Welcome to the fiscal 2020 second quarter earnings call for Applied Industrial Technologies. My name is Lindsay, and I'll be your operator for today's call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session. If you wish to ask a question at that time, please press star one on your telephone keypad. Prior to asking a question, lift your handset to ensure the best audio quality. Please note that this conference is being recorded. I will now turn the call over to Ryan Cieslak, Director of Investor Relations and Treasury. Ryan, you may begin.
Thank you, Lindsay, and good morning, everyone. This morning, we issued our earnings release and supplemental investor deck detailing our second quarter results. Both of these documents are available in the investor relations section of our website at applied.com. A replay of today's broadcast will be available for the next two weeks. Before we begin, just a reminder that we'll discuss our business outlook and make statements that are considered forward-looking. All forward-looking statements are based on current expectations that are subject to certain risks, including trends in sectors and geographies, the success of our business strategy, and other risk factors provided in our press release, our most recent periodic report, and other filings made with the SEC. These are available at the investor relations section of applied.com. Actual results may differ materially from those expressed in the forward-looking statements.
The company undertakes no obligation to update publicly or revise any forward-looking statement. In addition, the conference call will use non-GAAP financial measures explained in our press release and supplemental presentation, which are subject to the qualifications referenced in those documents. Today's teleconference is available to the media and general public, as well as to analysts and investors. Because the teleconference and its webcast are open to all constituents and prior notification has been widely and unselectively distributed, all content of the call will be considered fully disclosed. Our speakers today include Neil Schrimsher, Applied's President and Chief Executive Officer, and David Wells, our Chief Financial Officer. With that, I'll turn it over to Neil.
Thank you, Ryan. Good morning, everyone. We appreciate you joining us. I'll begin with some brief thoughts, and then Dave will follow to review our financial results in more detail. Our second quarter was characterized by cost discipline, margin control, and solid cash generation within a persistent soft end market backdrop. Execution in these areas is providing a path to deliver our earnings and cash commitments for the year and should support accretive growth once demand rebounds, as well as capital deployment opportunities going forward. We also remain highly focused on accelerating our company's specific outgrowth potential regardless of the industrial cycle.
As highlighted in recent quarters, our leading technical position and service capabilities across motion control, fluid power, flow control, and now automation, puts us in a unique position to capture greater share organically as our customers outsource their technical MRO and production infrastructure needs, as well as through M&A, as smaller players look to partner with a leading technical platform given increasing service, operational, and capital requirements. This trend should supplement a strong cross-selling opportunity here at Applied that remains in the early innings and is focused on expanding the reach of our fluid power, flow control, consumables, and automation solutions across our embedded service center network customer base.
We also enter our second half of fiscal 2020 with a strong balance sheet, having reduced outstanding debt by $115 million over two years post our acquisition of FCX, with net leverage down to our stated target of 2.5 times. Combined with our cash generation trajectory, we have notable flexibility for additional deleveraging, acquisitions, and pursuing other opportunities to enhance shareholder returns in the back half of our fiscal year. As it relates to the broader end market backdrop, as discussed in recent quarters and consistent with macroeconomic industrial reports, demand remains weak across our top industry verticals. After seeing some stabilization during October and November, customer activity was unusually weak during December and remains subdued, with organic sales trending down in the mid-single digits year-over-year so far in January.
While softness remains broad-based, declines are most notable within metals, mining, oil and gas, machinery, and process-related industries. We also saw greater weakness across our international operations during the quarter within Canada and Mexico. Some of the recent softness likely reflects demand abnormalities that occur this time of year given seasonality, plant shutdowns, and customer budget resets, in turn, making it difficult to fully gauge the underlying direction of current demand. We are also cognizant of potential positive momentum that could arise if a trade resolution can stay on track, which has the potential to positively influence trends for the balance of our fiscal 2020 and into fiscal 2021. That said, uncertainty remains, and we believe a sensible approach to our outlook remains prudent at this time. Regardless of the direction of the cycle near term, we know how to operate to it, as our industry and recent results highlight.
At the same time, there's a great understanding and commitment on the opportunity Applied has long term as the leading technical MRO distribution and solutions provider. Our strategy is deeply focused on this opportunity and moving the company toward its long-term financial goals, providing the framework for significant earnings growth and value creation in the coming years. At this time, I'll turn the call over to Dave for additional detail on our financial results.
Thanks, Neil, and good morning, everyone. Before I begin, another reminder that a supplemental investor deck recapping key financial and performance talking points is available on our investor site. To summarize, we are managing effectively in a slow and uncertain end market environment with timely execution of our recent cost initiatives, continued solid gross margin performance, and another positive quarter of cash generation. We expect cash generation momentum to continue into the second half of fiscal 2020, providing ample flexibility to pursue capital deployment opportunities. Overall, we believe we are well-positioned in the current environment. Highlighting results for the quarter, consolidated sales decreased 0.8% over the prior year quarter. Excluding 3.2% growth contribution from acquisitions, sales declined 4% on an organic basis. Both selling days and foreign currency had a neutral impact this quarter.
As previously highlighted, sustained weak demand across a number of key end markets remains the primary drag on sales. Looking at our results by segment, as highlighted on slide six and seven, sales in our Service Center segment declined 2.3% year-over-year, or 3.5%, excluding a 1.2% incremental impact from acquisitions. Results reflect continued weak manufacturing activity and related MRO needs across our service center network, as well as softer demand within our international operations in Canada and Mexico. Segment sales were unusually weak during the month of December. As mentioned earlier, we believe part of this reflects seasonal variations that occur around the holidays as customers take time off and adjust project and production schedules. Within our Fluid Power and Flow Control segment, sales increased 2.7% over the prior year quarter, with acquisitions adding 7.6% growth.
This includes a full quarter of contribution from our August 2019 acquisition of Olympus Controls, and one remaining month of contribution from our November 2018 acquisition of Fluid Power Sales. On an organic basis, segment sales declined 4.9%, reflecting weaker flow control sales and slower activity across our industrial OEM customer base, as well as the remaining year-over-year drag from the large project referenced in prior quarters. Excluding the project-related drag, segment sales declined approximately 3% on an organic basis over the prior year. We note declines in this segment moderated, and the daily sales rate was up modestly on a sequential basis, partially reflecting improving technology and market demand during the quarter. Moving on to margin performance, as highlighted on page eight of the deck, reported gross margin of 28.9% was up four basis points year-over-year.
Results include a non-cash LIFO charge during the quarter of approximately $1.9 million, which compared favorably to prior year LIFO expense of $2.7 million, resulting a roughly nine basis point positive impact year-over-year. Excluding LIFO, our gross margin was down a modest five basis points year-over-year. Margins were slightly pressured by an unfavorable mix impact resulting from slower growth within local accounts as compared to large national accounts in our U.S. Service Center operations. This modest headwind was partially balanced by ongoing execution on pricing and other margin expansion initiatives. Over time, we continue to expect mix to benefit margins, reflecting the positive contribution of expansionary products, growth among our technical service-oriented solutions, and ongoing actions to expand business across our local customer base. Turning to operating costs.
On a reported basis, selling, distribution, and administrative expenses were up 0.3% year-over-year, but down 3.4% on an organic basis when adjusting out the impact of acquisitions and foreign currency translation. SD&A was 21.9% of sales during the quarter, down 15 basis points sequentially on an adjusted basis. Our teams are doing a commendable job of managing expenses in a slower environment, including their timely execution of previously announced cost actions, while we remain highly focused on managing costs into the second half of our fiscal 2020, given the current environment. As a reminder, our SD&A expense will increase on an absolute basis sequentially into our third quarter, reflecting seasonality as well as the impact of annual merit increases and two extra selling days versus the second quarter.
That said, we still expect SD&A to decline as a percent of sales into our second half relative to first half levels. EBITDA in the quarter was $74.5 million compared to $76 million in the prior year quarter, while EBITDA margin was 8.9%, or 9.2% excluding non-cash LIFO expense in the quarter. Reported EPS for the quarter was $0.97 per share compared to $0.99 per share in the prior year. Cash generated from operating activities was $54.9 million, while free cash flow was $47.9 million or approximately 126% of net income. Year to date, free cash flow of $93 million represents 119% of adjusted net income and is up nearly 60% from the prior year. We are continuing to make good progress on our working capital initiatives in a slower demand environment. This includes ongoing traction from our shared services and other collection initiatives.
We expect additional tailwinds into the second half of fiscal 2020 as inventory levels decline from the second quarter ending position. We remain confident in our free cash flow potential for the full year, which will support our capital allocation strategy focused on reducing outstanding debt, funding M&A opportunities, and opportunistically buying back shares. We paid down $5 million of outstanding debt during the quarter. Our debt is down nearly $115 million since funding the acquisition of FCX, with net leverage at 2.5 times EBITDA at quarter end, below the prior year period of 2.8 times. As noted in our press release, today we announced that our board of directors approved an increase in the quarterly cash dividend to $0.32 per common share. This represents the 11th dividend increase since 2010 and underscores our strong cash generation and commitment to delivering shareholder value. Transitioning now to our outlook.
As noted in our press release, we are updating our guidance for fiscal 2020 in light of year-to-date performance and ongoing end market uncertainty. We are narrowing our previous guidance ranges and now expect sales of down 2% to flat year-over-year, or down 5% to down 3% on an organic day-per-day basis, as well as earnings per share in the range of $4.20-$4.40 per share. Previously, our guidance assumed sales down 5% to down 1% organically and EPS of $4.20-$4.50 per share. Our updated guidance assumes end market weakness seen during December and January continues in coming months, with seasonal Q3 sales step-up at the lower end of historical trends. At the midpoint, this implies mid-single-digit organic sales declines will persist in the third quarter, with declines easing to the low single digits in the fourth quarter on easier comparisons.
By segment, our guidance assumes mid to low single-digit organic declines year-over-year in our Service Center segment during the second half, and low single-digit organic declines in our Fluid Power and Flow Control segment. Our guidance also assumes gross margins are flat to up 10 basis points for the full year, slightly below our prior guidance of up 10 to 20 basis points. We continue to view 10 to 20 basis points of gross margin expansion as the appropriate annual target over time, given our internal initiatives. Lastly, we reaffirm our free cash flow outlook of $200 million to $220 million, which represents a 30% increase over fiscal 2019 at the midpoint. With that, I will now turn the call back over to Neil for some final comments.
Thanks, Dave. Overall, while we're executing largely to plan year to date, we remain prudent with our outlook given the backdrop of uncertainty in near-term industrial demand. We remain highly focused on our internal growth and margin initiatives, which in addition to potential benefits from trade resolution and ongoing cost opportunities, we see several levers that should support our earnings momentum in coming quarters if the current environment does not weaken further. Combined with our cash generation potential, we believe our position is strong, and we are eagerly moving forward to realize our full potential. With that, we'll open up the lines for your questions.
Thank you. We will now begin the question and answer session. If you would like to ask a question, please pick up your handset, press star, and then the number one on your telephone keypad. If you would like to withdraw your question from the queue, press the pound key. We'll pause for just a moment to compile the Q&A roster. Our first question comes from Chris Dankert with Longbow Research. Your line is open.
Hey, morning guys. Thanks for taking my questions. I guess first off, we did talk about electronics briefly inside of fluid power. Still a slight drag on the quarter, but going forward, just any comments on what backlog in that business looks like? Maybe it's backlog for total fluid power. Just any thoughts there would be really helpful.
Chris Dankert, I'll start. I think in the quarter, we did see some positive contribution. I think it still could be early to fully call it how it's going to be in the second half. It did provide some balance to Fluid Power and Flow Control. We still see some pressure in the general industry segments and some of the mobile segments to date. That leads to our view of combined, it would be down low single digits in the second half.
Got it. That's very helpful. Thanks, guys. Just if I could get your initial thoughts on the sale of Eaton's Hydraulics business to Danfoss. I assume it's probably a generally positive development, but just would love to hear how you're thinking about that change.
Yeah. I'd start with our view. I don't think it's a real surprise. Eaton has continued to work their business portfolio. I think the deal will take some time. I think they're talking about towards the end of the year. I see positives in the business, especially as we think about it going forward. I think Danfoss has described it as a once-in-a-lifetime opportunity with complementary product portfolios and the geographic footprint. I think for them, the industrial presence, the North American market is additive, fluid conveyance is additive. I think there's opportunities then around mobile presence and the potential technical add-value capabilities that really exist in both businesses around electronics.
Got it. If I could just sneak one more in quick and I'll turn it over. Is the expectation for the year still for about a $7 million-$8 million LIFO headwind? I know most of that was supposed to be in the first half. It's a little bit light here. Just any thoughts on LIFO for the year?
Yeah, given the kind of continued trend, though, we're still calling it $6 million-$7 million, but that is down slightly from our $7 million-$8 million previous guidance on LIFO.
Perfect. Thanks so much, guys. I'll hop back in queue here.
You bet.
Our next question comes from David Manthey with Baird. Your line is now open.
Thank you. Good morning, guys. Not to get too granular, relative to the weakness you saw in January, I assume that you saw incremental weakness around the midweek New Year's Day holiday, similar to the Christmas midweek holiday. Have you seen any improvement relative to historical trends over the past couple of weeks? Has the weakness been more broad-based and continuing beyond just that first week of January?
David, I'll start. I'd say, I think it's beyond just the early part. If I go back to December, we're probably till the 20th, December 20th, running mid-single digits decline, and then greater from the 23rd on. Pulled that probably to a high single digits decline. Coming in to January, we haven't seen the full snapback, bounce back. That's where, to date, through these kind of 15 or so days, still mid-single digits. With that said, hey, the remaining seven days, we could see some movement in January, and we think that's going to be more indicative then of, obviously, to the third and perhaps to the back half of our fiscal years. That's what leads us to kind of our overall view around this uncertainty and our guidance right now.
Okay, thank you. Relative to the 20 of your 30 end markets, your industry verticals being down, do you have any insight in terms of how many of those are inflecting one way or another? Meaning, relative to the rate of change, do you track the number that are improving versus worsening in terms of the second derivative of growth?
Well, there can be a little noise in the numbers. We will look, you obviously look for materiality in the change. I think in the last period, we would have had eight positive or thus 22 down, so a little bit of change in the overall segment. Some of those segments that would show positive trends still around food. We think about aggregate, rubber plastics, and paper. Top of mind, I don't get, at this level, a lot of takeaways from big inflection changes that would lead it towards one being more positive or one being more negative.
Okay, great. Final question on SD&A. Clearly, you're focused on day-to-day expense discipline. Have there been any additional cost actions taken since Q1 that would provide any step function benefits? I believe you said that the Q1 cost actions would be fully in the run rate in Q2. Just checking on that as well.
Largely in the Q2 run rate. There is some slight incremental benefit, which to my point, on an absolute basis, we're going to see a step-up just because of merit and the number of days in the back half. We'll go to offset on a percentage of sales basis, that back half step-up. Some modest incremental benefit and continue to evaluate across various businesses, just given the economic conditions, where it may warrant additional actions, and we have taken those, and we'll continue to take those as appropriate.
Yeah. David, I'd say, too, we remain focused on and in tune with the environment. We know how to operate in that. As I think about SD&A going forward in the third quarter, on an absolute basis, we'll have cost actions read through. It will be higher. We do our focal point merit planning to start the year in January, there will be some coming in there. There's extra selling days in as we look forward, obviously, M&A adds to that. If we're at the midpoint, our view from an SD&A standpoint, we're flat from a year-over-year standpoint in the third quarter.
Sounds good. Thanks very much, guys.
Okay.
Our next question comes from Adam Uhlman with Cleveland Research. Your line is now open.
Hi, good morning, everyone. Hey, can we start with the comments about the local business being down a bit more than the national accounts? I guess, is that just a cyclical thing that you're seeing there, or could you maybe just expand your thoughts on what you're seeing with the average customer count or average order sizes? Maybe just expand a bit more on that. Any kind of efforts that you have of kind of getting that business to pick up in the second half of the year, what kind of initiatives are underway?
Yeah. Adam, my view of a lot of that local account was December and maybe start till January, but especially December, late December into that. I think that had kind of a carryover influence of gross margins being flattish in that period. We think about less activity going on in December and especially over those last couple of weeks. We continue to have very good activities across our business and participate in the local economy. We have cross-sell opportunities with those. Hey, we like our position, we like our focus in that segment and on that business. We think it's more timing of year and some of those customers choosing to take that time out.
Okay, gotcha. David, could you talk a little bit more about the free cash flow outlook for the year? Usually, the fourth quarter is a big source of the pickup in cash. Do you expect that to happen again this year? Remind me how much inventory you expect to take out in the second half?
I think I am pleased with the sustained contraction across the year in terms of the cash generation. Much more level loaded this year, absolutely to your point, the back half does tend to be much seasonally stronger in terms of our cash flow generation profile. We've made, and I think very pleased with the progress we continue to make on reduction in past due receivables and collections. If you look at the overall reduction in AR year-over-year versus the decline in sales, certainly you can see that progress rating through. On the inventory side, we've still got work to do, and that, as I point out, will be a tailwind in the back half of the year.
I'm not going to hang a number on it at this point, but certainly we've continued to make good progress when you look across the service center network in terms of sizing inventories commensurate with some of the demand profile that we've seen. Have seen a bit of a build that causes inventory still to be higher year-over-year, and particularly in our fluid power flow control business, just given some project timing, project delays, and still some supplier constraints that have impeded some shipments. Some opportunity really on both sides of the equation, but certainly we'll continue to move the needle there, will be a tailwind, and that will help that stronger second half cash profile.
Okay, thanks.
You bet.
Our next question comes from Joe Mondillo with Sidoti & Company. Your line is now open.
Hi, everyone. Good morning. Just wanted to clarify regarding the cost initiatives. David, did you say that most of the cost initiatives were in place in the first quarter, so the run rate that we saw in the second quarter should be sort of similar in the back half unless the environment changes at all? Is that correct?
Yeah, there's marginal incremental benefit from a handful of those initiatives that we did not see the full benefit in the most recent quarter. As I indicated, we continue to take actions in some of the more challenged businesses to size the cost appropriately. Some modest incremental benefit as you think about that back half, and that's part of that offset once again to the focal point merits and the incremental selling days in the quarter.
All right, great. Thanks. Also, just looking at the Fluid Power and Flow Control segment, could you just give us sort of the puts and takes what's going on there outside of the electronics business, which is really a small piece of the business? Just given sort of the OEM exposure that you have at fluid power and then with capacity utilization, I think of some of your customers probably coming down at flow control. Just curious what the puts and takes are going where the trends are going, because I know that sort of there was a comp, sort of a tough comp that you've been going up against the last couple of quarters. Now we have some, I think, some organic negative trends that are going on in some of your end markets there.
I'm just curious of how you're thinking about that going forward.
We maybe take it from a few angles. On the flow control side, right, we've had a large project that we comped against that will for the most part now be behind us in that area. There are some general headwinds around process related to industries. The team looking back and somewhat expectations looking forward in this macro, while we have opportunities, it could result in kind of a low single digit. Then we think about fluid power, we talk about some of the electronics and technical being able to contribute. We'll see in the coming months and quarters to the level. To your point, there are industrials and some of those mobile OEs that are seeing slowness. With that, creates some opportunities for us to be with them, working their products, working the designs, how we can grow our content.
That will contribute to us in future periods, not necessarily in the quarter that we're in or in the back half. That kind of leads us to, we think, at our midpoint, there's a low single-digit headwind in the segment.
Okay, great. Thanks. Just to touch on your guidance, just wondering what part of the business or what line item or margin, revenue segment-wise, what was really the biggest cause that sort of took off the high end of the guidance off the table?
Yeah, Joe, to sum it up, it was just those softer daily sales rates that we saw, as indicated, both in December, but then continuing into the month to date, January, that gave us pause. Just given that uncertainty, the broad-based kind of market headwinds that we've seen, felt it appropriate to tug down that upper end just a bit in terms of relative expectations.
Okay. Then just lastly, the tax rate was lower than I anticipated. I didn't hear you mention anything in the prepared remarks, I was just wondering what you expect, I guess, for maybe the back half of the year, for the whole year?
You bet. As opposed to the 25%-26% we previously guided, we did see some discretes that benefit us again in Q2. As we look at the back half, we will see some upward pressure on the back half rate. We would now call it 24%-25% in terms of the overall full-year effective tax rate.
Okay, thanks. Appreciate you taking my questions.
Our next question comes from Steve Berger with KeyBanc Capital Markets. Your line is now open.
Morning, guys. I wanted to go back to the broader environment. I think there's a lot of expectation that there will be a recovery in calendar 2H 2020. When you say subdued demand will persist, do you have any additional thoughts about duration and what you're thinking about for catalysts to restart growth?
Obviously, we think that continues for the half, for the start of what will be our new fiscal year, I don't know that we're not fully into from a planning standpoint of those. Trade resolution obviously has the opportunity to help and contribute to that, potentially as we think about it going forward. If there's a broader infrastructure effort, that's probably not ahead of an election cycle. That perhaps occurs after an election cycle.
You think the phase one deal and maybe getting USMCA signed will provide enough clarity to get businesses looking to grow again, or do you need something or will they need something more specific?
I think it can start to help from a sentiment standpoint, but that's not all into our guidance right now.
Yeah. Given the environment, are you seeing any change in multiple in the private market, or do you expect that'll happen as trailing 12-month EBITDA numbers start to come down?
I think for us, probably early, but from an M&A standpoint, we're active, we're busy, but on those read-throughs, it's probably hard to say when they perfectly come through.
Yeah, just, I guess, philosophically, in recent quarters, we've seen private equity take out Command Distribution. Another one made a strong run at Anixter in the electrical distribution space. Given where public market multiples are, do you think there'll be more PE interest in public markets?
Hey, again, there's probably better experts than I. Clearly, money's available. There's interest in some of the spaces. Multiples in some of the segments. We think about Eaton, those can be attractive in the side. We have a disciplined approach as we think about it going forward and working our targets going through. I don't know that it creates undue pressure for us in an M&A environment.
All right, thanks.
Again, if you would like to ask a question, please press star one on your telephone keypad. Our next question comes from Michael McGinn with Wells Fargo. Your line is now open.
Thanks. Sticking with the M&A theme, can you give us an update on the underlying fundamentals of the robotics and automation market, specifically the growth rates you're seeing within Olympus relative to your base business?
Well, I think you can see in the quarter that Olympus performed well. It continues to be, as they term it, where innovation meets automation. We're excited about the product offerings that are available, our work on key projects that exist today, the broader engineered solutions and then that opportunity for us to expand that into some other markets or with some other customers in that side. The interest in and the growth and the adoption continues to be at a good rate. We're pleased with the performance in the quarter, and we think it can be a nice contributor for us in the business going forward.
Is it fair to say that growth rate, that nice growth rate, is better than the service center and where Fluid Power is operating right now?
I'd say today in the cycle, yes, we would say that.
Okay. Switching gears to gross margin, flat to up 10 basis points still sounds relatively positive, and you've never been the primary indicator for the trade war, given your limited direct exposure to China. Can you comment on how sticky this current run rate is if we see a broader tariff rollback and subsequent conversations with customers on pricing?
For us, we think it continues to stick and stay. If I look at suppliers today, there's still incoming price increases. They've moderated from the past, but there will still be some of those coming through, and we will be taking them to the marketplace. For us, on margins, we'll continue to work on point of sale, really just reducing variation around customer groups and product groups. We think mix helps us going forward in those as well. As we provide more value content, more value-added solutions and projects to that, helps us on the margin side. Over time, we think for a longer period, we still believe there's the 10-20 basis point improvement.
Okay. If I can sneak one more in on the international side of your business, you called out Canada and Mexico, but left out Australia. Was the Canada and East Coast comment more tied to general industrial or West Coast comment tied to natural resources? If you could just size Australia sales as a percent of total, that would be helpful.
Sure. I'd say Canada could be really across. Some challenges in the western provinces, and that's predominantly resource and resource connected. Also in some of those eastern provinces around the general industry activity. Their participation in either metals, mining, machinery, process related industries, there's some commonality in there. Maybe some uniqueness, but there's some commonality across. From an Australian standpoint, less than 2% of the overall.
All right, thanks a lot. I'll pass it along.
Okay.
At this time, I'm showing we have no further questions. I will now turn the call over to Mr. Schrimsher for any closing remarks.
Thank you very much. I just want to thank everyone for taking their time and joining us today, and we look forward to talking to many of you throughout the quarter.
Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.