Investment Thesis
Applied Industrial Technologies, Inc. (NYSE:AIT) should see a reacceleration in revenue growth as there are improving short-cycle indicators like stabilizing demand trends in the technology vertical, improving order rates in the Engineered Solutions (ES) segment, healthy sales pipeline for automation projects, etc. Further, the revenue growth should also benefit from easing Y/Y comparisons starting in Q4 2024. In the medium to long term, secular tailwinds from the recent reshoring trend and megatrends like automation should help revenue growth. Additionally, the company’s strong balance sheet positions it well to pursue M&A, complementing its organic growth.
Further, as the revenue reaccelerates in FY25, the benefit from operating leverage should help margins. In the long term, the company’s focus on initiatives such as improving mix and operational improvements should aid margin growth. In terms of valuation, the stock is trading at a discount compared to its peers like Fastenal (FAST) and Grainger (GWW), and as the company continues to execute well, I believe there is a potential for its P/E multiple re-rating. Hence, I maintain my buy rating on the stock.
Revenue Analysis and Outlook
I wrote a bullish article on AIT in March and the stock is up ~7.67% since then, slightly outperforming the S&P 500’s (SPY) 3.95% gains. The company has reported its Q3 2024 earnings results since then and posted low single-digit growth despite tough end-market conditions.
In the third quarter of 2024, the company’s sales grew by 1.3% Y/Y to $1.146 billion. Excluding a 1.2% contribution from acquisitions, 0.2% positive FX impact, and 0.8% negative impact of one less selling day, sales increased by 0.7% Y/Y on an organic daily basis.
On a segment basis, in the Service Center-Based Distribution segment, which operates primarily in Maintenance, Repair, and Operations (MRO) markets, sales increased by 3.6% Y/Y driven by 2.6% Y/Y growth in organic sales and 1.5% contribution from the acquisitions of Bearing Distributors (BDI) and Cangro Industries (Cangro). The increase in organic sales is attributed to sales process initiatives and good demand for technical MRO support across the U.S. manufacturing sector, including solid growth across national accounts and fluid power MRO in the U.S.
The Engineered Solutions segment’s sales declined by 3.6% Y/Y and 3.2% Y/Y organically due to lower fluid power sales against a tough Y/Y comparison and sales decline within automation operations, partially offset by sales growth across process flow control markets. The Y/Y sales decline was somewhat offset by a 0.4% contribution from acquisitions of Advanced Motion Systems (AMS) and Automation.
Looking forward, AIT’s growth outlook looks positive. On its last earnings call, management talked about improving short-cycle indicators including stabilizing demand trends in the tech vertical; improving order rate in the ES segment with book-to-bill reaching ~1x after several quarters; healthy sales pipeline for automation projects; and segment sales of the Service Center-Based Distribution business improving each month with March up mid-single digits. The factors bode well for near-term growth.
In addition, the company will see easier comparisons from the current quarter onwards. Compared to 15.0% Y/Y organic growth in Q3 2023, the company’s organic growth slowed to 8.6% Y/Y in Q4 2023. So, comparisons are getting meaningfully easier starting in Q4 2024.
The company’s medium to long-term prospects are also attractive with it poised to benefit from recent reshoring trends as well as megatrends like automation. I expect the company to start seeing benefits from these trends in its numbers in the coming years and expect organic growth reacceleration in FY25 and beyond.
In addition, the company also has good inorganic growth prospects given its strong balance sheet with net leverage of only 0.3x and a focus on accretive acquisitions.
Margin Analysis and Outlook
In Q3 2024, the company’s gross margin saw a favorable 30 bps impact due to a $3.4 million decrease in LIFO expense. This helped offset ~10 bps unfavorable mix impact from lower Engineered Solutions segment sales, national account growth, and a lower mix of Automation and Engineered Solutions compared to the prior year. As a result, the company’s gross margin improved by 8 bps Y/Y to 29.5%.
However, higher-than-expected expense deleveraging more than offset the positive impact from Y/Y gross margin expansion and resulted in a 56 bps Y/Y contraction in adjusted EBITDA margin which fell to 11.8%.
The company’s operating margins were impacted by a ~5.3% Y/Y increase in SD&A (Selling, Distribution, and Administrative expense) last quarter. However, I am not too worried about it. The major factor behind this was the company’s growth-related investment as it positioned itself to benefit from upcoming reacceleration in growth. Excluding these growth investments and a couple of one-time items like M&A-related costs, SD&A was up only 1.2% Y/Y.
On its last earnings call, explaining the transitional nature of this increase while answering a question, the company’s CFO David K. Wells commented:
I’d just tag on there, David, and add that a lot of this investment was more transitory in nature. I think if you look back, obviously, to the last couple of years and especially during the COVID downturn, we continue to make investments in the business while leveraging some of those shock absorbers that Neil indicated and some of the benefit from our systems investments, shared services, process improvement, et cetera. So if I strip apart the SD&A for you, point out the impact of currency, the M&A kind of cost that’s been at on a year-over-year basis and the AR provisioning, there was an unusual prior year benefit that we call it out, up only 1.2% operationally year-over-year.
And as I look at the kind of the impact of staffing, only 30 basis points of that was really driven by higher staffing costs, the merit impact, et cetera, and some of the investments that we’ve made in personnel resource, a lot of these investments were more transitory in the terms of supporting the Kopar acquisition, the legal work that went on behind that. Some of the Automation Greenfield activity we have going on as well as some of the expansion that we have ongoing with both Olympus to support some of the automation opportunities we see going forward as well as some expansion of facility in the tech side of the Fluid Power business, thinking about what’s coming out there with the particularly out of the semi space. So just to give some further clarification on some of those investments and how we see some of this normalizing to a degree in terms of the deleveraging in Q4.”
These investments position the company to gain share during the upcycle and, the benefit from operating leverage once the revenue growth starts accelerating in FY25 should more than offset the impact of these investments.
In the long run, the company is focusing on initiatives like improving mix (ex. expanding presence in higher-margin Class C consumables) and operational improvements to improve margins. Management has given a ~13% adjusted EBITDA margin target for the medium term which appears within reach.
Valuation
AIT is currently trading at 19.82x FY25 (ending June 2025) consensus EPS estimate of $10.14. This is a discount compared to peers like Fastenal trading at a P/E of 28.99x FY25 consensus estimates and Grainger trading at a P/E of 22.12x FY25 consensus estimates.
I believe one of the reasons behind this discount is that analysts are underestimating the company’s EPS growth potential. The company is expected to grow its EPS by 9.71% in the current year (FY24) despite revenue headwinds. However, for the next year, analysts are only expecting EPS growth of 5.65% despite revenue growth acceleration and margins improvement. Another factor that can result in an upside surprise is bolt-on M&A given the company’s strong balance sheet. The sell-side rarely builds in M&A benefits in their estimates unless the acquisitions are actually announced. So, benefits from any potential M&A are also likely not getting reflected in the current consensus estimates. I believe as the company provides FY25 guidance in the next couple of months and continues to execute well, sell-side consensus estimates will get revised upward and P/E should also re-rate. So, I see a further upside and continue to maintain my buy rating on the stock.
Risks
- While my thesis anticipates the company’s revenue growth to see benefits from future M&A with potential upward revision in the sell-side consensus estimates, it is important to note that inorganic growth is relatively riskier compared to organic growth and there are always risks related to integration missteps, overpaying for an acquisition, and the leverage a company takes to make an acquisition. In case any future acquisition goes wrong, it may negatively impact stock price.
- The company faces risks from the current macroeconomic environment, like high interest rates. If it worsens, this could adversely impact the company’s end market demand and potentially delay the anticipated acceleration in revenues.
Takeaway
The company has good growth prospects as it benefits from stabilizing tech vertical demand trends, improving the ES segment’s order rates, healthy automation project pipeline, healthy trends in the Service Center-Based Distribution segment, easing comps from Q4 2024 onward, and potential M&A. The medium to long-term revenue outlook is also favorable with secular demand tailwinds from the reshoring trend and megatrend such as automation. The margins should also expand helped by operating leverage, improving mix, and operational improvements. The valuation is at a discount compared to its peer distributors and given the company’s good execution, I see a potential for its P/E multiple re-rating. Therefore, I maintain my buy rating on AIT stock.
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