Applied Industrial
Annual Report 2007

Plain-text annual report

APPLIED®. VALUE FOCUS. 2007 ANNUAL REPORT AP PL I ED®. VAL UE FO CU S. Applied Industrial Technologies is one of North America’s largest independent industrial distributors. We supply customers in virtually every segment of industry, as well as government organizations. We are a vital link between a full scope of suppliers’ products and capabilities and a broad range of customers’ needs. Applied works in close collaboration with our customers to understand their needs and processes. That’s where value creation lies. We use that knowledge to provide products and services when and where they are needed. We have taken the idea of customer service to new levels, believing that we must make ourselves a vital part of our customers’ success. By focusing on our Four Cornerstone strategies – Profitable Sales Growth, Margin Enhancement, Cost Control, and Asset Management – we are driving value for all our stakeholders – customers, suppliers, associates and shareholders. APP LIE D AT A GL ANCE Applied serves the Maintenance Repair Operations (MRO) and Original Equipment Manufacturing (OEM) markets with bearings, power transmission components, fluid power components and systems, industrial rubber products, linear components, tools, safety products, and general maintenance and mill supply products. We also provide customized mechanical, fabricated rubber and fluid power shop services, as well as services to meet storeroom management and maintenance training needs. Headquarters: Cleveland, Ohio, USA Operating Facilities: 445 in 48 U.S. states, 5 Canadian provinces, Puerto Rico and 6 Mexican states E-Commerce: www.applied.com Distribution Centers: 7 Stock Keeping Units (SKUs) Available to Customers: More than 3 million Customer Accounts: More than 156,000 Product Manufacturers: More than 2,000 Stock Ticker Symbol: AIT is listed on the New York Stock Exchange Employee Associates: 4,649 This report contains statements that are forward-looking, as that term is defined by the Securities and Exchange Commission in its rules, regulations and releases. Applied intends that such forward-looking statements be subject to the safe harbors created thereby. All forward-looking statements are based on current expectations regarding identified important on page 15 of this report and in our Annual Report on Form 10-K for the fiscal year ended June 30, 2007. Accordingly, actual results may differ materially from those expressed in the forward-looking statements, and the making of such statements should not be regarded as a representation by Applied or any other person that results expressed therein will be achieved. including factors, those risk 20 07 FI NANCIAL HIG HLIGHT S (In millions except per share amounts, shareholder and employment figures) Year Ended June 30, 2007 Net Sales Income Before Income Taxes Net Income Net Income Per Share Number of Shareholders at June 30* Average Common Shares Outstanding Cash Dividends Per Share Number of Employees at June 30 Return on Equity Cash Provided From Operations 2007 2006 2005 $ 2,014.1 $ 133.8 $ 86.0 $ 1.93 6,242 44.5 $ 0.48 4,649 19.9% $ 70.9 $ 1,900.8 $ 113.1 $ 72.3 $ 1.57 6,192 46.2 $ 1,717.1 $ 86.3 $ 55.3 $ 1.20 6,079 46.1 $ 0.40 $ 0.29 4,684 17.9% 4,441 15.1% $ 69.9 $ 81.0 * Includes employee shareholders in the Applied Industrial Technologies Retirement Savings Plan. HIGHLIGHTS FI SC AL YEAR 2007 BUSINES S/O PE RATIONA L HIGHL IGH TS GROWTH Applied Industrial Technologies achieved record sales in fiscal 2007, crossing the $2 billion mark for the first time. Applied’s net sales in fiscal 2007 increased 6%. Operating margin improved to 6.7%, while operating income improved 16.8%. Selling, Distribution and Administrative expenses decreased to 20.5% of sales, representing a 0.5% improvement from last year. STOCK REPURCHASES AND DIVIDENDS During fiscal 2007, Applied purchased 1,401,000 shares of the company’s common stock on the open market. In April, the Board authorized the purchase of up to 1,500,000 additional shares, representing approximately 3% of the shares outstanding. Quarterly dividends for fiscal 2007 totaled $21 million. In July 2007, the Board increased the regular quarterly dividend to $0.15 per share, a 25% increase over the previous quarterly dividend. The company has raised the dividend 181% over the last three years. HONORS Applied received the 2007 Large Business Contractor of the Year award from the General Services Administration (GSA) in recognition of the Company’s growth, value to the federal marketplace and contribution to the GSA Multiple Award Schedule Program. Applied placed 26th on CMP Technology’s 2006 InformationWeek 500 for the innovative use of information technology. The Company has been featured annually on the listing since 2000 and within the top 100 three times. Applied regularly receives supplier and customer awards of excellence, and fiscal 2007 was another exceptional year. For example, we received the 2006 Gold Alliance Supplier Award from Vulcan Materials Company, which was presented in recognition of product quality, service, support, and value. Applied was named to the Forbes magazine Platinum 400 list of the Best Big Companies in America for the fourth consecutive year. The Company ranked 73rd based on metrics such as a five-year compounded annual growth rate of 31% in shareholder return, as computed by Forbes. SUPPLIER AGREEMENTS Fiscal 2007 included a new supplier agreement with Wire Belt Company of America and full authorization by Sumitomo at all U.S. locations. Applied formally launched the Rust-Oleum and 3M product lines, and continued a rollout of Parker Hannifin (pneumatics). SERVICE Applied opened a new Canadian headquarters facility in Saskatoon, Saskatchewan to support continued growth in sales. At fiscal year-end, Applied launched a new 1,100-page master catalog featuring nearly 40,000 parts from more than 100 suppliers. This landmark book is the first Applied-branded catalog to feature comprehensive product lines from bearings and power transmission to fluid power and specialty MRO items. The catalog also includes a 42-page technical section as value-added support to customers. TECHNOLOGY Applied enhanced its point-of-sale system, making the ordering process quicker and easier for Company associates and, in turn, serving to better satisfy day-to-day customer needs. Applied Industrial Technologies, Inc. and Subsidiaries 1 LET TER TO OUR SHAREHOLDERS Bill L. Purser, David L. Pugh Dear Shareholder: Our focus on value led Applied Industrial Technologies to a fifth consecutive year of improved financial results in fiscal 2007. These record results included crossing the $2 billion sales threshold for the first time, as well as achieving record earnings and significantly improved operating margin. Net sales in fiscal 2007 rose 6% to $2,014,109,000 as Applied’s business benefited from continued growth in the North American industrial economy. While the economy did not grow as fast as it did last year, our performance strategies helped us get the most out of our selling efforts. Most notably, our operating margin improved to 6.7% from last year’s 6.1%, while our overall operating income improved 16.8%. The continued improvement in operating margin has been driven by company-wide efforts to enhance our productivity, improve gross profit margins, and contain expenses. Selling, Distribution and Administrative expenses were 20.5% of sales, an improvement of 0.5% over last year and an indication that we continue to improve productivity by holding increases in expenses to a lower rate than our growth in sales. Our balance sheet remains healthy. Our cash balance of $120 million at year-end exceeds our outstanding long-term debt for the third consecutive year. This positions us well to continue to invest in the growth of the business and to return value to shareholders in the form of dividends and stock repurchases. Reflecting that strength, we raised our quarterly dividend rate 25% in July of 2007. Strategies Focused on Value Our Four Cornerstones, Applied’s operational strategies, helped us generate superior results while supporting our stated business strategy – to grow profitability in North America within our current product domain. Our focus on Profitable Sales Growth, Margin Enhancement, Cost Control, and Asset Management, drives our continuous improvement and makes us more efficient and more effective. They have guided our efforts now for six years, and we believe they will help us continue to grow our sales and further improve our operating margin, to deliver increased value to our shareholders. Applied’s expansion into Mexico and Canada has continued to benefit the corporation. Sales grew 8.7% at our Canadian facilities and 17.6% at our Mexican 2 Applied Industrial Technologies, Inc. and Subsidiaries facilities. We opened a new Canadian headquarters facility in Saskatoon mid-year to support our growing business and help us extend the Applied brand to new geographic regions. Another major strategy for 2007 was the expansion of our government sales. Now in year two of a five-year plan, we increased our sales by 80% in 2007 and are investing for additional growth over the next three years. We received several awards from the GSA this year, including recognition as their Large Business Contractor of the Year for 2007. During the year we converted our Applied.com e-commerce site to an “open” Browse and Buy design. This design will allow potential customers to easily access nearly 500,000 of our parts on the Internet and purchase using a credit card. At year-end we issued a new 1,100-page Applied-branded catalog that provides information on nearly 40,000 parts from more than 100 suppliers. Both our catalog and our open Web site are efforts to expand our market reach and find new customers. Actions to Grow Shareholder Value During fiscal 2007, Applied repurchased 1,401,000 shares of its common stock for $34 million. In April, the Board approved a new authorization to purchase up to 1,500,000 additional shares representing approximately 3% of the shares outstanding. These purchases can be made in open market and negotiated transactions, from time-to-time depending upon market conditions. During the past five years, Applied has repurchased more than 5,847,000 shares. Shareholders also benefited from payment of dividends during the year, which totaled $21 million. The quarterly rate of $0.12 was increased 25% to $0.15 in July of 2007. Over the last three years, Applied has raised its dividend 181% reflecting the improved profitability of our business and keeping with our strategy to return value to our shareholders. Succession in Place In January of 2007, we announced Bill Purser’s chosen retirement date of December 31, 2007. Bill has been our President since October of 2000 and has more than 40 years of experience in our business. His deep knowledge and superb leadership style helped us grow and succeed over the last seven years, and he will be personally and professionally missed. Picking a strong, knowledgeable successor was a critical need for the Company, and we worked on it for two years, closely involving our Board of Directors in the process. Our selection of Benjamin J. Mondics, age 49, was made with careful consideration and analysis. He was elected to the position of Executive Vice President and Chief Operating Officer and will succeed Bill as President at calendar year-end. Ben’s sales experience, industry knowledge and performance in running our Midwest Area made him a great choice and will ensure continuity of leadership. Throughout 2007 there has been close collaboration, mentoring and strategic planning to provide a smooth transition as the reins are handed over. Benjamin J. Mondics Creating More Value We believe fiscal 2008 should bring continued success in our strategies to create value. The Four Cornerstones will help us generate increased productivity and profitability, and North American economic conditions should continue to support profitable sales growth. We believe increased earnings leverage and additional shareholder value will ensue. In summary, we achieved substantial progress during 2007, our 84th year in business, thanks to the hard work and dedication of our more than 4,600 employee-associates. We thank our loyal customers and suppliers for their support in the past year, as well as our shareholders and Board of Directors. We look forward to another strong year in fiscal 2008. David L. Pugh Chairman & Chief Executive Offi cer Bill L. Purser President August 17, 2007 Applied Industrial Technologies, Inc. and Subsidiaries 3 value focus.x excellence is in the details. Value – it signifies worth, importance and achievement of excellence. It’s the ability to look more closely at every aspect of business and make the most of it – no matter how small. At Applied, our value focus lies in the ability to concentrate on individual market needs, single relationships, best practices and unique solutions that create customer success. That focus has been the driver for record-breaking growth and recognition for excellence. That well-honed ability to see things differently – more clearly focused on delivering value – prepares us to face new challenges, new markets and new potential. But that’s just the beginning, because the Applied value focus is built around our Four Cornerstones strategy. Applied’s value focus on Profitable Sales Growth is aimed at seeking new opportunities to grow and diversify within our current product and geographical areas. Our emphasis is on profit – not simply growth for growth’s sake. The difference is in our approach. profitable sales growth. the cornerstone of potential. We work to understand the critical influences for our customers and bring them value they can’t get anywhere else. We invest the time to visit plants, study new technologies and present new programs. Currently, the rise in energy costs has opened opportunities in energy efficiency solutions. Armed with targeted information, we seek to create value that overcomes, outperforms, and outlasts the competition. We continue to invest in Web-based transaction capabilities that offer convenience and speed. In 2007, we instituted a Browse and Buy feature on our Web site where visitors can rapidly search and securely order nearly 500,000 parts, 24 hours a day, 7 days a week. The new capabilities provide the opportunity for increased sales, while self-service technology improves efficiencies. Our push into new markets is built on a different value focus – knowledge, combined with an acceptable amount of risk. Applied invests the resources needed to understand every aspect of a new business. That experience helps define the right product mix and business tools to yield successful results. Two years ago, this focus launched us into the government service market. Our recognition by the GSA as the 2007 Large Business Contractor of the Year is proof that our investment is paying off, and we will continue looking for those business segments that we consider to be non- cyclical, persistent product businesses. 4 Applied Industrial Technologies, Inc. and Subsidiaries margin enhancement. the cornerstone of leadership. Applied’s value focus is dedicated to constant, incremental Margin Enhancement – a goal that remains always on the horizon, to be reached by employees looking closely at every factor, every day. We expect smart, focused decisions, and it starts with good purchasing procedures and disciplined pricing practices. Over the last four years, we have improved our gross profit by nearly two percentage points. But our value focus requires more. We continue to work hard to understand what matters to customers, deliver what counts and eliminate what doesn’t. We seek payment that is commensurate with the needed products, service and expertise we provide. It’s managing the Four Cornerstones at the customer level, and it’s what sets us apart. Through productivity analysis that offers robust data, tracks various metrics and identifies improvement opportunities, our field management can more efficiently and effectively monitor all factors that impact the profitability of a customer. Individual accountability is ingrained in each associate, and we continue to provide the necessary training that fosters continuous improvement in key business metrics. Applied Industrial Technologies, Inc. and Subsidiaries 5 value viewpoint. what makes us focused, makes us better. At Applied, we take great care in making sure that each Cornerstone is properly managed and in perfect balance. From a value viewpoint, the more we know, the more prosperity we can realize. For our customers, that means going beyond solving problems, beyond just finding solutions to offer the best products, the best expertise and the best support. Maintaining that value focus – steeped in the fundamentals of our business – will take us to new heights and lead us to opportunities for further improvements. We will do this one day at a time, one customer at a time. The focus on value at Applied includes an intensive oversight of Cost Control. Each opportunity to realize savings helps to enhance shareholder returns, support new training, supplement system efficiencies, and finance acquisitions and entry into new markets. cost control. the cornerstone of opportunity. At the core is a mindset bent on operating excellence. Practicing Cost Control diligently in every action, in every task; eliminating errors, exceptions and rework. Developing purchasing efficiencies that enhance buying strength and reduce inventory management costs. These are requirements that must constantly be monitored and controlled. Improved customer relationships often result, which can pay enormous dividends in customer loyalty, retention and profitability to Applied. To further support our Cost Control opportunities, we analyze the productivity metrics that drive success. Through constant measurement of sales per associate and gross profit per associate, we’re better able to manage our resources while continuing to increase sales. Objectives are quantified. Performance is monitored and managed. Opportunities are realized. 6 Applied Industrial Technologies, Inc. and Subsidiaries asset management. the cornerstone of strength. Applied’s value focus on Asset Management assures we get the most from every element of the organization. We strive for effective and efficient management of traditional measures – inventory, receivables, facilities, property and equipment. We desire highly-performing assets that support customer needs and shared expectations. By listening to our customers, we align our assets with their needs for mutual success. Yet, it’s our intellectual capital that sets us apart. Our knowledge and expertise are the very assets that position us ahead of our competitors – our customer satisfaction surveys tell us so. That’s why we’ve invested in development tools, and particularly electronic learning. Every day, throughout the organization, our associates gain more management training, business tools and product knowledge to deliver more value in every decision and interaction. In the past year, nearly 150,000 electronic learning hours have been logged by more than 3,800 associates. By preparing our associates to make smarter decisions, improvements are not only attainable, they’re surpassable. Applied Industrial Technologies, Inc. and Subsidiaries 7 focus on shareholder value A $100 investment in Applied shares on July 1, 2002 was worth $376 on June 30, 2007. That remarkable 276% improvement amply demonstrates our focus on creating value for our shareholders. How did we get there? By first creating value for our customers, and then working smart to generate shareholder value from that base. Our Four Cornerstone strategies have helped us produce continuous and notable improvement in our operating margin, growing it from 2.1% in fiscal 2002, to 6.7% in fiscal 2007. Quite simply, we are converting more profit from a given dollar of sales today than we have in the past. We are running our business better for the benefit of our owners, and our share price has responded in kind. COMPARISON OF CUMULATIVE TOTAL RETURN Performance Results from 7/1/02 through 6/30/07 Applied Industrial Technologies, Inc. Standard & Poor's 500 Peer Group $400.00 $350.00 $300.00 $250.00 $200.00 $150.00 $100.00 $50.00 $0.00 2002 2003 2004 2005 2006 2007 Assumes $100 invested at the close of trading 6/30/02 in Applied Industrial Technologies, Inc. common stock. Cumulative total return assumes reinvestment of dividends. The returns of the companies in the peer group are weighted based on the companies’ relative stock market capitalization. Applied Industrial Technologies, Inc. Standard & Poor’s 500 Peer Group Source: Value Line, Inc. 2002 $100.00 100.00 100.00 2003 $111.24 98.45 93.19 2004 $162.02 115.26 129.95 2005 $265.01 120.36 135.47 2006 $304.08 128.33 180.88 2007 $376.11 151.88 214.66 Peer group companies selected on a line-of-business basis include: Airgas, Inc., Genuine Parts Company, W.W. Grainger, Inc., Kaman Corporation, Lawson Products, Inc., MSC Industrial Direct Co., Inc., The Timken Company, and WESCO International, Inc. 8 Applied Industrial Technologies, Inc. and Subsidiaries  We continue to return profit to our shareholders through our dividends, raising our quarterly rate five times in the past three years. Most recently we raised our quarterly dividend to 15 cents, up from a split-adjusted 5.3 cents – a 181% increase. We have also repurchased shares when appropriate to support those who invest in our company. Speaking of investors – our officers, directors and 401(k) plan collectively own 12.5% of Applied stock, so we share in the risk and the rewards. We invest in our Company, as you do, because we believe in Applied’s future. Applied Industrial Technologies, Inc. and Subsidiaries 9 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW With more than 4,600 associates across North America, Applied Industrial Technologies (“Applied,” the “Company,” “We” or “Our”) is an industrial distributor that offers parts critical to the operations of MRO and OEM customers in virtually every industry. In addition, Applied provides customized mechanical, fabricated rubber and fluid power shop services, as well as storeroom management and maintenance training. We have a long tradition of growth dating back to 1923, the year our business was founded in Cleveland, Ohio. During fiscal 2007, business was conducted in the United States, Canada, Mexico and Puerto Rico from 445 facilities. Our fiscal 2007 sales hit a record two billion dollars on an increase of 6.0% compared to prior year. Our operating income and earnings per share increased 16.8% and 22.9%, respectively, compared to the prior year. Significant factors that contributed to these increases included the growth and improved profitability of the service center based distribution business, and the impact of acquired businesses. Gross margin improved 20 basis points to 27.2% due to higher levels of supplier purchasing incentives and lower net freight costs. In addition, the rate of growth in selling, distribution and administrative expense for fiscal 2007 was held below the rate of increase in sales. Our consolidated balance sheet remains strong as shown by the increase in shareholders’ equity from the June 30, 2006 level. Cash provided from operations was $70.9 million, holding steady with fiscal 2006’s $69.9 million. The Company has two credit/financing agreements available for a total of up to $250 million of additional borrowing to fund future acquisitions or other capital and operating requirements. Receivables and inventory increased as a result of our sales increase and anticipated future demand for our products. Working capital was only $4 million below 2006’s level even considering the classification of $50 million of long-term debt to current liabilities as it is due in December 2007. Continued management of our inventory, receivable and payable balances aided the stability of our working capital. Applied monitors the Purchasing Managers Index (PMI) published by the Institute for Supply Management and the Manufacturers Capacity Utilization (MCU) index published by the Federal Reserve Board and considers these indices key indicators of potential Company business environment changes. Both the PMI and the MCU continued to show a stable economy through the second half of fiscal 2007. Our sales activity traditionally lags these key indicators by approximately six months. Given the trend of these indicators, we expect sales improvements to continue into fiscal 2008. We are forecasting our sales in fiscal 2008 to increase in the 5% to 8% range and our gross profit percentage to be consistent with fiscal 2007 levels. In fiscal 2008, the gross profit margin will be highly dependent on our ability to manage and recover supplier price increases. We anticipate that fiscal 2008 supplier purchasing incentives will be consistent with the fiscal 2007 levels. While we consider these purchasing incentives to be compensation for various sales, marketing and logistics services performed, when they are recognized in our income statement, they are accounted for as a reduction of cost of sales as required by the Financial Accounting Standards Board (“FASB”) rules. Our overall growth in selling, distribution and administrative expenses most likely will exceed our goal of one half the rate of sales growth due to continued investments in initiatives that are expected to build profitable future growth. YEAR ENDED JUNE 30, 2007 VS. 2006 Net sales in fiscal 2007 were $2.0 billion or 6.0% above the prior year sales. This increase was primarily due to the 4.7% improvement in our service center based distribution sales and the impact of our acquisitions. The increase in service center based distribution sales was driven by sales mix, volume, the recovery of supplier price increases, the strengthening of the Canadian currency and sales generated by acquired businesses. The majority of the increase in sales at our fluid power businesses was attributable to businesses acquired in fiscal 2006 which were only included for a portion of that year. There was one less sales day in fiscal 2007 compared to fiscal 2006. The sales product mix for fiscal 2007 was 80.2% industrial products and 19.8% fluid power products compared to 81.8% industrial and 18.2% fluid power in the prior year. Business acquisitions accounted for most of the shift in sales product mix. At June 30, 2007, we had a total of 445 operating facilities in the U.S., Canada and Mexico versus 452 at June 30, 2006. Industrial production in the United States slowed somewhat in the first half of our fiscal year and increased slightly in the second half. There is improvement among manufacturing customers as reflected in the PMI and MCU indices. We would anticipate our positive financial results to continue if current economic trends continue. Gross profit margin increased to 27.2% during fiscal 2007 from 27.0% during fiscal 2006. The increase in gross profit margin during fiscal 2007 primarily reflects higher levels of supplier purchasing incentives. LIFO inventory layer liquidations resulted in a $1.6 million positive impact during fiscal 2006. Selling, distribution and administrative expense (“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 increased 3.7% during fiscal 2007 compared to the prior year, but decreased as a percent of sales to 20.5% from 21.0% in 2006. Approximately half of the fiscal 2007 increase was attributable to businesses acquired. The remainder of the increase was primarily due to increases in associate compensation tied to improved financial performance. Operating income increased 16.8% to $135.0 million during fiscal 2007 from $115.6 million during 2006. As a percent of sales, operating income increased to 6.7% in fiscal 2007 from 6.1% in 2006. The $19.4 million increase in operating income during fiscal 2007 was primarily due to the increase in gross profit generated by the service center based distribution business, reflecting higher sales and supplier purchasing incentives, as well as control of SD&A expenses and the impact of acquired businesses. Interest expense-net decreased by 26.5% or $0.9 million during fiscal 2007 compared with the prior year, primarily due to an increase in interest income associated with higher average balances of temporary investments and higher interest rates. Other income, net, represents certain non-operating items of income and expense. This line increased $0.5 million due primarily to appreciation in investments held by deferred compensation trusts. Income tax expense as a percentage of income before taxes was 35.7% for fiscal 2007 and 36.1% for 2006. The decrease in the effective tax rate was due 10 Applied Industrial Technologies, Inc. and Subsidiaries to higher levels of non-taxable interest income in the current year. We expect our overall tax rate for fiscal 2008 to rise to around 36.5%, primarily due to recent U.S. tax law changes which have eliminated certain deductions related to foreign sourced income. Net income for fiscal 2007 increased $13.7 million or 19.0% from the prior year, reflecting the increases in sales and margins. Net income per share increased 22.9% to $1.93 in fiscal 2007 from $1.57 in 2006. During fiscal 2007, we repurchased 1.4 million shares as part of our stock buyback program which resulted in fewer shares outstanding for the year compared to the prior year. The number of Company associates was 4,649 at June 30, 2007 and 4,684 at June 30, 2006. YEAR ENDED JUNE 30, 2006 VS. 2005 Net sales in fiscal 2006 were $1.9 billion or 10.7% above the prior year sales. This increase was primarily due to the 7.7% improvement in our service center based distribution sales and the impact of our acquisitions. The increase in service center based distribution sales was driven by sales mix, volume, recovery of supplier price increases, strengthening of the Canadian currency and sales generated by acquired businesses. The majority of the increase in sales at our fluid power businesses was attributable to the sales generated by businesses acquired during the year. The remainder of the increase reflects sales mix, pricing and volume and the impact of the strengthening of the Canadian currency. The number of sales days was the same in both annual periods. The sales product mix for fiscal 2006 was 81.8% industrial products and 18.2% fluid power products compared to 84.0% industrial and 16.0% fluid power in the prior year. Business acquisitions accounted for most of the shift in sales product mix. At June 30, 2006, we had a total of 452 operating facilities in the U.S., Canada and Mexico versus 440 at June 30, 2005. The net increase of 12 facilities was primarily due to the acquisition of two businesses during fiscal 2006. Gross profit margin increased to 27.0% during fiscal 2006 from 26.5% during 2005. The increase in gross profit margin during fiscal 2006 primarily reflected improved customer pricing, lower net freight costs and higher levels of supplier purchasing incentives. The increase in supplier purchasing incentives reflected the recording of certain supplier purchasing incentives during the first quarter of fiscal 2006 related to inventory purchases made in the prior year. The criteria under U.S. generally accepted accounting principles necessary to permit us to record these supplier purchasing incentives were not met until that time. The gross profit margin was also positively impacted by LIFO inventory layer liquidations during fiscal 2006, which increased gross profit by $1.6 million. There were no LIFO layer liquidations during fiscal 2005. Selling, distribution and administrative expense (“SD&A”) increased 8.6% during fiscal 2006 compared to the prior year, but decreased as a percent of sales to 21.0% from 21.4% in 2005. Approximately 40% of the fiscal 2006 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 31.4% to $115.6 million during fiscal 2006 from $88.0 million during 2005. As a percent of sales, operating income increased to 6.1% in fiscal 2006 from 5.1% in 2005. The $27.6 million increase in operating income during fiscal 2006 was primarily due to the increase in gross profit generated by the service center based distribution business, reflecting the improved gross profit margin noted above on higher sales levels. Operating income was also positively impacted by the acquisition of two businesses during fiscal 2006. These increases in operating income were only partially offset by the increase in SD&A noted above. Interest expense-net decreased by 32.1% or $1.5 million during fiscal 2006 compared with the prior year, primarily due to an increase in interest income associated with higher average balances of temporary investments and higher interest rates. Other income, net, represented certain non-operating items of income and expense. The decrease in other income, net in fiscal 2006 was due to $2.9 million of life insurance settlements received during 2005 which did not recur in 2006. Income tax expense as a percentage of income before taxes was 36.1% for fiscal 2006 and 35.9% for 2005. The increase in the effective income tax rate primarily reflected the benefit of tax-free life insurance proceeds recorded during fiscal 2005 that did not recur during fiscal 2006, partially offset by lower state and local income tax rates during fiscal 2006. Net income for fiscal 2006 increased $17.0 million or 30.6% from the prior year, reflecting the increases in sales and margins. Net income per share increased 30.8% to $1.57 in fiscal 2006 from $1.20 in 2005. Effective July 1, 2005, we closed our Denver distribution center. This was our smallest distribution center and the least efficient from a cost standpoint. We transferred a portion of the inventory to the area service centers to provide additional local inventory resources and availability for emergency shipment needs. The remainder of the inventory was transferred to our distribution centers in Texas, California and Oregon that now service the area previously serviced out of Denver. The number of Company associates was 4,684 at June 30, 2006 and 4,441 at June 30, 2005. This increase was primarily due to business acquisitions. LIQUIDITY AND CAPITAL RESOURCES 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 $70.9 million of cash from operating activities during fiscal 2007, $69.9 million during 2006, and $81.0 million during 2005. Cash provided from operations in fiscal 2007 benefited from our strong operating results. The operating cash flow increase was partially offset by higher receivables and inventory balances. Inventory balances did however rise at a lower level than sales. Prior year acquisitions were integrated allowing us to more efficiently manage our investment in inventory. 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. In fiscal 2007, we changed Applied Industrial Technologies, Inc. and Subsidiaries 11 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Continued The following table shows the Company’s approximate obligations and commitments to make future payments under contractual obligations as of June 30, 2007 (in thousands): Operating leases Interest payments on debt Planned funding of postretirement obligations Long-term debt Total Contractual Cash Obligations Period Less Than 1 yr. Period Period 4-5 yrs. over 5 yrs. 1-3 yrs. $ 65,400 $ 19,200 $ 24,200 $ 11,600 $ 10,400 Period Total 8,700 3,700 4,000 1,000 40,500 4,700 5,600 8,800 21,400 75,000 50,000 25,000 $189,600 $ 77,600 $ 33,800 $ 46,400 $ 31,800 Purchase orders for inventory and other goods and services are not included in our estimates, as purchase orders generally represent authorizations to buy rather than binding agreements. The Board of Directors has authorized the repurchase of shares of the Company’s common stock, at the Company’s discretion. These purchases may be made in open market and negotiated transactions, from time-to-time, depending upon market conditions. At June 30, 2007, we had authorization to purchase an additional 1,500,000 shares. Capital resources are obtained from income retained in the business, borrowings under the Company’s long-term debt facilities, and from operating lease arrangements. Additionally, we have revolving credit agreements available for borrowings as required. See Note 5 to the consolidated financial statements for details regarding the outstanding debt amounts as of June 30, 2007 and 2006. The average borrowings totaled $75.0 million during fiscal 2007 and 2006. In fiscal 2007, we classified $50.0 million of debt that matures in December 2007 as current as we plan to pay it off with cash at maturity. One-third of the Company’s outstanding 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 is affected by changes in the exchange rates of U.S. and Canadian dollars (see Note 6 to the consolidated financial statements). The weighted average interest rate on borrowings under our debt agreements, net of the benefits from interest rate swaps, was 6.8%, 6.7% and 6.5% in fiscal 2007, 2006 and 2005, respectively. The increase in the weighted average interest rate reflects the impact of the strengthening of the Canadian dollar during fiscal 2007 and 2006. We terminated our interest rate swap agreements for favorable settlements in prior years. The settlement gains are being amortized as a reduction in interest expense of $0.8 million per year over the remaining life of the notes through December 2007. how we fund our contributions to the Retirement Savings Plan. We now contribute cash (which is then used by the administrator to purchase Company stock in the open market) whereas previously we satisfied our obligation by contributing treasury shares. This reduced operating cash flow in fiscal 2007 by approximately $6.0 million. Cash used by investing activities was $10.2 million during fiscal 2007, $37.9 million during 2006 and $12.5 million during 2005. Cash was primarily used for capital expenditures in fiscal 2007, whereas 2006 and 2005 also included acquisitions. In fiscal 2006 we acquired two U.S. distributors for $27.7 million, net of cash acquired, and in fiscal 2005 we acquired one Canadian distributor for $5.9 million, net of cash acquired. Capital expenditures consisted primarily of computers and information technology equipment, and buildings and improvements. For fiscal 2008, our capital expenditures are expected to be in the $8 million to $10 million range, consisting primarily of additional computers, information system technology and infrastructure investments. Depreciation for fiscal 2008 is expected to be in the range of $12.5 million to $13.5 million. Cash used in financing activities was $48.4 million during fiscal 2007, $53.8 million during 2006 and $11.7 million during 2005. The reduction in cash used in financing activities represents fewer shares repurchased in fiscal 2007 versus fiscal 2006 (reduction of $20.8 million or 1 million shares). Offsetting this are the excess tax benefits from share-based compensation which dropped $12.5 million compared to prior year on lower exercises of stock options. Finally, the full year impact of the fiscal 2006 dividend rate increases accounted for an additional $3.0 million use of cash versus fiscal 2006. Over the last three fiscal years, we repurchased 1.4 million, 2.4 million and 0.9 million shares of the Company’s common stock at an average price per share of $24.26, $23.05 and $16.04, respectively. During fiscal year 2007, we paid a quarterly dividend of $.12 per share. In July 2007, the Board declared a quarterly dividend payable on August 31, 2007 to shareholders of record on August 15, 2007 of $.15 per share. This represents an increase of 25% over the previous regular quarterly cash dividend. The amount of the dividend paid is recommended quarterly by management and approved by our Board of Directors based on judgment, financial performance and cash flow and payout guidelines consistent with other industrial companies. 12 Applied Industrial Technologies, Inc. and Subsidiaries  We manage interest rate risk through the use of a combination of fixed rate long-term debt, variable rate borrowings under committed revolving credit agreement and interest rate swaps. At June 30, 2007, we had no variable rate debt or interest rate swaps outstanding. See Note 6 to the consolidated financial statements “Risk Management Activities” for additional discussion on our derivative activities. The Company’s working capital at June 30, 2007 was $365.5 million compared to $370.0 million at June 30, 2006. The current ratio was 2.6 at June 30, 2007 and 3.0 at June 30, 2006. The decrease in working capital at June 30, 2007 was primarily due to the increase in long-term debt payable within one year associated with the debt that matures in December 2007. The Company amended its five-year committed revolving credit agreement which now expires in June 2012. This agreement provides for unsecured borrowings of up to $150.0 million. We had no borrowings outstanding under this facility at June 30, 2007. Unused lines under this facility, net of outstanding letters of credit, totaling $144.7 million are available to fund future acquisitions or other capital and operating requirements. We also have an uncommitted long- term financing shelf facility which was renewed in fiscal 2007, and now expires in March 2010, that 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, 2007. The aggregate annual maturities of outstanding debt are $50.0 million in fiscal 2008 and $25.0 million in fiscal 2011. Management expects that cash provided from operations, available credit facilities and the use of operating leases will be sufficient to finance normal working capital needs, 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. 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, supplier purchasing incentives receivable, goodwill, other long-lived assets, 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 U.S. inventories are valued at the lower of cost or market, using the last-in, first- out (“LIFO”) method, and foreign inventories are valued using the average cost method. 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 $141.3 million as reflected on our consolidated balance sheet at June 30, 2007. 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. Supplier Purchasing Programs We enter into agreements with certain suppliers that provide for inventory purchase incentives. Although these agreements are unique to each supplier, they are generally annual programs that provide for purchase incentives to be earned upon achieving specified purchase volumes. These percentages can increase or decrease based on changes in the volume of purchases. We accrue for the receipt of these inventory purchase incentives based upon actual cumulative purchases of inventory and expected total purchases through the life of the program. Each supplier program is analyzed at least quarterly to determine the appropriateness of the amount estimated to be received. Differences between our estimates and actual incentives subsequently received have not been material. All benefits under these supplier purchasing programs are recognized under our LIFO inventory accounting method as a reduction of cost of sales when the inventories representing these purchases are recorded as cost of sales. Our accounting for inventory purchase incentives is in accordance with guidance issued by the FASB in EITF 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor.” While management believes we will continue to receive inventory purchase incentives, there can be no assurance that suppliers will continue to provide comparable amounts of incentives in the future. 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. Historically, most of our inventories have demonstrated long shelf lives, are not highly susceptible to obsolescence and are eligible for return under various supplier return programs. Applied Industrial Technologies, Inc. and Subsidiaries 13 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Continued 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 as a result of 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. Self-Insurance Liabilities We maintain business insurance programs with significant self-insured retention, which cover 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 under the plan. We maintain a reserve for all unpaid medical claims including those incurred but not reported based on historical experience and other assumptions. The Company utilizes independent actuarial firms and other specialists to assist in determining the adequacy of all self-insurance liability reserves. 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. liabilities related Pension and Other Postemployment Benefit Plans The measurement of to pension plans and other postemployment 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. In 2007, we adopted the recognition and disclosure provisions of 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, 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, 2007, the Company had recognized $30.9 million of net deferred tax assets. Management believes that sufficient income will be earned in the future to realize its deferred income tax assets. The realization of these deferred tax assets can be impacted by changes to tax laws, statutory tax rates and future taxable income levels. NEW ACCOUNTING PRONOUNCEMENTS In June 2006, the FASB issued 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. The Company is required to adopt FIN 48 during the first quarter of fiscal 2008. The Company is currently evaluating the requirements of FIN 48 and has not yet determined the impact, if any, this interpretation will have on its consolidated financial statements. In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). This statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. The provisions of SFAS 157 apply under other accounting pronouncements that require or permit fair value measurements. We are required to adopt SFAS 157 effective for our fiscal year 2009. The impact on our consolidated financial statements has not been determined. In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). This statement permits companies to measure many financial instruments and certain other items at fair value. We are required to adopt SFAS 159 effective for our fiscal year 2009. The impact on our consolidated financial statements has not been determined. OTHER MATTERS In two of the past three fiscal years, we have acquired distributors thereby extending our business over a broader geographic area. In fiscal 2006, we acquired two U.S. based distributors of industrial and fluid power products for a combined purchase price of $28.6 million. In fiscal 2005, we acquired a Canadian distributor of industrial products for a purchase price of $6.6 million. Results of operations of all of the above acquisitions, which have all been accounted for as purchases, are included in the accompanying consolidated financial statements from their respective acquisition dates. The results of operations for these acquisitions are not material for all years presented. 14 Applied Industrial Technologies, Inc. and Subsidiaries within the Company; the volatility of our stock price and the resulting impact on our financial statements; adverse regulation and legislation; 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 above in “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, 2007. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company has evaluated its exposure to various market risk factors, including but not limited to, interest rate, foreign currency exchange and commodity price risks. The Company is primarily affected by market risk exposure through the effect of changes in interest rates and, to a lesser extent, through the change in exchange rates. 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. The Company had no variable rate borrowings under its committed revolving credit agreement and no interest rate swap agreements outstanding at June 30, 2007. All the Company’s outstanding debt is currently at fixed interest rates at June 30, 2007 and scheduled for repayment in December 2007 and beyond. 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 business are not hedged, as our Mexican activity is not material. For the year ended June 30, 2007, a uniform 10% strengthening of the U.S. dollar relative to foreign currencies that affect the Company would have resulted in a $1.0 million decrease in net income. A uniform 10% weakening of the U.S. dollar would have resulted in a $1.0 million increase in net income. 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 “expect,” “believe,” “plan,” “intend,” “will,” “should,” “could,” “anticipate,” “forecast” 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 such 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; 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; changes in accounting policies and practices; organizational changes Applied Industrial Technologies, Inc. and Subsidiaries 15 STATEMENTS OF CONSOLIDATED INCOME (In thousands, except per share amounts) Year Ended June 30, Net Sales Cost of Sales Selling, Distribution and Administrative, including depreciation Operating Income Interest Expense Interest Income Other Income, net Income Before Income Taxes Income Tax Expense Net Income Net Income Per Share – Basic Net Income Per Share – Diluted See notes to consolidated financial statements. 2007 $ 2,014,109 1,466,057 548,052 413,041 135,011 5,798 (3,438) (1,179) 1,181 133,830 47,808 $ 86,022 $ 1.97 $ 1.93 2006 $ 1,900,780 1,386,895 513,885 398,293 115,592 5,523 (2,313) (717) 2,493 113,099 40,800 $ 72,299 $ 1.62 $ 1.57 2005 $ 1,717,055 1,262,206 454,849 366,881 87,968 5,816 (1,086) (3,101) 1,629 86,339 31,000 $ 55,339 $ 1.24 $ 1.20 16 Applied Industrial Technologies, Inc. and Subsidiaries CONSOLIDATED BALANCE SHEETS (In thousands) June 30, Assets Current assets Cash and cash equivalents Accounts receivable, less allowances of $6,134 and $6,000 Inventories Other current assets Total current assets Property – at cost Land Buildings Equipment Less accumulated depreciation Property – net Goodwill Other assets Total Assets Liabilities Current liabilities Accounts payable Long-term debt payable within one year Compensation and related benefits Other current liabilities Total current liabilities Long-term debt Postemployment benefits Other liabilities Total Liabilities Shareholders’ Equity Preferred stock – no par value; 2,500 shares authorized; none issued or outstanding Common stock – no par value; 80,000 shares authorized; 54,213 shares issued Additional paid-in capital Income retained for use in the business Treasury shares – at cost (11,097 and 10,146 shares) Accumulated other comprehensive (loss) income Total Shareholders’ Equity Total Liabilities and Shareholders’ Equity See notes to consolidated financial statements. 2007 2006 $ 119,665 $ 106,428 248,698 199,886 32,284 600,533 10,850 69,938 106,006 186,794 119,006 67,788 57,550 51,498 $ 777,369 $ 97,166 50,395 59,536 27,913 235,010 25,000 36,552 29,824 326,386 10,000 127,569 473,899 (159,803) (682) 450,983 $ 777,369 231,524 190,537 29,955 558,444 10,916 68,136 107,230 186,282 115,488 70,794 57,222 44,211 $ 730,671 $ 109,440 54,852 24,139 188,431 76,186 27,441 23,791 315,849 10,000 122,146 408,847 (130,967) 4,796 414,822 $ 730,671 Applied Industrial Technologies, Inc. and Subsidiaries 17 STATEMENTS OF CONSOLIDATED CASH FLOWS (In thousands) 2007 2006 2005 $ 86,022 $ 72,299 $ 55,339 13,489 (6,424) 2,927 1,045 1,462 (334) (791) 1,921 (17,415) (7,934) (1,369) (12,220) 10,546 70,925 (11,192) 1,275 (302) (10,219) (33,988) (20,970) 3,885 2,663 (48,410) 941 13,237 106,428 $ 119,665 13,128 1,000 2,978 732 1,953 (294) (791) 8,937 (17,067) 2,103 (8,066) 2,223 (9,282) 69,853 (11,057) 1,244 (27,672) (429) (37,914) (54,778) (17,973) 16,400 2,569 (53,782) 1,135 (20,708) 127,136 $ 106,428 13,832 (3,900) 2,437 992 1,958 (1,427) (790) 9,506 (9,594) (10,360) (2,658) 22,510 3,189 81,034 (9,208) 4,020 (5,914) (1,437) (12,539) (14,596) (12,740) 15,590 (11,746) 720 57,469 69,667 $ 127,136 $ 42,857 $ 5,488 $ 31,337 $ 5,290 $ 29,624 $ 5,343 Year Ended June 30, Cash Flows from Operating Activities Net income Adjustments to reconcile net income to cash provided by operating activities: Depreciation Deferred income taxes Stock-based compensation Amortization of intangibles Provision for losses on accounts receivable Gain on sale of property Amortization of gain on interest rate swap terminations Treasury shares contributed to employee benefit and deferred compensation plans Changes in assets and liabilities, net of acquisitions: Accounts receivable Inventories Other operating assets Accounts payable Accrued expenses Net Cash provided by Operating Activities Cash Flows from Investing Activities Property purchases Proceeds from property sales Net cash paid for acquisition of businesses, net of cash acquired of $968 in 2006 Other Net Cash used in Investing Activities Cash Flows from Financing Activities Purchases of treasury shares Dividends paid Excess tax benefits from share-based compensation Exercise of stock options Net Cash used in Financing Activities Effect of Exchange Rate Changes on Cash Increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and Cash Equivalents at End of Year Supplemental Cash Flow Information Cash paid during the year for: Income taxes Interest See notes to consolidated financial statements. 18 Applied Industrial Technologies, Inc. and Subsidiaries STATEMENTS OF CONSOLIDATED SHAREHOLDERS’ EQUITY (In thousands, except per share amounts) For the Years Ended June 30, 2007, 2006 and 2005 Balance at July 1, 2004 Net income Unrealized loss on cash flow hedge, net of income tax of $(634) Unrealized gain on investment securities available for sale, net of income tax of $42 Increase in minimum pension liability, net of income tax of $(1,643) Foreign currency translation adjustment, net of income tax of $693 Total comprehensive income Cash dividends – $.29 per share Purchases of common stock for treasury Treasury shares issued for: Retirement Savings Plan contributions Exercise of stock options Deferred compensation plans Compensation expense – stock options and appreciation rights Amortization of restricted common stock compensation Other Balance at June 30, 2005 Net income Unrealized gain on cash flow hedge, net of income tax of $384 Unrealized gain on investment securities available for sale, net of income tax of $43 Reduction in minimum pension liability, net of income tax of $283 Foreign currency translation adjustment, net of income tax of $1,258 Total comprehensive income Cash dividends – $.40 per share Purchases of common stock for treasury Treasury shares issued for: Retirement Savings Plan contributions Exercise of stock options Deferred compensation plans Compensation expense – stock options and appreciation rights Amortization of restricted common stock compensation Reclassification of unearned restricted stock compensation due to the adoption of SFAS 123[R] Other Balance at June 30, 2006 Net income Unrealized loss on cash flow hedge, net of income tax of $(59) Unrealized gain on investment securities available for sale, net of income tax of $68 Increase in minimum pension liability, net of income tax of $(185) Foreign currency translation adjustment, net of income tax of $194 Total comprehensive income Cash dividends – $.48 per share Purchases of common stock for treasury Treasury shares issued for: Retirement Savings Plan contributions Exercise of stock options Deferred compensation plans Compensation expense – stock options and appreciation rights Amortization of restricted common stock compensation Adjustment to initially apply SFAS 158, net of income tax of $(4,899) Other Balance at June 30, 2007 See notes to consolidated fi nancial statements. Shares of Common Stock Outstanding 43,886 Additional Paid-in Capital $ 10,000 $ 90,520 Common Stock (911) 446 1,467 114 45,002 10,000 (2,379) 348 1,088 21 (13) 44,067 10,000 (1,401) 5 366 78 4,623 4,934 728 2,111 253 71 103,240 4,892 11,279 269 2,658 320 (825) 313 122,146 47 796 1,613 2,494 433 Income Retained for Use in the Business $ 311,922 $ (72,870) Unearned Restricted Accumulated Other Treasury Total Shares - Common Stock Comprehensive Shareholders’ Equity at Cost Compensation $ 339,535 $ (1,158) 55,339 (Loss) Income $ 1,121 55,339 (12,740) 354,521 72,299 (14,596) 3,304 10,656 851 (5) (72,660) 326 7 (825) (17,973) (54,778) 3,583 (6,945) 193 (360) (130,967) 408,847 86,022 825 0 (20,970) (33,988) 65 4,157 1,046 (1,002) (1,002) 74 74 (2,858) (2,858) 1,676 (989) 598 72 542 4,573 4,796 (93) 110 (301) 2,703 (7,897) 1,676 53,229 (12,740) (14,596) 7,927 15,590 1,579 2,111 579 73 393,287 72,299 598 72 542 4,573 78,084 (17,973) (54,778) 8,475 4,334 462 2,658 320 (47) 414,822 86,022 (93) 110 (301) 2,703 88,441 (20,970) (33,988) 112 4,953 2,659 2,494 433 (7,897) (76) $ 450,983 1 43,116 40 $ 10,000 $ 127,569 (116) $ 473,899 $ (159,803) $ 0 $ (682) Applied Industrial Technologies, Inc. and Subsidiaries 19 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share amounts) NOTE 1: BUSINESS AND ACCOUNTING POLICIES Business Applied Industrial Technologies, Inc. and subsidiaries (the “Company”) is one of North America’s leading distributors of industrial products. Industrial products include bearings, power transmission components, fluid power components and systems, industrial rubber products, linear components, tools, safety products, general maintenance, and a variety of mill supply products. Fluid power products include hydraulic, pneumatic, lubrication, and filtration components and systems. The Company also provides mechanical, rubber shop and fluid power services. The Company offers technical application support for these products and provides solutions to help customers minimize downtime and reduce overall procurement costs. Although the Company does not generally manufacture the products it sells, it does assemble and repair certain products and systems. Most of the Company’s sales are in the maintenance and replacement markets to customers in a wide range of industries, principally in North America. Consolidation The consolidated financial statements include the accounts of Applied Industrial Technologies, Inc. and its subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation. The financial results of the Company’s Canadian subsidiaries are included in the consolidated financial statements based upon their fiscal year ended May 31. Prior to June 30, 2006, the Company was considered the primary beneficiary for iSource Performance Materials, LLC (iSource) and included their accounts in the consolidated financial statements. Effective June 30, 2006, the Company ended its venture with iSource and is no longer the primary beneficiary. As of June 30, 2006, iSource’s operating results and balances were no longer included in the Company’s consolidated financial statements. Foreign Currency The financial statements of the Company’s Canadian and Mexican subsidiaries are measured using local currencies as their functional currencies. Assets and liabilities are translated into U.S. dollars at current exchange rates, while income and expenses are translated at average monthly exchange rates. Translation gains and losses are included as components of accumulated other comprehensive income in shareholders’ equity. Transaction gains and losses included in the statements of consolidated income were not material. Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the period. Actual results may differ from the estimates and assumptions used in preparing the consolidated financial statements. Cash and Cash Equivalents The Company considers all short-term, highly liquid investments with maturities of three months or less at the date of purchase to be cash equivalents. Cash and cash equivalents are carried at cost, which approximates market value. Concentration of Credit Risk The Company has a broad customer base representing many diverse industries doing business throughout North America. As such, the Company does not believe that a significant concentration of credit risk exists. The Company maintains its cash and cash equivalents with federally insured financial institutions. Deposits held with banks may exceed insurance limits. These deposits may be redeemed upon demand. Allowances for Doubtful Accounts The Company evaluates the collectibility of trade accounts receivable based on a combination of factors. Initially, the Company estimates 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 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 the Company has a large customer base that is geographically dispersed, a general economic downturn in any of the industry segments in which the Company operates could result in higher than expected defaults, and therefore, the need to revise estimates for bad debts. Inventories U.S. inventories are valued at the lower of cost or market, using the last-in, first-out (LIFO) method, and foreign inventories are valued using the average cost method. The Company adopted the link chain dollar value LIFO method of accounting for U.S. inventories in fiscal 1974. At June 30, 2007, approximately one-third of the Company’s domestic inventory dollars relate to LIFO layers added in the 1970s. 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 for further information regarding inventories. The Company evaluates the recoverability of its slow moving or obsolete inventories at least quarterly. The Company estimates 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. The Company’s ability to recover its cost for slow moving or obsolete inventory can be affected by such factors as general market conditions, future 20 Applied Industrial Technologies, Inc. and Subsidiaries customer demand and relationships with suppliers. Historically, the Company’s inventories have demonstrated long shelf lives, are not highly susceptible to obsolescence and are eligible for return under various supplier return programs. Supplier Purchasing Programs The Company enters into agreements with certain suppliers providing for inventory purchase incentives. The Company’s inventory purchase incentive arrangements are unique to each supplier and are generally annual programs ending at either the Company’s fiscal year end or the supplier’s year end. Incentives are received in the form of cash or credits against purchases upon attainment of specified purchase volumes and are received monthly, quarterly or annually based upon actual purchases for such period. The incentives are a specified percentage of the Company’s net purchases based upon achieving specific purchasing volume levels. These percentages can increase or decrease based on changes in the volume of purchases. The Company accrues for the receipt of these inventory purchase incentives based upon cumulative purchases of inventory. The percentage level utilized is based upon the estimated total volume of purchases expected during the life of the program. Each supplier program is analyzed, reviewed and reconciled each quarter as information becomes available to determine the appropriateness of the amount estimated to be received. Upon program completion, differences between estimates and actual incentives subsequently received have not been material. Benefits under these supplier purchasing programs are recognized under the Company’s LIFO inventory accounting method as a reduction of cost of sales when the inventories representing these purchases are recorded as cost of sales. The Company’s accounting for inventory purchase incentives is in accordance with guidance issued by the Financial Accounting Standards Board (“FASB”) in EITF 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor.” Property and Depreciation Property and equipment are recorded at cost. Depreciation of buildings and equipment is computed using the straight-line method over the estimated useful lives of the assets and is included in selling, distribution and administrative expenses in the accompanying statements of consolidated income. Buildings and related improvements are depreciated over ten to thirty years and equipment is depreciated over three to eight years. The carrying values of property and equipment are reviewed for impairment on a quarterly basis or when events or changes in circumstances indicate that the recorded value cannot be recovered from undiscounted future cash flows. To analyze recoverability, the Company considers market values, where available, or will project undiscounted net future cash flows over the remaining life of such assets. If these market values or projected cash flows are less than the carrying amount, an impairment would be recognized, resulting in a write-down of assets with a corresponding charge to earnings. Impairment losses, if any, are measured based upon the difference between the carrying amount and the fair value of the assets. Goodwill and Other Intangible Assets Goodwill is recognized as the excess cost of an acquired entity over the net amount assigned to assets acquired and liabilities assumed. Goodwill is not amortized. The Company recognizes acquired intangible assets such as non-competition agreements, customer relationships, exclusive supplier distribution agreements, and trademarks apart from goodwill. Amortization of intangible assets is computed using the straight-line method over the estimated period of benefit and is included in selling, distribution and administrative expenses in the accompanying statements of consolidated income. The weighted-average amortization period for intangible assets with an unamortized balance as of June 30, 2007 was 7 years for non-competition agreements, 14 years for customer relationships, 12 years for exclusive supplier distribution agreements and 13 years for trademarks. Goodwill and other intangible assets are tested for impairment annually as of January 1 or when changes in conditions indicate carrying value may not be recoverable. Impairment exists when the carrying value of goodwill or other intangible assets exceed their fair value. The results of the Company’s annual testing indicated no impairment. Self-Insurance Liabilities The Company maintains business insurance programs with significant self-insured retention, which cover workers’ compensation, business automobile, general product liability and other claims. The Company accrues estimated losses using actuarial calculations, models and assumptions based on historical loss experience. The Company maintains a self-insured health benefits plan, which provides medical benefits to employees electing coverage under the plan. The Company estimates its reserve for all unpaid medical claims including those incurred but not reported based on historical experience and other assumptions. The Company utilizes independent actuarial firms and other specialists to assist in determining the adequacy of all self-insurance liability reserves. Revenue Recognition Sales are recognized when the sales price is fixed, collectibility is reasonably assured and the product’s title and risk of loss is transferred to the customer. Typically, these conditions are met when the product is shipped to the customer. The Company recognizes shipping and handling fees when products are shipped or delivered to a customer, and includes such amounts in net sales. The Company reports its sales net of the amount of actual sales returns and the amount of reserves established for anticipated sales returns based on historical return rates. Sales tax collected from customers is excluded from net sales in the accompanying statements of consolidated income. Shipping and Handling Costs The Company records freight payments to third parties in cost of sales and internal delivery costs in selling, distribution and administrative expenses in the accompanying statements of consolidated income. Applied Industrial Technologies, Inc. and Subsidiaries 21 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued (In thousands, except per share amounts) Income Taxes Income taxes are determined based upon income and expenses recorded for financial reporting purposes. Deferred income taxes are recorded for estimated future tax effects of differences between the bases of assets and liabilities for financial reporting and income tax purposes, giving consideration to enacted tax laws. Net Income Per Share The following is a computation of the basic and diluted earnings per share: Year Ended June 30, Net Income Average Shares Outstanding: Weighted average common shares outstanding for basic computation Dilutive effect of common stock equivalents Weighted average common shares outstanding for dilutive computation Net Income Per Share – Basic Net Income Per Share – Diluted 2007 $ 86,022 43,630 865 44,495 $ 1.97 $ 1.93 2006 $ 72,299 44,620 1,560 46,180 $ 1.62 $ 1.57 2005 $ 55,339 44,481 1,610 46,091 $ 1.24 $ 1.20 Options and stock appreciation rights to acquire 460, 301, and 516 shares of common stock were outstanding at June 30, 2007, 2006, and 2005, respectively, but were not included in the computation of diluted earnings per share for the fiscal years then ended as they were anti-dilutive. Stock-Based Compensation Effective July 1, 2005, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment” (“SFAS 123(R)”), which is a revision of SFAS 123. The adoption of SFAS 123(R) did not have a material impact on the determination of stock based compensation expense. The Company follows the transition guidance of SFAS 123(R) in determining the additional paid-in capital pool. Prior to the adoption of SFAS 123(R), all tax benefits resulting from the exercise of stock awards were reported as operating cash flows in the Company’s statements of consolidated cash flows. In accordance with and effective upon the adoption of SFAS 123(R), excess tax benefits are now reported as financing cash flows in the Company’s statements of consolidated cash flows. Excess tax benefits for fiscal year 2005 resulting from the vesting and exercise of stock awards totaled $4,828 and are reported as operating cash flows in the accompanying statements of consolidated cash flows. Also effective upon the adoption of SFAS 123(R), the amount of unearned restricted common stock compensation for non-vested awards, previously reported as a separate component of shareholders’ equity, was eliminated against additional paid-in capital. Treasury Shares Shares of common stock repurchased by the Company are recorded at cost as treasury shares and result in a reduction of shareholders’ equity in the consolidated balance sheets. The Company uses the weighted average cost method for determining the cost of shares reissued. The difference between the cost of the shares and the reissuance price is added to or deducted from additional paid-in capital. Accumulated Other Comprehensive (Loss) Income Accumulated other comprehensive (loss) income is comprised of the following: June 30, Unrealized loss in cash flow hedge, net of taxes Unrealized gain on investment securities available for sale, net of taxes Minimum pension liability, net of taxes Foreign currency translation, net of taxes Pension liability, net of taxes Total accumulated other comprehensive (loss) income 2007 $ (664) 256 10,240 (10,514) $ (682) 2006 $ (572) 145 (2,316) 7,539 $ 4,796 New Accounting Pronouncements In June 2006, the FASB issued 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. The Company is required to adopt FIN 48 during the first quarter of fiscal 2008. The Company is currently evaluating the requirements of FIN 48 and has not yet determined the impact, if any, this interpretation may have on its consolidated financial statements. In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). This statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. The provisions of SFAS 157 apply under other accounting pronouncements that require or permit fair value measurements. We are required to adopt SFAS 157 effective for our fiscal year 2009. The impact on our consolidated financial statements has not been determined. In February 2007, the FASB issued SFAS No.159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). This statement permits companies to measure many financial instruments and certain other items at fair value. We are required to adopt SFAS 159 effective for our fiscal year 2009. The impact on our consolidated financial statements has not been determined. 22 Applied Industrial Technologies, Inc. and Subsidiaries Reclassifications Certain prior period amounts have been reclassified to conform to current year presentation. NOTE 2: BUSINESS COMBINATIONS In two of the past three fiscal years, the Company acquired distributors to complement and extend its business over a broader geographic area. In fiscal 2006, the Company acquired two U.S. based distributors of industrial and fluid power products for a combined purchase price of $28,639. In 2005, the Company acquired a Canadian distributor of industrial products for a purchase price of $6,599. Results of operations of the above acquisitions, which have been accounted for as purchases, are included in the accompanying consolidated financial statements from their respective acquisition dates. The results of operations for these acquisitions are not material for all years presented. NOTE 3: INVENTORIES Inventories consist of the following: June 30, U.S. inventories at current cost Foreign inventories at average cost Less: Excess of current cost over LIFO cost for U.S. inventories Inventories on consolidated balance sheets 2007 $ 294,897 46,333 341,230 141,344 $ 199,886 2006 $ 279,619 48,547 328,166 137,629 $ 190,537 Reductions in certain U.S. inventories during fiscal 2006 resulted in the liquidation of LIFO inventory quantities carried at lower costs prevailing in prior years. The effect of the liquidations increased fiscal 2006 gross profit by $1,647, net income by $1,013 and net income per share by $0.02. There were no LIFO layer liquidations during fiscal 2007 and 2005. NOTE 4: GOODWILL AND OTHER INTANGIBLES The changes in the carrying amount of goodwill for the years ended June 30, 2007 and 2006, are as follows: Balance at July 1, 2005 Goodwill acquired during the year Currency translation adjustment Balance at June 30, 2006 Other, primarily currency translation Balance at June 30, 2007 Service Center Based Distribution Segment $ 51,083 4,801 1,079 $ 56,963 341 $ 57,304 Fluid Power Businesses Segment $ 259 $ 259 (13) $ 246 Total $ 51,083 5,060 1,079 $ 57,222 328 $ 57,550 The Company’s intangible assets resulting from business combinations are included in other assets in the consolidated balance sheets and are amortized over their estimated period of benefit and consist of the following: June 30, 2007 Non-competition agreements Customer relationships Exclusive supplier distribution agreements Trademarks June 30, 2006 Non-competition agreements Customer relationships Exclusive supplier distribution agreements Trademarks Amount (a) $ 657 8,347 1,071 924 $ 10,999 Amount (a) $ 750 8,397 1,127 1,163 $ 11,437 Accumulated Amortization $ 355 1,477 311 144 $ 2,287 Accumulated Amortization $ 380 954 305 174 $ 1,813 Net Book Value $ 302 6,870 760 780 $ 8,712 Net Book Value $ 370 7,443 822 989 $ 9,624 (a) Amounts include the impact of foreign currency translation. Fully amortized amounts are written off. During fiscal 2006, the Company recorded intangible assets of $200 for non-competition agreements, $4,890 for customer relationships, $290 for exclusive supplier distribution agreements and $750 for trade names in connection with the acquisition of two U.S. distributors of industrial products (see Note 2). Amortization expense for other intangible assets totaled $1,045, $732 and $992 in fiscal 2007, 2006, and 2005, respectively. Amortization of other intangible assets at June 30, 2007 is expected to be $1,350 for 2008, $1,250 for 2009, $1,150 for 2010, $1,000 for 2011 and $850 for 2012. Applied Industrial Technologies, Inc. and Subsidiaries 23 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued (In thousands, except per share amounts) NOTE 5: DEBT Long-term debt consists of: June 30, 7.98% Private placement debt, due at maturity in November 2010 6.60% Senior $50,000 unsecured term notes, due at maturity in December 2007, including effects of interest rate swaps (see Note 6) Total long-term debt Less payable within one year Total long-term debt less current portion 2007 $ 25,000 50,395 75,395 50,395 $ 25,000 2006 $ 25,000 51,186 76,186 $ 76,186 The aggregate annual maturities of long-term debt over the next five years as of June 30, 2007 include $50,395 in fiscal 2008 and $25,000 in fiscal 2011. Based upon current market rates for debt of similar maturities, the Company’s long-term debt had an estimated fair value of $76,995 and $77,305 as of June 30, 2007 and 2006, respectively. In June 2007, the Company replaced its existing revolving credit facility with a new five year committed revolving credit facility with a group of banks. This agreement provides for unsecured borrowings of up to $150,000 at various interest rate options, none of which is in excess of the banks’ prime rate at interest determination dates. Fees on this facility range from .07% to .15% per year on the average amount of the total revolving credit commitments during the year. Unused lines under this facility, net of outstanding letters of credit ($5,317 for securing certain insurance obligations), totaled $144,683 at June 30, 2007 and are available to fund future acquisitions or other capital and operating requirements. The Company had no borrowings outstanding under this facility at June 30, 2007. During March 2007, the Company renewed its agreement with Prudential Insurance Company, for an uncommitted shelf facility that enables the Company to borrow up to $100,000 in additional long-term financing at the Company’s sole discretion with terms of up to fifteen years. The new agreement expires in March 2010. At June 30, 2007, there was no borrowing under this agreement. The revolving credit facility, private placement debt and senior unsecured term notes contain restrictive covenants regarding liquidity, tangible net worth, financial ratios and other covenants. At June 30, 2007, 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, 2007, the Company was in compliance with all covenants. NOTE 6: RISK MANAGEMENT ACTIVITIES The Company is exposed to market risks, primarily resulting from changes in interest rates and currency exchange rates. To manage these risks, the Company may enter into derivative transactions pursuant to the Company’s written policy. These transactions are accounted for in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). The Company does not hold or issue derivative financial instruments for trading purposes. During fiscal 2002, the Company entered into two interest rate swap agreements with two banks which effectively converted the fixed interest rate on the 6.60% senior unsecured term notes to a floating variable rate based on LIBOR. In October 2001 and August 2002, the Company terminated the swap agreements for favorable settlements of $2,000 and $2,500, respectively. These settlement gains are being amortized as a reduction in interest expense of approximately $790 per year over the remaining life of the notes through December 2007. The effect of the swap agreements was to decrease interest expense by $791 in fiscal 2007, $791 in 2006 and $790 in 2005. In November 2000, the Company entered into two 10-year cross-currency swap agreements to manage its foreign currency risk exposure on private placement borrowings related to its wholly owned Canadian subsidiary. The cross-currency swaps effectively convert $25,000 of debt, and the associated interest payments, from 7.98% fixed rate U.S. dollar denominated debt to 7.75% fixed rate Canadian dollar denominated debt. The terms of the two cross-currency swaps mirror the terms of the private placement borrowings. The Company has designated one of the cross-currency swaps, with a $20,000 U.S. notional amount, as a foreign currency cash flow hedge. The fair value of the cross- currency swap was a liability of $9,372 and $8,401 at June 30, 2007 and 2006, respectively. These liabilities were recorded in other liabilities and the related unrealized losses are included in accumulated other comprehensive (loss) income (net of tax). The second cross-currency swap, however, has not been designated as a hedging instrument under the hedge accounting provisions of SFAS 133. The fair value of this cross-currency swap was a liability of $2,343 and $2,100 at June 30, 2007 and 2006, respectively. Changes in the fair value of this derivative instrument are recorded in the statements of consolidated income as a component of other income, net. NOTE 7: INCOME TAXES Income Before Income Taxes The components of income before income taxes are as follows: Year Ended June 30, U.S. Foreign Total income before taxes 2007 $ 119,275 14,555 $ 133,830 2006 $ 100,462 12,637 $ 113,099 2005 $ 77,263 9,076 $ 86,339 24 Applied Industrial Technologies, Inc. and Subsidiaries Provision The provision (benefit) for income taxes consists of: Year Ended June 30, Current: Federal State and local Foreign Total current Deferred: Federal State and local Foreign Total deferred Total 2007 2006 2005 $ 43,325 5,341 5,566 54,232 (5,914) (342) (168) (6,424) $ 47,808 $ 31,100 3,600 5,100 39,800 900 400 (300) 1,000 $ 40,800 $ 28,200 3,700 3,000 34,900 (4,500) (100) 700 (3,900) $ 31,000 The exercise of non-qualified stock options and stock appreciation rights during fiscal 2007, 2006 and 2005 resulted in $2,860, $16,155 and $4,575, respectively, of income tax benefits to the Company derived from the difference between the market price at the date of exercise and the option price. Vesting of stock awards and other stock compensation in fiscal 2007 and 2006 resulted in $1,025 and $245, respectively, of incremental income tax benefits over the amounts previously reported for financial reporting purposes. These tax benefits were recorded in additional paid-in capital. Effective Tax Rates The following reconciles the federal statutory income tax rate and the Company’s effective tax rate: Year Ended June 30, Statutory tax rate Effects of: State and local income taxes Foreign income taxes Tax exempt interest Non-deductible expenses Deductible dividend Non-taxable life insurance settlement Income tax examinations Other, net Effective tax rate Consolidated Balance Sheets Significant components of the Company’s net deferred tax assets are as follows: June 30, Deferred tax assets: Compensation liabilities not currently deductible Reserves not currently deductible Goodwill and other intangibles Net operating loss carryforwards Total deferred tax assets Deferred tax liabilities: Inventories Depreciation and differences in property bases Other Total deferred tax liabilities Net deferred tax assets 2007 35.0% 2.3 (.8) (.3) .1 (.5) .1 (.2) 35.7% 2006 35.0% 2.4 (.7) (.1) .2 (.6) (.1) 36.1% 2005 35.0% 2.8 (.7) .3 (.5) (1.2) .2 35.9% 2007 2006 $ 30,171 7,454 563 438 38,626 (4,061) (1,471) (2,181) (7,713) $ 30,913 $ 20,091 7,998 1,296 422 29,807 (5,471) (2,598) (2,045) (10,114) $ 19,693 At June 30, 2007 and 2006, $7,710 and $6,169, respectively, of the net deferred tax assets were included in other current assets and $19,597 and $13,524, respectively, were included in other assets in the accompanying consolidated balance sheets. Management believes that sufficient income will be earned in the future to realize its deferred income tax assets. The realization of these deferred tax assets can be impacted by changes to tax laws, statutory tax rates and future taxable income levels. No provision has been made for income taxes on undistributed earnings of consolidated non-U.S. subsidiaries since it is the Company’s intention to indefinitely reinvest undistributed earnings of its foreign subsidiaries. Determination of the net amount of unrecognized taxes with respect to these earnings is not practicable, however, foreign tax credits would be available to partially reduce U.S. income taxes in the event of a distribution. Applied Industrial Technologies, Inc. and Subsidiaries 25 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued (In thousands, except per share amounts) NOTE 8: SHAREHOLDERS’ EQUITY Stock-Based Incentive Plans The 1997 Long-Term Performance Plan (the “1997 Plan”), which expires in 2012, provides for granting of stock options, stock appreciation rights (“SARs”), stock awards, cash awards, and such other awards or combination thereof as the Executive Organization and Compensation Committee or the Corporate Governance Committee of the Board of Directors (the “Committees”) may determine to officers, other key associates and members of the Board of Directors. Grants are generally made by the Committees during regularly scheduled meetings. The number of shares of common stock which may be awarded in each fiscal year under the 1997 Plan is two percent (2%) of the total number of shares of common stock outstanding on the first day of each year for which the plan is in effect. Common stock available for distribution under the 1997 Plan, but not distributed, may be carried over to the following year. Shares available for future grants at June 30, 2007 and 2006 were 2,601 and 2,050, respectively. Stock Option and Appreciation Rights SARs and non-qualified stock options are granted with an exercise price equal to the market price of the Company’s common stock at the date of grant. SAR and stock option awards generally vest over four years of continuous service and have 10-year contractual terms. Compensation expense related to stock options and SARs recorded for the years ended June 30, 2007, 2006 and 2005 was $2,494, $2,658 and $2,111, respectively. Such amounts are included in selling, distribution and administrative expense in the accompanying statements of consolidated income. Compensation expense for stock options and SARs has been determined using the Black-Scholes option pricing model. Determining the appropriate fair value of stock-based awards requires management to select a fair value model and make certain estimates and assumptions. The weighted average assumptions used for SAR and stock option grants issued in fiscal 2007, 2006 and 2005 are: Expected life, in years Risk free interest rate Dividend yield Volatility 2007 5.1 4.8% 2.2% 46.7% 2006 7.2 4.3% 1.4% 42.3% 2005 8.0 3.9% 2.0% 31.5% The expected life is based upon historical exercise experience of the officers, other key associates and members of the Board of Directors currently awarded stock- based compensation. The risk free interest rate is based upon the U.S. Treasury zero-coupon bonds with remaining terms equal to the expected life of the stock options and SARs. The assumed dividend yield has been estimated based upon the Company’s historical results and expectations for changes in dividends and stock prices. The volatility assumption is calculated based upon historical daily price observations of the Company’s common stock for a period equal to the expected life. It has been the Company’s practice to issue shares from Treasury to satisfy requirements of SAR and option exercises. SARs are redeemable solely in Company common stock. The exercise price of option awards may be settled by the holder with cash or by tendering Company common stock. A summary of stock option and SAR activity is presented below: (Share amounts in thousands) 2007 Outstanding, beginning of year Granted Exercised Outstanding, end of year Exercisable at end of year Weighted average fair value of SARs and options granted during year 2006 Outstanding, beginning of year Granted Exercised Expired/canceled Outstanding, end of year Exercisable at end of year Weighted average fair value of SARs and options granted during year 2005 Outstanding, beginning of year Granted Exercised Expired/canceled Outstanding, end of year Exercisable at end of year Weighted average fair value of SARs and options granted during year 26 Applied Industrial Technologies, Inc. and Subsidiaries Shares 2,486 319 (421) 2,384 1,533 4,302 306 (2,103) (19) 2,486 1,381 5,253 516 (1,455) (12) 4,302 2,763 Weighted Average Exercise Price $ 11.23 22.11 8.61 $ 13.15 $ 10.63 $ 8.74 $ 8.68 23.40 7.76 14.04 $ 11.23 $ 9.85 $ 10.29 $ 7.87 13.80 7.57 7.76 $ 8.68 $ 8.18 $ 4.67  The weighted average remaining contractual terms for SARs/options outstanding and exercisable at June 30, 2007 were 6.3 and 5.4 years, respectively. The aggregate intrinsic values of SARs/options outstanding and exercisable at June 30, 2007 were $31,350 and $16,293, respectively. The aggregate intrinsic value of the SARs/options exercised during fiscal 2007, 2006 and 2005 was $7,887, $41,966 and $12,891, respectively. A summary of the status of the Company’s nonvested stock options and SARs at June 30, 2007, all of which are expected to vest, is presented below: (Share amounts in thousands) 2007 Nonvested, beginning of year Granted Vested Nonvested, end of year Weighted Average Grant-Date Fair Value $ 4.61 8.74 3.69 $ 6.77 Shares 1,105 319 (573) 851 As of June 30, 2007, unrecognized compensation cost related to stock options and SARs amounted to $2,787. That cost is expected to be recognized over a weighted average period of 2.6 years. The total fair value of shares vested during fiscal 2007, 2006 and 2005 was $2,116, $2,388 and $2,125, respectively. Restricted Stock Restricted stock award recipients are entitled to receive dividends on, and have voting rights with respect to their respective shares, but are restricted from selling or transferring the shares prior to vesting. Restricted stock awards vest over a period of one to four years. The aggregate fair market value of the restricted stock is considered unearned compensation at the time of grant and is amortized over the vesting period. At June 30, 2007 and 2006, the Company had 43 and 63 shares of restricted stock outstanding at weighted average prices of $13.77 and $10.14, respectively. During fiscal 2007, restricted stock was granted at an average grant price of $23.34 per share. Unamortized compensation related to unvested restricted stock awards aggregated $349 and $515 at June 30, 2007 and 2006, respectively. The unamortized compensation cost related to restricted stock is expected to be amortized over the remaining vesting period of 0.8 years. Long-Term Performance Grants The Committee also makes annual awards of three-year performance grants to key officers. A target payout is established at the beginning of each three-year performance period. The actual payout at the end of the period is calculated based upon the Company’s achievement of objective sales growth, return on sales, and total shareholder return targets. Total shareholder return is calculated based upon the increase in the Company’s common stock price, including dividend reinvestment, over the performance period as compared to the Company’s peers, as defined. Payouts are made in cash, common stock, or a combination thereof, as determined by the Committee at the end of the performance period. During fiscal 2007, 2006 and 2005, the Company recorded $549, $540 and $784, respectively, of compensation expense for achievement relative to the total shareholder return-based goals of the Company’s performance grants. At June 30, 2007 and 2006, the Company had accrued $1,174 and $1,308, respectively, for compensation relative to these goals. At June 30, 2007 and 2006, potential compensation expense related to the outstanding performance grants aggregated $2,124 and $1,234, respectively. This compensation expense is expected to be recognized over the remaining performance period of 1.6 years. Shareholders’ Rights In 1998 the Company’s Board of Directors adopted a Shareholder Rights Plan and declared a dividend distribution of one preferred share purchase right for each outstanding share of Company common stock. The rights become exercisable only if a person or group acquires beneficial ownership or commences a tender or exchange offer for 20% or more of the Company’s common stock, unless the tender or exchange offer is for all outstanding shares of the Company upon terms determined by the Company’s continuing directors to be in the best interests of the Company and its shareholders. When exercisable, the rights would entitle the holders (other than the acquirer) to buy shares of the Company’s common stock having a market value equal to two times the right’s exercise price or, in certain circumstances, to buy shares of the acquiring company having a market value equal to two times the right’s exercise price. Treasury Shares At June 30, 2007, 596 shares of the Company’s common stock held as treasury shares were restricted as collateral under escrow arrangements relating to change in control and director and officer indemnification agreements. NOTE 9: BENEFIT PLANS Retirement Savings Plan Substantially all U.S. associates participate in the Applied Industrial Technologies, Inc. Retirement Savings Plan. The Company makes a discretionary profit-sharing contribution to the Retirement Savings Plan generally based upon a percentage of the Company’s U.S. income before income taxes and before the amount of the contribution (5% for fiscal 2007, 2006 and 2005). The Company also partially matches 401(k) contributions by participants, who may elect to contribute up to 50% of their compensation, subject to Internal Revenue Code maximums. Until July 1, 2006, matching contributions were made with the Company’s common stock and were determined quarterly using rates based on achieving pre-determined quarterly earnings per share levels (ranging from 25% to 100% of the first 6% of compensation contributed to the plan). Effective July 1, 2006, the matching contribution is made in cash which is then used by the administrator to purchase Company stock in the open market. Applied Industrial Technologies, Inc. and Subsidiaries 27 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued (In thousands, except per share amounts) The Company’s expense for contributions to the above plan was $11,548, $11,365 and $9,947 during fiscal 2007, 2006 and 2005, respectively. Deferred Compensation Plans The Company has deferred compensation plans that enable certain associates of the Company to defer receipt of a portion of their compensation and non-employee directors to defer receipt of director fees. The Company funds these deferred compensation liabilities by making contributions to rabbi trusts. Contributions consist of Company common stock and investments in money market and mutual funds. Postemployment Benefit Plans The Company provides the following postemployment benefits: Supplemental Executive Retirement Benefits Plan The Company has a non-qualified pension plan to provide supplemental retirement benefits to certain officers. Benefits are payable at retirement based upon a percentage of the participant’s compensation. Qualified Defined Benefit Retirement Plan The Company has a qualified defined benefit retirement plan that provides benefits to certain hourly associates at retirement. The benefits are based on length of service and date of retirement. These associates do not participate in the Retirement Savings Plan. Salary Continuation Benefits The Company has agreements with certain retirees to pay monthly retirement benefits for a period not in excess of 15 years. The discount rates used in determining the benefit obligation were 6.0% and 5.8% at June 30, 2007 and 2006, respectively. Retiree Medical Benefits The Company provides health care benefits to eligible retired associates who elect to pay the Company a specified monthly premium. Premium payments are based upon current insurance rates for the type of coverage provided and are adjusted annually. Certain monthly health care premium payments are partially subsidized by the Company. Additionally, in conjunction with a fiscal 1998 acquisition, the Company assumed the obligation for a post-retirement medical benefit plan which provides health care benefits to eligible retired associates at no cost to the individual. Adoption of Statement of Financial Accounting Standards No. 158 In September 2006, the FASB issued SFAS No.158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of SFAS 87, 88, 106, and 132 (R)” (“SFAS 158”). This statement requires a company to recognize the funded status of retirement and other postretirement benefit plans as an asset or liability in its balance sheet, measured as the difference between plan assets at fair value and the benefit obligation. It also requires the Company to recognize changes in that funded status, other than those recognized as components of net periodic benefit cost, in the year in which the changes occur through accumulated other comprehensive income (loss), net of tax. The Company adopted SFAS 158 on a prospective basis effective June 30, 2007. The Company uses a June 30 measurement date for all plans. The following illustrates the incremental effect of applying SFAS 158 on individual lines on our consolidated balance sheet as of June 30, 2007: Other assets Total Assets Postemployment benefits Total Liabilities Accumulated other comprehensive income (loss), net of tax Total Shareholders’ Equity Before Application of SFAS 158 $ 51,736 $ 777,607 $ 28,894 $ 318,728 $ 7,215 $ 458,880 SFAS 158 Adjustments $ (238) $ (238) $ 7,658 $ 7,658 $ (7,897) $ (7,897) Reported as of June 30, 2007 $ 51,498 $ 777,369 $ 36,552 $ 326,386 $ (682) $ 450,983 28 Applied Industrial Technologies, Inc. and Subsidiaries  The changes in benefit obligations, plan assets and funded status for the plans described above were as follows: Pension Benefits 2007 2006 Other Benefits 2007 2006 Change in benefit obligation: Benefit obligation at beginning of the year Service cost Interest cost Plan participants’ contributions Benefits paid Amendments Actuarial loss (gain) during year Benefit obligation at June 30 Change in plan assets: Fair value of plan assets at beginning of year Actual return on plan assets Employer contributions Plan participants’ contributions Benefits paid Fair value of plan assets at June 30 Funded status at June 30 Net amount recognized: Obligations in excess of plan assets Unrecognized net loss (gain) Unrecognized prior service cost Net amount recognized Amounts recognized in the consolidated balance sheets consist of: Prepaid benefit cost Intangible assets Current liabilities Noncurrent liabilities Additional minimum liability recognized in accumulated other comprehensive loss Net amount recognized Amounts recognized in accumulated other comprehensive loss (income) consist of: Net actuarial loss (gain) Prior service cost Total accumulated other comprehensive loss (income) $ 32,035 1,450 1,601 (832) 817 $ 35,071 $ 4,831 515 740 (832) $ 5,254 $ (29,817) $ (29,817) 11,011 3,970 $ (14,836) $ 1,782 3,403 (716) (22,981) 3,676 $ (14,836) $ 35,071 1,685 2,032 (855) 1,404 2,873 $ 42,210 $ 5,254 731 763 (855) $ 5,893 $ (36,317) $ (36,317) $ (36,317) $ 873 (4,541) (32,649) $ (36,317) $ 12,813 4,716 $ 17,529 $ 3,981 56 222 28 (223) 141 (32) $ 4,173 $ 194 29 (223) $ 0 $ (4,173) $ (4,173) $ (4,173) $ 5,209 55 253 28 (265) (1,299) $ 3,981 $ 237 28 (265) $ 0 $ (3,981) $ (3,981) (837) 98 $ (4,720) $ (270) (3,903) $ (260) (4,460) $ (4,173) $ (4,720) $ (760) 190 $ (570) The discount rate is used to determine the present value of future payments. In general, the Company’s liability increases as the discount rate decreases and decreases as the discount rate increases. The Company selects a discount rate using the Citigroup Pension Liability Index over the estimated duration of the plans. The weighted-average actuarial assumptions at June 30 used to determine benefit obligations for the plans were as follows: Discount rate Expected return on plan assets Rate of compensation increase Pension Benefits Other Benefits 2007 6.0% 8.0% 5.5% 2006 5.8% 8.0% 5.5% 2007 6.0% N/A N/A 2005 5.8% N/A N/A The following table provides information for pension plans with an accumulated benefit obligation and projected benefit obligation in excess of plan assets: Projected benefit obligations Accumulated benefit obligations Pension Benefits 2007 $ 37,191 28,963 2006 $ 35,071 28,560 Applied Industrial Technologies, Inc. and Subsidiaries 29 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued (In thousands, except per share amounts) The net periodic pension costs are as follows: Service cost Interest cost Expected return on plan assets Recognized net actuarial loss Amortization of prior service cost Net periodic pension cost Service cost Interest cost Recognized net actuarial (gain) loss Amortization of prior service cost Net periodic pension cost 2007 $ 1,685 2,032 (415) 804 658 $ 4,764 2007 $ 56 222 (109) 49 $ 218 Pension Benefits 2006 $ 1,450 1,601 (381) 784 627 $ 4,081 Other Benefits 2006 $ 55 253 28 49 $ 385 2005 $ 1,274 1,638 (353) 479 627 $ 3,665 2005 $ 48 292 14 49 $ 403 The estimated net loss and prior service cost for the pension plans that will be amortized from accumulated other comprehensive (loss) income into net periodic benefit cost over the next fiscal year are $941 and $635, respectively. The estimated net gain and prior service cost for the other benefits that will be amortized from accumulated other comprehensive (loss) income into net periodic benefit cost over the next fiscal year are $107 and $45, respectively. The assumed health care cost trend rates used in measuring the accumulated benefit obligation for post-retirement benefits other than pensions were 10% as of June 30, 2007 and June 30, 2006, decreasing to 5% by 2012 and 2010, respectively. A one-percentage point change in the assumed health care cost trend rates would have had the following effects as of June 30, 2007 and for the year then ended: Effect on total service and interest cost components of periodic expense Effect on post-retirement benefit obligation One-Percentage Point Increase $ 46 $ 592 One-Percentage Point Decrease $ (38) $ (488) Obligations and Funded Status Plan Assets Applied Industrial Technologies, Inc.’s Qualified Defined Benefit Retirement Plan weighted average asset allocation and target allocation are as follows: Percentage of Pension Plan Assets At Fiscal Year End 2006 2007 Target Allocation 2008 Asset Category: Equity securities Debt securities Other Total 55-65% 30-35% 0-10% 100% 61% 33% 6% 100% 66% 34% 0% 100% Equity securities do not include any Applied Industrial Technologies, Inc. common stock. The Company has established an investment policy and regularly monitors the performance of the assets of the trust maintained in conjunction with the Qualified Defined Benefit Retirement Plan. The strategy implemented by the trustee of the Qualified Defined Benefit Retirement Plan is to achieve long-term objectives and invest the pension assets in accordance with ERISA and fiduciary standards. The long-term primary objectives are to provide for a reasonable amount of long-term capital, without undue exposure to risk; to protect the Qualified Defined Benefit Retirement Plan assets from erosion of purchasing power; and to provide investment results that meet or exceed the actuarially assumed long-term rate of return. The expected long-term rate of return on assets assumption was developed by considering the historical returns and the future expectations for returns of each asset class as well as the target asset allocation of the pension portfolio. 30 Applied Industrial Technologies, Inc. and Subsidiaries Cash Flows Employer Contributions The Company expects to contribute $4,500 to its pension benefit plans and $200 to its other benefit plans in 2008. Estimated Future Benefit Payments The Company expects to make the following benefit payments, which reflect expected future service: During Fiscal Years 2008 2009 2010 2011 2012 2013 through 2017 Pension Benefits $ 4,700 4,500 900 5,000 3,500 14,600 Other Benefits $ 200 200 300 300 300 1,300 NOTE 10: LEASES The Company leases its corporate headquarters facility along with certain service center and distribution center facilities, vehicles and equipment under non- cancelable lease agreements accounted for as operating leases. The minimum annual rental commitments under non-cancelable operating leases as of June 30, 2007 are as follows: 2008 2009 2010 2011 2012 Thereafter Total minimum lease payments $ 19,200 14,100 10,100 6,600 5,000 10,400 $ 65,400 Rental expenses incurred for operating leases, principally from leases for real property, vehicles and computer equipment were $28,300 in fiscal 2007, $26,700 in 2006 and $25,500 in 2005. NOTE 11: SEGMENT INFORMATION The Company has identified two reportable segments: Service Center Based Distribution and Fluid Power Businesses. The Service Center Based Distribution segment provides customers with solutions to their maintenance, repair and original equipment manufacturing needs through the distribution of industrial products including bearings, power transmission components, fluid power components, industrial rubber products, linear motion products, safety products, general maintenance and a variety of mill supply products. The Fluid Power Businesses segment distributes fluid power components and operates shops that assemble fluid power systems and components, performs equipment repair, and offers technical advice to customers. The accounting policies of the Company’s reportable segments are the same as those described in Note 1. Sales between the Service Center Based Distribution segment and the Fluid Power Businesses segment have been eliminated. Segment Financial Information: Year Ended June 30, 2007 Net sales Operating income Assets used in the business Depreciation Capital expenditures Year Ended June 30, 2006 Net sales Operating income Assets used in the business Depreciation Capital expenditures Year Ended June 30, 2005 Net sales Operating income Assets used in the business Depreciation Capital expenditures Service Center Based Distribution $ 1,806,284 122,684 715,864 12,166 10,074 $ 1,725,392 111,774 670,619 12,019 10,310 $ 1,601,531 83,059 660,616 13,135 8,789 Fluid Power Businesses $ 207,825 14,427 61,505 1,323 1,118 $ 175,388 11,849 60,052 1,109 747 $ 115,524 7,183 29,554 697 419 Total $ 2,014,109 137,111 777,369 13,489 11,192 $ 1,900,780 123,623 730,671 13,128 11,057 $ 1,717,055 90,242 690,170 13,832 9,208 Applied Industrial Technologies, Inc. and Subsidiaries 31 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued (In thousands, except per share amounts) A reconciliation of operating income for reportable segments to the consolidated income before income taxes is as follows: Year Ended June 30, Operating income for reportable segments Adjustments for: Amortization expense of intangibles Corporate and other expense, net (a) Total operating income Interest expense, net Other income, net Income before income taxes 2007 $ 137,111 2006 $ 123,623 2005 $ 90,242 1,045 1,055 135,011 2,360 1,179 $ 133,830 732 7,299 115,592 3,210 717 $ 113,099 992 1,282 87,968 4,730 3,101 $ 86,339 (a) The change in corporate and other expense, net is due to various changes in the levels and amounts of expenses being allocated to the segments. The expenses being allocated include miscellaneous corporate charges for working capital, logistics support and other items. Net sales by product category are as follows: Year Ended June 30, Industrial Fluid power (b) Net sales 2007 $ 1,614,515 399,594 $ 2,014,109 2006 $ 1,554,589 346,191 $ 1,900,780 2005 $ 1,442,308 274,747 $ 1,717,055 (b) The fluid power product category includes sales of hydraulic, pneumatic, lubrication and filtration components, and systems and repair services through the Company’s service centers as well as the fluid power businesses. Net sales are presented in the geographic area in which the Company’s customers are located. Information by geographic area is as follows: Year Ended June 30, Net Sales: United States Canada Other Total Long-Lived Assets: United States Canada Other Total 2007 2006 2005 $ 1,539,143 160,396 17,516 $ 1,717,055 $ 1,778,993 211,446 23,670 $ 2,014,109 $ 111,357 19,440 3,253 $ 134,050 $ 1,686,066 194,594 20,120 $ 1,900,780 $ 115,935 18,445 3,260 $ 137,640 Long-lived assets are comprised of property, goodwill and other intangible assets. NOTE 12: COMMITMENTS AND CONTINGENCIES In connection with the construction and lease of its corporate headquarters facility, the Company has guaranteed repayment of a total of $5,678 of taxable development revenue bonds issued by Cuyahoga County and the Cleveland-Cuyahoga County Port Authority. These bonds were issued with a 20-year term and are scheduled to mature in March 2016. Any default, as defined in the guarantee agreements, would obligate the Company for the full amount of the outstanding bonds through maturity. Due to the nature of the guarantee, the Company has not recorded any liability on the financial statements. In the event of a default and subsequent payout under any or all guarantees, the Company maintains the right to pursue all legal options available to mitigate its exposure. The Company is a party to various pending judicial and administrative proceedings. Based on circumstances currently known, the Company does not believe that any liabilities that may result from these proceedings are reasonably likely to have a material adverse effect on the Company’s consolidated financial position, results of operations, or cash flows. 32 Applied Industrial Technologies, Inc. and Subsidiaries NOTE 13: OTHER INCOME, NET Other income, net consists of the following: Year Ended June 30, Unrealized loss on cross-currency swap Unrealized gain on deferred compensation trusts Benefit from payouts on corporate-owned life insurance policies Gain on sale of investments available for sale Other Total other income, net 2007 $ 243 (1,397) (25) $ (1,179) 2006 $ 595 (869) (443) $ (717) 2005 $ 901 (518) (2,945) (166) (373) $ (3,101) The Company is the owner and beneficiary under life insurance policies acquired in conjunction with a fiscal 1998 acquisition, with benefits in force of $14,000 and a net cash surrender value of $2,700 at June 30, 2007. Applied Industrial Technologies, Inc. and Subsidiaries 33 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Shareholders of Applied Industrial Technologies, Inc. We have audited the accompanying consolidated balance sheets of Applied Industrial Technologies, Inc. and subsidiaries (the “Company”) as of June 30, 2007 and 2006, and the related statements of consolidated income, shareholders’ equity, and cash flows for each of the three years in the period ended June 30, 2007. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Applied Industrial Technologies, Inc. and subsidiaries at June 30, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 2007, in conformity with accounting principles generally accepted in the United States of America. As discussed in Notes 1 and 9, respectively, to the consolidated financial statements, the Company changed its method of accounting for stock-based compensation to conform to Statement of Financial Accounting Standards (“SFAS”) No. 123(R), Share-Based Payment, effective July 1, 2005, and adopted SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, in 2007. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of June 30, 2007, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated August 17, 2007 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. Cleveland, Ohio August 17, 2007 34 Applied Industrial Technologies, Inc. and Subsidiaries MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING The Management of Applied Industrial Technologies, Inc. is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is a process designed by, or under the supervision of, the Chairman & Chief Executive Officer and the Vice President – Chief Financial Officer & Treasurer, and effected by the Company’s Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of consolidated financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. The Company’s internal control over financial reporting includes those policies and procedures that: (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of consolidated financial statements in accordance with accounting principles generally accepted in the United States of America and that receipts and expenditures of the Company are being made only in accordance with authorizations of the Company’s Management and Board of Directors; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the consolidated financial statements. Because of inherent limitations, internal control over financial reporting can provide only reasonable, not absolute, assurance with respect to the preparation and presentation of the consolidated financial statements and may not prevent or detect misstatements. Further, because of changes in conditions, effectiveness of internal control over financial reporting may vary over time. Management conducted an evaluation of the effectiveness of the Company’s internal control over financial reporting as of June 30, 2007. This evaluation was based on the criteria set forth in the framework Internal Control—Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, Management determined that the Company’s internal control over financial reporting was effective as of June 30, 2007. Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of June 30, 2007 has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report which is included herein. August 17, 2007 David L. Pugh Chairman & Chief Executive Officer Mark O. Eisele Vice President – Chief Financial Officer & Treasurer Bill L. Purser President Daniel T. Brezovec Corporate Controller Applied Industrial Technologies, Inc. and Subsidiaries 35 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Shareholders of Applied Industrial Technologies, Inc. We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Applied Industrial Technologies, Inc. and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of June 30, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions. A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of June 30, 2007, is fairly stated, in all material respects, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of June 30, 2007, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet and the related statements of consolidated income, shareholders’ equity and cash flows as of and for the year ended June 30, 2007 of the Company and our report dated August 17, 2007 expressed an unqualified opinion on those consolidated financial statements. Cleveland, Ohio August 17, 2007 36 Applied Industrial Technologies, Inc. and Subsidiaries QUARTERLY OPERATING RESULTS AND MARKET DATA Unaudited (In thousands, except per share amounts) Per Common Share (B) 2007 (A) First Quarter Second Quarter Third Quarter Fourth Quarter 2006 (A) First Quarter Second Quarter Third Quarter Fourth Quarter 2005 (A) First Quarter Second Quarter Third Quarter Fourth Quarter Net Sales Gross Profit Operating Income Net Income $ 492,590 472,365 521,129 528,025 $ 2,014,109 $ 135,134 130,151 140,572 142,195 $ 548,052 $ 443,205 456,180 497,198 504,197 $ 1,900,780 $ 122,304 121,397 136,815 133,369 $ 513,885 $ 33,377 28,929 34,105 38,600 $ 135,011 $ 27,802 25,214 32,085 30,491 $ 115,592 $ 21,117 18,568 21,697 24,640 $ 86,022 $ 16,850 15,294 19,990 20,165 $ 72,299 $ 413,126 404,139 446,470 453,320 $ 1,717,055 $ 109,522 103,948 119,293 122,086 $ 454,849 $ 21,503 17,223 24,080 25,162 $ 87,968 $ 13,040 9,980 16,336 15,983 $ 55,339 Net Income - Diluted $ 0.47 0.42 0.49 0.56 $ 1.93 $ 0.36 0.33 0.43 0.44 $ 1.57 $ 0.29 0.22 0.35 0.34 $ 1.20 Cash Price Range Dividend High Low $0.12 $ 25.50 $ 20.75 23.61 30.00 0.12 22.72 26.95 0.12 0.12 24.26 30.73 $ 0.48 $ 0.08 $ 25.03 $ 21.33 20.41 22.50 21.97 24.54 31.15 31.67 0.10 0.10 0.12 $ 0.40 $ 0.06 $ 15.89 $ 11.73 14.83 15.19 16.13 21.33 20.01 22.60 0.06 0.08 0.08 $ 0.29 (A) Cost of sales for interim financial statements are computed using estimated gross profit percentages which are adjusted throughout the year based upon available information. Adjustments to actual cost are primarily made based on periodic physical inventory and the effect of year-end inventory quantities on LIFO costs. Reductions in year-end inventories during the fiscal year ended June 30, 2006 resulted in liquidations of LIFO inventory quantities carried at lower costs prevailing in prior years. The effect of these liquidations for the year ended June 30, 2006 increased gross profit by $1,647, net income by $1,013 and diluted net income per share by $0.02, respectively. There were no LIFO layer liquidations for fiscal 2007 and 2005. (B) On August 10, 2007 there were 6,265 shareholders of record including 3,962 shareholders in the Applied Industrial Technologies, Inc. Retirement Savings Plan. The Company’s common stock is listed on the New York Stock Exchange. The closing price on August 10, 2007 was $29.93 per share. Applied Industrial Technologies, Inc. and Subsidiaries 37 10 YEAR SUMMARY (In thousands, except per share amounts and statistical data) sales Consolidated Operations – Year Ended June 30 Net Operating income Income before cumulative effect of accounting change Net Per share data income Income before cumulative effect of accounting change Basic Diluted Net income Basic Diluted Cash dividend Year-End Position – June 30 Working capital Long-term debt (including amounts classified as current) Total assets Shareholders’ equity Year-End Statistics – June 30 Current ratio Operating facilities Shareholders of record 38 Applied Industrial Technologies, Inc. and Subsidiaries 2007 2006 2005 2004 $ 2,014,109 135,011 86,022 86,022 $ 1,900,780 115,592 72,299 72,299 $ 1,717,055 87,968 55,339 55,339 $ 1,517,004 51,448 31,471 31,471 1.97 1.93 1.97 1.93 0.48 1.62 1.57 1.62 1.57 0.40 1.24 1.20 1.24 1.20 0.29 0.73 0.71 0.73 0.71 0.21 $ 365,523 75,395 777,369 450,983 $ 370,013 76,186 730,671 414,822 $ 345,806 76,977 690,170 393,287 $ 286,022 77,767 596,841 339,535 2.6 445 6,242 3.0 452 6,192 2.9 440 6,079 2.9 434 6,154 NET INCOME PER SHARE (Dollars) $0.06 $0.71 $0.46 $0.63 $0.67 $0.61 $0.41 NET SALES (Dollars in Billions) 07 06 05 04 03 02 01 00 99 98 07 06 05 04 03 02 01 00 99 98 $1.93 $1.57 $1.20 $2.01 $1.90 $1.72 $1.52 $1.46 $1.45 $1.63 $1.60 $1.56 $1.52  2003 2002 2001 2000 1999 1998 $ 1,464,367 36,254 19,832 19,832 $ 1,446,569 30,834 14,755 2,655 $ 1,625,755 55,001 28,048 28,048 $ 1,601,084 57,779 31,048 31,048 $ 1,555,424 42,269 19,933 19,933 $ 1,518,615 58,520 30,125 30,125 0.47 0.46 0.47 0.46 0.21 $ 259,359 78,558 553,404 307,856 2.8 440 6,157 0.34 0.34 0.06 0.06 0.21 0.64 0.63 0.64 0.63 0.21 $ 250,644 83,478 534,566 298,147 $ 279,001 113,494 578,854 311,518 2.9 449 6,455 3.2 469 6,697 0.68 0.67 0.68 0.67 0.21 $ 255,132 112,168 594,667 299,331 2.6 478 6,548 0.41 0.41 0.41 0.41 0.21 $ 258,730 126,000 574,349 293,586 3.0 444 6,869 0.62 0.61 0.62 0.61 0.21 $ 221,766 90,000 606,091 299,502 2.1 449 6,731 NET INCOME (Dollars in Millions) SHAREHOLDERS’ EQUITY (Dollars in Millions) 07 06 05 04 03 02 01 00 99 98 07 06 05 04 03 02 01 00 99 98 $2.7 $31.5 $19.8 $28.0 $31.0 $30.1 $19.9 $86.0 $72.3 $55.3 07 06 05 04 03 02 01 00 99 98 DIVIDENDS PER SHARE (Dollars) $0.48 $0.40 $0.29 $0.21 $0.21 $0.21 $0.21 $0.21 $0.21 $0.21 $451.0 $414.8 $393.3 $339.5 $307.9 $298.1 $311.5 $299.3 $293.6 $299.5 Applied Industrial Technologies, Inc. and Subsidiaries 39 Back Row (L to R): Peter A. Dorsman, Thomas A. Commes, William G. Bares, Stephen E. Yates, John F. Meier, David L. Pugh, Peter C. Wallace Front Row (L to R): L. Thomas Hiltz, Edith Kelly-Green, J. Michael Moore, Jerry Sue Thornton, Ph.D. DIRECTORS OFFICERS WILLIAM G. BARES (3, 4) Age 66 Former Chairman and Chief Executive Officer The Lubrizol Corporation (Specialty Chemical Products) THOMAS A. COMMES (1, 3) Age 65 Former President and Chief Operating Officer The Sherwin-Williams Company (Paints and Coatings) PETER A. DORSMAN (2) Age 52 Vice President and General Manager NCR Corporation, Systemedia Division (Transaction and Data Warehousing Solutions) L. THOMAS HILTZ (2) Age 61 Attorney EDITH KELLY-GREEN (1) Age 54 Former Vice President and Chief Sourcing Officer FedEx Express (Express Transportation) JOHN F. MEIER (4) Age 59 Chairman and Chief Executive Officer Libbey Inc. (Tableware Products) J. MICHAEL MOORE (1) Age 64 President Oak Grove Consulting Group, Inc. (Management Consulting) Former Chairman and Chief Executive Officer Invetech Company (Industrial Distributor) DAVID L. PUGH (3) Age 58 Chairman & Chief Executive Officer Applied Industrial Technologies, Inc. JERRY SUE THORNTON, Ph.D. (2) Age 60 President Cuyahoga Community College (Two-Year Educational Institution) PETER C. WALLACE (2) Age 53 President and Chief Executive Officer Robbins & Myers, Inc. (Equipment Manufacturer) STEPHEN E. YATES (4) Age 59 Executive Vice President and Chief Information Officer KeyCorp (Financial Services) Committees of The Board (1) Audit Committee (2) Corporate Governance Committee (3) Executive Committee (4) Executive Organization and Compensation Committee DAVID L. PUGH, Age 58 Chairman & Chief Executive Officer BILL L. PURSER, Age 64 President BENJAMIN J. MONDICS, Age 49 Executive Vice President & Chief Operating Officer TODD A. BARLETT, Age 52 Vice President – Acquisitions and Global Business Development FRED D. BAUER, Age 41 Vice President – General Counsel & Secretary MICHAEL L. COTICCHIA, Age 44 Vice President – Chief Administrative Officer and Government Business MARK O. EISELE, Age 50 Vice President – Chief Financial Officer & Treasurer JAMES T. HOPPER, Age 63 Vice President – Chief Information Officer JEFFREY A. RAMRAS, Age 52 Vice President – Marketing and Supply Chain Management RICHARD C. SHAW, Age 58 Vice President – Communications and Learning DANIEL T. BREZOVEC, Age 46 Corporate Controller JODY A. CHABOWSKI, Age 47 Assistant Controller ALAN M. KRUPA, Age 51 Assistant Treasurer OTH ER KE Y MAN AGEM ENT THOMAS E. ARMOLD, Age 52 Vice President – Product Management & Marketing IVAN J. BATISTA, Age 34 General Director – Rafael Benitez Carrillo, Inc. (Puerto Rico) HENRY C. CARL, Age 63 Vice President – Strategic Accounts ROBERT E. CURLEY, Age 47 Vice President – Southeast Area BARBARA D. EMERY, Age 48 Vice President – Human Resources WARREN E. HOFFNER, Age 47 Vice President, General Manager – Fluid Power MARY E. KERPER, Age 56 Vice President – Operational Excellence JOHN M. LEYO, Age 56 Vice President – North Atlantic Area MARK A. STONEBURNER, Age 43 Vice President – Midwest Area SERGIO H. NEVÁREZ, Age 49 General Director – Applied Mexico RONALD A. SOWINSKI, Age 46 President & Chief Operating Officer – Applied Industrial Technologies Ltd. (Canada) DONN G. VEENHUIS, Age 58 Vice President – Western Area THEODORE L. WOLICKI, Age 53 Vice President – Central States Area 40 Applied Industrial Technologies, Inc. and Subsidiaries SHAREHOLDER INFORMATION Applied Industrial Technologies, Inc. common stock is listed on the New York Stock Exchange under the symbol AIT. The company is identified in most financial listings as “AppliedIndlTch.” Research on Applied Industrial Technologies is available through: BB&T CAPITAL MARKETS Holden Lewis, 804/782-8820 SOLEIL – GREAT LAKES REVIEW Elliot Schlang, 216/767-1340 CLEVELAND RESEARCH COMPANY Adam Uhlman, 216/649-7241 STEPHENS INC. Matt Duncan, 501/377-3723 KEYBANC CAPITAL MARKETS® Jeffrey D. Hammond, 216/443-2825 WACHOVIA CAPITAL MARKETS, LLC Allison Poliniak, 212/214-5062 MORGAN KEEGAN Brent D. Rakers, 901/579-4427 SHAREHOLDER INQUIRIES Requests to transfer Applied Industrial Technologies, Inc. shares and all correspondence regarding address change information, duplicate mailings, missing certificates, failure to receive dividend checks in a timely manner or to participate in the Company’s direct stock purchase program should be directed to the Company’s transfer agent and registrar: COMPUTERSHARE INVESTOR SERVICES 250 Royall Street Mail Stop 1A Canton, MA 02021 800/988-5291 Investor relations inquiries should be directed to: MARK O. EISELE Vice President – Chief Financial Officer & Treasurer Applied Industrial Technologies One Applied Plaza Cleveland, OH 44115-5014 Telephone: 216/426-4000, Fax: 216/426-4845 ANNUAL REPORT ON FORM 10-K The Applied Industrial Technologies, Inc. Annual Report on Form 10-K for the fiscal year ended June 30, 2007, including the financial statements and schedules thereto, is available at our Web site at www.applied.com. It is also available without charge upon written request to the Vice President – Chief Financial Officer & Treasurer at the preceding address. REGULATORY CERTIFICATIONS In fiscal 2007, the Chief Executive Officer (CEO) of Applied Industrial Technologies, Inc. provided to the New York Stock Exchange (NYSE) the annual CEO certification regarding the Company’s compliance with NYSE corporate governance listing standards. In addition, the Company’s CEO and Chief Financial Officer filed with the Securities and Exchange Commission the required certifications regarding the quality of the Company’s public disclosures in its fiscal 2007 reports and the effectiveness of internal control over financial reporting. ANNUAL MEETING The Annual Meeting of Shareholders will be held at 10:00 a.m., Tuesday, October 23, 2007, at the Corporate Headquarters of Applied Industrial Technologies, One Applied Plaza, East 36th and Euclid Avenue, Cleveland, Ohio 44115. QUARTERLY VOLUME, PRICE AND DIVIDEND INFORMATION 2007 First Quarter Second Quarter Third Quarter Fourth Quarter 2006 First Quarter Second Quarter Third Quarter Fourth Quarter 2005 First Quarter Second Quarter Third Quarter Fourth Quarter Shares Traded Average Daily Volume High Low Cash Dividend Price Range 20,528,900 16,447,500 17,787,400 18,389,300 11,773,500 17,774,000 15,937,300 26,181,000 14,504,400 20,312,400 16,635,500 15,018,000 325,900 261,100 291,600 291,900 184,000 282,100 257,000 415,600 226,700 317,400 272,700 234,600 $ 25.50 30.00 26.95 30.73 $ 25.03 24.54 31.15 31.67 $ 15.89 21.33 20.01 22.60 $ 20.75 23.61 22.72 24.26 $ 21.33 20.41 22.50 21.97 $ 11.73 14.83 15.19 16.13 $ 0.12 0.12 0.12 0.12 $ 0.08 0.10 0.10 0.12 $ 0.06 0.06 0.08 0.08 Applied Industrial Technologies, Inc. and Subsidiaries 41 Applied Industrial Technologies Corporate Headquarters One Applied Plaza Cleveland, Ohio 44115 216/426-4000 

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