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Applied Industrial Technologies (NYSE:AIT), a leading distributor of power transmission, fluid power, specialty flow control, and automation products to a range of industrial customers, has done everything I could have asked of it since my August and February 2022 write-ups. Not only has the company successfully leveraged strong underlying demand driven by customers’ needs to quickly scale up production to meet growing post-pandemic backlogs, the company has executed very well on its expansion into automation distribution and services.
Up more than 25% since my last update, AIT has continued to grow ahead of its markets, and that’s my only real concern at this point. Outgrowing suppliers like ABB (ABB), Parker-Hannifin (PH), SKF (OTCPK:SKFRY), does suggest market share growth (and share-of-wallet growth with customers), and I don’t think we’re near the end of automation adoption or factory capex expansion as longer-term trends. I’m more cautious now simply because of near-term trends in the markets AIT serves (if Rockwell (ROK) says automation equipment demand is slowing in the near term, it’s worth listening), but if AIT were to sell off meaningfully, it’s a name I’d look to reload.
Excellent Growth Becoming A Habit
AIT once again posted excellent results in its fiscal second quarter. Revenue rose 21% on an organic basis, one of the best results in the space and well ahead of many of its suppliers, with balanced growth between Service Center and Engineered Solutions, including 24% growth in its automation business. That automation wasn’t a profoundly outsized driver for Engineered Solutions says a lot of good things about the breadth of demand there.
Revenue was 6% better than expected, and as this is a volume-driven business, that growth translated into better operating leverage. Gross margin declined 30bp yoy and rose 20bp qoq to 29.1%, but EBITDA rose 36% (margin up 80bp to 11.8%), while operating income rose 44% (margin up 170bp to 10.6%) and segment-level profits rose 33% (margin up 120bp to 13.0%).
By segment, Service Center profits grew 28%, with margin up 80bp to 12.3%, while Engineered Solutions grew 42%, with margin up almost two points to 14.5%. It’s not historically unusual for Engineered Solutions to out-earn Service Center margins, but the growth of the automation business does seem to be stretching that a bit further.
There are limited comps to go on right now, though ABB and Parker-Hannifin will report tomorrow (as of this writing). Looking at last quarter’s results, AIT’s 19% organic growth compares well with suppliers like ABB (Motion up 23% org, RDA up 13% org), Parker (Industrial North America up 18% org), Rockwell (up 11% org), and SKF (up 11% org), and I’d expect outperformance again based upon those numbers.
Cyclical Pressures Starting To Mount
AIT has clearly hit the mark during this recent industrial upswing, but weakening production levels do seem poised to slow the business. At this point, most industrials that have reported have continued to see generally favorable trends in the fourth quarter and early in the first quarter of 2023, but do see growing evidence of weakness building through 2023.
For its part, AIT management is looking for full-year revenue growth of 13% to 15%, with a slowdown to high single-digit growth in the second half of the year on the assumption of little-to-no industrial production growth in the next quarter (March) and a mid-single-digit decline in the June quarter. As this outlook is very close to my own, I really can’t quibble with it.
Management did note growth in 25 of its 30 largest verticals this quarter, down from 27 in the prior quarter. Food/beverage, pulp/paper, energy, metals, and aggregates remain strong end-markets, but chemicals/refining and machinery have started to slow, and I expect will see further slowdowns as 2023 develops.
In the interests of cross-referencing, I’d note that Rockwell tagged food/beverage as one of its strongest markets (with 15% growth, trailing autos and semiconductors), and was also positive on energy, mining, metals, and aggregates. I don’t believe we’re going to see much of a slowdown in mining, aggregates, or energy this year (nor much of one in 2024), but I do expect machinery and “general industrial” markets to weaken into the third quarter of this year, while food/beverage is a harder industry to forecast.
I would note, though, that even with evidence of a downturn, companies are still investing in automation-enabling technologies. Atlas Copco (OTCPK:ATLKY) saw generally softer demand among industrial customers, but did see growth in categories like machine vision. I do expect automation investments to slow as companies defer capex decisions through this period of heightened uncertainty, but I believe that will recover relatively quickly.
The Outlook
I will be curious to see the extent to which the growth of the automation distribution business (and value-added services like planning/evaluation, kitting, customization, and validation) can drive sustainably higher margins for AIT. While AIT actually enjoys larger market share within its part of the industrial distribution world (more than 10% share in fluid power distribution), its margins have long been lower than those of Fastenal (FAST) or MSC Industrial (MSM). In a narrow-margin business like distribution, any uplift can make meaningful long-term differences in profit growth.
Given how well AIT has executed, I’m comfortable with a more bullish outlook for long-term growth, but I think it can be easy to get carried away. I believe automation can drive 6%-plus growth for the leading suppliers, and I can see AIT continuing to expand its addressable market and share of wallet, but I’m not really comfortable going beyond 6% to 7% as a sustainable long-term top-line growth rate.
I’ve been bullish on AIT’s margin expansion potential, and the company has come through. I think mid-teens EBITDA margins are a possibility in a few years, and I believe FCF margins can climb into the high single-digits, supporting normalized FCF growth of close to 10%.
Even with those upgrades to my growth and margin expectations, the valuation argument is harder to make. Between discounted cash flow and a forward EBITDA multiple of 14x, I can argue for a fair value above $160, but a lot of low-hanging fruit has been picked.
The Bottom Line
So far, the stock seems to be absorbing expectations of a slowdown with no issues, and it’s worth noting that the “slowdown” management is expecting here is still quite a bit better than likely underlying supplier growth. I do see a long runway for AIT to leverage growth in automation and factory capacity expansion, but if I weren’t already involved in the stock, I think I’d wait in the hope of a pullback, as there have been a few 10%-plus pullbacks in recent years.
