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Applied Industrial Technologies Inc
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Welcome to Applied Industrial Technologies review of its transaction with FCX Performance. This conference call is being webcast simultaneously in listen only mode on the investor relations page of Applied's web site at applied.com. A question and answer session will follow today's presentation. An archived replay of the webcast will be available for two weeks as noted in Applied's press release. Please note that today's call is being recorded.
At this time, I'd like to turn the call over to Julie Kho. Julie, please go ahead.
Thank you, and good morning everyone. Our press release to announce this transaction was issued this morning before the market opened, and can be retrieved from our Web site at Applied.com. Our presenters today include Neil Schrimsher, Applied's President and Chief Executive Officer and Dave Wells, our Chief Financial Officer.
Before we continue, I'd like to remind everyone that today's conference call and presentation material include forward looking statements as defined by the Securities and Exchange Commission in its rules, regulations and releases. Any forward looking statements speak only as of the date hereof and the Company undertakes no obligation to update or revise any forward looking statements whether due to new information or events or otherwise. A full declaration regarding forward looking statements summarizing key risk factors related to and arising out of FCX acquisition is provided in our press release and in today's slide presentation.
In addition, the conference call and presentation material include the use of non-GAAP financial measures. These measures are explained in our press release and in the presentation material and are subject to the qualifications referenced in those documents.
At this time, I will turn the call over to Neil.
Thank you, Julie and good morning everyone. We appreciate you joining us. As you know from our press release, we announced an agreement to acquire FCX Performance, a leading distributor of specialty processed flow control products and services based in Columbus, Ohio. We're here today to provide some additional insight on the transaction and to answer your questions.
To begin with, we are very pleased about the pending acquisition of FCX, which further enhances our position as a differentiated industrial distributor, while also positioning Applied as the industry leader for engineered fluid power and flow control systems. The acquisition is expected to close within 30 days upon completion of the Hart-Scott-Rodino waiting period and satisfaction of other customary conditions.
FCX is the premier specialty flow controlled distributor of highly engineered valves, actuators, instrumentation, pumps and life cycle services to MRO and OEM customers across diverse industrial and processed end markets. The Company's comprehensive value added solutions help customers improve cost productivity, reduce downtime, increase efficiency and effectively meet increasing regulatory compliance standards. FCX operates 68 locations with more than 1,000 team members, and we're anticipating approximately 550 million in sales and 68 million in EBITDA in the first 12 months. The combined resources of Applied and FCX will make us a leading technical solutions provider with significant opportunities for growth.
Now, at this time, Dave and I will turn to the slide deck to provide some additional comments and color on this pending acquisition.
So when turning to page four, we covered much of this, but this is a very compelling strategic acquisition and natural strategic adjacency for Applied, especially considering how well FCX fits with our existing strengths, capability and experience, providing additional growth opportunities for both businesses. The fit includes critical areas around common industry served, customer base, value added services and engineering.
Value added services require strong technical capability and engineering support. Every day FCX and Applied engineers work with pressure, flow, temperature, pressure drop and fluid compatibility requirements within customer applications. In addition, Applied’s electronic control integration capabilities provide additional opportunities for precision valve control that can benefit customers and applications across FCX locations. So we're really bringing together the leading fluid power and specialty flow control businesses in the North American markets.
If we turn to page five, we cover the highlights including the anticipated 12 month performance, the close proximity of the headquarters of the two businesses and also FCX industry leading position in this highly fragmented market. The U.S. flow control market is a $33 billion market today with mid-single digit growth and projected to reach 44 billion by 2022 with highly engineered products leading the way, representing nearly 50% of the market.
They have an attractive business profile, the reoccurring MRO focused to 75% of their sales, a very balanced market participation and a diverse customer base with really low concentration from their top customer segment.
If we turn to page six, the performance overview is a broad engineered solution offering, which really enables customers one stop shopping. There is a best in class technical sales force with deep application expertise, plus over 260 service technicians, providing value added engineering and onsite service to customers, helping customer have greater uptime and avoiding costly down time. The business has strong size and scale and clear potential to grow from the existing footprint.
We turn to page seven, the complimentary MRO solutions; FCX brings the market leading specialty flow control position; a large install base; the highly technical sales force and clear runway for organic growth; margin expansion and ongoing M&A opportunities. While applied provides a leading value added distribution platform with national presence and global reach; electronic control integration capabilities as demonstrated in our fluid power business and our recent results; a large diversified customer base; and a strong e-commerce platform and capabilities.
There is significant cross selling opportunity through this extensive product portfolio if we consider the process flow side plus the industrial side, really positioning Applied as the clear technical MRO distribution leader.
So, at this time I am going to turn the call over to Dave to walk through some of the transaction details.
Thank you. Turning now to slide eight, I'll recap key highlights of the transaction. As noted in our press release this morning, purchase price is approximately $768 million, representing 11.3 times multiple of projected over 12 month EBITDA for the business, excluding one-time transaction cost.
The acquisition is being funded with a combination of cash on hand and proceeds from the new credit facility. The facility will be comprised with $780 million Term Loan A, and $250 million revolver, approximately $112 million of which is expected to be drawn at close. The new facility is designed to be implemented in conjunction with the transaction closing tenure of the new facility will be for duration of five years. Initial leverage post close is projected to approximate 3.65 times EBITDA or 3.3 times on a net leverage basis as calculated for the definition of net leverage outlined in the new financing agreement.
Key covenants include the maximum permitted net leverage ratio of 4.25 times following acquisition Holidays with subsequent step downs, and an interest coverage ratio of covenants of 3 times EBITDA. Given the positive cash generation profile of the business and benefit of lower go forward U.S. federal tax rates, we expect to return to leverage under 3 times EBITDA for the end of year two.
Our pay down projections include allocation of capital to continue to drive value for our shareholders in the form of annual dividends and share repurchases with residual excess cash flow forecast after meeting our credit obligations and our capital allocation priorities given the positive cash generation profile of the combined businesses. As a result of one-time transaction related expenses, we anticipate the transaction to be -- to apply full year 2018 results by $0.17 to $0.24 per share but accretive in fiscal year 2019 and beyond. The transaction is expected to close to latter of January 31, 2018 or two days following the receipts of Hart-Scott-Rodino regulatory approval.
Moving on now to slide nine. We provided snapshot of the financial impact of the acquisition. The attractive gross margin and EBITDA profile of the FCX business will be amplified by continued execution of growth initiatives and leverage of synergy sales opportunities following the combination of the businesses. Merge and expansion initiatives already ongoing in both the Applied and FCX businesses, will be enhanced to be a leverage of tools, best practices and operating models each business brings to the equation.
Attractive SG&A leverage characteristics on incremental growth similar to those within the core Applied business coupled with targeted synergy opportunities will combine to drive EBITDA expansion and solid cash generation, providing the ability to continue investing in the business while de-levering and servicing other capital allocation priorities designed to drive shareholder value.
Given the several acquisitions completed by FCX during the quarter ending December 2017, we have utilized and relied on independent quality of earnings reports prepared in conjunction with the sale of the business and independent quality earnings report prepared by one of the big four auto firms engaged by Applied to supplement internal financial and tax diligence efforts and supporting diligence to compile a pro forma view of recent historical financial results for the combined business.
Because of the recent acquisitions completed by the FCX coupled with the nature of the additional pro forma adjustments required to conform accounting policies with Applied's and normalize results to exclude certain one-time items and approximate results under Applied's ownership, we do not attempt to reconcile these measures with the most directly comparable GAAP financial measures because of the inherent difficulty in quantifying certain amounts that are necessary for such reconciliations.
The forward 12 month projected results provided within our presentation represent a good proxy for recent historical performance as supported by the quality of earnings report prepared by our independent auditors, allowing our investors to evaluate the financial impact of the pending acquisition.
Our work shows that FCX business been acquired continues to benefit from growth, which had a minimum has pace to market margin improvement initiatives underway and synergy benefits from business consolidations undertaking to date. As such, we were excited about the strong foundation for driving incremental shareholder value represented by the transaction and that further opportunities to leverage the combination of these two leading businesses.
With that, I'll turn it back to Neil to wrap this up.
Thanks Dave. If we go to slide 10, the pending acquisition really further enhances Applied's differentiation. Around critical core products, 8% of the sales will be from engineered products components and solutions, which really 50% of the sales occurring at a critical brake fix time for our customers; will have a wide range of value added services, our technicians and engineering teams will be involved upfront in engineering design in the build and assembly of the solutions and then in the ongoing services and repair; will be the leader in fluid power and flow control engineered solutions and will broaden the geographic reach with over 600 local facilities, 3,600 forward facing resources and five channels to market.
Page 11 provides the overview of the product portfolio in excess to over 6.5 million SKUs; with 44% of that offering in bearings and power transmission and 38% in fluid power and flow control; critical parts, services and solutions to benefit our customers and reducing downtime and increasing their uptime.
And page 12 outlines then the go forward channels to market; there will be over 430 service centers with experience in diverse industries and local markets to promptly address customer needs with dedicated associates; there'll be 70 plus fluid power service and repair facilities in hydraulics with mobile and industrial customers and pneumatic products and innovative solutions focused on energy sustainability; will have the strength in the addition of the 68 locations in service repair and specialty flow control, along with vendor managed inventories specialist in our maintenance, supplies and solutions business having expertise in managing C Class MRO Supplies. And then supporting all of them applied.com with an increased or enhanced search and navigation capabilities along with order and account management; truly productively reaching the end markets, providing our customers choice, convenience and expertise. And if we go to 13, the combined businesses truly will be industry leaders, proven track record, leadership in fluid power and flow control, as well as bearing some power transmission.
We'll be well positioned in large fragmented markets, we'll move from a $44 billion addressable market today to over $60 billion with the pending acquisition, and in time over $70 billion. We'll have strong cash generation, providing the business flexibility and the ability to quickly de-lever; and the businesses are operating aggressively, implementing strategic plans to accelerate growth; around the core in current and new customers with product and service expansion and operationally pursuing continuous improvement on how we link with our suppliers to reduce redundancy cost and improve our overall margins.
We know we can continue to drive shareholder value via our business execution, strategic investments that we'll make around technology and acquisitions and returning cash to shareholders via dividends and share repurchases. We have a strong foundation, expanding business capabilities and outstanding business potential today and in the years ahead.
Now the exciting part begins as we look forward to completing the acquisitions and working with the FCX team to realize the excellent growth potential from our combined organizations. I'd like to recognize our business teams for their efforts on this transaction and getting us to this point and just days away from celebrating Applied's 95th anniversary. We're focused on our customers and energized by our momentum in the pursuit of realizing our full potential. While continuous improvement is a never-ending goal, teamwork makes the meaningful progress possible, further strengthening our foundation and generating benefits for all Applied stakeholders in the years ahead.
With that, we'll open up the lines for your questions.
Thank you. We will now begin the question-and-answer session [Operator Instructions]. Your first question comes from the line of Ryan Cieslak with Northcoast Research. Your line is open.
Good morning Neil and Dave and congratulations on the transaction. My first question, I just wanted to get maybe a little bit more color on the growth profile of FCX. I think you mentioned the market it was growing in that mid single digit. How do we think about their organic growth historically maybe even so maybe more detail on the past 12 months and the past year or so?
So if we look back, they have performed at market or slightly better. Obviously, they too have been acquisitive in the period but they really had at market growth as the market turns down in '14, they participated in that but more so on the project side of their business than the MRO after market side of their business. So they've had very good market type performance as we look back, nice job in working their margins and we feel confident of that continuing going forward.
And then, if I hear you right today, there's been a history of acquisitions. How do we frame that up? I mean how much has that contributed to the revenue profile the last several years. And you mentioned some acquisitions made in, I think, the last quarter here. Maybe just if you could frame it up a little bit to get a sense of how sizeable some of these recent acquisitions have been for them.
If we go look back in history, may be similar to Applied, the Company had 21 acquisitions all the way back to 2000. picking up their pace like Applied, most recently in November, they would have acquired Eads, which would have had 25 service centers, 13 states, I would say approaching over 100 million of revenue, so that would be clearly a large recent acquisition. If I look back at their history, really similar to ours, the average size of acquisitions have been more in the $25 million to $30 million range.
And then may be just one last one and then I will hope back in the queue. And thinking about the $30 million of synergies that you guys laid out, how do we think about, may be if you put in buckets in terms of how you think about sales synergy versus cost synergy and the cadence of that as well. Is that something that should be gradually we start to see more of this creep into the P&L, in year two or year three? Any color around that would be helpful. Thanks.
And so as we think about $30 million of synergies over the five year period, really review 60% will result from operational cost savings activities, logistics, physical distribution perhaps some back office efficiencies and potential shared services, while maintaining strong forward facing presence. We’ve been able to successfully do that within applied and it allows our forward facing teams to have more customer facing and customer focused activities. We think the other 40% results from revenues and margin enhancement with about two third around cross sell opportunities, extension of service, in time geographic expansion.
We think there is a third of that 40% from margins, and as Dave outlined continued use of tools, best practices, reducing variation across product ranges and customer groups. As far as timing, we know within the acquisition you need to be intelligent in the first periods and we plan that. It’s a very good operating team, very good business. I would expect the ramp of the synergies about 35% to 40% of it over the first half of the five years and then 60% or two thirds over the second half of that five year period. And as we think about the $30 million, we’re netting those expectations. So those include in the investments or implementation cost that would add, so that’s our thinking today.
Okay, thanks guys, best of luck.
Thank you. In fact on the acquisition discussion for just a minute, it might be worth mentioned that Eads was an acquisition that certainly Applied is very familiar with the company that Applied is familiar with them and one that we have looked at is an alternative to potentially growing at this pace the other channel, so certainly very complimentary to the business and a great fit in terms of the strategy here.
Your next question comes from the line of Jason Rodgers with the Great Lakes Review. Your line is open.
Just had a question on the expected impact on EPS from FCX, if you exclude those one-time transaction costs, what would be your estimate for the EPS impact in fiscal '18. And do you plan on excluding those costs from your EPS guidance that you provide?
We will bracket those that impact out as we move forward back to the original portion of the question the acquisition would be just nominally accretive based on our latest projections as we look about fiscal '18, excluding those one-time transaction costs.
And would you care to give a estimate or range of what you think the EPS accretion could be in fiscal '19?
I think we'll get back to you about that as we continue to work through the guidance, the updated guidance as we move forward here with the combination of businesses.
And then how much product and customer overlap is there between the two companies?
So when we think about product overlap, very little in doing it, perhaps a little around some of the pumped category. So it's a very nice adjacency on that side, I think there is common customers that we may be entering through different avenues to reach so there'll be some common customer opportunity but also new customer opportunity where one side of the business or the other has a very good position and relationship.
And then finally is it possible to give an estimate of the total combined company as far as the percent of revenue from product sales versus service and repair?
I need to further work on it but I would say it's -- service and repair will approach 20% plus of the overall revenues. And some of that will be the degree of service because both businesses do assembly of products to provide a solution. And while that may not take a depth of service and service time, it does take a qualified technician with expertise to do some of those assemblies and combination. So depending on how you think about those from a definitional standpoint. But I think we know it approaches 20% perhaps could be more.
And I apologize, if I could squeeze in one more, ERP systems. Is there comparable or a compatible adherence or is any work to do there?
So from a ERP system, FCX would have really over 95% of their business on a common platform, it is a system that we use in our fluid power business as well. So we have very good familiarity with that system so there'd be little requirements. Now as we both use it, especially in the service and repair modules, perhaps will be learnings and opportunities on both sides but high already consolidation, concentration on the FCX side, to a common system that we operate with today.
[Operator Instructions] Your next question comes from the line of Chris Dankert with Longbow Research. Your line is open.
Just to want to just focus in here, you highlighted highly engineered nature of these products I guess. Is there more labor intensive sales for some of the FCX’s products or is it pretty comfortable to AIT? Just trying to think about where SG&A cost can go longer term?
I would say, first off, I think it's very comparable to how we operate within our fluid power business. And while there is a technical application understanding and requirement to that, it does not bring over burdensome SG&A requirements to do that. You need the expertise, you need the service and repair capabilities, you need the facilities, you need the local presence but that really looks and operates a lot like our fluid power.
And then I assume you guys have gotten to know leadership of FCX is pretty closely here. Will that structures in place and that FCX runs somewhat independently early days or how do we think about that leadership integration?
So we have, you are right. We have I guess you got to know the team Tom Cox, the leader of the business and then some of the expanded management through the dialogue and the sessions that we’re very pleased with them. They have a great understanding of the business. They've driven a lot of success in the business that’s going to continue. It will operate as a subsidiary of Applied and will have quite annuity in the leadership team and that organization structure. We’ve talked, we will include a experienced integration manager in and there our view is to determine what opportunities that we have to go fast on and perhaps what areas should we moderate or go a little slower on. But we think that that helps us in delivering the business cases and the synergy cases that really both teams have indentified.
And then just one last one if I could, and sorry if I missed it in the 8K. But any color around what the rate on that new term loan?
Yes, certainly there’ll be step downs as we work through the leverage profile but initially we’ll be right around 4% in terms of the all in cost inclusive facility piece and that'll step down pretty nicely as we move through it, so very competitive in terms of the rate structure there.
Your next question comes from the line of Steve Barger with KeyBanc Capital Markets. Your line is open.
I wanted to go back to the gross margin, obviously nicely accretive to yours. Is that a function of the value added services side or the product line, or what. Can you talk about the structural differences to FCX that allow them to have that higher gross margin?
I think it is a function of the product line, the technical capabilities and requirements of the channel. The value added services, I think industries and segments develop norms and standards, and they've done a very nice job operating in that environment. But if you look back at their history, they've also done a nice job of growing those margins over the years, 20 to 30 basis points and that with a view of clear opportunities to continue to do that, going forward.
So it is what we see in the process control space and we know providing solutions to customers, especially as they look to reduce their maintenance teams and stats counting on others to help them maintain up time, that margin profile continues.
And maybe this question goes back to the definitional approach you talked about 20% being service and repair. But what percentage of their sales have a value added service attached to them, if you know?
I would say, similar to our fluid power a really if we think about the technical products, assembly to value added services I think it approaches 80% of their base and really only 20% is a read and replace type component. Now they earn that right for that side of the business very well for all the service and the repair that you do, but I think there's very little separate, unique, discrete read and replace components that they're providing.
And is that really what's allowed them to drive that 20 or 30 basis points of margin expansion over time?
It is clearly helpful, yes.
So if you rank what made this deal really make sense for you. Is it the technical knowledge or the customer relationships or the product line? What made it such a strong acquisition for you?
So really the opportunity to move and be the clear leader in engineered fluid power and flow control, it's just such a natural adjacency and we talked a little bit earlier. Our engineers in fluid power are doing the engineering, the power requirements to move fluids throughout all of these systems. They're around these systems and these products, they were just not always specking the flow, the instrumentation the control of it, which is a little downstream in those applications. So we think this is a great combination for us with OEMs but also in the industrial after market around these systems.
And you mentioned accelerating growth several times. Any more specifics on what the combined team will be doing differently going forward to drive that.
We think about the analysis with customers. We know we have opportunities to further expand within current customers. And the current team looks at where they would have high concentration of either pumps or valves and perhaps an instrumentation opportunity or in two of their other product categories but not rounding it out. And then you add to that the Applied position with customers, we just know there's going to be the opportunity to accelerate that where we have strong fluid power presence or perhaps where we have strong bearing and power transmission.
We think in essence no selling team should have to have cold call. Now Tom and I are still going to encourage them to make cold calls where appropriate, but there's likely going to be an opening or reception that we can have to a high number of customers.
Do you think this is a hard cultural shift to get technical sales team to start talking about the broader product line or will you have dual coverage of accounts to really showcase the platform's entire product line?
We think especially with fluid power and flow control, those are natural synergies. Then I think we augment those that are more flow products with other resources. We think about our business today. We do not bought down our selling teams on vendor managed inventory and consumables replacements, right. They are solving more technical value add solutions generating what we would call documented value add for our customers. So that would be the same here but the technical expertise awareness competency across flow control and fluid power is very high. And I think it's going to be welcome by many other selling teams.
That’s really great detail, I appreciate. I guess, one housekeeping can you give us FCX D&A?
Roughly $3 million of depreciation a year, amortization obviously will be a piece we look at the combined profile, going forward. So working through the valuation of the business and that’s one of the variable as we think about the forward EPS estimates.
Your next question comes from the line of Garo Norian with Palisade Capital Management. Your line is open.
I am curious considering that FCX has been pretty aggressive acquirer of businesses the past few years. What level of integration exist in their company? And maybe you could compare that with what you found at AIT when you first joined Neil versus where you brought AIT to that.
I think they have a very good level of integration. So we talked about 95% of the business already own a common platform and I really think there is plans and timelines for the remaining side of the business. So that’s been very encouraging on the approach. But I also think with the leadership team and especially over the last couple of years, they’ve moved from just assimilating businesses to operating businesses, especially in their market approach, their sales planning to think about customers broadly of how they grow their share position across their three or four big product categories with those customers and also how they perform operationally linked with best suppliers.
So I believe that work is well underway, it's not been all delivered, all the opportunities haven't been captured but that progress is showing in the results and we feel confident together. We’re just going to be able to accelerate that with even more opportunities.
And then just I don’t know if you the industry landscape of what these guys have been rolling up. But obviously the whole is the West Coast of the U.S. Is there somebody that’s been focused on that part of the country or is that really diversified as far as what the supply base or distribution base looks like today?
That would be diversified as well. So clearly, there is opportunity pipeline going forward but also there is a landscape opportunity as well as we think about the common footprint of where we operate today in fluid power with technical capability, can we augmented or extend the business in there and have forward facing resources just like FCX operates in some geographies today, perhaps where we don’t have the full forward reach from a hydraulics standpoint, will that make sense going forward. So the footprint today we feel we can grow the coverage and reach in time and will be part of our collective plans.
Your next question comes from the line of Ryan Cieslak with Northcoast Research. Your line is open.
Just wanted to go back Neil and think about your fluid power business, the legacy business. You've been very successful in gaining share there. It seems like the last several years, particularly the last 12 months some really nice growth. When you think about the solutions you're providing to the variety of customers within your fluid power segment, how much of that system that you're working with or that solution you're providing actually would encompass some products or services on the flow control side, whether it'd be valves or pumps or actuator. I am just trying to get a sense ultimately of the opportunity to really complement the fluid power portfolio for your guys, going forward?
There'd be definite opportunity on the industrial side, right, every day as we think about the industrial applications and those products. We also believe there will be opportunities on the OEMs, mobile OEMs but perhaps less in that product range and in that solution. So to-date, I believe more of the opportunity is going to be industrially around those applications where they are fully installed for their customers. Now the opportunity -- as automation, intelligence and control of products become more and more in use, so just like we're doing in our fluid power that opportunity will exist for precision flow type control and intelligence and automation coming to that.
We think there is an opportunity for that acceleration I think it started, but we think that can accelerate. And so just like you see in our results in fluid power over the last 12, 18, 24 months, we believe the same potential opportunity exists in flow control.
And then the way to think about this then is with this new product portfolio, on the flow control side, does this make that portion of the business for you, the fluid side of the business, unique within the industry or you look at some other competitors out there, do they have similar type of portfolio maybe not to the scale and size, just trying to get a sense of that as well?
Today, I would say unique in industry and especially at the size and scale to be determined going forward. But it's nice to be moving and have the leadership position in both segments.
And then just a housekeeping question, Dave. Just I am assuming you're using a new tax rate post tax reform for some of the dilution estimates you gave for fiscal '18. Is that right? And then just can you maybe give us a sense of how to think about that tax rate here going forward?
Ryan, fiscal year at June, we'll see a blended rate for fiscal year '18. But going forward, we would expect rate in the 25% to 26% range just based on the mix of international and state local taxes.
At this time, I am showing we have no further questions. I will now turn the call over to Mr. Schrimsher for any closing remarks.
I just want to thank everyone for joining us today and we look forward to talking with many of you in the coming days, and we’ll be back together on January 25th on our quarterly results. Thank you very much.
Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.