AIT

Business Context and Reporting Period

Company: Applied Industrial Technologies, Inc.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: March 31, 2008 (Third Quarter of Fiscal Year 2008)
Business Overview: An industrial distributor of parts critical to maintenance, repair, and original equipment manufacturing operations across North America. The company operates approximately 450 facilities and employs over 4,600 associates.

Key Financial Metrics

Liquidity and Debt:

• Cash and Equivalents: $70.6 million (down from $119.7 million at June 30, 2007).
• Current Ratio: 3.3 (improved from 2.6 at June 30, 2007).
• Long-Term Debt: $25.0 million (matures fiscal 2011).
• Revolving Credit Facility: $150.0 million available; $0 outstanding.

Material Changes vs. Prior Period

• Revenue Growth: Sales increased 1.7% ($9.0 million) for the quarter and 5.0% ($73.6 million) for the nine-month period. Growth was driven by both the Service Center Distribution and Fluid Power segments.
• Profitability: Operating income rose 10.5% for the quarter and 18.4% for the nine-month period. Net income increased 8.7% (quarter) and 15.7% (nine months).
• Expense Management: Selling, Distribution, and Administrative (SD&A) expenses decreased as a percentage of sales to 20.1% (quarter) and 20.0% (nine months), despite absolute dollar increases due to currency and acquisition impacts.
• Interest Expense: Net interest expense dropped 67.8% for the quarter and 74.3% for the nine months, primarily due to the December 2007 repayment of $50.0 million in senior unsecured term notes.
• Acquisitions: The acquisition of Vycmex S.A. de C.V. in Mexico (closed Dec 2007) contributed approximately $1.5 million to sales growth in the quarter.

Outlook, Risks, and Management Commentary

Management Commentary:

• Economic Indicators: Management monitors the Purchasing Managers Index (PMI) and Manufacturers Capacity Utilization (MCU), which declined slightly in the quarter, signaling a potential economic weakening. The company's performance typically lags these indicators by up to six months.
• Canadian Operations: While reported sales in Canada increased due to favorable currency translation, sales in local currency declined 8.9% (quarter) and 5.2% (nine months) due to a slowdown in the Canadian economy, particularly in lumber, wood products, and natural gas/oil sectors.
• Shareholder Returns: The company increased its quarterly dividend to $0.15 per share (from $0.12) and continued its share repurchase program, buying back 434,900 shares for $12.2 million in the quarter.

• Market Risk: A 10% strengthening of the U.S. dollar would decrease net income by approximately $0.7 million for the nine-month period.
• Legal Proceedings: The company is involved in various product liability and commercial matters but believes the likelihood of a material adverse effect is remote.
• Customer Concentration: Risks related to reduced demand due to consolidation in customer industries and transfer of manufacturing capacity to foreign countries.

Investor Verification Checklist

• Debt Repayment Impact: Verify the sustainability of operating income growth given the one-time benefit of retiring $50 million in debt.
• Canadian Currency Exposure: Assess the divergence between reported sales growth and local currency sales declines in Canada.
• Margin Pressure: Monitor the impact of national contract business (lower margins) on future gross profit percentages.
• Cash Flow Utilization: Review the significant cash outflow for share repurchases ($33.2 million) and dividends ($19.4 million) against the decline in cash reserves.
• Acquisition Integration: Evaluate the performance contribution of the Vycmex acquisition in subsequent quarters.