Applied Industrial Annual Report 2008

Plain-text annual report

2008 Annual Report Applied® Providing Solutions, Creating Value 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 important risk factors, including those identified on pages 14 and 15 of this report and in our Annual Report on Form 10-K for the fiscal year ended June 30, 2008. 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. Applied Industrial Technologies is one of North America’s largest independent industrial distributors with more than 3 million parts critical to the manufacturing and maintenance operations of businesses in virtually every industry segment. We are a vital link between suppliers and customers, providing value-added services for both groups. Our people make a difference and provide us with unique advantages that other distributors cannot offer. We use our knowledge and expertise to better understand our customers’ businesses, and we help them ﬁ nd ways to manage their operations more effectively. We are redeﬁ ning the role of customer service by providing solutions and creating value for our customers and suppliers, which in turn create gains for our associates and shareholders. Applied At A Glance Applied Industrial Technologies serves Maintenance Repair Operations (MRO), Original Equipment Manufacturing (OEM), and Government markets with a diverse range of quality products, including bearings, power transmission components, ﬂ uid 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 ﬂ uid power shop services, as well as services to meet storeroom management and maintenance training needs. Headquarters: Cleveland, Ohio, USA Customer Accounts: More than 156,000 Operating Facilities: 459 in 48 U.S. states, 5 Canadian provinces, Puerto Rico and 13 Mexican states E-Commerce: www.applied.com Distribution Centers: 7 Product Manufacturers: More than 2,000 Stock Ticker Symbol: AIT is listed on the New York Stock Exchange Employee Associates: 4,831 Stock Keeping Units (SKUs) Available to Customers: More than 3 million ABOUT THE COVER Today’s plant managers are continuously looking for new solutions to improve the efﬁ ciency of their operations. Applied is focused on Providing Solutions and Creating Value. Photo © SKF USA Inc. 2008 Financial Highlights (In millions except per share amounts, shareholder and employment figures) Year Ended June 30, 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 2008 $ 2,089.5 151.7 $ 95.5 $ 2.19 $ 6,305 43.6 0.60 4,831 20.0% $ $ 110.3 * Includes employee shareholders in the Applied Industrial Technologies Retirement Savings Plan. FISCAL YEAR 2008 BUSINESS/OPERATIONAL HIGHLIGHTS 2007 $ 2,014.1 $ 133.8 86.0 $ 1.93 $ 6,242 44.5 0.48 4,649 19.9% 70.9 $ $ 2006 $ 1,900.8 $ 113.1 $ 72.3 $ 1.57 6,192 46.2 $ 0.40 4,684 17.9% $ 69.9 GROWTH Applied Industrial Technologies achieved record sales in ﬁscal 2008 of $2.1 billion. Net sales increased 3.7% over ﬁscal 2007 and earnings per share increased 13.5% to $2.19. Operating income improved to $152.8 million, a 13.2% improvement over last year, while operating margin improved to 7.3%, compared to 6.7% last year. Selling, distribution and administrative expenses decreased to 19.9% of sales from 20.5% last year. STOCK REPURCHASES AND DIVIDENDS During ﬁscal 2008, Applied purchased 1,144,900 shares of the company’s common stock on the open market. Quarterly dividends for ﬁscal 2008 totaled $25.7 million or $0.60 per share, a 25% increase over last year. The company has increased its quarterly dividend 181% over the last four years. ACQUISITIONS Strengthening its position in the Mexican markets, Applied acquired Suministros Industriales Enol, S.A. de C.V. (Enol) and its group of companies. Headquartered in Puebla with 10 service center locations, Enol distributes power transmission products, bearings, hydraulic hose, electric motors, conveyor products and lubricants. Applied also acquired VYCMEX S.A. de C.V. (VYCMEX) and its group of companies headquartered in Monterrey, Mexico. VYCMEX is the region’s largest independent ﬂuid power distributor, serving the manufacturing, mining and metal processing industries with expertise and capabilities in ﬂuid power products and systems. for NSK Corporation, SUPPLIER AGREEMENTS in August 2008, the company became an Effective authorized distributor further broadening Applied’s offering of bearing products. In ﬁscal 2008, the company formally launched the Sumitomo Drive Technologies product line and entered into new supplier agreements with Dixon Sanitary, a supplier of stainless steel sanitary ﬁttings and valves, and DeWALT Industrial Tool Company, a leading manufacturer of industrial power tools and accessories. HONORS Applied received numerous customer and supplier awards for its operational strengths, including outstanding customer service, technical support, and overall value added. Forbes magazine again selected Applied to its Platinum 400 List of The Best Big Companies in America. This is the ﬁfth consecutive year Applied has made the list and is ranked within the top 100 this year. Forbes’ selection criteria include ﬁve-year proﬁtability and growth, sales and earnings performance, accounting and governance practices, and ﬁnancial condition. Applied continues to climb the ranks of the prestigious list of U.S. companies using InformationWeek 500 information technology (IT) in an innovative manner. For 2007, Applied ranked number 21 out of 500 ﬁrms, up from number 26 last year, for its innovative use of information technology systems for customer service, its business-to- business web site, as well as internal IT systems for employee effectiveness and efﬁciency. The company has been on this list annually since 2000 and within the Top 100 four times. TECHNOLOGY Applied continues to invest in technology systems that improve its operating efﬁciencies and add value to customer interactions. In ﬁscal 2008, Applied further developed ASYST, a web-based, user-friendly interface for internal associates. Going forward, we expect ASYST will help us to continue to reduce transaction cycle time and improve customer service and associate productivity. Applied Industrial Technologies, Inc. and Subsidiaries 1 Letter to our Shareholders David L. Pugh, Benjamin J. Mondics DEAR SHAREHOLDER: We are pleased to report that ﬁscal 2008 was another record year for Applied Industrial Technologies. Our focus on proﬁtable sales growth has yielded our sixth consecutive year of record sales and earnings. Although the economy did soften in the second half of the year, our active management of inventory and other assets, productivity improvements, and implementation of cost controls produced ﬁnancial results of which we are proud. Net sales in ﬁscal 2008 rose 3.7% to $2,089,456,000, while earnings per share rose to $2.19, which represents a 13.5% improvement over last year. Overall net income improved 11.0% to $95.5 million. Despite pricing pressures, our focus on operating margins was successful as they increased to 7.3%. Our investments in information technology systems and corporate-wide employee training programs have boosted the efﬁciency of our day-to-day operations, while also improving the level of service we deliver to our customers. Our selling, distribution and administrative expenses were reduced to 19.9% of sales, an historical low, reﬂecting the productivity improvements we’ve been developing. Our cash generation from operations also set a record at $110 million, providing us with a healthy cash balance of $101.8 million and working capital of $409.2 million at year end. Our debt-to- equity ratio was 5% and the current ratio (current assets to current liabilities) was 3:1. As a result of our strong ﬁnancial position, we paid cash dividends of $0.60 per share during the year, which equates to a current yield of 2.4%. Our cash ﬂow positions us well to invest in continued growth of the business. PROVIDING SOLUTIONS AND CREATING VALUE Our strength in providing solutions and technical expertise strategies, inventory management and training. By bringing is unique and allows us to focus on creating value for our these solutions to our customers, we build loyalty and customers. We help customers improve the efﬁciency of increase sales, which yields greater shareholder value. their operations because we have vast product solutions and we understand the technical aspects of energy efﬁciency, preventative maintenance, parts replacement Our growth in sales to the government sectors and in ﬂuid power systems is reﬂective of the efforts we are putting into these target markets because they offer proﬁtable 2 Applied Industrial Technologies, Inc. and Subsidiaries growth potential. Our full-service approach to ﬂ uid power about the industrial distribution business and we distribution provides system design, product solutions, communicate clearly to our associates, talk frequently with and repair services, and has proven to be an effective our suppliers to understand their objectives, and spend time differentiator that also builds customer loyalty and with our customers understanding their needs. increased sales. During ﬁ scal 2008, Applied repurchased 1,144,900 shares We have continued to make signiﬁ cant investments in our of its common stock for $33.2 million. At June 30, 2008, we government business. In ﬁ scal 2008, sales in this segment had remaining authorization to repurchase an additional continued to grow at double-digit rates to more than 1,065,100 shares. In keeping with our strategy to return value $72 million. Our status as a Government Services to our shareholders, we paid dividends totaling $25.7 million Administration (GSA) contract holder has helped us win in ﬁ scal 2008. signiﬁ cant business for our core products. We have added government industry managers and expanded our focus on federal, state and local government opportunities along with government contractors/agencies. Our large inside and outside sales force gives us the ability to reach a broad range of government organizations, including the armed forces, Army Corps of Engineers, Coast Guard, FEMA, Homeland Security, local police, ﬁ re and rescue, and many other government agencies. We have also enhanced our e-commerce capabilities dedicated to GSA and DOD Emall contracts, which is having a positive impact on growing our online business. ACQUISITIONS Geographically, we continue to capitalize on market opportunities in North America with two signiﬁ cant acquisitions in ﬁ scal 2008. Applied purchased the Enol and VYCMEX companies located in Mexico and expects these businesses to prosper as we integrate them with our current Mexican operations. Sales grew 18% in Mexico in ﬁ scal 2008. Consistent with our strategy to pursue acquisitions that are aligned with our geographic and product needs, and offer a good return to our shareholders, we expect additional acquisitions in ﬁ scal 2009. Already into this new year, we plan to ﬁ nalize the acquisition of Fluid Power Resource, LLC and seven of its ﬂ uid power distribution businesses. These businesses had sales totaling approximately $244 million in calendar 2007. We believe that, following the purchase, Applied will be North America’s largest distributor of ﬂ uid power products. Looking further into ﬁ scal 2009 and beyond, we expect to remain active in acquiring ﬂ uid power distributors in North America as we expand further with this product category. ACTIONS TO CREATE SHAREHOLDER VALUE First and foremost, we focus on delivering value to our customers because we know that translates into more proﬁ table sales and, ultimately, enhanced shareholder value. Our experienced management team is knowledgeable GROWING OUR BUSINESS We achieved considerable success in ﬁ scal 2008 but we recognize the need for continuous improvement if we are to achieve our goals for ﬁ scal 2009. The economic climate may present new challenges, but we believe our focus on proﬁ table sales growth, margin enhancement, cost control, asset management and hard work will allow us to build on our growth of the past. We thank our employee-associates for their dedication and commitment to our goals; we thank our loyal customers and suppliers for their support; and we thank you, our shareholders, for your conﬁ dence in our team. We look forward to another successful year in ﬁ scal 2009. David L. Pugh Chairman & Chief Executive Ofﬁ cer Benjamin J. Mondics President & Chief Operating Ofﬁ cer August 15, 2008 NET SALES (Dollars in Billions) 08 07 06 05 04 08 07 06 05 04 08 07 06 05 04 $2.09 $2.01 $1.90 $1.72 $1.52 (Dollars) $2.19 $1.93 $1.57 $1.20 $0.71 SHAREHOLDERS’ EQUITY (Dollars in Millions) $502.1 $451.0 $414.8 $393.3 $339.5 Applied Industrial Technologies, Inc. and Subsidiaries 3 Our Focus on Solutions Quality Products and Exceptional Service Drive Value Applied Industrial Technologies is one of North America’s largest distributors of industrial parts and components. We deliver the products, technology and expertise that help our customers run their facilities more efﬁciently. We are focused on delivering solutions that add value and build customer loyalty. This solution-based selling allows us to manage our business for proﬁtable growth, where customers come to us for advanced levels of expertise. Customer Service drives Customer Satisfaction, which drives Customer Success, and therefore drives Shareholder Value. Customer Service Customer Satisfaction Customer Success Shareholder Value Applied is an authorized distributor for more than 2,000 parts that will meet the most common needs of local high-quality manufacturers, offering more than 3 million businesses with same day or next day availability. Seven products. When a customer needs a part fast, we can distribution centers across North America provide deliver. And, we have the technical expertise to make sure overnight product delivery to our service centers and can the part they get will deliver maximum life, performance get most parts to any customer the next day if necessary. and energy efﬁciency. Our associates are trained in problem solving and work to achieve the highest levels of customer satisfaction. We support our people with superior infrastructure, continuous training, and information technology systems that make them more efﬁcient in their jobs. Providing Solutions and Creating Value are the differentiators that make Applied the best at what we do. This business strategy has helped us achieve consistent sales and earnings growth, and proﬁtable returns on investment, for our associates and our shareholders. We support customers in a very diverse group of industries Applied has more than 400 locally-managed service so we are better able to manage growth across multiple centers throughout North America. These centers stock sectors of the economy. We recognize the importance of evolving the business to meet emerging market needs, to introduce new products, and to use technology to reduce expenses. We are continuing to expand our ﬂuid power and government sales activity where solution selling is an advantage. We are expanding our product lines with a growing number of green and sustainable products. And, we are investing in information technology solutions that are streamlining our internal operations and expanding our external offerings. 4 Applied Industrial Technologies, Inc. and Subsidiaries Our Focus on People We Hire Great People and Motivate Them to Excel Ingrained in the culture of our company is a respect for and dedication to the people we serve and work with. Whether they are customers, suppliers, associates or shareholders, we realize this is a team effort that requires the best people, skills and results. Associates are trained and motivated to achieve stretch goals that help them personally and professionally. Managers are encouraged to use their knowledge and skills to create new opportunities to manage the business for proﬁtable growth. We expect our people to produce extraordinary results, and they do. We realize that different parts of the country serve different types of manufacturing industries and we provide each service center with the support and tools they need to do their jobs efﬁciently, while giving them the ﬂexibility to meet the needs of their unique sales and service area. In some parts of the country we have primary metals manufacturing expertise, while other locales may have more experience with paper mills or metal fabrication. We employ product and industry specialists to meet the needs of a speciﬁc market so we can add value to our customers in that area. Our associates undergo extensive professional training each and every year. Our investment in online e-learning has made it easier and more effective for our associates to average more than 40 hours of training annually. Whether it is technical knowledge or management training, associates are required to study, train and advance their individual skills in order to make themselves and our company more valuable. We recognize it is knowledge and expertise that position us ahead of our competition. We are investing in our people because they are Providing Solutions and Creating Value. Applied has received numerous awards as a result of our ability to attract, develop and retain highly skilled associates, while creating a culture that makes Applied a great place to work. We clearly communicate our expectations, we measure our results, and we make continuous adjustments to improve our performance. 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(cid:84)(cid:72)(cid:69)(cid:0)(cid:70)(cid:65)(cid:83)(cid:84)(cid:69)(cid:83)(cid:84)(cid:0)(cid:80)(cid:82)(cid:79)(cid:68)(cid:85)(cid:67)(cid:84)(cid:0)(cid:68)(cid:69)(cid:76)(cid:73)(cid:86)(cid:69)(cid:82)(cid:89)(cid:14)(cid:0)(cid:33)(cid:51)(cid:57)(cid:51)(cid:52)(cid:0)(cid:72)(cid:69)(cid:76)(cid:80)(cid:83)(cid:0)(cid:85)(cid:83)(cid:0)(cid:80)(cid:82)(cid:79)(cid:86)(cid:73)(cid:68)(cid:69)(cid:0)(cid:79)(cid:80)(cid:69)(cid:82)(cid:65)(cid:84)(cid:73)(cid:79)(cid:78)(cid:65)(cid:76)(cid:0)(cid:69)(cid:88)(cid:67)(cid:69)(cid:76)(cid:76)(cid:69)(cid:78)(cid:67)(cid:69)(cid:0)(cid:73)(cid:78)(cid:0)(cid:79)(cid:85)(cid:82)(cid:0)(cid:67)(cid:85)(cid:83)(cid:84)(cid:79)(cid:77)(cid:69)(cid:82)(cid:0)(cid:84)(cid:82)(cid:65)(cid:78)(cid:83)(cid:65)(cid:67)(cid:84)(cid:73)(cid:79)(cid:78)(cid:83)(cid:14) Providing Solutions and Creating Value(cid:0) (cid:77)(cid:69)(cid:65)(cid:78)(cid:83)(cid:0) (cid:67)(cid:85)(cid:83)(cid:84)(cid:79)(cid:77)(cid:69)(cid:82)(cid:83)(cid:0) (cid:67)(cid:65)(cid:78)(cid:0) (cid:73)(cid:78)(cid:84)(cid:69)(cid:82)(cid:65)(cid:67)(cid:84)(cid:0) (cid:87)(cid:73)(cid:84)(cid:72)(cid:0) (cid:33)(cid:80)(cid:80)(cid:76)(cid:73)(cid:69)(cid:68)(cid:0) (cid:84)(cid:72)(cid:82)(cid:79)(cid:85)(cid:71)(cid:72)(cid:0) (cid:79)(cid:85)(cid:82)(cid:0) (cid:65)(cid:80)(cid:80)(cid:82)(cid:79)(cid:88)(cid:73)(cid:77)(cid:65)(cid:84)(cid:69)(cid:76)(cid:89)(cid:0) (cid:17)(cid:12)(cid:21)(cid:16)(cid:16)(cid:0) 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(cid:84)(cid:82)(cid:65)(cid:68)(cid:73)(cid:84)(cid:73)(cid:79)(cid:78)(cid:65)(cid:76)(cid:0)(cid:80)(cid:82)(cid:73)(cid:78)(cid:84)(cid:69)(cid:68)(cid:0)(cid:67)(cid:65)(cid:84)(cid:65)(cid:76)(cid:79)(cid:71)(cid:14)(cid:0)(cid:37)(cid:65)(cid:67)(cid:72)(cid:0)(cid:79)(cid:70)(cid:0)(cid:84)(cid:72)(cid:69)(cid:83)(cid:69)(cid:0)(cid:73)(cid:77)(cid:80)(cid:79)(cid:82)(cid:84)(cid:65)(cid:78)(cid:84)(cid:0)(cid:83)(cid:65)(cid:76)(cid:69)(cid:83)(cid:0)(cid:67)(cid:72)(cid:65)(cid:78)(cid:78)(cid:69)(cid:76)(cid:83)(cid:0)(cid:73)(cid:83)(cid:0)(cid:68)(cid:69)(cid:83)(cid:73)(cid:71)(cid:78)(cid:69)(cid:68)(cid:0)(cid:84)(cid:79)(cid:0)(cid:83)(cid:85)(cid:80)(cid:80)(cid:79)(cid:82)(cid:84)(cid:0)(cid:79)(cid:85)(cid:82)(cid:0)(cid:67)(cid:85)(cid:83)(cid:84)(cid:79)(cid:77)(cid:69)(cid:82)(cid:83)(cid:0)(cid:87)(cid:73)(cid:84)(cid:72)(cid:0)(cid:84)(cid:72)(cid:69)(cid:0)(cid:76)(cid:69)(cid:86)(cid:69)(cid:76)(cid:0)(cid:79)(cid:70)(cid:0) (cid:83)(cid:69)(cid:82)(cid:86)(cid:73)(cid:67)(cid:69)(cid:0)(cid:84)(cid:72)(cid:69)(cid:89)(cid:0)(cid:78)(cid:69)(cid:69)(cid:68)(cid:0)(cid:84)(cid:79)(cid:0)(cid:77)(cid:69)(cid:69)(cid:84)(cid:0)(cid:84)(cid:72)(cid:69)(cid:73)(cid:82)(cid:0)(cid:85)(cid:78)(cid:73)(cid:81)(cid:85)(cid:69)(cid:0)(cid:82)(cid:69)(cid:81)(cid:85)(cid:73)(cid:82)(cid:69)(cid:77)(cid:69)(cid:78)(cid:84)(cid:83)(cid:14) The new ASYST program has several productivity enhancements including: (cid:115)(cid:0)(cid:73)(cid:77)(cid:80)(cid:82)(cid:79)(cid:86)(cid:69)(cid:68)(cid:0)(cid:79)(cid:82)(cid:68)(cid:69)(cid:82)(cid:0)(cid:80)(cid:82)(cid:79)(cid:67)(cid:69)(cid:83)(cid:83)(cid:73)(cid:78)(cid:71) (cid:115)(cid:0)(cid:69)(cid:88)(cid:80)(cid:65)(cid:78)(cid:68)(cid:69)(cid:68)(cid:0)(cid:83)(cid:69)(cid:65)(cid:82)(cid:67)(cid:72)(cid:0)(cid:67)(cid:65)(cid:80)(cid:65)(cid:66)(cid:73)(cid:76)(cid:73)(cid:84)(cid:73)(cid:69)(cid:83) (cid:115)(cid:0)(cid:65)(cid:67)(cid:67)(cid:79)(cid:85)(cid:78)(cid:84)(cid:0)(cid:83)(cid:84)(cid:65)(cid:84)(cid:85)(cid:83)(cid:0)(cid:86)(cid:65)(cid:76)(cid:73)(cid:68)(cid:65)(cid:84)(cid:73)(cid:79)(cid:78) (cid:115)(cid:0)(cid:83)(cid:84)(cid:79)(cid:67)(cid:75)(cid:0)(cid:76)(cid:79)(cid:67)(cid:65)(cid:84)(cid:73)(cid:79)(cid:78)(cid:0)(cid:65)(cid:78)(cid:68)(cid:0)(cid:65)(cid:86)(cid:65)(cid:73)(cid:76)(cid:65)(cid:66)(cid:73)(cid:76)(cid:73)(cid:84)(cid:89)(cid:0)(cid:83)(cid:84)(cid:65)(cid:84)(cid:85)(cid:83) (cid:115)(cid:0)(cid:65)(cid:68)(cid:68)(cid:73)(cid:84)(cid:73)(cid:79)(cid:78)(cid:65)(cid:76)(cid:0)(cid:84)(cid:69)(cid:67)(cid:72)(cid:78)(cid:73)(cid:67)(cid:65)(cid:76)(cid:0)(cid:73)(cid:78)(cid:70)(cid:79)(cid:82)(cid:77)(cid:65)(cid:84)(cid:73)(cid:79)(cid:78) (cid:115)(cid:0)(cid:69)(cid:77)(cid:65)(cid:73)(cid:76)(cid:0)(cid:80)(cid:65)(cid:82)(cid:84)(cid:0)(cid:65)(cid:78)(cid:68)(cid:0)(cid:79)(cid:82)(cid:68)(cid:69)(cid:82)(cid:0)(cid:83)(cid:69)(cid:65)(cid:82)(cid:67)(cid:72)(cid:0)(cid:82)(cid:69)(cid:83)(cid:85)(cid:76)(cid:84)(cid:83) (cid:115)(cid:0)(cid:79)(cid:80)(cid:84)(cid:73)(cid:77)(cid:73)(cid:90)(cid:69)(cid:68)(cid:0)(cid:83)(cid:72)(cid:73)(cid:80)(cid:80)(cid:73)(cid:78)(cid:71)(cid:0)(cid:84)(cid:79)(cid:79)(cid:76)(cid:83) 6 Applied Industrial Technologies, Inc. and Subsidiaries Our Focus on Creating Value Our Documented Value Added® Programs Have Tracked Billions of Dollars Saved and we know how to manage our own inventory to provide same day delivery when necessary. All of our service centers offer 24-hour emergency service, seven days a week, and customers know they can call on us whenever they need our assistance. Applied is a leader in offering our customers a Documented Value Added® (DVA®) program where our associates monitor and report value-added services on a monthly, quarterly, semi-annual or annual basis. Beyond product cost, we track many underlying costs that can be minimized to increase a facility’s proﬁtability. We calculate savings from improved product life, reduced maintenance and labor costs, reduced energy consumption, reduced inventory investment, and other transactional savings. In one example, a manufacturer’s production line came to a halt because a unique bearing assembly failed and the replacement parts were not available. The Applied associate used his knowledge to modify a standard bearing assembly that was in stock and saved the company 12 days of downtime, plus signiﬁcant transportation and labor costs, totaling more than $2 million. In another case, Applied saw that a large manufacturing operation was investing a lot of time and expense in relubricating bearings on a cooling conveyor. Our recommendation to replace those bearings with composite Applied associates are constantly looking for ways to create value for the organization. When we create value in our jobs, we create value for our customers, our suppliers, our shareholders and ourselves. We have been successful offering our customers energy-efﬁciency programs that allow us to analyze their business operations and make product recommendations that will reduce their energy usage and minimize energy costs. New, high-efﬁciency motors, drives and power transmission components can signiﬁcantly reduce energy consumption. Applied account managers are trained to be experts in evaluating plant operations and recommending solutions that save our customers money or improve productivity. In addition, Applied offers world-class supply chain management systems bearings that require no relubrication saved that can support our customers with on-site and off-site inventory. We the company $155,000 per year at one have replacement part strategies that advise customers on when it is more plant and is being implemented at two cost-effective to replace a part than to repair a part, based on new energy- additional plants. efﬁciency improvements and expected product life. Many customers have goals to reduce Downtime can cost an organization thousands of dollars per minute, and costs within their organization and our DVA Applied is proactive about helping customers manage their service needs programs are Providing Solutions and to reduce downtime. We also understand the needs of many businesses Creating Value. Applied Industrial Technologies, Inc. and Subsidiaries 7 Our Focus on Growth & Acquisition Building On Our Strengths Applied will continue to focus on its core businesses in The ﬂuid power business continues to be a strong part of our North America as our best opportunities for growth. We growth strategy as we pursue acquisitions for geographic have core competencies in providing sales and service penetration, as well as new suppliers for an expanded line support for a wide range of industrial supplies that include of products and services. Our technical expertise in system bearings, power transmission components, ﬂuid power design and integration has become a solid opportunity to components and systems, industrial rubber products, linear grow the business with a stronger presence in hydraulic, components, tools, safety products, general maintenance pneumatic, and ﬂuid ﬁltration applications. and a variety of mill supply products. With the planned acquisition of Fluid Power Resource, Our government sales have experienced double-digit LLC (ﬁscal 2009), Applied will have 67 sales and service growth the past few years and are forecast to continue at facilities across North America dedicated to providing this rate. This business has allowed us to expand into new ﬂuid power products and services. Applied’s strong track federal markets with our core products, while also allowing record of ﬂuid power sales, aided by acquisitions and us to introduce new products to a very broad and diverse effective management, will result in this product category market of state and local government facilities. representing approximately 25% of total net sales in Federal and defense spending is expected to be strong for ﬁscal 2009. the next several years. The federal government has many Our steady growth in this market will allow us to expand our buildings and vehicles that are targeted for refurbishment, services to include additional capabilities for ﬂuid power while the Air Force has a “Refresh and Reset” program that system integration, manifold design, machining, assembly, will provide growth opportunities. and repair shop services in many locations, giving us unique advantages for Providing Solutions and Creating Value. Applied is an authorized GSA contract holder and offers procurement and logistic services that meet the needs of many government contract purchase agreements. We have added government industry managers in many of our regional ofﬁces to increase our proactive sales efforts for this market. We are also training our service center staff to be supportive of the unique requirements for government business opportunities. Our technical service expertise is a key advantage and differentiator for our business in this market. New products introduced as a result of government business opportunities include: (cid:115)(cid:0)(cid:0)(cid:48)(cid:79)(cid:87)(cid:69)(cid:82)(cid:38)(cid:76)(cid:65)(cid:82)(cid:69)® – tough, durable LED ﬂares used by police, ﬁre and EMS agencies (cid:115)(cid:0)(cid:0)(cid:34)(cid:73)(cid:79)(cid:50)(cid:69)(cid:77)(cid:0)(cid:18)(cid:16)(cid:16)(cid:16)(cid:0)(cid:110)(cid:0) biodegradable cleaner that neutralizes chemical spills (cid:115)(cid:0)(cid:0)(cid:45)(cid:65)(cid:75)(cid:73)(cid:84)(cid:65)(cid:0)(cid:83)(cid:80)(cid:65)(cid:82)(cid:75)(cid:76)(cid:69)(cid:83)(cid:83)(cid:0)(cid:68)(cid:82)(cid:73)(cid:76)(cid:76)(cid:0)(cid:110)(cid:0) for hazardous environments (cid:115)(cid:0)(cid:0)(cid:37)(cid:77)(cid:69)(cid:82)(cid:71)(cid:69)(cid:78)(cid:67)(cid:89)(cid:0)(cid:48)(cid:82)(cid:69)(cid:80)(cid:65)(cid:82)(cid:69)(cid:68)(cid:78)(cid:69)(cid:83)(cid:83)(cid:0)(cid:48)(cid:82)(cid:79)(cid:68)(cid:85)(cid:67)(cid:84)(cid:83) (cid:115)(cid:0)(cid:52)(cid:79)(cid:79)(cid:76)(cid:83)(cid:0)(cid:65)(cid:78)(cid:68)(cid:0)(cid:52)(cid:79)(cid:79)(cid:76)(cid:75)(cid:73)(cid:84)(cid:83) PowerFlare® 8 Applied Industrial Technologies, Inc. and Subsidiaries Our Focus on Shareholder Value Superior 5-Year Growth A $100 investment in Applied shares at the close of business on June 30, 2003 was worth $282 on June 30, 2008. This cumulative total return is signiﬁcantly better than industry average returns for the same period and is a result of our focus on the four cornerstones of our strategy: (cid:0) (cid:115)(cid:0)(cid:48)(cid:82)(cid:79)(cid:108)(cid:84)(cid:65)(cid:66)(cid:76)(cid:69)(cid:0)(cid:51)(cid:65)(cid:76)(cid:69)(cid:83)(cid:0)(cid:39)(cid:82)(cid:79)(cid:87)(cid:84)(cid:72)(cid:0)(cid:0) (cid:115)(cid:0)(cid:45)(cid:65)(cid:82)(cid:71)(cid:73)(cid:78)(cid:0)(cid:37)(cid:78)(cid:72)(cid:65)(cid:78)(cid:67)(cid:69)(cid:77)(cid:69)(cid:78)(cid:84)(cid:0) (cid:0)(cid:115)(cid:0)(cid:35)(cid:79)(cid:83)(cid:84)(cid:0)(cid:35)(cid:79)(cid:78)(cid:84)(cid:82)(cid:79)(cid:76)(cid:0)(cid:0) (cid:115)(cid:0)(cid:33)(cid:83)(cid:83)(cid:69)(cid:84)(cid:0)(cid:45)(cid:65)(cid:78)(cid:65)(cid:71)(cid:69)(cid:77)(cid:69)(cid:78)(cid:84) We continue to manage the business for growth and a proﬁtable return on investments. Our strategy of focusing on value-based solutions for our customers is the foundation of our business. We manage our investment opportunities to yield increased sales and productivity improvements that boost shareholder value. We have signiﬁcantly outperformed our peers over this 5-year period. We continue to return proﬁt to our shareholders through our dividends, and we repurchase shares when appropriate to support our investments. Ofﬁcers, directors and associates all share in the risks and rewards of our business. It is our commitment to continue our focus on shareholder value. COMPAPP RISON OF FIVE-YEAR CUMULATAA IVE TOTATT L RETURN Applied Industrial TeTT chnologies, Inc., Standard & Poor’s 500, and Peer Group (Perfoff rmance Results from 7/01/03 through 6/30/08) Applied Industrial Technologies, Inc. Standard & Poor’s 500 Peer Group $238.24 $273.36 $194.10 $145.66 $145.38 $139.45 $117.07 $122.25 $130.34 $338.11 $230.35 $154.27 $282.75 $203.61 $131.35 $400.00 $350.00 $300.00 $250.00 $200.00 $150.00 $100.00 $50.00 $0.00 2003 2004 2005 2006 2007 2008 Assumes $100 invested at the close of trading 6/30/03 in Applied Industrial TeTT chnologies, Inc. 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 markket capitalization. Peer group companies selected on a line-of-business basis include: Airgas, Inc., Genuine Parts Company, W.W. Grainger,rr Inc., Kaman Corporation, Lawson Products, Inc., MSC Industrial Direct Co., Inc., The Timken Company, and WEESCO International, Inc. Applied Industrial Technologies, Inc. Standard & Poor’s 500 Peer Group Source: Value Line, Inc. 2005 2004 2003 2008 $ 100.00 $ 145.66 $ 238.24 $ 273.36 $ 338.11 $ 282.75 131.35 203.61 117.07 139.45 100.00 100.00 122.25 145.38 130.34 194.10 154.27 230.35 2006 2007 Applied Industrial Technologies, Inc. and Subsidiaries 9 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW With more than 4,800 associates across North America, Applied Industrial Technologies (“Applied,” the “Company,” “We,” “Us” or “Our”) is an industrial distributor that offers parts critical to the operations of MRO and OEM customers in a wide range of industries. In addition, Applied provides engineering, design and systems integration for industrial and ﬂuid power applications, as well as customized ﬂuid power shop, mechanical and fabricated rubber services. We have a long tradition of growth dating back to 1923, the year our business was founded in Cleveland, Ohio. During ﬁscal 2008, business was conducted in the United States, Canada, Mexico and Puerto Rico from 459 facilities. Applied is an authorized distributor for more than 2,000 manufacturers and offers access to approximately 3 million stock keeping units (“SKUs”). A large portion of our business is selling replacement parts to manufacturers for repair or maintenance of machinery and equipment. When reviewing the discussion and analysis set forth below, please note that the majority of SKUs we sell in any given year were not sold in the prior year, resulting in the inability to quantify commonly used comparative metrics such as changes in product mix and volume. Our ﬁscal 2008 sales hit a record $2.1 billion dollars, an increase of 3.7% compared to the prior year. Our operating income and earnings per share increased 13.2% and 13.5%, 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 held steady at 27.2%. In addition, the rate of growth in selling, distribution and administrative expense for ﬁscal 2008 was held below the rate of increase in sales, coming in at less than 1.0%. Our consolidated balance sheet remains strong as shown by the increase in shareholders’ equity from the June 30, 2007 level. Management of our working capital and strong earnings resulted in cash provided by operations of $110.3 million, more than 50% higher than ﬁscal 2007’s $70.9 million. Working capital increased $43.7 million from June 30, 2007 to $409.2 million at June 30, 2008. 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 business environment changes. Both the PMI and the MCU signaled a weakening economy in ﬁscal 2008. Our sales activity traditionally lags these key indicators by approximately 6 months. Consistent with these indicators, we saw greater sales increase percentages in the ﬁrst half of ﬁscal 2008 versus the second half. Industrial production in the United States slowed in this ﬁscal year and there continues to be projected softness in the industrial economy in ﬁscal 2009 as reﬂected in the PMI and MCU indices. Exclusive of the impact of any acquisitions subsequent to June 30, 2008, we are forecasting our sales in ﬁscal 2009 to increase in the 2.0% to 7.0% range and our gross proﬁt percentage to be consistent with ﬁscal 2008 levels. In ﬁscal 2009, the gross proﬁt margin will be highly dependent on our ability to manage and recover supplier price increases. We anticipate that ﬁscal 2009 supplier purchasing incentives will be consistent with the ﬁscal 2008 levels. While 10 Applied Industrial Technologies, Inc. and Subsidiaries we consider these purchasing incentives to be compensation for various sales, marketing and logistics services performed, when they are recognized in our statements of consolidated income, 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 expense (“SD&A”) 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, 2008 vs. 2007 Net sales in ﬁscal 2008 were $2.1 billion or 3.7% above the prior year sales. This increase was due to improvements in our service center based distribution sales of 3.3% and in our ﬂuid power businesses’ sales of 7.7%. The increase in service center based distribution sales was primarily driven by an increase in national contract business and the recovery of supplier price increases. Within the service center based distribution segment, the impact of the strengthening Canadian currency was largely offset by a 9.3% volume decline in our Canadian market. The increase in sales at our ﬂuid power businesses was approximately 45% attributable to favorable currency ﬂuctuations at the Canadian locations and approximately 25% related to the VYCMEX S.A. de C.V. (“VYCMEX”) acquisition. Also contributing to these increases was an additional sales day in ﬁscal 2008 compared to ﬁscal 2007. The sales product mix for ﬁscal 2008 was 80.0% industrial products and 20.0% ﬂuid power products compared to 80.2% industrial and 19.8% ﬂuid power in the prior year. At June 30, 2008, we had a total of 459 operating facilities in the U.S., Canada and Mexico versus 445 at June 30, 2007. The increase in facilities is largely attributed to 5 facilities from the acquisition of VYCMEX midway through the ﬁscal year and 10 facilities from the acquisition of Suministros Industriales Enol, S.A. de C.V. (“Enol”) at the end of ﬁscal 2008. Our gross proﬁt margin maintained the 27.2% achieved in ﬁscal 2007. Slightly higher levels of supplier purchasing incentives were largely offset by continued pressures in gross proﬁt margin with national contracts. LIFO inventory layer liquidations resulted in a $0.6 million positive impact during ﬁscal 2008. SD&A 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 0.8% during ﬁscal 2008 compared to the prior year, but decreased as a percent of sales to 19.9% from 20.5% in 2007. Approximately one third of the ﬁscal 2008 increase was attributable to SD&A amounts of businesses acquired. The remainder of the increase was primarily due to increases in associate compensation tied to improved ﬁnancial performance. Operating income increased 13.2% to $152.8 million during ﬁscal 2008 from $135.0 million during 2007. As a percent of sales, operating income increased to 7.3% in ﬁscal 2008 from 6.7% in 2007. The $17.8 million increase in operating income during ﬁscal 2008 primarily reﬂects the impact of higher sales at a stable gross proﬁt percentage with only modest increases in SD&A expenses. Interest expense, net decreased by 62.6% or $1.5 million during ﬁscal 2008 compared with the prior year, primarily due to repayment of $50.0 million of long-term debt in December 2007. Other expense (income), net, represents certain non-operating items of income and expense. This line decreased $1.4 million due primarily to the loss in market value in investments held by deferred compensation trusts. Income tax expense as a percentage of income before taxes was 37.1% for ﬁscal 2008 and 35.7% for 2007. The increase in the effective tax rate was due to higher effective state tax rates in the current year and U.S. federal tax law changes which have eliminated the deductibility of certain expenses. Exclusive of the impact of any acquisitions subsequent to June 30, 2008, we expect our overall tax rate for ﬁscal 2009 to rise to around 37.5%, primarily due to the full year impact of the items noted above. As a result of the factors addressed above, net income for ﬁscal 2008 increased $9.4 million or 11.0% from the prior year. Net income per share increased 13.5% to $2.19 in ﬁscal 2008 from $1.93 in 2007. During ﬁscal 2008 and 2007, we repurchased 1.1 million and 1.4 million shares, respectively, which resulted in fewer shares outstanding for the year compared to the prior year. The buybacks in ﬁscal 2008 contributed approximately $0.03 cents per share. The number of Company associates was 4,831 at June 30, 2008 and 4,649 at June 30, 2007. 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 improvement in our service center based distribution sales and the impact of our acquisitions which accounted for approximately one quarter of the increase in sales. The increase in service center based distribution sales was driven by sales mix, volume, the recovery of supplier price increases, sales generated by acquired businesses and the strengthening of the Canadian currency. 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. 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 reﬂected higher levels of supplier purchasing incentives. LIFO inventory layer liquidations resulted in a $1.6 million positive impact during ﬁscal 2006. 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 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 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 on the growth 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 expense (income), net, 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 to higher levels of non-taxable interest income in ﬁscal year 2007. 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, 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. in investment income, controlling LIQUIDITY AND CAPITAL RESOURCES Cash ﬂows from operations depend primarily upon generating operating 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 $110.3 million of cash from operating activities during ﬁscal 2008, $70.9 million during 2007, and $69.9 million during 2006. Cash provided from operations in ﬁscal 2008 beneﬁted from our strong operating results. The operating cash ﬂow increase was largely generated by a lower receivables balance, timing of certain supplier payments and improved net income. 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 how we fund our contributions to the Applied Industrial Technologies Retirement Savings Plan (section 401(k) plan). We 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 $26.8 million during ﬁscal 2008, $10.2 million during 2007 and $37.9 million during 2006. Cash was primarily used for acquisitions in ﬁscal 2008 and ﬁscal 2006, whereas it was primarily used for capital expenditures in ﬁscal 2007. In ﬁscal 2008, we acquired two Mexican distributors for $28.7 million, of which $22.1 million was paid at closing, net of cash acquired. In ﬁscal 2006, we acquired two U.S. distributors for $28.6 million, of which $27.7 million was paid at closing, net of cash acquired. Capital expenditures consisted primarily of information technology equipment, and buildings and improvements. Applied Industrial Technologies, Inc. and Subsidiaries 11 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Continued Exclusive of the impact of any acquisitions subsequent to June 30, 2008, for ﬁscal 2009, our capital expenditures are expected to be in the $10.0 million to $12.0 million range, consisting primarily of additional information system technology equipment and infrastructure investments. Depreciation for ﬁscal 2009 is expected to be in the range of $12.5 million to $13.5 million. Cash used in ﬁnancing activities was $103.5 million during ﬁscal 2008, $48.4 million during 2007 and $53.8 million during 2006. The increase in cash used in ﬁnancing activities is primarily due to repayment of $50.0 million long-term debt in December 2007. We increased our quarterly dividend to $0.15 per share in ﬁscal 2008 which accounted for approximately $4.8 million of this increase. The amount of the dividend paid is based on judgment, ﬁnancial performance and payout guidelines consistent with other industrial companies. Comparing ﬁscal 2007 and ﬁscal 2006, we repurchased fewer shares, accounting for a reduction of $20.8 million of cash used. Partially offsetting this was $12.5 million in lower excess tax beneﬁts from share-based compensation due to fewer 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 in ﬁscal 2007 versus ﬁscal 2006. Over the last three ﬁscal years, we repurchased 1.1 million, 1.4 million and 2.4 million shares of the Company’s common stock at an average price per share of $29.02, $24.26 and $23.05, respectively. The following table shows the Company’s approximate obligations and commitments to make future payments under contractual obligations as of June 30, 2008 (in thousands): Total $ 68,100 Period Less Than 1 yr. $ 20,700 Period 1-3 yrs. $ 24,300 Period 4-5 yrs. $ 13,000 Period over 5 yrs. $ 10,100 5,000 2,000 3,000 42,600 25,000 3,200 8,300 8,700 22,400 25,000 $ 140,700 $ 25,900 $ 60,600 $ 21,700 $ 32,500 Operating leases Interest payments on debt Planned funding of postretirement obligations Long-term debt Total Contractual Cash Obligations 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 table above excludes the liability for unrecognized income tax beneﬁts as the Company is unable to make a reasonable estimate regarding the timing of cash settlements with the respective taxing authorities. At June 30, 2008, the Company has a gross liability for unrecognized income tax beneﬁts of $2,498, including interest and penalties of $494. The Board of Directors has authorized the repurchase of shares of the Company’s stock. These purchases may be made in open market and negotiated transactions, from time to time, depending upon market conditions. At June 30, 2008, we had authorization to purchase an additional 1,065,100 shares. 12 Applied Industrial Technologies, Inc. and Subsidiaries 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 credit facilities available for borrowings as required. See Note 5 to the consolidated ﬁnancial statements for details regarding the outstanding debt amounts as of June 30, 2008 and 2007. The average borrowings totaled $47.1 million during ﬁscal 2008 and $75.0 million during ﬁscal 2007. In ﬁscal 2008, we paid off $50.0 million of debt that matured in December 2007. The Company’s remaining 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 8.4%, 6.8% and 6.7% in ﬁscal 2008, 2007 and 2006, respectively. The increase in the weighted average interest rate reﬂects the impact of the strengthening of the Canadian dollar. We terminated certain interest rate swap agreements for favorable settlements in prior years. The settlement gains were amortized as a reduction in interest expense of $0.8 million per year through December 2007. 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, 2008, we had no variable rate debt or interest rate swaps outstanding. See Note 6 to the consolidated ﬁnancial statements for additional discussion on our derivative activities. The Company’s working capital at June 30, 2008 was $409.2 million compared to $365.5 million at June 30, 2007. The current ratio was 3.1 at June 30, 2008 and 2.6 at June 30, 2007. The increase in working capital at June 30, 2008 was primarily due to strong operating cash ﬂows. The Company has a ﬁve-year committed revolving credit agreement which expires in June 2012. This agreement provides for unsecured borrowings of up to $150.0 million. We had no borrowings outstanding under this facility at June 30, 2008. Unused lines under this facility, net of outstanding letters of credit totaling $144.9 million, are available to fund future acquisitions or other capital and operating requirements. We also have an uncommitted long-term ﬁnancing shelf facility which 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, 2008. The aggregate annual maturity of outstanding debt is $25.0 million due 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. SUBSEQUENT EVENT On July 14, 2008, Applied entered into an agreement to acquire certain assets of Fluid Power Resource, LLC, including seven ﬂuid power businesses for cash consideration of $169.0 million. The Company intends to fund the acquisition by drawing down its existing revolving credit facility and from its available cash. These businesses employ 455 people and for the year ended December 31, 2007 had sales of approximately $244.0 million. Results of operations acquired will be included in the Company’s results of operations from the date of closing. CRITICAL ACCOUNTING POLICIES The preparation of ﬁnancial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates at a speciﬁc point in time that affect the amounts reported in the consolidated ﬁnancial statements and disclosed in the accompanying notes. Note 1 to the consolidated ﬁnancial statements describes the signiﬁcant accounting policies and methods used in preparation of the consolidated ﬁnancial statements. Estimates are used for, but not limited to, determining the net carrying value of trade accounts receivable, inventories, recording self- insurance liabilities and other accrued liabilities. Actual results could differ from these estimates. The following critical accounting policies are impacted signiﬁcantly by judgments, assumptions and estimates used in the preparation of the consolidated ﬁnancial statements. LIFO Inventory Valuation and Methodology 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 $150.1 million as reﬂected on our consolidated balance sheet at June 30, 2008. The Company maintains ﬁve LIFO pools based on the following product groupings: bearings, power transmission products, rubber products, ﬂuid power products and other products. LIFO layers and/or liquidations are determined consistently year-to-year in a manner which is in accordance with the guidance in the 1984 AICPA LIFO Issues Paper, “Identiﬁcation and Discussion of Certain Financial Accounting and Reporting Issues Concerning LIFO Inventories.” See Note 3 to the consolidated ﬁnancial statements for further information regarding inventories. Allowances for Slow-Moving and Obsolete Inventories We evaluate the recoverability of our slow moving or obsolete inventories at least quarterly. We estimate the recoverable cost of such inventory by product type while considering factors such as its age, historic and current demand trends, the physical condition of the inventory, as well as assumptions regarding future demand. Our ability to recover our cost for slow moving or obsolete inventory can be affected by such factors as general market conditions, future customer demand and relationships with suppliers. 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. Allowances for Doubtful Accounts We evaluate the collectibility of trade accounts receivable based on a combination of factors. Initially, we estimate an allowance for doubtful accounts as a percentage of net sales based on historical bad debt experience. This initial estimate is adjusted based on recent trends of certain customers and industries estimated to be a greater credit risk, trends within the entire customer pool and changes in the overall aging of accounts receivable. While we have a large customer base that is geographically dispersed, a general economic downturn in any of the industry segments in which we operate could result in higher than expected defaults, and therefore, the need to revise estimates for bad debts. Self-Insurance Liabilities We maintain business insurance programs with signiﬁcant self-insured retention covering workers’ compensation, business, automobile, general product liability and other claims. We accrue estimated losses using actuarial calculations, models and assumptions based on historical loss experience. We maintain a self-insured health beneﬁts plan, which provides medical beneﬁts to employees electing coverage 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. Although management believes that the estimated liabilities for self- insurance are adequate, the estimates described above may not be indicative of current and future losses. In addition, the actuarial calculations used to estimate self-insurance liabilities are based on numerous assumptions, some of which are subjective. We will continue to adjust our estimated liabilities for self-insurance, as deemed necessary, in the event that future loss experience differs from historical loss patterns. Pension and Other Postemployment Beneﬁt Plans The measurement of liabilities related to pension plans and other post- employment beneﬁt plans is based on management’s assumptions related to future events including interest rates, return on pension plan assets, rate of compensation increases, and healthcare cost trend rates. We evaluate these assumptions and adjust them as necessary. Changes to these assumptions could result in a material change to the Company’s pension obligation causing a related increase or decrease in reported net operating results in the period of change in the estimate. A 1% decrease in the discount rate would result in an additional liability of $3.3 million and additional expense of $0.3 million. A 1% increase in the discount rate would result in a decrease in the liability of $2.9 million and a decrease in expense of $0.3 million. A 1% decrease in the salary scale would result in a decrease in the liability and expense of $1.3 million and $0.3 million, respectively. A 1% increase in the salary scale would increase the liability and expense by $1.5 million and $0.3 million, respectively. A 1% change in the return on assets is not material since most of the plans are non-qualiﬁed and unfunded. In ﬁscal 2007, we adopted FASB Statement of Financial Accounting Standards (“SFAS”) No. 158, “Employers’ Accounting for Deﬁned Beneﬁt Pension and Other Postretirement Plans” (“SFAS 158”). As a result of our adoption of SFAS 158 in ﬁscal 2007, we recorded a decrease in other non-current assets of $0.2 million, an increase in postemployment beneﬁts of $7.7 million, and a decrease in accumulated other comprehensive income (loss) of $7.9 million. Applied Industrial Technologies, Inc. and Subsidiaries 13 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Continued Income Taxes As of June 30, 2008, the Company had recognized $35.1 million of net deferred tax assets. This ﬁgure includes a valuation allowance of $1.0 million recorded as a result of recent changes in U.S. federal income tax regulations which resulted in limitations to the deductibility of certain expenses. Management believes that sufﬁcient income will be earned in the future to realize its other 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. 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. In accordance with FIN 48, the Company recognized an immaterial cumulative effect adjustment decreasing its liability for unrecognized tax beneﬁts, interest, and penalties and increasing the July 1, 2007 balance of retained earnings. See Note 7 for more information on income taxes. NEW ACCOUNTING PRONOUNCEMENTS 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 in the United States, and expands disclosures about fair value measurements. The provisions of SFAS 157 apply under other accounting pronouncements that require or permit fair value measurements; it does not expand the use of fair value in any new circumstances. The provisions of this statement are to be applied prospectively as of the beginning of the ﬁscal year in which this statement is initially applied, with any transition adjustment recognized as a cumulative-effect adjustment to the opening balance of retained earnings. SFAS 157 is effective for ﬁscal years beginning after November 15, 2007. At its February 6, 2008 meeting, the FASB agreed to defer for one year the effective date of SFAS 157 for all non-ﬁnancial assets and non-ﬁnancial liabilities, except those that are recognized or disclosed at fair value in the ﬁnancial statements on a recurring basis (that is, at least annually). The impact of SFAS 157 on our consolidated ﬁnancial statements is not expected to be material. 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 that are not currently required to be measured at fair value. SFAS 159 is effective for ﬁscal years beginning after November 15, 2007. The impact of SFAS 159 on our consolidated ﬁnancial statements is not expected to be material. In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” (“SFAS 141(R)”), which replaces SFAS 141. SFAS 141(R) requires most assets acquired and liabilities assumed in a business combination, contingent consideration, and certain acquired contingencies to be measured at their fair values as of the date of acquisition. SFAS 141(R) also requires that acquisition related costs and restructuring costs be recognized separately from the business combination. SFAS 141(R) is effective for ﬁscal years beginning after December 15, 2008 and, therefore, will be effective for the Company for business combinations entered into after July 1, 2009. 14 Applied Industrial Technologies, Inc. and Subsidiaries 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 2008, we acquired two Mexican based distributors of industrial and ﬂuid power products for a combined purchase price of $28.7 million. 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. 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. CAUTIONARY STATEMENT UNDER PRIVATE SECURITIES LITIGATION REFORM ACT including Management’s This Annual Report to Shareholders, Discussion and Analysis, contains statements that are forward- looking based on management’s current expectations about the future. Forward-looking statements are often identiﬁed by qualiﬁers, such as “guidance,” “expect,” “expectation,” “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 those statements should not be regarded as a representation by the Company or any other person that the results expressed in the statements will be achieved. In addition, the Company assumes no obligation publicly to update or revise any forward-looking statements, whether because of new information or events, or otherwise, except as may be required by law. Important risk factors include, but are not limited to, the following: risks relating to the operations levels of our customers and the economic factors that affect them; 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 within the Company; the volatility of our stock price and the resulting impact on our consolidated 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 throughout our “Management’s Discussion and Analysis” as well as other of our ﬁlings with the Securities and Exchange Commission, including our Annual Report on Form 10-K for the year ended June 30, 2008. 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 and foreign currency exchange risks. The Company is primarily affected by market risk exposure through the effect of changes in exchange rates and changes in interest rates. 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. For the year ended June 30, 2008, a uniform 10% strengthening of the U.S. dollar relative to foreign currencies that affect the Company would have resulted in a $1.3 million decrease in net income. A uniform 10% weakening of the U.S. dollar would have resulted in a $0.7 million increase in net income. 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, 2008. The Company’s outstanding debt is currently at ﬁxed interest rates at June 30, 2008 and scheduled for repayment in November 2010. 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 Expense (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. 2008 $ 2,089,456 1,520,173 569,283 416,459 152,824 4,939 (4,057) 227 1,109 151,715 56,259 $ 95,456 $ 2.23 $ 2.19 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 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 $6,119 and $6,134 Inventories Other current assets Total current assets Property – at cost Land Buildings Equipment Less accumulated depreciation Property – net Goodwill Other intangibles 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 (11,923 and 11,097 shares) Accumulated other comprehensive income (loss) Total Shareholders’ Equity Total Liabilities and Shareholders’ Equity See notes to consolidated financial statements. 2008 2007 $ 101,830 245,119 210,723 48,525 606,197 10,639 71,142 108,162 189,943 124,946 64,997 64,685 19,164 43,728 $ 798,771 $ 109,822 56,172 31,017 197,011 25,000 37,746 36,939 296,696 10,000 133,078 543,692 (190,944) 6,249 502,075 $ 798,771 $ 119,665 248,698 199,886 32,284 600,533 10,850 69,938 106,006 186,794 119,006 67,788 57,550 8,712 42,786 $ 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 Applied Industrial Technologies, Inc. and Subsidiaries 17 2008 2007 2006 $ 95,456 $ 86,022 $ 72,299 12,776 (5,809) 3,376 1,663 2,595 (1,214) (395) 812 8,306 (1,484) (13,950) 11,881 (3,710) 110,303 (8,410) 1,372 (22,105) 2,304 (26,839) (50,000) (33,224) (25,728) 3,761 1,664 (103,527) 2,228 (17,835) 119,665 $ 101,830 13,489 (6,424) 2,927 1,045 1,462 (334) (791) 13,128 1,000 2,978 732 1,953 (294) (791) 1,921 8,937 (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 (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 $ 60,049 $ 4,763 $ 42,857 $ 5,488 $ 31,337 $ 5,290 STATEMENTS OF CONSOLIDATED CASH FLOWS (In thousands) Year Ended June 30, Cash Flows from Operating Activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation Deferred income taxes Share-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 Other operating liabilities 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 $2,355 and $968 in 2008 and 2006, respectively Other Net Cash used in Investing Activities Cash Flows from Financing Activities Long-term debt repayment 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 (Decrease) increase 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, 2008, 2007 and 2006 Shares of Common Stock Outstanding Common Stock Additional Paid-in Capital Income Retained for Use in the Business Unearned Restricted Accumulated Other Treasury Total Shares - Common Stock Comprehensive Shareholders’ at Cost Compensation (Loss) Income Equity 45,002 $ 10,000 $ 103,240 $ 354,521 $ (72,660) $ (825) $ (989) 72,299 $ 393,287 72,299 Balance at July 1, 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 Net income Unrealized gain on cash flow hedge, net of income tax of $414 Unrealized gain on investment securities available for sale, net of income tax of $50 Pension and postemployment adjustment, net of income tax of $293 Foreign currency translation adjustment, net of income tax of $912 Total comprehensive income Cash dividends – $.60 per share Purchases of common stock for treasury Treasury shares issued for: Exercise of stock options Deferred compensation plans Compensation expense – stock options and appreciation rights (2,379) 348 1,088 21 (13) 4,892 11,279 269 2,658 320 (825) 313 44,067 10,000 122,146 (1,401) 5 366 78 1 47 796 1,613 2,494 433 40 43,116 10,000 127,569 598 72 542 4,573 (17,973) (54,778) 3,583 (6,945) 193 (360) (130,967) 408,847 86,022 825 0 4,796 (93) 110 (301) 2,703 (20,970) (33,988) 65 4,157 1,046 (116) (159,803) 473,899 95,456 (7,897) 0 (682) 645 82 478 5,726 (1,145) 315 26 (25,728) (33,224) 2,330 402 65 (649) 1,800 410 2,999 377 (77) 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 95,456 645 82 478 5,726 102,387 (25,728) (33,224) 4,130 812 2,999 377 (661) Amortization of restricted common stock compensation Other (22) Balance at June 30, 2008 42,290 $ 10,000 $ 133,078 $ 543,692 $ (190,944) $ 0 $ 6,249 $ 502,075 See notes to consolidated financial statements. 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 and Mexican subsidiaries are included in the consolidated financial statements for the 12 months ended May 31. Prior to June 30, 2006, the Company was considered the primary beneficiary for iSource Performance Materials, LLC (iSource), a certified minority-owned distributor, and included their accounts in the consolidated financial statements. Effective June 30, 2006, the Company ended its venture with iSource and stopped including its operating results and balances 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 exchange rates. Translation gains and losses are included as components of accumulated other comprehensive income (loss) 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. Marketable Securities The primary marketable security investments of the Company, included in other assets, are classified as trading securities and reported at fair value, based on quoted market prices. These marketable securities (money market and mutual funds) totaled $10,527 and $10,925 at June 30, 2008 and 2007, respectively. Unrealized gains and losses are recorded in other expense (income), net in the statements of consolidated income and reflect changes in the fair value of the investment during the period. 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, 2008, 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 20 Applied Industrial Technologies, Inc. and Subsidiaries 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 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 generally 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.” Accrued incentives expected to be settled as a credit against purchases are reported on the consolidated balance sheet as an offset to amounts due to the related supplier. 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, building improvements and leasehold improvements are depreciated over ten to thirty years or the life of the lease if a shorter period, and equipment is depreciated over three to eight years. The carrying values of property and equipment are reviewed for impairment when events or changes in circumstances indicate that the recorded value cannot be recovered from undiscounted future cash flows. 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 customer relationships, exclusive supplier distribution agreements, trade names, and non-competition agreements apart from goodwill. Customer relationship intangibles are amortized using the sum-of-the years digits method over estimated useful lives consistent with assumptions used in the determination of their value. Amortization of all other intangible assets is computed using the straight- line method over the estimated period of benefit. Amortization of intangible assets 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, 2008 was 12 years for customer relationships, 11 years for exclusive supplier distribution agreements, 11 years for trade names, and 8 years for non-competition agreements. 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 covering workers’ compensation, business, automobile, general product liability and other claims. The Company accrues estimated losses including those incurred but not reported 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. 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 charges 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. Internal delivery costs in selling, distribution and administrative expenses were approximately $17,000, $16,000 and $15,500 for the fiscal years ended June 30, 2008, 2007 and 2006, respectively. 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. Effective July 1, 2007, the Company adopted FASB Interpretation No. 48 “Accounting for Uncertainty in Income Taxes” (“FIN 48”). This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 109 “Accounting for Income Taxes”. FIN 48 prescribes a recognition threshold and measurement attribute for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Income tax positions must meet a more-likely-than-not recognition threshold at the effective date to be recognized upon the adoption of FIN 48 and in subsequent periods. 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 2008 $ 95,456 42,797 755 43,552 $ 2.23 $ 2.19 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 Options to acquire and stock appreciation rights relating to 255, 460, and 301 shares of common stock were outstanding at June 30, 2008, 2007 and 2006, respectively, but were not included in the computation of diluted earnings per share for the fiscal years then ended as they were anti-dilutive. 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 Income (Loss) Accumulated other comprehensive income (loss) is comprised of the following: June 30, Unrealized loss on cash flow hedge, net of taxes Unrealized gain on investment securities available for sale, net of taxes Foreign currency translation, net of taxes Pension liability, net of taxes Total accumulated other comprehensive income (loss) 2008 $ (19) 338 15,966 (10,036) $ 6,249 2007 $ (664) 256 10,240 (10,514) $ (682) New Accounting Pronouncements 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 in the United States, and expands disclosures about fair value measurements. The provisions of SFAS 157 apply under other accounting pronouncements that require or permit fair value measurements; it does not expand the use of fair value in any new circumstances. The provisions of this statement are to be applied prospectively as of the beginning of the fiscal year in which this statement is initially applied, with any transition adjustment recognized as a cumulative-effect adjustment to the opening balance of retained earnings. SFAS 157 is effective for fiscal years beginning after November 15, 2007. At its February 6, 2008 meeting, the FASB agreed to defer for one year the effective date of SFAS 157 for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (that is, at least annually). The impact of SFAS 157 on the Company’s consolidated financial statements is not expected to be material. 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 that are not currently required to be measured at fair value. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The impact of SFAS 159 on the Company’s consolidated financial statements is not expected to be material. In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” (“SFAS 141(R)”), which replaces SFAS 141. SFAS 141(R) requires most assets acquired and liabilities assumed in a business combination, contingent consideration, and certain acquired contingencies to be measured at their fair values as of the date of acquisition. SFAS 141(R) also requires that acquisition related costs and restructuring costs be recognized separately from the business combination. SFAS 141(R) is effective for fiscal years beginning after December 15, 2008 and, therefore, will be effective for the Company for business combinations entered into after July 1, 2009. 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 2008, the Company acquired two Mexican based distributors for a combined purchase price of $28,703. VYCMEX S.A. de C.V., a distributor of fluid power products, was acquired in December 2007 and Suministros Industriales Enol, S.A. de C.V., an industrial products distributor, was acquired in May 2008. The purchase price allocations are considered preliminary as reflected in the financial statements; and will be finalized as we obtain more information regarding asset valuations. 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. 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 based on the Company’s consolidation policy. 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 2008 $ 305,377 55,441 360,818 150,095 $ 210,723 2007 $ 294,897 46,333 341,230 141,344 $ 199,886 Reductions in certain U.S. inventories during fiscal 2008 and 2006 resulted in the liquidation of LIFO inventory quantities carried at lower costs prevailing in prior years. The effect of the liquidations increased gross profit by $626 and $1,647, net income by $383 and $1,013, and diluted net income per share by $0.01 and $0.02, respectively. There were no LIFO layer liquidations during fiscal 2007. NOTE 4: GOODWILL AND OTHER INTANGIBLES The changes in the carrying amount of goodwill for the years ended June 30, 2008 and 2007, are as follows: Balance at July 1, 2006 Other, primarily currency translation Balance at June 30, 2007 Goodwill acquired during the year Other, primarily currency translation Balance at June 30, 2008 Service Center Based Distribution Segment $ 56,963 341 57,304 3,486 657 $ 61,447 Fluid Power Businesses Segment $ 259 (13) 246 2,692 300 $ 3,238 Total $ 57,222 328 57,550 6,178 957 $ 64,685 The Company’s other intangible assets resulting from business combinations are amortized over their estimated period of benefit and consist of the following: June 30, 2008 Customer relationships Exclusive supplier distribution agreements Trade names Non-competition agreements June 30, 2007 Customer relationships Exclusive supplier distribution agreements Trade names Non-competition agreements Amount (a) $ 11,824 4,731 4,240 2,441 $ 23,236 Amount (a) $ 8,347 1,071 924 657 $ 10,999 (a) Amounts include the impact of foreign currency translation. Fully amortized amounts are written off. Accumulated Amortization $ 2,716 575 278 503 $ 4,072 Accumulated Amortization $ 1,477 311 144 355 $ 2,287 Net Book Value $ 9,108 4,156 3,962 1,938 $ 19,164 Net Book Value $ 6,870 760 780 302 $ 8,712 Applied Industrial Technologies, Inc. and Subsidiaries 23 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued (In thousands, except per share amounts) During fiscal 2008, the Company recorded intangible assets of $3,210 for customer relationships, $3,440 for exclusive supplier distribution agreements, $3,200 for trade names and $1,740 for non-competition agreements in connection with the acquisition of two Mexican distributors of industrial and fluid power products (see Note 2). During fiscal 2006, the Company recorded intangible assets of $4,890 for customer relationships, $290 for exclusive supplier distribution agreements, $750 for trade names and $200 for non-competition agreements in connection with the acquisition of two U.S. distributors of industrial and fluid power products (see Note 2). Amortization expense for other intangible assets totaled $1,663, $1,045, and $732 in fiscal 2008, 2007 and 2006, respectively. Amortization of other intangible assets at June 30, 2008 is expected to be $3,100 for 2009, $2,800 for 2010, $2,600 for 2011, $2,300 for 2012 and $2,000 for 2013. 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, paid off in December 2007 Total long-term debt Less: Payable within one year Total long-term debt less current portion 2008 $ 25,000 25,000 $ 25,000 2007 $ 25,000 50,395 75,395 50,395 $ 25,000 Based upon current market rates for debt of similar maturities, the Company’s long-term debt had an estimated fair value of $26,336 and $76,995 as of June 30, 2008 and 2007, respectively. The Company has a revolving credit facility with a group of banks expiring in June 2012. 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 of $5,105 to secure certain insurance obligations, totaled $144,895 at June 30, 2008 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, 2008. The Company has an 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 agreement expires in March 2010. There were no borrowings at June 30, 2008. The revolving credit facility, private placement debt and uncommitted shelf facility contain restrictive covenants regarding liquidity, tangible net worth, financial ratios, and other covenants. At June 30, 2008, 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, 2008, 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 currency exchange rates and interest 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. 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 $10,479 and $9,372 at June 30, 2008 and 2007, respectively. These liabilities were recorded in other liabilities and the related unrealized losses are included in accumulated other comprehensive income (loss), (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 $2,620 and $2,343 at June 30, 2008 and 2007, respectively. Changes in the fair value of this derivative instrument are recorded in the statements of consolidated income as a component of other expense (income), net. 24 Applied Industrial Technologies, Inc. and Subsidiaries 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 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 2008 $ 136,179 15,536 $ 151,715 2007 $ 119,275 14,555 $ 133,830 2006 $ 100,462 12,637 $ 113,099 2008 2007 2006 $ 49,532 7,025 5,511 62,068 (5,028) (346) (435) (5,809) $ 56,259 $ 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 The exercise of non-qualified stock options and stock appreciation rights during fiscal 2008, 2007 and 2006 resulted in $3,140, $2,860 and $16,155, 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 2008 and 2007 resulted in $577 and $1,025, 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 Valuation allowance Foreign income taxes Deductible dividend 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 Expenses and reserves not currently deductible Goodwill and other intangibles Net operating loss carryforwards (expiring in years 2014 - 2021) Other Total deferred tax assets Less: Valuation allowance Deferred tax assets net of valuation allowance Deferred tax liabilities: Currency translation Inventories Depreciation and differences in property bases Other Total deferred tax liabilities Net deferred tax assets 2008 35.0% 2.8 .7 (.9) (.5) 37.1% 2007 35.0% 2.3 (.8) (.5) (.3) 35.7% 2006 35.0% 2.4 (.7) (.6) 36.1% 2008 2007 $ 33,248 7,523 451 880 42,102 (1,019) 41,083 (4,024) (1,813) (124) (52) (6,013) $ 35,070 $ 30,171 7,454 563 438 932 39,558 39,558 (3,113) (4,061) (1,471) (8,645) $ 30,913 Applied Industrial Technologies, Inc. and Subsidiaries 25 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued (In thousands, except per share amounts) At June 30, 2008 and 2007, $9,288 and $7,710, respectively, of the net deferred tax assets were included in other current assets and $25,782 and $19,597, respectively, were included in other assets in the accompanying consolidated balance sheets. Valuation allowances are provided against deferred tax assets where it is considered more-likely-than-not that the Company will not realize the benefit of such assets. Recent changes in U.S. tax regulations resulted in limitations to the deductibility of certain expenses. Management believes it is not likely the Company will be able to utilize certain expenses and has established a valuation allowance against them. The net deferred tax asset is the amount management believes is more likely than not of being realized. The realization of these deferred tax assets can be impacted by changes to tax laws, statutory rates and future income levels. No provision has been made for income taxes on undistributed earnings of non-U.S. subsidiaries of approximately $62.0 million at June 30, 2008, 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. Unrecognized Income Tax Benefits The Company and its subsidiaries file income tax returns in the U.S. federal, various state and local and foreign jurisdictions. Effective July 1, 2007, the Company adopted FIN 48. As a result of adopting FIN 48, the Company reduced its liability by approximately $65 for “unrecognized tax benefits,” defined as the aggregate tax effect of differences between tax return positions and the benefits recognized in the financial statements. In accordance with FIN 48, such amount was accounted for as an increase to the beginning balance of retained earnings. The following is a reconciliation of the Company’s total gross unrecognized tax benefits for the year ended June 30, 2008: Unrecognized tax benefits at July 1, 2007 Additions Current year tax positions Prior year tax positions Expirations of statutes of limitations Settlements Unrecognized tax benefits at June 30, 2008 2008 $ 1,903 369 (31) (216) (21) $ 2,004 Included in the balance of unrecognized tax benefits at June 30, 2008, are $1,124 of tax benefits that, if recognized, would affect the effective tax rate. The Company recognizes accrued interest and penalties related to unrecognized tax benefits in the provision for income taxes. The Company accrued $97 during the year for interest and penalties related to unrecognized benefits and, as of June 30, 2008 has recognized a liability for penalties and interest of $494. The Company does not anticipate a significant change to the total amount of unrecognized tax benefits within the next 12 months. The Company is subject to U.S. federal jurisdiction income tax examinations for the tax years 2005 through 2008. In addition, the Company is subject to foreign, state and local income tax examinations for the tax years 2003 through 2008. Effective with the adoption of FIN 48, the majority of the Company’s unrecognized tax benefits are classified as noncurrent liabilities since payment of cash is not expected within one year. Prior to the adoption of FIN 48, the Company classified unrecognized tax benefits in current liabilities. NOTE 8: SHAREHOLDERS’ EQUITY Share-Based Incentive Plans Following its approval by the Company’s shareholders in October 2007, the 2007 Long-Term Performance Plan (the “2007 Plan”) replaced the 1997 Long- Term Performance Plan. The 2007 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 may determine to officers, other key associates and members of the Board of Directors. Grants are generally made by the two committees at regularly scheduled meetings. The aggregate number of shares of common stock which may be awarded under the 2007 Plan is 2,000. Shares available for future grants at June 30, 2008 were 1,963. Stock Option and Stock 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. SARs 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, 2008, 2007 and 2006 was $2,999, $2,494 and $2,658, 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 share-based awards requires management to select a fair value model and make certain estimates and assumptions. 26 Applied Industrial Technologies, Inc. and Subsidiaries The weighted average assumptions used for SARs and stock option grants issued in fiscal 2008, 2007 and 2006 are: Expected life, in years Risk free interest rate Dividend yield Volatility 2008 5.3 4.4% 2.2% 45.9% 2007 5.1 4.8% 2.2% 46.7% 2006 7.2 4.3% 1.4% 42.3% The expected life is based upon historical exercise experience of the officers, other key associates and members of the Board of Directors currently awarded share-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 SARs and stock option exercises. SARs are redeemable solely in Company common stock. The exercise price of stock option awards may be settled by the holder with cash or by tendering Company common stock. A summary of stock option and SARs activity is presented below: (Share amounts in thousands) 2008 Outstanding, beginning of year Granted Exercised Outstanding, end of year Exercisable at end of year Weighted average fair value of SARs and stock options granted during year 2007 Outstanding, beginning of year Granted Exercised Outstanding, end of year Exercisable at end of year Weighted average fair value of SARs and stock 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 stock options granted during year Weighted Average Exercise Price Shares 2,384 263 (452) 2,195 1,596 2,486 319 (421) 2,384 1,533 4,302 306 (2,103) (19) 2,486 1,381 $ 13.15 25.32 10.43 $ 15.17 $ 12.61 $ 9.79 $ 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 The weighted average remaining contractual terms for SARs/stock options outstanding and exercisable at June 30, 2008 were 5.6 and 4.7 years, respectively. The aggregate intrinsic values of SARs/stock options outstanding and exercisable at June 30, 2008 were $20,107 and $18,528, respectively. The aggregate intrinsic value of the SARs/stock options exercised during fiscal 2008, 2007 and 2006 was $9,356, $7,887 and $41,966, respectively. A summary of the status of the Company’s nonvested stock options and SARs at June 30, 2008, all of which are expected to vest is presented below: (Share amounts in thousands) 2008 Nonvested, beginning of year Granted Vested Nonvested, end of year Weighted Average Grant-Date Fair Value $ 6.77 9.79 6.19 $ 8.64 Shares 851 263 (515) 599 As of June 30, 2008, unrecognized compensation cost related to stock options and SARs amounted to $2,356. That cost is expected to be recognized over a weighted average period of 2.5 years. The total fair value of shares vested during fiscal 2008, 2007 and 2006 was $3,190, $2,116 and $2,388, respectively. Applied Industrial Technologies, Inc. and Subsidiaries 27 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued (In thousands, except per share amounts) 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, 2008 and 2007, the Company had 14 and 43 shares of unvested restricted stock outstanding at weighted average prices of $23.94 and $13.77, respectively. During fiscal 2008, 11 shares of restricted stock were granted at an average grant price of $24.31 per share. Unamortized compensation related to unvested restricted stock awards aggregated $375 and $349 at June 30, 2008 and 2007, respectively. The unamortized compensation cost related to restricted stock is expected to be amortized over the remaining vesting period of 1.2 years. Long-Term Performance Grants The Executive Organization and Compensation 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 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 in the plan. Payouts are made in cash, common stock, or a combination thereof, as determined at the end of the performance period. During fiscal 2008, 2007 and 2006, the Company recorded $493, $549 and $540, respectively, of compensation expense for achievement relative to the total shareholder return-based goals of the Company’s performance grants. At June 30, 2008, and 2007, the Company had accrued $762 and $1,174, respectively, for compensation relative to these goals. At June 30, 2008, potential compensation expense related to the outstanding performance grants was $2,274. This compensation expense is expected to be recognized over the remaining performance period of 1.6 years. Shareholders’ Rights The Company previously had a shareholder rights plan which expired in January 2008. No rights were issued under the plan. Treasury Shares At June 30, 2008, 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 2008, 2007 and 2006). 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. Effective July 1, 2007, the match is based on achieving pre-determined quarterly net income levels and continues to be made in cash which is then used to purchase Company stock in the open market. The Company’s expense for contributions to the above plan was $12,442, $11,548 and $11,365 during fiscal 2008, 2007 and 2006, 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 which, except for the Qualified Defined Benefit Retirement Plan, are unfunded: 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 rate used in determining the benefit obligation was 6.0% at June 30, 2008 and 2007. Retiree Health Care Benefits The Company provides health care benefits to eligible retired associates who 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 28 Applied Industrial Technologies, Inc. and Subsidiaries 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. On June 30, 2007, the Company prospectively adopted 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. Adoption of SFAS 158 did not change amounts recognized in the consolidated income statement as net periodic benefit cost, nor did it affect retirement plan funding requirements. The Company uses a June 30 measurement date for all plans. The changes in benefit obligations, plan assets and funded status for the postemployment plans described above were as follows: Pension Benefits 2008 2007 Retiree Health Care Benefits 2007 2008 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 (loss) gain on plan assets Employer contributions Plan participants’ contributions Benefits paid Fair value of plan assets at June 30 Funded status at June 30 Amounts recognized in the consolidated balance sheets consist of: Prepaid benefit cost Current liabilities Noncurrent liabilities Net amount recognized Amounts recognized in accumulated other comprehensive loss (income) consist of: Net actuarial loss (gain) Prior service cost Total amounts recognized in accumulated other comprehensive loss (income) $ 42,210 2,090 2,413 (4,655) 249 269 $ 42,576 $ 5,893 (249) 4,541 (4,655) $ 5,530 $ (37,046) $ (2,953) (34,093) $ (37,046) $ 35,071 1,685 2,032 (855) 1,404 2,873 $ 42,210 $ 5,254 731 763 (855) $ 5,893 $ (36,317) $ 873 (4,541) (32,649) $ (36,317) $ 12,834 4,330 $ 12,813 4,716 $ 17,164 $ 17,529 $ 4,173 49 271 31 (207) 419 (812) $ 3,924 $ 176 31 (207) $ 0 $ (3,924) $ (270) (3,654) $ (3,924) $ (1,465) 490 $ (975) $ 3,981 56 222 28 (223) 141 (32) $ 4,173 $ 194 29 (223) $ 0 $ (4,173) $ (270) (3,903) $ (4,173) $ (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 2008 6.0% 8.0% 5.5% 2007 6.0% 8.0% 5.5% Retiree Health Care Benefits 2007 2008 6.0% N/A N/A 6.0% 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 2008 $ 42,576 35,385 2007 $ 37,191 28,963 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 2008 $ 2,090 2,413 (466) 962 635 $ 5,634 2008 $ 49 271 (107) 119 $ 332 Pension Benefits 2007 $ 1,685 2,032 (415) 804 658 $ 4,764 2006 $ 1,450 1,601 (381) 784 627 $ 4,081 Retiree Health Care Benefits 2007 $ 56 222 (109) 49 $ 218 2006 $ 55 253 28 49 $ 385 The estimated net loss and prior service cost for the pension plans that will be amortized from accumulated other comprehensive income (loss) into net periodic benefit cost over the next fiscal year are $917 and $688, respectively. The estimated net gain and prior service cost for the retiree health care benefits that will be amortized from accumulated other comprehensive income (loss) into net periodic benefit cost over the next fiscal year are ($126) and $119, respectively. The assumed health care cost trend rates used in measuring the accumulated benefit obligation for post-retirement benefits other than pensions were 8% and 10% as of June 30, 2008 and June 30, 2007, respectively, decreasing to 5% by 201 and 201 ,2 respectively. A one-percentage point change in the assumed health care cost trend rates would have had the following effects as of June 30, 2008 and for the year then ended: 5 Effect on total service and interest cost components of periodic expense Effect on post-retirement benefit obligation One-Percentage Point Increase $ 53 541 One-Percentage Point Decrease $ (43) (449) Applied Industrial Technologies, Inc.’s Qualified Defined Benefit Retirement Plan weighted average asset allocation and target allocation are as follows: Asset Category: Equity securities Debt securities Other Total Target Allocation 2009 40-70% 20-50% 0-20% 100% Percentage of Pension Plan Assets at Fiscal Year End 2007 2008 57% 39% 4% 100% 61% 33% 6% 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. Cash Flows Employer Contributions The Company expects to contribute $3,000 to its pension benefit plans and $200 to its retiree health care benefit plans in 2009. 30 Applied Industrial Technologies, Inc. and Subsidiaries Estimated Future Benefit Payments The Company expects to make the following benefit payments, which reflect expected future service: During Fiscal Years 2009 2010 2011 2012 2013 2014 through 2018 NOTE 10: LEASES Pension Benefits Retiree Health Care Benefits $ 3,100 1,800 6,100 4,100 4,300 14,600 $ 200 300 300 300 300 1,200 The Company leases its corporate headquarters facility along with many 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, 2008 are as follows: During Fiscal Years 2009 2010 2011 2012 2013 Thereafter Total minimum lease payments $ 20,700 14,100 10,200 8,000 5,000 10,100 $ 68,100 Rental expenses incurred for operating leases, principally from leases for real property, vehicles and computer equipment were $29,000 in fiscal 2008, $28,300 in 2007 and $26,700 in 2006. 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, 2008 Net sales Operating income Assets used in the business Depreciation Capital expenditures 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 Service Center Based Distribution $ 1,865,663 124,271 712,546 11,441 7,550 $ 1,806,284 122,684 715,864 12,166 10,074 $ 1,725,392 111,774 670,619 12,019 10,310 Fluid Power Businesses $ 223,793 17,320 86,225 1,335 860 $ 207,825 14,427 61,505 1,323 1,118 $ 175,388 11,849 60,052 1,109 747 Total $ 2,089,456 141,591 798,771 12,776 8,410 $ 2,014,109 137,111 777,369 13,489 11,192 $ 1,900,780 123,623 730,671 13,128 11,057 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 (income) expense, net (a) Total operating income Interest expense, net Other expense (income), net Income before income taxes 2008 $ 141,591 2007 $ 137,111 2006 $ 123,623 1,663 (12,896) 152,824 882 227 $ 151,715 1,045 1,055 135,011 2,360 (1,179) $ 133,830 732 7,299 115,592 3,210 (717) $ 113,099 (a) The change in corporate and other (income) 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 2008 $ 1,670,464 418,992 $ 2,089,456 2007 $ 1,614,515 399,594 $ 2,014,109 2006 $ 1,554,589 346,191 $ 1,900,780 (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 Mexico Total Long-Lived Assets: United States Canada Mexico Total 2008 2007 2006 $ 1,686,066 194,594 20,120 $ 1,900,780 $ 1,839,410 222,121 27,925 $ 2,089,456 $ 107,384 19,455 22,007 $ 148,846 $ 1,778,993 211,446 23,670 $ 2,014,109 $ 111,357 19,440 3,253 $ 134,050 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 consolidated 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 believes the likelihood is remote that the ultimate resolution of any of these matters will have, either individually or in the aggregate, 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 EXPENSE (INCOME), NET Other expense (income), net consists of the following: Year Ended June 30, Unrealized loss on cross-currency swap Unrealized loss (gain) on deferred compensation trusts Other Total other expense (income), net 2008 $ 277 327 (377) $ 227 2007 $ 243 (1,397) (25) $ (1,179) 2006 $ 595 (869) (443) $ (717) 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 $2,900 at June 30, 2008. NOTE 14: SUBSEQUENT EVENT On July 14, 2008, the Company entered into an agreement to acquire certain assets of Fluid Power Resource, LLC, including seven ﬂuid power businesses for cash consideration of $169.0 million. The Company intends to fund the acquisition by drawing down its existing revolving credit facility and from its available cash. These businesses employ 455 people and for the year ended December 31, 2007 had sales of approximately $244.0 million. Results of operations acquired will be included in the Company’s results of operations from the date of closing. 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. Cleveland, Ohio We have audited the accompanying consolidated balance sheets of Applied Industrial Technologies, Inc. and subsidiaries (the “Company”) as of June 30, 2008 and 2007, and the related statements of consolidated income, shareholders’ equity, and cash flows for each of the three years in the period ended June 30, 2008. 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 the Company at June 30, 2008 and 2007, and the results of its operations and its cash flows for each of the three years in the period ended June 30, 2008, in conformity with accounting principles generally accepted in the United States of America. As discussed in Note 7 to the consolidated financial statements, effective July 1, 2007, the Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes. Also, as discussed in Note 9 to the consolidated financial statements, the Company 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 Company’s internal control over financial reporting as of June 30, 2008, 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 15, 2008 expressed an unqualified opinion on the Company’s internal control over financial reporting. Cleveland, Ohio August 15, 2008 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, 2008. 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, 2008. The effectiveness of the Company’s internal control over financial reporting has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report which is included herein. August 15, 2008 David L. Pugh Chairman & Chief Executive Officer Mark O. Eisele Vice President – Chief Financial Officer & Treasurer Benjamin J. Mondics President & Chief Operating Officer 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. Cleveland, Ohio We have audited the internal control over financial reporting of Applied Industrial Technologies, Inc. and subsidiaries (the “Company”) as of June 30, 2008, 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, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on 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, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. 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, the Company maintained, in all material respects, effective internal control over financial reporting as of June 30, 2008, 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, 2008 of the Company and our report dated August 15, 2008 expressed an unqualified opinion on those consolidated financial statements and included an explanatory paragraph regarding the Company’s adoption of a new accounting standard. Cleveland, Ohio August 15, 2008 36 Applied Industrial Technologies, Inc. and Subsidiaries QUARTERLY OPERATING RESULTS AND MARKET DATA Unaudited (In thousands, except per share amounts) 2008 (A) First Quarter Second Quarter Third Quarter Fourth Quarter 2007 (A) First Quarter Second Quarter Third Quarter Fourth Quarter 2006 (A) First Quarter Second Quarter Third Quarter Fourth Quarter Net Sales Gross Profit Operating Income Net Income Per Common Share (B) Net Income - Diluted Cash Price Range Low High Dividend $ 518,547 511,008 530,156 529,745 $ 2,089,456 $ 142,056 139,491 144,500 143,236 $ 569,283 $ 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 $ 39,216 37,268 37,685 38,655 $ 152,824 $ 33,377 28,929 34,105 38,600 $ 135,011 $ 27,802 25,214 32,085 30,491 $ 115,592 $ 24,457 22,967 23,595 24,437 $ 95,456 $ 21,117 18,568 21,697 24,640 $ 86,022 $ 16,850 15,294 19,990 20,165 $ 72,299 $ 0.56 0.52 0.55 0.57 $ 2.19 $ 0.47 0.42 0.49 0.56 $ 1.93 $ 0.36 0.33 0.43 0.44 $ 1.57 $ 33.26 $ 22.90 28.01 22.05 23.81 35.68 30.68 32.20 $ 25.50 $ 20.75 23.61 22.72 24.26 30.00 26.95 30.73 $ 25.03 $ 21.33 20.41 22.50 21.97 24.54 31.15 31.67 $ 0.15 0.15 0.15 0.15 $ 0.60 $ 0.12 0.12 0.12 0.12 $ 0.48 $ 0.08 0.10 0.10 0.12 $ 0.40 (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 years ended June 30, 2008 and 2006 resulted in liquidations of LIFO inventory quantities carried at lower costs prevailing in prior years. The effect of these liquidations for the years ended June 30, 2008 and 2006 increased gross profit by $626 and $1,647, net income by $383 and $1,013, and diluted net income per share by $0.01 and $0.02, respectively. There were no LIFO layer liquidations for fiscal 2007. (B) On August 11, 2008 there were 6,311 shareholders of record including 4,073 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 11, 2008 was $30.76 per share. Applied Industrial Technologies, Inc. and Subsidiaries 37 10 YEAR SUMMARY (In thousands, except per share amounts and statistical data) Consolidated Operations – Year Ended June 30 Net sales Operating income Income before cumulative effect of accounting change Net income Per share data Income before cumulative effect of accounting change Basic Diluted Net income Basic Diluted Cash dividend 2008 2007 2006 2005 $ 2,089,456 152,824 95,456 95,456 $ 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 2.23 2.19 2.23 2.19 0.60 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 Year-End Position – June 30 Working capital Long-term debt (including amounts classified as current) Total assets Shareholders’ equity $ 409,186 25,000 798,771 502,075 $ 365,523 75,395 777,369 450,983 $ 370,013 76,186 730,671 414,822 $ 345,806 76,977 690,170 393,287 Year-End Statistics – June 30 Current ratio Operating facilities Shareholders of record 3.1 459 6,305 2.6 445 6,242 3.0 452 6,192 2.9 440 6,079 NET INCOME PER SHARE (Dollars) (Dollars in Billions) NET INCOME (Dollars in Millions) 08 07 06 05 04 03 02 01 00 99 $0.06 $0.71 $0.46 $0.63 $0.67 $0.41 $2.19 $1.93 $1.57 $1.20 08 07 06 05 04 03 02 01 00 99 $2.09 $2.01 $1.90 $1.72 $1.52 $1.46 $1.45 $1.63 $1.60 $1.56 08 07 06 05 04 03 02 01 00 99 $31.5 $19.8 $2.7 $28.0 $31.0 $19.9 $95.5 $86.0 $72.3 $55.3 38 Applied Industrial Technologies, Inc. and Subsidiaries 2004 2003 2002 2001 2000 2000 1999 $ 1,517,004 51,448 31,471 31,471 $ 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 0.73 0.71 0.73 0.71 0.21 $ 286,022 77,767 596,841 339,535 2.9 434 6,154 0.47 0.46 0.47 0.46 0.21 0.34 0.34 0.06 0.06 0.21 $ 259,359 78,558 553,404 307,856 $ 250,644 83,478 534,566 298,147 2.8 440 6,157 2.9 449 6,455 0.64 0.63 0.64 0.63 0.21 $ 279,001 113,494 578,854 311,518 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 SHAREHOLDERS’ EQUITY (Dollars in Millions) DIVIDENDS PER SHARE (Dollars) $502.1 $451.0 $414.8 $393.3 $339.5 08 07 06 05 04 03 02 01 00 99 $307.9 $298.1 $311.5 $299.3 $293.6 08 07 06 05 04 03 02 01 00 99 $0.21 $0.21 $0.21 $0.21 $0.21 $0.21 $0.60 $0.48 $0.40 $0.29 Applied Industrial Technologies, Inc. and Subsidiaries 39 DIRECTORS WILLIAM G. BARES (3, 4) Age 67 Former Chairman and Chief Executive Officer The Lubrizol Corporation (Specialty Chemical Products) JOHN F. MEIER (4) Age 60 Chairman and Chief Executive Officer Libbey Inc. (Tableware Products) THOMAS A. COMMES (1, 3) Age 66 Former President and Chief Operating Officer The Sherwin-Williams Company (Paints and Coatings) PETER A. DORSMAN (2) Age 53 Senior Vice President, Global Operations NCR Corporation (Transaction and Data Warehousing Solutions) L. THOMAS HILTZ (2) Age 62 Attorney EDITH KELLY-GREEN (1) Age 55 Former Vice President and Chief Sourcing Officer FedEx Express (Express Transportation) J. MICHAEL MOORE (1) Age 65 President Oak Grove Consulting Group, Inc. (Management Consulting) Former Chairman and Chief Executive Officer Invetech Company (Industrial Distributor) DAVID L. PUGH (3) Age 59 Chairman & Chief Executive Officer Applied Industrial Technologies, Inc. JERRY SUE THORNTON, Ph.D. (2) Age 61 President Cuyahoga Community College (Two-Year Educational Institution) PETER C. WALLACE (2) Age 54 President & Chief Executive Officer Robbins & Myers, Inc. (Equipment Manufacturer) STEPHEN E. YATES (4) Age 60 Executive Vice President & 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 OFFICERS DAVID L. PUGH Age 59 Chairman & Chief Executive Officer BENJAMIN J. MONDICS Age 50 President & Chief Operating Officer THOMAS E. ARMOLD Age 53 Vice President – Marketing and Strategic Accounts TODD A. BARLETT Age 53 Vice President – Acquisitions and Global Business Development FRED D. BAUER Age 42 Vice President – General Counsel & Secretary OTHER KEY MANAGEMENT IVAN J. BATISTA Age 35 General Director – Rafael Benitez Carrillo, Inc. (Puerto Rico) ROBERT E. CURLEY Age 48 Vice President – Southeast Area BARBARA D. EMERY Age 49 Vice President – Human Resources WARREN E. “BUD” HOFFNER Age 48 Vice President, General Manager– Fluid Power 40 Applied Industrial Technologies, Inc. and Subsidiaries MICHAEL L. COTICCHIA Age 45 Vice President – Chief Administrative Officer and Government Business MARK O. EISELE Age 51 Vice President – Chief Financial Officer & Treasurer JAMES T. HOPPER Age 64 Vice President – Chief Information Officer JEFFREY A. RAMRAS Age 53 Vice President – Supply Chain Management RICHARD C. SHAW Age 59 Vice President – Communications and Learning DANIEL T. BREZOVEC Age 47 Corporate Controller JODY A. CHABOWSKI Age 48 Assistant Controller ALAN M. KRUPA Age 52 Assistant Treasurer MARY E. KERPER Age 57 Vice President – Operational Excellence LONNY D. LAWRENCE Age 45 Vice President – Information Technology JOHN M. LEYO Age 57 Vice President – North Atlantic Area SERGIO H. NEVÁREZ Age 50 General Director – Applied Mexico RONALD A. SOWINSKI Age 47 President & Chief Operating Officer – Applied Industrial Technologies Ltd. (Canada) MARK A. STONEBURNER Age 44 Vice President – Midwest Area DONN G. VEENHUIS Age 59 Vice President – Western Area THEODORE L. WOLICKI Age 54 Vice President – Central States Area 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 CLEVELAND RESEARCH COMPANY Adam Uhlman, 216/649-7241 KEYBANC CAPITAL MARKETS Jeffrey D. Hammond, 216/443-2825 MORGAN KEEGAN Brent D. Rakers, 901/579-4427 SOLEIL – GREAT LAKES REVIEW Elliot Schlang, 216/767-1340 STEPHENS INC. Matt Duncan, 501/377-3723 WACHOVIA CAPITAL MARKETS, LLC Allison Poliniak, 212/214-5062 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 1 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, 2008, 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 2008, 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 2008 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 21, 2008, at the Corporate Headquarters of Applied Industrial Technologies, 1 Applied Plaza, East 36th and Euclid Avenue, Cleveland, Ohio 44115. QUARTERLY VOLUME, PRICE AND DIVIDEND INFORMATION 2008 First Quarter Second Quarter Third Quarter Fourth Quarter 2007 First Quarter Second Quarter Third Quarter Fourth Quarter 2006 First Quarter Second Quarter Third Quarter Fourth Quarter Shares Traded Average Daily Volume High Low Cash Dividend Price Range 21,416,800 19,630,600 26,431,600 26,215,300 20,528,900 16,447,500 17,787,400 18,389,300 11,773,500 17,774,000 15,937,300 26,181,000 339,900 306,700 433,300 409,600 325,900 261,100 291,600 291,900 184,000 282,100 257,000 415,600 $ 33.26 35.68 30.68 32.20 $ 25.50 30.00 26.95 30.73 $ 25.03 24.54 31.15 31.67 $ 22.90 28.01 22.05 23.81 $ 20.75 23.61 22.72 24.26 $ 21.33 20.41 22.50 21.97 $ 0.15 0.15 0.15 0.15 $ 0.12 0.12 0.12 0.12 $ 0.08 0.10 0.10 0.12 Applied Industrial Technologies, Inc. and Subsidiaries 41 Applied Industrial Technologies Corporate Headquarters 1 Applied Plaza Cleveland, Ohio, 44115 216/426-4000 www.applied.com

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