Ladies and gentlemen, thank you for standing by, and welcome to the Fiscal 2016 Third Quarter Earnings Call for Applied Industrial Technologies. My name is France, and I'll be your operator for today's call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session.

Please note that this conference is being recorded. I will now like to turn the call over to Julie Kho. Julie, you may begin..

Thank you, France, and good morning, everyone. 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 two weeks, as noted in the press release.

Before we begin, I'd 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 various industry sectors and geographies and 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 statement. The company undertakes no obligation to update publicly or revise any forward-looking statement 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 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.

At this time, I will hand the call over to Neil..

Thank you, Julie, and good morning, everyone. We appreciate you joining us today.

As noted in our news release this morning, our third quarter and year-to-date results were largely influenced by a non-cash goodwill impairment charge of $64.8 million, driven by the declines in global energy markets, including mining and oil and gas, as business conditions dramatically slowed over the last 12 to 18 months.

We continued to respond to the energy market challenges by decreasing operating expenses, while positioning Applied for ongoing value creation. Our third quarter restructuring charge of $7 million is part of our actions to align resources to opportunities, customer requirements and market conditions.

While it's significant to absorb into one quarter, these restructuring moves will prepare us for the fourth quarter, fiscal 2017 and further strengthen our competitive position. At this time, I'll turn the call over to Mark for more detailed walkthrough, the goodwill impairment, restructuring charges and our overall results..

Thanks, Neil. Good morning, everyone. I'll provide some additional insight regarding our third quarter fiscal 2016 financial performance. Before getting into our normal operational discussion, I will address the goodwill impairment and restructuring charges. First, for the goodwill.

This charge resulted from our annual goodwill impairment testing that we performed during the March quarter. We considered current and expected market conditions and concluded that two out of our seven reporting units had carrying value of goodwill that exceeded their fair value of goodwill.

These two reporting units are our Canadian Service Center unit and our Australia/New Zealand reporting unit. For Canada, the goodwill impairment was $56 million, which represents 68% of the goodwill assigned to that reporting unit.

The impairment charge is primarily the result of the substantial and sustained decline in the upstream oil and gas energy sector of the economy during calendar 2015 and continuing into 2016. For Australia/New Zealand, the goodwill impairment was $8.8 million and represented 100% of their goodwill.

This impairment charge is primarily the result of the multi-year decline in the mining and extraction industries in Australia. The total goodwill impairment of $64.8 million decreased net income by $63.8 million and decreased earnings per share by $1.62 per share during the March quarter.

In evaluating our Canadian, Australian and oil and gas focused businesses, we recorded $7 million of restructuring charges in the March quarter. $3.6 million of these impacted cost of goods sold, as we increased inventory reserves for potential excess inventory due to declining customer demand requirements.

The remaining $3.4 million relates to items included in SG&A expenses pertaining to severance for reduced head count and expenses for seven facility consolidations in Canada and three in Australia. The $7 million of restructuring charges reduced net income by $4.9 million and reduced earnings per share by $0.13 per share during the March quarter.

Now I'll move into a discussion of our more traditional financial information. Our sales per day rate during the quarter was $10 million, 7.6% below the prior year quarter and 1.3% above our rate in the December quarter. We had 63.5 selling days in the March 2016 quarter and 63 selling days in the March 2015 quarter.

Acquisitions had a positive impact on sales of 2.3% during the quarter and foreign currency impacts decreased sales by 1.8%. Therefore, overall core same-store operations experienced a 7.4% decrease in sales compared to the prior year.

This 7.4% decline consists of a 2.7% decrease attributable to traditional core operations and a 4.7% decrease in sales for our operations serving the upstream oil and gas markets. In addition, we believe the impact of vendor price increases was minimal during the quarter.

Our product mix during the quarter was 27.3% fluid power products and 72.7% industrial products. Third quarter sales in our Service Center Based Distribution segment decreased $33 million, or 5.9%. Acquisitions added $9.7 million, or 1.7%, and negative foreign currency impact reduced sales 1.8%.

Therefore, core same-store operations in the Service Center Based Distribution segment, experienced a 5.8% decrease. The majority of this relates to our operations that sell to the upstream oil and gas industry, as our other traditional operations had a decrease of only 1.1%.

Taking a closer look at our operations that sell to upstream oil and gas customers, we experienced a 51% decline in our sales from the March 2015 quarter and a 28% decline in sales when compared to our December 2015 quarter.

A portion of this decline in sales from the December quarter to the March quarter reflects seasonality due to weather within the Canadian portion of this business. We expect overall sales to upstream oil and gas customers to be stable from the March quarter to the June quarter.

Our Fluid Power Businesses segment had a broad-based sales decrease throughout the U.S., Mexico, and Canada, totaling $13.8 million, or 11.2%. Acquisitions within this segment increased sales $5.8 million, or 4.7%, while unfavorable foreign currency translation decreased sales by 2.1%.

Excluding the acquisition and currency impacts, core fluid power operations saw a sales decrease of 14.2%. From a geographic perspective, sales in the third quarter from our overall U.S. operations were down 4.4% compared to the prior year quarter and experienced a positive impact from acquisitions of $15.5 million, or 2.8%.

Our Canadian operations experienced a sales decrease in local currency of 16% and the negative foreign currency translation impact of 8.3%, resulting in a combined sales decrease of $19.4 million, or 24.3%.

The sales decline in local currency was related to our Reliance operations serving upstream oil and gas customers, as the other traditional broad-based Canadian operations were only down a small amount.

Consolidated sales from our other country operations, which include Mexico, Australia and New Zealand, had an overall decrease of $2.8 million, or 7.4%. This consisted of a sales increase in local currency of 7.9% and a negative foreign currency translation impact of 15.3% in the quarter.

The local currency sales increase in the quarter is all related to our Mexican operations. Our gross profit percentage for the quarter was 27.6%, the same as last year's third quarter, and 80 basis points below our run rate from the December quarter.

60 basis points of this 80-point sequential decline relates to the restructuring inventory reserve adjustments. The remaining decline is from the lower gross profit realization for our operations, serving upstream oil and gas markets.

Looking forward to our June quarter, we expect overall reported gross profit percent to again be above 28%, as we don't expect further material inventory charges to negatively impact our margins. Our selling, distribution and administrative expenses, on an absolute basis, decreased $0.6 million in the quarter, or 0.4%.

Excluding SG&A related to restructuring expenses, as well as those incurred by our acquired businesses, our operational SG&A was 6% lower on a year-over-year comparison. In addition, during the March quarter, we recorded $1.3 million of expense for potential bad debts. The effective income tax rate was a negative 26.2% for the quarter.

This is due to the reporting of $64.8 million of goodwill impairment during the quarter, of which $61.3 million is non-tax deductible. Exclusive of goodwill impairment, our effective tax rate for the quarter would have been 35.0%.

Comparing this to our 32.7% rate in the previous March quarter, the increase is due to lower foreign earnings and discrete tax items in the current period, which negatively impacted the rate. We believe our tax rate for the June quarter will be in the range of 34.5% to 35.0%.

Our consolidated balance sheet remained strong, with shareholder's equity of $656.8 million and a conservative debt to total capitalization ratio of 36.1%. Excluding the impairment and restructuring charges in the March quarter, our after tax return on assets for the third quarter and year-to-date was 7.0% versus 7.8% in the prior year.

Inventory at March 31 is $12.7 million below our December levels. Reported inventory balances had increases of $3.1 million from acquisitions during the quarter and $5 million from strengthening foreign currency rates during March. Offsetting these increases are $15.7 million of operational inventory decreases throughout all of our operations.

We expect continued operational inventory decreases from April to June. The remaining reported decrease in inventory pertains to changes in inventory reserves for obsolescence as well as LIFO. Cash generated from operating activities was $57.4 million for the third quarter, resulting in $90.3 million year-to-date.

Our year-to-date cash generation is $51 million ahead of our prior-year amounts, relating entirely to operational working capital improvements in receivables and inventory, offset somewhat by lower earnings. We expect cash flows from operations to remain solid for the rest of the fiscal year.

In this morning's release, we announced that our Board of Directors declared a quarterly cash dividend of $0.28 per common share. We were also active in share repurchases during the quarter, with the purchase of 250,000 shares of common stock for $9.7 million.

Our fiscal 2016 is on track to be our second highest year in returning cash to shareholders, further demonstrating our commitment to generating increased shareholder value. Now, I'll the turn the call back to Neil for some final comments..

serving our customers, delivering a strong close to the fiscal year, and building momentum heading into fiscal 2017. We've provided fourth quarter guidance of earnings per share of $0.62 to $0.70 per share on sales of $640 million to $650 million.

All across Applied, our associates continue to be energized and excited about our business potential and growth prospects in our core businesses and with acquisitions. At this time, we'll open up the lines for your questions..

Thank you. We will now begin the question-and-answer session. Our first question comes from the line of Matt Duncan with Stephens. You may proceed..

Hey, good morning, guys..

Good morning, Matt..

Just wanted to see if we could start by talking about the sales trends that you guys saw month-to-month through the quarter and into April. And really I'm just curious if you're seeing any kind of improvement out of the industrial sector at all? It seems like from what some of your peers have said, things may be stabilizing a little bit there.

Just curious what you guys are seeing?.

Yeah. For us, our sales per day, we had improvements really each month throughout the quarter, with a couple of days remaining April is consistent with March. So, perhaps I'd say consistent with others then, right, (17:10) seeing a stabilization perhaps as we go through the balance of our fiscal year and perhaps on through calendar 2016..

Neil, how about just on a percentage basis? I mean, I guess obviously it would be pretty normal for a distributor to see sales be a little bit bigger each month through the quarter just based on customer spending patterns, but what do the percentage declines look like on a year-over-year basis? Are the declines getting smaller as we're moving month-to-month here?.

Matt, this is Mark. I don't have that information right at my fingertips for all of those situations, but I will say that our sales for our U.S. fluid power operations, those percentage declines are getting smaller because our results, while down a material percentage this quarter, it's smaller than what it was last quarter. So....

Sure..

So, we're seeing that..

Okay.

And then last thing for me just in terms of M&A appetite, how are you guys feeling about acquisitions right now? What does the M&A funnel look like? Are you finding willing sellers with reasonable valuation expectations? Just give us an update there?.

I'd say short answer would be yes, but our M&A pipeline remains productive. We're busy, I'd say, we have prospects or opportunities at really each stage of our funnel..

Okay, great. Thanks, guys..

Okay..

Our next question will be from the line of David Stratton with Great Lakes Review. Please go ahead..

Good morning. Thanks for taking the question.

Could you give a little more insight into the restructuring activities, especially in the oil and gas sector? And then, the $7.8 million you expect to realize annually, where are you as far as the run rate on that, both this quarter and going into the fourth quarter?.

Sure. I'll start. So, many of the activities will be, as we looked at locations, the opportunity to consolidate into common Applied facilities. So, we could have had multiple locations and given geographies. We would look to consolidate those. So, there is a mid-single-digit number of those in Canada, a few in Australia and there'll be some in the U.S.

as we look to do that as well. We also took a look at some markets that says, hey, we have closed proximity and can cover it that we would look for that consolidation opportunity as well. And from the benefit standpoint, I'd say we may have had a little bit of that benefit in our Q3.

We'd expect a little more in our Q4 but really the balance of it going into start of our fiscal 2017..

All right.

And then the HUB integration, how is that proceeding and are there any notable things you'd like to discuss on that?.

Sure. Well, the HUB integration is proceeding very well and I'd say, overall, we very much like the Maintenance Supplies and Solutions business, what HUB brings to that. So, we feel like we continue to build out that platform in MRO consumables, in models that reach customers directly.

in a vendor-managed service model and also on the MROP, the production side of that with Atlantic Fasteners. The group, less acquisitions, had growth in the quarter. So, we're encouraged by that but probably more encouraged about our growth prospects going forward..

Great. And then one final thing.

The 30 industry groups that you track, can you kind of a breakout where you saw the winners and losers in that area?.

Sure. I think. Okay. Sure. Probably the math on the total 13 of those would have been showing increases and probably the real positives around expected areas of food, construction-related industries, including aggregate, building materials, lumber wood products and we would also see some increases around transportation..

All right. Thank you..

Okay..

Our next question from the line of Adam Uhlman with Cleveland Research. Please go ahead..

Hi, good morning..

Good morning, Adam..

Good morning..

I guess to start with the sales trend discussion, some other distributors have noted that the second half of March kind of slowdown for them, or there was a bit of hick-up in demand. I'm wondering if you saw anything like that.

And then on the commentary about April looking like March, is that normal seasonality for the company on a dollars basis?.

Sure. I would say for March, I'd say no noticeable decline in the back-half of March. So, I wouldn't have seen or noticed that. And I would say April is consistent.

Usually at month end, you can have a pickup in volume activity – hey, to be determined if we see that over this last couple of days, but it is looking like March, which was stronger as we moved through quarter three and we'll look to being better in May and June to close out the quarter..

Okay. And then, Mark, I think you mentioned that there was a step-up in bad debt expense.

Could you talk through what you're seeing there?.

Yeah. Adam, I'm happy to do that. I would say the majority of the bad debt expense increase really is relating to reserves that we're putting on the books for receivables for our upstream oil and gas subsidiaries. And so they've had a meaningful increase for the whole year.

So, it continues to happen even in the March quarter, as the customer base is challenged in certain cases. We believe that our reserves are adequate and appropriate at this point in time for protecting the organization for any potential bad debts and non-payments in the future.

We wanted to call out that number of bad debt expense within SG&A, because it can really be up or down in any potential quarter compared to prior quarters or prior years..

Okay. Got you.

And then overall just thinking about the acquisition pipeline that the company is working on, given the goodwill write-down, what is the company doing differently in regards of sourcing acquisitions, looking at new deals, has there been any structural change on how you're running the process?.

I'd say maybe not structural changes, with the impairment, we don't like it. We could say misery has company in this regard. I'd say our approach in M&A remains disciplined. We know our priorities. We have focused targets and prospects.

We've built long-term relationships in those categories, and then we have regular management reviews and a consistent process at expression of interest as we go through diligence and prior to closing. And then I'd say after that, it kicks-off all again on integration.

So, from an oil and gas standpoint, obviously a turn or a change in those events, but we are committed to being a well-diversified industrial distributor. So, we're going to represent those industrial end market segments in our served geographies. And so today, I believe we are at market weight from a oil and gas standpoint.

We believe it will continue to be an important part of the North American economy going forward. We like those businesses that we have and we expect to perform better as we move out, and they will be very valuable in the mid-term and the long-term..

Okay. Thank you..

Our next question from the line of Brent Rakers with Thompson Research Group. You may go ahead..

Yes. Good morning. I wanted to follow-up first on the bad debt expense comments. I think you said – I think you're meaning $1.6 million higher on a year-over-year basis.

First wanted to clarify that, and then also if you could remind us what the first half change was year-over-year?.

Yeah. Yeah, Brent, I believe we said in the call, it was $1.3 million of expense in the quarter. And that was higher than the prior year quarter by probably a little over $1 million.

I don't have that exact number in front of me, but I can tell you year-to-date for the nine-month period, our bad debt expense is about $2.7 million higher than it was in the prior nine-month period..

Okay, great. And then just I think, Neil, you talked a little bit about already receiving benefits from the restructuring, and then more benefits coming in Q4.

Will Q4 be at the full annual run rate yet, and then maybe if you can give us a little bit more color on how much the impact was in Q3?.

I would say it will – perhaps, not at the full run rate of the annualized amount in Q4. So, some of those activities are going on now as we look to productively close or consolidate locations. Obviously, we have our attention and focus on customers and the associates as we make those moves.

So, I would say all in degrees of progress or implementation, a few will be going on as we move through this quarter..

Yeah. And Brent let me just chime in on that too. We believe that beginning in July that we will be at that full run rate at that point in time..

Okay. Great.

And then did you comment specifically on how much benefit you might have seen in Q3 from that?.

We have not specifically commented on that but we did see some benefit, because obviously some of the reductions that we're seeing in expenses are head count related, and we did have a reduction of head count during the March quarter. So, we did experience some of the benefits during the March quarter..

Ok. And then Mark, good segue.

Do you have the head count numbers for the end of March?.

Yeah. I do. We have 5,635 associates at March 31. Now, this includes about 50 from our recent acquisition of HUB during the month of January. So, we believe we're down about 100 associates to 125 associates from December 31 to March 31 from the ongoing operations..

Okay. And then final question. Based on some of your SG&A comments earlier, it seems to imply that your acquired operations, SG&A as a percent of revenue, is running around 30% in the quarter.

Can you maybe elaborate on what the implication would be for the gross margins of those acquired businesses?.

Yeah. The businesses that we've acquired during this fiscal year, they do have gross profit margins that are above the average for the corporation and they also do have above average SG&A expense levels for that too.

What I will say is from an EBITDA percentage perspective that these organizations are providing solid EBITDA percentages and they are meeting or exceeding our expectations that we had when we repurchased these folks, and that they are at or above company averages..

Okay, great. Thank you..

Thank you. 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 just want to thank everyone for joining us today and we'll 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 your lines. Have a great day everyone..