Applied Industrial Technologies

Moat: 2/5

Understandability: 3/5

Balance Sheet Health: 4/5

Applied Industrial Technologies is a leading industrial distributor, providing a wide variety of industrial parts, components, and engineered solutions to MRO (maintenance, repair, and operations) and OEM (original equipment manufacturers) customers.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

AIT’s business model relies on technical expertise and logistical capabilities rather than strong brand recognition.

Business Description:

Applied Industrial Technologies (AIT) operates primarily as an industrial distributor. It supplies a vast array of products, including bearings, power transmission components, fluid power solutions, and other industrial parts, acting as a vital link between manufacturers and their end customers. AIT’s services are divided into two main segments: Service Center Based Distribution, and Engineered Solutions, reflecting its capabilities in both distribution and customized solutions.

Revenue Distribution:

AIT generates its revenue through two major business segments:

  1. Service Center Based Distribution: This segment, which provides a mix of standardized and customized products, accounts for the majority of revenues. Sales are driven by customer demand for MRO and general industrial supplies. The products include bearings, power transmission components, fluid power components, and other industrial supplies, which are sold through a network of approximately 500 facilities across North America, Australia, New Zealand, and Singapore. The company services a vast array of industries such as general industry, industrial machinery, metals, power transmission, food, beverage, and transportation.

AIT’s Service Center Based Distribution segment serves a vast array of industries and geographies

  1. Engineered Solutions: This segment, while contributing a smaller portion of revenue, provides more specialized engineered solutions and services. These solutions are customized to meet specific customer needs and often involve more technical design and engineering capabilities.

Engineered Solutions provide specialized and customized services.

Trends in the Industry: *The industrial distribution industry is highly fragmented, with numerous local and regional distributors often competing on price and service. *Consolidation within the industry is ongoing, as larger distributors seek to expand their geographic reach and product offerings. *E-commerce is a growing trend, with customers increasingly seeking online options for procurement. *Automation, robotics, and data analytics are becoming more prevalent, which affects the company’s operations and strategy. *Macroeconomic factors can significantly influence the company’s sales.

Competitive Landscape:

AIT operates in a competitive environment characterized by numerous competitors of varying sizes and specialization. Key players include other large industrial distributors, local and regional distributors, and manufacturers that choose to directly sell their components. The company faces pressure from both price-conscious customers and from competitors that offer specialized services or products. AIT competes primarily through its extensive network of distribution centers, its technical expertise, and its broad product offerings. In addition, given the variety of different industry segments they serve, there are additional competitors from all of those various segments.

The industrial distribution industry is fragmented, so AIT faces heavy competition

What Makes AIT Different:

While there are many industrial distributors, AIT differentiates itself through a couple of key factors. First, their extensive distribution network, which spans North America, Australia, New Zealand, and Singapore, allows them to deliver products to customers quickly. This network includes more than 500 branches and distribution centers. Next, their ability to offer comprehensive service through their technical expertise gives them an edge over companies that strictly focus on distribution.

AIT’s key differentiators are its distribution network and ability to offer comprehensive service.

Financials In-Depth:

  • Recent Performance: AIT’s most recent quarterly results show consolidated sales of $1.4 billion for the quarter ended June 30, 2024, compared to $1.36 billion for the same quarter in 2023, as sales increased by 3.8%. However, net income decreased from $113.1 million to $99 million, as operating income only increased by 0.4% due to rising costs of products and services. As we can see, AIT has had positive revenue growth, but there are also increasing costs associated with that growth.

Revenue is up, however, margins have been impacted due to an increase in the costs.

  • Revenue and Profitability: Historically, the company has generated consistent revenues and solid growth, and is highly leveraged to industrial production growth rates. The gross profit margin has remained fairly stable over the past few years, at 29.6%. However, this means that they are quite sensitive to the costs of goods sold, and the changes in margins on their revenue are not high.
  • Financial Leverage: AIT’s total debt has seen some variation, with an increase to $622.3 million from $596.3 million in the latest quarter. Total capitalization at ~$3 Billion.
  • Earnings Trends: Earnings per share (EPS) diluted have been $3.72 for the recent quarter vs. $3.58 the year before.
  • Share Repurchases: The company has authorized the repurchase of up to 1.5 million shares of its common stock.

AIT has also repurchased 632,000 shares for $149.5 million so far in the year.

  • Working Capital: Working capital has increased substantially, rising from 655.9 million to $728 million.
  • Free Cash Flow (FCF): They generated free cash flow of $112 million for the most recent quarter, and are targeting around $450 million for the year, as they anticipate lower debt service costs. They also anticipate their cash conversion cycle to improve substantially in the coming year. They expect to return capital via dividends and share repurchases going forward.

AIT has a strong FCF generation, and this will allow them to increase share buybacks going forward.

Recent Concerns, Controversies, and Problems:

High costs have caused margins to drop, which may impact AIT’s attractiveness

  • During the latest quarterly report and earnings call, the main concern for the company was its declining margins, primarily due to an increase in input costs, higher operating expenses, and restructuring costs associated with acquisitions, with the company working towards optimizing its global network and controlling expenses to achieve better margins going forward. *The company has a lot of new automation implementations which they will need time to adopt and fully integrate into their processes. *Foreign currency translations have also hurt the company to a modest degree. *The main focus on the company appears to be on growth, and in implementing systems to enhance their global operations, but they are actively also looking at cost controls to mitigate these concerns about margins.

Moat Rating and Justification: 2/5

AIT does not have a wide moat, though some may argue they have a narrow moat based on switching costs. The company’s competitive advantage is limited by its reliance on its large distribution network and the technical service they offer. Here’s why they don’t have a wide moat and their rating:

  • Intangible Assets (Brand Recognition & Patents): AIT has a minimal brand recognition in the eyes of end-customers. They don’t have any patents or any major regulatory licenses either, which leaves them heavily reliant on distribution.
  • Switching Costs: Switching costs are present with their ability to create solutions for customers, however, they are not very high. Many of their offerings are replaceable and not unique to their client’s business, which makes it easier for competitors to step in.
  • Network Effects: There is no network effect that gives AIT an advantage.
  • Cost Advantage: There are no significant advantages in their cost structure, and they don’t make use of any unique resources. They have not achieved economies of scale that cannot be replicated by their competitors. *They do, however, have a scale advantage that makes them more efficient, meaning smaller competitors may struggle to compete with them on costs- though that doesn’t stop new companies from entering the industry.

Legitimate Risks That Could Harm the Moat and Business Resilience:

  • Increased Competition: The fragmented nature of the industry and the presence of both large and small competitors create an ongoing threat to AIT’s market position and margins. New players could erode existing relationships.
  • Economic Slowdowns: As a distributor, the company is dependent on the overall level of economic activity. Cyclical shifts in the economy can quickly reduce demand and hurt the business’ financials.
  • Technology Disruption: The growing trend of using digital means to order could hurt their business if they can’t adapt their distribution network and processes appropriately, or they could have other tech firms try to muscle in on the business using technology to disintermediate them.
  • Supply Chain Disruptions: AIT’s reliance on its suppliers makes it vulnerable to material disruptions, which have occurred recently and can impact its ability to meet customer demand.
  • Failure of Acquisitions: AIT has grown aggressively via acquisition and has acquired numerous companies over the years. A large amount of this expansion can cause poor integration between acquisitions, making them poor for the business.

Understandability: 3/5

AIT’s business model, while not overly complex, requires some understanding of supply chain management and industrial distribution. The core business of selling and distributing industrial parts is easy to grasp, but understanding the complexities of their service offerings and operations in multiple sectors can be complicated. Additionally, their financials are quite complex due to the volume of acquisitions that have happened in the past few years and their effects. Therefore, the company is a 3/5.

Balance Sheet Health: 4/5

AIT’s balance sheet is reasonably healthy but needs some improvement. It is not in any significant distress, as it maintains enough liquidity and manageable debt, and their overall performance and cash flow is strong. While it isn’t in any critical distress, they are looking to rebalance and improve it by reducing debt.