2023-10-03 12:06:54 ET
Summary
- Applied Industrial Technologies is expected to benefit from easing comparisons, cross-selling actions, and inorganic growth opportunities.
- The company's revenue growth is expected to slow from the previous year but remains healthy.
- The company's gross margin is expected to improve due to lower LIFO expenses and operating leverage.
Investment Thesis
Applied Industrial Technologies' ( AIT ) revenue growth should benefit from good execution, cross-selling initiatives, bolt-on acquisitions, tailwinds from reshoring trends supported by government stimulus such as the CHIPS and Science Act, and the company’s focus on expanding into new high growth markets.
On the margin front, benefits from lower year-over-year LIFO expenses, moderating inflation, and operating leverage should help the margins. While the valuation is in line with the company’s 5-year historical averages based on the current consensus estimates, I believe the company can beat the consensus estimates. This coupled with good growth prospects make AIT stock a good buy.
Revenue Analysis and Outlook
The company has seen strong sales growth in the last couple of years driven by good demand, pricing increases and solid execution. In the fourth quarter of FY2023, the company posted a 9.1% Y/Y growth in net sales to $1.158 billion driven by an 8.6% Y/Y growth in organic sales and 0.7% Y/Y increase from acquisitions. These positives were partially offset by a 0.2% negative impact from FX translation.
In the Service Center-Based Distribution segment, net sales of $781.9 million increased 8.8% Y/Y and organic sales increased 9.1% Y/Y driven by the strong growth across national strategic accounts and incremental benefits from cross-selling actions. FX translation had a negative impact of 30 bps Y/Y in the fourth quarter.
The Engineered Solutions segment’s net sales grew 9.7% Y/Y on a reported basis and 7.5% Y/Y on an organic basis to $376.2 million driven by expanding technical and engineering capabilities, healthy backlog, and cross selling initiatives which more than offset the slower order activity across the fluid power technology verticals and ongoing supply chain constraints.
AIT’s Historical Revenue Growth (Company Data, GS Analytics Research)
Looking forward, the company’s sales growth is expected to slow from the solid 15.8% Y/Y growth it posted in FY23 but should remain at a healthy level.
Management has guided for between low single digit Y/Y revenue growth in FY24 and the consensus estimates are currently 2.29% . However, I believe the consensus estimates will likely prove conservative.
At the time of the last earnings call , management mentioned that the company was seeing low-single digit sales growth in Q1 FY24 quarter-to-date and this was likely the reason for their low-single digit guidance for the full year. However, the comparisons are getting much easier as the year progresses, especially in the back half. In the first half of FY23, sales were up ~20% Y/Y while in 2H FY23 sales were up low double digits Y/Y. So, based on easy comps alone sales growth can increase to high single digit Y/Y in the back half resulting in mid-single digit sales growth for the full year. Further, the company is seeing good progress on its cross-selling initiatives. At the time of the last earnings call, the company had over 100 open projects related to its cross-selling initiatives and, as it continues to get traction in these efforts, I believe it should be able to offset the impact from any macroeconomic slowdown.
The company is also well-positioned to deliver good inorganic growth given its healthy balance sheet. At the end of last quarter, the company’s net leverage was just 0.5x which is much below its target level of 2.5x. Post FY23 year-end, AIT has already acquired one company which is expected to contribute ~$50 mn in sales this year, and I am expecting further bolt-on acquisitions as the year progresses which should add to mid-single digit organic sales and help AIT do better than consensus expectations.
The company’s medium to long term growth prospects also look attractive with recent trends towards reshoring driven by the Federal stimulus from the CHIPS and Science Act and Inflation Reduction Act. The company also has good exposure toward secular growth markets like industrial automation and is focusing on expanding into new vertical markets tied to electric vehicle production, semiconductors, renewable energy, life science, logistics and wastewater which should also help its sales growth in the medium to long run. Overall, I am optimistic about the company’s near as well as long term growth.
Margin Analysis and Outlook
In Q4 2023, the gross margin expanded 35 bps Y/Y to 29.2% due to a favorable 24 bps Y/Y impact due to lower LIFO expense, good execution, and effective freight management. The improvement in gross margin coupled with SG&A leverage led to an 80 bps Y/Y increase in adjusted EBITDA margin to 12.1%.
AIT’s Adjusted EBITDA margin and Gross margin (Company Data, GS Analytics Research)
Looking forward, I am optimistic about the company’s margin growth prospects. The company’s gross margin was adversely impacted by LIFO expense headwinds over the last couple of years, but with inflation easing, LIFO expenses were lower year-over-year in Q4 FY23 for the first time in two years. As inflation continues to normalize, I believe the company should see lower Y/Y LIFO expenses in the coming quarters as well, helping margins. The company is also undertaking various initiatives to improve gross margin like the application of enhanced analytics and freight cost recovery which should also help margins.
The company is also doing a good job leveraging SG&A costs and, with volume expected to continue growing, I believe the margins should also benefit from operating leverage. Management has given FY23 adjusted EBITDA guidance of between 11.9% and 12.1%. However, I believe they can do better than this guidance range given AIT's margin was already at the upper end of this range last quarter and my expectations about revenue growth beating their guidance and consensus estimates.
Valuation and Conclusion
AIT is currently trading at 16.94x FY24 consensus EPS estimates of $9.13 and 15.69x FY25 consensus EPS estimates of $9.85. The company has traded at an average forward P/E of 16.66x over the last five years.
While the company’s current year P/E is almost in line with its historical 5-year forward P/E based on the current consensus estimates, I believe there is a good chance for the company beating the consensus estimates and this makes the stock attractive.
The company has executed well in the last year, posting solid revenue growth and margin improvement. I believe there is multi-year growth ahead for AIT driven by solid execution, a focus on cross-selling initiatives and new growth markets, reshoring trend and an opportunity for further bolt-on acquisitions. Given the company’s good growth prospects and potential for the company beating estimates, I have a buy rating on the stock.
For further details see:
Applied Industrial Technologies: Conservative Estimates And Good Growth Prospects