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Applied Industrial Technologies, Inc. (NYSE:AIT)

F1Q09 (Qtr. End 9/30/08) Earnings Call

October 27, 2008 11:00 am ET

Executives

David Pugh - Chairman and CEO

Ben Mondics - President and COO

Mark Eisele - VP and CFO

Analysts

Matt Duncan - Stephens Incorporated

Jeffrey Hammond - KeyBanc Capital Markets

Adam Uhlman - Cleveland Research

Joe Mondello - Sidoti & Company

Richard Marshall - Longbow Research

Brent Rakers - Morgan Keegan

Greg Halter - Great Lakes Review

Holden Lewis - BB&T Capital Markets

Operator

Welcome to the Applied Industrial Technologies first quarter 2009 financial earnings teleconference. All lines will be in a listen-only mode until the formal question-and-answer session. At that time, instructions will be given. At the request of Applied Industrial Technologies, today's conference is being recorded. If you should have any objections, you may disconnect at this time.

Applied issued its first quarter earnings release early this morning before the market opened. You may retrieve a copy of the release by visiting the company's website at www.applied.com. A replay of today's teleconference will be available for the next two weeks as noted in the news release.

Before we begin the teleconference, I would like to remind everyone that there will be discussions regarding Applied's business outlook and there will be forward-looking statements. All forward-looking statements are based on current expectations regarding important risk factors including trends in the industrial sector of the economy, the success of our various marketing strategies and other risk factors identify in Applied's most recent periodic report and other filings made with the SEC. Accordingly, actual results may differ materially from those experienced in the forward-looking statements.

Our speakers today include David Pugh, Chairman and CEO of Applied, who will discuss Applied's overall performance during the quarter. We'll also hear from Ben Mondics, President and Chief Operating Officer, who will discuss operational activities and Mark Eisele, Vice President and Chief Financial Officer who will discuss the financial performance in detail.

I would now like to turn the call over to David Pugh, Applied's Chairman and CEO.

David Pugh

Glad you could be with us considering all the other things you could be covering in the global economy. When you take a look at our first quarter, it was a bit of a rollercoaster ride. We achieved record sales for several reasons, which Mark will cover a little bit later on. We didn't translate those sales into expected levels of earnings. As the quarter progressed, we experienced an economy that was putting on the brakes in a hurry, especially domestically and especially in the latter part of the quarter.

This slowing economy has caused many of our customers to cancel or just simply delay capital spending projects that were aimed at improving their production capability and capacity. And the movement in the supply and demand equation has been reflected in greater price pressure and that affects the bottom line.

By my experience, in my history, the rapidity of this economic downturn is remarkable and not exactly in a great way for us, considering where we are currently positioned with market segments.

The economic indices that we normally track, such as the Purchasing Managers Index, the Industrial Production Index, manufacturing capacity utilization, all of those have fallen. These declines are in keeping with the economic climate that's generated by our current financial crisis. Housing starts are at their lowest level in 17 years and it looks like we are staring a recession square in the face and unless we have a significant positive reaction to the financial initiatives that are being put forth by the Federal Government, we expect the next 12 months to be quite a challenge.

Now, while we weren't satisfied with our earnings performance during the quarter, there were some bright spots. We achieved a solid 6.9% operating margin. Now although this is down slightly from prior periods, it's not a sign that we've thrown caution to the wind in order to gain sales. It has more to do with a mix shift from small customers to large national accounts and with costs associated with our acquisition of Fluid Power Resource.

Cost controls and pricing discipline are still in place and coupled with excellent asset management, they have given us an exemplary cash generation. We did see good performance by certain customers in markets that haven't slowed as much as those related to housing and transportation. Ben's going to share a little bit more about that when he's on.

In August, we did complete a major acquisition of Fluid Power Resource and seven of its Fluid Power distribution businesses in the United States. They contributed one month of their performance to our top line. This acquisition really strengthens our presence in the distribution of Fluid Power products.

As we stated before, with regard to the economy, you can't control the wind but you can adjust your sails. Our management team is confidently working on short-term changes that are going to help us cope with this looming recession and even longer-term changes that are aimed at softening the blow of future market gyrations such as we are now seeing.

Ben is going to add more details about the market segments and their effect on our top line in his comments but operationally in total I want to assure you, we are still strong and we continue to improve. It's in times like this that I truly appreciate the quality of our processes and the controls that are in place for oversight.

Last quarter, when we finished up, I shared that the pressure on our sales line was of a temporary concern. Since we all watch a constant stream of economic news today, I know it's not surprising that my concern is no longer temporary. It seems there is a global recession and it remains to be seen how deeply it's going to go and how long it's going to take to shake it.

Having said that, I'm going to turn it over to Ben now for a few thoughts about our markets and where he thinks things are going.

Ben Mondics

Thanks, Dave and good morning everyone. As Dave indicated, the economic indicators we follow took a serious downturn during our first quarter and we experienced a similar downturn with many of our customers.

The latest Purchasing Managers Index fell 6.4 points to 43.5, almost a 13% drop in one month. Generally, any score below 50 indicates a contracting economy. Adding to that, manufacturing capacity utilization at 74.5 is still well below the 80% benchmark that is considered expansionary and it is showing declines that are widespread among its components.

Admittedly, two hurricanes and a strike on aircraft production had a sizable impact on both the MCU and the Industrial Production Index, but even adjusting for those events, the indexes are declining.

We're seeing the lowest number of housing starts in 17 years. Housing construction dropped in September to a seasonally adjusted annual rate of 817,000 units from its peak of almost 2.2 million units.

Not a cheery outlook for industrial America. The real question we face is how deep the decline will go and how fast it can recover. We can't give you any real insight into those questions, but we may know more by January.

In spite of all the bad trends, the economy fought to right itself during the quarter and out of our top 30 industries that we serve, we saw sales increases in 16, more than half. Primary metals, food, coal mining, and power generation turned in solid performances. Lagging in performance were transportation equipment, lumber and wood products, non-metallic mineral production, petroleum products, and metal mining.

Our government sales continued to improve during the quarter showing a double-digit increase and our sales efforts continued to expand into all types of government entities, including local, county, state and Federal Government. For the third year in a row, we have received an Excellence in Partnership Award from the General Services Administration this year naming Applied as the 2008, Most Valuable Contractor.

All in all these are not terrible numbers, but when combined with the performance of the economic indices, the turmoil and the financial markets and a slowing exit rate coming out of the quarter, it generates concern for the month ahead. Clearly, there is a slowdown in the works. Those of you who know us well understand that we will not accept the foxhole mentality toward the economy. We already have several initiatives in place that will help us to control our cost, manage our assets, and expand our sales where we can.

During these difficult economic times, our customers appreciate the value we provide more than ever. We have a dedicated team of associates and we view our people as our strongest asset. Their knowledge of our customers, our products, and the application of technology is what differentiates us from our competitors. They are genuine intellectual capital that our customers depend on for superior service.

In summary, the economy is in a bit of turmoil and it is difficult for us to predict the future but we are preparing for a tougher business climate based on what we are seeing.

I will now turn the call over to Mark Eisele for a discussion of the quarter's financial results.

Mark Eisele

Thanks Ben. Good morning everyone. Let me provide some additional insight for our first quarter financial performance. We reported first quarter earnings of $0.52 per share. Sales for the first quarter ended at $543.9 million. This represents a 4.9% increase over last year's first quarter. We had 64 selling days in this year's first quarter which was one additional day compared to last year.

Sales at our US service centers were down from the prior year quarter, 0.5%, even after factoring the one extra selling day for the quarter which provided a positive sales impact of 1.6%.

Additionally for the US service centers, we estimate that sales were positively impacted by approximately 1% to 2% from the impact of passing along supplier price increases.

Sales at our US Fluid Power businesses excluding acquisitions were down for the quarter just under 2%. Our overall US Fluid Power sales however, increased significantly due to incorporation of the first month of sales activity totaling approximately $17.9 million of sales for the Fluid Power Resources acquisition. Sales in our Canadian operations increased by 5.8% in the quarter, slightly over half of this is due to currency translation.

Our same-store Mexican operations had a 13% sales increase during the quarter. Our overall Mexican operations like our US Fluid Power operations also produced significant sales increases bolstered by our acquisitions of VYCMEX in December 2007, and Enol in May of 2008.

During the quarter, our number of operating facilities increased by 15 locations to 474, due to the 19 locations related to the US Fluid Power acquisition, partially offset by the merger of four locations in the quarter; two in Mexico related to the Enol acquisition, one in Canada and one in the US.

Our number of associates rose to 5,254 as of September 30th, 2008 due to adding 430 associates from the FPR acquisition. Our product mix during the quarter was 22.6% Fluid Power products, and 77.4% industrial products compared to 19.6% and 80.4% in the prior year. The recent acquisitions within our Fluid Power businesses account for the shifts in product mix.

Our gross profit percentage for the quarter was 26.9%, slightly below the guidance we previously provided for fiscal 2009 of 27.2%. This 26.9% margin is 50 basis points below last year's first quarter and 10 basis points lower than the June 2008 quarter. This decrease reflects the ongoing challenges of passing on supplier price increases to our large contractual customers, as well as the price competitiveness in the marketplace related to the overall economic conditions.

Our selling, distribution and administrative expense as a percentage of sales were 20% in the quarter. This rate is approximately 20 basis points higher than the first quarter of fiscal 2008, which relates entirely to the additional $1.1 million if intangible asset amortization expense for our recent acquisitions.

The absolute dollar increase in SD&A expenses for the quarter was 5.8% compared to a sales increase of 4.9%. Approximately $6 million of the increase related to our recent acquisitions. The $1.1 million of intangible amortization expense mentioned previously is included in this $6 million figure.

In addition, the prior year SD&A expense has additional benefits from gains on the sale of three locations, which lowered our SD&A expenses by $750,000. In the current year, we had $200,000 of gains on property sales.

Our operating margin in the quarter was 6.9% compared to 7.6% in the prior year's first quarter. The decreased sales and lower gross profit percentage was the reason for the lower operating margin. In addition, the incremental intangible asset amortization from the recent acquisitions decreased our quarterly operating margin by 20 basis points.

Our net interest expense for the quarter increased over $400,000 from the same period in the prior year. This net increase is attributable to additional interest expense and lower interest income related to the borrowings under our existing revolving credit facility and the use of cash to acquire the FPR Fluid Power business at the end of August.

The overall increase was somewhat mitigated by the elimination of interest expense in the prior year associated with $50 million of unsecured term notes that were paid off in December 2007.

The effective tax rate for the quarter was 37.2% compared to 36.8% in the first quarter last year. We continue to anticipate our tax rate for the year to be in the 37.0% to 37.5% range.

Our balance sheet remained solid with shareholders' equity at approximately $515 million and a current ratio of 2.4:1. This ratio is below prior year levels, due to the impact of our recent Fluid Power acquisition.

As previously discussed, we did draw down our existing revolving credit facility to help pay for the acquisition of FPR. $50 million of this debt is classified as long-term due to our intentions to keep this amount of debt outstanding for at least two years. This long-term debt is mirrored by a two-year interest rate swap agreement that we entered into in September, which effectively converts this amount of debt to a fixed interest rate.

Our pre-tax return on assets was 16.9% for the quarter compared to 19.6% in the prior year quarter. This decrease is primarily due to the large amount of intangible assets and goodwill added to our asset base from the FPR acquisition, as well as lower operating results.

Our September 2008 inventory balance was higher than the June 30 levels due to the inventory acquired in the Fluid Power acquisition. We do anticipate a seasonal increase in inventories of approximately $25 million during our second quarter. This increase is then expected to be reduced in our third and fourth quarters so that inventory levels at year-end excluding acquisitions should be close to our prior year levels.

Cash provided from operations for the quarter was a solid $48.9 million compared to $28.9 million in the prior year first quarter. The majority of this improvement is bringing forward cash-flow benefits from the second quarter to the first quarter. These include improved timing on collections at fiscal year-end supplier purchase incentives and the timing of payments for accounts payable for quarterly inventory purchases.

Our revised forecast is for our gross profit percentage to be around 27.0% for the remaining three quarters of fiscal 2009. In addition, as sales slow, our SG&A expense as a percentage of sales is now forecasted to grow by 30 to 50 basis points from our current run rate. Most of this increase will be due to additional intangible asset amortization expense, which is expected to be approximately $2.9 million per quarter for the remainder of the year.

The sales run rate for our US service centers declined throughout the quarter. In addition, we have seen a lower sales run rate so far in October. Because of the lower than expected results in quarter one, and the continued downturn in the US and world economies, we have reduced our sales guidance for fiscal 2009 to approximately $2.2 to $2.3 billion, and have decreased our annual earnings per share guidance to a range of $1.90 to $2.15 per share.

And now some closing remarks by Dave Pugh.

David Pugh

Thanks, Mark; and thanks, Ben. Couple of weeks ago an article hit my desk, it was an analysis of our economy and basically it said that since peaking 54, we've had 33 economic slowdowns in United States. The average contraction was 12 to 18 months. The average expansion beyond that was 36 months. Closer to current times, since 1948, we've had 10 economic slowdowns.

The average contraction was 11 months and the average expansion beyond that was 48 months. So, if you look at that data, it says we spent 80% of our time in good economic conditions. That's the kind of positive information I like to hear reminds us not to overreact in times of uncertainty.

As for Applied, we've had three straight quarters of what we consider to be underperformance in the growth of our top line. But in two of those quarters, we set records in both sales and earnings and in the third, we set records in sales. So we aren't exactly in a panic mode. But I would be less than candid if I didn't admit to a heightened sense of urgency and certainly a need to have all hands on deck.

We are in the midst of an unprecedented housing drop driven by crisis in the mortgage industry which very few saw coming and couldn't prepare for. Unfortunately, markets related to housing had been legacy strength for us.

Concurrently, we've seen an unprecedented boom in energy markets driven by oil prices that unpredictably skyrocketed for still unexplained reasons. While that's not going back to more realistic levels, the growth that has occurred was in markets where we were not the legacy dominant force, so by comparison, we've lagged there.

It's been a perfect storm through which we will navigate using our sound financial position, our strong internal controls, and our strong management team. So rest assured, we are going to make the necessary course corrections.

Having said that, operator, Terry, we will open this up for some questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from Matt Duncan with Stephens Incorporated.

Matt Duncan - Stephens Incorporated

Good morning, guys.

David Pugh

Hi, Matt.

Matt Duncan - Stephens Incorporated

First question I've got, Mark, I missed a couple of the numbers. Can you just repeat real quick what the acquired sales were both from FPR in total and then what the change in organic revenues was in the quarter?

Mark Eisele

The sales for FPR were $17.9 million and that's basically one month worth of sales.

Matt Duncan - Stephens Incorporated

And then adding Enol and VYCMEX, and then what were the total acquired revenues and then what was the organic change in sales?

Mark Eisele

The Enol and VYCMEX sales run rates were a little over $8 million to $8.5 million in the quarter.

Matt Duncan - Stephens Incorporated

Okay. All right, we can do the math on the rest then. I'm wondering if maybe you can talk about just looking at your various end markets and I know you've talked about housing and transportation has been weak and you mentioned a couple of the others that are starting to show some weakness. Can you kind of expand upon when this weakness started and kind of what your customers in your various end markets are telling you to expect going forward?

Ben Mondics

Hey Matt, a number of the industries we serve have been in the declining mode for some time, especially transportation, the automotive segment of that and the housing, anything related to housing. For the quarter, a number of the industries that have been strong for us over the last six, seven quarters continued strong in the quarter but starting to show some weakness towards the end of the quarter.

Primary metals for example has been strong for a long time for us and starting to see some weakness there and cuts in production and I think food and power generation are strong and continue to be strong. We don't expect to see any slowdown there, but in general, just meeting with customers, I've traveled a good bit in the last few months and met with a number of customers; a lot of input from our field management team as well as our sales force that there is concern out there even amongst those industries that are strong, wondering what's going to be the ripple effect with the financial situation and a number of customers are looking at holding off on expenditures as Dave mentioned on CapEx right now. So a lot of concern out there, even in the industries that are, have been relatively strong for the last year or so.

Matt Duncan - Stephens Incorporated

Okay. And then as we look at the difficulty that you mentioned in passing along supplier price increases and kind of what that did to gross margin. If you had to characterize that, was it more of a timing issue? Was it more customer pushback or was it some combination of both?

Ben Mondics

In large national contracts, it's a timing issue. I think in general, also, I think Mark had mentioned that just the general economic conditions right now, the market is very competitive, so we've had to make some adjustments there.

Matt Duncan - Stephens Incorporated

Keeping that in mind, I guess, you tell us you expect gross margin to basically flat line here, kind of around 27%. You know in an economic downturn, does your gross margin not typically come under some pressure?

Ben Mondics

Yes, it does come under pressure and I think that's reflecting in our reduced guidance on the gross margin percentage for the rest of the fiscal year.

Matt Duncan - Stephens Incorporated

Okay. So I guess it was kind of 27.3 or, sorry, 27.2% in total last year, so you're now expecting it to be down about 20 basis points; correct?

Ben Mondics

That's correct.

Matt Duncan - Stephens Incorporated

Okay. With regard to supplier price increases, again, are you still seeing those or have those sort of stopped now that the economy is turned?

Ben Mondics

Through the September quarter, the price increases came along as normal, whatever normal is, and it's really been through the quarter that we've seen the downturn and I think the indications for the future months are we may see a slowdown in the price increases, but for the September quarter, there was really no slowdown in the increases.

Mark Eisele

Right. And then we really don't know, a lot of this reduction that we've been all reading about in the press for the last, month or so has been relatively recent with commodity prices and things. So we are unsure, you know what and how the suppliers and manufacturers are going to react to that, with price increases in the future towards us.

Matt Duncan - Stephens Incorporated

Okay. And then last question and then I'll jump back in queue. Can you address the impact of foreign exchange now that the US dollar has strengthened so significantly in the past couple of months here?

Mark Eisele

I think a lot of that strengthening has really happened in the last couple weeks and the impact in Canada for the currency there we said the sales in Canada were up about 5.8% for the quarter, and little over half of that was currency fluctuations is a positive, so…

Matt Duncan - Stephens Incorporated

We should probably be a negative then going forward; I think the right way to look at it, Mark?

Mark Eisele

Yes.

Matt Duncan - Stephens Incorporated

Okay.

Mark Eisele

And I don't know what those numbers could be.

David Pugh

And that's just on the translation. It doesn't speak to what's going to happen to customers who have been exporting as far as their performance.

Matt Duncan - Stephens Incorporated

Okay, guys. Thanks for the commentary. I appreciate it.

David Pugh

Sure.

Matt Duncan - Stephens Incorporated

Thank you.

Operator

Your next question comes from the line of Jeff Hammond with KeyBanc Capital Markets.

Jeffrey Hammond - KeyBanc Capital Markets

Hi, good morning, guys.

David Pugh

Good morning, Jeff.

Jeffrey Hammond - KeyBanc Capital Markets

Just wanted to focus a little bit on FPR, did you, I'm just looking at the various releases and when you had announced the deal, their historical revenues were $244 million and then I think when it closed you kind of said, hey, we think it’s going to be about $230 million and I think now in your release you're saying $220 million. Are they seeing, I guess the same level of slowdown since you've acquired them or maybe just talk through what they're seeing specifically?

Ben Mondics

Jeff, I think you summed it up pretty well. You laid out the numbers we have put forward and they are their business overall is seeing the same general slowdown that we're seeing and it’s reflected in the numbers.

Mark Eisele

And that of course wasn’t annual run rate of that $220 million, not necessarily the impact on fiscal 2009.

Jeffrey Hammond - KeyBanc Capital Markets

Right, right.

Mark Eisele

In the press release.

Jeffrey Hammond - KeyBanc Capital Markets

And then Mark, how should we think about accretion, dilution within the deal given the change in revenue dynamics?

Mark Eisele

We have talked before that we expected the deal would be positive to our fiscal 2009 earnings. While we think that there will be a step backwards, we don't expect it to be negative this year.

Jeffrey Hammond - KeyBanc Capital Markets

Okay. And then just, Dave, you’ve mentioned I think some of maybe the ones versus your competitors, because they do seem to be putting up better growth rates over the past two, three quarters. Can you just help us understand, maybe just remind us what you think your housing related exposure is as a percentage and maybe your energy or oil and gas related exposure and maybe how that differs versus your comps?

David Pugh

Yeah, let me talk just briefly about the overall piece and then I'm going to let Ben talk a little bit to the specifics of the market that you're talking about because you mentioned our competitors and we certainly can't comment on those and we hear what they put up but we don't have total transparency as to what the underlying elements driving their performance. We can only talk about ours.

And as for our performance, when I do look at the housing slump, the credit crisis, the automotive crisis, the dive in the Purchasing Managers Index, the current state of capacity utilization, the drop in industrial production, I could go on and on. An 8% drop in our earnings for one quarter is not going to cause us to panic and it's not going to cause us to abdicate our focus on our fundamentals.

We always analyze the markets we serve and consider whether changes need to be made. I'd say that our performance, whether we like it or not is totally explainable in the context of the environment in the markets that we serve. So, I'll let Ben answer just a couple of specific market questions for you.

Ben Mondics

Yeah, from an industry standpoint, share of our total business just due to the market and some of our changes we've made in the marketplace, we've decreased our dependence on the wood products and the automotive industries and adjusted our cost down in these markets at the same time.

So, those two industries in particular as a share of our total business have dropped by a number of points. At the same time, the food industry, power generation, and primary metals have been strong and we've grown share in those markets, so they've grown as a share of our total business.

Jeffrey Hammond - KeyBanc Capital Markets

Okay and then just a final question. Dave, again, you’ve mentioned that we thought this was going to be kind of a short-term downturn and now it seems to be longer-term just given the macro considerations. What are you guys doing in terms of contingency planning or how are you thinking about the cost structure differently given that this downturn may run out a little longer?

David Pugh

Jeff, honestly, we're not looking at it any differently from what we've always looked at it. I guess strategy is continuing to align as to as with opportunities and it's not a digital thing. It's an analog deal. And as the markets move, we will move. There's a certain level to which we can offset market declines. There's a critical mass required that says if it goes double-digit and stays there, it's tough to offset that kind of a decline.

So, we continue to make moves at all times. It's not just in the bad times in making sure from a return on assets basis that we have the right assets in the right place for the opportunity. So, we don't have a digital ABC level of what we're going to go do. We will continue to make the moves as the market requires to make sure that we are in place for when this market recovers and that we are not doing anything crazy in expenditures during the down time.

Jeffrey Hammond - KeyBanc Capital Markets

Okay. Thanks, guys.

Ben Mondics

Thank you.

Operator

Your next question comes from the line of Adam Uhlman with Cleveland Research.

Adam Uhlman - Cleveland Research

Hi, good morning.

David Pugh

Good morning.

Adam Uhlman - Cleveland Research

Mark, could you break out the sales growth rates between those large national account customers and then your smaller customer base?

Mark Eisele

Adam, I don't have that information with me right now, so I'm unable to do that.

Adam Uhlman - Cleveland Research

Okay. Then I guess could you talk about bad debt expense in the quarter and also the quality of the receivables, have you seen any deterioration there?

Mark Eisele

Yeah, I'll address those. Specifically on the quality of our receivables, when we look at our aging and the amount of past dues in the aging, our aging at September 30 continues to look very, very good. And as a matter of fact, the percentage of past dues as a percent of the total is still at an all-time low.

So, we continue to see good quality within our overall receivables balances and I think that correlates still when you look at our customer base and you look at industrial America, people are still saying that they still have a lot of cash balances available so they still have a lot of strength for this and I think we are seeing that reflected in that, and they're still paying their bills on a timely basis.

Now with that said, we still did increase our bad debt expense for the quarter. It was just slightly higher than what it was in the prior years and that has reflected in increased allowance for doubtful accounts that you can see on the balance sheet. And we're doing that just because of the view of the potential bankruptcies in the future, for the most part, the majority of our bad debt expense is when people go bankrupt.

And one-third of our business is strategic account business and two-thirds is non-strategic account business. So, we look in all of those and when we try to encompass, what the bad debt expense is and what our exposure is. But for the quarter, we added about $0.5 million of bad debt expense when compared to the same quarter prior year.

Adam Uhlman - Cleveland Research

Okay, great, that's helpful, thanks. And then historically?

Mark Eisele

The original question you had. Did that answer your question about the mix of large accounts, small accounts on the one-third of our business is strategic accounts?

Adam Uhlman - Cleveland Research

No.

Mark Eisele

Okay. Just a comment that while we don't have the exact numbers right now, during the period, sales to our top 100 accounts went up in a domestic sales period where the total domestic sales were down, so our ratio toward the large customers has gone up and typically that's a lower margin type group.

Adam Uhlman - Cleveland Research

Would you care to comment on how much lower the gross margin is for that group?

Mark Eisele

No, no, we would not talk about that, please.

Adam Uhlman - Cleveland Research

Okay. The last question, then, for you, is historically Applied has had really great cash flow during softer economic times. So Mark, could you talk about the priorities for that cash flow? Would it be paying down debt or I noticed that you had not bought back any stock in the quarter, have you repurchased any shares so far here in the fiscal second quarter?

Mark Eisele

You know, well, right now for the second quarter, we're still in our traditional blackout period for buying stock. So the answer is no, we have not bought any so far in this current quarter. And our view of capital today and with the cash generation today is, we want to make sure we have bided a proper amounts of dry powder and as much dry powder as we possibly can in these turbulent economic times.

So our priorities on our cash and our cash generation is, obviously we would like to pay down some of the debt and we would like to keep our flexibility for business expansion and investing in the business open to us in the future. And we're not thinking about investing in buying a lot of company stock in the near-term, because we want to use our capital to expand the business in the near-term.

Adam Uhlman - Cleveland Research

Okay. Great, thanks.

Mark Eisele

Sure.

Operator

Your next question comes from the line of Joe Mondello with Sidoti & Company.

Joe Mondello - Sidoti & Company

Good morning, guys.

David Pugh

Good morning.

Mark Eisele

Good morning, Joe.

Joe Mondello - Sidoti & Company

Most of my questions were asked, so I really only have one question. If I could just comment, it seems like the fluid handling business has been doing growing a little faster than the service center segment. However, now it seems like it's slowing a lot faster, I think, you said it was down 2% organically for the quarter. Is that correct?

Mark Eisele

Yeah, the same store fluid power locations were down a little under 2%. I don't know, if I would say it's slowing any faster. I think it's slowing at a comparable rate as with the US service centers.

Joe Mondello - Sidoti & Company

Could you just comment on the difference in end markets in those two segments?

David Pugh

Yeah, our fluid power business is more heavily weighted towards original equipment manufacturers as compared to the MRO side of the business. It's probably the major difference.

Ben Mondics

And a fair amount of those are in construction related equipment. So as the housing construction and subsequently commercial construction declines, the need for the OEM equipment declines, so it follows the markets.

Joe Mondello - Sidoti & Company

Okay. Okay, great, guys. That's about it for me.

Ben Mondics

Thanks, Joe.

Joe Mondello - Sidoti & Company

Thanks a lot.

Operator

Your next question comes from the line of Richard Marshall with Longbow Research.

Richard Marshall - Longbow Research

Good morning.

David Pugh

Good morning.

Richard Marshall - Longbow Research

A lot of the questions have already been addressed, but just wanted to talk a little bit about the industrial machinery and general industrial markets. I mean, what's kind, looking forward, what's kind of your outlook on those two portions of the business?

David Pugh

Well, for the last few quarters, we've seen a decline in the general category of industrial machinery and equipment and accelerated in the September quarter and I think as a general indicator of the business that we service, we're concerned going forward with that segment.

Richard Marshall - Longbow Research

Okay. I mean, are you more concerned with that than some of these other, I mean, auto and housing have been weak for a while now. Would you say you're more concerned about the industrial portions than you are about in the auto and housing bits?

Mark Eisele

I'd say it's probably a good indicator for our overall business. So, it's probably average for us in that segment.

Richard Marshall - Longbow Research

Okay, all right. And just a last thing, I mean, it sounded from your commentary like you were sort of favoring more M&A activity over share repurchase in the near-term, is that a fair characterization?

Mark Eisele

Absolutely.

Richard Marshall - Longbow Research

Okay. So in terms of share count I guess you have a million left, roughly, a million shares left on your current authorization. I mean do you expect to use up that authorization this year, how should we kind of look at share count for the remainder of the year?

Mark Eisele

Richard, it's tough to tell what's going to happen between now and the end of the fiscal year. Our philosophy on share buybacks has been very consistent over the last 10 plus years and we're going to keep that same philosophy now. We just think it's prudent to make sure that we have capital available to us for growing the business in this time period right now.

David Pugh

Yeah, I'd rather generate my own than try to have to go and borrow some right now.

Richard Marshall - Longbow Research

Okay. All right, that's pretty much it. Thank you very much.

David Pugh

Thank you.

Operator

Our next question comes from the line of Brent Rakers with Morgan Keegan.

Brent Rakers - Morgan Keegan

Yes, good morning. First I wanted to follow-up, you had made some earlier comments about the month-to-month sales progression and you’ve talked about even in October, I think it sounds like it has deteriorated worse than the August and September months. Could you maybe elaborate and give us a little more color on that?

Mark Eisele

Well, we have seen our sales run rate basically coming down throughout the quarter and really the actual run rate, rates have increased that we've been seeing have been coming down for the last couple of quarters and we’ve actually saw negative from the US service center perspective in the quarter that we just finished and we have seen that decline continue to increase in October. So, our October rate is lower than what it was at the exit rate at the end of September and also the rate at the end of September was greater than our average rate during the quarter.

David Pugh

Hey, Brent, if you just take a look at the last PMI index, it dropped about 13% in one month. Our rate, what we are seeing in a rate of decline isn't that far off of what the purchasing managers are out there projecting.

Brent Rakers - Morgan Keegan

Okay. And just to clarify so you're saying, I mean, again, I know that index doesn't read typically like a percent drop should correlate with your business. I mean, are you suggesting that your business, let's say, in September was maybe down 4%, 5% and then you're possibly down double-digits in the October month?

David Pugh

Not going to put a number on it, but I'm just saying the rate at which PMI is going down indicates what's happening in the marketplace out there and that's a little bit of a lead indicator.

Brent Rakers - Morgan Keegan

Okay.

David Pugh

There are some things to be handled as we go forward.

Brent Rakers - Morgan Keegan

Okay, great. And I think you said earlier, one of the industries that was weak for you in the quarter was the petroleum business. Could you maybe talk a little bit more about, I mean, you're not particularly active in the Gulf Coast refining, is that correct?

Ben Mondics

That's true. We're not as strong in that area as we are in other parts of the country.

Brent Rakers - Morgan Keegan

So when you refer to petroleum being weak, which aspects of that business would that pertain to?

Ben Mondics

It's all petro-chem type business, petroleum refining, chemical products and it's not a large segment for us but we did see a downturn in that segment.

Brent Rakers - Morgan Keegan

Okay. And then if you could comment maybe give us a better sense, because I guess the SG&A of all the line items really to me surprised me on the negative side in the quarter. I mean, that's been an area that it seems like the last several years you've consistently come in below or better than what we would have expected.

Is there anything tied to FPR other than the amortization added in there, and maybe operating margin contribution, can you give us any sense of what the accretion or dilution might have been in that first month from FPR?

Mark Eisele

Brent, I mean, FPR basically from a percentage perspective, they were able to hit our expectations on a gross profit percent and operating margin percent. Their sales were a little bit under what our expectations we are going in. But from that perspective, they were performing well.

Brent Rakers - Morgan Keegan

Okay. And then I guess just two final questions. I guess first on the, Dave, you’ve mentioned earlier about your preferences to do M&A. Just wanted to get a better sense of what multiples you're comfortable of paying and in terms of accretion versus dilution, how important are you looking at those versus the strategic implications of a particular acquisition?

David Pugh

We're in a different time right now and I'm not sure we have all those answers sitting here right in front of you. We're going to look at each one case-by-case and I honestly don't know how to answer that question right now.

Brent Rakers - Morgan Keegan

Okay. Fair enough. And then just last question, you talked earlier about having some initiatives in place going forward to some programs to reduce costs. Could you maybe talk a little bit more specifically about what some of those are and maybe also give us a better sense for some of the important items within SG&A, I mean, obviously personnel is I guess first and foremost an maybe some of the other categories as well.

David Pugh

It's the normal stuff. We have thousands of lines of cost and we analyze every one and you’re starting right off the back from T&E and that sort of stuff, it's easy to go put your horns in, on down the line, to where you start hitting more critical stuff and start cutting into some of the muscle and bone. So we haven’t outlined, it's not much different from what we've done in the past and like I say, it's not a digital process. We don't have a step function; here is a trigger point that you're going to drop another 10%. It's an analog deal and we will continue to manage every element of our line cost as we go forward.

Brent Rakers - Morgan Keegan

Okay. Great. Thank you.

Operator

Your next question comes from the line of Greg Halter with Great Lakes Review.

Greg Halter - Great Lakes Review

Yes, good morning, guys.

David Pugh

Hey, Greg.

Greg Halter - Great Lakes Review

Quick one on your relationships with your banks currently, if you could just detail what you're seeing or hearing from that group.

David Pugh

Well, we have excellent relations with all of our banks. Our current bank group, with our committed facility, there's five banks as part of that group. We have great relations with all of those banks. We have no concerns regarding our availability of capital under that group. We've also have been in contact with banks that are not part of our group that have expressed an interest in lending us money, in case anyone in the group might falter or might go away through a merger or something of that nature.

So we feel very fortunate right now that even in today's environment with tight credit that we will have credit available to us, obviously with our current bank facility and with additional borrowings through banks, or other private placement facilities available to us as we, if and when we need it.

Greg Halter - Great Lakes Review

Okay. Great, thank you.

Operator

Our next question comes from the line of Holden Lewis with BB&T.

Holden Lewis - BB&T Capital Markets

Good morning.

David Pugh

Good morning, Holden.

Holden Lewis - BB&T Capital Markets

I thought, I’ll try to ask question in a slightly different way to try to get a more comprehensive answer, so we’ll see how that goes. You know, again, on the SG&A you talked about basically doing the same things that you’ve done in the past to try to limit SG&A. Without talking about what you plan on doing this cycle, can you talk about what you’ve done in past cycles that might be replicated?

Ben Mondics

Well, if you go back, Holden, to the last major downturn we had, we got through that without any reductions in workforce from an overall standpoint, just as Dave said, the simple ones, looking at T&E, looking at a lot of scrutiny on replacements through attrition and then adjusting our cost in those markets where the business is turning down and really the question for us is, how far is it going to go down and how long is the downturn going to be there, because in our business, with our people being a large expense, but also our greatest asset, we can't replace those folks very easily.

So we take a long hard look at and the markets and whether or not they're going to stay down for a long time and then as we lose people through attrition, we either replace them or hold off on those replacements until the economy comes back.

Holden Lewis - BB&T Capital Markets

Okay. What about the store base, if memory serves, I think last time you also did fair number of closures of underperforming branches and then consolidations and things of that sort. I mean, is there any infrastructure changes that one would look at?

Mark Eisele

Holden, let me just comment on that. The last time that happened, we were just heading into a change of focus on a return on assets base for our company and there were a number of service centers out there that had been long-term underperforming. We have been making those moves as we go on now. So we're not sitting here with a whole belly of underperforming assets sitting out there. We will continue to look at return on assets as we have been for the last five, six years, once we got that big pool under control.

David Pugh

And Holden, to add to that, I think Mark had stated that we had four mergers through the quarter, two being related to the Enol acquisition, so we had one merger in Canada, one in the US, but at the same time, we had some openings also. We've opened a few locations in market areas where we did not have a presence before and so at the same time we're looking at reducing our expenses, we're also making the investments we need to grow the market, grow the business.

Holden Lewis - BB&T Capital Markets

Based on what you're seeing now, that you will continue to look at opportunities to sort of open new branches?

Ben Mondics

We're constantly looking at that, just as we're looking at underperforming locations, we're looking at opening in new markets also.

David Pugh

And Holden, opening in new markets mostly has come through acquisition lately, so just to tell you.

Holden Lewis - BB&T Capital Markets

So what I am hearing in terms of the SG&A approach is that, you might see heads come down a bit by attrition. The branches, you kind of have the structure you like, there's not going to be any wholesale changes there and so occupancy and salary and those sorts of things are probably going to remain somewhat sticky. So it's primarily just on the smaller travel and expense type budget that there's much to do. Is that sort of a reasonable way to look at it?

David Pugh

Current plans.

Holden Lewis - BB&T Capital Markets

Okay. Okay. I think you gave a number for the Mexican acquisitions of $8 million to $8.5 million. I think that was the run rate from the two deals. But that's not all incremental, is it? Some of that is actually anniversary and overlapped. Do you know what the incremental piece is?

Mark Eisele

Holden, that that is our incremental. We bought VYCMEX in December of ‘07. So, we‘ve only own them for two quarters so far. This is the third quarter, so that’s all still incremental sales of $8 million to $8.5 million for both VYCMEX and Enol.

Holden Lewis - BB&T Capital Markets

And when did you buy Enol again?

Mark Eisele

May of '08, so this is the actual, basically the first full quarter that they're in for us. And then VYCMEX, this is their third full quarter they are in for is.

Holden Lewis - BB&T Capital Markets

Got it. That 8 to 8.5 is entirely incremental?

Mark Eisele

Correct.

Holden Lewis - BB&T Capital Markets

Okay. Anything from in terms of the hurricane impact, pro or con, did you have any impact from that in the quarter?

Ben Mondics

It was a small impact. We had about 18 locations that were affected from Texas all the way up to Ohio and probably about eight locations that were affected from the weekend through middle of the week.

Holden Lewis - BB&T Capital Markets

Okay. And so netting it all out was the closures of those for any period of time greater than sort of the recovery contribution or what was the net affect on results from the hurricane in the quarter?

Mark Eisele

I think it would be negligible.

Holden Lewis - BB&T Capital Markets

Okay. And then last thing, and more of sort of a bigger picture question for you, in past downturns obviously you have seen reductions in EPS that have been pretty significant, certainly 50% or more in many cases. You're a much more profitable company this time. Your peak earnings are greater but is there anything about the company that would lead us to believe that the volatility of the earnings delta would be any greater or worse than it has been in past downturns?

Mark Eisele

Holden, I think it's, our expectation is that it will look better in this downturn that we're in now than it has in the past and that the volatility going downwards will not be as dramatic as it has in the past. Obviously, there's a lot of hard work that we need to do to make that happen.

Ben Mondics

To add a little bit more to that, if you look over the past few years we've decreased our dependence on wood products and automotive and at the same time, we've increased our investment in the government segment significantly and also in the food industry which is much less cyclical, if at all, and although we're still heavily tied to industrial production, we've diversified the industries we serve.

And then also from a channel standpoint, we've grown our catalog sales and our online sales in the past six, seven years and we have expanded geographically also with an increase in sales in Canada, as well as Mexico. And then combining that with all of our operational excellence initiatives and our productivity and things we've done from an information systems and training standpoint, it's much different today than it was in the last downturn.

Holden Lewis - BB&T Capital Markets

Okay. Can you also just when you talk about sort of the markets, you talked a lot about your customers and their capital spending plans and I think you sort of consider the majority of your business to be more MRO driven. Can you just sort of talk about the capital side of the business versus the MRO side of the business, how much would be sort of attribute and what you're kind of seeing it in each?

Ben Mondics

It's very difficult for us to break that. We don't have that data to break it out into percentage of our business that's MRO versus OE, but obviously grown more on the OE side on the Fluid Power of the side of the business growing but don't have exact numbers in front of me.

Holden Lewis - BB&T Capital Markets

All right. Thanks, guys.

David Pugh

Thank you.

Operator

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

Matt Duncan - Stephens Incorporated

Hey, guys. Just, Mark, a follow-up question on the debt; you said you guys entered into a swap on $50 million of your debt, can you tell us what the interest rate on that swap is?

Mark Eisele

Sure, we swapped to one month LIBOR is the rate for that and the fixed rate we were able to get on the one month LIBOR, plus the spread that we need to pay on top of that is giving us an interest rate of 3.33% right now.

Matt Duncan - Stephens Incorporated

Okay. And then what is the interest rate on the rest of your debt and is it also floating with LIBOR?

Mark Eisele

Yeah, it floats. It's currently floating mainly with LIBOR but the agreement here makes it float with either LIBOR, Fed funds rates, prime rates, basically at our choice. But at the end of September, the rate was around 3.67, I believe, for the remainder of the debt at September. But the net changes constantly as it gets reset.

Matt Duncan - Stephens Incorporated

Sure. So with LIBOR up, are you borrowing against something else right now?

Mark Eisele

We are still using LIBOR.

Matt Duncan - Stephens Incorporated

Okay.

Mark Eisele

And for the most part it's mainly LIBOR.

Matt Duncan - Stephens Incorporated

Okay. Thank you.

Mark Eisele

Okay.

Operator

And your next question comes from the line of Jeff Hammond with KeyBanc Capital Markets.

Jeffrey Hammond - KeyBanc Capital Markets

Hey, just a follow-up question on the organic revenue growth dynamic. Can you just speak to what, either at the midpoint or at the range, what you're assuming for organic declines in fiscal '09 within your guidance?

Mark Eisele

Well I think if you look at the range of the sales guidance, you have about a potential 5% decline on the low end for those things.

Jeffrey Hammond - KeyBanc Capital Markets

On an organic basis?

Mark Eisele

Yeah.

Jeffrey Hammond - KeyBanc Capital Markets

Okay. Okay and then maybe just I want to go back to the comment about September October and the PMI. I mean are you seeing organic revenue declines in September October less than that kind of 5% or worse at this point?

Mark Eisele

I don't have that information right in front of me there, Jeff. We have seen an increase with the rate of decline let's say in our same-store sales throughout the quarter and then a slight increase going down into October but I just don't have the information right in front of me to quantify that.

Jeffrey Hammond - KeyBanc Capital Markets

I just want to come back to Dave's comment about the PMI being down 13% and then comparing trends in your business and that I know the PMI jumps around, so I just didn't. I didn't get the sense that you were experiencing at least the same level of volatility on a percentage basis but I just want to understand that a little bit better from a trend perspective.

David Pugh

Okay, understood.

Jeffrey Hammond - KeyBanc Capital Markets

Okay. Thanks.

David Pugh

Yeah, thank you.

Operator

I would now like to turn the call back over to Mr. Ben Mondics for closing remarks.

Ben Mondics

Okay. Thank you everyone. Thank you, Terry and thank you everyone for your interest in the company. As we stated, we've seen some economic indicators that are showing a downturn. We will make adjustments. We’ve made adjustments and we will continue to work our strategies and our plans to improve our results going forward and we look forward to talking to you again in January. Thank you very much.

Operator

That concludes today's call. You may now disconnect.

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Source: Applied Industrial Technologies, Inc. F1Q09 (Qtr. End 9/30/08) Earnings Call Transcript
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