AIT

Business Context and Reporting Period

Company: Applied Industrial Technologies, Inc.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: December 31, 2008 (Second Quarter of Fiscal 2009)
Business Overview: An industrial distributor offering parts for maintenance, repair, and operations (MRO) and original equipment manufacturing. The company operates through two segments: Service Center Based Distribution and Fluid Power Businesses. As of December 31, 2008, the company operated 474 facilities with 5,203 associates.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue: Net sales for the quarter decreased 1.7% ($8.6 million) compared to the prior year, driven by a 13.4% decline in U.S. same-store sales within the Service Center segment. This was partially offset by $53.3 million in sales from recent acquisitions. For the six-month period, sales increased 1.6% due to strong growth in the Fluid Power segment.
• Profitability: Net income for the quarter dropped 29.5% ($6.8 million) to $16.2 million. Operating income margin declined to 5.7% from 7.3% in the prior year quarter. Gross margins compressed slightly (27.0% vs 27.3%) due to lower purchasing volumes and reduced supplier incentives.
• Acquisitions: The company completed the acquisition of Fluid Power Resource, LLC (FPR) on August 29, 2008, for $166 million, and Cincinnati Transmission Company for $5.5 million. These acquisitions significantly increased the Fluid Power segment's revenue but added $13.7 million in selling, distribution, and administrative (SD&A) expenses for the quarter.
• Foreign Currency: Unfavorable foreign currency translation impacted results, particularly in Canada, where local currency sales increases were offset by exchange rate losses. Total foreign currency translation losses for the six months were $23.5 million (net of tax), recorded in other comprehensive income.

Guidance, Outlook, and Risks

• Economic Outlook: Management notes that the U.S. economy is in a recession (declared by NBER since Dec 2007). Key indicators like the Purchasing Managers Index (PMI) and Manufacturers Capacity Utilization (MCU) have declined, suggesting further softening of sales. U.S. service center same-store sales declines have accelerated to 13% in the current quarter.
• Liquidity: The company has $111 million outstanding on a $150 million revolving credit facility, with $33.9 million remaining available. Management expects to generate positive cash flow in the next two quarters to pay down short-term borrowings.
• Goodwill Impairment Risk: Due to deteriorating economic conditions, there is a risk of goodwill impairment. Management performed an analysis as of December 31, 2008, and concluded no impairment was necessary at that time, but future charges could occur if conditions worsen.
• Market Risks: Significant exposure to foreign currency fluctuations (Canadian and Mexican peso) and interest rate changes on variable debt. The company utilizes interest rate swaps to fix rates on $50 million of debt.

Investor Verification Checklist

• Acquisition Integration: Verify the timeline for realizing synergies from the $166 million FPR acquisition and the impact on future operating margins.
• Same-Store Sales Trend: Monitor the acceleration of same-store sales declines in the U.S. Service Center segment (down 13% in Q2) as a leading indicator of broader economic impact.
• Debt Utilization: Track the utilization of the revolving credit facility ($111M used of $150M) and the company's ability to refinance or pay down debt in a tightening credit market.
• Goodwill Valuation: Review future quarterly reports for any goodwill impairment charges, given the $98.6 million goodwill balance and the current recessionary environment.
• Foreign Currency Exposure: Assess the impact of continued currency weakness on reported earnings, as 13.4% of sales are generated outside the U.S.