EXHIBIT 13
Applied Industrial Technologies, Inc. and Subsidiaries
Management's Discussion and Analysis
of Financial Condition and Results of Operations
OVERVIEW
The Company's sales, net income and earnings per share increased 3.6%, 59% and
55% respectively compared to the prior year. Significant factors that
contributed to these increases included the improving U.S. economy, the return
to profitability of our U.S. fluid power subsidiaries and the continued strength
of the Canadian operations and Canadian currency. Gross margin improved as our
initiatives in the areas of product pricing, freight recovery, cost controls and
asset management continue to show progress. Our balance sheet remains strong, as
our working capital and current ratio both increased compared to fiscal 2003.
The Company also entered into two credit/financing agreements enabling
borrowings of up to $200 million. These facilities are available to fund future
acquisitions or other capital and operating requirements. During the year, the
Company recorded non-recurring tax benefits primarily from a settlement with the
Internal Revenue Service related to audits of our 1997 and 1998 tax returns and
the acceptance by the IRS of tax refund claims for 1999, 2000 and 2001. These
items added approximately $1.6 million, or $0.08 per share to net income.
The Company monitors the Purchasing Managers Index (ISM) as published by
the Institute for Supply Management and the Manufacturers Capacity Utilization
(MCU) index published by the Federal Reserve Board and considers these indexes
key indicators of potential Company business environment changes. Both the ISM
and the MCU began to show improvement in the summer of 2003. The Company's
performance traditionally lags these key indicators by approximately 6 months.
Given the recent improvement in sales and the upward trend of these indicators,
we expect the improvements to continue into our 2005 fiscal year.
Year-over-year sales increases for fiscal 2005 should start out strong in
the first half of the year and then moderate in the second half, primarily
because of comparisons to strong sales in the last half of fiscal 2004. We
anticipate our next year sales to increase 3.5% to 6.0% and our gross profit
percentage to be consistent with, or slightly better than, fiscal 2004 levels.
In fiscal 2005, the gross profit margin will be dependent on certain Company
initiatives in the areas of pricing and freight recovery and the continued
growth of our catalog. Our ability to pass along supplier price increases to
customers continues to be a difficult challenge. We anticipate that fiscal 2005
supplier rebates will be consistent with the fiscal 2004 levels as our suppliers
are experiencing real cost inflation. We will strive to keep our growth in
selling, distribution and administrative expenses for fiscal 2005 to one half
the rate of our sales increases.
YEAR ENDED JUNE 30, 2004 VS. 2003
Net sales in 2004 were $1.52 billion or 3.6% above the prior year sales. This
increase was primarily due to increased sales from our Canadian operations ($25
million or approximately 27%), the increase in our U.S. service center sales
beginning in February 2004, and having one additional business day during the
year. The Canadian sales increase was attributable in part (approximately 50% of
the reported increase) to the impact of the strength of the Canadian currency.
Also contributing to the Canadian sales increase was the inclusion of a full 12
months, versus 9 months in fiscal 2003, of our Industrial Equipment Co. Ltd.
(IECO) acquisition, as well as overall Canadian economy improvements.
The sales product mix for the year was 84.4% industrial products and 15.6%
fluid power products compared to 84.9% industrial and 15.1% fluid power in the
prior year.
Although the domestic same store sales increase of approximately .8% was
only slightly above the prior year, in the second half of our fiscal year, and
particularly our fourth quarter, same store domestic sales increased
approximately 4.8% and 6.9% respectively. There was a net reduction of 6
facilities in the U.S., Canada and Mexico, composed of 6 new or acquired
locations, 4 closed and 8 merged facilities. At June 30, 2004, the Company had a
total of 434 operating facilities versus 440 at June 30, 2003. Industrial
production in the United States continued to improve throughout the year. Our
industry, specifically over the last 5 months of the fiscal year, began to see
improvement among manufacturing customers. Should these economic trends
continue, the Company anticipates our improving financial results to continue.
The Company does not expect inflation or deflation to have a material impact on
future revenues.
Gross profit margin (net sales less cost of sales) improved to 26.5% from
25.9% in 2003. The impact of improved pricing initiatives, higher recovery of
our shipping expenses, lower freight costs,
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increased margin attributable to new product and service offerings, our
investment in training and systems and the growth of our catalog business
contributed to this increase. These were somewhat offset by a reduction in
supplier rebates in 2004 as compared to 2003. The effect of the current year
LIFO layer liquidations increased gross profit by $672 thousand versus an
increase of $741 thousand in fiscal 2003.
Selling, distribution and administrative expense ("SD&A") consists of
employee compensation, benefits and other expenses associated with 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 legal, treasury, accounting, tax and facility
related expenses. SD&A increased 2.2% compared to the prior year, but decreased
slightly as a percent of sales to 23.1% from 23.4% in 2003. The increase was
primarily due to the Rodamientos y Bandas de la Laguna S.A. de C.V. (Rybalsa)
acquisition (see Note 2), higher associate benefit costs related to stock option
expensing (see Note 1) and increased employer 401(k) plan matching due to the
improved profitability compared to fiscal 2003. SD&A in fiscal 2003 also
reflected gains on sales of assets of approximately $3.2 million which reduced
the prior year SD&A amounts for comparative purposes. The current year increases
were partially offset by a reduction in rental expenses due to the Company
buyout of certain properties under lease agreement (see Note 11), and a
reduction of vehicle leasing costs.
Operating income increased to $51.4 million in 2004 from $36.3 million in
2003. As a percent of sales, operating income increased to 3.4% in 2004 from
2.5% in 2003. The $15.2 million increase in operating income was due primarily
to the increase in domestic same store sales over the second half of our fiscal
year, the return to profitability of our domestic fluid power businesses, the
improved results from our Canadian subsidiary and the improved gross profit
margin factors noted above.
Interest expense - net for 2004 increased slightly to $5.4 million, or
2.1%, compared with the prior year primarily due to the effect of the exchange
rates on our Canadian dollar denominated debt.
The line item of Other (Income) Expense, net, represents certain
non-operating items of income and expense. Current year amounts represent
returns derived from investments in assets of non-qualified benefit programs
offset by the changes in the fair value of the Company's cross currency swap
(see Note 7).
Income tax expense as a percentage of income before taxes was 32.3% for
the year ended June 30, 2004 and 35.9% for the year ended June 30, 2003. This
decrease related to the Company's recording, in the third quarter of fiscal
2004, non-recurring tax benefits from a settlement with the Internal Revenue
Service (IRS) related to audits of our 1997 and 1998 tax returns and the
acceptance by the IRS of tax refund claims for 1999, 2000 and 2001. We expect
our overall tax rate for fiscal 2005 to be approximately 36.0% as the impact of
the current year benefits will not recur.
Net income for the fiscal year ended June 30, 2004, increased $11.6
million or approximately 59% from prior years' income. The impact of the LIFO
liquidation increased net income by $420 thousand or $.02 per share compared to
an increase in net income of $453 thousand or $.02 per share in fiscal 2003.
Overall, net income per share increased 55% to $1.60 in 2004 from $1.03 in 2003
primarily due to the factors described above.
The number of Company associates was 4,323 at June 30, 2004 and 4,384 at
June 30, 2003.
YEAR ENDED JUNE 30, 2003 VS. 2002
Net sales in 2003 were $1.46 billion or slightly above (1%) the prior year
sales. This increase was primarily due to the acquisition of IECO and having one
additional business day during the year. The sales product mix for the year was
84.9% industrial products and 15.1% fluid power products compared to 85.2%
industrial and 14.8% fluid power in the prior year. Same store sales were
slightly above (.4%) the prior year. While there was a reduction of 25
facilities in the U.S., Canada and Mexico, these were offset by the acquisition
of 16 IECO facilities in Western Canada. At June 30, 2003, the Company had a
total of 440 operating facilities versus 449 at June 30, 2002.
Despite the relatively flat sales, the Company improved its gross profit
margins to 25.9% from 25.3% in 2002. Improved purchasing practices, improved
pricing, training, systems and the growth of our catalog business contributed to
this increase.
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Applied Industrial Technologies, Inc. and Subsidiaries
Management's Discussion and Analysis, Continued
Selling, distribution and administrative expense increased 2.4% compared
to the prior year, and increased slightly as a percent of sales to 23.4% from
23.1% in 2002. The increase was primarily due to the IECO acquisition, higher
compensation and benefit costs and related payroll taxes based on improved
profitability. These additional costs were partially offset by approximately
$3.2 million of gains on sales of unneeded real estate and a decrease in bad
debt expense due to fewer customer bankruptcies during fiscal 2003.
Operating income increased to $36.3 million in 2003 from $30.8 million in
2002. As a percent of sales, operating income increased to 2.5% in 2003 from
2.1% in 2002. The $5.4 million increase in operating income was due primarily to
the improved gross profit margin factors noted above.
Interest expense - net for 2003 decreased $1.4 million, or 21.4%, compared
with the prior year primarily from a decrease in average borrowings of $26.5
million related to strong cash flows from operations and lower interest rates.
The line item of Other (Income) Expense, net, represents certain
non-operating items of income and expense. During fiscal 2003, the Company
recorded a charge of $2.1 million to provide for its share of net loss and other
reserves associated with the Company's iSource Performance Materials LLC
("iSource") affiliate. The Company owns 49% of iSource, a certified
minority-owned distributor of standard-use industrial specialty and general
maintenance items requiring special shipping and handling. Offsetting the impact
of this charge was the receipt of insurance proceeds of $2.1 million for the
settlement of a fiscal 2000 property casualty claim.
Income tax expense as a percentage of income before taxes was 35.9% for
the year ended June 30, 2003 and 37.9% for the year ended June 30, 2002. This
decrease related to a change in the tax law that reduced the Company's taxable
income beginning in fiscal 2003. Specifically, the Company can now take a tax
deduction for cash dividends paid on Company stock to participant 401(k) plan
accounts. Another factor that contributed to the rate decrease was a reduction
in effective state, local and foreign tax rates, primarily due to the
implementation of various tax planning initiatives.
Net income for the fiscal year ended June 30, 2003, increased $5.1 million
or 34.4% from prior years' income before the cumulative effect of accounting
change. Net income per share increased 35.5% to $1.03 in 2003 from $.76 in 2002
before the cumulative effect of the accounting change primarily due to the
factors described above and a decrease in the average shares attributable to
company repurchases.
The number of Company associates was 4,384 at June 30, 2003 and 4,508 at
June 30, 2002.
LIQUIDITY AND CAPITAL RESOURCES
The Company generated $43.1 million of cash from operating activities in 2004
and $63.9 million in 2003.
Cash flow from operations depends primarily upon generating operating
income, controlling investment in inventories and receivables, and managing the
timing of payments to suppliers. The Company has continued to monitor and
control its investments in inventories by taking advantage of various vendor
purchasing programs and through the use of system enhancements to improve
inventory tracking. The Company has continued to improve its collection of
accounts receivable through improved billing systems and collection efforts.
During the year ended June 30, 2004, inventories remained at prior year levels
while sales and inventory turns increased. The increase in sales and overall net
income were the primary factors in the operating cash generated in fiscal 2004.
Other factors contributing to the operating cash flows were the annual
depreciation and an increase in accrued expenses related to higher personnel
costs attributed to overall company performance. Overall operating cash was
reduced by the increase in our receivables balances due primarily to increased
fourth quarter sales.
Cash used by investing activities of $15.8 million for the year ended June
30, 2004 consisted primarily of property purchases of approximately $14.4
million, and the expenditure for the purchase of Rybalsa. A major component of
our property and equipment purchases related to the Company exercising its
option in September 2003 to purchase properties under lease for $7.5 million.
Additional purchases were made to enhance our AppliedAccess(R) Web site and
expand our electronic catalog content.
For fiscal 2005, our property purchases are expected to be in the $9.0
million to $10.0 million range consisting primarily of
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additional computer technology and infrastructure investments. Depreciation for
fiscal 2005 is expected to be in the range of $14.0 to $15.0 million.
Cash used in financing activities was approximately $12.7 million in
fiscal 2004 and $15.6 million in fiscal 2003. During fiscal 2004, the Company
paid a total of $9.3 million in cash dividends to its shareholders and retired
$2.9 million in debt.
The following table shows the Company's approximate obligations and
commitments to make future payments under contractual obligations as of June 30,
2004 (in thousands):
Period Less Period Period Period
Total Than 1 yr 2-3 yrs. 4-5 yrs. Over 5 yrs.
-------- ----------- -------- -------- -----------
Operating Leases $ 68,124 $16,127 $20,099 $12,146 $19,752
Long-term Debt 75,000 50,000 25,000
-------- ------- ------- ------- -------
Total Contractual
Cash Obligations $143,124 $16,127 $20,099 $62,146 $44,752
======== ======= ======= ======= =======
The Company also used approximately $6.3 million to repurchase 290
thousand shares during the year for an average price of approximately $22 per
share compared to $9.9 million for 581 thousand shares in fiscal 2003.
The Board of Directors has authorized the repurchase of shares of the
Company's common stock, at the Company's discretion, to fund employee benefit
programs, equity award programs, and future business acquisitions. These
purchases may be made in open market and negotiated transactions, from time to
time, depending upon market conditions. At June 30, 2004, the Company has
authorization to purchase an additional 841,000 shares.
In fiscal 2004, the Company continued its practice of paying cash
dividends each quarter. Due to increased profitability and cash flow, the
Company raised its quarterly dividend in July 2004 approximately 17% to 14 cents
per share. In earlier quarters, the Company's dividend was 12 cents per share
per quarter. The amount of the dividend paid is recommended quarterly by
management and approved by the Company's Board of Directors based on financial
performance, cash flow and payout guidelines consistent with other industrial
companies.
Capital resources are obtained from income retained in the business,
borrowings under the Company's lines of credit, revolving credit agreement and
long-term debt facilities and from operating lease arrangements.
See Note 6 to the consolidated financial statements for details regarding
the outstanding debt amounts as of June 30, 2004. The average long-term
borrowings in fiscal 2004 were $75.0 million compared to $76.4 million in fiscal
2003. Approximately one-third of the Company's outstanding debt has been
converted from fixed rate U.S. dollar denominated debt to fixed rate Canadian
dollar denominated debt through the use of a cross currency swap. As such, the
consolidated interest expense is affected by changes in the exchange rates of
U.S. and Canadian dollars (see Note 7). The weighted average interest rate on
borrowings under our long-term debt agreements, net of the benefits from
interest rate swaps, was 6.3% in 2004 and 5.9% in 2003, respectively. The
increase in the weighted average interest rate was due to the effect of the
exchange rates as noted above and lower benefits from interest rate swap
agreements of $791 thousand in fiscal 2004 versus $880 thousand in fiscal 2003.
These swaps were terminated in fiscal 2003 or prior for favorable settlements.
The settlement gains are being amortized as a reduction in interest expense of
approximately $790 thousand per year over the remaining life of the notes
through December 2007.
The Company manages interest rate risk through the use of a combination of
fixed rate long-term debt, variable rate borrowings under its committed
revolving credit agreement and interest rate swaps. At June 30, 2004, the
Company has no variable rate debt or interest rate swaps outstanding. See Note 7
"Risk Management Activities" for additional discussion on the Company's
derivative activities.
The Company's working capital at June 30, 2004 was $291.7 million compared
to $259.4 million at June 30, 2003. The current ratio was 2.9 and 2.8 at June
30, 2004 and 2003, respectively. The increase in working capital is due to cash
generated from our operations and from the increase in receivables due to the
strong fourth quarter sales.
The Company has a five-year committed revolving credit agreement, which
was entered into in November 2003 with a group of banks. This agreement provides
for unsecured borrowings of up to $100.0 million. The Company had no borrowings
outstanding under this facility at June 30, 2004. Unused lines under this
facility,
13
Applied Industrial Technologies, Inc. and Subsidiaries
Management's Discussion and Analysis, Continued
net of outstanding letters of credit, totaling $92.1 million are available to
fund future acquisitions or other capital and operating requirements. Effective
February 2004, the Company also entered into an uncommitted long-term financing
shelf facility enabling the Company to borrow up to $100.0 million at its
discretion with terms up to twelve years. The Company has no outstanding
borrowings under this facility at June 30, 2004.
The aggregate annual maturities of long-term debt are $50.0 million in
fiscal 2008 and $25.0 million in fiscal 2011.
Management expects that cash provided from operations, available lines of
credit, long-term debt and the use of operating leases will be sufficient to
finance normal working capital needs, acquisitions, investments in properties,
facilities and equipment and the purchase of additional Company common stock.
Management also believes that additional long-term debt and line of credit
financing could be obtained based on the Company's credit standing and financial
strength.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements and related disclosures in conformity
with accounting principles generally accepted in the United States of America
requires management to make judgments, assumptions and estimates at a specific
point in time that affect the amounts reported in the consolidated financial
statements and disclosed in the accompanying notes. Note 1 to the consolidated
financial statements describes the significant accounting policies and methods
used in preparation of the consolidated financial statements. Estimates are used
for, but not limited to, determining the net carrying value of trade
receivables, inventories, supplier rebates receivable, goodwill, other
intangible assets and recording self-insurance liabilities and other accrued
liabilities. Actual results could differ from these estimates. The following
critical accounting policies are impacted significantly by judgments,
assumptions and estimates used in the preparation of the consolidated financial
statements.
LIFO Inventory Valuation and Methodology
U.S. inventories are valued at the lower of cost or market, using the last-in,
first-out (LIFO) method, and foreign inventories are valued using the average
cost method. The Company adopted the link chain dollar value LIFO method of
accounting for domestic inventories in fiscal 1974. Approximately half of our
inventory dollars relate to LIFO layers added in the 1970's which results in a
$125.5 million excess of current cost over LIFO cost as reflected on our
consolidated balance sheet at June 30, 2004. The Company maintains five LIFO
pools based on the following product groupings: bearings, drive products, rubber
products, fluid power products and other products. LIFO layers and/or
liquidations are determined consistently year-to-year in a manner which is in
accordance with the guidance in the 1984 AICPA LIFO Issue Paper, "Identification
and Discussion of Certain Financial Accounting and Reporting Issues Concerning
LIFO Inventories." See Note 3 for further information regarding inventories.
Allowances for Slow-Moving and Obsolete Inventories
The Company identifies slow moving or obsolete inventories and estimates
appropriate loss provisions related thereto. The majority of the Company's
inventories are not highly susceptible to obsolescence. In addition, the Company
is generally eligible for credit or return allowances under various supplier
return programs. While the Company has no reason to believe its inventory return
privileges and programs will be discontinued in the future, its risk of loss
associated with obsolete or slow moving inventories would increase if such were
to occur.
Allowances for Doubtful Accounts
The Company evaluates the collectibility of 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 periodically adjusted when the Company
becomes aware of a specific customer's inability to meet its financial
obligations (e.g., bankruptcy filing) or as a result of changes in the overall
aging of accounts receivable. While the Company has a large customer base that
is diverse as to industry and geography, a general economic downturn in any of
the industry segments in which the Company
14
operates could result in higher than expected customer defaults, and, therefore,
the need to revise estimates for bad debts.
Goodwill Accounting
The Company adopted Statement of Financial Accounting Standard ("SFAS") No. 142,
"Goodwill and Other Intangible Assets," effective July 1, 2001. Goodwill is no
longer amortized but rather is evaluated for impairment. The Company performs
annual tests of impairment as of January 1 of each year or whenever conditions
would indicate an evaluation should be completed. The Company utilizes
discounted cash flow models and market multiples for comparable businesses to
determine fair value used in the goodwill impairment evaluation. Management's
estimates of fair value are based upon factors such as projected future sales,
price increases, and other uncertain elements requiring significant judgments.
While the Company uses available information to prepare its estimates and to
perform impairment evaluations, actual results could differ significantly,
resulting in future impairment and losses related to recorded goodwill balances.
Supplier Purchasing Programs
The Company enters into agreements with certain suppliers providing for
inventory purchase rebates. The Company's inventory purchase rebate 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. Rebates are received
in the form of cash or credits against purchases upon attainment of specified
purchase volumes and are received monthly, quarterly or annually based upon
actual purchases for such period. The supplier rebates are a specified
percentage of the Company's net purchases based upon achieving specific
purchasing volume levels. These percentages can increase or decrease based on
changes in the volume of purchases.
The Company accrues for the receipt of these inventory purchase rebates
based upon actual cumulative purchases of inventory. The percentage level
utilized is based upon the estimated total volume of purchases we expect to
achieve 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.
Differences between our estimates and actual rebates received have not been
material.
All rebates 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 sold and recorded as cost
of sales. The Company's accounting for rebates is in accordance with guidance
issued by the FASB in EITF 02-16, "Accounting by a Customer (Including a
Reseller) for Certain Consideration Received from a Vendor." While management
believes the Company will continue to receive inventory purchase rebates, there
can be no assurance that suppliers will continue to provide comparable amounts
of rebates in the future.
Self-Insurance Liabilities
The Company has insurance programs to cover workers' compensation, business,
automobile, general and product liability risks. The insurance programs have
self-insured retention to $350 thousand per claim. On an annual basis, an
independent actuarial firm is hired to determine the adequacy of estimated
liabilities. The Company accrues estimated losses based on actuarial models and
assumptions as well as the Company's historical loss experience. 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. The Company will continue to adjust its estimated liabilities for
self insurance, as deemed necessary, in the event that future loss experience
differs from historical loss patterns.
Pension & Other Postretirement Benefit Plans
The measurement of liabilities related to pension plans and other postretirement
benefit plans is based on management's assumptions related to future events
including interest rates, return on pension
15
Applied Industrial Technologies, Inc. and Subsidiaries
Management's Discussion and Analysis, Continued
plan assets, rate of compensation increases, and health care cost trend rates.
The Company evaluates these assumptions and adjusts them as necessary.
Guarantees
In December 2002, the Financial Accounting Standards Board issued Interpretation
No. (FIN) 45, "Guarantor's Accounting and Disclosure Requirements." FIN 45
requires the disclosure of any guarantees in place at December 31, 2002 and the
recognition of a liability for any guarantees entered into or modified after
that date.
The Company is a guarantor in connection with the construction and lease
of its corporate headquarters facility entered into prior to December 31, 2002
that requires disclosure under FIN 45. The Company has guaranteed repayment of a
total of approximately $5.7 million 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 Applied for the
full amount of the outstanding bonds through maturity.
Due to the nature of the guarantee, the Company has not recorded any
liability on the financial statements. In the event of a default and subsequent
payout under this guarantee, the Company maintains the right to pursue all legal
options available to mitigate its exposure.
NEW ACCOUNTING PRONOUNCEMENTS
Effective July 1, 2003, the Company adopted for stock options the fair value
recognition provisions of SFAS 123, "Accounting for Stock-Based Compensation,"
using the modified prospective method for the transition. Under the modified
prospective method, stock based compensation cost recognized during this fiscal
year is the same as that which would have been recognized had the fair value
recognition provisions for stock options been applied to all awards granted
after July 1, 1995. The compensation expense recorded for stock options during
the year ended June 30, 2004, was $1.6 million, $1.1 million net of tax, or $.05
per share.
In January 2003, the Financial Accounting Standards Board issued FIN 46,
"Consolidation of Variable Interest Entities." The Company is a minority owner
in iSource. iSource maintains assets of approximately $2.9 million at June 30,
2004. The Company's purchases currently account for more than 90% of iSource's
sales and the Company is considered the primary beneficiary of iSource's
operations. Accordingly, iSource's financial statements have been consolidated
with the Company's beginning in July 2003 in accordance with the effective date
of FIN 46. The consolidation of iSource's financial statements did not have a
material impact on the Company's consolidated income or cash flow statements.
OTHER MATTERS
In November 2003, the Company acquired the stock of Rodamientos y Bandas de la
Laguna S.A. de C.V. (Rybalsa), a Mexican distributor of industrial products, for
approximately $2.8 million. The acquisition was paid for from existing cash
balances. The results of the acquired business operations have been combined
with our previous operations in Mexico, but are not considered material for the
periods presented. The operating results are reported in our service center
based distribution segment from the acquisition date. The business contributed
$6.0 million in sales from the date of acquisition through June 30, 2004. Sales
and operating results to date have met Company expectations.
In October 2002, the Company acquired certain assets of Industrial
Equipment Co., Ltd. (IECO), a Canadian distributor of industrial products, for
approximately $11.5 million. This acquisition was paid for from existing cash
balances. The results of the acquired business operations are not material for
periods represented. The acquired operations are reported in our service center
based distribution segment from the acquisition date. Sales and operating
results to date have met Company expectations.
CAUTIONARY STATEMENT
UNDER PRIVATE SECURITIES LITIGATION REFORM ACT
This Annual Report to Shareholders, including Management's Discussion and
Analysis, contains statements that are forward-look-
16
ing, based on management's current expectations about the future.
Forward-looking statements are often identified by qualifiers, such as "expect,"
"believe," "intend," "will," "should," "anticipate," and similar expressions.
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. Accordingly, actual results may differ
materially from those expressed in the forward-looking statements, and the
making of such statements should not be regarded as a representation by the
Company or any other person that the results expressed in the statements will be
achieved. In addition, the Company undertakes no obligation publicly to update
or revise any forward-looking statements, whether because of new information or
events, or otherwise.
Important risk factors include, but are not limited to, the following:
changes in the economy or in specific customer industry sectors; reduced demand
for our products in targeted markets including consolidation in customer
industries and the transfer of manufacturing capacity to foreign countries;
changes in interest rates and inflation; changes in customer procurement
policies and practices; changes in product manufacturer sales policies and
practices; the availability of products and labor; changes in operating
expenses; price increases or decreases; the variability and timing of business
opportunities including acquisitions, alliances, customer relationships and
supplier authorizations; the Company's ability to realize the anticipated
benefits of acquisitions and other business strategies; the incurrence of debt
and contingent liabilities in connection with acquisitions; changes in
accounting policies and practices; organizational changes within the Company;
the emergence of new competitors, including firms with greater financial
resources than the Company; risks and uncertainties associated with the
Company's foreign operations, including inflation, recessions, and foreign
currency exchange rates; adverse results in significant litigation matters;
adverse regulation and legislation; and the occurrence of extraordinary events
(including prolonged labor disputes, natural events and acts of God, terrorist
acts, fires, floods and accidents).
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company has evaluated its exposure to various market risk factors, including
but not limited to, interest rate, foreign currency exchange and commodity price
risks. The Company is primarily affected by market risk exposure through the
effect of changes in interest rates. The Company manages interest rate risk
through the use of a combination of fixed rate long-term debt, variable rate
borrowings under its committed revolving credit agreement and interest rate
swaps. The Company had no variable rate borrowings under its committed revolving
credit agreement and no interest rate swap agreements outstanding at June 30,
2004. All the Company's outstanding debt is currently at fixed interest rates at
June 30, 2004 and scheduled for repayment in December 2007 and beyond.
The Company mitigates its foreign currency exposure from the Canadian
dollar through the use of cross currency swap agreements as well as
foreign-currency denominated debt. Hedging of the U.S. dollar denominated debt,
used to fund a substantial portion of the Company's net investment in its
Canadian operations, is accomplished through the use of cross currency swaps.
Any gain or loss on the hedging instrument offsets the gain or loss on the
underlying debt. Translation exposures with regard to our Mexican business are
not hedged, as our Mexican activity is not material. For the year ended June 30,
2004, a uniform 10% strengthening of the U.S. dollar relative to foreign
currencies that affect the Company would have resulted in a $.1 million decrease
in net income. A uniform 10% weakening of the U.S. dollar would have resulted in
a $.1 million increase in net income.
17
Applied Industrial Technologies, Inc. and Subsidiaries
Statements of Consolidated Income
Year Ended June 30
(In thousands, except per share amounts) 2004 2003 2002
- ---------------------------------------- ----------- ----------- -----------
NET SALES $ 1,517,004 $ 1,464,367 $ 1,446,569
COST OF SALES 1,114,861 1,085,072 1,080,879
----------- ----------- -----------
402,143 379,295 365,690
SELLING, DISTRIBUTION AND ADMINISTRATIVE 350,695 343,041 334,856
----------- ----------- -----------
OPERATING INCOME 51,448 36,254 30,834
----------- ----------- -----------
INTEREST EXPENSE 5,814 5,677 7,078
INTEREST INCOME (405) (379) (340)
OTHER (INCOME) EXPENSE, NET (432) 24 341
----------- ----------- -----------
4,977 5,322 7,079
----------- ----------- -----------
INCOME BEFORE INCOME TAXES 46,471 30,932 23,755
----------- ----------- -----------
INCOME TAX EXPENSE 15,000 11,100 9,000
----------- ----------- -----------
INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE 31,471 19,832 14,755
CUMULATIVE EFFECT OF ACCOUNTING CHANGE (12,100)
----------- ----------- -----------
NET INCOME $ 31,471 $ 19,832 $ 2,655
=========== =========== ===========
NET INCOME PER SHARE - BASIC
Before cumulative effect of accounting change $ 1.64 $ 1.05 $ 0.77
Cumulative effect of accounting change (0.63)
----------- ----------- -----------
NET INCOME PER SHARE - BASIC $ 1.64 $ 1.05 $ 0.14
=========== =========== ===========
NET INCOME PER SHARE - DILUTED
Before cumulative effect of accounting change $ 1.60 $ 1.03 $ 0.76
Cumulative effect of accounting change (0.63)
----------- ----------- -----------
NET INCOME PER SHARE - DILUTED $ 1.60 $ 1.03 $ 0.13
=========== =========== ===========
See notes to consolidated financial statements.
18
Applied Industrial Technologies, Inc. and Subsidiaries
Consolidated Balance Sheets
June 30
(In thousands) 2004 2003
- -------------- --------- ---------
Assets
Current assets
Cash and temporary investments $ 69,667 $ 55,079
Accounts receivable, less allowances of $6,400 and $6,100 190,815 173,915
Inventories 159,594 159,798
Other current assets 22,957 11,702
--------- ---------
Total current assets 443,033 400,494
--------- ---------
Property - at cost
Land 10,458 10,632
Buildings 69,637 62,179
Equipment 95,051 90,967
--------- ---------
175,146 163,778
Less accumulated depreciation 98,121 85,836
--------- ---------
Property - net 77,025 77,942
--------- ---------
Goodwill - net of accumulated amortization of $13,069 49,852 49,687
Other assets 26,931 25,281
--------- ---------
Total Assets $ 596,841 $ 553,404
========= =========
Liabilities
Current liabilities
Accounts payable $ 78,767 $ 75,411
Compensation and related benefits 47,032 42,479
Other current liabilities 25,530 23,245
--------- ---------
Total current liabilities 151,329 141,135
Long-term debt 77,767 78,558
Other liabilities 28,210 25,855
--------- ---------
Total Liabilities 257,306 245,548
--------- ---------
Shareholders' Equity
Preferred stock - no par value; 2,500 shares
authorized; none issued or outstanding
Common stock - no par value; 50,000 shares
authorized; 24,096 shares issued 10,000 10,000
Additional paid-in capital 90,520 84,898
Income retained for use in the business 311,922 289,724
Treasury shares - at cost (4,591 and 5,076 shares) (72,870) (78,706)
Unearned restricted common stock compensation (1,158) (114)
Accumulated other comprehensive income 1,121 2,054
--------- ---------
Total Shareholders' Equity 339,535 307,856
--------- ---------
Total Liabilities and Shareholders' Equity $ 596,841 $ 553,404
========= =========
See notes to consolidated financial statements.
19
Applied Industrial Technologies, Inc. and Subsidiaries
Statements of Consolidated Cash Flows
Year Ended June 30
(In thousands) 2004 2003 2002
- -------------- -------- -------- --------
Cash Flows from Operating Activities
Net income $ 31,471 $ 19,832 $ 2,655
Adjustments to reconcile net income to cash provided
by operating activities:
Cumulative effect of accounting change 12,100
Depreciation 14,390 14,458 15,294
Deferred income taxes (5,700) (2,700) (5,000)
Amortization of restricted common stock compensation,
stock options and other intangible assets 2,653 1,499 2,499
Provision for losses on accounts receivable 2,525 2,510 4,488
Loss (gain) on sale of property 13 (3,249) (1,327)
Amortization of gain on interest rate swap terminations (791) (752) (245)
Treasury shares contributed to employee benefit and deferred
compensation plans 6,497 3,156 2,977
Changes in current assets and liabilities, net of acquisitions:
Accounts receivable (17,266) 8,004 7,237
Inventories 4,795 10,436 27,020
Other current assets (11,064) (659) (688)
Accounts payable 5,913 (4,276) 2,593
Accrued expenses 9,652 15,661 1,518
-------- -------- --------
Net Cash provided by Operating Activities 43,088 63,920 71,121
-------- -------- --------
Cash Flows from Investing Activities
Property purchases (14,387) (12,794) (10,050)
Proceeds from property sales 1,441 7,456 3,610
Net cash paid for acquisition of businesses, net of cash
acquired of $815 in 2004 (1,285) (10,255) (2,574)
Deposits and other (1,589) (689) 274
-------- -------- --------
Net Cash used in Investing Activities (15,820) (16,282) (8,740)
-------- -------- --------
Cash Flows from Financing Activities
Repayments under revolving credit agreements - net (2,850) (21,350)
Long-term debt repayments (5,714) (11,429)
Proceeds from termination of swap 2,517 2,038
Change in cash overdrafts (2,557) 3,371 (2,173)
Purchases of treasury shares (6,336) (9,946) (14,318)
Dividends paid (9,273) (9,154) (9,270)
Exercise of stock options 8,336 3,307 3,200
-------- -------- --------
Net Cash used in Financing Activities (12,680) (15,619) (53,302)
-------- -------- --------
Increase in cash and temporary investments 14,588 32,019 9,079
Cash and temporary investments at beginning of year 55,079 23,060 13,981
-------- -------- --------
Cash and Temporary Investments at End of Year $ 69,667 $ 55,079 $ 23,060
======== ======== ========
Supplemental Cash Flow Information
Cash paid during the year for:
Income taxes $ 20,434 $ 13,204 $ 8,182
Interest $ 5,379 $ 4,995 $ 6,205
See notes to consolidated financial statements.
20
Applied Industrial Technologies, Inc. and Subsidiaries
Statements of Consolidated Shareholders' Equity
For the Years Ended June 30, 2004, 2003 and 2002
------------------------------------------------------------
Unearned
Income Restricted
Shares of Additional Retained for Treasury Common
Common Stock Common Paid-in Use in the Shares-at Stock
(In thousands, except per share amounts) Outstanding Stock Capital Business Cost Compensation
- ---------------------------------------- ------------ ------- ---------- ------------ --------- ------------
Balance at July 1, 2001 19,647 $10,000 $ 84,221 $ 285,661 $ (66,227) $ (1,955)
Net income 2,655
Minimum pension liability
Unrealized gain on cross currency swap
Foreign currency translation adjustment
Total comprehensive income
Cash dividends - $.48 per share (9,270)
Purchases of common stock for treasury (817) (14,318)
Treasury shares issued for:
Retirement Savings Plan contributions 148 434 2,243
Exercise of stock options 226 (183) 3,383
Deferred compensation plans 14 52 248
Forfeiture of restricted common stock
compensation (15) (76) (229) 305
Amortization of restricted
common stock compensation (169) 818
Other 238
------ ------- ---------- ------------ --------- ------------
Balance at June 30, 2002 19,203 10,000 84,517 279,046 (74,900) (832)
Net income 19,832
Unrealized loss on cross currency swap
Foreign currency translation adjustment
Total comprehensive income
Cash dividends - $.48 per share (9,154)
Purchases of common stock for treasury (581) (9,946)
Treasury shares issued for:
Retirement Savings Plan contributions 164 348 2,505
Exercise of stock options 217 (63) 3,370
Deferred compensation plans 17 38 265
Amortization of restricted
common stock compensation 30 718
Other 28
------ ------- ---------- ------------ --------- ------------
Balance at June 30, 2003 19,020 10,000 84,898 289,724 (78,706) (114)
Net income 31,471
Unrealized loss on cross currency swap
Foreign currency translation adjustment
Total comprehensive income
Cash dividends - $.48 per share (9,273)
Purchases of common stock for treasury (290) (6,336)
Treasury shares issued for:
Retirement Savings Plan contributions 229 1,713 3,609
Exercise of stock options 438 1,497 6,839
Deferred compensation plans 51 344 831
Restricted common stock awards 57 392 893 (1,285)
Compensation expense - stock options 1,586
Amortization of restricted
common stock compensation 9 241
Other 81
------ ------- ---------- ------------ --------- ------------
Balance at June 30, 2004 19,505 $10,000 $ 90,520 $ 311,922 $ (72,870) $ (1,158)
====== ======= ========== ============ ========= ============
For the Years Ended June 30, 2004, 2003 and 2002
-------------------------------------------------
Accumulated
Other Total
Comprehensive Shareholders'
(In thousands, except per share amounts) Income (loss) Equity
- ---------------------------------------- ------------- -------------
Balance at July 1, 2001 $ (182) $ 311,518
Net income 2,655
Minimum pension liability 285 285
Unrealized gain on cross currency swap 297 297
Foreign currency translation adjustment (84) (84)
-------------
Total comprehensive income 3,153
-------------
Cash dividends - $.48 per share (9,270)
Purchases of common stock for treasury (14,318)
Treasury shares issued for:
Retirement Savings Plan contributions 2,677
Exercise of stock options 3,200
Deferred compensation plans 300
Forfeiture of restricted common stock
compensation
Amortization of restricted
common stock compensation 649
Other 238
-------------- -------------
Balance at June 30, 2002 316 298,147
Net income 19,832
Unrealized loss on cross currency swap (1,019) (1,019)
Foreign currency translation adjustment 2,757 2,757
-------------
Total comprehensive income 21,570
-------------
Cash dividends - $.48 per share (9,154)
Purchases of common stock for treasury (9,946)
Treasury shares issued for:
Retirement Savings Plan contributions 2,853
Exercise of stock options 3,307
Deferred compensation plans 303
Amortization of restricted
common stock compensation 748
Other 28
-------------- -------------
Balance at June 30, 2003 2,054 307,856
Net income 31,471
Unrealized loss on cross currency swap (701) (701)
Foreign currency translation adjustment (232) (232)
-------------
Total comprehensive income 30,538
-------------
Cash dividends - $.48 per share (9,273)
Purchases of common stock for treasury (6,336)
Treasury shares issued for:
Retirement Savings Plan contributions 5,322
Exercise of stock options 8,336
Deferred compensation plans 1,175
Restricted common stock awards
Compensation expense - stock options 1,586
Amortization of restricted
common stock compensation 250
Other 81
------------- -------------
Balance at June 30, 2004 $ 1,121 $ 339,535
============= =============
See notes to consolidated financial statements.
21
Applied Industrial Technologies, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
Years Ended June 30, 2004, 2003 and 2002
(Dollar amounts in thousands, except per share amounts)
NOTE_1: BUSINESS AND ACCOUNTING POLICIES
Business
The Company is one of North America's leading distributors of industrial and
fluid power products and systems. Industrial products include bearings and
seals, linear motion products, power transmission products, industrial rubber
products, general maintenance and safety products and tools. Fluid power
includes hydraulic, pneumatic, lubrication and filtration components and
systems. The Company also provides mechanical, rubber shop and fluid power
services. The Company offers technical application support for these products
and provides creative solutions to help customers minimize downtime and reduce
overall procurement costs. Although the Company does not generally manufacture
the products it sells, it does assemble and repair certain products and systems.
Most of the Company's sales are in the maintenance and replacement markets to
customers in a wide range of industries, principally in North America.
Consolidation
The consolidated financial statements include the accounts of Applied Industrial
Technologies, Inc. and its subsidiaries. The Company is considered the primary
beneficiary for iSource Performance Materials, LLC (iSource) and includes their
accounts in the consolidated financial statements. All significant intercompany
transactions and balances have been eliminated in consolidation. The financial
statements of the Company's Canadian subsidiaries are included in the
consolidated financial statements based upon their fiscal year ended May 31.
Certain reclassifications have been made to prior year amounts to be consistant
with the presentation in the current year.
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 the exchange rates as of
year-end, while income statement amounts are translated at average monthly
exchange rates. Translation gains and losses are included as components of
accumulated other comprehensive income in shareholders' equity. Transaction
gains and losses included in the statements of consolidated income were not
material.
Estimates
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amount of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amount of revenues and expenses during
the period. Actual results may differ from the estimates and assumptions used in
preparing the consolidated financial statements.
Cash and Temporary Investments
The Company considers all temporary investments with maturities of three months
or less at the date of purchase to be cash equivalents. Cash overdrafts of
$8,070 at June 30, 2004 and $10,627 at June 30, 2003 are classified as a current
liability in accounts payable.
Goodwill
Effective July 1, 2001, the Company adopted Statement of Financial Accounting
Standards ("SPAS") 142, "Goodwill and Other Intangible Assets." Under SFAS 142,
goodwill is no longer amortized, but is tested for impairment upon adoption and
at least annually thereafter. The Company has established January 1 as its
annual impairment testing date. The results of the Company's January 1, 2004
testing indicated no impairment. For purposes of completing impairment testing
upon adoption of SFAS 142 at July 1, 2001, the Company determined the fair value
of its reporting units utilizing discounted cash flow models and market
multiples for comparable businesses. The Company compared the fair value of each
of its reporting units to its carrying value. This evaluation indicated that
goodwill associated with its fluid power business was impaired. This impairment
was primarily attributed to a downturn in the industrial economy in the years
following the Company's fluid power business acquisitions. A non-cash charge
totaling $17,600, $12,100 after tax, was recorded as the cumulative effect of a
change in accounting principle effective July 1, 2001 to write-off the remaining
goodwill relating to the fluid power business.
Inventories
U.S. inventories are valued at the lower of cost or market, using the last-in,
first-out (LIFO) method, and foreign inventories are valued using the average
cost method. The Company adopted the link chain dollar value LIFO method of
accounting for domestic inventories in fiscal 1974. At June 30, 2004,
approximately half of our inventory dollars relate to LIFO layers added in the
1970's. The Company maintains five LIFO pools based on the following product
groupings: bearings, drive products, rubber products, fluid power products and
other products. LIFO layers and/or liquidations are determined consistently
year-to-year in a manner which is in accordance with the guidance in the 1984
AICPA LIFO Issue Paper, "Identification and Discussion of Certain Financial
Accounting and Reporting Issues Concerning LIFO Inventories." See Note 3 for
further information regarding inventories.
22
Property and Depreciation
Property and equipment are initially stated at cost. Depreciation of buildings
and equipment is computed using the straight-line method over the estimated
useful lives of the assets. Buildings and related improvements are depreciated
over 10 to 30 years and equipment over 3 to 8 years. The carrying values of
long-lived assets, including property and equipment, are reviewed for impairment
on a quarterly basis or whenever events or changes in circumstances indicate
that the recorded value cannot be recovered from undiscounted future cash flows.
Estimated Liability for Self-Insurance
The Company maintains business insurance programs with significant self-insured
retention, which covers workers' compensation, business automobile and general
products liability claims. The Company accrues estimated losses using actuarial
calculations, models and assumptions based on historical loss experience. The
Company maintains a self-insured health benefits plan, which provides medical
benefits to employees electing coverage under the plan. The Company maintains a
reserve for incurred but not reported medical claims and claims development. The
reserve is based on historical experience and other assumptions. The Company
utilizes independent actuarial firms to assist in determining the adequacy of
these reserves.
Revenue Recognition
Sales are recognized when products are shipped or delivered to a customer which
occurs when title is transferred to the customer. Products are billed at agreed
upon prices. The Company's experience is that collection of receivables recorded
for all sales is reasonably assured.
Shipping and Handling
The Company recognizes shipping and handling fees billed when products are
shipped or delivered to a customer, and includes such amounts in net sales.
Third party freight payments are recorded in cost of sales in the accompanying
statements of consolidated income.
Income Taxes
Income taxes are determined based upon income and expenses recorded for
financial reporting purposes. Deferred income taxes are recorded for estimated
future tax effects of differences between the bases of assets and liabilities
for financial reporting and income tax purposes giving consideration to enacted
tax laws.
Net Income Per Share
The following is a computation of the basic and diluted earnings per share:
Year Ended June 30
2004 2003 2002
----------- ------- --------
Net Income
Income before cumulative effect of
accounting change $ 31,471 $19,832 $ 14,755
Cumulative effect of accounting change (12,100)
----------- ------- --------
Net Income $ 31,471 $19,832 $ 2,655
=========== ======= ========
Average Shares Outstanding
Weighted average common shares outstanding
for basic computation 19,238 18,908 19,079
Dilutive effect of stock based options and
awards 453 314 338
----------- ------- --------
Weighted average common shares outstanding
for dilutive computation 19,691 19,222 19,417
=========== ======= ========
Net Income Per Share - Basic
Before cumulative effect of accounting change $ 1.64 $ 1.05 $ 0.77
Cumulative effect of accounting change (0.63)
----------- ------- --------
Net Income Per Share - Basic $ 1.64 $ 1.05 $ 0.14
=========== ======= ========
Net Income Per Share - Diluted
Before cumulative effect of accounting change $ 1.60 $ 1.03 $ 0.76
Cumulative effect of accounting change (0.63)
----------- ------- --------
Net Income Per Share - Diluted $ 1.60 $ 1.03 $ 0.13
=========== ======= ========
Stock Based Compensation
At June 30, 2004, the Company had outstanding stock options and other
stock-based awards (see Note 9). Effective July 1, 2003, the Company adopted for
stock options the fair value recognition provisions of SEAS 123, "Accounting for
Stock-Based Compensation" as amended by SPAS 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure," using the modified prospective method
for the transition. Under the modified prospective method, stock-based
compensation cost recognized during this fiscal year for stock options is the
same as that which would
23
Applied Industrial Technologies, Inc. and Subsidiaries
Notes to Consolidated Financial Statements, Continued
have been recognized had the fair value recognition provisions been applied to
all stock option awards granted after July 1, 1995. Results for prior years have
not been restated. The compensation expense for stock options recorded during
the year ended June 30, 2004 was $1,586, $1,074 net of tax, or $0.05 per share.
The Company also records expense for other stock-based compensation, including
restricted stock awards, ratably over the vesting period based upon the
aggregate fair market value at the date of grant. The following table discloses
the compensation expense and net income as if the fair value based method had
been applied for stock options in each period:
Year Ended June 30
2004 2003 2002
---------- ---------- ----------
Net income, as reported $ 31,471 $ 19,832 $ 2,655
PLUS: Stock option compensation expense included
in reported net income, net of tax 1,074
Restricted stock compensation expense
included in reported net income, net of tax 163 460 508
LESS: Total stock-based employee compensation
expense determined under fair value based method,
net of tax (1,237) (1,710) (1,829)
---------- ---------- ----------
Pro forma net income $ 31,471 $ 18,582 $ 1,334
========== ========== ==========
Earnings per share:
Basic - as reported $ 1.64 $ 1.05 $ .14
========== ========== ==========
Basic - pro forma $ 1.64 $ .98 $ .07
========== ========== ==========
Diluted - as reported $ 1.60 $ 1.03 $ .13
========== ========== ==========
Diluted - pro forma $ 1.60 $ .97 $ .07
========== ========== ==========
Compensation expense for stock options has been determined using the Black
Scholes option pricing model. The weighted average assumptions used for stock
option grants issued in 2004, 2003 and 2002 are:
2004 2003 2002
--------- --------- ---------
Expected life 7.3 YEARS 7.0 years 7.0 years
Risk free interest rate 3.8% 3.9% 4.9%
Dividend yield 2.9% 3.0% 3.0%
Volatility 31.7% 30.9% 29.1%
New Accounting Pronouncements
In January 2003, the Financial Accounting Standards Board issued Financial
Interpretations No. (FIN) 46, "Consolidation of Variable Interest Entities,"
which the Company adopted as of July 1, 2003. The Company is a minority owner in
iSource. iSource has assets of $2,900 and accounts payable of $2,400 at June 30,
2004. In December 2003, the Company paid iSource's outstanding amount of bank
debt of $2,990 and assumed the bank's rights under the loan agreement. The
Company's purchases currently account for more than 90% of iSource's sales and
the Company is considered the primary beneficiary of iSource's operations. In
accordance with FIN 46, iSource's financial statements were consolidated with
the Company's beginning in July 2003. This consolidation did not have a
significant impact on consolidated income or cash flow statements.
During December 2003, the Financial Accounting Standards Board issued a
revision to SFAS 132, "Employers' Disclosures about Pensions and Other
Postretirement Benefits, an amendment of SFAS 87, 88, and 106," which expands
the disclosure requirements regarding plan assets, benefit costs and benefit
obligations for the Company's benefit and pension plans. Provisions relating to
the annual financial statement disclosures are effective for the fiscal year
ending June 30, 2004 (see Note 10).
NOTE_2: BUSINESS COMBINATIONS
In November 2003, the Company acquired the stock of a Mexican distributor of
industrial products for approximately $2,800. The results of the acquired
operations are included in our service center based distribution segment from
the acquisition date. Other intangibles of $880, consisting of customer
relationships and non-competition agreements, were recognized in connection with
this combination and will be amortized over periods of seven to ten years.
During the year ended June 30, 2003, the Company acquired assets from a
Canadian distributor of industrial products for approximately $11,500. The
results of the acquired business operations are included in our service center
based distribution segment. Goodwill of $2,486 and other intangible assets of
$1,977, consisting of customer relation-
24
ships, trademark, exclusive supplier distribution agreements and a
non-competition agreement, were recognized in connection with this combination.
The other intangible assets are being amortized over periods of one to fifteen
years.
For the acquisitions made during the years ended June 30, 2004 and 2003,
the fair values of the acquired assets and liabilities assumed at the dates of
acquisition are as follows:
2004 2003
-------- --------
Cash $ 815
Accounts receivable 2,159 $ 2,600
Inventory 1,815 4,200
Other current assets 212
Property 201 700
Other assets 2 237
Goodwill 162 2,486
Other intangibles 880 1,977
-------- --------
Total assets acquired 6,246 12,200
Current liabilities (3,446) (700)
-------- --------
Net assets acquired $ 2,800 $ 11,500
======== ========
During the year ended June 30, 2002, the Company acquired the stock of a Mexican
distributor of bearing and power transmission products for $3,200. Results of
the business operations are included in our service center based distribution
segment. Non-tax deductible goodwill of $1,989 and other intangible assets,
primarily non-competition agreements of $350, were recognized in connection with
this combination.
Results of operations of all of the above acquisitions, which have all
been accounted for as purchases, are included in the accompanying consolidated
financial statements from their respective acquisition dates. The results of
operations for these acquisitions are not material for all years presented.
NOTE_3: INVENTORIES
Inventories consist of the following:
June 30
2004 2003
----------------------------------
U.S. inventories at current cost $ 253,881 $ 248,147
Foreign inventories at average cost 31,226 26,228
------------- -------------
285,107 274,375
Less: Excess of current cost over LIFO cost for U.S. inventories 125,513 114,577
------------- -------------
Inventories on consolidated balance sheet $ 159,594 $ 159,798
============= =============
Reductions in inventories during the fiscal years ended June 30, 2004, 2003 and
2002 resulted in liquidation of LIFO inventory quantities carried at lower costs
prevailing in prior years. The effect of these liquidations for the years ended
June 30, 2004, 2003 and 2002 increased gross profit by $672, $741 and $915, net
income by $420, $453 and $546 and net income per share by $.02, $.02 and $.03
respectively.
NOTE_4: GOODWILL & OTHER INTANGIBLES
The changes in the carrying amount of goodwill for the years ended June 30, 2004
and 2003, are as follows:
Service Center Based
Distribution Segment
--------------------
Balance at July 1, 2002 $ 46,410
Goodwill of acquired businesses 2,486
Currency translation adjustment 791
----------
Balance at June 30, 2003 49,687
Goodwill of acquired businesses 162
Currency translation adjustment 3
----------
Balance at June 30, 2004 $ 49,852
==========
25
Applied Industrial Technologies, Inc. and Subsidiaries
Notes to Consolidated Financial Statements, Continued
The Company's intangible assets resulting from business combinations are
amortized over their estimated useful lives and consist of the following:
June 30, 2004 June 30, 2003
------------------------------------------ ------------------------------------------
Accumulated Net Accumulated Net
Amount (a) Amortization Book Value Amount (a) Amortization Book Value
- ----------------------------------------------------------------------------------------------------------------------------------
Non-competition agreements $ 9,315 $ 8,349 $ 966 $ 9,124 $ 7,704 $ 1,420
Customer relationships 2,290 215 2,075 1,534 68 1,466
Exclusive supplier distribution
agreements 549 61 488 548 24 524
Trademarks 73 73 73 49 24
------------ ------------ ------------ ------------ ------------ ------------
$ 12,227 $ 8,698 $ 3,529 $ 11,279 $ 7,845 $ 3,434
============ ============ ============ ============ ============ ============
(a) Amounts include the impact of foreign currency translation.
For the year ended June 30, 2004, the Company recorded intangible assets of $100
for non-competition agreements and $780 for customer relationships in connection
with the acquisition of a Mexican distributor of industrial products (see Note
2). These intangibles are being amortized over 7 to 10 years, respectively.
Amortization expense for other intangible assets totaled $826 in 2004,
$781 in 2003 and $1,651 in 2002. Estimated amortization of other intangible
assets at June 30, 2004 is expected to be $621 for 2005; $412 for 2006; $324 for
2007; $291 for 2008; $278 for 2009 and $1,603 after 2009.
NOTE_5: OTHER BALANCE SHEET INFORMATION
Other assets consist of the following:
June 30
2004 2003
---------------------------
Deferred tax assets - non-current $ 12,294 $ 12,450
Deposits and investments 4,454 4,459
Other intangibles 3,529 3,434
Other 6,654 4,938
--------- -----------
Total $ 26,931 $ 25,281
========= ===========
The fair values of deposits and investments approximates their carrying values.
Other current liabilities consist of the following:
June 30
2004 2003
--------------------------
Accrued income and other taxes $ 8,725 $ 10,349
Accrued self insurance liabilities 4,458 4,760
Deferred lease liabilities 4,247 4,557
Currency swap liabilities 3,024
Other 5,076 3,579
--------- -----------
Total $ 25,530 $ 23,245
========= ===========
NOTE_6: DEBT
During February, 2004, the Company entered into an agreement with Prudential
Insurance Company, expiring in February 2007, for an uncommitted shelf facility
that enables the Company to borrow up to $100,000 in additional long-term
financing at the Company's sole discretion with terms of up to twelve years. At
June 30, 2004, there was no borrowing under this agreement.
In November 2003, the Company replaced its existing revolving credit
facility with a five year committed revolving credit facility with a group of
banks. This agreement provides for unsecured borrowings of up to $100,000 at
various interest rate options, none of which is in excess of the banks' prime
rate at interest determination dates. The Company had no borrowings outstanding
under this facility at June 30, 2004. Fees on this facility range from .15% to
..30% per year on the average amount of the total revolving credit commitments
during the year. Unused lines under this facility, net of outstanding letters of
credit, totaled $92,114 and are available to fund future acquisitions or other
capital and operating requirements.
26
Long-term debt consists of:
June 30
2004 2003
-----------------
7.98% Private placement debt, due at maturity in November 2010 $25,000 $25,000
6.6% Senior $50,000 unsecured term notes, due at maturity in
December 2007, including effects of interest rate swaps (see Note 7) 52,767 53,558
------- -------
Total $77,767 $78,558
======= =======
The revolving credit facility, private placement debt and senior unsecured term
notes contain restrictive covenants regarding liquidity, tangible net worth,
financial ratios and other covenants. At June 30, 2004, the most restrictive of
these covenants required that the Company have consolidated income before
interest and taxes at least equal to 300% of net interest expense. At June 30,
2004, the Company was in compliance with all covenants. Based upon current
market rates for debt of similar maturities, the Company estimates that the fair
value of its debt is greater than its carrying value at June 30, 2004 by
approximately $672.
The aggregate annual maturities of long-term debt over the next five years
include $50,000 in fiscal 2008 and $25,000 in fiscal 2011.
NOTE_7: RISK MANAGEMENT ACTIVITIES
The Company is exposed to market risks, primarily resulting from changes in
interest rates and currency exchange rates. To manage these risks, the Company
may enter into derivative transactions pursuant to the Company's written policy.
These transactions are accounted for in accordance with SFAS 133, "Accounting
for Derivative Instruments and Hedging Activities." The Company does not hold or
issue derivative financial instruments for trading purposes.
During fiscal 2002 the Company entered into two interest rate swap
agreements with two domestic banks which effectively converted the fixed
interest rate on the 6.6% senior unsecured term notes to a floating variable
rate based on LIBOR. In October 2001 and August 2002, the Company terminated the
swap agreements for favorable settlements of $2,000 and $2,500, respectively.
These settlement gains are being amortized as a reduction in interest expense of
approximately $790 per year over the remaining life of the notes through
December 2007. The effect of the swap agreements was to decrease interest
expense by $791 in 2004, $880 in 2003 and $1,390 in 2002.
In November 2000, the Company entered into two 10 year cross-currency swap
agreements to manage its foreign currency risk exposure on private placement
borrowings related to its wholly owned Canadian subsidiary. The cross currency
swaps effectively convert $25,000 of debt, and the associated interest payments,
from 7.98% fixed rate U.S. dollar denominated debt to 7.75% fixed rate Canadian
dollar denominated debt. The terms of the two cross-currency swaps mirror the
terms of the private placement borrowings.
The Company has designated one of the cross-currency swaps, with a $20,000
U.S. notional amount, as a foreign currency cash flow hedge. The fair value of
the cross-currency swap was a liability of $2,419 and $999 at June 30, 2004 and
2003, respectively, which were recorded in current liabilities and the related
unrealized loss is recorded in accumulated other comprehensive income (net of
tax). The second cross-currency swap, however, has not been designated as a
hedging instrument under the hedge accounting provisions of SFAS 133. The fair
value of this cross-currency swap was a liability of $605 and $250 at June 30,
2004 and 2003, respectively. Changes in the fair value of this derivative
instrument are recorded in earnings as a component of other (income) expense,
net.
NOTE_8: INCOME TAXES
Provision
The provision (benefit) for income taxes consists of:
Year Ended June 30
2004 2003 2002
--------------------------------
Current
Federal $ 17,500 $ 12,300 $ 12,350
State 2,800 1,300 1,450
Foreign 400 200 200
-------- -------- --------
Total current 20,700 13,800 14,000
-------- -------- --------
Deferred
Federal (5,900) (2,200) (4,500)
State (600) (500) (600)
Foreign 800 100
-------- -------- --------
Total deferred (5,700) (2,700) (5,000)
-------- -------- --------
Total $ 15,000 $ 11,100 $ 9,000
======== ======== ========
The exercise of non-qualified stock options during fiscal 2004, 2003 and 2002
resulted in $1,353, $466 and $605, respectively, of income tax benefits to the
Company derived from the difference between the market price at the date
27
Applied Industrial Technologies, Inc. and Subsidiaries
Notes to Consolidated Financial Statements, Continued
of exercise and the option price. Accelerated vesting of restricted stock in
fiscal 2003 resulted in $30 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 is a reconciliation between the federal statutory income tax rate
and the Company's effective tax rate:
Year Ended June 30
2004 2003 2002
--------------------------------
Statutory tax rate 35.0% 35.0% 35.0%
Effects of:
State and local income taxes 3.1 1.3 2.4
Foreign income taxes (1.4) (1.4) (.1)
Non-deductible expenses .1 1.4 1.4
Deductible dividend (.6) (2.2)
Income tax examinations (2.8) 2.2 .8
Other, net (1.1) (.4) (1.6)
------ ------- -------
Effective tax rate 32.3% 35.9% 37.9%
====== ======= =======
Balance Sheet
The significant components of the Company's deferred tax assets (liabilities)
are as follows:
June 30
2004 2003
--------------------
Inventories $ (7,338) $ (8,972)
Depreciation and differences in property bases (5,691) (6,240)
Compensation liabilities not currently deductible 13,983 11,705
Reserves not currently deductible 9,543 8,254
Goodwill 5,568 6,366
Canadian net operating loss carry forwards,
expiring 2010 and 2009 649 1,476
State and other net operating loss carry forwards 697 796
Other 1,641 939
-------- --------
Net deferred tax asset $ 19,052 $ 14,324
======== ========
NOTE_9: SHAREHOLDERS' EQUITY
Stock Incentive Plans
The 1997 Long-Term Performance Plan (the "1997 Plan") provides for granting of
stock options, stock awards, cash awards, and such other awards or combination
thereof as the Executive Organization and Compensation Committee of the Board of
Directors may determine. The number of shares of common stock which may be
awarded in each fiscal year under the 1997 Plan is two percent (2%) of the total
number of shares of common stock outstanding on the first day of each year for
which the plan is in effect. Common stock available for distribution under the
1997 Plan, but not distributed, may be carried over to the following year.
Shares available for future grants at June 30, 2004 and 2003 were 168,000 and
142,000, respectively.
Under the 1997 Plan, the Company has awarded restricted stock and/or stock
options to officers, other key associates and members of the Board of Directors.
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
generally vest 25% each year. The aggregate fair market value of the restricted
stock is considered unearned compensation at the time of grant and is amortized
over the vesting period or until such time as acceleration of vesting takes
place.
At June 30, 2004, the Company had outstanding stock options granted under
the 1997 Plan. In general, the stock options vest over a period of 4 years and
expire after 10 years. Effective July 1, 2003, the Company adopted the fair
value recognition provisions of SFAS 123, "Accounting for Stock-Based
Compensations" as amended by SFAS 148, "Accounting for Stock-Based Compensation
and Disclosure" using the modified prospective method for transition (see Note
1). Prior to fiscal 2004, the Company accounted for stock options under the
provisions of APB Opinion No. 25, "Accounting for Stock Issued to Employees."
28
Information regarding these option plans is as follows:
2004 2003 2002
------------------------------------------------------------
Weighted- Weighted- Weighted-
Average Average Average
Exercise Exercise Exercise
(Share amounts in thousands) Shares Price Shares Price Shares Price
- ------------------------------ ------------------------------------------------------------
Outstanding, beginning of year 2,474 $ 16.89 2,199 $ 16.80 2,124 $ 16.10
Granted 320 21.76 522 15.67 401 17.86
Exercised (436) 16.00 (219) 13.01 (226) 11.57
Expired/canceled (23) 18.53 (28) 17.94 (100) 17.82
------------------------------------------------------------
Outstanding June 30 2,335 17.70 2,474 16.89 2,199 16.80
============================================================
Options exercisable June 30 1,519 $ 17.41 1,460 $ 16.92 1,322 $ 16.25
Weighted-average fair value
of options granted
during the year $ 6.21 $ 4.26 $ 4.65
The following table summarizes information about stock options outstanding at
June 30, 2004:
Options Outstanding Options Exercisable
----------------------------------- -----------------------
Weighted-
Average Weighted- Weighted-
Remaining Average Average
Ranges of Number Life (in Exercise Number Exercise
Exercise Prices Outstanding years) Price Exercisable Price
- -------------------------------------------------------------------------------
$13 - $17 1,060 5.8 $ 15.55 727 $ 15.48
17 - 21 929 5.4 18.48 717 18.52
21 - 25 315 9.2 21.77 44 24.52
25 - 29 31 3.5 26.93 31 26.93
- -------------------------------------------------------------------------------
Total 2,335 1,519
===============================================================================
At June 30, 2004, exercise prices for outstanding options ranged from $13.16 to
$27.03 per share.
Shareholders' Rights
In 1998 the Company's Board of Directors adopted a Shareholder Rights Plan and
declared a dividend distribution of one preferred share purchase right for each
outstanding share of Company common stock. The rights become exercisable only if
a person or group acquires beneficial ownership or commences a tender or
exchange offer for 20% or more of the Company's common stock, unless the tender
or exchange offer is for all outstanding shares of the Company upon terms
determined by the Company's continuing directors to be in the best interests of
the Company and its shareholders. When exercisable, the rights would entitle the
holders (other than the acquirer) to buy shares of the Company's common stock
having a market value equal to two times the right's exercise price or, in
certain circumstances, to buy shares of the acquiring company having a market
value equal to two times the right's exercise price.
Treasury Shares
At June 30, 2004, 596,000 shares of the Company's common stock held as treasury
shares are restricted as collateral under escrow arrangements relating to
certain change in control and director and officer indemnification agreements.
NOTE_10: BENEFIT PLANS
Retirement Savings Plan
Substantially all associates of the Company's U.S. subsidiaries participate in
the Applied Industrial Technologies, Inc. Retirement Savings Plan. The Company
makes a discretionary profit-sharing contribution to the Retirement Savings Plan
generally based upon a percentage of the Company's domestic income before income
taxes and before the amount of the contribution (5% for 2004, 2003, and 2002).
The Company also partially matches 401(k) contributions by participants, who may
elect to contribute up to 50 percent of their compensation. The matching
contribution is made with the Company's common stock and is determined quarterly
using rates based on achieving certain quarterly earnings per share levels
(ranging from 25% to 100% of the first 6% of compensation contributed to the
plan).
The Company's expense for contributions to the above plan was $6,808,
$3,990, and $2,841 for the years ended June 30, 2004, 2003, and 2002,
respectively.
29
Applied Industrial Technologies, Inc. and Subsidiaries
Notes to Consolidated Financial Statements, Continued
Deferred Compensation Plans
The Company has deferred compensation plans that enable certain associates of
the Company to defer receipt of a portion of their compensation and non-employee
directors to defer receipt of director fees. The Company funds these deferred
compensation liabilities by making contributions to rabbi trusts. Contributions
consist of Company common stock and investments in money market and mutual
funds.
Postemployment Benefit Plans
The Company provides the following postemployment benefits:
Supplemental Executive Retirement Benefit Plan
The Company has a non-qualified pension plan to provide supplemental
retirement benefits to certain officers. Benefits are payable at
retirement based upon a percentage of the participant's compensation. The
plan specifies minimum annual retirement benefits for certain
participants.
Qualified Defined Benefit Retirement Plan
The Company has a qualified defined benefit retirement plan that provides
benefits to certain hourly employees at retirement. The benefits are based
on length of service and date of retirement.
Salary Continuation Benefits
The Company has agreements with certain retirees to pay monthly retirement
benefits for a period not in excess of 15 years. The discount rate used in
determining the benefit obligation was 5.5% at June 30, 2004 and 2003.
Retiree Medical Benefits
The Company provides health care benefits to eligible retired associates
who elect to pay the Company a specified monthly premium. Premium payments
are based upon current insurance rates for the type of coverage provided
and are adjusted annually. Certain monthly health care premium payments
are partially subsidized by the Company. Additionally, in conjunction with
a fiscal 1998 acquisition, the Company assumed the obligation for a
post-retirement medical benefit plan which provides health care benefits
to eligible retired associates at no cost to the individual.
The changes in benefit obligations, plan assets and funded status for the plans
described above were as follows:
Pension Benefits Other Benefits
---------------------- --------------------
2004 2003 2004 2003
------------------------------------------------
Change in benefit obligation:
Benefit obligation at beginning of the year $ 20,830 $ 18,514 $ 5,225 $ 4,244
Service cost 1,051 712 57 63
Interest cost 1,250 1,123 304 287
Plan participants' contributions 21 16
Benefits paid (2,446) (1,996) (255) (244)
Amendments 2,036 148
Actuarial (gain) loss during year 2,919 2,329 (341) 859
------------------------------------------------
Benefit obligation at June 30 $ 25,640 $ 20,830 $ 5,011 $ 5,225
================================================
Change in plan assets:
Fair value of plan assets at beginning of year $ 3,985 $ 3,261
Actual return on plan assets 581 113
Employer contribution 2,352 2,607 $ 234 $ 228
Plan participants' contributions 21 16
Benefits paid (2,446) (1,996) (255) (244)
------------------------------------------------
Fair value of plan assets at June 30 $ 4,472 $ 3,985 $ 0 $ 0
================================================
Reconciliation of funded status:
Funded status $(21,168) $(16,845) $(5,011) $(5,225)
Unrecognized net loss 7,102 4,669 316 676
Unrecognized prior service cost 4,965 3,519 195 244
------------------------------------------------
Accrued benefit cost at June 30 $ (9,101) $ (8,657) $(4,500) $(4,305)
================================================
30
The weighted-average actuarial assumptions at June 30 used to determine benefit
obligations for the plans were as follows:
Pension Benefits Other Benefits
---------------- --------------
2004 2003 2004 2003
-------------------------------------
Discount rate 6.0% 6.0% 6.0% 6.0%
Expected return on plan assets 8.0% 8.0% N/A N/A
Rate of compensation increase 5.5% 5.5% N/A N/A
The amounts recognized on the balance sheet at June 30 were as follows:
Pension Benefits Other Benefits
-------------------- --------------------
2004 2003 2004 2003
------------------------------------------
Prepaid benefit cost $ 1,949 $ 2,027
Accrued benefit liability (14,631) (13,327) $ (4,500) $ (4,305)
Intangible asset 3,581 2,643
-----------------------------------------
Net amount recognized $ (9,101) $ (8,657) $ (4,500) $ (4,305)
=========================================
The accumulated benefit obligations were approximately $18,568 and $17,060 at
June 30, 2004 and 2003, respectively.
The following table provides information for pension plans with an accumulated
benefit obligation and projected benefit obligation in excess of plan assets:
Pension Benefits
------------------
2004 2003
------------------
Projected benefit obligations $ 21,704 $ 17,098
Accumulated benefit obligations 14,632 13,327
Fair value of plan assets at end of year 0 0
The net periodic pension costs are as follows:
Pension Benefits Other Benefits
--------------------------------- ------------------------
2004 2003 2002 2004 2003 2002
---------------------------------------------------------------
Service cost $ 1,051 $ 712 $ 628 $ 57 $ 63 $ 57
Interest cost 1,250 1,123 1,732 304 287 306
Expected return on plan assets (315) (258) (172)
Recognized net actuarial (gain) loss 220 74 157 19 (6) 13
Amortization of prior service cost 590 475 458 49 49 29
---------------------------------------------------------------
Net periodic pension cost $ 2,796 $ 2,126 $ 2,803 $ 429 $ 393 $ 405
===============================================================
The assumed health care cost trend rates used in measuring the accumulated
benefit obligation for post-retirement benefits other than pensions were 10% as
of June 30, 2004 and 11% as of 2003 decreasing to 5% by 2010. A one-percentage
point change in the assumed health care cost trend rates would have had the
following effects as of June 30, 2004 and for the year then ended:
One-Percentage One-Percentage
Point Increase Point Decrease
-------------- --------------
Effect on total service and interest cost
components of periodic expense $ 51 $ (42)
Effect on post-retirement benefit obligation $ 608 $ (507)
Obligations and Funded Status Plan Assets
Applied Industrial Technologies, Inc.'s Qualified Defined Benefit Retirement
Plan weighted-average asset allocation at fiscal year end 2004 and 2003, and
target allocation for 2005 are as follows:
Percentage of Pension Plan
Assets At Fiscal Year End
Target --------------------------
Allocation 2004 2003
---------------------------------------
Asset Category:
Equity Securities 60% 62% 57%
Debt Securities 32 31 33
Other 8 7 10
--- --- ---
Total 100% 100% 100%
=== === ===
Equity securities do not include any Applied Industrial Technologies, Inc.
common stock at June 30, 2004 or 2003.
31
Applied Industrial Technologies, Inc. and Subsidiaries
Notes to Consolidated Financial Statements, Continued
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 $1,100 to its pension benefit plans and
$300 to its other benefit plans in 2005.
Estimated Future Benefit Payments
The Company expects to make the following benefit payments, which reflect
expected future service:
During Fiscal Years Pension Benefits Other Benefits
- ------------------- ---------------- --------------
2005 $ 1,200 $ 300
2006 4,800 300
2007 1,100 400
2008 1,100 400
2009 1,200 400
2010 through 2014 16,700 1,800
NOTE_11: COMMITMENTS, LEASE OBLIGATIONS AND RENT EXPENSES
The Company leases its corporate headquarters facility along with certain
service center and distribution center facilities, vehicles and equipment under
non-cancelable lease agreements accounted for as operating leases. The minimum
annual rental commitments under non-cancelable operating leases are $16,127 in
2005; $11,120 in 2006; $8,979 in 2007; $6,845 in 2008; $5,301 in 2009 and
$19,752 after 2009.
Rental expenses incurred for operating leases, principally from leases for
real property, vehicles and computer equipment was $26,938 in 2004, $30,067 in
2003, and $27,922 in 2002.
The Company had outstanding letters of credit of $7,886 at June 30, 2004.
These letters of credit secure certain insurance obligations.
In connection with the construction and lease of its corporate
headquarters facility, the Company has guaranteed repayment of a total of $5,678
of taxable development revenue bonds issued by Cuyahoga County and the
Cleveland-Cuyahoga County Port Authority. These bonds were issued with a 20-year
term and are scheduled to mature in March 2016. Any default, as defined in the
guarantee agreements, would obligate Applied for the full amount of the
outstanding bonds through maturity. Due to the nature of the guarantee, the
Company has not recorded any liability on the financial statements.
The Company had a construction and lease facility under which a
distribution center and three service centers were constructed by the lessor and
leased to the Company under operating lease arrangements. At the end of the
lease term in September 2003, the Company purchased the properties for $7,500.
The residual value guarantee provisions of this lease arrangement expired with
the purchase of the properties.
In December 2003, the Company paid the $2,990 outstanding balance of bank
debt for iSource and assumed the bank's rights under the loan agreement. Prior
to assuming the loan, the Company had guaranteed the bank debt of iSource.
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.
NOTE_12: SEGMENT INFORMATION
The Company has identified one reportable segment: Service Center Based
Distribution. 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 "Other" column consists of the aggregation of all
other non-service center based distribution operations that sell directly to
customers, including fluid power.
The accounting policies of the Company's reportable segment and its other
businesses are the same as those described in Note 1. Certain reclassifications
have been made to prior year amounts to be consistent with the presentation in
the current year. Sales between the service center based distribution segment
and the other businesses are not
32
significant. Operating results are in the United States, Canada, Mexico and
Puerto Rico. Operations in Canada, Mexico and Puerto Rico represent 9.2% of the
total net sales of Applied, and therefore, are not presented separately. In
addition, approximately 30% of these operations' net sales are included in the
"Other" column relating to the fluid power business. The long-lived assets
located outside of the United States are not material.
Segment Financial Information:
Service Center
Based Distribution Other Total
----------------------------------------------
YEAR ENDED JUNE 30, 2004
Net sales $1,419,386 $ 97,618 $1,517,004
Operating income 55,737 4,127 59,864
Assets used in the business 572,617 24,224 596,841
Depreciation 13,713 677 14,390
Capital expenditures 14,102 285 14,387
----------------------------------------------
Year Ended June 30, 2003
Net sales $1,373,961 $ 90,406 $1,464,367
Operating income (loss) 43,358 (420) 42,938
Assets used in the business 530,540 22,864 553,404
Depreciation 13,693 765 14,458
Capital expenditures 12,273 521 12,794
----------------------------------------------
Year Ended June 30, 2002
Net sales $1,354,793 $ 91,776 $1,446,569
Operating income (loss) 29,015 (2,049) 26,966
Assets used in the business 507,467 27,099 534,566
Depreciation 14,749 545 15,294
Capital expenditures 9,773 277 10,050
-----------------------------------------------
A reconciliation from the segment operating profit to the consolidated balance
is as follows:
Year Ended June 30
2004 2003 2002
------------------------------------
Operating income for reportable segment $ 55,737 $ 43,358 $ 29,015
Other operating income (loss) 4,127 (420) (2,049)
Adjustments for:
Goodwill and other intangibles amortization (826) (781) (1,651)
Corporate and other income (expense), net (a) (7,590) (5,903) 5,519
------------------------------------
Total operating income 51,448 36,254 30,834
Interest expense, net 5,409 5,298 6,738
Other (income) expense, net (432) 24 341
------------------------------------
Income before income taxes $ 46,471 $ 30,932 $ 23,755
====================================
(a) The change in corporate and other income (expense), net is due to various
changes in the levels and amounts of expenses being allocated to the
segments. The expenses being allocated include miscellaneous corporate
charges for working capital, logistics support and other items.
Net sales by product category are as follows:
Year Ended June 30
2004 2003 2002
----------------------------------------
Industrial $1,281,037 $1,243,377 $1,232,388
Fluid power (b) 235,967 220,990 214,181
----------------------------------------
Net sales $1,517,004 $1,464,367 $1,446,569
========================================
(b) The fluid power product category includes sales of hydraulic, pneumatic,
lubrication and filtration components and systems and repair services
through the Company's service centers as well as the fluid power businesses.
33
Applied Industrial Technologies, Inc. and Subsidiaries
Notes to Consolidated Financial Statements, Continued
NOTE_13: LITIGATION
The Company is a party to various pending judicial and administrative
proceedings. Based on circumstances currently known, the Company does not
believe that any liabilities that may result from these proceedings are
reasonably likely to have a material adverse effect on the Company's
consolidated financial position, results of operations, or cash flows.
NOTE_14: OTHER (INCOME) EXPENSE, NET
Other (income) expense, net consists of the following:
Year Ended June 30
2004 2003 2002
-----------------------------
Benefit from settlement of fiscal 2000 property
insurance claim $(2,133)
Loss on iSource 2,085
Unrealized (gain)/loss on deferred
compensation trusts $ (781) (30) $ 417
Unrealized (gain)/loss on cross currency swap 355 464 (88)
Other (6) (362) 12
-----------------------------
Total other (income) expense, net $ (432) $ 24 $ 341
=============================
During the year ended June 30, 2003, the Company recorded a liability consisting
of $1,150 for potential losses on the Company's investment in iSource, $550 for
allowances on advances to iSource and $385 for the Company's share of iSources's
net losses. In accordance with FIN 46, "Consolidation of Variable Interest
Entities," iSource's financial statements were consolidated with the
Company's beginning in July 2003 (see Notes 1 and 11 for further discussion on
iSource).
34
Report of Independent Registered Public Accounting Firm
[DELOITTE & TOUCHE LOGO]
Shareholders and Board of Directors
Applied Industrial Technologies, Inc.
We have audited the accompanying consolidated balance sheets of
Applied Industrial Technologies, Inc. and its subsidiaries (the
"Company") as of June 30, 2004 and 2003, and the related statements
of consolidated income, shareholders' equity, and cash flows for
each of the three years in the period ended June 30, 2004. 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 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, 2004 and 2003, and the results of its operations
and its cash flows for each of the three years in the period ended
June 30, 2004, in conformity with accounting principles generally
accepted in the United States of America.
As discussed in Notes 1 and 9 to the consolidated financial
statements, effective July 1, 2003, the Company changed its method
of accounting for stock-based compensation to conform to Statement
of Financial Accounting Standards No. 123, "Accounting for
Stock-Based Compensation."
As discussed in Note 1 to the consolidated financial
statements, effective July 1, 2001, the Company changed its method
of accounting for goodwill as a result of the adoption of Statement
of Financial Accounting Standards No. 142, "Goodwill and Other
Intangible Assets."
/s/ Deloitte & Touche LLP
Cleveland, Ohio
August 6, 2004
35
Applied Industrial Technologies, Inc. and Subsidiaries
Quarterly Operating Results and Market Data (Unaudited)
Per Common Share (D)
-----------------------------------------------
Income Income Net
Before Net Before Income Price Range
(Dollars in thousands, Net Gross Operating Cumulative Income Cumulative (loss)- Cash ----------------
except per share amounts) Sales Profit Income Effect (loss) Effect Diluted Dividend High Low
- ------------------------- ----- ------ ------ ------ ------ ------ ------- -------- ---- ---
2004 (A) (B)
First Quarter $ 361,146 $ 93,477 $ 8,996 $ 4,832 $ 4,832 $ 0.25 $ 0.25 $ 0.12 $ 22.99 $ 19.75
Second Quarter 359,711 95,166 9,250 5,133 5,133 0.26 0.26 0.12 24.86 19.85
Third Quarter 391,053 104,423 14,880 10,611 10,611 0.54 0.54 0.12 26.16 19.70
Fourth Quarter 405,094 109,077 18,322 10,895 10,895 0.55 0.55 0.12 30.35 22.45
----------- --------- -------- -------- -------- --------- ------ -------
$ 1,517,004 $ 402,143 $ 51,448 $ 31,471 $ 31,471 $ 1.60 $ 1.60 $ 0.48
=========== ========= ======== ======== ======== ========= ====== =======
2003 (A)
First Quarter $ 368,019 $ 89,902 $ 7,844 $ 3,905 $ 3,905 $ 0.20 $ 0.20 $ 0.12 $ 19.75 $ 14.81
Second Quarter 355,707 91,191 7,320 3,860 3,860 0.20 0.20 0.12 19.23 14.70
Third Quarter 368,203 97,732 10,154 4,383 4,383 0.23 0.23 0.12 18.85 15.36
Fourth Quarter 372,438 100,470 10,936 7,684 7,684 0.40 0.40 0.12 21.10 16.60
----------- --------- -------- -------- -------- --------- ------ -------
$ 1,464,367 $ 379,295 $ 36,254 $ 19,832 $ 19,832 $ 1.03 $ 1.03 $ 0.48
=========== ========= ======== ======== ======== ========= ====== =======
2002 (A)
First Quarter (C) $ 367,990 $ 92,431 $ 10,112 $ 4,889 $ (7,211) $ 0.25 $(0.38) $ 0.12 $ 19.13 $ 16.50
Second Quarter 347,550 87,013 6,032 2,918 2,918 0.15 0.15 0.12 19.46 16.00
Third Quarter 361,542 91,870 5,833 2,707 2,707 0.14 0.14 0.12 20.91 17.28
Fourth Quarter 369,487 94,376 8,857 4,241 4,241 0.22 0.22 0.12 21.25 18.61
----------- --------- -------- -------- -------- --------- ------ -------
$ 1,446,569 $ 365,690 $ 30,834 $ 14,755 $ 2,655 $ 0.76 $ 0.13 $ 0.48
=========== ========= ======== ======== ======== ========= ====== =======
(A) Cost of sales for interim financial statements are computed using estimated
gross profit percentages which are adjusted throughout the year based upon
available information. Adjustments to actual cost are primarily made based upon
the annual physical inventory and the effect of year-end inventory quantities on
LIFO costs. Fourth quarter adjustments in 2004, 2003 and 2002 increased gross
profit by $3,283, $4,410 and $3,171; net income by $2,131, $2,682 and $1,868 and
diluted net income per share by $0.11, $0.14, and $0.10 respectively. Reductions
in year end inventories during the fiscal years ended June 30, 2004, 2003 and
2002 resulted in liquidations of LIFO inventory quantities carried at lower
costs prevailing in prior years. The effect of these liquidations for the years
ended June 30, 2004, 2003 and 2002 increased gross profit by $672, $741 and
$915, net income by $420, $453 and $546 and diluted net income per share by
$0.02, $0.02 and $0.03 respectively.
(B) Effective July 1, 2003, the Company adopted for stock options the fair value
recognition provisions of SFAS 123, "Accounting for Stock-Based Compensation,"
using the modified prospective method for the transition. Under the modified
prospective method, stock based compensation cost recognized during this fiscal
year for stock options is the same as that which would have been recognized had
the fair value recognition provisions been applied to all awards granted after
July 1, 1995. During the year ended June 30, 2004, compensation expense recorded
for stock options compensation was $1,586, ($1,074 net of tax) or $0.05 per
share.
(C) Effective July 1, 2001, the Company adopted SFAS 142, "Goodwill and Other
Intangible Assets." Upon adoption the Company determined that goodwill
associated with its fluid power business was impaired. A non-cash charge
totaling $17,600, $12,100 after tax, has been recorded as a change in accounting
principle effective July 1, 2001 to write-off the remaining goodwill relating to
the fluid power business. See Note 1 to the Consolidated Financial Statements
for additional information.
(D) On August 16, 2004 there were 6,154 shareholders of record, including 3,604
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 16, 2004 was $29.30 per share.
37
Applied Industrial Technologies, Inc. and Subsidiaries
10 Year Summary
(Dollars in thousands, except per share
amounts and statistical data) 2004 2003 2002 2001
- --------------------------------------- ---- ---- ---- ----
Consolidated Operations-
Year Ended June 30
Net sales $ 1,517,004 $ 1,464,367 $ 1,446,569 $ 1,625,755
Operating income 51,448 36,254 30,834 55,001
Income before cumulative effect
of accounting change 31,471 19,832 14,755 28,048
Net income 31,471 19,832 2,655 28,048
Per share data
Income before cumulative effect
of accounting change
Basic 1.64 1.05 .77 1.43
Diluted 1.60 1.03 .76 1.41
Net Income
Basic 1.64 1.05 .14 1.43
Diluted 1.60 1.03 .13 1.41
Cash dividend .48 .48 .48 .48
Year End Position - June 30
Working capital $ 291,704 $ 259,359 $ 250,644 $ 279,001
Long-term debt 77,767 78,558 83,478 113,494
Total assets 596,841 553,404 534,566 578,854
Shareholders' equity 339,535 307,856 298,147 311,518
Year End Statistics - June 30
Current ratio 2.9 2.8 2.9 3.2
Operating facilities 434 440 449 469
Shareholders of record (A) 6,154 6,157 6,455 6,697
(A)Includes participant-shareholders in the Applied Industrial Technologies,
Inc. Retirement Savings Plan, and since 1998, shareholders in the Automatic
Dividend Reinvestment Plan.
38
2000 1999 1998 1997 1996 1995
---- ---- ---- ---- ---- ----
$ 1,601,084 $ 1,555,424 $ 1,518,615 $ 1,182,152 $ 1,164,778 $ 1,073,875
57,779 42,269 58,520 50,599 49,281 36,923
31,048 19,933 30,125 27,092 23,334 16,909
31,048 19,933 30,125 27,092 23,334 16,909
1.52 .93 1.40 1.47 1.26 .97
1.50 .93 1.38 1.44 1.25 .96
1.52 .93 1.40 1.47 1.26 .97
1.50 .93 1.38 1.44 1.25 .96
.48 .48 .47 .41 .36 .31
$ 255,132 $ 258,730 $ 221,766 $ 164,723 $ 151,956 $ 153,555
112,168 126,000 90,000 51,428 62,857 74,286
594,667 574,349 606,091 394,114 404,072 359,231
299,331 293,586 299,502 212,874 192,264 169,760
2.6 3.0 2.1 2.4 2.1 2.4
478 444 449 377 376 374
6,548 6,869 6,731 4,676 4,636 4,379
39