Applied Industrial Technologies: Opportunity is Knocking

This weekend's Wall Street Transcript (subscription required) features an interview with David Pugh, the CEO of Applied Industrial Technologies (AIT)

This company has a long history dating back to 1923 and has been public since 1953. The company is a value-added distributor of industrial products, fluid power products and engineered products that keep manufacturing systems going. From what originally was a focus on maintenance and repair parts, the company has expanded into power transmission and fluid power products.

This has been an impressive company in terms of its continuous improvement in its basic blocking and tackling. Here is an excerpt from the interview:

The goal would be a continuous increase in return on invested capital. We want to make sure that all of our assets are working properly for us. To do that, we watch many things. We've had an emphasis on gross margins. We've had an emphasis on top-line growth. We've had an emphasis on getting more efficient with receivables. We've certainly had an emphasis on inventory management. Our return on invested capital has continued to go up. In fact, over the past four years, we have been growing this metric at a compounded annual rate of a little over 40%, which would rank us pretty highly with regard to the best in class.

I am impressed with the commitment to ROIC. Again, from the Wall Street Transcript interview:

The single most important one is return on invested capital. That is one that we heard very loudly and clearly about four years ago. We have transformed this company from looking at return on sales to return on invested capital. There was a point in our history where how many assets we had to throw at something to get to the next half point of market share didn't bother us. We changed that and became much more expeditious in closing down under-performing assets that were providing us sales, but no income. We have a stated strategy that we are going to grow profitably in North America within our current product domain - that tells you what we are going to do and what we are not going to do. Getting that focus has helped us take the value of this company up.

Note the improvement that has occurred in ROIC:

1999....4.7%
2000...7.50%
2001...6.60%
2002...3.90%
2003...5.10%
2004...7.50%
2005...11.80%
2006...14.70%
2007 [TTM]...15.48%

Sustainable Free Cash Flow per share has improved to $1.64 per share on a TTM basis. Applied's Board of Directors has authorized the purchase of up to 1,500,000 shares of the Company's common stock. This authorization replaces the previous one under which 1,401,000 shares were purchased through March 31, 2007. The new authorization represents approximately 3% of the shares currently outstanding. Prior buybacks have been effective in reducing fully diluted shares outstanding to a current 44.41 million from about 46.6 million two years ago

At current valuations, AIT has a market cap of $1.2 billion. With $85 million in cash on the balance sheet and $76 million in total debt, the company has an enterprise value also of roughly $1.2 billion.

Enterprise Value/EBITDA is about 8.5 times.

The market dynamics of consolidation push smaller competitors out of the marketplace. Though the migration of the US manufacturing base offshore is an ongoing concern, specialization and consolidation emphasize the triumph of service over product price. There remains upside in margin. The company is ramping up its government related business which tends to be persistent and anti-cyclical.

The combination of a sensible M&A strategy that respects return on invested capital looks like a winning approach to me. Combine that with a reasonable valuation, I believe spells opportunity.

Disclaimer: Neither I, my family, nor clients own a current position in AIT.