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Welcome to the Fiscal 2020 Third Quarter Earnings Call for Applied Industrial Technologies. My name is Jason, and I will 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. [Operator Instructions] Please note that today’s 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, Jason, and good morning, everyone. This morning, we issued our earnings release and supplemental investor deck detailing our third 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 our comments on the potential impact from the COVID-19 pandemic, as well as 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 Dave Wells, our Chief Financial Officer.
With that, I’ll turn it over to Neil.
Thank you, Ryan, and good morning, everyone. We appreciate you joining us, and I hope everyone is staying safe and healthy during this time. With COVID-19 top of everyone’s mind, I want to start with a summary of how Applied is responding and what we’re seeing across our business as the situation continues to evolve. Dave will follow with a summary of our financials and some specifics on our third quarter and outlook, and then I’ll close with some final thoughts.
First and foremost, I want to thank our more than 6,000 associates, as well as our customers, suppliers and other business partners for their continued effort and support. Our top priority during this time is their well-being and we have implemented various actions across our operating facilities to reinforce our longstanding focus on the safety, health and productivity of our organization.
We’ve taken steps to enhance sanitation and preventative maintenance protocols in our facilities and offices, as well as promote social distancing, restrict travel, stagger work hours and institute remote working when possible. We have a cross-functional task force to ensure we make decisions using the most up-to-date information from the CDC and other authorities. We’re also leveraging our internal HR, communication and IT systems and finding new ways to collaborate and lead during these times.
I’d like to recognize all associates that have made a swift and effective adjustment. Their ongoing support and dedication is what our One Applied culture is all about and is allowing us to proactively and effectively respond across many essential industries, where we play a vital role in keeping the industrial supply chain running effectively and productively.
We’re classified as critical infrastructure and our facilities remain open, as they continue to support our customers while adhering to health and safety guidelines. We’re also seeing sustained demand levels across various industry verticals, such as food and beverage, agriculture, pulp and paper, infrastructure, power generation, life sciences and technology.
With more than 50% of our service center network demand tied to break-fix requirements, essential customers within these verticals are depending on us for critical parts, services and solutions as they sustain operations and support vital areas of the economy.
For some customers, the current slowdown is driving incremental maintenance on their direct production infrastructure and flow control systems given extended downtime. And we remain a valued partner in supporting their engineering and maintenance teams in addressing any related needs. We’ve also had minimal supply chain constraints to date with fulfillment at our distribution centers and local service centers remaining efficient, though, we’re keeping a close eye on it.
In instances, where customers are restricting facility access, our sales teams are utilizing virtual selling and other communication platforms to understand our customer requirements and execute accordingly, as well as providing support through our applied.com channel. This is also a time when we are reengaging with infrequent customers and identifying new opportunities.
As we’ve discussed in the past, Applied’s value proposition has expanded in recent years, reflecting investments in our leading fluid power and flow control solutions, as well as complementary consumables and emerging automation platforms. Our service capabilities and cross-selling opportunity is the greatest in company history. Our tenured team has experienced past down cycles and now focuses on establishing a stronger foundation for greater market share potential once a recovery unfolds.
It’s also important to reflect on what Applied has accomplished in recent years to optimize our operational position. This includes investments and initiatives that enhance our systems, talent, processes, analytics and leadership across the organization. While we understand the challenges the current environment is presenting, I believe Applied has never been in a better position to manage through this and exit this pandemic-driven downturn in an even stronger position as the overall macro economy eventually rebounds.
That said, in the near-term, there’s considerable uncertainty as it relates to the scope and duration of the impact of COVID-19 will have on the industrial economy and our industry. We are monitoring the situation closely as it evolves.
Prior to March, our sales trends reflected an ongoing sluggish industrial environment, as we had expected, following a slower start to the year. Demand weakened further, however, during March as the COVID-19 impact became more prominent. March organic sales declined in the mid-teens percent year-over-year on a days adjusted basis.
During April, organic sales are trending down high-teens percent year-over-year, as we continue to see more customers announce temporary facility shutdowns, idle equipment, limit production and defer projects. This has been most notable in heavy industries and OEM end markets.
While we’re hopeful April or May will present trough periods for this downturn, our visibility remains limited and uncertainty exists around the trajectory of recovery in coming quarters as society adjusts to new realities. As such, we are proactively adjusting costs to manage to this new environment and prepare for potential ongoing headwinds in coming quarters.
Various cost measures have already been implemented in addition to the actions discussed earlier in our fiscal 2020. These incremental actions are designed to further align expenses and support liquidity, while remaining agile to respond quickly once demand starts to recover. Dave will provide more detail on the cost measures in a moment. But as our history and recent results have shown, we understand our requirements and know how to manage through the cycle.
We also ended March in positive liquidity position with over $165 million of cash on hand, following our strongest third quarter of free cash generation to date, as well as approximately $250 million of undrawn revolver capacity, while our net debt is down over 20% from last year. We are closely monitoring our working capital and are focused on driving additional cash generation in this, our fourth quarter.
Overall, our cash-centric and adaptable business model provides financial flexibility in the current economic environment. Our capital deployment priorities will remain prudent near-term, with a focus on supporting liquidity, opportunistically reducing debt and sustaining our dividend payment.
We continue to view acquisitions as core to our growth strategy over time and remain active with our pipeline. We understand these are times when valuable relationships are reinforced and made and we remain focused on the right opportunities to further scale our value proposition when the timing is most ideal.
At this time, I’ll turn the call over to Dave for additional detail on our financial results and outlook.
Thanks, Neil, and good morning, everyone. Before I begin, a reminder that a supplemental investor deck recapping key financial performance and COVID-19-related talking points is available on our Investor site for your additional reference.
To provide more detail on our third quarter, consolidated sales decreased 6.2% over the prior year quarter. Acquisitions contributed 1.9% growth, while an extra selling day was a 1.6% positive impact. This benefit was partially offset by an unfavorable foreign currency impact of 0.2%. Netting these factors, sales decreased 9.5% on an organic daily basis.
Looking at our results by segment, as highlighted on Slide 7 and 8. Sales in our Service Center segment declined 8.9% year-over-year, or 10.9% on an organic daily basis. Lower industrial production activity and related MRO needs continued across the majority of our service center customer base into the quarter, and this was subsequently compounded by idle production and customer facility closures during March as COVID-19 precautions unfolded.
Within our Fluid Power & Flow Control segment, sales increased 0.6% over the prior year quarter, with our August 2019 acquisition of Olympus Controls contributing 5 points of growth.
On an organic daily basis, segment sales declined 6%, reflecting lower fluid power sales within industrial OEM and mobile off-highway applications, as well as weaker flow control sales from slower project activity.
As March played out against the emerging COVID-19 crisis, we saw customers reduce or halt production and trim capital spending. This adverse impact was partially offset by fluid power sales growth within the technology end market during the quarter.
Moving to margin performance, as highlighted on Page 9 of the deck, adjusted gross margin of 29% was largely unchanged year-over-year. Adjusted results exclude non-routine expense of $3.9 million related to business rationalization in our Service Center segment.
Included in adjusted gross margin was approximately $2 million of non-cash LIFO expense, which compared favorably to prior year LIFO expense of $3.6 million, resulting in an approximate 20 basis point positive impact year-over-year. Excluding LIFO, adjusted gross margin was down 15 basis points year-over-year and unchanged on a sequential basis.
Gross margin performance was in line with our expectations and reflects solid execution, considering greater top line headwinds, ongoing inflation and slightly unfavorable mix.
Turning to our operating costs. On an adjusted basis, selling, distribution and administrative expenses declined 3.3% year-over-year, excluding $2.1 million of non-routine costs in the quarter. These costs include severance and facility exit costs in our Service Center segment, reflecting additional cost actions implemented in response to the weaker demand environment. Adjusted SD&A expense declined 7.5% on an organic per day basis when adjusting our operating costs associated with acquisitions.
Our team continues to display strong operational discipline in the current environment, including sustaining results from previously announced cost actions, while swiftly executing on additional measures in March as we begin to face weaker demand. We remain highly focused on managing costs into our fourth quarter and beyond, given the current environment.
Additional initiatives implemented in the quarter include restricting T&E over time, temporary labor and consulting spend. In addition, personnel spend is being rationalized with staffing alignment to near-term demand, including reductions in force, freezing of new hires, implementation of furloughs and pay reductions and temporary suspension of the company’s 401(k) match.
While material and difficult, these actions were taken across our organization and include a mix of both structural and near-term actions, which can be quickly adjusted as we assess the evolving demand environment and balance necessary cost alignment with execution on our strategic growth initiatives and requirements to ramp and effectively respond as a recovery eventually unfolds.
Adjusted EBITDA in the quarter was $75.9 million, compared to $84.6 million in the prior year quarter, while adjusted EBITDA margin was 9.1%, or 9.4%, excluding non-cash LIFO expense in the quarter.
On a GAAP basis, we reported an operating loss of $2.14 per share, which includes a non-cash goodwill impairment charge of $131 million and $6 million of previously referenced non-routine costs on a pre-tax basis, as well as $1 million non-routine tax benefit related to the recently passed CARES Act.
On a non-GAAP adjusted basis, excluding these items, we reported earnings per share of $1.02, compared to $1.16 in the prior year quarter. The non-cash goodwill impairment charge during the quarter is associated with our fiscal 2018 acquisition of FCX Performance.
Given overall declines in the industrial economy, including ongoing softness across a number of our flow control end markets, we have lowered near-term growth protections – projections for this business unit, which drove the impairment.
Despite softer end-market demand near-term, we remain positive on our flow control platform and growth opportunities over the intermediate to long-term. Our strategic rationale for this acquisition remains firmly intact and we continue to execute on our five-year synergy plan as we initially laid out.
This includes cost synergies already realized that have supported margin accretion in recent years, as well as sales synergies tied to various cross-selling opportunities, expansion of service capabilities, improved sales productivity and geographic expansion. We are still in the early innings of the sales synergy potential across our flow control operations, as we continue to execute on our five-year plan.
I will move on now to an update on our cash flow performance and liquidity. During the third quarter, cash generated from operating activities was $64.7 million, while free cash flow was $60.5 million, or approximately 153% of adjusted net income.
Year-to-date free cash flow of $153 million, represents 135% of adjusted net income and is up $65 million from the prior year comparable period. Year-to-date cash generation highlights the continued contribution of our working capital initiatives and the countercyclical cash flow profile of our business model.
Following our strong cash performance in the quarter, we ended March with over $165 million of cash on hand, with 80% of that unrestricted U.S.-held cash. Our net debt is down 20% over the prior year, with total debt outstanding down $120 million since early 2018.
Net leverage stood at 2.5 times adjusted EBITDA at quarter-end, similar to end of calendar 2019 levels and below the prior year period of 2.8 times. We are in compliance across our financial covenants with cushion at the end of March given a maximum net leverage ratio covenant of 3.75 times EBITDA.
Combined with approximately $250 million of undrawn revolver capacity, an additional $250 million accordion option and $100 million of incremental capacity on our uncommitted private shelf facility, we remain in a positive liquidity position. Dialogue with our lending partners remains active and constructive, highlighting available funding support and keen understanding of our industry position and flexible business model.
We have no material debt maturities until fiscal 2023 and make regular amortization payments on our term loan, which equate to approximately $10 million a quarter. We also have a $40 million private shelf placement note coming due in July, which we intend to refinance with our shelf capacity or extinguish with available cash depending on the market backdrop and our working capital initiatives in coming months.
We have taken and will continue to take precautionary steps to maintain ample liquidity and drive additional cash generation into our fourth quarter, while opportunistically reducing debt in the near-term. Actions include cash savings from the cost measures deployed, deferring nonessential capital expenditures, leveraging our shared services model to optimize collections and deploying additional cross-functional inventory initiatives.
We are also conducting robust analysis and cadence reviews to identify sensitivities to our model across various sales, margin and working capital scenarios. This will support agility and timely response as the environment continues to evolve. As it relates to collections, performance has remained in line with our expectations April to date and we will continue to manage appropriately.
Transitioning now to our outlook. As noted in our press release, we have withdrawn our fiscal 2020 financial guidance due to the evolving and uncertain impact of the COVID-19 pandemic. We will reevaluate guidance and our long-term financial targets in coming months, as we fully assess the impact ahead of our fiscal 2021 outlook and continue to respond and execute cost actions and liquidity initiatives.
If appropriate and necessary, we will provide additional color on sales and margin trends in the coming months in an effort to support transparency and your modeling assumptions.
To provide some more direction into the fourth quarter, assuming the level of April organic sales declines continue into May and June, we believe high-teens decremental margins is an appropriate benchmark to use near-term. In addition, we remain constructive on our cash flow potential for the fourth quarter based on our ongoing initiatives, cost actions, business model response and April trends.
With that, I will now turn the call back over to Neil for some final comments.
Thanks, Dave. Overall, while life can seem complicated at the moment and we face new challenges given the environment, I firmly believe in our company’s position and ability to emerge stronger than ever as markets rebound. Our core values of customer focus, accountability, continuous improvement, innovation and teamwork will continue to lead the way.
I’m proud of and grateful for how our team has responded and we remain committed to being the solution to our customers’ needs and challenges. We have a remarkably strong business model that generates cash and adapts well during downturns. History highlights this and recent operational initiatives reinforce it. As the industrial economy begins to recover, we will be ready to leverage our capabilities and support customers’ early cycle growth requirements.
We believe this will be meaningful, as industrial equipment and facility infrastructure ramps, following an unprecedented period of idle production and maintenance deferrals. This will drive critical break-fix demand across our network. We will respond swiftly with local expertise and the most comprehensive suite of motion control technologies and services within our industry, as well as in Applied’s history.
In addition, we believe behaviors reshaped by the pandemic will reinforce secular growth opportunities tied to our technical service and engineered solutions portfolio, which has become a greater portion of our business in recent years. In particular, we believe customers will increasingly focus on addressing skilled labor constraints, plant efficiency and regulatory requirements, while considerations around manufacturing reshoring and U.S. industrial infrastructure have potential to gain momentum.
Ultimately, this can accelerate customers’ outsourcing of technical MRO and service needs, investments in automation and the consolidation of market share towards leading distribution platforms, giving increasing service, operational and capital requirements.
We’ve made targeted investments in recent years to position the company as the leading distributor of technical solutions across the industrial supply chain. This has differentiated our value proposition, one in which we believe will be ever more relevant as the industrial economy starts its next phase of growth. Once again, we thank you for your continued support and wish you all the best during this time. Stay well, stay strong.
And 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 David Manthey from Baird. Your line is open.
Good morning. I hope you guys are well.
Doing well, doing well. In the conference room here, socially distance at 12 o’clock, 3 o’clock, 6 o’clock and 9 o’clock.
Good to hear. So mid-teens declines in March, that seems a little outsized relative to both other industrial distributors, as well as the high-teens declines you’re seeing now in April. Just trying to understand, if you started seeing the COVID impact earlier or more acutely? And then, secondarily, if there’s any implications for what we should expect during or coming out of the crisis?
So we think the impacts probably started to show middle of March and for us, more prominent in the heavy industries as they look to adjust. And I think some made some adjustments to – in the time period around COVID-19 and also make adjustments if they’re in markets they were seeing slowing and adjust capacity to it. So I think that’s where we’ve seen the most impact in our Service Center side of our segment.
And with that, we’re just seeing a lot of activity in many of the essential industries that we’ve called out in the remarks. And so while fluid at this time, we do think this pause, this idle production, these downtimes will create a lot of opportunity as we start to work out of it, starting obviously with the early cycle industries and customers and then heading towards the mid-cycle.
Okay, thanks. And coming out of the downturn, I would assume Service Center revenues will rebound once production starts back up, some of the break-fix sales. But could we see Fluid Power & Flow Control stay lower for longer, as capacity utilization is freed up here with the economy turning off? And a lot of companies planning on cutting their CapEx, at least, for the remainder of this year. What are your thoughts on that?
So at this stage, I’m not convinced yet of lower for longer around those customer segments. They, too, are pretty well diversified and we think about some of those end segments like technology and pharma and life science with those participations. The Flow Control business is also heavily involved in paper industries and such, so there’s a lot of good activity.
And if I think about our flow control also, we’re probably at our highest level of shared pipeline of targets and quotes going on across the business right now to be determined with customer back and working in access to ship some of those units as they come back in and open back up.
So we are finding ways to stay virtually connected, work with our customers physically when required in their operations and then remotely as needed. And the engineering exchange is still going on at a good productive level with customers. And so I’ve been impressed with our actions, but also with our customers and the level of exchange and the project work that’s going on. People are wanting to find ways to stay active and productive.
Thanks, Neil.
Thank you.
Your next question comes from the line of Chris Dankert from Longbow Research. Your line is open.
Hey, good morning, everyone. I guess, if I could dig in a little bit on some of the cost cuts, it sounds like the majority of that is kind of temporary reacting to the shock we’ve seen here, I guess. Just any quantification on how big those cuts are? What you’d have to see to kind of get into more structural cuts, just if we can kind of build that conversation out a bit?
Good morning, Chris, this is Dave. I think, we’re not going to quantify numerically the impact that we expect from those cost actions. I would say that 75% to 80% of those are temporary in nature. So that we are able to flex and respond as we see the business come back and we’ll continue to evaluate those actions of a temporary nature as we move through the quarter.
I would add that, given the insight that we provided on the decremental margin expectations of high teens for the fourth quarter, you could somewhat size the cost actions accordingly. But we will continue to remain cost accountable, managing the business to the near-term, as we call it.
And so I’d say, Chris, at this stage, really it’s temporary by design and we want to maintain the flexibility to be able to respond to customer needs quickly. And so we have geographic footprints that dispersed and close to these industries. So I’d say, by design in that, obviously, it’s tiered. My participation should be higher, it is. But I’m also pleased our Board of Directors are participating in a reduction in their cash retainer in the quarter.
And so those are, we think, the appropriate temporary adjustments we need to make for where we’re at in this environment, and then we’ll see what the type of recovery looks like. But we made appropriate adjustments as we started the fiscal year to lighter volume reductions and activities. If I look back in our past, we’ve done the same, so we will in this one. I think the appropriate actions are the temporary ones. But as Dave laid out, those do have some consequences to them, to individuals, and I appreciate the team’s response across the business.
Yes. That makes a lot of sense. Thanks for the color, guys. And I hate to focus so much on the short-term. But I guess, is there any significant divergence in that performance April to date, Fluid Power & Flow Control versus the Service Center business? I mean, are they both down in a similar amount? Just any color there?
Yes. I would say, the collective Service Center business and everything that’s included would approach the down $20 million. And then the Fluid Power & Flow Control, in the mid-teens, high teens in that area. If I think about FCX in that, maybe running a little better, maybe more mid-teens right now, and so that is encouraging also.
Got it. Thanks so much, guys. I’ll hope back in queue.
[Operator Instructions] Your next question comes from the line of Adam Uhlman from Cleveland Research. Your line is open.
Yes. Hi, guys, good morning. Hope everybody is staying healthy. Dave, I was wondering if you could just expand the discussion a bit more on your working capital aspirations, I guess, just here in the near-term, but maybe over the next three to six months. But understand everything is fluid with the pace of revenue, it’s tough to determine. But any kind of rough ranges that you can provide us on how you think you could manage inventories and receivables?
And my second question then would be related to that. I know everybody is asking for extended terms. Are you seeing that with your customers? And how are you addressing that? Thanks.
You bet. I would just kind of walk through those. Here again, very pleased with the results in Q3, our strongest third quarter of cash generation in history. I think we’ve continued to show the benefit of our working capital initiatives. We’ve talked about those on prior calls, certainly around the shared services efforts on the collection side of the business, as well as the cross-functional engagement on continuing to rightsize inventory levels. So that certainly was a benefit as we work through Q3.
If you look historically in this business, we’ve had cash flow during downturns that did pace our EBITDA. So that would be our aspiration. Assuming, like we’ve said, the continued down, tight teens that we’re seeing in April and with the benefit of the cost actions that we’ve rolled through and some further reduction in working capital as we move through Q4, we would expect our Q4 cash flow to outpace what we saw in Q3.
And then, hey, Adam, as it relates to the customer side, I mean, obviously, for us, right, we know our sources of cash. We know higher uses of cash. We know what our customers want and expect really from us to be there for them with the right inventories, the right service model in the break-fix MRO, and we perform a critical function to them.
And so I won’t say that there’s no discussion, no pressure as it goes through. But we are essential to keep them up and running during this time. I think that’s recognized in that. So we will appropriately manage through it. If I look back to other cycles, we have a strong history of doing that, and I expect we will continue to do that in this environment.
Great. Thanks, guys.
Your next question comes from the line of Michael McGinn from Wells Fargo. Your line is open.
Good morning, everybody. I was wondering if I could just touch a little more on the margin framework within Fluid Power and Service Center. Is there a large divergence in margins similar to that of what you’re seeing on the top line between the mid-teens and then 20% in Service Center?
Not significant margin divergence. We do serve slightly better margins on the Fluid Power & Flow Control, and that’s part of the accretive mix of benefit that we’ve talked about as we continue to grow in those expansionary areas. But we’ve not seen any change in that trend as we’ve moved through the most recent quarter. I would not expect that trend to change as we continue into Q4 and beyond.
Yes.
I’d say both segments and teams are doing the appropriate – the right job of being focused on point of sale. Both groups have mix opportunities around service and repair, but also the customer and product mix that we have in the area. So all have appropriate focus. I think, it’s showing well in the quarter. And really, those are kind of what we expect in this coming quarter, as we said earlier.
Okay. I appreciate it. And then, obviously, the game has changed here. You guys had some pretty big, both organic and inorganic growth opportunities. I’m just wondering what signpost, what guidepost do you need to see to dip your toe back into the water for bolt-on M&A? Is it a market-based function or just getting to a certain leverage target that may be different than before? Can you just comment on that?
I’d say, one. I mean, we have work and activity going on now with various shelters in place, right? It creates distance. So it’s a little harder to have some of those closer dialogue and diligence items that would be occurring in that time period. So we’ll see when those ease up a little bit going forward.
But right now, we’re focused on running and operating the business very well. It will generate cash for us to those priorities in time. I would expect we will be active in the game. And as I think about our longer-term objectives, we – for 2023, we still think – we still believe those hold.
Now we will get into determining what does it mean on the timing. And then we’ll work through the quarter. And I expect that we will be providing input on those in the August time period. I think they’re absolutely the right objectives. The company, in my view, will accomplish those and that probably, as we’ve discussed, even likely higher levels in time. So we’ll let this thing play out. We will deal appropriately in the near-term. I think, as we come into ending the fiscal year and looking forward, we’ll provide more commentary on what we expect those to be over the three-year horizon and perhaps a little longer.
Okay. Talk to you next week in our conference.
Very good.
Your next question comes from the line of Joe Mondillo from Sidoti & Company. Your line is open.
Hi, everyone. Good morning.
Good morning, Joe.
Good morning, Joe.
So I was wondering, in terms of the reopen of the economy, what you are seeing and what you have at your – what you can see at this point in time. Do you have any visibility to say that April is going to be sort of the worst month?
I would say in that, no, not perfect visibility to that. And so will April or May be kind of that trough period? We’re already there, but it extends on. I mean, we know about 75% of our customers are deemed more essential in that. If we think about certain segments of them that we went through, in food and beverage and life science and technology, that’s a good segment of our business base that’s running highly productive. And then there’s geographic variances that would go on, on the various shelter in place and perhaps how certain companies interpret those or where they’re at in their own demand cycle.
I do suspect there will be some increased activities as states come back on and open up their economy some more from local accounts and doing it. If I think about our national account type business, I would say, we would have maybe 10% to 15% of those that have either idled capacity or dealing with a temporary type shutdown. How will that play out in May and beyond? We’ll see. But that’s kind of the level now. And so I think April – or May could look like a little bit of April today, we’ll see. And then I think we all will be rooting for improvements from the June period on. But I think that’s to be determined.
Okay. And then in terms of your energy exposure, could you talk about how you’re looking at that end market, specifically compared to 2015, 2016, how that compares? I mean, it feels a lot worse, not to think that we thought that it could have gotten that worse, but it seems like it has. But what is your general feeling, just given what your conversations are like with your customers?
Yes. So I’d say, overall for us, right, it’s still now less than 7% of the overall business. With our teams and locations, we’re having the right exchanges and dialogue with customers. We’re making appropriate adjustments to the business model. We’re positioned well. We have made the determination to look at where we had some maybe additional locations in sites or coverage to combine some of those. And so that is, in the quarter, a little bit in results and activities.
So we will continue to rightsize the business to the current environment and then stay prepared for when it starts to improve. And so the position, we think, between Permian and Anadarko, we’re positioned. We have coverage. We’re in the right locations. I don’t think it stays at this level for a long, long while. But for us, it’s still less than 7% of the overall.
Okay. And then I wanted to ask a question on gross margins. Historically, even in downturns, you’re able to – I guess, just your business model is able to perform quite well in terms of gross margins, maintaining them. Your business has changed a lot over the years, specifically with Fluid Power & Flow Control.
So could you, number one, describe any risks at all that you’re always concerned of going into a downturn regarding your gross margins, just in general, and then more specifically, how the gross margins change? I guess, I know you don’t define the gross margins on the segment level, but maybe you can just talk qualitatively on how Fluid Power & Flow Control differs a little bit. Are there more fixed costs? Would it be a little more – do you see any more operating leverage at the gross margin level at that segment? Thanks.
Yes. So historically, to your point, we’ve done a very nice job of protecting margins during downturns. I think, quite frankly, given the mix evolution and as the business continues to grow into some of these expansionary products, namely fluid power, flow control, as you point out, I think, that even betters our opportunity to be able to protect those gross margins during the downturn.
So pleased that we saw here, again, flat sequential margin performance, essentially flat in terms of our gross margin year-over-year in the most recent quarter. As we’ve talked, as I mentioned to Chris, a slight – slightly higher gross margin contribution out of those Fluid Power & Flow Control businesses. And there, you would see a little bit more SD&A support just given the engineered component to that business, which here again, those are addressed with the additional cost actions in terms of furloughs and some of the salary reductions to help manage overall operating margins.
So more than ever, I like with the tools we have at our disposal with the systems investments we’ve made and the critical break-fix nature of the product and the business and the value-add that we provide to customers, our ability to actually protect margins, again, through this downturn.
I’m sorry, go ahead.
Go ahead. I was just going to add and I think we’ve discussed it, right? As we think about margins in the current quarter, perhaps they’re at a level maybe slightly lower in it in the fourth quarter. But we like the opportunities that we have. And I think on the service center side, there’s continued work around point of sale.
I think around the product mix, we are finding our way in this time, right? A little bit more consumables coming in. We know those have a positive mix up as we go through. As the various shelter in place goes on, as those open back up and more local customers open back up, right, that will get us back and running. So to be determined how that mix plays out perfectly in this quarter, and that’s why we think maybe there’s a little bit of – it’s at the same level or maybe just slightly down in that.
And then on the Fluid Power & Flow Control side, if you think about the margin opportunity for customers, and in this environment, there’s going to be more service requirements. There’s going to be more people looking for repair opportunities in that. And so that will create work and mix opportunities for those – that business segment and those businesses in it for us going forward.
Hey, Joe, this is Ryan. I just wanted to add a little bit on that. If you think about the LIFO as well has been a headwind for us still as it relates to our fiscal 2020. And so certainly, it will depend on the direction of inflation, but that could certainly start to ease even more so into our fiscal 2021.
And then if you go back and you look historically, the way the gross margins have performed during downturns, you’re correct in saying some nice resiliency there. I think part of that is a reflection of where we play within the supply chain as it relates to break-fix products and solutions, as well as technical solutions. I think there’s certainly a more critical aspect to what we’re doing there that allows us to manage the inflationary and overall gross margin dynamic during downturns.
Okay, great. Thanks. I’ll hop back in queue. Thanks.
Your next question comes from the line of Steve Barger from KeyBanc Capital Markets. Your line is open.
Good morning, guys.
Hi, Steve.
Good morning.
I’m curious how the competitive environment may have changed. Are you hearing about stress from smaller competitors? Are you seeing more inquiries as people think about going to channel partners with more scale or staying power?
Well, I think our customers and even in early to mid-March and the various shelter in place, we’d have key customers put in the calls and want to know what that meant for our business. And we were able to answer across our operating platform. We’re deemed critical infrastructure. We’re here to serve essential businesses and we’ve operated continuously in that.
And if you’re just in a certain market or geography, I could get, it’s a little bit more stressful. I mean, we’ve talked about the times. I mean, working through cycles, depending on where you’re at in stage of business can all be a challenge in doing it. So perhaps it’s a little early for all of that, but hey, no doubt, there’s stressors in the economy. There’s stressors in the supply chain a little bit right now. But hey, we’ve weathered through these before and we’re operating effectively and efficiently right now.
Yes. Just thinking about some of those stressors in the supply chain and you already addressed some of this. But are people talking more about reshoring or localizing? And are you seeing more inquiries or conversations about robotics or automation?
So let’s talk about the reshoring. On that one, I’m going to say, yes. And so just in the short-term, right, as you think about in North America, as countries make different interpretations on essential industries and timing and who is in, who is out, that’s creating some movement of production and capacity that goes on.
As you think about Asia markets or India, right, as they shelter in place for a period of time, I don’t know that there’s great finished products that come to the U.S., but there would be components that would get worked or go into items. Now where we’re at now and transit on water, I think, everyone is fine. If that plays out longer, that will get considerations, do people make changes in their capacity models and decide to do more in the geographic markets they’re serving, i.e., U.S. and North America.
And then as we think about robotics, yes. And so whether that be in material and logistics and people wanting to stay running and operating and be able to have cobots to create some additional social distancing and space of that workforce, and I think it’s going to come in more and more to some of these other essential industries. People are going to be more open to having that dialogue and we’re working on those type projects.
We were in reviews with the team on Monday, and I’m very impressed with the projects in the pipeline that’s going on, the technology collaboration that’s going on in those businesses and the types of projects they’re involved with. And some of them are related to COVID support industries and projects that are going to help in this recovery. So all of those are encouraging.
Do you expect to start monetizing some of those opportunities as you go into 4Q even that quickly?
To be determined on 4Q. I think, as we think about that business, they’re probably essentially flat, would be my starter to say how they’re going to do and probably challenging them to be a little better if they’re on the line. But that’s how I think about them in that, because they’ve also got to work with customers on delivery of some of those projects and receipts.
So they’ve had some of those customers put in more restrictive delivery requirements or perhaps they’re down for a period of time in their receiving areas. So is it as fast as Q4? Maybe not. I think clearly, as we turn the corner and go into our new fiscal year, I think, more and more of those play in.
Right. And then last one for me, Dave, your comment on managing the high-teen decremental and if April trends come in for the full quarter, is that based on what you can see and control in the model right now, or based what you’ve seen from the business in past downturns?
That’s a combination of looking back at what we’ve done historically and then looking very carefully at what we’re seeing now and projecting, Steve, for the balance of the quarter. And I think, here again, the investments we’ve made, we’re better positioned to be able to manage the cost base appropriately, given the kind of the – both the systems investments, as well as the shared services model we’ve deployed, in many cases and elements of the business. I think all that just makes us better positioned to be able to react and manage those high-teens decrementals.
And Steve, I’d say the – I’d just say the business and the team, I think, were very responsive and proactive in, okay, seeing what’s coming and making the appropriate adjustments. So I think, to Dave’s point, it’s a little bit of, okay, history. But we’re not relying on history, it’s really actions that have been taken that builds those comments.
Understood. Thank you.
Your next question comes from the line of Garo Norian from Palisade Capital Management. Your line is open.
Hey, Neil. I know that for several years, you were talking about increasing kind of safety products, building up that vertical. I was just curious how that has helped or what it’s done for you during this period?
Yes. So we would see as a category. For us, overall, it’s probably still low single digits, but we would see growth in that. And so as we provide expanded consumables to our current customers, we are rounding out that offering. Our vendor managed inventory specialists, depending on geography, are finding the ways to stay active, some with the appropriate safety and precautions on site.
I think the team has also developed some nice virtual tools that they can do that and have someone that’s in the facility actually electronically do the infill and it weaves into our system. So it has contributed, and I think our teams across the service center networks and the other side of our businesses have been resourceful to help our customers deal with jan-san issues, hand sanitizers and those.
So it has contributed, and I would expect that it would. But it’s still in the – overall for us, in the low single digits type portion of the product mix.
Thanks. And then I don’t recall offhand what your guys’ exposure might be into the aerospace chain. But if you could talk about what it may be now and then also strategically as that industry is likely to be challenged for, let’s say, the near to intermediate term, but still has an attractive arguably, long-term outlook. I’d be curious about your thoughts of potentially using this period to maybe expand more into that end market?
Yes. So, Garo, for us, overall now, it’s a small participation that we have. As we go into the planning cycle and with our locations and their regional management, we’ll have some of those dialogues. But I expect over the mid-term, it likely for us stays at that. Perhaps a growth area could be if we find or believe we have some automation contributions to add into the space, perhaps that would be one. But to date, it’s not very significant for us as a participating segment.
Great. Thanks very much.
And for our final question, it comes from the line of Joe Mondillo from Sidoti & Company. Your line is open.
Hi, guys. Just two quick follow-up calls, and they’re both accounting-related questions. The tax benefit related to the CARES Act, I was just wondering what that is related to?
Yes. That was the ability to recognize pre-acquisition carryforward losses related to the FCX business, with the provisions included in the act. So about $1 million tax benefit for us in the quarter that we did strip out as an unusual item in the adjusted results.
Okay. And then also the impairment write-down related to FCX, not totally surprised that – I imagine other companies are going to start writing down goodwill in a similar fashion. The bigger surprise to me, though, was how early you are writing it down? And then I always thought this was sort of an end of year – addressing that end of year kind of a thing. So what caused you to have to do that?
We have a January 1 test date for goodwill impairment. That said, the business, as we’ve talked in prior quarters, has seen some softness creep in related to some of the project spend as the overall industrial economy has slowed, particularly with the exposure to metals and some of the other industries that FCX plays in.
I think, it was really a matter of taking a realistic look at the – how quickly that recovers. And certainly, against these – as you do these acquisitions of distribution businesses, very asset-light, you’re carrying a higher level of goodwill than potentially a manufacturing business, just thinking about the shape of that recovery. And certainly, I said in the script, we’re still optimistic in terms of the intermediate and longer-term growth potential as we continue to work the cross-selling opportunities, expanding the service capabilities, et cetera, but being prudent in terms of that likelihood and shape of that recovery, how quickly that bounces back and the pressure that put on the model in the near-term.
And just a follow-up, why wouldn’t this happen in the prior quarter then if it’s January 1 test date? I guess, it’s following the prior quarter?
Yes. It is within our fiscal Q3.
Got it.
…and gets finalized – we would continue to evaluate even up to the data, publishing the financials. And that – the hindsight of here again, so maybe more recent near-term expectations for the business as we continue to evolve that model looking at the test date.
Got it. All right. Thanks a lot, guys. Good luck with everything.
Thank you.
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.
Yes, I just want to thank everyone for taking the time to join us today for their interest and support. We look forward to talking with you throughout the quarter.
That concludes today’s conference. Ladies and gentlemen, thank you very much for joining. You may now disconnect.