Applied Industrial Technologies: Still An Underappreciated Industrial Growth Story

I can’t really complain about the performance of Applied Industrial Technologies (NYSE:AIT) since my last update, as this leading distributor of fluid power, power transmission, and flow control components has continued to outperform the broader industrial sector. Up about 18% over that time, AIT has handily outpaced suppliers like Parker-Hannifin (PH), other distributors like Fastenal (FAST), and most of its customer base as well.

It’s certainly true that trees don’t grow to the sky and AIT cannot maintain a high-teens revenue growth pace for much longer. Still, the company remains strongly leveraged to the ongoing “catch-up cycle” as companies work to deliver on their backlogs, as well as longer-term secular growth drivers like automation and decarbonization. Share price outperformance has shrunk some of the discount to fair value here, but I believe this remains a well-run and under-known small/mid-cap industrial with above-average growth potential.

 

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Applied Industrial Technologies: Still An Underappreciated Industrial Growth Story

Applied Industrial Technologies Applying The Throttle To A Good Growth Story

 

A broad recovery across multiple end-markets continues to benefit Applied Industrial Technologies (AIT), as does the company’s internal offsets to inflationary pressures and focus on higher value-added product and service mixes. On top of all of this is an attractive automation kicker, as AIT is well-positioned as a design partner and integrator of automation technology for its broad industrial customer base.

I liked AIT back in September largely for its leverage to a continuing broad industrial recovery in 2022 and its underappreciated margin strength and leverage to automation. Since then, the shares have risen around 13%, good for a solid beat versus the S&P 500, a better beat against the roughly flat industrial sector, and better than other distributors like Fastenal (FAST), MSC Industrial (MSM), and Genuine Parts (GPC), but not quite as good as Grainger (GWW).

Although the stock performance has outpaced the underlying improvement a bit since that last article, I still like the story and the stock, particularly as I see more potential beat-and-raise quarters in the future and less vulnerability to shorter-cycle slowdowns (if we get one…). With near-term double-digit appreciation potential and long-term annualized total return potential close to the double-digits, this is still an underfollowed and undervalued name worth considering.

 

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Applied Industrial Technologies Applying The Throttle To A Good Growth Story

Automation And Catch-Up Capex Make Applied Industrial Technologies A Name To Watch

 

Automation is an undeniable trend in the broad industrial end-markets that Applied Industrial Technologies (NYSE:AIT) serves, and management is positioning itself accordingly – acquiring capabilities in design, assembly, and integration to leverage growth opportunities as more and more industries/companies incorporate automation into their manufacturing and warehouse processes.

AIT isn’t just an automation story, it’s also a value-added industrial distribution story where management has wisely steered clear of fast-turn, low-value MRO components and has instead focused on higher-value critical components and service. This has led to something extremely rare in the industrial distribution space over the past decade – actual gross margin improvement.

AIT has historically had some of the strongest cyclical volatility in the space, and I am worried that as with other supposedly “short cycle” names like Parker Hannifin (NYSE:PH) (an OEM, not a distributor), the Street thinks the story is over now that manufacturing PMI is well above 55. I wouldn’t ignore that cyclical risk, but I think automation is a leverageable long-term trend for AIT, and the long-term prospective return is looking pretty interesting.

 

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Automation And Catch-Up Capex Make Applied Industrial Technologies A Name To Watch

Applied Industrial Technologies Starting To See The Slowdown

Wall Street hates uncertainty and there’s plenty of that when it comes to distributors in general and Applied Industrial Technologies (AIT) in particular. With two-thirds of Applied Industrial Technologies’ verticals still growing and macroeconomic metrics like manufacturing capacity utilization, PMI, and industrial production still favorable but weakening, there’s plenty of uncertainty as to just how well the U.S. (and global) economy will perform in 2019.

AIT has done a lot to build up its business, and particularly its higher-margin fluid power business, and this a company with a strong ROIC record. I’m concerned about slowing momentum in 2019 and the possibility of further revisions to near-term guidance, but I do see a path for mid-single-digit revenue growth and double-digit FCF growth that can support a higher share price from here.

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Applied Industrial Technologies Starting To See The Slowdown

Green Shoots May Be On The Way For Applied Industrial Technologies

Conditions are still challenging for industrial MRO and component distributors like Applied Industrial Technologies (NYSE:AIT). While construction-related markets are pretty healthy, manufacturing is still in rough shape and most MRO distributors like Grainger (NYSE:GWW), Fastenal (NASDAQ:FAST), MSC Industrial (NYSE:MSM), and Kaman (NASDAQ:KAMN) are still looking at pretty uninspiring near-term growth prospects.

And yet, there are some reasons to be encouraged. Only about a third of Applied Industrial's markets have been contributing growth, but the last quarter was a little stronger and it looks as though markets like oil/gas and metals are stabilizing and the recent improvement in the metalworking index could be an encouraging sign for manufacturing. The surge in this sector has taken Applied Industrial's stock out of clear value territory, with the shares up 20% since the election and about 40% since just before the last quarter's earnings, but the shares do seem priced for a roughly double-digit total return and the quality of this business makes it a name to consider as a play on a future industrial recovery if and when the sector pulls back.

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Green Shoots May Be On The Way For Applied Industrial Technologies

Seeking Alpha: Fastenal Caught Up In The Distributor Slowdown

When your business revolves around supplying manufacturing and construction companies with (literally) nuts and bolts, your fate is always going to be tied to the underlying health of the manufacturing sector. That's a problem for Fastenal (NASDAQ:FAST), as well as other industrial MRO distributors like MSC Industrial (NYSE:MSM), Grainger (NYSE:GWW), and Applied Industrial Technologies (NYSE:AIT), as various metrics of industrial and manufacturing activity have weakened in response to a softer export market, a weak domestic energy market, and still-sluggish construction activity.

Pricing power seems to be almost non-existent in the distributor space right now, and that's going to continue to pressure gross margin. Fastenal has done a good job of offsetting this with tight expense management elsewhere in the business, but nothing will help as much as a solid upturn in underlying manufacturing and construction activity. As for the shares, they have long carried a premium due to the company's above-average growth, but they haven't really outperformed MSC Industrial by all that much over the last five years and they've actually underperformed over the last three (and both have underperformed Grainger and AIT). I still don't like the price today and would rather play an industrial recovery through other names.

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Fastenal Caught Up In The Distributor Slowdown

Investopedia: Post-Barnes, MSC Industrial Has Multiple Growth Opportunities

Although distribution is not typically a high-margin/high-return sort of business, industrial supply is a different story, as MSC Industrial (NYSE:MSM), Fastenal (Nasdaq:FAST), and Grainger (NYSE:GWW) have all managed to generate solid margins, returns on capital, and free cash flow. With the acquisition of Barnes' (NYSE:B) North American distribution business (BDNA) now complete, MSC Industrial has an interesting set of options in front of it. While management will find itself occupied initially with fixing BDNA's flabby margins, the opportunities for product, end market, and geographical expansion make this a name worth knowing and owning today.

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Seeking Alpha: Lawson Products Toils Away In Obscurity

I would never say that the industrial maintenance, repair, and operations (MRO) space is wildly popular with investors, but analyst coverage for Grainger (GWW), Fastenal (FAST), Applied Industrial Technologies (AIT), and MSC Industrial (MSM) does at least stretch into the double-digits. By comparison, Lawson Products (LAWS) is barely covered at all.

It takes more than obscurity to make a bargain, though. To that end, I'm concerned about the long history of uninspired financial performance from Lawson, as well as a business model that appears to overlap with many better-positioned rivals without a true, strong core of specialization. On the other hand, management is relatively new here and the MRO market is still scattered enough to let a company like Lawson grow.

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Lawson Products Toils Away In Obscurity

Seeking Alpha: MSC Industrial Hits The Cliff

The markets reacted to the fiscal cliff resolution last week with relief, but the dickering and delays had real consequences to companies. As one example, industrial distributor MSC Industrial (MSM) saw a very pronounced stagnation of business in its fiscal first quarter, and the Street was not happy to hear lower guidance from management. While I expect investors to approach this stock with caution until ISM numbers and reported growth improve, this remains a quality long-term name for investors to consider.

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MSC Industrial Hits The Cliff

Seeking Alpha: A Supposedly Weak Economy Isn't Holding MSC Industrial Back

There are certainly plenty of valid economic indicators that say conditions today are not strong – whether its high unemployment, stagnant wage growth, poor housing prices, or low interest rates. At the same time, it's not all bleak. Plenty of industrial companies have continued to post robust earnings and indicators like ISM and rail traffic have been modestly positive. It's interesting, then, is that an industrial supply company like MSC Industrial Direct (NYSE: MSM) is enjoying some of the best operating performance of its corporate history against a such a mixed backdrop.

A Solid Start To The Year
MSC Industrial posted first-quarter results that met the midpoint on revenue, but showed a little bit extra on the bottom line. Revenue grew more than 15% this quarter, with a recent acquisition chipping in about 2.5% growth (meaning organic growth was just under 13%). Sales to manufacturing customers were even stronger, growing almost 20% and making up nearly three-quarters of sales. Sales growth to non-manufacturing customers was less impressive, up just about 4%, as expected declines in sales to government buyers weighed on results.

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A Supposedly Soft Economy Isn't Holding MSC Industrial Back

Seeking Alpha: MSC Industrial - Good Growth, Great Returns, And Rich Valuation

Sooner or later, every investor will find a company that challenges his or her beliefs on the proper trade-off between quality and value. For me, that company is MSC Industrial Direct (NYSE: MSM). This industrial supply company has posted excellent growth over the past decade and boasts full-cycle returns that many far larger companies in less cyclical businesses never approach. While this company has ample potential to grow its footprint and top line, as well as expand those margins even further, today's valuation seems already predicated on those assumptions.

Carving A Niche In A Huge Market
Figuring out MSC Industrial's market potential is no easy task; my first job on the Street was with an analyst team that covered this company and that was a constant struggle. A good estimate, though, is probably in the $140 billion neighborhood – suggesting that MSC has less than 2% share.

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MSC Industrial - Good Growth, Great Returns And Rich Valuation

Investopedia: Fastenal Not Slowing Down Yet

There is ample fodder for a dour outlook on the U.S. economy. Politicians in Washington, D.C. continue to play chicken with the budget. Debt discussions, economic statistics like employment, wage growth and ISM are not terribly encouraging, and indicators like rail traffic look sluggish.


Nevertheless, plenty of companies with strong correlations to the health of manufacturing are still performing well. Growth at industrial supplier Grainger (NYSE:GWW) has slowed but is still pretty solid, while other industrial input companies like Lincoln Electric (Nasdaq:LECO) and Praxair (NYSE:PX) have strong stocks and good earnings estimate momentum.

With that backdrop, then, it is perhaps not so surprising that Fastenal (Nasdaq:FAST) reported solid top-line growth for the second quarter. Though it was not a perfectly clean quarter and the stock is quite expensive, Fastenal's results suggest underlying business activity is not so terrible. (For related reading, see Profit By Understanding Fundamental Trends.)


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Seeking Alpha: MSC Industrial Direct Continues To Ride The Recovery

It's generally a good idea to keep up with the bear story on your holdings, if only to formulate a list of red flags to watch for or potentially under-appreciated aspects of the story that may drive the shares higher. In the case of MSC Industrial (MSM), there has been a fairly constant skepticism about the reproducibility of the company's growth – sure, they've grown this far, but they will find it increasingly difficult to go further. And yet, the company keeps doing precisely that.

Rebounding Manufacturing Showing Up In Higher Sales
Whether you want to look at rail traffic data or dive into the particulars of the Institute of Supply Management's regular reports, it is clear that manufacturing has been rebounding in the United States. That is good for an industrial supplier like MSC Industrial. Better still, that rebound seems to be broadening out and spreading into the small/medium-sized business sector – a key market for the company.

With that backdrop, the company favorably surprised the Street with 22% revenue growth in the fiscal second quarter. At $483 million, revenue surpassed even the highest published analyst estimate.


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MSC Industrial Direct Continues to Ride The Recovery

Looking Ahead To Industrial Supplier Earnings

As the calendar has turned into October, it is time once again to prepare for the cycle of earnings reports that will follow the end of the calendar third quarter. The third quarter was a rather strong period for the stock market, as the S&P 500 rose nearly 11%, even though there was a constant drumbeat of worry about the possibility of a double-dip recession. 

Looking at the industrial supply market, there are reasons to be optimistic about the third quarter. Rail traffic continues to recover, which can be read in more detail in this article, suggesting that industrial activity is solid. Likewise, the recent ISM report highlights ongoing growth in the manufacturing sector, even if at a slower pace. In particular, 13 of the 18 reported industries showed growth in September, with the exceptions being wood products, printing and nonmetallic minerals contracting. While the slowing pace of orders, the growing level of inventory and the reversal of backlog are concerning indicators for the fourth quarter, the third quarter appears to have been a good one for manufacturers, and presumably the companies that supply them. (For more, check out Economic Indicators: Purchasing Managers Index.)

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MSC Industrial - Another Good Quarter From A Good Company

Another one of my portfolio holdings reported today. This time it was industrial supplier MSC Industrial Direct (NYSE: MSM). As has often been the case, management's initial guidance proved conservative and the company beat expectations. Nevertheless, the market didn't exactly do handsprings over the results -- probably because the valuation (and expectations) were already high and this is not a management team that is really going to give ebullient guidance that gets everybody fired up.

As an industrial supply company, it probably will not surprise anybody to hear that the 2009 was a very tough year. Consequently, even with a tepid economic recovery, the company is benefiting from some very easy comps.

Revenue this quarter rose 28.5% as reported (to over $450M), and was up 26.5% on a per-day basis. Gross margins weakened just a bit, from 45.9% to 45.5%. Interestingly, about half of the growth came from the company's large customers, with the other half come from the much larger number of smaller companies. To a large extent, this confirms a lot of what I've been seeing about the economy - namely, that the bigger companies are recovering relatively better than the smaller ones.

This is a company famous for efficient management, and operating income jumped about 56% to 70.4M. As you might imagine, the results of this growth filtered on down through the rest of the income and earnings lines.

Cash flow was not great in this quarter, but that does not worry me. First, quarter-to-quarter cash flow is just not something I worry about because there are so many eccentricities and timing artifacts that create problems. Second, as part of the recovery in business, I expected to see higher accounts receivables and inventory levels and that does not help operating cash flow.

Management gave more of its customary guarded optimism with the release. Earnings guidance was modestly positive and I would expect the company to outperform those expectations once again. So, to the extent that the company has control over its business (which is tenuous given how reliant it is upon overall manufacturing and economic health), I feel pretty good about the rest of this year.

As I said, it is not a cheap stock and it can be pretty volatile. I figure that these shares are worth something in the vicinity of $58/share. That number could go up a bit as I update in the wake of this quarter, but I doubt it will go up much. So, with all that in mind, I'm happy to hang on for now.

Other similar companies like W.W. Grainger (NYSE: GWW) and Applied Industrial Technologies (NYSE: AIT) are certainly cheaper, and maybe some would argue that Grainger is just as good. WESCO (NYSE: WCC) is likewise a great play on economic recovery, but the stock has already had a hell of a run and is not exactly dirt-cheap. I suppose you could also throw Airgas (NYSE: ARG) and Anixter (NYSE: AXE) into the analysis, but they do not excite me after the runs they have already had. All in all, I'd rather pay up for MSC, but WESCO could still be interesting if you think the economy will avoid a double-dip.

Disclosure - I own shares of MSC Industrial