A Small Cap that Qualifies for Buffett Munger Status

They’re not glamorous, but ball bearings and millions of other industrial bits and pieces keep our world moving, everything from our cars to our factories.

Of course, all those bits and pieces in existing machines keep wearing out and must be replaced, while other companies keep building new machines to replace those that can’t be repaired any more. Partner that ongoing need with sophisticated and competent retailing, and you’ve got a business that Warren Buffett (Trades, Portfolio) would understand and likely appreciate.

Applied Industrial Technologies Inc (AIT, Financial) is one of those companies. It’s a small cap company with predictable earnings and a reasonable valuation. Founded more than 50 years ago, it operates more than 500 service centers and plants, most of them in the U.S.A., but with some international exposure in Canada, Mexico, Australia, and New Zealand.

You can find AIT on the current Buffett Munger screener at GuruFocus, because of its earnings and valuation. We can summarize its story with the following graph, which shows EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) on the blue line, and the share price on the green line:

History

1923: The Ohio Ball Bearing Company founded in Cleveland, Ohio, by Joseph M. Bruening

1953: Company changes its name to Bearings, Inc.; begins trading on American Stock Exchange

1965: Begins trading on the New York Stock Exchange

1972: Opens its first distribution center.

1995: Sales exceed $1 billion for the first time; pays first dividend, 3.6 cents per share

1997: Changes name to Applied Industrial Technologies.

2000: Acquires a company in Canada.

2001: Sets up an outlet in Mexico.

2014: Acquires 5 different companies; since its first major acquisition in 1957, Applied has bought more than 50 companies.

History based on information supplied at the company website and Dividend Channel.

Comments: This growing company celebrated its 90th anniversary two years ago, in 2013 and this year will celebrate 50 years on the New York Stock Exchange. It has grown both domestically and internationally, with much of that growth coming from acquisitons.

The Business of Applied Industrial Technologies

An industrial distributor with core competencies in bearings, power transmission components, fluid power products, and other maintenance supplies and solutions. Handles more than five million products.

Those product sales are divided into two segments:

• Service Center-Based Distribution: Distributes industrial products through service centers in North America, Australia, and New Zealand. Customers mainly use its products for scheduled maintenance of machinery and equipment, and for emergency repairs. This segment includes regional fabricated rubber shops, which modify and repair conveyor belts and make custom hose assemblies, and rubber service field crews, which install and repair conveyor belts and rubber linings.
• Fluid Power Businesses. A specialized fluid power business distributing fluid power components; also assembles fluid power systems and components, performs equipment repair, and offers technical advice to customers. Customers buy for maintenance, repair, and operational needs, as well as for original equipment manufacturing applications.

The Service Center segment accounted for about 80% of sales in the fiscal year ending on June 30, 2014, while the Fluid Power segment brought in about 20%. Foreign operations provided 17.4% of sales in 2014.

Its products come mainly from big manufacturers, on a non-exclusive basis. Some of these manufacturers sell directly to end users, if the end users represent very large accounts.

Competition

The company‘s competitive advantage comes from helping customers select and use products, and from helping customers manage their inventory. In addition, the company sees its information system as an aid to competitiveness; it allows customers to search for, learn about and price products, as well as track orders.

It describes its environment as highly competitive; with low barriers to entry; there are many companies trying to sell into the same markets, and a high degree of fragmentation, “Our principal competitors are other bearing, power transmission, industrial rubber, fluid power, linear motion, tools, and safety product distributors, as well as specialized oilfield supply distributors and distributors of other industrial and maintenance supplies and catalog companies. These competitors include local, regional, national, and multinational operations.”

Yahoo! Finance lists Applied’s competitors as Genuine Parts Company (GPC, Financial), Kaman Corporation (KAMN, Financial), and W.W. Grainger, Inc. (GWW, Financial).

Customers

“Customers range from very large businesses, with which we may have multiple-location relationships, to very small ones. We are not significantly dependent on a single customer or group of customers, the loss of which would have a material adverse effect on our business as a whole, and no single customer accounts for more than 3% of our net sales.” 10-K for 2013.

Revenue

The following chart shows how Applied has grown its revenue (while the yellow-shaded section shows analysts’ expectations for the next two years):

Other

Incorporated in Ohio, and headquartered in Cleveland, Ohio.

As of June 30, 2014, AIT had 5,472 employees.

Four distribution centers.

Comments: An industrial products company with two main lines of business, and analysts expect it be close to $3 billion in revenue within a couple of years. It’s competitive advantage in a fragmented marketplace is its ability to provide customer service and information systems that help customers solve their problems.

Opportunities, Risks, & Growth Prospects

In its Annual Report for 2014, Applied lists five areas of opportunity:

• Increasing sales by offering more and improved services to existing customers and new customers;
• Product expansion beyond the current base offerings;
• More North American fluid power growth with OEM (Original Equipment Manufacturer) customers, and getting a bigger share of MRO (Maintenance, Repair, and Operations) end users;
• Enhanced operational improvements with continuous improvement, and realizing the full potential from ERP (Enterprise Resource Planning software) investments;
• Accelerating acquisitions that deliver business synergies.

On the other side, AIT includes the following in its 10-K Risks assessment:

• Its customers needs are cyclical, and affected by overall economic conditions;
• Tied to that is the issue of supplier discounts and incentives, which in many cases require year-over-year increases in volume;
• And while the improving American economy helps its customers, economic improvement also makes it more difficult to recruit and keep employees;
• Both its customers and its suppliers have been consolidating, making the company increasingly dependent on fewer of each;
• It operates in mature industries, and as a result may not be able to find as many acquisition targets, or find them at suitable prices.

Growth

The following chart shows Applied’s growth of revenue (green line) and Earnings Per Share (blue line) in historical context (the band in yellow shows estimates).

Analysts followed by Yahoo! Finance expect revenue for fiscal 2015 (year ending June 30th) to hit $2.81 billion and $2.91 billion for fiscal 2015 (compared with $2.46 billion in fiscal 2014).

Their estimates of earnings per share come in at $2.98 for 2015 and $3.22 for 2016, compared with $2.76 for fiscal 2014.

The company, in its Annual Report, lays out its strategic objectives this way:

• “Reaching $3.7 billion in revenues – through organic growth and acquisitions”
• “Growing our international presence – to 25% of revenues
• “Improving our profitability –through sales and margin expansion, and with continued discipline on cost and operational controls”

Comments: Comparing the estimates of the analysts and the company, it appears the company expects to grow more sales quickly through the next three years than do the analysts. Perhaps that reflects acquisitions the company has in mind, but not announced. But whichever turns out to the case, the company has plans to continue increasing both its revenues and its earnings per share.

Management

President & CEO: Neil A. Schrimsher, age 50; CEO since 2011; previously Executive Vice President of Cooper Industries plc, an electrical products manufacturer.

Vice President - Chief Financial Officer & Treasurer: Mark O. Eisele, age 57, joined AIT in 1991 as Manager of Internal Audit, in 1997, he became Vice President – Chief Financial Officer & Treasurer in 2004.

Independent Chairman of the Board: Peter C. Wallace, age 60, is CEO of Gardner Denver, Inc. and joined the Applied board in 2005.

Board of Directors: A board of 9 including Chairman Wallace and CEO Schrimsher; experience and expertise in manufacturing, data warehousing, aviation maintenance, law, transportation, industrial distribution, college administration.

ISS Governance QuickScore: Rated at 3 on a scale in which 1 indicates lesser governance risk and 10 indicates greater governance risk. It receives red flags for Takeover Defences and Meeting and Voting Related Issues; and three green stars for Use of Equity, Equity Risk Mitigation, and Other Issues.

Management profile based on information from the company website and Reuters.com.

Ownership

Gurus: Four of the ultra-successful investors followed by GuruFocus own shares in AIT: Chuck Royce (Trades, Portfolio), Jim Simons (Trades, Portfolio), Paul Tudor Jones (Trades, Portfolio), and Jeremy Grantham (Trades, Portfolio). Chuck Royce (Trades, Portfolio) had made the biggest commitment; as of the end of December, he owned 4,737,896 shares, which represent an 11.5% stake in Applied.

Institutions: As the following chart from nasdaq.com shows, institutions own almost 90% of the outstanding shares; it shows Chuck Royce (Trades, Portfolio) as the largest single shareholder.

Short interests: GuruFocus puts short ownership at just under 3%, and provides this historical context:

Insider Ownership: According to GuruFocus, insiders own 4% of the company; Yahoo! Finance shows CFO Mark Eisele holding the largest stake, with 165,844 shares; CEO Schrimsher holds 83,866 shares.

Comments: For a relatively small-cap company (or any company for that matter), this one has a high level of institutional confidence. And, insiders hold a solid 4%. Together, this information suggest the smart money sees good times ahead for Applied Industrial Technologies.

AIT by the Numbers

Comments: This is a small cap company, with a market valuation of $1.8 billion; the current stock price is not far from the 52-week low; Price to Sales is low at .68; it pays a good dividend, one which should be sustainable at the current payout ratio.

Financial Strength

The GuruFocus automated system gives Applied a relatively rare 9/10 for financial strength, and 7/10 for profitability and growth:

We see a red icon/flag for Cash to Debt, historically. But, looking more closely, we see that flag was likely triggered because the company has taken on a modest amount of debt after recording several years of no debt:

How much debt is there? $168 million, and the following chart shows that in historical context:

The company reports in its 10-K that it used this debt to finance acquisitions, “Net cash provided by financing activities in fiscal 2014 included $100.0 million from borrowings under long term debt facilities as well as $69.0 million in borrowings under our revolving credit facility, both of which were utilized for the financing of acquisitions.”

Applied has a long history of buying companies and integrating them into its stable of productive subsidiaries. Because of this, we expect both accretive earnings and synergies; in turn that means debt should be positive, helping the company increase its earnings, and increase them more quickly.

Let’s also review the free cash flow, the source with which the company will pay the interest and principle on the debt:

The GuruFocus automated system generates two Severe Warning Signs: one for Asset Growth and one for the Piotroski F-Score. The following chart shows the wide variation in the latter over the past decade and a half:

Investors considering positions in AIT will want to perform due diligence on these issues.

Comments: Applied took on $170 million in debt in 2014 to finance its acquisitions. That has triggered some red flags in the automated system, however, we do not see this level of debt as a problem. Free cash flow is strong, and the company has a history of making acquisitions that add to earnings.

Valuation

Applied Industrial Technologies appears on the Buffett Munger screener at GuruFocus, on the strength of its predictability and its PEG ratio.

It scores a 4.5 (out of 5) stars for predictability, a score matched by very few publicly-traded companies. The following chart shows its EBITDA (green line) and net income (blue line):

While the company’s earnings have not gone up in a straight line, they have shown an upward thrust. Stocks with a good predictability have been shown more likely to produce higher share prices and fewer losses over the medium- and longer-terms (five to 10 years).

The other key ingredient in the Buffett Munger recipe is the PEG ratio, a metric that connects the price of a stock with its earnings growth over the previous five years. Look for PEG on the right side of the GuruFocus summary page, under the Ratios heading. Alternatively, if you find the stock in the Buffett Munger screener, you’ll find the PEG number in the column headed PE/EBITDA growth rate.

With a PEG of 1.01 (at closing, March 4, 2015), AIT is at the bottom of the fair-value range. A ratio below 1.0 is considered under-valued, a ratio between 1.0 and 2.0 is fair-valued, and a ratio greater than 2.0 indicates a stock that is over-valued.

Comments: the PEG ratio suggests the current price (at closing, March 4, 2015) would be a good buy (assuming it passes the other aspects of your due diligence). The ratio of 1.01 is just above the under-valued mark, and the company’s high earnings predictability suggest Applied’s share price should be pulled up by earnings growth.

Conclusions

For investors willing to put their money into small caps, Applied Industrial Technologies holds promise.

It has a strong history of growing its revenues and its earnings, and both the company and analysts expect that growth to continue over at least the next two years.

In addition, with a sustainable dividend of 2.5%, it offers a reasonable amount of income while waiting for the share price to recover and grow.