but -- and I think on the other front, customers continue to look at how they can reduce transaction costs, consolidate their spend, do business with better, fewer partners. And we think that's positive for us going forward..

Our next question comes from the line of Jon Tanwanteng from CJS Securities..

This is Jack Omarion [ph] filling in for Jon.

Can you take a quick moment to talk about the environment for acquisitions? Are valuations getting better or worse? And what are the biggest obstacles you're facing in getting more or larger deals done?.

Yes, so -- maybe, I can't speak to all the environment. I just think from our side, we remain busy, the M&A team, myself personally. Got a good pipeline that we are working. We know we have clear priorities. We think industrial distribution will continue to consolidate. It's got a pretty high fragmentation.

And we've said, we want to be busy and active every year, really, like we were in 2012. So we -- and we closed one late in 2013. As I look forward, I expect us to be busy throughout with opportunities around our priorities. And we're also looking to raise the sites of the targets.

I think historical average has been more around the $30 million in revenues, and we think there's going to be opportunities for larger prospects..

Okay, great. And international headwinds have been pretty strong for you guys over the past year.

Do you see any sort of stabilization or recovery there?.

If you'd look at the macro trends, and so one would be coming out of Australia, and we've got some of our leadership team going there for customer meetings and supplier reviews coming up, I would say that two-speed economy kind of consolidated to a one-speed economy in some slowness as resources really got challenged.

I think we saw a little bit of improvement in some of the macro indicators. I think they're predicting their industrial activity, their GDP, to improve in 2014. We're busy on the product expansion side around power transmission products. We think that really helps us to be more valuable to our current customers and new customers. So we'll see.

With those indicators, it kind of speaks to a little bit of improvement, as we move throughout 2014. And we're working hard to improve our results, ourselves, as we move through the calendar year..

Our next question comes from the line of Matt Duncan from Stephens Inc..

So the first thing I've got, I want to get back to Jon's earlier question, just on the sales trends. I don't know if you're willing to talk about just organic daily sales growth that you saw through the quarter.

And also, into January, I'm curious, are you seeing any impact from all the winter weather we've had? It's obviously been mentioned by some of your peers.

So have you guys -- do you feel like you've been impacted by that? And do you think maybe that's why December could have slowed down in the back half of the month?.

Yes. I'll start out on the last one, and maybe Mark can jump in. I can't guess or predict on kind of the weather impact, right? We're all working through it. So I told my guys, right, let's plow forward. So I'm not sure of the back half of December, what, and to be determined as we go through January. We're active. I know customers are operating.

They have needs, telling our sales guys in our stores to be going. Maybe I got a little empathy on the Atlanta guys for a little bit for a day or 2, but we expect to get back at it..

Okay. And then, Neil, just looking more broadly at the manufacturing sector, I'm sure you've heard what a lot of the other guys have been saying that maybe trends are bottoming or improving there. We've obviously had slight improvements to capacity utilization. PMI has been in pretty positive territory for more than half a year now.

Do you think maybe the pickup you're seeing in fluid power sales could be tied into that recovery in manufacturing? And then do you feel like the lag between economic data and your sales is shorter or longer, typically, between Fluid Power and the MRO products?.

Yes. So I'd say, first, I'm not sure that macro indicators are the best translation to our Fluid Power business, where we'd see some of that segment in growth, right, because we do well with OEMs through our subsidiaries.

And I think we've got a nice opportunity to further expand our MRO coverage and penetration with existing customers and new ones through our service centers. And so on the OEM side, that's some in agriculture, that's some in construction, that's some in medical and some other segments on the Fluid Power side.

If I think broadly on the other indicators, our traditional lag has been around that 4- to 6-month time frame, and maybe a little closer to 6. I think we've said, right, some of those improvements were not fully translating to segments that are heavy in industrial product consumption, like machinery OEMs, maybe metals and chemical production.

So we're thinking, as we move through '14 in some of that dialogue with people in those spaces that some of those macro indicators do start to translate more into those results. And that would be good for, really, the industry and everyone on the industrial MRO side, as we go through the calendar year..

Okay. That's very helpful. And then last thing for me, just going back to the SG&A cost controls, I'm curious, what type of expenses you guys were cutting this quarter, because it was down close to $7 million from the level that you had in SD&A expenses back in the September quarter.

And I'm just curious, what exactly you took out to do that? Is it mostly just discretionary? Or were there some more fixed cost adjustments lower that occurred during the quarter?.

Let me address the overall level for something, first, Matt. We did have 2 fewer business days in the second quarter versus the first quarter, and so that does have an impact. So 2 fewer -- we have 64 selling days in Q1 and 62 in Q2. So as a percentage, that's meaningful from a number perspective.

So when we look at SD&A costs, that means something for us. And I would say from controlling overall costs, we constantly look at all available costs to manage, and there's a mix of those.

And so discretionary items, other things where we can pull levers on, we're always looking at that to try to make sure things are reasonable, appropriate for the business. Since the overall top line sales dollars for our core operations for this quarter, we said they were down 1.5%.

We're looking to make sure we do the things that need to be done to make sure we can support the business we have and also to be ready to support the business increases that are coming at us in the future..

And that's part of what I'm getting at, Mark, on the things that drive growth within SG&A, like your sales force, for example.

Have you been adjusting that lower? Or has that level stayed pretty constant and it's the other levers that you're pulling?.

It's the other levers. We're not going to reduce our forward-facing capabilities or our presence in any of the markets, so....

Our next question comes from the line of Courtney Killion from Cleveland Research..

Just curious if you could give a little bit more color around the MSS improvements or expansion there that you've seen.

Any goals for that program? Is it outgrowing the core business? And what are the kind of gross margin trends look like there?.

I think the gross margin capability and trends are -- remained positive to us in the business. We like the space a lot. In helping on those classy MRO consumables, they're doing a good job with their existing customers, and we think the Applied customer base does a really nice opportunity for that.

And so we're working on that, teaming that, partnering up, reaching more and more of those accounts. So -- and we like the business. We wanted to get even bigger as we go forward. That was really our look at doing the analysis of -- it makes sense for us to have product presence in one more geographic area.

We've got, obviously, strong distribution center capability to do that in. So we'll do that, and we'll augment with some additional selling team to do that. And we think that's good for us throughout 2014 and beyond..

[Operator Instructions] Our next question comes from the line of Jason Rodgers from Great Lakes Review..

It's Greg Halter, on for Jason.

Wonder if you could detail the sectors of your business or the end markets that were either good, outliers on the good side and then on the bad as well?.

Yes. So I would say, for the most part, consistent. We track 30 or so industries. I think looking back in the quarter, things like lumber, wood products, aggregate, those still around, some construction and housing, doing well in that space. Probably the weakness around machinery manufacturers, maybe pulp, paper, some of those.

So not a lot of change, but maybe a little bit of an improvement or less of a negative on some of the big categories like the machinery side..

Okay.

And what's the outlook for price increases out there in today's environment?.

I'd say, from my perspective, I think, overall, it's stable pricing environment. We're seeing some modest increase activity from suppliers in the industry. So it's expected, kind of moderate stable increases that would be coming in, and as you expect from many of them at this time of the calendar year..

And finally, were there any LIFO layer liquidations in the quarter?.

No, there were not. Our inventory numbers did have an increase from September to December and also then from June through December. And as we look for the rest of the fiscal year, our expectations are that we will have no LIFO layer liquidation benefits at June 30. And as you know, LIFO is a once-a-year annual calculation.

And we continue to look at the numbers, but as of this time, we don't think there'll be any LIFO benefits in fiscal '14..

Our next question comes from the line of Anjali Voria from Wunderlich Securities..

Yes. I have -- I wanted to start out with the SD&A side. Do you have any examples of cost-containment initiatives? Just trying to get a handle of what that entails..

Well, do we need to replace that headcount from the back-office supporters or a way to work around that? So we're looking at these things one at a time.

These are really looking at individual trees versus a forest and saying, "Okay, which of these trees could we potentially thin?" And looking at those individually is just helping us in viewing the overall expense perspective, and then just trying to set the tone of trying to contain expenses. So I'd say it's really more of a mindset.

It's not anything that's new and different for us as an organization. But in this slow growth environment that we've been experiencing in our core operations, it's become a little more acute for us..

Okay.

Then -- and I guess, what was the headcount change sequentially?.

I have that information here, just a moment. Our FTE headcount as of December 31 is 5,063 associates. I don't have with me what it was in September. So I think it's pretty stable..

And were there any compensation-related, maybe, adjustments to incentive compensation during the quarter? Or any compensation accrual adjustments?.

Not materially. But one of the things that we did do during the quarter is we did make some tweaks to our compensation programs for our sales reps. And so our forward-facing folks with our customers in efforts to try to incent them to grow.

And so these were adjustments that to try to take advantage of growth opportunities and to keep them incentive, to keep knocking on the doors and trying to be out there hunting and gathering sales opportunities..

Okay.

Do you have an organic change in payroll costs year-over-year or sequentially or both?.

No, not really. I mean, what we do from a payroll perspective, is we try to manage the business, is we give target potential merit increases for managers to utilize and, as a guideline, to start with and then that's how they use to manage their departments with those..

Okay.

And I guess, the unrealized loss on deferred compensation trusts, do you have -- what's that number by any chance because that is an offsetting impact in the OpEx line?.

Yes. That's a number that's buried down in our other income and expense for the quarter, and that dollar amount for this quarter was about $650,000. And so we -- we're showing a gain as our disclosed numbers of, what, $270,000 on the income statement.

And so we -- that number is made up of 2 things, primarily, which is the $650,000 gain from the assets held in the Rabbi trust for the nonqualified deferred comp plans, and that's offset by various foreign currency transaction losses to net to the $270,000..

Okay. And I guess, just lastly, on the ERP side. It sounds like you have a good number of your branches on the system.

Are there any early indications on whether you're seeing maybe gross margin benefits from price costs? Or anything on the SG&A side that we could look forward to? Or any thoughts on how ERP is playing out for you?.

I think from our view on ERP, as we continue to roll this out, I think as we've talked in the past, one of our perspectives is that a lot of the benefits will be accruing to us through gross margin dollars, as we march into the future with the tools available to us under SAP and taking advantage of those tools.

What I will say is that we do see instances out there where the -- being on SAP and using the information is helpful for us. But again, we need to get all of the U.S. on SAP, so that we can wield these tools more in a holistic manner versus a one-off manner..

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'd just say, okay, thank you for joining us today. We appreciate your interest and investment in Applied, and we look forward to talking with you throughout the quarter. Thanks a lot..

Ladies and gentlemen, this concludes today's conference call. Have a great day, everybody..