Applied Industrial Annual Report 2015

Plain-text annual report

BUILDING ON OUR STRENGTHS 2011 ANNUAL REPORT APPLIED® AT A GLANCE Applied Industrial Technologies is one of North America’s largest industrial distributors serving Maintenance Repair Operations (MRO), Original Equipment Manufacturing (OEM), and Government markets. Applied is an authorized source for a diverse range of products, including bearings, power transmission components, ﬂ uid power components and systems, industrial rubber products, linear motion components, tools, safety products, and general maintenance and mill supply products. The Company also provides customized shop services for mechanical, fabricated rubber and ﬂ uid power products, as well as services to meet storeroom management and maintenance training needs. Headquarters: Cleveland, Ohio, USA Operating Facilities: 474 in 48 U.S. states, 7 Canadian provinces, Puerto Rico and 13 Mexican states E-Commerce: www.Applied.com Distribution Centers: 7 Stock Keeping Units (SKUs) Available to Customers: More than 4 million Product Manufacturers: More than 2,000 Stock Ticker Symbol: AIT, listed on the New York Stock Exchange Employee Associates: 4,640 Data current as of June 30, 2011 About The Cover Applied Industrial Technologies was founded in Cleveland, Ohio in 1923 with a single branch and two employees. At that time, our primary business was selling replacement parts for cars and trucks. Today, our service network includes more than 470 facilities throughout North America serving a spectrum of industries - from Food to Primary Metals, Petrochemical to Aggregate/Mining, plus many more. Building on our strengths of providing quality brands, industry know-how, technical knowledge, and application expertise, we are poised for continued growth and success. This report contains statements that are forward-looking, as that term is deﬁ ned 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 identiﬁ ed on pages 10 and 11 of this report and in our Annual Report on Form 10-K for the ﬁ scal year ended June 30, 2011. 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. LETTER TO OUR SHAREHOLDERS BENJAMIN J. MONDICS, DAVID L. PUGH Dear Shareholder: increase in sales since ﬁ scal 2008 and resulted in an all-time high net income - - exceeding all W e’re pleased to report that ﬁ scal 2011 was a record year that produced our highest percentage debt, and we have made signiﬁ cant investments to assure further operating efﬁ ciencies in the future. expectations. The changes we made in our operating fundamentals during the recession have allowed us to take maximum advantage of a moderate market recovery. We have eliminated all FINANCIAL RESULTS Sales in ﬁ scal 2011 increased by 16.9% to a record $2.2 billion from $1.9 billion in ﬁ scal 2010. Net income improved 46.8% to a record $96.8 million, or $2.24 per share, from $65.9 million, or $1.54 per share, in ﬁ scal 2010. Cash provided from operations for the year was a healthy $76.8 million. Our SD&A as a percent of sales improved to 20.9% compared to 21.4% last year. This improvement reﬂ ects the productivity improvements we’ve continued to foster in a post-recession climate and includes investments in our technology infrastructure. Our current ratio (current assets to current liabilities) remains strong at 2.9 to 1. 2011 FINANCIAL HIGHLIGHTS • Achieved record sales of $2.2 billion • Increased net income to a record $96.8 million or $2.24 per share • Posted a gross proﬁ t margin of 27.7% and an operating margin of 6.8% • Returned $29.8 million to shareholders in dividends Applied Industrial Technologies, Inc. and Subsidiaries 1 FINANCIAL RESULTS (Continued) We’re confident that our solid balance sheet positions us for growth and that we’re delivering results that continue to reward our shareholders. Our dedicated efforts reflect a simple principle: Properly stress excellence and all else will follow. It’s a focus that’s grounded in our Four Cornerstones – Profitable Sales Growth, Margin Enhancement, Asset Management and Cost Control. These Cornerstones drive our continuous improvement and make us more efficient, effective and accountable. Accountability is ingrained in our associates at every level - - for their personal success, for our customers’ success and for Applied’s success. Our strong communication process assures that our associates understand what is expected and allows them to identify what training and resources are required to meet those expectations. Our sales increase for the year played out in concert with a broad manufacturing upturn. Throughout the ﬁ rst half of ﬁ scal 2011, we saw increased demand from the majority of our industrial segments and double-digit growth in more than half of them. This is especially pleasing considering that the segments related to new construction, which have been one of our traditional strengths, are still slow to recover. Maintaining the agility to adapt to shifting markets will remain a focus for us. As our ﬁ scal year progressed, we continued to see growth in manufacturing - - albeit at a slowing rate. The slowdown that occurred in the spring was driven by some extraordinary events, most notably the tragic earthquake and tsunami in Japan and severe tornado activity across the U.S. South and Midwest. In the wake of these catastrophes, our depth of inventory and sourcing expertise saw our customers through many challenges. Fortunately, we did not experience any major disruptions to our own Japanese supply chain. In addition to natural disasters, rising prices for oil, chemicals, metals and other raw materials further hindered economic growth. As a result, supplier price increases have been more frequent and margins have remained a challenge. Meeting the challenge, our gross proﬁ t margin increased to 27.7% in ﬁ scal 2011 from 27.2% in 2010, and our operating margin of 6.8% showed strong improvement compared to last year’s 5.8%. For the second year in a row, our asset management efforts provided excellent cash ﬂ ow and positioned us to capture LIFO layer liquidation beneﬁ ts. We are very satisﬁ ed with our efforts to balance our inventories, and we feel conﬁ dent that our levels are now optimized to support current business conditions. Combined with our record earnings, this focus on asset management has allowed us to achieve excellent return-on-assets results of 11.1% after tax. Our dedicated efforts reﬂ ect a simple principle: “Properly stress excellence and all else will follow.” Net Sales (Dollars in Billions) Net Income Per Share (Dollars) Shareholders' Equity (Dollars in Millions) $2.5 $2.0 $1.5 $1.0 $0.5 $0.0 $2.09 $2.01 $2.21 $2.19 $2.24 $2.5 $1.92 $1.89 $2.0 $1.93 $1.54 * $0.99 $1.5 $1.0 $0.5 $0.0 $633.6 $555.0 $502.1 $508.1 $451.0 $700 $600 $500 $400 $300 $200 $100 $0 07 08 09 10 11 07 08 09 10 11 07 08 09 10 11 * The goodwill impairment charge in fiscal 2009 reduced net income per share by $0.54. 2 Applied Industrial Technologies, Inc. and Subsidiaries Net Sales (Dollars in Billions) Net Income (Dollars in Millions) Net Income Per Share (Dollars) Shareholders' Equity (Dollars in Millions) Dividends Per Share (Dollars) 1 2 . 2 $ 9 0 . 2 $ 1 0 . 2 $ 2 9 . 1 $ 9 8 . 1 $ 0 9 . 1 $ 2 7 . 1 $ 5 4 . 1 $ 6 4 . 1 $ 2 5 . 1 $ $2.5 $2.0 $1.5 $1.0 $0.5 $0.0 8 . 6 9 $ 5 . 5 9 $ 0 . 6 8 $ 3 . 2 7 $ 3 . 5 5 $ 9 . 5 6 $ * 3 . 2 4 $ $100 $80 $60 $40 $20 $0 5 . 1 3 $ 8 . 9 1 $ 7 . 2 $ 4 2 . 2 $ 9 1 . 2 $ 3 9 . 1 $ 7 5 . 1 $ 0 2 . 1 $ 4 5 . 1 $ * 9 9 . 0 $ $2.5 $2.0 $1.5 $1.0 $0.5 $0.0 1 7 . 0 6 $ 4 . 0 $ 6 0 . 0 $ * The goodwill impairment charge in fiscal 2009 * The goodwill impairment charge in fiscal 2009 reduced net income by $23.0 million. reduced net income per share by $0.54. 6 . 3 3 6 0 $ . 5 5 5 $ 1 . 2 0 5 $ 1 . 8 0 5 $ 0 . 1 5 4 $ 8 . 4 1 4 $ 3 . 3 9 3 $ 5 . 9 3 3 $ 1 . 8 9 2 $ 9 . 7 0 3 $ $700 $600 $500 $400 $300 $200 $100 $0 0 7 . 0 $ 0 6 . 0 $ 0 6 . 0 $ 0 6 . 0 $ 8 4 . 0 $ 0 4 . 0 $ 9 2 . 0 $ 1 2 . 0 $ 1 2 . 0 $ 1 2 . 0 $ $0.7 $0.6 $0.5 $0.4 $0.3 $0.2 $0.1 $0.0 02 03 04 05 06 07 08 09 10 11 02 03 04 05 06 07 08 09 10 11 02 03 04 05 06 07 08 09 10 11 02 03 04 05 06 07 08 09 10 11 02 03 04 05 06 07 08 09 10 11 BUILDING ON OUR STRENGTHS During ﬁ scal 2011 we continued to build on our strengths of providing quality brands, industry know-how, technical knowledge, and application expertise. This strategic approach has helped our ﬂ uid power business to become the largest in North America - - and it has been a great contributor to our overall success in 2011. This business provides ﬂ uid power system integration; manifold design, machining, and assembly; and the integration of hydraulics with electronics for complete machine design. Applied today has one of the largest teams of Certiﬁ ed Fluid Power Specialists, Certiﬁ ed Electronic Control Specialists, and Certiﬁ ed Fluid Power Mechanics and Technicians. This level of expertise and service offering is our special edge in a competitive marketplace. Our strong – and resilient – ﬂ uid power business remains a solid building block for our future. Our operations in Canada and Mexico were also notable contributors in ﬁ scal 2011. We continue to point to Canada as an area where we want to expand. Improvements in the economy and acquisition landscape have heightened that interest. In August 2010 we completed the purchase of SCS Supply Group, a distributor of bearings, power transmission and industrial components with locations in southern Ontario. SCS established our presence in Ontario and opens access to the major economic sector of Eastern Canada. Most recently, we entered the Montreal market with the acquisition of Chaines-Plus, a distributor of bearings, power transmission, and related products. Other ﬁ scal year 2011 acquisitions included the July 2010 purchase of UZ Engineered Products, which has a presence in the government arena, and the May 2011 purchase of Gulf Coast Bearing & Supply Co., a bearing and power transmission distributor in south Texas. We continue to seek acquisitions that will build on our strengths and expand our product breadth, service expertise and geographic position. While we are also on the lookout for potential acquisitions abroad, we still feel Applied has tremendous opportunity for growth in North America. During the ﬁ rst half of the ﬁ scal year, we paid off $75 million of debt as well as related cross-currency swap liabilities of $12.8 million. We are presently debt free - - an action that further improves our capacity to grow and invest in the business. To that end, we are currently undertaking a major investment in our information technology that holds signiﬁ cant promise for improving our operations for years to come. In October 2010, Applied embarked on an enterprise resource planning (ERP) initiative to help transform the company’s technology platforms and enhance our business information and transaction systems to support future growth. The project, which is called Genesis, includes the engagement of our most experienced people. We are pleased to report it is progressing both on-time and on-budget. We anticipate a multi-year implementation of our new ERP system, with certain of our Canadian businesses expected to “go-live” by 2011 calendar year end, followed by a roll- out to other North American businesses over the next two years. We expect the new system will contribute to greater productivity, enhanced proﬁ tability, improved visibility, and more efﬁ cient overall operation of our business. While we have exciting initiatives underway to support future growth, we remain attentive to providing value to our shareholders today. Applied shareholders beneﬁ ted through dividend payments which totaled $29.8 million, or $0.70 per share, over the past year. In April 2011, Applied increased the quarterly dividend 12% to $0.19 per share. This follows a 13% increase in July 2010. Our shareholders received a total return of 43.8% on their investment during ﬁ scal 2011 and a compounded annual total return of 18.1% over the past 10 years. In addition, during ﬁ scal 2011, Applied purchased 189,600 shares of the company’s common stock on the open market. During ﬁ scal 2011 we continued to build on our strengths of providing quality brands, industry know-how, technical knowledge, and application expertise. Applied Industrial Technologies, Inc. and Subsidiaries 3 INDUSTRY AND CUSTOMER RECOGNITION Our high level of attention to customer service and the quality of our associates has been recognized through numerous awards we’ve received over the course of the ﬁ scal year. Once again, we were named to Selling Power magazine’s annual list of “The 50 Best Companies to Sell For” in the U.S. For the third consecutive year, Applied was the highest ranked distribution company on the list and ranked third overall in the service category. We earned a Silver Performance Excellence award from The Boeing Company as well as a Gold Supplier of the Year award from Vulcan Materials Company for our strong standing in the areas of product quality, service, support, ease of transaction and value. Most recently, Applied received both Excellence and Innovation awards from Eastman Chemical Company for our quality materials, on-time shipping, and our ability to improve their efﬁ ciency and competitiveness. And, for the tenth time, Applied has received the annual NorthCoast 99 award from the Employers’ Resource Council (ERC) for being a great workplace for top talent in Northeast Ohio. Our product suppliers play a critical role in our customer recognition and success. We choose supplier partners for their commitment to high-quality products and innovation. They help us introduce new technologies, provide training when needed, and supply strategic input on future trends. In addition, our suppliers share our philosophy of working together to create value for our customers. Every year we recognize outstanding supplier achievements and their commitment to excellence. We have tremendous pride in our accomplishments, and it stems from the fact that we are a learning organization - - always striving to continuously improve and create value. We encourage ongoing training and skills enhancement for our associates. From computer and professional skills training to product training, our associates are able to expand their knowledge base through varied training initiatives, including in-house and e-learning product courses to stay abreast of the latest technology. LOOKING AHEAD The strength of our organization has enabled us to weather many storms over the years and emerge stronger each time. As we look ahead, we remain optimistic about our ability to seize opportunities for growth and proﬁ tability. Applied today is strong, growing and well-positioned to meet the future needs of its customers. As we close the chapter on Applied’s ﬁ scal 2011, we wish to express our gratitude to Stephen E. Yates who retired from our Board of Directors in October 2010 after nine years of service. We also thank our associates, customers, suppliers, and shareholders for their continued support. David L. Pugh Chairman & Chief Executive Ofﬁ cer Benjamin J. Mondics President & Chief Operating Ofﬁ cer August 17, 2011 4 Applied Industrial Technologies, Inc. and Subsidiaries A NOTE FROM DAVID PUGH In April it was announced that I would be retiring as Chairman & Chief Executive Ofﬁ cer of Applied Industrial Technologies and also stepping down from the Board of Directors. Personally, my career with Applied has been a very gratifying period of my life. I inherited a wonderful organization, was given excellent mentoring, and have been but a small part of moving the company ahead. From the moment I arrived at Applied, I stressed the importance of cost control, customer service, proﬁ table growth, prudence in asset management, and employee development; our hardworking associates enthusiastically followed suit. By God’s grace, these efforts allow me to depart on the heels of a record earnings year from a company which is debt free, has made good investments for the future, and has a solid management team in place. We have taken the market capitalization of Applied from $240 million in 1999 to $1.5 billion at June 30, 2011. Most importantly, we have done this in a manner which has gained us a reputation for the utmost integrity by our peers and our customers. I want to personally thank all of our associates for their loyalty and hard work over the last 12-plus years. I would also like to thank our customers, our suppliers and our shareholders whose support has brought the company continued success. I could not be more satisﬁ ed with what we have accomplished together, and I look forward to watching Applied rise to even greater heights in the years to come. With sincere appreciation, I simply say, “Good-bye and God bless.” MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW With more than 4,600 associates across North America, Applied Industrial Technologies (“Applied,” the “Company,” “We,” “Us” or “Our”) is one of North America’s largest industrial distributors serving MRO, OEM and Government markets. Applied is an authorized source for a diverse range of products, including bearings, power transmission components, fluid power components and systems, industrial rubber products, linear motion components, tools, safety products, and general maintenance and mill supply products. The Company also provides customized shop services for mechanical, fabricated rubber and fluid power products, as well as services to meet storeroom management and maintenance training needs. We have a long tradition of growth dating back to 1923, the year our business was founded in Cleveland, Ohio. At June 30, 2011, business was conducted in the United States, Canada, Mexico and Puerto Rico from 474 facilities. When reviewing the discussion and analysis set forth below, please note that the majority of SKUs we sell in any given year were not sold in the prior year, resulting in the inability to quantify certain commonly used comparative metrics analyzing sales, such as changes in product mix and volume. Our fiscal 2011 sales were $2.2 billion, an increase of $319.6 million or 16.9% compared to the prior year. Net sales from acquired businesses added $40.8 million or 1.8% to the current year. Gross margin increased to 27.7% from 27.2% in the prior year. Our operating margin increased to 6.8% compared to the prior year’s 5.8%. Our earnings per share was $2.24 versus $1.54 in fiscal year 2010, an increase of 45.5%. Our consolidated balance sheet remains strong. Shareholders’ equity is $633.6 million, up from $555.0 million at June 30, 2010. Working capital increased $56.7 million from June 30, 2010 to $404.2 million at June 30, 2011, driven by operations. Our current ratio remains strong at 2.9 to 1 versus 2.3 to 1 in fiscal year 2010. Applied monitors several economic indices that have been key indicators for industrial economic activity. These include the Manufacturing Capacity Utilization (MCU) index published by the Federal Reserve Board and the Purchasing Managers Index (PMI) published by the Institute for Supply Management (ISM). Historically, our performance correlates well with the MCU, which measures productivity and calculates a ratio of actual manufacturing output versus potential full capacity output. When manufacturing plants are running at a high rate of capacity, they tend to wear out machinery and require replacement parts. Our sales tend to lag the MCU on the upswing by up to six months and move closer in alignment with the declines. These indices showed an improving economy during fiscal 2011 that slowed noticeably during our fiscal fourth quarter. The MCU was 74.4 in June of 2011, up from 71.7 in June of 2010. The ISM PMI was 55.3 in June of 2011, essentially flat with June of 2010 and down from its year-long high of 61.4 in February of 2011. The ISM PMI further declined in July 2011 to 50.9. We believe that the U.S. industrial economy has settled into a slower pace of growth which will continue into fiscal 2012. YEAR ENDED JUNE 30, 2011 vs. 2010 The following table is included to aid in review of Applied’s statements of consolidated income. The percent increase column is comparative to the same period in the prior year. Net Sales Gross Profit Selling, Distribution & Administrative Operating Income Net Income Year Ended June 30, As a % of Net Sales 2011 2010 100.0% 100.0% 27.7% 20.9% 6.8% 4.4% 27.2% 21.4% 5.8% 3.5% Percent Increase 16.9% 18.9% 14.0% 37.0% 46.8% Net sales in fiscal 2011 were $2.2 billion, which was $319.6 million or 16.9% above the prior year driven by improvements in the industrial economy. Incremental net sales from companies acquired in the year contributed approximately $40.8 million or 1.8%. Currency translation increased fiscal year sales by approximately $16.3 million or 0.7%. In local currency, net sales from our Canadian operations were up 23.1% from fiscal 2010, including 8.4% from acquisitions. In local currency, net sales from our Mexican operations were up 17.9%. The number of selling days in fiscal 2011 was the same as in fiscal 2010. Net sales of our Service Center Based Distribution segment increased $234.3 million, or 15.2%, compared to fiscal year 2010 led by improvements in the industrial economy, with acquisitions adding $40.8 million or 2.7%. Net sales of our Fluid Power Businesses segment increased $85.4 million or 23.9%, driven by improvements in the industrial economy. The sales product mix for fiscal 2011 was 70.5% industrial products and 29.5% fluid power products compared to 71.7% industrial and 28.3% fluid power in the prior year. At June 30, 2011, we had a total of 474 operating facilities in the U.S., Canada and Mexico versus 455 at June 30, 2010. The increase in operating facilities represents 11 new locations due to acquisitions, the opening of 2 new locations, the impact of redefining certain shop operations which added 11 locations, and the merger of 5 locations with other locations. Our gross profit margin increased to 27.7% in fiscal 2011 from 27.2% in fiscal 2010. LIFO benefits recorded during the year totaled $5.3 million which provided an overall benefit in our gross profit percent of 0.2%. This compares to a LIFO benefit of $23.5 million in fiscal 2010 which added 1.2% to gross profit. The improvement in gross profit is attributable to higher point-of-sale supplier purchasing incentives in the current year, the positive impact on annual LIFO expense from the resumption of a more normal level of supplier purchasing incentives based upon Applied Industrial Technologies, Inc. and Subsidiaries 5 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION (Continued) volume, lower scrap expense and the positive impact on margins from businesses acquired during the fiscal year. Selling, distribution and administration expenses (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 $56.7 million or 14.0% during fiscal 2011 compared to the prior year, and as a percent of sales decreased to 20.9% from 21.4% in fiscal 2010. Associate compensation and benefits, including amounts tied to financial performance, increased $27.4 million. Acquisitions added $18.4 million of SD&A compared to the prior year, including additional amortization expense of $1.4 million. Incremental expenses associated with the development of a new ERP platform totaled $8.6 million. Foreign currency translation had an unfavorable impact of $3.1 million in the year. Operating income increased 37.0% to $150.8 million during fiscal 2011 from $110.1 million during 2010. As a percent of sales, operating income increased to 6.8% in fiscal 2011 from 5.8% in 2010. The $40.7 million increase in operating income during fiscal 2011 primarily reflects higher sales levels, improved gross profit margins and the impact of leverage on increased sales. Operating income of both of our segments increased, reflecting improved operating leverage on sales increases. Operating income as a percentage of sales for the Service Center Based Distribution segment increased to 6.5% in fiscal 2011 from 5.0% in fiscal 2010. The Fluid Power Businesses segment operating income increased to 9.5% in fiscal 2011 from 7.5% in fiscal 2010. Interest expense, net, decreased $3.8 million during fiscal 2011 compared with the prior year. We repaid all of our outstanding debt in fiscal 2011 which lowered interest expense. Other (income) expense, net, represents certain non-operating items of income and expense. This was $3.8 million of income in fiscal 2011 compared to income of $0.4 million in fiscal 2010. Current year includes $2.0 million of unrealized gains on investments held by non-qualified deferred compensation trusts and recognition of a $1.7 million gain from death benefits received under two life insurance policies. Income tax expense as a percent of income before taxes was 36.7% for fiscal 2011 and 37.2% for fiscal 2010. The net decrease in the effective tax rate reflects higher income levels earned in fiscal 2011 in foreign jurisdictions which have a lower overall statutory rate than the U.S. as well as the reversal of a valuation allowance no longer necessary. These factors were offset somewhat by provision made for U.S. income tax on a portion of undistributed earnings not considered permanently reinvested in our Canadian subsidiaries. We expect our comparable tax rate for fiscal 2012 to be in the range of 37.0% to 38.0%. 6 Applied Industrial Technologies, Inc. and Subsidiaries As a result of the factors addressed above, net income for fiscal 2011 increased $30.9 million or 46.8% from the prior year. Net income per share increased at a comparable rate. The number of Company associates was 4,640 at June 30, 2011 and 4,468 at June 30, 2010. The net associate increase year- over-year is attributable primarily to acquisitions (net increase of 239 associates), partially offset by headcount reductions in pre- existing operations. YEAR ENDED JUNE 30, 2010 vs. 2009 Net sales in fiscal 2010 were $1.9 billion, which was 1.6% below fiscal 2009. Incremental net sales from companies acquired contributed approximately $25.3 million. Currency translation increased fiscal year 2010 sales by approximately $11.7 million or 0.6%. In local currency our Canadian business was down 6.4% from overall fiscal 2009 levels. Net sales from our Mexican operations were up 3.4% in local currency in fiscal 2010. The number of selling days in fiscal 2010 and 2009 were the same. Within the Service Center Based Distribution segment, net sales decreased $60.5 million or 3.8% compared to fiscal year 2009, attributed to declines in the industrial economy. Within the Fluid Power Businesses segment, net sales increased $30.5 million or 9.4%, including $23.1 million in incremental sales from acquisitions. Sales to customers in high-tech industries led the recovery in this segment. The sales product mix for fiscal 2010 was 71.7% industrial products and 28.3% fluid power products compared to 74.0% industrial and 26.0% fluid power in the prior year. The shift in mix to fluid power products in fiscal 2010 was driven by incremental sales from the fiscal 2009 Fluid Power Resource, LLC acquisition and strong increases in sales to customers in high-tech industries. At June 30, 2010, we had a total of 455 operating facilities in the U.S., Canada and Mexico versus 464 at June 30, 2009. The net reduction in operating facilities represents four new locations offset by the merger or closure of locations. Our gross profit margin increased to 27.2% in fiscal 2010 from 27.0% in fiscal 2009. LIFO benefits recorded during the year totaled $23.5 million which provided an overall benefit in our gross profit percent of 1.2%. These benefits more than offset lower point-of-sale pricing and reduced supplier purchasing incentives. The Company uses the LIFO method of valuing U.S. inventories. In fiscal 2010, we undertook an inventory management program which resulted in a significant decrease of inventory from the June 30, 2009 levels. The annual current cost reduction in U.S. bearings and drives products inventory was $101.4 million. These inventory reductions were targeted to reduce excess quantities of certain products within our system and therefore had no negative impact on customer service or order fulfillment. Reductions in the levels of inventory purchases in fiscal 2010 resulted in significant reductions in supplier purchasing incentives which flow through the income statement as inventory is sold to customers. This negatively impacted gross profit margins. Reductions in our inventory levels also resulted in the liquidation of LIFO inventory quantities carried at lower costs prevailing in prior years. The impact of these liquidations had a positive impact on our gross profit margins in fiscal 2010. The LIFO benefit recorded in fiscal 2010 was $23.5 million which reduced our cost of goods sold and equated to $0.33 of earnings per share. The overall LIFO reserves were reduced by the same amounts. Total fiscal year 2010 LIFO benefits were recorded as follows: $0.7 million in the first quarter, $1.8 million in the second quarter, $4.8 million in the third quarter and $16.2 million in the fourth quarter. If inventory levels had remained constant with the June 30, 2009 levels, instead of recording the benefit as described above, the Company would have recorded LIFO expense of $19.2 million in fiscal 2010. The overall impact of LIFO layer liquidations during the fiscal year resulted in an improvement in gross profit of $42.7 million. LIFO layer liquidations recorded for fiscal year 2009 increased gross profit by $4.4 million. Supplier purchasing incentives which flowed into the income statement as inventory was sold decreased $8.0 million from 2009. SD&A decreased $5.2 million or 1.3% during fiscal 2010 compared to fiscal year 2009, and as a percent of sales remained flat at 21.4% in both years. Acquisitions added $6.9 million of SD&A compared to fiscal year 2009, including additional amortization expense of $1.4 million. Associate compensation and benefits, including amounts tied to financial performance, were down $2.7 million year-over-year, as company-wide reductions in workforce and deferral of replacements for normal associate attrition were largely offset by increases in variable compensation. Other SD&A costs were down $9.0 million (excluding the impact of additional SD&A from companies acquired and not included in the full prior period), primarily reflecting cost cutting measures, and lower bad debt and depreciation expenses, partially offset by unfavorable foreign currency translation of approximately $2.2 million. Operating income increased 51.8% to $110.1 million during fiscal 2010 from $72.5 million during 2009. As a percent of sales, operating income increased to 5.8% in fiscal 2010 from 3.8% in 2009. The $37.6 million increase in operating income during fiscal 2010 primarily reflects the impact of a $36.6 million goodwill impairment charge recognized in fiscal 2009. The favorable impact of the LIFO benefits in fiscal 2010 offset lower point-of-sale pricing and lower supplier purchasing incentives. Operating income of both of our segments increased in fiscal 2010. Operating income as a percentage of sales for the Service Center Based Distribution segment increased to 5.0% in fiscal 2010 from 4.7% in fiscal 2009, reflecting the impact of reduced discretionary spending. The Fluid Power Businesses segment operating income increased to 7.5% in fiscal 2010 from 5.8% in fiscal 2009 due to improved sales volume largely to customers in the high-tech industries, cost reduction measures and lower bad debt expense. Interest expense, net, increased $1.0 million during fiscal 2010 compared with the prior year. Lower interest rates on invested cash led to a reduction in interest income of approximately $0.8 million. Other (income) expense, net, was $0.4 million of income in fiscal 2010 compared to expense of $2.3 million in fiscal 2009. Fiscal 2009 included $1.7 million in unrealized losses on investments held by non-qualified deferred compensation trusts. The market value of these investments recovered somewhat in fiscal 2010, resulting in a $1.0 million unrealized gain. Income tax expense as a percentage of income before taxes was 37.2% for fiscal 2010 and 35.8% for 2009. The lower effective tax rate in fiscal 2009 was primarily due to the reversal of a valuation allowance. As a result of the factors addressed above, net income for fiscal 2010 increased $23.6 million or 55.9% from the prior year. Net income per share increased at a comparable rate. The number of Company associates was 4,468 at June 30, 2010 and 4,729 at June 30, 2009. The net associate reduction year- over-year is attributable primarily to the economic slowdown and reflects the impact of company-wide reductions in workforce and deferral of replacements for normal associate attrition. LIQUIDITY AND CAPITAL RESOURCES Our primary source of capital is cash flow from operations, supplemented as necessary by bank borrowings or other sources of debt. At June 30, 2011, we have no outstanding borrowings, whereas at June 30, 2010, we had $50.0 million outstanding on our revolving credit facility and $25.0 million outstanding on private placement borrowings. These facilities were drawn on primarily to fund acquisitions. Management expects that our existing cash, cash equivalents, funds available under the revolving credit facility, cash provided from operations, and the use of operating leases will be sufficient to finance normal working capital needs in each of the countries we operate in, payment of dividends, acquisitions, investments in properties, facilities and equipment, and the purchase of additional Company common stock. Management also believes that additional long-term debt and line of credit financing could be obtained based on the Company’s credit standing and financial strength. The Company’s working capital at June 30, 2011 was $404.2 million compared to $347.5 million at June 30, 2010. The current ratio was 2.9 to 1 at June 30, 2011 and 2.3 to 1 at June 30, 2010. Applied Industrial Technologies, Inc. and Subsidiaries 7 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION (Continued) Net Cash Flows The following table is included to aid in review of Applied’s statements of consolidated cash flows; all amounts are in thousands. consisting of capital associated with additional information system technology equipment and infrastructure investments. Depreciation for fiscal 2012 is expected to be in the range of $11.5 million to $12.5 million. Net Cash Provided by (Used in): Year Ended June 30, 2011 2010 2009 Share Repurchases 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, 2011, we had authorization to purchase an additional 647,600 shares. In fiscal 2011, 2010 and 2009, we repurchased 189,600, 159,900 and 68,000 shares of the Company’s common stock, respectively, at an average price per share of $32.09, $24.57 and $17.80, respectively. Borrowing Arrangements The Company has a five-year committed revolving credit agreement that expires in June 2012 which it intends to renew. This agreement provides for unsecured borrowings of up to $150.0 million. We have no borrowings outstanding under this facility at June 30, 2011 (versus $50.0 million at June 30, 2010). Unused lines under this facility, net of outstanding letters of credit, total $143.1 million and are available to fund future acquisitions or other capital and operating requirements. Borrowings under this agreement would be at variable interest rates tied to either LIBOR, prime, or the bank’s cost of funds. We also have an uncommitted long-term financing shelf facility which expires in February 2013 and enables us to borrow up to $100.0 million with terms of up to fifteen years. We had no outstanding borrowings under this facility at June 30, 2011. The revolving credit facility and uncommitted shelf facility contain restrictive covenants regarding liquidity, net worth, financial ratios, and other covenants. At June 30, 2011, 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, 2011, the Company was in compliance with all covenants and expects to remain in compliance during the terms of the agreements. Operating Activities $ 76,842 $184,324 $ 81,300 Investing Activities Financing Activities Exchange Rate Effect (Decrease) Increase in Cash and Cash Equivalents (47,887) (116,523) 2,883 (6,784) (178,430) (30,514) 1,109 28,502 (5,560) $ (84,685) $148,135 $ (74,188) In fiscal 2011 and typical during periods of sales expansion, cash generated from operations is invested in working capital, particularly receivables and inventory. The most significant factor in the spike in 2010 operating cash flows relates to the fiscal 2010 inventory management program which by June 30, 2010 had resulted in a $101.4 million reduction in U.S. bearing and drives products inventory amounts from the June 30, 2009 levels. These inventory reductions were targeted to reduce excess quantities of certain products within our system. Inventory increased in fiscal 2011 due to acquisitions, increased business levels and some increases to compensate for an increase in manufacturer lead times. Net cash used by investing activities in fiscal 2011 included $30.5 million for acquisitions and $20.4 million for capital expenditures. Capital expenditures included $12.5 million related to the ERP project (discussed further below). Net cash used by investing activities was primarily used for capital expenditures in fiscal 2010, whereas it was primarily used for acquisitions in fiscal 2009. Capital expenditures consist primarily of information technology equipment and building improvements. In fiscal 2011, we repaid $50.0 million under our revolving credit facility, $25.0 million under our private placement debt and $12.8 million related to the associated cross-currency swaps. Additionally, we paid dividends of $29.8 million and repurchased 189,600 shares of treasury stock for $6.1 million. In fiscal 2010, financing activities included dividends paid of $25.4 million, repayment of a net $5.0 million on our revolving credit facility, and $3.9 million to repurchase 159,900 shares of treasury stock. ERP Project and Capital Expenditures On October 1, 2010, Applied announced its selection of the SAP software platform to help transform the Company’s technology infrastructure and enhance its business information and transaction systems for future growth. We expect capital expenditures for this ERP project for all of fiscal 2012 to be in the range of $14.0 million to $16.0 million. We expect SD&A expenses associated with this project to be in the range of $16.5 million to $18.5 million in fiscal year 2012. Other non-ERP capital expenditures for fiscal 2012 are expected to be in the $10.0 million to $12.0 million range, 8 Applied Industrial Technologies, Inc. and Subsidiaries CONTRACTUAL OBLIGATIONS The following table shows the approximate value of the Company’s contractual obligations and other commitments to make future payments as of June 30, 2011 (in thousands): Period Less Than 1 yr Total Period 1-3 yrs Period 4-5 yrs Period Over 5 yrs Other Operating leases $ 75,000 $23,200 $ 30,500 $16,000 $ 5,300 Planned funding of postretirement obligations Unrecognized income tax benefit liabilities, including interest and penalties Total Contractual Cash Obligations 61,500 4,400 10,100 10,000 37,000 1,700 $ 1,700 $138,200 $27,600 $ 40,600 $26,000 $ 42,300 $ 1,700 Purchase orders for inventory and other goods and services are not included in our estimates as we are unable to aggregate the amount of such purchase orders that represent enforceable and legally binding agreements specifying all significant terms. The previous table includes the gross liability for unrecognized income tax benefits including interest and penalties in the “Other” column as the Company is unable to make a reasonable estimate regarding the timing of cash settlements with the respective taxing authorities. 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. The Business and Accounting Policies note to the consolidated financial statements describes the significant accounting policies and methods used in preparation of the consolidated financial statements. Estimates are used for, but not limited to, determining the net carrying value of trade accounts receivable, inventories, recording self-insurance liabilities and other accrued liabilities. Actual results could differ from these estimates. The following critical accounting policies are impacted significantly by judgments, assumptions and estimates used in the preparation of the consolidated financial statements. LIFO Inventory Valuation and Methodology Inventories are valued at the lower of cost or market, using the last-in, first-out (LIFO) method for U.S. inventories, and the average cost method for foreign inventories. We adopted the link chain dollar value LIFO method for accounting for U.S. inventories in fiscal 1974. Approximately 40% of our domestic inventory dollars relate to LIFO layers added in the 1970s. The excess of current cost over LIFO cost is $137.6 million as reflected in our consolidated balance sheet at June 30, 2011. 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. See the Inventories note to the consolidated financial statements for further information. Allowances for Slow-Moving and Obsolete Inventories We evaluate the recoverability of our slow-moving or obsolete inventories at least quarterly. We estimate the recoverable cost of such inventory by product type while considering factors such as its age, historic and current demand trends, the physical condition of the inventory, as well as assumptions regarding future demand. Our ability to recover our cost for slow moving or obsolete inventory can be affected by such factors as general market conditions, future customer demand and relationships with suppliers. Most of the products we hold in inventory have long shelf lives, are not highly susceptible to obsolescence and are eligible for return under various supplier return programs. Allowances for Doubtful Accounts We evaluate the collectibility of trade accounts receivable based on a combination of factors. Initially, we estimate an allowance for doubtful accounts as a percentage of net sales based on historical bad debt experience. This initial estimate is adjusted based on recent trends of certain customers and industries estimated to be a greater credit risk, trends within the entire customer pool and changes in the overall aging of accounts receivable. While we have a large customer base that is geographically dispersed, a general economic downturn in any of the industry segments in which we operate could result in higher than expected defaults, and therefore, the need to revise estimates for bad debts. Accounts are written off against the allowance when it becomes evident collection will not occur. As of June 30, 2011 and 2010, our allowance for doubtful accounts was 2.4% and 2.5% of gross receivables, respectively. Our provision for losses on accounts receivable was $2.0 million, $2.5 million and $4.5 million in fiscal 2011, 2010 and 2009, respectively. Goodwill and Intangibles Goodwill is recognized as the amount by which the cost of an acquired entity exceeds the net amount assigned to assets acquired and liabilities assumed. As part of acquisition accounting, we also recognize acquired intangible assets such as customer relationships, vendor relationships, trade names, and non-competition agreements apart from goodwill. Finite-lived intangibles are evaluated for impairment when changes in conditions indicate carrying value may not be recoverable. We evaluate goodwill and indefinite-lived intangibles for impairment at least annually. This evaluation requires significant judgment by management, including estimated future operating results, estimated future cash flows, the long-term rate of growth of our business, and determination of an appropriate discount rate. While we use available information to prepare the estimates and evaluations, actual results could differ significantly. For example, a worsening of economic conditions beyond those assumed in an Applied Industrial Technologies, Inc. and Subsidiaries 9 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION (Continued) impairment analysis could impact the estimates of future growth and result in an impairment charge in a future period. Any resulting impairment charge could be viewed as having a material adverse impact on our financial condition and results of operations. All of the goodwill remaining on our consolidated financial statements is related to the Service Center Based Distribution segment. We believe the fair value of this segment is well in excess of its carrying value. Self-Insurance Liabilities We maintain business insurance programs with significant self- insured retention covering workers’ compensation, business, automobile, general product liability and other claims. We accrue estimated losses using actuarial calculations, models and assumptions based on historical loss experience. We maintain a self-insured health benefits plan, which provides medical benefits to employees electing coverage. We maintain a reserve for all unpaid medical claims including those incurred but not reported based on historical experience and other assumptions. Although management believes that the estimated liabilities for self- insurance are adequate, the estimates described above may not be indicative of current and future losses. In addition, the actuarial calculations used to estimate self-insurance liabilities are based on numerous assumptions, some of which are subjective. We will continue to adjust our estimated liabilities for self- insurance, as deemed necessary, in the event that future loss experience differs from historical loss patterns. Pension and Other Postemployment Benefit Plans The measurement of liabilities related to pension plans and other post-employment benefit plans is based on management’s assumptions related to future events including interest rates, return on pension plan assets, rate of compensation increases, and healthcare cost trend rates. We evaluate these assumptions and adjust them as necessary. Changes to these assumptions could result in a material change to the Company’s pension obligation causing a related increase or decrease in reported net operating results in the period of change in the estimate. A 1% point change would have the following effects (in thousands): Effect of change in: Discount rate on liability Discount rate on net periodic benefit cost Salary scale on liability Salary scale on net periodic benefit cost One-Percentage Point Increase $ (3,554) (151) 1,900 328 Decrease $ 4,049 158 (1,700) (302) A 1% change in the return on assets is not material since most of the plans are non-qualified and unfunded. Income Taxes Deferred income taxes are recorded for estimated future tax effects of differences between the bases of assets and liabilities 10 Applied Industrial Technologies, Inc. and Subsidiaries for financial reporting and income tax purposes, giving consideration to enacted tax laws. As of June 30, 2011, the Company had recognized $46.7 million of net deferred tax assets. This includes a $0.2 million valuation allowance recorded related to estimated limitations in the deductibility of certain expenses. Management believes that sufficient income will be earned in the future to realize its deferred income tax assets. The realization of these deferred tax assets can be impacted by changes to tax laws, statutory tax rates and future taxable income levels. Income taxes on undistributed earnings of non-U.S. subsidiaries are not accrued for the portion of such earnings management considers to be permanently reinvested. At June 30, 2011, undistributed earnings of non-U.S. subsidiaries considered permanently reinvested totaled approximately $58.3 million for which no provision for U.S income tax had been made. At June 30, 2011, undistributed earnings of non-U.S. subsidiaries not considered permanently reinvested totaled $13.3 million for which $2.8 million in U.S. income taxes were accrued and charged to income tax expense during fiscal 2011. CAUTIONARY STATEMENT UNDER PRIVATE SECURITIES LITIGATION REFORM ACT This Annual Report to Shareholders, including Management’s Discussion and Analysis, contains statements that are forward- looking based on management’s current expectations about the future. Forward-looking statements are often identified by qualifiers, such as “guidance,” “expect,” “believe,” “plan,” “intend,” “will,” “should,” “could,” “would,” “anticipate,” “estimate,” “forecast,” “may,” and derivative or similar words or 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 instruments for speculative or trading purposes. We do not currently have any outstanding derivative instruments. Foreign Currency Exchange Rate Risk Since we operate throughout North America and approximately 15% of our fiscal year 2011 net sales were generated outside the United States, foreign currency exchange rates can impact our financial position, results of operations and competitive position. The financial statements of foreign subsidiaries are translated into their U.S. dollar equivalents at end-of-period exchange rates for assets and liabilities, while income and expenses are translated at average monthly exchange rates. Translation gains and losses are included as components of accumulated other comprehensive income (loss) in consolidated shareholders’ equity. Transaction gains and losses arising from fluctuations in currency exchange rates on transactions denominated in currencies other than the functional currency are recognized in the consolidated statements of income as a component of other (income) expense, net. Applied does not currently hedge the net investments in our foreign operations. Since the beginning of the fiscal year, the Canadian and Mexican foreign exchange rates to the U.S. dollar increased by 10.5% and 6.9%, respectively. In the twelve months ended June 30, 2011, we experienced foreign currency translation gains, totaling $10.3 million, net of income tax, which were included in accumulated other comprehensive income (loss). We utilize a sensitivity analysis to measure the potential impact on earnings based on a hypothetical 10% change in foreign currency rates. A 10% strengthening from the levels at June 30, 2011 of the U.S. dollar relative to foreign currencies that affect the Company would have resulted in a $1.8 million decrease in net income for the year ended June 30, 2011. A 10% weakening from the levels at June 30, 2011 of the U.S. dollar would have resulted in a $1.8 million increase in net income for the year ended June 30, 2011. Interest Rate Risk We repaid the debt that was outstanding at June 30, 2010 during fiscal 2011, thus, we are not currently exposed to interest rate fluctuations on outstanding debt. We do monitor third-party depository institutions that hold our cash and cash equivalents, primarily for safety of principal and secondarily for maximizing yield on those funds. We diversify our cash and cash equivalents among counterparties to minimize exposure to any of these entities. and the economic factors that affect them; changes in the prices for products and services relative to the cost of providing them; reduction in supplier inventory purchase incentives; loss of key supplier authorizations, lack of product availability, or changes in supplier distribution programs; the cost of products and energy and other operating costs; changes in customer preferences for products and services of the nature and brands sold by us; changes in customer procurement policies and practices; the potential for product shortages if suppliers are unable to fulfill in a timely manner increased demand in the economic recovery; competitive pressures; our reliance on information systems; our ability to implement our ERP system in a timely, cost-effective, and competent manner, and to capture its planned benefits while maintaining an adequate internal control environment; the impact of economic conditions on the collectability of trade receivables; reduced demand for our products in targeted markets due to reasons including consolidation in customer industries and the transfer of manufacturing capacity to foreign countries; 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; the variability and timing of new business opportunities including acquisitions, alliances, customer relationships, and supplier authorizations; the incurrence of debt and contingent liabilities in connection with acquisitions; our ability to access capital markets as needed on reasonable terms; disruption of operations at our headquarters or distribution centers; risks and uncertainties associated with our foreign operations, including volatile economic conditions, political instability, cultural and legal differences, and currency exchange fluctuations; the potential for goodwill and intangible asset impairment; changes in accounting policies and practices; organizational changes within the Company; the volatility of our stock price and the resulting impact on our consolidated financial statements; risks related to legal proceedings to which we are a party; adverse regulation and legislation, including potential changes in tax regulations (e.g., those affecting the use of the LIFO inventory accounting method and the taxation of foreign- sourced income); and the occurrence of extraordinary events (including prolonged labor disputes, natural events and acts of God, terrorist acts, fires, floods, and accidents). Other factors and unanticipated events could also adversely affect our business, financial condition or results of operations. We discuss certain of these matters more fully throughout our “Management’s Discussion and Analysis” as well as other of our filings with the Securities and Exchange Commission, including our Annual Report on Form 10-K for the year ended June 30, 2011. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Our market risk is impacted by changes in foreign currency exchange rates and to a lesser extent by changes in interest rates. We occasionally utilize derivative instruments as part of our overall financial risk management policy, but do not use derivative Applied Industrial Technologies, Inc. and Subsidiaries 11 STATEMENTS OF CONSOLIDATED INCOME (In thousands, except per share amounts) Year Ended June 30, Net Sales Cost of Sales Gross Profit Selling, Distribution and Administrative, including depreciation Goodwill Impairment Operating Income Interest Expense Interest Income Other (Income) Expense, 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. 2011 $ 2,212,849 1,599,739 613,110 462,347 150,763 2,081 (413) (3,793) 152,888 56,129 96,759 2.28 2.24 $ $ $ 2010 $1,893,208 1,377,486 515,722 405,672 110,050 5,738 (280) (425) 105,017 39,114 65,903 1.56 1.54 $ $ $ 2009 $ 1,923,148 1,403,138 520,010 410,912 36,605 72,493 5,523 (1,099) 2,255 65,814 23,554 42,260 1.00 0.99 $ $ $ 12 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 $7,016 and $6,379 Inventories Other current assets Total current assets Property - at cost Land Buildings Equipment, including computers and software Total Property - at cost Less accumulated depreciation Property - net Intangibles, net Goodwill Deferred tax assets Other assets Total Assets Liabilities Current liabilities Accounts payable Short-term debt Compensation and related benefits Other current liabilities Total current liabilities 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 (11,611 and 11,837 shares) Accumulated other comprehensive income (loss) Total Shareholders’ Equity Total Liabilities and Shareholders’ Equity See notes to consolidated financial statements. 2011 2010 $ 91,092 290,751 204,066 33,005 618,914 10,428 73,399 129,117 212,944 143,930 69,014 89,551 76,981 43,447 17,024 $ 914,931 $ 108,509 65,413 40,766 214,688 47,730 18,950 281,368 10,000 148,307 668,421 (198,224) 5,059 633,563 $ 914,931 $ 175,777 246,402 173,253 23,428 618,860 10,569 73,099 113,593 197,261 138,790 58,471 85,916 63,405 48,493 16,375 $ 891,520 $ 94,529 75,000 50,107 51,696 271,332 48,560 16,589 336,481 10,000 143,185 601,370 (193,468) (6,048) 555,039 $ 891,520 Applied Industrial Technologies, Inc. and Subsidiaries 13 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: 2011 2010 2009 $ 96,759 $ 65,903 $ 42,260 Goodwill impairment Deferred income taxes Depreciation and amortization of property Amortization of intangibles Provision for losses on accounts receivable Amortization of stock options and appreciation rights Unrealized foreign exchange transaction (gains) losses Other share-based compensation expense Gain on sale of property 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 $168 and $185 in 2011 and 2009, respectively Other Net Cash used in Investing Activities Cash Flows from Financing Activities Net short-term (repayments) borrowings under revolving credit facility (Repayments) borrowings under revolving credit facility originally classified as long-term Long-term debt repayment Settlements of cross-currency swap agreements Purchases of treasury shares Dividends paid Excess tax benefits from share-based compensation Exercise of stock options and appreciation rights Other Net Cash (used in) provided by 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. 4,784 11,234 11,382 2,029 2,473 3,379 (765) (36,271) (21,197) (11,185) 12,926 1,294 76,842 (20,431) 1,326 (30,504) 1,722 (47,887) (50,000) (25,000) (12,752) (6,085) (29,751) 6,404 661 (116,523) 2,883 (84,685) 175,777 $ 91,092 2,408 11,465 10,151 2,508 3,020 (4) 2,361 (198) (48,578) 83,497 17,408 13,566 20,817 184,324 (7,216) 532 36,605 (16,648) 12,736 9,655 4,540 3,702 806 800 (320) 63,929 (20,581) 6,858 (38,124) (24,918) 81,300 (6,988) 757 (100) (172,199) (6,784) (178,430) (5,000) 5,000 50,000 (3,929) (25,416) 2,492 1,339 (30,514) 1,109 148,135 27,642 $175,777 (1,210) (25,378) 802 408 (1,120) 28,502 (5,560) (74,188) 101,830 $ 27,642 $ 47,251 2,248 $ 31,179 5,195 $ 43,081 5,265 14 Applied Industrial Technologies, Inc. and Subsidiaries STATEMENTS OF CONSOLIDATED SHAREHOLDERS’ EQUITY (In thousands, except per share amounts) For the Years Ended June 30, 2011, 2010 and 2009 Balance at July 1, 2008 Net income Unrealized loss on cash flow hedges, net of income tax of $(457) Reclassification of interest expense into income, net of income tax of $264 Unrealized loss on investment securities available for sale, net of income tax of $(105) Reclassification of pension and postemployment expense into income, net of income tax of $691 Pension and postemployment adjustment, net of income tax of $(1,154) Foreign currency translation adjustment, net of income tax of $(3,793) Total comprehensive income Cash dividends - $0.60 per share Purchases of common stock for treasury Treasury shares issued for: Exercise of stock options and appreciation rights Deferred compensation plans Compensation expense - stock options and appreciation rights Amortization of restricted common stock compensation Other Balance at June 30, 2009 Net income Unrealized loss on cash flow hedges, net of income tax of $(365) Reclassification of interest expense into income, net of income tax of $535 Unrealized loss on investment securities available for sale, net of income tax of $(19) Reclassification of pension and postemployment expense into income, net of income tax of $677 Pension and postemployment adjustment, net of income tax of $(1,467) Foreign currency translation adjustment, net of income tax of $(32) Total comprehensive income Cash dividends - $0.60 per share Purchases of common stock for treasury Treasury shares issued for: Exercise of stock options and appreciation rights Deferred compensation plans Compensation expense - stock options and appreciation rights Amortization of other share-based compensation Other Balance at June 30, 2010 Net income Current period cash flow hedging activity, net of income tax of $(82) Reclassification of interest expense into income, net of income tax of $116 Unrealized loss on investment securities available for sale, net of income tax of $(31) Reclassification of pension and postemployment expense into income, net of income tax of $850 Pension and postemployment adjustment, net of income tax of $(435) Foreign currency translation adjustment, net of income tax of $(264) Total comprehensive income Cash dividends - $0.70 per share Purchases of common stock for treasury Treasury shares issued for: Exercise of stock options and appreciation rights Deferred compensation plans Compensation expense - stock options and appreciation rights Amortization of other share-based compensation Other Balance at June 30, 2011 See notes to consolidated financial statements. Shares of Common Stock Outstanding 42,290 Common Stock Additional Paid-in Capital $ 10,000 $ 133,078 Income Treasury Retained Shares- for Use in at Cost the Business $ 543,692 $ (190,944) 42,260 (68) 73 18 (29) 42,284 10,000 (25,378) 560,574 65,903 (1,210) 1,007 300 (671) (191,518) 47 110 3,701 391 (432) 136,895 (160) 214 11 27 42,376 10,000 (25,416) (3,929) 1,372 187 309 601,370 96,759 420 (193,468) 1,499 68 3,020 2,106 (403) 143,185 Accumulated Other Comprehensive Income (Loss) $ 6,249 (569) 437 (177) Total Shareholders’ Equity $ 502,075 42,260 (569) 437 (177) 1,127 1,127 (1,883) (13,033) (7,849) (738) 873 (27) 1,104 (2,393) 2,982 (6,048) (184) 200 (53) (1,883) (13,033) 28,162 (25,378) (1,210) 1,054 410 3,701 391 (1,103) 508,102 65,903 (738) 873 (27) 1,104 (2,393) 2,982 67,704 (25,416) (3,929) 2,871 255 3,020 2,106 326 555,039 96,759 (184) 200 (53) 1,364 1,364 (495) (495) 10,275 (29,751) (6,085) 706 119 43 504 $ 668,421 $ (198,224) $ 5,059 10,275 107,866 (29,751) (6,085) 597 221 2,473 3,158 45 $ 633,563 (190) 379 6 31 42,602 (109) 102 2,473 3,158 (502) $10,000 $148,307 Applied Industrial Technologies, Inc. and Subsidiaries 15 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” or “Applied”) is one of North America’s largest industrial distributors serving Maintenance Repair Operations (MRO), Original Equipment Manufacturing (OEM) and Government markets. Applied is an authorized source for a diverse range of products, including bearings, power transmission components, fluid power components and systems, industrial rubber products, linear motion components, tools, safety products, and general maintenance and mill supply products. The Company also provides customized shop services for mechanical, fabricated rubber and fluid power products, as well as services to meet storeroom management and maintenance training needs. Although the Company does not generally manufacture the products it sells, it does assemble and repair certain products and systems. Consolidation The consolidated financial statements include the accounts of Applied Industrial Technologies, Inc. and its subsidiaries. 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 twelve months ended May 31. 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 consolidated shareholders’ equity. Gains and losses resulting from transactions denominated in foreign currencies are included in the statements of consolidated income as a component of other (income) expense, net. 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 fair value. Marketable Securities The primary marketable security investments of the Company include money market and mutual funds held in a rabbi trust for a non-qualified compensation plan. These are included in other assets in the consolidated balance sheets, are classified as trading securities, and reported at fair value based on quoted market prices. Unrealized gains and losses are recorded in other (income) expense, net in the statements of consolidated income and reflect changes in the fair value of the investments during the period. Concentration of Credit Risk The Company has a broad customer base representing many diverse industries across North America. As such, the Company does not believe that a significant concentration of credit risk exists in its accounts receivable. The Company’s cash and cash equivalents include deposits with commercial banks and investments in money market funds. While Applied monitors the creditworthiness of these commercial banks and institutions, a crisis in the U.S., Canadian or Mexican financial systems could limit access to funds and/or result in the loss of principal. The terms of these deposits and investments provide that all monies are available to the Company 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 greater credit risks, trends within the entire customer pool and changes in the overall aging of accounts receivable. Accounts are written off against the allowance when it becomes evident collection will not occur. 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. 16 Applied Industrial Technologies, Inc. and Subsidiaries Inventories Inventories are valued at the lower of cost or market, using the last-in, first-out (LIFO) method for U.S. inventories and the average cost method for foreign inventories. The Company adopted the link chain dollar value LIFO method of accounting for U.S. inventories in fiscal 1974. At June 30, 2011, approximately 40% 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. The Company evaluates the recoverability of its slow moving or obsolete inventories at least quarterly. The Company estimates the recoverable cost of such inventory by product type while considering factors such as its age, historic and current demand trends, the physical condition of the inventory as well as assumptions regarding future demand. The Company’s ability to recover its cost for slow moving or obsolete inventory can be affected by such factors as general market conditions, future 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. 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. 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 Related Depreciation and Amortization Property and equipment are recorded at cost. Depreciation 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 Company capitalizes internal use software development costs in accordance with guidance on accounting for costs of computer software developed or obtained for internal use. Amortization is recorded as the software is placed in service on a straight-line basis over the estimated useful life of the software, generally not to exceed twelve years. Capitalized software and hardware costs are classified as property on the consolidated balance sheets. 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, would be measured based upon the difference between the carrying amount and the fair value of the assets. Goodwill and 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. Goodwill is reviewed for impairment annually as of January 1 or whenever changes in conditions indicate an evaluation should be completed. These conditions could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant portion of a reporting unit. The Company utilizes discounted cash flow models and market multiples for comparable businesses to determine the fair value of reporting units. Evaluating impairment requires significant judgment by management, including estimated future operating results, estimated future cash flows, the long-term rate of growth of the business, and determination of an appropriate discount rate. While the Company uses available information to prepare the estimates and evaluations, actual results could differ significantly. The Company recognizes acquired intangible assets such as customer relationships, trade names, vendor relationships, 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 finite-lived intangible assets is computed using the straight-line method over the estimated period of benefit. The Company also maintains intangible assets with indefinite lives which are not amortized. Amortization of intangible assets is included in selling, distribution and administrative expenses in the accompanying statements of consolidated income. Intangible assets with finite lives are reviewed for impairment when changes in conditions indicate carrying value may not be recoverable. Intangible assets with indefinite lives are reviewed for impairment on an annual basis or whenever changes in conditions indicate an evaluation should be completed. Applied Industrial Technologies, Inc. and Subsidiaries 17 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share amounts) 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, adjusted as necessary based upon management’s reasoned judgment. 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 actual sales returns and the amount of reserves established for anticipated sales returns based on historical 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 $15,400, $14,400 and $15,400 for the fiscal years ended June 30, 2011, 2010 and 2009, respectively. 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. Uncertain tax positions meeting a more-likely-than-not recognition threshold are recognized in accordance with the Income Taxes topic of the Accounting Standards Codification (ASC). The Company recognizes accrued interest and penalties related to unrecognized income tax benefits in the provision for income taxes. Share-Based Compensation Share-based compensation represents the cost related to share-based awards granted to associates under the 2007 Long-Term Performance Plan (the 2007 Plan). The Company measures share-based compensation cost at grant date, based on the estimated fair value of the award and recognizes the cost over the associate requisite service period. Non-qualified stock options and stock appreciation rights (SARs) are granted with an exercise price equal to the closing market price of the Company’s common stock at the date of grant and the fair values are determined using a Black-Scholes option pricing model, which incorporates assumptions regarding the expected volatility, the expected option life, the risk-free interest rate and the expected dividend yield. SARs and stock option awards generally vest over four years of continuous service and have 10-year contractual terms. The fair value of restricted stock awards, restricted stock units (RSUs), and performance shares are based on the closing market price of Company common stock on the grant date. 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. NOTE 2: BUSINESS COMBINATIONS Results of operations of acquired businesses are included in the accompanying consolidated financial statements from their respective acquisition dates based on the Company’s consolidation policy. Fluid Power Resource Acquisition On August 29, 2008, Applied acquired Fluid Power Resource, LLC and the following fluid power distribution businesses: Bay Advanced Technologies, Carolina Fluid Components, DTS Fluid Power, Fluid Tech, Hughes HiTech, Hydro Air, and Power Systems (collectively “FPR”). Applied acquired certain assets and assumed certain specified liabilities of FPR for an aggregate cash purchase price of $166,000. 18 Applied Industrial Technologies, Inc. and Subsidiaries The acquired businesses included 19 locations and the associated assembled workforce. This acquisition is part of the Fluid Power Businesses segment whose base business is distributing fluid power components, assembling fluid power systems, performing equipment repair, and offering technical advice to customers. This acquisition increased the Company’s capabilities in the following areas: fluid power system integration; manifold design, machining, and assembly; and the integration of hydraulics with electronics. The excess of the purchase price over the estimated fair values was assigned to goodwill and is expected to be deductible for tax purposes. The goodwill was written off as part of an impairment charge in the fourth quarter of fiscal 2009. The table below presents summarized unaudited pro forma results of operations as if FPR had been acquired effective at the beginning of the fiscal year ended June 30, 2009. No pro forma results are presented for fiscal year 2011 or 2010 as the results of the acquired company are included in the actual results. (unaudited) Net sales Income before income taxes Net income Net income per share – diluted Other Acquisitions 2009 $1,962,882 66,357 42,601 1.00 $ The Company acquired the following distributors to complement and extend its business over a broader geographic area. Results of operations for the acquired businesses below are all part of the Service Center Based Distribution segment. The results of operations for these acquisitions are not material for any year presented. In May 2011, the Company acquired Gulf Coast Bearing & Supply Co., a full line bearing and power transmission distributor, located in the U.S. In July 2010, the Company acquired UZ Engineered Products, a distributor of industrial supply products for maintenance, repair, and operational needs, in the government and commercial sectors, throughout the U.S. and Canada. In August 2010, the Company acquired SCS Supply Group, a distributor of bearings, power transmission components, electrical components, fluid power products and industrial supplies in Canada. In December 2008, the Company acquired certain assets of Cincinnati Transmission Company, a distributor of power transmission and motion control products as well as gearbox repair solutions located in the U.S. 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 2011 $280,875 60,837 341,712 137,646 $204,066 2010 $268,021 48,403 316,424 143,171 $173,253 In fiscal 2011 and 2010, reductions in certain U.S. inventories resulted in the liquidation of LIFO inventory quantities carried at lower costs prevailing in prior years. As a result, LIFO benefits reduced cost of goods sold by $5,300 in fiscal 2011 and $23,500 in fiscal 2010. The LIFO reserves were reduced by the same amounts. If inventory levels had remained constant with the prior year’s levels, instead of recording these benefits, the Company would have recorded LIFO expense of $7,000 in fiscal 2011 and $19,200 in fiscal 2010. Therefore, the overall impact of LIFO layer liquidations increased gross profit by $12,300 in fiscal 2011 and $42,700 in fiscal 2010. NOTE 4: GOODWILL AND INTANGIBLES The changes in the carrying amount of goodwill for the Service Center Based Distribution segment for the years ended June 30, 2011 and 2010 is as follows: Balance at July 1, 2009 Other, primarily currency translation Balance at June 30, 2010 Goodwill acquired during the year Other, primarily currency translation Balance at June 30, 2011 $ 63,108 297 63,405 11,700 1,876 $ 76,981 Applied Industrial Technologies, Inc. and Subsidiaries 19 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share amounts) At June 30, 2011, accumulated goodwill impairment losses subsequent to fiscal year 2002, totaled $36,605 and related to the Fluid Power Businesses segment. During the fourth quarter of fiscal 2009, the Company performed an interim goodwill impairment test since operating results and expected future market conditions had deteriorated from the annual goodwill impairment testing performed during the third quarter of fiscal 2009. The fair value of the Fluid Power Businesses segment was estimated based on discounted cash flows. The Company utilized information from the annual financial planning process completed in the fourth quarter of fiscal 2009, reviewed external economic forecasts published in the fourth quarter of fiscal 2009, considered continuing declines in key economic indices that correlate with the business, and considered the continuing declines in sales and operating results experienced in the third and fourth quarters of fiscal 2009 compared to previous forecasts and projections. The Company deemed the business climate to have dramatically changed and adjusted the longer term outlook for recovery of operating results to reflect management’s belief that it would take longer and be more gradual than initially forecast. As a result of this interim test, the Company determined that all of the goodwill associated with the Fluid Power Businesses segment was impaired as of June 30, 2009. Virtually all of the goodwill in the Fluid Power Businesses segment related to the FPR acquisition in August 2008. Therefore, in accordance with the Intangibles – Goodwill and Other topic of the ASC, the Company recognized an impairment charge of $36,605 for goodwill in the fourth quarter of fiscal 2009, which decreased net income by $23,000 and earnings per share by $0.54. In addition, the Company performed an impairment analysis of its intangible assets and noted no further impairment. Intangibles consist of the following: June 30, 2011 Finite-Lived Intangibles: Customer relationships Trade names Vendor relationships Non-competition agreements Total Finite-Lived Intangibles Indefinite-Lived Trade Names Total Intangibles June 30, 2010 Customer relationships Trade names Vendor relationships Non-competition agreements Total Intangibles Amount $ 78,084 25,944 14,211 5,127 123,366 1,290 $124,656 Amount $ 65,324 25,648 13,842 4,394 $109,208 Accumulated Amortization Net Book Value $23,111 5,666 3,696 2,632 35,105 $35,105 Accumulated Amortization $ 15,328 3,777 2,511 1,676 $ 23,292 $54,973 20,278 10,515 2,495 88,261 1,290 $89,551 Net Book Value $ 49,996 21,871 11,331 2,718 $ 85,916 Amounts include the impact of foreign currency translation. Fully amortized amounts are written off. Finite-lived intangible assets acquired in fiscal 2011 had original weighted-average useful lives of 18 years. These consist of customer relationships of $12,100 (19-year weighted-average useful life), finite-lived trade names of $267 (3-year weighted-average useful life), and non-competition agreements of $554 (4-year weighted-average useful life). Indefinite-lived trade names valued at $1,290 were also acquired in fiscal 2011. Amortization of intangibles totaled $11,382, $10,151 and $9,655 in fiscal 2011, 2010 and 2009, respectively, and is included in selling, distribution and administrative expenses in the statements of consolidated income. Amortization expense based on the Company’s intangible assets as of June 30, 2011 is estimated to be $10,900 for 2012, $10,200 for 2013, $8,800 for 2014, $8,200 for 2015 and $7,600 for 2016. NOTE 5: DEBT While the Company had no outstanding borrowings as of June 30, 2011, the amounts outstanding as of June 30, 2010 consisted of: June 30, 7.98% Private placement debt, paid at maturity in November 2010 Revolving credit facility Total outstanding debt Less: Payable within one year Long-term portion of outstanding debt 20 Applied Industrial Technologies, Inc. and Subsidiaries 2010 $25,000 50,000 75,000 75,000 0 $ 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. Fees on this facility range from 0.07% to 0.15% per year on the average amount of the total revolving credit commitments during the year. Borrowings under this agreement carry variable interest rates tied to either LIBOR, prime, or the bank’s cost of funds at the Company’s discretion. Unused lines under this facility, net of outstanding letters of credit of $6,854 to secure certain insurance obligations, totaled $143,146 at June 30, 2011 and are available to fund future acquisitions or other capital and operating requirements. As of June 30, 2011, the Company had no outstanding borrowings on this revolving credit facility. At June 30, 2010, there was $50,000 outstanding on this facility with a weighted-average interest rate (including the associated interest rate swap) of 3.3%. 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 with terms of up to fifteen years. The agreement expires in February 2013. There were no borrowings under this agreement at June 30, 2011. The revolving credit facility and uncommitted shelf facility contain restrictive covenants regarding liquidity, net worth, financial ratios, and other covenants. At June 30, 2011, 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, 2011, the Company was in compliance with all covenants. NOTE 6: RISK MANAGEMENT ACTIVITIES Derivative instruments held by the Company as of June 30, 2010 were settled in the first half of fiscal 2011. The Company is exposed to market risks, primarily resulting from changes in foreign currency exchange rates. To manage this risk, the Company may enter into derivative transactions pursuant to the Company’s written policy. Derivative instruments are recorded on the consolidated balance sheet at their fair value and changes in fair value are recorded each period in current earnings or comprehensive income. The Company does not hold or issue derivative financial instruments for trading purposes. The criteria for designating a derivative as a hedge include the assessment of the instrument’s effectiveness in risk reduction, matching of the derivative instrument to its underlying transaction, and the probability that the underlying transaction will occur. In fiscal 2011, the Company settled cross-currency swap agreements outstanding since November 2000, and an interest rate swap outstanding since September 2008. The following table summarizes the fair value of derivative instruments as recorded in other current liabilities in the consolidated balance sheet as of June 30, 2010 (there are no amounts outstanding as of June 30, 2011): June 30, Derivatives designated as hedging instruments: Cross-currency swap Interest rate swap Total derivatives designated as hedging instruments Derivative not designated as a hedging instrument – cross-currency swap Total Derivatives 2010 $ 8,728 316 9,044 2,182 $11,226 The following table summarizes the effects of derivative instruments on income and other comprehensive income (OCI) for the years ended June 30, 2011, 2010 and 2009 (amounts presented exclude any income tax effects): Derivatives in Cash Flow Hedging Relationships Amount of Gain (Loss) Recognized in OCI on Derivatives (Effective Portion) Amount of Loss Reclassified from Accumulated OCI into Income (Effective Portion), Included in Interest Expense Cross-currency swap Interest rate swap Total Derivative Not Designated as Hedging Instrument Cross-currency swap 2011 2010 $(2,039) (343) $(2,382) 2009 $ 3,790 (1,381) $ 2,409 2011 2010 2009 $ (316) $ (316) $ (1,408) $ (1,408) $ (701) $ (701) Amount of Gain (Loss) Recognized on Derivative, Included in Other (Income) Expense, net 2011 $(368) 2010 $ (510) 2009 $ 947 Applied Industrial Technologies, Inc. and Subsidiaries 21 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share amounts) NOTE 7: FAIR VALUE MEASUREMENTS Financial assets and liabilities measured at fair value on a recurring basis are as follows: Fair Value Measurements Quoted Prices in Active Markets for Identical Instruments Level 1 Recorded Value Significant Other Observable Inputs Level 2 Significant Unobservable Inputs Level 3 2011 2010 2011 2010 2011 2010 2011 2010 June 30, Assets: Marketable securities $10,881 $ 8,592 $10,881 $8,592 Liabilities: Cross-currency swaps Interest rate swap Total Liabilities $10,910 316 $11,226 $10,910 316 $11,226 Marketable securities in the previous table are held in a rabbi trust for a non-qualified deferred compensation plan. The marketable securities are included in other assets in the consolidated balance sheets. The fair values were derived using quoted market prices. Fair values for cross-currency and interest rate swaps shown in the previous table were derived based on valuation models using foreign currency exchange rates and inputs readily available in the public swap markets for similar instruments adjusted for terms specific to these instruments. Since the inputs used to value these instruments were observable and the counterparties were creditworthy, the Company classified them as Level 2 inputs. These liabilities have been settled in fiscal 2011, the balances at June 30, 2010 were included in other current liabilities in the consolidated balance sheets. NOTE 8: 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 income taxes Provision The provision (benefit) for income taxes consists of: 2011 $ 127,567 25,321 $ 152,888 2010 $ 91,932 13,085 $ 105,017 2009 $ 54,916 10,898 $ 65,814 Year Ended June 30, 2011 2010 2009 Current: Federal State and local Foreign Total current Deferred: Federal State and local Foreign Total deferred Total $ 36,799 6,208 8,338 51,345 5,648 169 (1,033) 4,784 $ 28,342 $ 30,142 4,123 4,241 36,706 1,880 (311) 839 2,408 4,235 5,825 40,202 (14,492) (769) (1,387) (16,648) $ 56,129 $ 39,114 $ 23,554 The exercise of non-qualified stock options and appreciation rights during fiscal 2011, 2010 and 2009 resulted in $6,003, $1,466 and $452, 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 2011, 2010 and 2009 resulted in 22 Applied Industrial Technologies, Inc. and Subsidiaries $401, $1,026 and $422, 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 income tax rate: Year Ended June 30, Statutory income tax rate Effects of: State and local taxes U.S. tax on foreign income, net Foreign tax credit carryforwards Valuation allowance Foreign income taxes Deductible dividend Other, net Effective income 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 intangibles Net operating loss carryforwards (expiring in years 2015-2026) Foreign tax credits (expiring in years 2020 and 2021) Other Total deferred tax assets Less: Valuation allowance Deferred tax assets, net of valuation allowance Deferred tax liabilities: Inventories Unremitted foreign earnings Depreciation and differences in property bases Currency translation Total deferred tax liabilities Net deferred tax assets The net deferred tax asset is classified as follows: Other current assets Deferred tax assets (long-term) Other current liabilities Other liabilities Net deferred tax assets 2011 35.0% 2.8 1.8 (.6) (1.0) (.5) (.8) 2010 35.0% 2.2 .8 .5 (.7) (.6) 2009 35.0% 3.2 6.4 (6.0) (1.5) (.4) (1.2) .3 36.7% 37.2% 35.8% 2011 2010 $36,746 $ 34,963 5,498 9,075 432 4,090 677 56,518 (158) 56,360 (4,755) (2,804) (2,062) (9,621) $46,739 $ 5,510 43,447 (2,218) $46,739 8,442 11,334 843 4,086 939 60,607 (997) 59,610 (4,764) (480) (264) (5,508) $ 54,102 $ 6,813 48,493 (349) (855) $ 54,102 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. The remaining 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. U.S. federal income taxes are provided on the portion of non-U.S. subsidiaries income that is not considered to be permanently reinvested outside the U.S. and may be remitted to the U.S. At June 30, 2011, undistributed earnings of non-U.S. subsidiaries considered to be permanently reinvested and for which no U.S. tax has been provided totaled approximately $58,300. Determination of the net amount of the unrecognized tax liability with respect to these earnings is not practicable; however, foreign Applied Industrial Technologies, Inc. and Subsidiaries 23 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share amounts) tax credits would be available to partially reduce U.S. income taxes in the event of a distribution. Undistributed earnings of non-U.S. subsidiaries not considered to be permanently reinvested totaled approximately $13,600. U.S. taxes totaling $2,804 have been accrued on these earnings. Unrecognized Income Tax Benefits The Company and its subsidiaries file income tax returns in U.S. federal, various state, local and foreign jurisdictions. The following is a reconciliation of the Company’s total gross unrecognized income tax benefits: Year Ended June 30, Unrecognized Income Tax Benefits at beginning of the year Current year tax positions Prior year tax positions Expirations of statutes of limitations Settlements 2011 $ 1,842 153 50 (273) (591) 2010 $1,860 130 46 (194) 2009 $ 2,004 183 (51) (167) (109) Unrecognized Income Tax Benefits at end of year $ 1,181 $1,842 $ 1,860 Included in the balance of unrecognized income tax benefits at June 30, 2011, 2010 and 2009 are $659, $988 and $984, respectively, of income tax benefits that, if recognized, would affect the effective income tax rate. During 2011, 2010 and 2009, the Company recognized $(22), $22 and $32, respectively, for interest and penalties related to unrecognized income tax benefits in its statements of consolidated income. The Company had a liability for penalties and interest of $525 and $547 as of June 30, 2011 and 2010, respectively. The Company does not anticipate a significant change to the total amount of unrecognized income tax benefits within the next twelve months. The Company is subject to U.S. federal income tax examinations for the tax years 2008 through 2011. In addition, the Company is subject to foreign, state and local income tax examinations for the tax years 2008 through 2011. The Company’s unrecognized income tax benefits are included in other liabilities in the consolidated balance sheets since payment of cash is not expected within one year. NOTE 9: SHAREHOLDERS’ EQUITY Treasury Shares At June 30, 2011, 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. Accumulated Other Comprehensive Income (Loss) Accumulated other comprehensive income (loss) is comprised of the following: June 30, Pension liability, net of taxes Foreign currency translation, net of taxes Unrealized gains on investment securities available for sale, net of taxes Unrealized losses on cash flow hedges, net of taxes Total accumulated other comprehensive income (loss) Net Income Per Share The following is a computation of 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 potential common shares Weighted-average common shares outstanding for dilutive computation Net Income Per Share – Basic Net Income Per Share – Diluted 2011 $(11,212) 16,189 82 $ 5,059 2011 $ 96,759 42,433 821 43,254 $ $ 2.28 2.24 2010 $ 65,903 42,312 549 42,861 $ $ 1.56 1.54 2010 $ (12,081) 5,914 135 (16) $ (6,048) 2009 $42,260 42,287 507 42,794 $ $ 1.00 0.99 24 Applied Industrial Technologies, Inc. and Subsidiaries Stock options and appreciation rights relating to the acquisition of 176, 1,034 and 1,208 shares of common stock were outstanding at June 30, 2011, 2010 and 2009, respectively, but were not included in the computation of diluted earnings per share for the fiscal years then ended as they were anti-dilutive. NOTE 10: SHARE-BASED COMPENSATION Share-Based Incentive Plans The 2007 Long-Term Performance Plan (the 2007 Plan), which expires in 2012, provides for granting of stock options, SARs, stock awards, cash awards, and such other awards or combination thereof as the Executive Organization and Compensation Committee or the Corporate Governance Committee of the Board of Directors (the Committee) may determine to officers, other key associates and members of the Board of Directors. Grants are generally made by the Committee at regularly scheduled meetings. Compensation costs charged to expense under award programs paid (or to be paid) with shares (including stock options, SARs, restricted stock, RSUs and performance shares) are summarized in the table below: Year Ended June 30, SARs and options Performance shares Restricted stock and RSUs Total compensation costs under award programs 2011 $ 2,473 1,705 1,453 $ 5,631 2010 $ 3,020 1,076 1,029 $ 5,125 2009 $ 3,702 392 $ 4,094 Such amounts are included in selling, distribution and administrative expenses in the accompanying statements of consolidated income. It has been the practice of the Company to issue shares from treasury to satisfy requirements of awards paid with shares. The aggregate unamortized compensation cost for award programs paid (or to be paid) with shares at June 30, 2011 is $6,730. This amount will be recognized in expense over the weighted-average remaining vesting period of 2.0 years. 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, 2011 were 629. Stock Appreciation Rights and Stock Options The weighted-average assumptions used for SARs and stock option grants issued in fiscal 2011, 2010 and 2009 are: Expected life, in years Risk free interest rate Dividend yield Volatility Per share fair value of SARs and stock options granted during the year 2011 5.1 1.6% 2.5% 46.2% $ 9.78 2010 5.5 2.4% 2.5% 52.2% $ 8.45 2009 5.5 2.9% 2.2% 48.4% $ 10.31 The expected life is based upon historical exercise experience of the officers, other key associates and members of the Board of Directors. The risk free interest rate is based upon U.S. Treasury zero-coupon bonds with remaining terms equal to the expected life of the SARs and stock options. 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. 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 SARs and stock options activity is presented below: June 30, 2011 (Share amounts in thousands) Outstanding, beginning of year Granted Exercised Forfeited Outstanding, end of year Exercisable at end of year Shares 2,400 227 (822) (1) 1,804 1,169 Weighted-Average Exercise Price $ 18.19 29.60 11.50 20.99 $ 22.68 $ 21.03 The weighted-average remaining contractual terms for SARs and stock options outstanding and exercisable at June 30, 2011 were 6.1 and 5.1 years, respectively. The aggregate intrinsic values of SARs and stock options outstanding and exercisable at June 30, 2011 were $15,564. The aggregate intrinsic value of the SARs and stock options exercised during fiscal 2011, 2010 and 2009 was $18,526, $5,157 and $1,453, respectively. Applied Industrial Technologies, Inc. and Subsidiaries 25 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share amounts) As of June 30, 2011, unrecognized compensation cost related to SARs and stock options amounted to $1,775. That cost is expected to be recognized over a weighted-average period of 2.3 years. The total fair value of shares vested during fiscal 2011, 2010 and 2009 was $2,645, $2,673 and $2,495, respectively. Performance Shares Performance shares are a type of award under the 2007 Plan that are intended to provide incentives to achieve three-year goals. Performance shares pay out in shares of Applied stock at the end of a three-year period provided the Company achieves the established goals. The number of Applied shares payable will vary depending on the level of the goal achieved. A summary of nonvested performance shares activity at June 30, 2011 is presented below: June 30, 2011 (Share amounts in thousands) Nonvested, beginning of year Granted Vested Nonvested, end of year Weighted-Average Grant-Date Fair Value $ 20.67 29.27 $ 23.23 Shares 156 66 222 The Committee set three one-year goals for the 2011 grant tied to the Company’s earnings before interest, tax, depreciation, and amortization (EBITDA) and after-tax return on assets (ROA). Each fiscal year during the three-year term has its own separate goals. Achievement during any particular fiscal year is “banked” for payout at the end of the three-year term. Fiscal 2010 was the first year performance shares were granted. Because of volatile market conditions at the beginning of fiscal 2010, the Committee set one-year goals for the fiscal 2010 grant tied to the Company’s EBITDA. As the targeted goals were accomplished, the performance shares have been converted to 156 restricted stock units (performance share RSUs or PSRSUs). These PSRSUs vest at the end of the original three-year performance share grant period, with dividend equivalents paid on each PSRSU on a current basis. At June 30, 2010, 156 PSRSUs were issued under the fiscal 2010 performance share awards. These PSRSUs are reported in the prior table. As of June 30, 2011, unamortized compensation cost related to performance shares was $2,384 to be amortized over the weighted-average remaining vesting period of 1.5 years. Restricted Stock and Restricted Stock Units 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 periods of one to four years. In fiscal 2010, the Company began to grant RSUs. RSUs are grants valued in shares of Applied stock, but shares are not issued until the grants vest three years from the award date, assuming continued employment with Applied. RSUs vest on a pro rata basis upon retirement during the three-year term. Applied pays dividend equivalents on RSUs on a current basis. A summary of the status of the Company’s nonvested restricted stock and RSUs at June 30, 2011 is presented below: June 30, 2011 (Share amounts in thousands) Nonvested, beginning of year Granted Vested Nonvested, end of year Weighted-Average Grant-Date Fair Value $21.41 30.31 22.13 $25.97 Shares 104 85 (27) 162 Unamortized compensation cost related to unvested restricted stock awards and RSUs aggregated $2,571 and $1,477 at June 30, 2011 and 2010, and is expected to be amortized over the weighted-average remaining vesting period of 2.1 years. Performance Grants In fiscal 2009 and 2008, the Executive Organization and Compensation Committee made annual awards of three-year performance grants to key officers. A target payout was 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 by the Committee at the end of the performance period. At June 30, 2011 and 2010, the Company had no liability recorded for the sales growth and return on sales goals as the Company estimated there would be no payouts under these goals. During fiscal 2011, 2010 and 2009, the Company recorded $1,020, $(231) and $7, respectively, of compensation expense (income) for achievement relative to the total shareholder 26 Applied Industrial Technologies, Inc. and Subsidiaries return-based goals of the Company’s performance grants. At June 30, 2011 and 2010, the Company had accrued $1,558 and $538, respectively, for compensation expense relative to these goals. At June 30, 2011, all performance periods had expired. NOTE 11: BENEFIT PLANS Retirement Savings Plan Substantially all U.S. associates participate in the Applied Industrial Technologies, Inc. Retirement Savings Plan. Participants may elect to contribute up to 50% of their compensation, subject to Internal Revenue Code maximums. 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 2011 and fiscal 2010 and 2.5% for fiscal 2009). The Company partially matches 401(k) contributions by participants; this match was suspended from January 1, 2009 to June 30, 2010. The Company’s expense for profit sharing and matching of associates’ 401(k) contributions was $11,251, $4,891 and $3,086 during fiscal 2011, 2010 and 2009, 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. Assets held in these rabbi trusts consist of investments in money market and mutual funds and Company common stock. 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 beginning at retirement and determinable at retirement based upon a percentage of the participant’s historical compensation. Qualified Defined Benefit Retirement Plan The Company has a qualified defined benefit retirement plan that provides benefits to certain hourly associates at retirement. These associates do not participate in the Retirement Savings Plan. The benefits are based on length of service and date of retirement. Salary Continuation Benefits The Company has agreements with certain retirees of acquired companies to pay monthly retirement benefits for a period not in excess of 15 years. 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 subsidized by the Company. Additionally, in conjunction with a fiscal 1998 acquisition, the Company assumed the obligation for a postretirement medical benefit plan which provides health care benefits to eligible retired associates at no cost to the individual. The Company uses a June 30 measurement date for all plans. Applied Industrial Technologies, Inc. and Subsidiaries 27 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share amounts) The changes in benefit obligations, plan assets and funded status for the postemployment plans were as follows: June 30, 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 end of year Change in plan assets: Fair value of plan assets at beginning of year Actual gain (loss) on plan assets Employer contributions Plan participants’ contributions Benefits paid Fair value of plan assets at end of year Funded status at end of year Pension Benefits Retiree Health Care Benefits 2011 2010 2011 2010 $ 51,114 460 2,232 (1,856) 151 1,389 $ 53,490 $ 5,229 984 1,699 (1,856) $ 6,056 $ (47,434) $ 45,466 574 2,911 (1,801) 3,964 $ 51,114 $ 4,757 575 1,698 (1,801) $ 5,229 $(45,885) $ 4,593 $ 4,353 39 235 37 (227) 52 259 35 (226) (10) $ 4,667 120 $ 4,593 $ 190 37 (227) $ 0 $ (4,667) $ 191 35 (226) $ 0 $ (4,593) The amounts recognized in the consolidated balance sheets and in accumulated other comprehensive income (loss) for the postemployment plans were as follows: June 30, Amounts recognized in the consolidated balance sheets: Other current liabilities Postemployment benefits Net amount recognized Amounts recognized in accumulated other comprehensive income (loss): Net actuarial (loss) gain Prior service cost Total amounts recognized in accumulated other comprehensive income (loss) Pension Benefits Retiree Health Care Benefits 2011 2010 2011 2010 $ 4,151 43,283 $ 47,434 $ (15,012) (3,808) $ 1,698 44,187 $ 45,885 $(15,670) (4,368) $ 220 4,447 $ 4,667 $ 892 (274) $ (18,820) $(20,038) $ 618 $ 220 4,373 $ 4,593 $ 965 (413) $ 552 28 Applied Industrial Technologies, Inc. and Subsidiaries The following table provides information for pension plans with projected benefit obligations and accumulated benefit obligations in excess of plan assets: June 30, Projected benefit obligations Accumulated benefit obligations Fair value of plan assets The net periodic costs are as follows: Pension Benefits 2011 $ 53,490 43,528 6,056 2010 $ 51,114 39,363 5,229 Pension Benefits Retiree Health Care Benefits Year Ended June 30, Service cost Interest cost Expected return on plan assets Recognized net actuarial loss (gain) Amortization of prior service cost 2011 $ 460 2,232 (385) 1,449 710 2010 $ 574 2,911 (351) 924 797 2009 $2,139 2,518 (436) 911 920 Net periodic cost $ 4,466 $4,855 $6,052 2011 $ 39 235 (83) 139 $ 330 2010 $ 52 259 (87) 148 $ 372 2009 $ 41 228 (125) 119 $ 263 The estimated net actuarial 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 $1,256 and $741, respectively. The estimated net actuarial 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 $(72) and $139, respectively. Assumptions 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 computes a weighted-average discount rate taking into account anticipated plan payments and the associated interest rates from the Citigroup Pension Discount Yield Curve. The weighted-average actuarial assumptions used to determine benefit obligations and net periodic benefit cost for the plans were as follows: June 30, Assumptions used to determine benefit obligations at year end: Discount rate Rate of compensation increase Assumptions used to determine net periodic benefit cost: Discount rate Expected return on plan assets Rate of compensation increase Pension Benefits Retiree Health Care Benefits 2011 2010 2011 2010 4.5% 5.5% 4.3% 7.5% 5.5% 4.3% 5.5% 6.0% 7.5% 5.5% 5.5% N/A 5.5% N/A N/A 5.5% N/A 6.3% N/A N/A The assumed health care cost trend rates used in measuring the accumulated benefit obligation for retiree health care benefits were 8.0% and 8.5% as of June 30, 2011 and 2010, respectively, decreasing to 5% by 2018. A one-percentage point change in the assumed health care cost trend rates would have had the following effects as of June 30, 2011 and for the year then ended: Effect on total service and interest cost components of periodic expense Effect on postretirement benefit obligation One-Percentage Point Increase $ 47 722 Decrease $ (39) (598) Applied Industrial Technologies, Inc. and Subsidiaries 29 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share amounts) Plan Assets The fair value of each major class of plan assets for the Company’s Qualified Benefit Retirement Plan are valued using quoted market prices in active markets for identical instruments, or Level 1 in the fair value hierarchy. Following are the fair values and target allocation as of June 30: Asset Class: Equity securities Debt securities Other Total Target Allocation 40 – 70% 20 – 50% 0 – 20% 100% Fair Value 2011 $ 3,876 1,756 424 $ 6,056 2010 $ 2,987 1,977 265 $ 5,229 Equity securities do not include any Company 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 $4,200 to its pension benefit plans and $240 to its retiree health care benefit plans in 2012. Contributions do not equal estimated future payments as certain payments are made from plan assets. Estimated Future Benefit Payments The following benefit payments, which reflect expected future service, as applicable, are expected to be paid in each of the next five years and in the aggregate for the subsequent five years: During Fiscal Years 2012 2013 2014 2015 2016 2017 through 2021 NOTE 12: LEASES Pension Benefits $ 4,300 4,300 5,600 5,000 5,100 25,500 Retiree Health Care Benefits $ 200 300 200 200 200 1,500 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, 2011 are as follows: During Fiscal Years 2012 2013 2014 2015 2016 Thereafter Total minimum lease payments $23,200 16,900 13,600 10,300 5,700 5,300 $75,000 Rental expenses incurred for operating leases, principally from leases for real property, vehicles and computer equipment were $31,400 in 2011, $30,700 in 2010 and $30,900 in 2009. 30 Applied Industrial Technologies, Inc. and Subsidiaries NOTE 13: SEGMENT AND GEOGRAPHIC 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 generally the same as those described in Note 1. Sales primarily from the Fluid Power Businesses segment to the Service Center Based Distribution segment of $17,665, $14,006 and $5,247, in fiscal 2011, 2010 and 2009, respectively, have been eliminated in the table below. Segment Financial Information Year Ended June 30, 2011 Net sales Operating income for reportable segments Assets used in the business Depreciation and amortization of property Capital expenditures Year Ended June 30, 2010 Net sales Operating income for reportable segments Assets used in the business Depreciation and amortization of property Capital expenditures Year Ended June 30, 2009 Net sales Operating income for reportable segments Assets used in the business Depreciation and amortization of property Capital expenditures Service Center Based Distribution Fluid Power Businesses $ 1,770,798 115,798 700,486 9,152 19,392 $ 1,536,543 77,029 690,970 9,336 6,389 $ 1,596,998 75,411 611,255 10,876 5,537 $ 442,051 41,793 214,445 2,082 1,039 $ 356,665 26,794 200,550 2,129 827 $ 326,150 18,942 198,073 1,860 1,451 Total $ 2,212,849 157,591 914,931 11,234 20,431 $ 1,893,208 103,823 891,520 11,465 7,216 $ 1,923,148 94,353 809,328 12,736 6,988 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: Goodwill impairment Intangible amortization – Service Center Based Distribution Intangible amortization – Fluid Power Businesses Corporate and other income, net Total operating income Interest expense, net Other (income) expense, net Income before income taxes 2011 $157,591 3,384 7,998 (4,554) 150,763 1,668 (3,793) $152,888 2010 $103,823 1,890 8,261 (16,378) 110,050 5,458 (425) $105,017 2009 $ 94,353 36,605 2,265 7,390 (24,400) 72,493 4,424 2,255 $ 65,814 The change in corporate and other income, 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. Applied Industrial Technologies, Inc. and Subsidiaries 31 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share amounts) Product Category Net sales by product category are as follows: Year Ended June 30, Industrial Fluid power Net sales 2011 $ 1,559,859 652,990 $ 2,212,849 2010 $1,357,206 536,002 $1,893,208 2009 $ 1,422,518 500,630 $ 1,923,148 The fluid power product category includes sales of hydraulic, pneumatic, lubrication and filtration components and systems, and repair services through the Company’s Service Center Based Distribution segment as well as the Fluid Power Businesses segment. Geographic Information Net sales are presented in geographic areas based on the location of the facility shipping the product. Long-lived assets are based on physical locations and are comprised of the net book value of property, goodwill and intangible assets. Information by geographic area is as follows: Year Ended June 30, Net Sales: United States Canada Mexico Total June 30, Long-Lived Assets: United States Canada Mexico Total 2011 2010 2009 $ 1,891,700 260,015 61,134 $ 2,212,849 $1,644,237 199,772 49,199 $1,893,208 $ 1,674,769 197,795 50,584 $ 1,923,148 2011 2010 $ 191,947 29,893 13,706 $ 235,546 $177,713 16,356 13,723 $207,792 NOTE 14: COMMITMENTS AND CONTINGENCIES In connection with the construction and lease of its corporate headquarters facility, the Company has guaranteed repayment of a total of $4,600 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 15: OTHER (INCOME) EXPENSE, NET Other (income) expense, net, consists of the following: Year Ended June 30, Unrealized (gain) loss on assets held in rabbi trust for a nonqualified deferred compensation plan Benefit from payouts on corporate-owned life insurance policies Foreign currency transaction (gains) losses Unrealized loss (gain) on cross-currency swap Other, net Total other (income) expense, net 2011 $ (2,016) (1,722) (541) 368 118 $ (3,793) 2010 $ (1,012) 36 510 41 $ (425) 2009 $ 1,741 1,466 (947) (5) $ 2,255 The Company is the owner and beneficiary under life insurance policies acquired in conjunction with a fiscal 1998 acquisition, with benefits in force of $12,300 and a net cash surrender value of $3,100 at June 30, 2011. In January 2011, the Company received death benefits under two of these policies and realized a gain of $1,722. 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, 2011 and 2010, and the related statements of consolidated income, shareholders' equity, and cash flows for each of the three years in the period ended June 30, 2011. 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, 2011 and 2010, and the results of its operations and its cash flows for each of the three years in the period ended June 30, 2011, in conformity with accounting principles generally accepted in the United States of America. 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, 2011, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated August 17, 2011 expressed an unqualified opinion on the Company's internal control over financial reporting. Cleveland, Ohio August 17, 2011 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, 2011. 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, 2011. 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. 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 August 17, 2011 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, 2011, 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, 2011, 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, 2011 of the Company and our report dated August 17, 2011 expressed an unqualified opinion on those consolidated financial statements. Cleveland, Ohio August 17, 2011 36 Applied Industrial Technologies, Inc. and Subsidiaries QUARTERLY OPERATING RESULTS (In thousands, except per share amounts) (UNAUDITED) 2011 First Quarter Second Quarter Third Quarter Fourth Quarter 2010 First Quarter Second Quarter Third Quarter Fourth Quarter 2009 First Quarter Second Quarter Third Quarter Fourth Quarter Net Sales Gross Profi t Operating Income (Loss) Net Income (Loss) Per Common Share Net Income (Loss) Cash Dividend $ 527,501 529,517 565,970 589,861 $ 2,212,849 $ 437,743 446,253 486,141 523,071 $ 1,893,208 $ 543,906 502,412 451,647 425,183 $ 1,923,148 $ 143,120 144,281 156,566 169,143 $ 613,110 $ 115,444 116,905 130,356 153,017 $ 515,722 $ 146,058 135,469 122,246 116,237 $ 520,010 $ 34,891 33,056 38,201 44,615 $150,763 $ 17,641 18,903 27,037 46,469 $ 110,050 $ 37,375 28,807 21,019 (14,708) $ 72,493 $ 20,755 21,193 26,536 28,275 $ 96,759 $ 11,187 10,487 16,525 27,704 $ 65,903 $ 22,536 16,194 11,560 (8,030) $ 42,260 $ 0.48 0.49 0.61 0.65 $ 2.24 $ 0.26 0.24 0.39 0.64 $ 1.54 $ 0.52 0.38 0.27 (0.19) $ 0.99 $ 0.17 0.17 0.17 0.19 $ 0.70 $ 0.15 0.15 0.15 0.15 $ 0.60 $ 0.15 0.15 0.15 0.15 $ 0.60 On August 5, 2011 there were 6,146 shareholders of record including 4,190 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 5, 2011 was $29.07 per share. The sum of the quarterly per share amounts may not equal per share amounts reported for year-to-date. This is due to changes in the number of weighted shares outstanding and the effects of rounding for each period. Cost of sales for interim fi nancial statements are computed using estimated gross profi t 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. During the year ended June 30, 2011, the Company recorded overall LIFO benefi ts of $5,294, which reduced cost of goods sold. The overall LIFO reserves were reduced by the same amounts. Total fi scal year 2011 LIFO benefi ts were recorded as follows: $301 in the fi rst quarter, $1,823 in the second quarter, $356 in the third quarter and $2,814 in the fourth quarter. The LIFO benefi t recorded in fi scal 2010 was $23,500, which reduced cost of goods sold. The overall LIFO reserves were reduced by the same amounts. Total fi scal year 2010 LIFO benefi ts were recorded as follows: $710 in the fi rst quarter, $1,800 in the second quarter, $4,840 in the third quarter and $16,150 in the fourth quarter. The fi scal 2009 fourth quarter includes a goodwill impairment charge of $36,605, which decreased net income by $23,000 and earnings per share by $0.54. QUARTERLY VOLUME AND PRICE INFORMATION Shares Traded Average Daily Volume 2011 First Quarter Second Quarter Third Quarter Fourth Quarter 2010 First Quarter Second Quarter Third Quarter Fourth Quarter 2009 First Quarter Second Quarter Third Quarter Fourth Quarter 18,731,300 22,875,900 17,150,600 19,014,600 12,316,800 13,876,700 11,246,000 23,193,800 23,839,000 25,940,700 27,478,700 22,937,700 292,700 357,400 276,600 301,800 192,400 216,800 184,400 368,200 372,500 405,300 450,500 364,100 Price Range High $31.08 33.34 34.92 36.01 $ 23.17 22.91 25.20 33.00 $ 31.29 26.78 20.49 23.95 Low $24.15 29.00 30.36 31.94 $ 18.11 18.80 21.06 24.80 $ 22.92 14.12 14.63 16.25 Applied Industrial Technologies, Inc. and Subsidiaries 37 2011 2010 2009(a) 2008 2007 2006 2005 2004 2003 2002 $2,212,849 11,234 $1,893,208 11,465 $1,923,148 12,736 $2,089,456 12,776 $2,014,109 13,489 $1,900,780 13,128 $1,717,055 13,832 $1,517,004 14,381 $1,464,367 14,458 $1,446,569 15,294 10 YEAR SUMMARY (In thousands, except per share amounts and statistical data) Consolidated Operations - Year Ended June 30 Net sales Depreciation and amortization of property Amortization: Intangible assets Stock options and SARs (b) Operating income Income before cumulative effect of accounting change Net Sales Net income Per share data: (Dollars in Billions) Income before cumulative effect of accounting change Net Income Per Share (Dollars) 11,382 2,473 150,763 96,759 96,759 2.28 2.24 $2.24 2.28 2.24 0.70 10,151 3,020 110,050 65,903 Shareholders' Equity 65,903 (Dollars in Millions) 1.56 1.54 $633.6 $555.0 1.56 $502.1 $508.1 1.54 0.60 $451.0 46,260 3,702 72,493 42,260 42,260 1.00 0.99 1.00 0.99 0.60 $2.0 $2.5 $2.21 $2.09 $1.92 $1.89 Basic Diluted $2.5 Net income Basic $2.01 Diluted Cash dividend $1.5 Year-End Position - June 30 Working capital $1.0 Long-term debt (including long-term debt classifi ed as current) Total assets Shareholders’ equity $0.5 $1.93 $0.5 $1.0 $1.5 $2.0 $2.19 $1.54 * $0.99 $ 404,226 914,931 633,563 08 Year-End Statistics - June 30 $0.0 Current ratio 07 Operating facilities Shareholders of record Return on assets (c) Return on equity (d) 09 10 11 07 08 09 10 $0.0 * The goodwill impairment charge in fiscal 2009 reduced net income per share by $0.54. 11 2.9 474 6,208 11.1% 16.3% $700 $600 $500 $400 $300 $200 $100 $0 $ 347,528 75,000 891,520 555,039 07 08 2.3 455 5,884 09 10 11 7.9% 12.4% $ 369,038 75,000 809,328 508,102 3.4 464 6,329 7.7% 8.4% 1,663 2,999 152,824 95,456 95,456 2.23 2.19 2.23 2.19 0.60 1,045 2,494 135,011 86,022 86,022 1.97 1.93 1.97 1.93 0.48 732 2,658 115,592 72,299 72,299 1.62 1.57 1.62 1.57 0.40 993 2,111 87,968 55,339 55,339 1.24 1.20 1.24 1.20 0.29 826 1,586 51,448 31,471 31,471 0.73 0.71 0.73 0.71 0.21 781 36,254 19,832 19,832 0.47 0.46 0.47 0.46 0.21 1,651 30,834 14,755 2,655 0.34 0.34 0.06 0.06 0.21 $ 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 $ 286,022 77,767 596,841 339,535 $ 259,359 $ 250,644 78,558 553,404 307,856 83,478 534,566 298,147 3.1 459 6,305 12.2% 20.0% 2.6 445 6,242 11.6% 19.9% 3.0 452 6,192 10.3% 17.9% 2.9 440 6,079 8.8% 15.1% 2.9 434 6,154 5.6% 9.7% 2.8 440 6,157 3.7% 6.5% 2.9 449 6,455 2.6% 4.8% Capital expenditures EBITDA (e) $ 20,431 175,852 $ 7,216 134,686 $ 6,988 135,191 $ 8,410 170,262 $ 11,192 152,039 $ 11,057 132,110 $ 9,208 104,904 $ 14,383 68,241 $ 12,794 51,493 $ 10,050 47,779 (a) The goodwill impairment charge in fi scal 2009 reduced operating income by $36,605, net income by $23,000 and net income per share by $0.54. (b) Prior to 2004, the Company did not record stock option expense as it was not required by Generally Accepted Accounting Principles. (c) Return on Assets is calculated as net income divided by monthly average assets, exclusive of the goodwill impairment. (d) Return on Equity is calculated as net income divided by the average shareholders’ equity (beginning of the year and end of the year divided by 2). (e) EBITDA is calculated as operating income, plus depreciation and amortization of property and amortization of intangible assets, stock options and SARs. Net Sales (Dollars in Billions) Net Income (Dollars in Millions) Net Income Per Share (Dollars) Shareholders' Equity (Dollars in Millions) Dividends Per Share (Dollars) $2.5 $2.0 $1.5 $1.0 $0.5 $0.0 1 2 . 2 $ 9 0 . 2 $ 1 0 . 2 $ 2 9 . 1 $ 9 8 . 1 $ 0 9 . 1 $ 2 7 . 1 $ 5 4 . 1 $ 6 4 . 1 $ 2 5 . 1 $ 02 03 04 05 06 07 08 09 10 11 $100 $80 $60 $40 $20 $0 8 . 6 9 $ 5 . 5 9 $ 0 . 6 8 $ 3 . 2 7 $ 3 . 5 5 $ 9 . 5 6 $ * 3 . 2 4 $ 5 . 1 3 $ 8 . 9 1 $ 7 . 2 $ 02 03 04 05 06 07 08 09 10 11 $2.5 $2.0 $1.5 $1.0 $0.5 $0.0 4 2 . 2 $ 9 1 . 2 $ 3 9 . 1 $ 7 5 . 1 $ 0 2 . 1 $ 4 5 . 1 $ * 9 9 . 0 $ 1 7 . 0 6 $ 4 . 0 $ 6 0 . 0 $ 02 03 04 05 06 07 08 09 10 11 02 03 04 05 06 07 08 09 10 11 02 03 04 05 06 07 08 09 10 11 6 . 3 3 6 0 $ . 5 5 5 $ 1 . 2 0 5 $ 1 . 8 0 5 $ 0 . 1 5 4 $ 8 . 4 1 4 $ 3 . 3 9 3 $ 5 . 9 3 3 $ 1 . 8 9 2 $ 9 . 7 0 3 $ $700 $600 $500 $400 $300 $200 $100 $0 0 7 . 0 $ 0 6 . 0 $ 0 6 . 0 $ 0 6 . 0 $ 8 4 . 0 $ 0 4 . 0 $ 9 2 . 0 $ 1 2 . 0 $ 1 2 . 0 $ 1 2 . 0 $ $0.7 $0.6 $0.5 $0.4 $0.3 $0.2 $0.1 $0.0 38 Applied Industrial Technologies, Inc. and Subsidiaries * The goodwill impairment charge in fiscal 2009 reduced net income by $23.0 million. * The goodwill impairment charge in fiscal 2009 reduced net income per share by $0.54. Consolidated Operations - Year Ended June 30 Net sales Depreciation and amortization of property Amortization: Intangible assets Stock options and SARs (b) Operating income Net Sales Net income Per share data: (Dollars in Billions) Income before cumulative effect of accounting change Income before cumulative effect of accounting change $2,212,849 11,234 11,382 2,473 150,763 96,759 96,759 $1,893,208 11,465 10,151 3,020 110,050 65,903 Net Income Per Share (Dollars) Shareholders' Equity 65,903 (Dollars in Millions) $2.21 $2.19 $2.24 $1.92 $1.89 $2.0 $1.93 Year-End Position - June 30 Working capital Long-term debt (including long-term debt classifi ed as current) $1.54 $0.99 * $ 404,226 $2.5 $1.5 $1.0 $0.5 $0.0 Net income $2.09 Basic Diluted $2.01 Basic Diluted Cash dividend $2.5 $2.0 $1.5 $1.0 Total assets Shareholders’ equity $0.5 $0.0 Current ratio 07 08 Operating facilities Shareholders of record Return on assets (c) Return on equity (d) Capital expenditures EBITDA (e) 2.28 2.24 2.28 2.24 0.70 1.56 1.54 1.56 0.60 $633.6 $555.0 $502.1 $508.1 1.54 $451.0 $700 $600 $500 $400 $300 $200 $100 $0 914,931 633,563 2.9 474 6,208 11.1% 16.3% $ 347,528 75,000 891,520 555,039 2.3 455 09 5,884 7.9% 12.4% Year-End Statistics - June 30 09 10 11 07 08 09 10 11 07 08 10 11 * The goodwill impairment charge in fiscal 2009 reduced net income per share by $0.54. $1,923,148 12,736 46,260 3,702 72,493 42,260 42,260 1.00 0.99 1.00 0.99 0.60 $ 369,038 75,000 809,328 508,102 3.4 464 6,329 7.7% 8.4% (a) The goodwill impairment charge in fi scal 2009 reduced operating income by $36,605, net income by $23,000 and net income per share by $0.54. (b) Prior to 2004, the Company did not record stock option expense as it was not required by Generally Accepted Accounting Principles. (c) Return on Assets is calculated as net income divided by monthly average assets, exclusive of the goodwill impairment. (d) Return on Equity is calculated as net income divided by the average shareholders’ equity (beginning of the year and end of the year divided by 2). (e) EBITDA is calculated as operating income, plus depreciation and amortization of property and amortization of intangible assets, stock options and SARs. 2011 2010 2009(a) 2008 2007 2006 2005 2004 2003 2002 $2,089,456 12,776 $2,014,109 13,489 $1,900,780 13,128 $1,717,055 13,832 $1,517,004 14,381 $1,464,367 14,458 $1,446,569 15,294 1,663 2,999 152,824 95,456 95,456 2.23 2.19 2.23 2.19 0.60 1,045 2,494 135,011 86,022 86,022 1.97 1.93 1.97 1.93 0.48 732 2,658 115,592 72,299 72,299 1.62 1.57 1.62 1.57 0.40 993 2,111 87,968 55,339 55,339 1.24 1.20 1.24 1.20 0.29 826 1,586 51,448 31,471 31,471 0.73 0.71 0.73 0.71 0.21 781 36,254 19,832 19,832 0.47 0.46 0.47 0.46 0.21 1,651 30,834 14,755 2,655 0.34 0.34 0.06 0.06 0.21 $ 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 $ 286,022 77,767 596,841 339,535 $ 259,359 78,558 553,404 307,856 $ 250,644 83,478 534,566 298,147 3.1 459 6,305 12.2% 20.0% 2.6 445 6,242 11.6% 19.9% 3.0 452 6,192 10.3% 17.9% 2.9 440 6,079 8.8% 15.1% 2.9 434 6,154 5.6% 9.7% 2.8 440 6,157 3.7% 6.5% 2.9 449 6,455 2.6% 4.8% $ 20,431 175,852 $ 7,216 134,686 $ 6,988 135,191 $ 8,410 170,262 $ 11,192 152,039 $ 11,057 132,110 $ 9,208 104,904 $ 14,383 68,241 $ 12,794 51,493 $ 10,050 47,779 Net Sales (Dollars in Billions) Net Income (Dollars in Millions) Net Income Per Share (Dollars) Shareholders' Equity (Dollars in Millions) Dividends Per Share (Dollars) 1 2 . 2 $ 9 0 . 2 $ 1 0 . 2 $ 2 9 . 1 $ 9 8 . 1 $ 0 9 . 1 $ 2 7 . 1 $ 5 4 . 1 $ 6 4 . 1 $ 2 5 . 1 $ $2.5 $2.0 $1.5 $1.0 $0.5 $0.0 8 . 6 9 $ 5 . 5 9 $ 0 . 6 8 $ 3 . 2 7 $ 3 . 5 5 $ 9 . 5 6 $ * 3 . 2 4 $ $100 $80 $60 $40 $20 $0 5 . 1 3 $ 8 . 9 1 $ 7 . 2 $ 4 2 . 2 $ 9 1 . 2 $ 3 9 . 1 $ 7 5 . 1 $ 0 2 . 1 $ 4 5 . 1 $ * 9 9 . 0 $ $2.5 $2.0 $1.5 $1.0 $0.5 $0.0 1 7 . 0 6 $ 4 . 0 $ 6 0 . 0 $ * The goodwill impairment charge in fiscal 2009 * The goodwill impairment charge in fiscal 2009 reduced net income by $23.0 million. reduced net income per share by $0.54. 02 03 04 05 06 07 08 09 10 11 02 03 04 05 06 07 08 09 10 11 02 03 04 05 06 07 08 09 10 11 $700 $600 $500 $400 $300 $200 $100 $0 6 . 3 3 6 0 $ 5 5 5 $ . 1 . 2 0 5 $ 1 . 8 0 5 $ 0 . 1 5 4 $ 8 . 4 1 4 $ 3 . 3 9 3 $ 5 . 9 3 3 $ 1 . 8 9 2 $ 9 . 7 0 3 $ 02 03 04 05 06 07 08 09 10 11 $0.7 $0.6 $0.5 $0.4 $0.3 $0.2 $0.1 $0.0 0 7 . 0 $ 0 6 . 0 $ 0 6 . 0 $ 0 6 . 0 $ 8 4 . 0 $ 0 4 . 0 $ 9 2 . 0 $ 1 2 . 0 $ 1 2 . 0 $ 1 2 . 0 $ 02 03 04 05 06 07 08 09 10 11 Applied Industrial Technologies, Inc. and Subsidiaries 39 DIRECTORS WILLIAM G. BARES (4) Age 70 JOHN F. MEIER (4) Age 63 PETER C. WALLACE (3, 4) Age 57 Former Chairman and Chief Executive Ofﬁ cer Former Chairman and Chief Executive Ofﬁ cer President and Chief Executive Ofﬁ cer The Lubrizol Corporation (Specialty Chemical Products) Libbey Inc. (Tableware Products) Robbins & Myers, Inc. (Equipment Manufacturer) THOMAS A. COMMES (1, 3) Age 69 J. MICHAEL MOORE (1) Age 68 Former President and Chief Operating Ofﬁ cer President Committees of The Board (1) Audit Committee The Sherwin-Williams Company (Paints and Coatings) Oak Grove Consulting Group, Inc. (2) Corporate Governance Committee PETER A. DORSMAN (2, 3) Age 56 Senior Vice President, Global Operations, and Chief Operations Ofﬁ cer (Management Consulting) (3) Executive Committee Former Chairman and Chief Executive Ofﬁ cer (4) Executive Organization and Compensation Invetech Company (Industrial Distributor) Committee NCR Corporation (Self-Service Technology Solutions) DAVID L. PUGH (3) Age 62 L. THOMAS HILTZ (2) Age 65 Attorney EDITH KELLY-GREEN (2) Age 58 Former Vice President and Chief Sourcing Ofﬁ cer FedEx Express (Express Transportation) Chairman & Chief Executive Ofﬁ cer Applied Industrial Technologies, Inc. JERRY SUE THORNTON, Ph.D. (1) Age 64 President Cuyahoga Community College (Two-Year Educational Institution) OFFICERS DAVID L. PUGH Age 62 FRED D. BAUER Age 45 RICHARD C. SHAW Age 62 Chairman & Chief Executive Ofﬁ cer Vice President – General Counsel & Secretary Vice President – Communications and Learning BENJAMIN J. MONDICS Age 53 President & Chief Operating Ofﬁ cer MICHAEL L. COTICCHIA Age 48 DANIEL T. BREZOVEC Age 50 Vice President – Chief Administrative Ofﬁ cer Corporate Controller THOMAS E. ARMOLD Age 56 MARK O. EISELE Age 54 JODY A. CHABOWSKI Age 51 Vice President – Marketing and Strategic Accounts Vice President – Chief Financial Ofﬁ cer & Treasurer Assistant Controller TODD A. BARLETT Age 56 Vice President – Acquisitions and Global Business Development OTHER KEY MANAGEMENT IVAN J. BATISTA Age 38 General Director – Rafael Benitez Carrillo, Inc. (Puerto Rico) ROBERT E. CURLEY Age 51 Vice President – Southeast Area BARBARA D. EMERY Age 52 Vice President – Human Resources JEFFREY A. RAMRAS Age 56 ALAN M. KRUPA Age 55 Vice President – Supply Chain Management Assistant Treasurer JAMES A. JEFFIERS Age 37 Vice President – Midwest Area MARY E. KERPER Age 60 RONALD A. SOWINSKI Age 50 President & Chief Operating Ofﬁ cer – Applied Industrial Technologies Ltd. (Canada) Vice President – Operational Excellence MARK A. STONEBURNER Age 47 LONNY D. LAWRENCE Age 48 Vice President – Information Technology JOHN M. LEYO Age 60 Vice President – Enterprise Transformation DONN G. VEENHUIS Age 62 Vice President – Western Area THEODORE L. WOLICKI Age 57 Vice President – Central States Area WARREN E. “BUD” HOFFNER Age 51 Vice President – North Atlantic Area Vice President, General Manager – Fluid Power SERGIO H. NEVÁREZ Age 53 General Director – Applied Mexico 40 Applied Industrial Technologies, Inc. and Subsidiaries SHAREHOLDER INFORMATION Applied Industrial Technologies, Inc. common stock is listed on the New York Stock Exchange under the symbol AIT. The Company is identiﬁ ed in most ﬁ nancial listings as “AppliedIndlTch.” RESEARCH ON APPLIED INDUSTRIAL TECHNOLOGIES IS AVAILABLE THROUGH: BB&T CAPITAL MARKETS Holden Lewis, 804/782-8820 MORGAN KEEGAN STEPHENS INC. Brent D. Rakers, 901/579-4427 Matt Duncan, 501/377-3723 CLEVELAND RESEARCH COMPANY SIDOTI & CO. Adam Uhlman, 216/649-7241 Joseph Mondillo, 212/894-3339 WELLS FARGO SECURITIES, LLC Allison Poliniak-Cusic, 212/214-5062 KEYBANC CAPITAL MARKETS GREAT LAKES REVIEW – Division of Jeffrey D. Hammond, 216/689-0236 Wellington Shields & Co. Elliot Schlang, 216/767-1340 SHAREHOLDER INQUIRIES INVESTOR RELATIONS INQUIRIES SHOULD ANNUAL REPORT ON FORM 10-K Requests to transfer Applied Industrial BE DIRECTED TO: MARK O. EISELE Vice President – Chief Financial Ofﬁ cer & Treasurer Applied Industrial Technologies 1 Applied Plaza Cleveland, OH 44115-5014 Telephone: 216/426-4000, Fax: 216/426-4845 Technologies, Inc. shares and all correspondence regarding address change information, duplicate mailings, missing certiﬁ cates, 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 TRUST COMPANY, N.A. 250 Royall Street Canton, MA 02021 800/988-5291 The Applied Industrial Technologies, Inc. Annual Report on Form 10-K for the ﬁ scal year ended June 30, 2011, including the ﬁ nancial statements and schedules thereto, is available at our website at www.Applied.com. It is also available without charge upon written request to the Vice President – Chief Financial Ofﬁ cer & Treasurer at the address shown. ANNUAL MEETING The Annual Meeting of Shareholders will be held at 10:00 a.m., Tuesday, October 25, 2011, at the Corporate Headquarters of Applied Industrial Technologies, 1 Applied Plaza, East 36th and Euclid Avenue, Cleveland, Ohio 44115. COMPARISON OF FIVE-YEAR CUMULATIVE TOTAL RETURN Applied Industrial Technologies, Inc., Standard & Poor’s 500, and Peer Group (Performance Results from 7/1/2006 through 6/30/2011) $200.00 $150.00 $100.00 $50.00 $0.00 Applied Industrial Technologies, Inc. Standard & Poor’s 500 Peer Group Assumes $100 invested at the close of trading 6/30/06 in Applied Industrial Technologies, Inc. common stock, Standard & Poor’s 500, and Peer Group. Cumulative total return assumes reinvestment of dividends. The returns of the companies in the Peer Group are weighted based on the companies’ relative stock market capitalization. Peer Group companies selected on a line-of-business basis include: DXP Enterprises, Inc.; Fastenal Company; Genuine Parts Company; W. W. Grainger, Inc.; Kaman Corporation; Lawson Products, Inc.; MSC Industrial Direct Co., Inc.; and WESCO International, Inc. 2006 2007 2008 2009 2010 2011 Applied Industrial Technologies, Inc. $100.00 $123.69 $103.43 2006 2007 2008 Standard & Poor’s 500 Peer Group Source: Value Line, Inc. 100.00 100.00 120.59 115.59 104.77 100.52 2009 $86.85 77.31 86.45 2010 $114.55 88.47 116.02 2011 $164.72 115.62 171.68 Corporate Headquarters 1 Applied Plaza Cleveland, Ohio 44115 216/426-4000 Applied.com

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