2023-12-17 08:21:27 ET
Summary
- Applied Industrial Technologies is well-positioned for growth in the coming quarters, with orders in the technology vertical stabilizing and potential for M&A.
- The company's revenue increased by 3.1% YoY in Q1 2024, and it is expected to see good strength in its end markets supported by government industrial infrastructure stimulus.
- The company's margins are expected to benefit from declining LIFO expenses and operating leverage due to sales growth, making it an attractive investment opportunity.
Investment Thesis
Applied Industrial Technologies (AIT) is up over 12% since my previous buy rating on the stock. AIT is well-positioned to deliver good growth and I expect this uptrend to continue moving forward. The company’s technology vertical, which was experiencing a slowdown over the last year is seeing orders bottoming which should pave the way for recovery in the coming quarters. In addition, easing comparisons in the second half of fiscal 2024, good strength in the majority of end markets supported by government industrial infrastructure stimulus, and potential M&A should also help the revenue growth moving ahead.
On the margin front, the company should benefit from declining LIFO expenses as inflation continues to moderate. In addition, operating leverage due to sales growth should also support margin growth. So, I believe the company has good margin expansion prospects ahead. Moreover, AIT is also trading at a discount to its peer distributors like W.W. Grainger ( GWW ) and Fastenal Co. ( FAST ). This along with good growth prospects makes the company a buy.
Revenue Analysis and Outlook
Over the last year, the company’s sales growth benefited from good demand, price increases, and strong execution across the segments. In addition, accretive M&As also helped sales growth. This growth continued in the first quarter of fiscal 2024, and the company’s revenue increased by 3.1% YoY to $1.09 billion. Excluding, a 1.1 percentage point benefit from acquisitions, a 0.2 percentage point benefit of favorable foreign currency, and a 1.6 percentage point headwind from one less sales day in the quarter, sales increased by 3.4% on an organic daily basis.
AIT’s Historical Net Sales by Segment (Company Data, GS Analytics Research)
Looking forward, I am optimistic about the company’s revenue growth prospects. The company’s sales were impacted by a slower technology vertical for about a year. However, on the last earnings call , management noted that orders in this vertical have stabilized which bodes well for future growth.
Most of the end markets outside the technological vertical remain strong benefiting from the ongoing reshoring activity and investment in U.S. industrial infrastructure catalyzed by the federal stimulus in the form of the CHIPS and Science Act, and Inflation Reduction Act. As the deployment of funds under these programs continues to increase, I expect the company to see good strength in its end markets. Further, a potential reversal in the interest rate cycle next year should add to this end-market momentum.
In addition to end market strength, the company continues to benefit from market share gain through cross-selling initiatives, local service capabilities, and its industry-leading position.
In addition, the company should also benefit from significantly easier comps in Q3 and Q4. If we look at last year’s FY23 organic sales growth, it was up 19.4% Y/Y in Q1, 21.1% Y/Y in Q2, 15% Y/Y in Q3, and 8.6% Y/Y in Q4. So while Y/Y organic growth comparisons are getting slightly tougher in Q2, they should meaningfully ease going in Q3 and Q4.
One of the things that continues to baffle me if low sell-side revenue growth estimates for the back half of this fiscal year.
AIT Consensus Revenue Estimates (Seeking Alpha)
For Q2, the sell side is expecting flattish sales which I understand has to do with slightly tougher comps in Q2 vs Q1. But with organic growth comps getting 610 bps and 1240 bps easier in Q3 and Q4, respectively versus Q2, I don’t see a reason why the sell-side is stuck at Y/Y low single-digit percentage growth for Q3 and Q4. The sales should accelerate to mid-single digits in Q3 and low double digits in Q4 based on easy comparisons alone. Add to that the bottoming technology vertical, recovering other markets, and share gains from good execution, we can see much better growth than market expectations.
Moreover, the company should also benefit from potential M&As. Management is targeting inorganic growth opportunities in the high growth areas like automation and the company’s healthy balance sheet with net leverage of just 0.5x should enable the company to pursue these opportunities.
Margin Analysis and Outlook
In recent years, the company’s margins benefited from volume leverages, price increases, and good execution which were partially offset by higher LIFO expenses due to inflationary input costs. However, over the last couple of quarters, LIFO expenses have begun to ease on a year-over-year basis, and in the first quarter of fiscal 2024, the company saw a ~40 bps YoY benefit from lower LIFO costs. In addition, sales leverage continued to favor margin growth. As a result, the gross margin increased by 80 bps YoY to 29.7% and the adjusted EBITDA margin increased by 100 bps YoY to 12.2%
AIT’s Historical Gross Margin and Adjusted EBITDA Margin (Company Data, GS Analytics Research)
Looking forward, I expect the YoY LIFO expense reduction to continue benefiting gross margins. Last quarter, the company recognized LIFO expense of $4.6 billion which was lower than prior year LIFO expense of $9.1 million. I expect the LIFO expense to continue to trend downwards as inflation continues to moderate and the inventory level stabilizes.
Further, with a meaningful acceleration in growth in the back half of this year the company’s margins should also benefit from operating leverage due to higher sales.
Valuation and Conclusion
Applied Industrial Technologies is currently trading at an EV/EBITDA ((TTM)) of 12.88x and an EV/EBITDA ((FWD)) of 12.67x. If we compare the company’s valuation to its peer distributors, AIT valuation is at a discount to WW Grainger, Inc. (trading at an EV/EBITDA ((TTM)) of 15.58x and an EV/EBITDA ((FWD)) of 15.46x) and Fastenal Co. (trading at an EV/EBITDA ((TTM)) of 21.89x and EV/EBITDA ((FWD)) of 21.86.)
The company has good growth prospects as it should benefit from the recovery of the technological vertical after order bottoming in the coming quarters, easing comparison, good demand in the rest of the end-markets supported by government infrastructure stimulus, and potential M&As. Margins should also trend upward as LIFO expenses continue to decline with moderating inflation. So, these good growth prospects over the coming quarters and lower valuation as compared to its peer distributors make AIT stock a good investment opportunity. Hence I have a buy rating on the stock.
For further details see:
Applied Industrial Technologies: The Uptrend Should Continue