CAUTIONARY STATEMENT
UNDER PRIVATE SECURITIES LITIGATION REFORM ACT

          This report, including the documents incorporated by reference, contains statements that are forward-looking, based on management’s current expectations about the future. Forward-looking statements are often identified by qualifiers such as “guidance,” “expect,” “believe,” “plan,” “intend,” “will,” “should,” “could,” “would,” “anticipate,” “estimate,” “forecast,” “may,” and derivative or similar words or expressions. Similarly, descriptions of our objectives, strategies, plans, or goals are also forward-looking statements. These statements may discuss, among other things, expected growth, future sales, future cash flows, future capital expenditures, future performance, and the anticipation and expectations of Applied and its management as to future occurrences and trends. Applied intends that the forward-looking statements be subject to the safe harbors established in the Private Securities Litigation Reform Act of 1995 and by the Securities and Exchange Commission in its rules, regulations, and releases.

          Readers are cautioned not to place undue reliance on any forward-looking statements. All forward-looking statements are based on current expectations regarding important risk factors, many of which are outside Applied’s control. Accordingly, actual results may differ materially from those expressed in the forward-looking statements. The making of those statements should not be regarded as a representation by Applied or any other person that the results expressed in the statements will be achieved. In addition, Applied assumes no obligation publicly to update or revise any forward-looking statements, whether because of new information or events, or otherwise, except as may be required by law.

          Applied believes its primary risk factors include, but are not limited to, those identified in “Risk Factors” at Part I, Item 1A, and in “Narrative Description of Business,” at Part I, Item 1, section (c), in this annual report on Form 10-K, as well as in “Management’s Discussion and Analysis” in Applied’s 2009 annual report to shareholders. PLEASE READ THOSE DISCLOSURES CAREFULLY.

 

 

 

 

 

 

 

 

OVERVIEW

With more than 4,700 associates across North America, Applied Industrial Technologies (“Applied,” the “Company,” “We,” “Us” or “Our”) is an industrial distributor that offers parts critical to the operations of MRO and OEM customers in a wide range of industries. In addition, Applied provides engineering, design and systems integration for industrial and fluid power applications, as well as customized fluid power shop, mechanical and fabricated rubber services. As an authorized distributor for more than 2,000 manufacturers, we offer access to approximately 3 million stock keeping units (“SKUs”). A large portion of our business is selling replacement parts to manufacturers and other industrial concerns for repair or maintenance of machinery and equipment. We have a long tradition of growth dating back to 1923, the year our business was founded in Cleveland, Ohio. At June 30, 2009, business was conducted in the United States, Canada, Mexico and Puerto Rico from 464 facilities.

When reviewing the discussion and analysis set forth below, please note that the majority of SKUs we sell in any given year were not sold in the prior year, resulting in the inability to quantify certain commonly used comparative metrics analyzing sales, such as changes in product mix and volume.

On August 29, 2008, Applied completed the acquisition of certain assets of Fluid Power Resource, LLC, (“FPR”). The results of FPR’s operations have been included in the consolidated financial statements since that date.

Our fiscal 2009 sales came in at $1.9 billion, a decrease of $166.3 million or 8.0% compared to the prior year. The effects of the worldwide recession are being felt in the industries we serve. Declines in same-store business of 14.6% were only partially offset by net sales from acquired businesses which added $160.6 million. Our operating margin declined to 3.8% compared to the prior year’s 7.3%. The current year includes the impact of a goodwill impairment charge of $36.6 million related to our Fluid Power Businesses segment, which decreased operating margins by 1.9% and earnings per share by $0.54. Gross margin declined slightly to 27.0% from 27.2% in the prior year. Our earnings per share was $0.99 versus $2.19 in fiscal year 2008, a decline of 54.8%. Goodwill impairment accounted for approximately half of this decline, whereas the remaining decline represents the impact of lower sales and higher net interest costs partially offset by reductions in operating expenses.

During the fourth quarter of fiscal 2009, the Company performed an interim goodwill impairment test based on current and expected market conditions, including reduced operating results and a worsening economic outlook. As a result of this test, the Company determined that all of the goodwill associated with the Fluid Power Businesses segment was impaired as of June 30, 2009. Accordingly, the Company recognized an impairment charge of $36.6 million for goodwill in the fourth quarter of fiscal 2009, which decreased net income by $23.0 million and earnings per share by $0.54.

Our consolidated balance sheet remains strong. Shareholders’ equity is $508.1 million, up slightly from the June 30, 2008 level of $502.1 million. Working capital decreased $40.1 million from June 30, 2008 to $369.0 million at June 30, 2009, primarily reflecting the impact of the FPR acquisition. Our current ratio remains strong at 3.4 to 1 versus 3.1 to 1 in fiscal year 2008.

Applied monitors several economic indices that have proven to be key indicators for industrial economic activity. These include the Manufacturing Index published by the Institute for Supply Management (“ISM”), and the

Manufacturing Capacity Utilization (“MCU”) published by the Federal Reserve Board.

Historically our performance correlates well with the MCU, which measures productivity and calculates a ratio of actual manufacturing output versus potential full capacity output. When manufacturing plants are running at a high rate of capacity, they tend to wear out machinery and require replacement parts. Our sales tend to lag the MCU on the upswing and move with the decline.

Over the last five quarters, both of these indices have been signifying a severe recessionary economy for the United States, which has heavily impacted the industries we serve. Our U.S. same-store sales have declined steadily during this same period. For instance, our U.S. service center same-store sales fell compared to the same quarter of the prior year as follows:

Quarter Ended		Sales Decline
June 2008			2	%
September 2008			3	%
December 2008			13	%
March 2009			23	%
June 2009			27	%

Although there has been some improvement in the ISM Manufacturing Index through the first two calendar quarters of 2009, it (along with the MCU) is still showing an economy in recession. Hence, we believe our sales will be sluggish through most, if not all, of fiscal 2010, barring any sudden and dramatic increase in capacity utilization.

YEAR ENDED JUNE 30, 2009 vs. 2008

Net sales in fiscal 2009 were $1.9 billion or 8.0% below the prior year. Net sales from companies acquired since the prior year contributed approximately $160.6 million. Our same-store sales declined 14.6% due to the slowing industrial economy. Currency translation accounted for approximately $32.4 million of the decline or 1.5%. In local currency, our Canadian business was up 0.5% from fiscal 2008 levels. Net sales from our Mexican operations more than doubled to $50.6 million, driven primarily by newly acquired businesses. The number of selling days in fiscal 2009 was the same as in fiscal 2008.

Within the Service Center Based Distribution segment, net sales decreased $268.7 million or 14.4% compared to fiscal year 2008. Net sales from acquired businesses contributed $21.1 million, while our same-store sales saw a net decline of $289.8 million or 15.5%. Within the Fluid Power Businesses segment, net sales increased $102.4 million or 45.7%. This increase was primarily due to our U.S. and Mexican acquisitions in this segment which added $139.5 million to net sales. Same-store sales declined in our Fluid Power Businesses segment by 16.6%.

The sales product mix for fiscal 2009 was 74.0% industrial products and 26.0% fluid power products compared to 80.0% industrial and 20.0% fluid power in the prior year. Acquisitions since the prior year have been primarily in our Fluid Power Businesses segment, accounting for the shift in product mix.

At June 30, 2009, we had a total of 464 operating facilities in the U.S., Canada and Mexico versus 459 at June 30, 2008. The net increase in facilities reflects 20 new facilities from acquisitions and 2 newly opened locations, offset by 17 mergers/closures of locations in the current year.

Our gross profit margin declined to 27.0% in fiscal 2009 from 27.2% in fiscal 2008. LIFO inventory layer liquidations resulted in a $4.4 million

 

 

positive impact during fiscal 2009, which helped offset a reduction in U.S. point-of-sale margin.

SD&A consists of associate compensation, benefits and other expenses associated with selling, purchasing, warehousing, supply chain management and providing marketing and distribution of the Company’s products, as well as costs associated with a variety of administrative functions such as human resources, information technology, treasury, accounting, legal, and facility related expenses. SD&A decreased $5.5 million or 1.3% during fiscal 2009 compared to the prior year, and increased as a percent of sales to 21.4% in 2009 from 19.9% in 2008. Acquisitions added $44.0 million of SD&A compared to the prior year, including additional amortization expense of $8.1 million. Healthcare costs and severance expense increased $5.8 million. Associate compensation and benefits, including amounts tied to financial performance, were $38.5 million lower in the current fiscal year. During the latter half of the year, we reviewed our operations and reduced staff and hours worked, resulting in an additional reduction of wage and benefit costs for the year of $4.4 million. Foreign currency translation and reduced discretionary spending account for the majority of the remaining decrease.

During the fourth quarter of fiscal 2009, the Company performed an interim goodwill impairment test based on current and expected market conditions, including reduced operating results and a worsening economic outlook. As a result of this test, the Company determined that all of the goodwill associated with the Fluid Power Businesses segment was impaired as of June 30, 2009. Accordingly, the Company recognized an impairment charge of $36.6 million for goodwill in the fourth quarter of fiscal 2009, which decreased net income by $23.0 million and earnings per share by $0.54.

Operating income decreased 52.6% to $72.5 million during fiscal 2009 from $152.8 million during 2008. As a percent of sales, operating income decreased to 3.8% in fiscal 2009 from 7.3% in 2008. The $80.3 million decrease in operating income during fiscal 2009 primarily reflects the impact of sales declining at a greater rate than SD&A expenses and the goodwill impairment charge of $36.6 million.

Operating income of both of our segments declined. Operating income as a percentage of sales for the Service Center Based Distribution segment declined from 6.7% in fiscal 2008 to 4.7% in fiscal 2009 and for the Fluid Power Businesses segment from 7.7% to 5.8%. Again, these changes reflect the impact of a sales decline at a greater rate than SD&A expenses.

Interest expense, net, increased $3.5 million during fiscal 2009 compared with the prior year. Lower invested cash balances and lower interest rates on invested cash led to a reduction in interest income of approximately $2.9 million. Interest expense increased $0.6 million due to higher average borrowings.

Other expense (income), net, represents certain non-operating items of income and expense. This line increased $2.0 million due primarily to $1.9 million in foreign currency transaction losses and $1.4 million of a loss in market value in investments held by deferred compensation trusts. These losses were partially offset by $1.2 million of foreign currency gains on our cross-currency swap.

Income tax expense as a percentage of income before taxes was 35.8% for fiscal 2009 and 37.1% for 2008. The decrease in the effective tax rate was primarily due to the reversal of a valuation allowance as the related deferred tax asset is now expected to be utilized. This reduction was partially offset by higher effective state and local tax rates and foreign income taxes. We

expect our overall tax rate for fiscal 2010 to be in the range of 37.0% to 37.5%, since the valuation allowance reversal will not recur and state and local taxes are expected to increase.

As a result of the factors addressed above, net income for fiscal 2009 decreased $53.2 million or 55.7% from the prior year. Net income per share decreased 54.8% to $0.99 in fiscal 2009 from $2.19 in 2008.

The number of Company associates was 4,729 at June 30, 2009 and 4,831 at June 30, 2008. The acquisition of FPR added more than 400 associates in August 2008; the net decline year-over-year represents the impact of these additions offset by company-wide reductions in workforce. Additionally, during the latter half of the year, we took measures to further reduce compensation costs including reducing scheduled work hours. The number of associates adjusted to reflect an equivalent full-time work status (“full-time equivalent”) at June 30, 2009 was about 10% lower than the same measure at December 31, 2008.

YEAR ENDED JUNE 30, 2008 vs. 2007

Net sales in fiscal 2008 were $2.1 billion or 3.7% above the prior year sales. This increase was due to improvements in our Service Center Based Distribution segment sales of 3.3% and in our Fluid Power Businesses segment sales of 7.7%. The increase in Service Center Based Distribution segment sales was primarily driven by an increase in national contract business and the recovery of supplier price increases. Within the Service Center Based Distribution segment, the impact of the strengthening Canadian currency was largely offset by a 9.3% volume decline in our Canadian market. The increase in sales of our Fluid Power Businesses segment was approximately 45% attributable to favorable currency fluctuations at the Canadian locations and approximately 25% related to the VYCMEX S.A. de C.V. (“VYCMEX”) acquisition. Also contributing to these increases was an additional sales day in fiscal 2008 compared to fiscal 2007.

The sales product mix for fiscal 2008 was 80.0% industrial products and 20.0% fluid power products compared to 80.2% industrial and 19.8% fluid power in the prior year.

At June 30, 2008, we had a total of 459 operating facilities in the U.S., Canada and Mexico versus 445 at June 30, 2007. The increase in facilities was largely attributed to 5 facilities from the acquisition of VYCMEX midway through the fiscal year and 10 facilities from the acquisition of Suministros Industriales Enol, S.A. de C.V. (“Enol”) at the end of fiscal 2008.

Our gross profit margin maintained the 27.2% achieved in fiscal 2007. Slightly higher levels of supplier purchasing incentives were largely offset by continued pressures in gross profit margin with national contracts. LIFO inventory layer liquidations resulted in a $0.6 million positive impact during fiscal 2008.

SD&A increased 0.8% during fiscal 2008 compared to the prior year, but decreased as a percent of sales to 19.9% from 20.5% in 2007. Approximately one-third of the fiscal 2008 increase was attributable to SD&A amounts of businesses acquired. The remainder of the increase was primarily due to increases in associate compensation tied to improved financial performance.

Operating income increased 13.2% to $152.8 million during fiscal 2008 from $135.0 million during 2007. As a percent of sales, operating income increased to 7.3% in fiscal 2008 from 6.7% in 2007. The $17.8 million increase in operating income during fiscal 2008 primarily reflects the impact

 

 

of higher sales at a stable gross profit percentage with only modest increases in SD&A expenses.

Interest expense, net decreased by 62.6% or $1.5 million during fiscal 2008 compared with the prior year, primarily due to repayment of $50.0 million of long-term debt in December 2007.

Other expense (income), net, represents certain non-operating items of income and expense. This line decreased $1.4 million due primarily to the loss in market value in investments held by deferred compensation trusts.

Income tax expense as a percentage of income before taxes was 37.1% for fiscal 2008 and 35.7% for 2007. The increase in the effective tax rate was due to higher effective state tax rates and U.S. federal tax law changes that eliminated the deductibility of certain expenses.

As a result of the factors addressed above, net income for fiscal 2008 increased $9.4 million or 11.0% from the prior year. Net income per share increased 13.5% to $2.19 in fiscal 2008 from $1.93 in 2007. During fiscal 2008 and 2007, we repurchased 1.1 million and 1.4 million shares, respectively, which resulted in fewer shares outstanding for the year compared to the prior year. The buybacks in fiscal 2008 contributed approximately $0.03 cents per share.

The number of Company associates was 4,831 at June 30, 2008 and 4,649 at June 30, 2007.

LIQUIDITY AND CAPITAL RESOURCES

Net cash flows from operations depend primarily upon generating operating income, controlling investment in inventories and receivables and managing the timing of payments to suppliers. We continue to monitor and control our investments in inventories and receivables by taking advantage of supplier purchasing programs, making internal information system enhancements and accelerating receivables collection through improvements in invoice delivery, customer communications, and expanded external collection efforts.

We generated $81.3 million of cash from operating activities during fiscal 2009, $110.3 million during 2008 and $70.9 million during 2007. Cash provided by operating activities of $81.3 million decreased $29.0 million in fiscal 2009 compared with 2008. The slowing of sales in 2009 resulted in a reduction in income and in cash provided. Cash generated by declines in receivables was offset by cash used for declines in accounts payable and compensation related liabilities. Inventories increased despite the slowdown in sales as we fulfilled purchase commitments in place before the downturn in the economy. We expect to reduce these inventory levels over the coming year which will generate cash inflows. Cash provided from operations in fiscal 2008 benefited from our strong operating results. Cash flows from operations in fiscal 2007 were also impacted by the timing of certain income tax payments and the timing of receipts from certain supplier purchasing programs.

Net cash used by investing activities was $178.4 million during fiscal 2009, $26.8 million during fiscal 2008 and $10.2 million during 2007. Cash was primarily used for acquisitions in fiscal 2009 and fiscal 2008, whereas it was primarily used for capital expenditures in fiscal 2007. In fiscal 2009, net cash paid for acquisitions of $172.2 million was primarily due to the FPR acquisition in August 2008 ($166.0 million paid at closing) and a Service Center Based Distributor acquisition in December 2008 ($4.7 million paid at closing). In fiscal 2008, we acquired two distributors based in Mexico for $28.7 million, of which $22.1 million was paid at closing. Capital

expenditures for all years presented consist primarily of information technology equipment, and buildings and improvements.

For fiscal 2010, our capital expenditures are expected to be in the $8.0 million to $9.5 million range, consisting primarily of additional information system technology equipment and infrastructure investments. Depreciation for fiscal 2010 is expected to be in the range of $12.0 million to $13.0 million.

Cash provided by (used in) financing activities was $28.5 million during fiscal 2009, ($103.5) million during fiscal 2008 and ($48.4) million during 2007. Cash provided by financing activities in fiscal 2009 was primarily due to net borrowings of $55.0 million on our revolving credit facility, which were primarily used to fund acquisitions. Partially offsetting these borrowings was the payment of $25.4 million in dividends in fiscal 2009.

In fiscal 2008, we utilized cash in financing activities to repay $50.0 million of long-term debt, repurchase $33.2 million worth of shares for our treasury and pay $25.7 million in dividends which included the effect of an increase in our quarterly dividend to $0.15 per share. The amount of the dividend paid is based on judgment, financial performance and payout guidelines consistent with other industrial companies.

In fiscal 2009, 2008 and 2007, we repurchased 68,000, 1.1 million and 1.4 million shares of the Company’s common stock, respectively, at an average price per share of $17.80, $29.02, and $24.26, respectively.

The following table shows the approximate value of the Company’s contractual obligations and other commitments to make future payments as of June 30, 2009 (in thousands):

					Period Less				Period				Period				Period
		Total			Than 1 yr				1-3 yrs				4-5 yrs				Over 5 yrs				Other
Operating leases		$	78,400			$ 21,800			$	28,200			$	15,300				$ 13,100
Interest payments on long-term debt			5,100			3,700				1,400
Planned funding of postretirement obligations			54,000			1,900				3,000				3,300				45,800
FIN 48 liabilities, including interest and penalties			2,400																			$ 2,400
Long-term debt			75,000							75,000
Total Contractual Cash Obligations		$	214,900			$ 27,400			$	107,600			$	18,600				$ 58,900				$ 2,400

Purchase orders for inventory and other goods and services are not included in our estimates as we are unable to aggregate the amount of such purchase orders that represent enforceable and legally binding agreements specifying all significant terms. The table above includes the gross liability for unrecognized income tax benefits (“FIN 48 liabilities, including interest and penalties”) in the “Other” column as the Company is unable to make a reasonable estimate regarding the timing of cash settlements with the respective taxing authorities. See Note 8 to the consolidated financial statements, for further information on income taxes and the FIN 48 liability.

The Board of Directors has authorized the repurchase of shares of the Company’s stock. These purchases may be made in open market and negotiated transactions, from time to time, depending upon market conditions. At June 30, 2009, we had authorization to purchase an additional 997,100 shares.

 

 

Capital resources are obtained from income retained in the business, borrowings under the Company’s credit facilities, and operating lease arrangements.

See Note 5 to the consolidated financial statements for details regarding outstanding debt as of June 30, 2009 and 2008. The average borrowings totaled $105.0 million during fiscal 2009 and $47.1 million during fiscal 2008. The Company has a five-year committed revolving credit agreement which expires in June 2012. This agreement provides for unsecured borrowings of up to $150.0 million. In fiscal 2009, we drew down on our revolving credit facility; borrowings have primarily been used to fund acquisitions. We had $55.0 million of borrowings outstanding under this facility at June 30, 2009, of which $5.0 million is classified as current and $50.0 million is classified as long-term. It is the Company’s intention to maintain a balance of at least $50.0 million outstanding on the revolving credit facility, utilizing the one-month LIBOR borrowing option through September 19, 2010 per the terms of the interest rate swap agreement described in Note 6 to the consolidated financial statements, “Risk Management Activities.” Unused lines under this facility, net of outstanding letters of credit, total $88.9 million and are available to fund future acquisitions or other capital and operating requirements. Borrowings under this agreement carry variable interest rates tied to either LIBOR, prime, or the bank’s cost of funds at the Company’s discretion. We also have an uncommitted long-term financing shelf facility which expires in March 2010, which enables us to borrow up to $100.0 million at our discretion with terms of up to fifteen years. We had no outstanding borrowings under this facility at June 30, 2009.

The weighted average interest rate on borrowings under our debt agreements, including the effects of interest rate swaps, was 4.4%, 8.4%, and 6.8% in fiscal 2009, 2008 and 2007, respectively. The decrease in the weighted average interest rate primarily reflects the impact of borrowings under the revolver at lower interest rates.

We manage interest rate risk through the use of a combination of fixed-rate long-term debt, variable rate borrowings under a committed revolving credit agreement and interest rate swaps. At June 30, 2009, we had $55.0 million of variable rate debt outstanding of which $50.0 million was effectively converted to fixed-rate debt under the terms of an interest rate swap agreement. The Company’s private placement debt has been converted from fixed-rate U.S. dollar denominated debt to fixed-rate Canadian dollar denominated debt through the use of a cross-currency swap. As such, consolidated interest expense was affected by changes in the exchange rates of U.S. and Canadian dollars. See Note 6 to the consolidated financial statements for additional discussion on our derivative activities.

In fiscal 2008, we paid off $50.0 million of debt that matured in December 2007. We terminated certain interest rate swap agreements for favorable settlements in prior years. The settlement gains were amortized as a reduction in interest expense of $0.8 million per year through December 2007.

The Company’s working capital at June 30, 2009 was $369.0 million compared to $409.2 million at June 30, 2008. The current ratio was 3.4 to 1 at June 30, 2009 and 3.1 to 1 at June 30, 2008. The decrease in working capital at June 30, 2009 was primarily due to utilization of cash to purchase FPR.

Debt classified as long-term includes $50.0 million borrowed under our revolving credit facility as discussed above. The remaining $25.0 million of long-term debt matures in November 2010.

The revolving credit facility, private placement debt and uncommitted shelf facility contain restrictive covenants regarding liquidity, net worth, financial ratios, and other covenants. At June 30, 2009, the most restrictive of these covenants required that the Company have consolidated income before interest, taxes, depreciation and amortization at least equal to 300% of net interest expense. At June 30, 2009, the Company was in compliance with all covenants and expects to remain in compliance during the terms of the agreements.

Management expects that our existing cash, cash equivalents, funds available under the revolving credit facility, cash provided from operations, and the use of operating leases will be sufficient to finance normal working capital needs, payment of dividends, acquisitions, investments in properties, facilities and equipment, and the purchase of additional Company common stock. Management also believes that additional long-term debt and line of credit financing could be obtained based on the Company’s credit standing and financial strength, however at higher rates than the Company is currently paying.

CRITICAL ACCOUNTING POLICIES

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates at a specific point in time that affect the amounts reported in the consolidated financial statements and disclosed in the accompanying notes. Note 1 to the consolidated financial statements describes the significant accounting policies and methods used in preparation of the consolidated financial statements. Estimates are used for, but not limited to, determining the net carrying value of trade accounts receivable, inventories, recording self-insurance liabilities and other accrued liabilities. Actual results could differ from these estimates. The following critical accounting policies are impacted significantly by judgments, assumptions and estimates used in the preparation of the consolidated financial statements.

LIFO Inventory Valuation and Methodology

Inventories are valued at the lower of cost or market, using the last-in, first-out (“LIFO”) method for U.S. inventories, and the average cost method for foreign inventories. We adopted the link chain dollar value LIFO method for accounting for U.S. inventories in fiscal 1974. Approximately one-third of our domestic inventory dollars relate to LIFO layers added in the 1970s. The excess of current cost over LIFO cost is $166.9 million as reflected in our consolidated balance sheet at June 30, 2009. The Company maintains five LIFO pools based on the following product groupings: bearings, power transmission products, rubber products, fluid power products and other products. LIFO layers and/or liquidations are determined consistently year-to-year in a manner which is in accordance with the guidance in the 1984 AICPA LIFO Issues Paper, “Identification and Discussion of Certain Financial Accounting and Reporting Issues Concerning LIFO Inventories.” See Note 3 to the consolidated financial statements for further information regarding inventories.

 

 

Allowances for Slow-Moving and
Obsolete Inventories

We evaluate the recoverability of our slow-moving or obsolete inventories at least quarterly. We estimate the recoverable cost of such inventory by product type while considering factors such as its age, historic and current demand trends, the physical condition of the inventory, as well as assumptions regarding future demand. Our ability to recover our cost for slow moving or obsolete inventory can be affected by such factors as general market conditions, future customer demand and relationships with suppliers. Most of the products we hold in inventory have long shelf lives, are not highly susceptible to obsolescence and are eligible for return under various supplier return programs.

Allowances for Doubtful Accounts

We evaluate the collectibility of trade accounts receivable based on a combination of factors. Initially, we estimate an allowance for doubtful accounts as a percentage of net sales based on historical bad debt experience. This initial estimate is adjusted based on recent trends of certain customers and industries estimated to be a greater credit risk, trends within the entire customer pool and changes in the overall aging of accounts receivable. While we have a large customer base that is geographically dispersed, a general economic downturn in any of the industry segments in which we operate could result in higher than expected defaults, and therefore, the need to revise estimates for bad debts.

Reflecting the current economic slowdown, as of June 30, 2009 and 2008, our allowance for doubtful accounts was 3.1% and 2.4% of gross receivables, respectively. Our provision for losses on accounts receivable was $4.5 million and $2.6 million in fiscal 2009 and 2008, respectively.

Goodwill and Intangibles

Goodwill is recognized as the amount by which the cost of an acquired entity exceeds the net amount assigned to assets acquired and liabilities assumed. As part of purchase accounting, we also recognize acquired intangible assets such as customer relationships, vendor relationships, trade names, and non-competition agreements apart from goodwill. Intangibles are evaluated for impairment when changes in conditions indicate carrying value may not be recoverable. We evaluate goodwill for impairment at least annually. This evaluation requires significant judgment by management, including estimated future operating results, estimated future cash flows, the long-term rate of growth of our business, and determination of an appropriate discount rate. While we use available information to prepare the estimates and evaluations, actual results could differ significantly. For example, a worsening of economic conditions beyond those assumed in an impairment analysis could impact the estimates of future growth and result in an impairment charge in a future period. Any resulting impairment charge could be viewed as having a material adverse impact on our financial condition and results of operations.

During the fourth quarter of fiscal 2009, the Company performed an interim goodwill impairment test based on current and expected market conditions, including reduced operating results and a worsening economic outlook. As a result of this test, the Company determined that all of the goodwill associated with the Fluid Power Businesses segment was impaired as of June 30, 2009. Accordingly, the Company recognized an impairment charge of $36.6 million for goodwill in the fourth quarter of fiscal 2009, which decreased net income by $23.0 million and earnings per share by $0.54. In addition, the Company performed an impairment analysis of its intangible

assets and noted no further impairment. As of June 30, 2009, we had $63.1 million of goodwill remaining on our consolidated financial statements, all of which is related to the Service Center Based Distribution segment. We believe the fair value of this segment is well in excess of its carrying value.

Self-Insurance Liabilities

We maintain business insurance programs with significant self-insured retention covering workers’ compensation, business, automobile, general product liability and other claims. We accrue estimated losses using actuarial calculations, models and assumptions based on historical loss experience. We maintain a self-insured health benefits plan, which provides medical benefits to employees electing coverage. We maintain a reserve for all unpaid medical claims including those incurred but not reported based on historical experience and other assumptions. Although management believes that the estimated liabilities for self-insurance are adequate, the estimates described above may not be indicative of current and future losses. In addition, the actuarial calculations used to estimate self-insurance liabilities are based on numerous assumptions, some of which are subjective. We will continue to adjust our estimated liabilities for self-insurance, as deemed necessary, in the event that future loss experience differs from historical loss patterns.

Pension and Other Postemployment
Benefit Plans

The measurement of liabilities related to pension plans and other post-employment benefit plans is based on management’s assumptions related to future events including interest rates, return on pension plan assets, rate of compensation increases, and healthcare cost trend rates. We evaluate these assumptions and adjust them as necessary. Changes to these assumptions could result in a material change to the Company’s pension obligation causing a related increase or decrease in reported net operating results in the period of change in the estimate. A 1% decrease in the discount rate would result in an additional liability of $3.2 million and additional expense of $0.2 million. A 1% increase in the discount rate would result in a decrease in the liability of $2.8 million and a decrease in expense of $0.2 million. A 1% decrease in the salary scale would result in a decrease in the liability and expense of $1.4 million and $0.3 million, respectively. A 1% increase in the salary scale would increase the liability and expense by $1.5 million and $0.3 million, respectively. A 1% change in the return on assets is not material since most of the plans are non-qualified and unfunded.

In fiscal 2007, we adopted Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (“SFAS 158”). As a result of our adoption of SFAS 158 in fiscal 2007, we recorded a decrease in other non-current assets of $0.2 million, an increase in postemployment benefits of $7.7 million, and a decrease in accumulated other comprehensive income (loss) of $7.9 million.

Income Taxes

As of June 30, 2009, the Company had recognized $55.4 million of net deferred tax assets, including a $0.1 million valuation allowance. Management believes that sufficient income will be earned in the future to realize its deferred income tax assets, except for the minor amount for which a valuation allowance is recorded. The realization of these deferred tax assets can be impacted by changes to tax laws, statutory tax rates and future taxable income levels.

 

 

Effective July 1, 2007, the Company adopted FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48, which is an interpretation of SFAS No. 109, “Accounting for Income Taxes,” provides guidance on the manner in which tax positions taken or to be taken on tax returns should be reflected in an entity’s financial statements prior to their resolution with taxing authorities. In accordance with FIN 48, the Company recognized an immaterial cumulative effect adjustment decreasing its liability for unrecognized tax benefits, interest, and penalties and increasing the July 1, 2007 balance of retained earnings. See Note 8 to the consolidated financial statements for more information on income taxes.

NEW ACCOUNTING PRONOUNCEMENTS

In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” (“SFAS 141(R)”), which replaces SFAS 141. SFAS 141(R) requires most assets acquired and liabilities assumed in a business combination, contingent consideration, and certain acquired contingencies to be measured at their fair values as of the date of acquisition. SFAS 141(R) also requires that acquisition related costs and restructuring costs be recognized separately from the business combination. SFAS 141(R) is effective for the Company for business combinations entered into after July 1, 2009.

In December 2008, the FASB issued FASB Staff Position (“FSP”) FAS 132(R)-1 “Employers’ Disclosures about Postretirement Benefit Plan Assets,” which amends SFAS 132(R) “Employers’ Disclosures about Pensions and Other Postretirement Benefits.” FSP FAS 132(R)-1 requires additional detailed disclosures about employers’ plan assets, including employers’ investment strategies, major categories of plan assets, concentrations of risk within plan assets, and valuation techniques used to measure the fair value of plan assets. FSP FAS 132(R)-1 is effective for the Company in fiscal 2010.

In June 2009, the FASB issued SFAS No. 168, “The FASB Accounting Standards Codification™ and the Hierarchy of Generally Accepted Accounting Principles.” This standard replaces SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles,” and establishes only two levels of U.S. generally accepted accounting principles (“GAAP”), authoritative and non-authoritative. The FASB Accounting Standards Codification™ (the “Codification”) will become the source of authoritative, non-governmental GAAP, except for rules and interpretive releases of the Securities and Exchange Commission (“SEC”), which are sources of authoritative GAAP for SEC registrants. All other non-grandfathered, non-SEC accounting literature not included in the Codification will become non-authoritative. The Company will begin to use the new guidelines and numbering system prescribed by the Codification when referring to GAAP in the first quarter of fiscal 2010. As the Codification was not intended to change or alter existing GAAP, the Company does not believe it will have any impact on the consolidated financial statements.

OTHER MATTERS

We have made acquisitions of other distributors in two of the past three fiscal years. On August 29, 2008, Applied completed the acquisition of certain of the assets of FPR for a purchase price of $166.9 million. Also in fiscal 2009, we acquired an industrial distributor for $5.5 million. In fiscal 2008, we acquired two distributors of industrial and fluid power products based in Mexico for a combined purchase price of $28.7 million.

Results of operations of all of the above acquisitions, which have been accounted for as purchases, are included in the accompanying consolidated financial statements from their respective acquisition dates. Pro-forma

disclosures are included in Note 2 to the consolidated financial statements related to the FPR acquisition. The results of operations for the other acquisitions are not material for all years presented.

CAUTIONARY STATEMENT UNDER PRIVATE SECURITIES LITIGATION REFORM ACT

This Annual Report to Shareholders, including Management’s Discussion and Analysis, contains statements that are forward-looking based on management’s current expectations about the future. Forward-looking statements are often identified by qualifiers, such as “guidance,” “expect,” “expected,” “expectation,” “believe,” “plan,” “intend,” “will,” “should,” “could,” “anticipate,” “intention,” “estimated,” “would be,” and similar expressions. Similarly, descriptions of objectives, strategies, plans, or goals are also forward-looking statements. These statements may discuss, among other things, expected growth, future sales, future cash flows, future capital expenditures, future performance, and the anticipation and expectations of the Company and its management as to future occurrences and trends. The Company intends that the forward-looking statements be subject to the safe harbors established in the Private Securities Litigation Reform Act of 1995 and by the Securities and Exchange Commission in its rules, regulations and releases.

Readers are cautioned not to place undue reliance on any forward-looking statements. All forward-looking statements are based on current expectations regarding important risk factors, many of which are outside the Company’s control. Accordingly, actual results may differ materially from those expressed in the forward-looking statements, and the making of those statements should not be regarded as a representation by the Company or any other person that the results expressed in the statements will be achieved. In addition, the Company assumes no obligation publicly to update or revise any forward-looking statements, whether because of new information or events, or otherwise, except as may be required by law.

Important risk factors include, but are not limited to, the following: risks relating to the operations levels of our customers and the economic factors that affect them; the impact of current economic conditions on the collectibility of trade receivables; reduced demand for our products in targeted markets due to reasons including consolidation in customer industries and the transfer of manufacturing capacity to foreign countries; changes in customer preferences for products and services of the nature and brands sold by us; changes in customer procurement policies and practices; changes in the prices for products and services relative to the cost of providing them; loss of key supplier authorizations, lack of product availability, or changes in supplier distribution programs; competitive pressures; the cost of products and energy and other operating costs; disruption of our information systems; our ability to retain and attract qualified sales and customer service personnel; our ability to identify and complete acquisitions, integrate them effectively, and realize their anticipated benefits; disruption of operations at our headquarters or distribution centers; risks and uncertainties associated with our foreign operations, including more volatile economic conditions, political instability, cultural and legal differences, and currency exchange fluctuations; risks related to legal proceedings to which we are a party; the variability and timing of new business opportunities including acquisitions, alliances, customer relationships, and supplier authorizations; the incurrence of debt and contingent liabilities in connection with acquisitions; our ability to access capital markets as needed on reasonable terms; the potential for

 

 

goodwill and intangible asset impairment; changes in accounting policies and practices; organizational changes within the Company; the volatility of our stock price and the resulting impact on our consolidated financial statements; adverse regulation and legislation, including potential changes in tax regulations (i.e., utilization of LIFO inventory accounting method and taxation of foreign-sourced income); and the occurrence of extraordinary events (including prolonged labor disputes, natural events and acts of God, terrorist acts, fires, floods, and accidents). Other factors and unanticipated events could also adversely affect our business, financial condition or results of operations. We discuss certain of these matters more fully throughout our “Management’s Discussion and Analysis” as well as other of our filings with the Securities and Exchange Commission, including our Annual Report on Form 10-K for the year ended June 30, 2009.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company has evaluated its exposure to various market risk factors, including its primary market risk exposures through the effects of changes in exchange rates and changes in interest rates. We occasionally utilize derivative instruments as part of our overall financial risk management policy, but do not use derivative instruments for speculative or trading purposes. We utilize a sensitivity analysis to measure the potential impact on earnings based on a hypothetical 1% increase in interest rates and a 10% change in foreign currency rates. A summary of our primary market risk exposures follows.

Interest Rate Risk

The Company manages interest rate risk through the use of a combination of fixed rate long-term debt, variable rate borrowings under its committed revolving credit agreement and interest rate swaps. At June 30, 2009, the Company had $55.0 million outstanding in variable rate borrowings under its committed revolving credit agreement. In conjunction with this facility, on September 19, 2008, the Company entered into a two-year agreement for a $50.0 million interest rate swap to effectively convert a portion of this variable-rate debt to fixed-rate debt at a fixed rate of 3.33%. The impact of a 1% increase in the interest rate on the remaining $5.0 million of outstanding variable rate debt would be immaterial to interest expense. In the current borrowing environment, borrowings beyond the amounts available under the revolving credit agreement would carry interest rates higher than our current borrowing rates.

The Company also had $25.0 million of outstanding long-term debt at fixed interest rates at June 30, 2009, which is scheduled for repayment in November 2010.

Foreign Currency Rate Risk

The financial statements of foreign subsidiaries are translated into their U.S. dollar equivalents at end-of-period exchange rates for assets and liabilities, while income and expenses are translated at average monthly exchange rates. Translation gains and losses are included as components of accumulated other comprehensive (loss) income in consolidated shareholders’ equity. Transaction gains and losses arising from fluctuations in currency exchange rates on transactions denominated in currencies other than the functional currency are recognized in the consolidated statements of income as a component of other expense (income), net. Since we operate internationally and approximately 12.9% of our fiscal 2009 net sales were generated outside the Unites States, foreign currency exchange rates can impact our financial position, results of operations and competitive position.

The Company mitigates its foreign currency exposure from the Canadian dollar through the use of cross-currency swap agreements as well as foreign-currency denominated debt. Hedging of the U.S. dollar denominated debt, used to fund a substantial portion of the Company’s net investment in its Canadian operations, is accomplished through the use of cross-currency swaps. Any gain or loss on the hedging instrument offsets the gain or loss on the underlying debt. Translation exposures with regard to our Mexican businesses are not hedged.

In the twelve months ended June 30, 2009, we experienced foreign currency translation losses, totaling $13.0 million, net of tax, which were included in accumulated other comprehensive (loss) income. The Canadian and Mexican foreign exchange rates to the U.S. dollar dropped by approximately 10% and 22%, respectively, since the beginning of the fiscal year. A 10% strengthening from the levels at June 30, 2009 of the U.S. dollar relative to foreign currencies that affect the Company would have resulted in a $1.1 million decrease in net income for the year ended June 30, 2009. A 10% weakening from the levels at June 30, 2009 of the U.S. dollar would have resulted in a $0.6 million increase in net income for the year ended June 30, 2009.