SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended DECEMBER 31, 2003 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ___________ to ____________ Commission File Number 1-2299 APPLIED INDUSTRIAL TECHNOLOGIES, INC. - -------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) Ohio 34-0117420 - -------------------------------------------------------------------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) One Applied Plaza, Cleveland, Ohio 44115 - -------------------------------------------------------------------------------- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (216) 426-4000 - -------------------------------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ] Shares of common stock outstanding on January 31, 2004 19,392,190 ------------------------------------------ (No par value)
APPLIED INDUSTRIAL TECHNOLOGIES, INC. AND SUBSIDIARIES INDEX <TABLE> <CAPTION> Page No. <S> <C> Part I: FINANCIAL INFORMATION Item 1: Financial Statements Condensed Statements of Consolidated Income - 2 Three Months and Six Months Ended December 31, 2003 and 2002 Condensed Consolidated Balance Sheets - 3 December 31, 2003 and June 30, 2003 Condensed Statements of Consolidated Cash Flows - 4 Six Months Ended December 31, 2003 and 2002 Notes to Condensed Consolidated Financial Statements 5 -10 Review By Independent Public Accountants 11 Item 2: Management's Discussion and Analysis of 12-17 Financial Condition and Results of Operations Item 3: Quantitative and Qualitative Disclosures About Market Risk 18 Item 4: Controls and Procedures 19 Part II: OTHER INFORMATION Item 1: Legal Proceedings 20 Item 4: Submission of Matters to a Vote of Security Holders 20 Item 6: Exhibits and Reports on Form 8-K 20 Signatures 22 Exhibit Index Exhibits </TABLE>
PART I: FINANCIAL INFORMATION ITEM I: Financial Statements APPLIED INDUSTRIAL TECHNOLOGIES, INC. AND SUBSIDIARIES CONDENSED STATEMENTS OF CONSOLIDATED INCOME (Unaudited) (Thousands, except per share amounts) <TABLE> <CAPTION> THREE MONTHS ENDED SIX MONTHS ENDED DECEMBER 31 DECEMBER 31 2003 2002 2003 2002 ---------------------------- ---------------------------- <S> <C> <C> <C> <C> Net Sales $ 359,711 $ 355,707 $ 720,857 $ 723,726 Cost of sales 264,545 264,516 532,214 542,633 ------------ ------------ ------------ ------------ Gross Profit 95,166 91,191 188,643 181,093 Selling, distribution and administrative expenses 85,916 83,871 170,397 165,929 ------------ ------------ ------------ ------------ Operating Income 9,250 7,320 18,246 15,164 Interest expense, net 1,405 1,342 2,723 2,603 Other, net (108) 38 58 326 ------------ ------------ ------------ ------------ Income Before Income Taxes 7,953 5,940 15,465 12,235 Income Taxes 2,820 2,080 5,500 4,470 ------------ ------------ ------------ ------------ Net Income (Loss) $ 5,133 $ 3,860 $ 9,965 $ 7,765 ============ ============ ============ ============ Earnings Per Share - Basic $ 0.27 $ 0.20 $ 0.52 $ 0.41 ============ ============ ============ ============ Earnings Per Share - Diluted $ 0.26 $ 0.20 $ 0.51 $ 0.40 ============ ============ ============ ============ Cash dividends per common share $ 0.12 $ 0.12 $ 0.24 $ 0.24 ============ ============ ============ ============ Weighted average common shares outstanding for basic computation 19,227 18,954 19,117 18,985 Dilutive effect of stock options and awards 410 279 423 282 ------------ ------------ ------------ ------------ Adjusted average common shares outstanding for diluted computation 19,637 19,233 19,540 19,267 ============ ============ ============ ============ </TABLE> See notes to condensed consolidated financial statements. 2
APPLIED INDUSTRIAL TECHNOLOGIES, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited) (Amounts in thousands) <TABLE> <CAPTION> DECEMBER 31 JUNE 30 2003 2003 ----------- --------- <S> <C> <C> ASSETS Current assets Cash and temporary investments $ 24,401 $ 55,079 Accounts receivable, less allowances of $6,200 and $6,100 170,074 173,915 Inventories (at LIFO) 191,249 159,798 Other current assets 13,536 11,702 ----------- --------- Total current assets 399,260 400,494 Property, less accumulated depreciation of $92,746 and $85,836 81,207 77,942 Goodwill 50,433 49,687 Other assets 25,600 25,281 ----------- --------- TOTAL ASSETS $ 556,500 $ 553,404 =========== ========= LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities Accounts payable $ 74,040 $ 75,411 Other accrued liabilities 58,592 65,724 ----------- --------- Total current liabilities 132,632 141,135 Long-term debt 78,163 78,558 Other liabilities 26,684 25,855 ----------- --------- TOTAL LIABILITIES 237,479 245,548 ----------- --------- 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 86,498 84,898 Income retained for use in the business 295,079 289,724 Treasury shares - at cost, 4,763 and 5,076 shares (74,418) (78,706) Unearned restricted common stock compensation (31) (114) Accumulated other comprehensive income 1,893 2,054 ----------- --------- TOTAL SHAREHOLDERS' EQUITY 319,021 307,856 ----------- --------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 556,500 $ 553,404 =========== ========= </TABLE> See notes to condensed consolidated financial statements. 3
APPLIED INDUSTRIAL TECHNOLOGIES, INC. AND SUBSIDIARIES CONDENSED STATEMENTS OF CONSOLIDATED CASH FLOWS (Unaudited) (Amounts in thousands) <TABLE> <CAPTION> Six Months Ended December 31 2003 2002 -------- -------- <S> <C> <C> Cash Flows from Operating Activities Net income $ 9,965 $ 7,765 Adjustments to reconcile net income to cash provided by (used in) operating activities: Depreciation and amortization 8,491 7,953 Gain on sale of property (89) (2,577) Treasury shares contributed to employee benefit and deferred compensation plans 3,775 1,724 Changes in operating assets and liabilities, net of effects from acquisition of businesses (35,053) 8,063 Other - net (395) (330) -------- -------- Net Cash provided by (used in) Operating Activities (13,306) 22,598 -------- -------- Cash Flows from Investing Activities Property purchases (10,317) (5,049) Proceeds from property sales 373 5,151 Net cash paid for acquisition of businesses, net of cash (1,285) (10,255) Deposits and other (149) 1,426 -------- -------- Net Cash used in Investing Activities (11,378) (8,727) -------- -------- Cash Flows from Financing Activities Borrowings and (repayments) - net (2,850) Long-term debt repayments (5,714) Proceeds from termination of interest rate swap 2,517 Dividends paid (4,610) (4,596) Purchases of treasury shares (2,091) (3,934) Exercise of stock options 3,557 275 -------- -------- Net Cash used in Financing Activities (5,994) (11,452) -------- -------- Increase (decrease) in cash and temporary investments (30,678) 2,419 Cash and temporary investments at beginning of period 55,079 23,060 -------- -------- Cash and Temporary Investments at End of Period $ 24,401 $ 25,479 ======== ======== </TABLE> See notes to condensed consolidated financial statements. 4
APPLIED INDUSTRIAL TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Amounts in thousands, except per share amounts) (Unaudited) 1. BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and therefore do not include all information and footnotes necessary for a fair presentation of financial position, results of operations and cash flows in conformity with generally accepted accounting principles. However, in the opinion of management, all adjustments (consisting of only normal recurring adjustments) necessary to a fair statement of operations of the interim periods have been made. This Quarterly Report on Form 10-Q should be read in conjunction with the Applied Industrial Technologies, Inc. (the Company) Annual Report on Form 10-K for the year ended June 30, 2003. The results of operations for the three and six month periods ended December 31, 2003 are not necessarily indicative of the results to be expected for the fiscal year. 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 made based on periodic physical inventories and the effect of year-end inventory quantities on LIFO costs. 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 consolidated statements of income. 2. SEGMENT INFORMATION The accounting policies of the Company's reportable segment and its other businesses are the same as those used to prepare the condensed consolidated financial statements. 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 significant. Operating results are in the United States, Canada, Mexico and Puerto Rico. Operations in Canada, Mexico and Puerto Rico represent approximately 9.0% of the total net sales of Applied for the six months ended December 31, 2003 and therefore are not presented separately. In addition, approximately 31.1% 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. 5
APPLIED INDUSTRIAL TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Amounts in thousands, except per share amounts) (Unaudited) SEGMENT FINANCIAL INFORMATION: <TABLE> <CAPTION> SERVICE CENTER BASED DISTRIBUTION OTHER TOTAL -------------- ----------- ----------- <S> <C> <C> <C> THREE MONTHS ENDED DECEMBER 31, 2003 Net sales $ 335,633 $ 24,078 $ 359,711 Operating income 10,844 1,299 12,143 Depreciation 3,707 167 3,874 Capital expenditures 1,552 23 1,575 -------------- ----------- ----------- THREE MONTHS ENDED DECEMBER 31, 2002 Net sales $ 333,964 $ 21,743 $ 355,707 Operating income 8,423 13 8,436 Depreciation 3,253 192 3,445 Capital expenditures 1,988 177 2,165 -------------- ----------- ----------- </TABLE> A reconciliation from the segment operating profit to the condensed consolidated balances is as follows: <TABLE> <CAPTION> THREE MONTHS ENDED DECEMBER 31 -------------------------- 2003 2002 ----------- ----------- <S> <C> <C> Operating income for reportable segment $ 10,844 $ 8,423 Other operating income 1,299 13 Adjustments for: Other intangible amortization (188) (174) Corporate and other income (expense), net of allocations (a) (2,705) (942) ----------- ----------- Total operating income 9,250 7,320 Interest expense, net 1,405 1,342 Other expense, net (108) 38 ----------- ----------- Income before income taxes $ 7,953 $ 5,940 =========== =========== </TABLE> SEGMENT FINANCIAL INFORMATION: <TABLE> <CAPTION> SERVICE CENTER BASED DISTRIBUTION OTHER TOTAL -------------- ----------- ----------- <S> <C> <C> <C> SIX MONTHS ENDED DECEMBER 31, 2003 Net sales $ 673,536 $ 47,321 $ 720,857 Operating income 20,647 2,011 22,658 Assets used in the business 532,514 23,986 556,500 Depreciation 7,008 337 7,345 Capital expenditures 10,254 63 10,317 -------------- ----------- ----------- </TABLE> 6
APPLIED INDUSTRIAL TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Amounts in thousands, except per share amounts) (Unaudited) <TABLE> <S> <C> <C> <C> SIX MONTHS ENDED DECEMBER 31, 2002 Net sales $ 678,934 $ 44,792 $ 723,726 Operating income 17,886 73 17,959 Assets used in the business 510,911 24,009 534,920 Depreciation 6,792 366 7,158 Capital expenditures 4,720 329 5,049 ----------- ------------ ------------- </TABLE> A reconciliation from the segment operating profit to the condensed consolidated balances is as follows: <TABLE> <CAPTION> SIX MONTHS ENDED DECEMBER 31 -------------------------- 2003 2002 ----------- ----------- <S> <C> <C> Operating income for reportable segment $ 20,647 $ 17,886 Other operating income 2,011 73 Adjustments for: Other intangible amortization (377) (417) Corporate and other income (expense), net of allocations (a) (4,035) (2,378) ----------- ----------- Total operating income 18,246 15,164 Interest expense, net 2,723 2,603 Other expense, net 58 326 ----------- ------------ Income before income taxes $ 15,465 $ 12,235 =========== =========== </TABLE> (a) The change in corporate and other income (expense), net, is due to various changes in the levels and amounts of expense being allocated to the segments. The expenses being allocated include corporate charges for working capital, logistics support and other items. 3. GUARANTEES 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. The Company purchased the properties for $7,500 at the end of the lease term in September 2003. 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 Performance Materials, L.L.C. (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. 7
APPLIED INDUSTRIAL TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Amounts in thousands, except per share amounts) (Unaudited) 4. STOCK OPTIONS Effective July 1, 2003, the Company adopted the fair value recognition provisions of SFAS 123, "Accounting for Stock-Based Compensation" as amended by SFAS 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 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. Results for prior years have not been restated. The compensation expense recorded during the quarter and six months ended December 31, 2003 was $327, $211 net of tax, or $0.01 per share and $686, $442 net of tax, or $0.02 per share, respectively. The following table discloses the compensation expense and net income as if the fair value based method had been applied in each period: <TABLE> <CAPTION> Three Months Ended Six Months Ended December 31 December 31 ---------------------- ---------------------- 2003 2002 2003 2002 --------- --------- --------- --------- <S> <C> <C> <C> <C> Net income, as reported $ 5,133 $ 3,860 $ 9,965 $ 7,765 Plus: Stock-based employee compensation expense included in reported net income, net of related tax effects 211 442 Less: Total stock-based employee compensation expense determined under fair value based method, net of tax (211) (336) (442) (644) ========= ========= ========= ========= Pro forma net income $ 5,133 $ 3,524 $ 9,965 $ 7,121 ========= ========= ========= ========= Earnings per share: Basic - as reported $ 0.27 $ 0.20 $ 0.52 $ 0.41 ========= ========= ========= ========= Basic - pro forma $ 0.27 $ 0.19 $ 0.52 $ 0.38 ========= ========= ========= ========= Diluted - as reported $ 0.26 $ 0.20 $ 0.51 $ 0.40 ========= ========= ========= ========= Diluted - pro forma $ 0.26 $ 0.18 $ 0.51 $ 0.37 ========= ========= ========= ========= </TABLE> Compensation expense has been determined using the Black-Scholes option-pricing model. The assumptions used for grants issued during the six months ended December 31, 2003 and 2002 are: 8
APPLIED INDUSTRIAL TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Amounts in thousands, except per share amounts) (Unaudited) <TABLE> <CAPTION> SIX MONTHS ENDED DECEMBER 31 ------------------ 2003 2002 ------- ------- <S> <C> <C> Expected life 7 years 7 years Risk free interest rate 3.8% 3.9% Dividend yield 3.0% 3.0% Volatility 31.7% 30.9% </TABLE> 5. CONSOLIDATION OF VARIABLE INTEREST ENTITIES In January 2003, the Financial Accounting Standards Board issued 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 $2,500 and accounts payable of $2,300. In December 2003, the Company paid the outstanding amount of $2,990 of bank debt 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. The effect of the consolidation was not material to the Company's consolidated financial statements. 6. BUSINESS COMBINATION 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. Results of operations for this acquisition are not material for all periods presented. Other intangibles of $880, consisting of customer relationships and non-competition agreements were recognized in connection with this combination and will be amortized over a period of seven to ten years. The preliminary fair value of the acquired assets and liabilities assumed at the date of acquisition are as follows: <TABLE> <S> <C> Cash $ 815 Accounts receivable 2,313 Inventory 1,815 Other current assets 90 Property 238 Other assets 7 Goodwill 398 Other intangibles 880 --------- Total assets acquired 6,556 Liabilities assumed 3,756 --------- Net assets acquired $ 2,800 ========= </TABLE> 9
APPLIED INDUSTRIAL TECHNOLOGIES, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Amounts in thousands, except per share amounts) (Unaudited) 7. DEBT During the quarter ended December 31, 2003, the Company replaced its existing revolving credit facility with a new, five year 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 December 31, 2003. 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, totaling $92,114, are available to fund future acquisitions or other capital and operating requirements. 8. NEW ACCOUNTING STANDARD During December 2003, the FASB issued a revision to Statement of Financial Accounting Standards No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits, an amendment of FASB Statements No. 87, 88, and 106," which expands the disclosure requirements regarding plan assets and benefit obligations for the Company's benefit and pension plans. Certain provisions of this statement are effective for the third quarter of fiscal 2004, while the remaining provisions relating to the annual financial statement disclosures, are effective for the fiscal year ending June 30, 2004. 10
APPLIED INDUSTRIAL TECHNOLOGIES, INC. AND SUBSIDIARIES REVIEW BY INDEPENDENT PUBLIC ACCOUNTANTS The accompanying condensed consolidated financial statements of the Company have been reviewed by the Company's independent accountants, Deloitte & Touche LLP, whose report covering their review of the financial statements follows. INDEPENDENT ACCOUNTANTS' REPORT Applied Industrial Technologies, Inc. We have reviewed the accompanying condensed consolidated balance sheet of Applied Industrial Technologies, Inc. and subsidiaries (the "Company") as of December 31, 2003, and the related condensed statements of consolidated income for the three-month and six-month periods ended December 31, 2003 and 2002, and of consolidated cash flows for the six-month periods ended December 31, 2003 and 2002. These interim financial statements are the responsibility of the Company's management. We conducted our reviews in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States of America, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our reviews, we are not aware of any material modifications that should be made to such condensed consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America. We have previously audited, in accordance with auditing standards generally accepted in the United States of America, the consolidated balance sheet of Applied Industrial Technologies, Inc. and subsidiaries as of June 30, 2003, and the related statements of consolidated income, shareholders' equity, and cash flows for the year then ended (not presented herein); and in our report dated August 8, 2003, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of June 30, 2003 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived. As discussed in Note 4 to the condensed consolidated interim financial statements, effective July 1, 2003, the Company changed its method of accounting for stock-based compensation and adopted the fair value recognition provisions of SFAS 123 "Accounting for Stock-Based Compensation," as amended by SFAS 148, "Accounting for Stock-Based Compensation - Transition and Disclosure." /s/ Deloitte & Touche LLP Cleveland, Ohio February 6, 2004 11
APPLIED INDUSTRIAL TECHNOLOGIES, INC. AND SUBSIDIARIES ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following is Management's Discussion and Analysis of certain significant factors which have affected the Company's (1) financial condition at December 31, 2003 and June 30, 2003, and (2) results of operations and cash flows during the periods included in the accompanying Condensed Statements of Consolidated Income and Consolidated Cash Flows. Overview During the quarter, income increased 33.0% compared to the same quarter in the prior year. Sales increased 1.1% primarily due to our Canadian operations. Gross margin performance was improved as our initiatives in the areas of product pricing, freight recovery, cost controls and asset management continue to show progress. The balance sheet remains solid. Inventories increased $27.2 million from September balances primarily due to special calendar year-end buying opportunities. These inventories of standard product are expected to be sold off in the normal course of business. We expect the total inventory dollars to return to the June 30, 2003 levels by the end of fiscal 2004. The Company monitors the ISM Purchasing Managers Index (ISM) and the government's Manufacturers Capacity Utilization (MCU) index and considers these indexes key indicators of potential Company business environment changes. The ISM has increased recently and the MCU had increased for the 4th consecutive month. The Company's performance traditionally lags these key indicators by approximately 6 months. Therefore, the Company expects relatively flat sales on a sales per day basis for the fiscal third quarter with improvement possible in the 4th quarter of fiscal 2004. The Company expects to sustain our improvements in profitability. We anticipate fiscal third quarter gross profit levels to be in the range of 26.0% to 26.5%. We anticipate that a decline in rebates during the remainder of the year will continue to be offset by improvements in freight recovery, pricing and asset management. We expect selling, distribution and administrative expenses for the third quarter to be relatively flat compared to the prior year. Liquidity and Capital Resources Cash used in operating activities was $13.3 million in the six months ended December 31, 2003. This compares to $22.6 million provided by operating activities in the same period a year ago. Cash flow from operations depends primarily upon generating operating income, controlling the investment in inventories and receivables, and managing the timing of payments to suppliers. In the area of inventory, the Company has attempted to secure cost advantages by buying product through special vendor purchasing programs. In addition, the Company has made system enhancements in recent quarters to improve inventory tracking and receivables collection efforts. During the six month period ended December 31, 2003, inventories increased approximately $31.5 million primarily due to purchases made under special calendar year-end programs offered by certain of our suppliers. These inventories of standard product are expected to be sold in the normal course of business. The inventory increase also includes $2.3 million from the 12
APPLIED INDUSTRIAL TECHNOLOGIES, INC. AND SUBSIDIARIES ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS consolidation of iSource resulting from the adoption of FIN 46 and $1.8 million from the acquisition of a Mexican distributor (see notes to the condensed consolidated financial statements). Accounts receivable decreased $3.8 million during the six months ended December 31, 2003 due to improved collections and accounts payable and other accrued liabilities decreased $12.0 million due to the payment during the period of fiscal year-end accrued compensation benefits. Capital expenditures were $10.3 million for the period ended December 31, 2003 compared to $5.0 million in the prior year. In September 2003, the Company purchased, for $7.5 million, four operating facilities which had previously been leased (see notes to the condensed consolidated financial statements). For the entire year we expect our total capital expenditures to be approximately $15.0 million. Our depreciation and amortization for the entire year is expected to be within the range of $16.0 million to $17.0 million. During the quarter ended December 31, 2003, the Company replaced its existing revolving credit facility with a new $100 million revolving credit facility with a group of banks expiring in November 2008. The Company had no borrowings outstanding under this facility at December 31, 2003. Unused lines under this facility, net of outstanding letters of credit, totaling $92.1 million are available to fund future acquisitions or other capital and operating requirements. Additionally, the Company is currently negotiating with Prudential Insurance Company for an uncommitted shelf facility that would enable the Company to borrow up to $100 million in additional long-term financing at the Company's sole discretion. This shelf agreement will replace a previously unused facility that expired on October 31, 2003. The new facility is expected to be completed by the end of February, 2004. At December 31, 2003, the Company had $25.0 million of private placement debt outstanding that was entered into to refinance a portion of the debt incurred in connection with its 2000 Canadian acquisition. The full $25.0 million is due at maturity in November 2010. The Company has mitigated the foreign currency exposure though the use of cross currency swaps on the $25.0 million of debt. The aggregate annual maturities of long-term debt include $50.0 million in fiscal 2008 and $25.0 million in fiscal 2011. The Board of Directors has authorized the purchase of shares of the Company's common stock to fund employee benefit programs, stock option and award programs, and future business acquisitions. These purchases are made in open market and negotiated transactions, from time to time, depending upon market conditions. The Company acquired 96,000 shares of its common stock for $2.1 million during the six months ended December 31, 2003 compared to 232,000 shares for $3.9 million during the six months ended December 31, 2002. At December 31, 2003, the Company had remaining authorization to repurchase up to 1 million additional shares. 13
APPLIED INDUSTRIAL TECHNOLOGIES, INC. AND SUBSIDIARIES ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Other Matters In November 2003, the Company acquired the stock of a Mexican distributor of industrial products for approximately $2.8 million. The acquisition was paid for from our cash balances. The results of the acquired operations are not material for all periods presented. The acquired operations are reported in our service center based distribution segment from the acquisition date. In January 2003, the Financial Accounting Standards Board issued FIN 46, "Consolidation of Variable Interest Entities." The Company is a minority owner in iSource Performance Materials L.L.C. (iSource). iSource has assets of $2.5 million and accounts payable of $2.3 million. In December 2003, the Company paid the outstanding amount of $3.0 million of bank debt 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. The effect of the consolidation was not material to the Company's consolidated financial statements. Effective July 1, 2003, the Company adopted 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 stock option awards granted after July 1, 1995. The compensation expense recorded during the quarter and six months ended December 31, 2003 related to stock options was $.3 million, or $.01 per share after tax and $.7 million or $.02 per share after tax, respectively. RESULTS OF OPERATIONS THREE MONTHS ENDED DECEMBER 31, 2003 AND 2002 Net sales increased 1.1% compared to the prior year primarily due to the strength of performance of our Canadian operations. Service center based same store sales in the U.S. decreased 1.5% compared to those in the same quarter last year. The U.S. fluid power sales also declined 5.1% during the quarter. Gross profit as a percentage of sales increased to 26.5% from 25.6%. This increase is primarily due to higher recovery of our shipping expenses, lower freight costs and improvements from product pricing initiatives. The increase was also due to recording cost adjustments during the quarter related to inventory cycle counting programs and interim inventory reconciliations. In the prior year, these factors were incorporated to a greater extent in the 4th quarter annual physical inventory results. These factors were offset somewhat by lower purchase rebates from our product suppliers. 14
APPLIED INDUSTRIAL TECHNOLOGIES, INC. AND SUBSIDIARIES ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Selling, distribution and administrative expenses increased 2.4% compared to the prior year. The difference primarily relates to a relatively high level of gains on the sales of unneeded real estate and other property in the prior year. These gains are recorded as a reduction in selling, distribution and administrative expense. Health care and other benefit expenses increased versus last year and the Company also began to expense stock options during the quarter ended September 30, 2003. Interest expense-net for the quarter increased by 4.7% as compared to the prior year as a result of the consolidation of iSource (see notes to the condensed consolidated financial statements). Income tax expense as a percentage of income before taxes was 35.5% for the quarter ended December 31, 2003 compared to 35.0% for the quarter ended December 31, 2002 and 35.9% for all of fiscal 2003. As a result of the above factors, net income increased by 33.0% compared to the same quarter of last year and earnings per share increased 30.0%. SIX MONTHS ENDED DECEMBER 31, 2003 AND 2002 Net sales decreased slightly compared to the prior year. Same store sales for our U.S. service centers decreased 3.3% compared to those in the same period last year. The U.S. fluid power sales also declined 7.1% during the period. Offsetting the decrease was an increase in Canadian sales. While a portion of this increase was due to the strengthening of the Canadian dollar, the majority relates to actual year over year volume increases. Gross profit as a percentage of sales increased to 26.2% from 25.0%. This increase is primarily due to higher recovery of our shipping expenses, lower freight costs and improvements from product pricing initiatives. The increase was also due to recording throughout the year, cost adjustments related to inventory cycle counting programs and interim inventory reconciliations. In the prior year, these factors were incorporated to a greater extent in the 4th quarter annual physical inventory results. These factors were offset somewhat by lower purchase rebates from our product suppliers. Selling, distribution and administrative expenses increased 2.7% compared to the prior year. The difference primarily relates to a relatively high level of gains on the sales of unneeded real estate and other property in the prior year. Health care and other benefit expenses increased versus last year and the Company also began to expense stock options during the quarter ended September 30, 2003. 15
APPLIED INDUSTRIAL TECHNOLOGIES, INC. AND SUBSIDIARIES ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Interest expense-net for the quarter increased by 4.6% as compared to the prior year as a result of lower interest income and the consolidation of iSource (see notes to the condensed consolidated financial statements). Income tax expense as a percentage of income before taxes was 35.6% for the period ended December 31, 2003 compared to 36.5% for the period ended December 31, 2002. This decrease is due to a lower proportion of non-deductible expenses and lower effective state, local and Canadian tax rates. As a result of the above factors, net income increased by 28.3% compared to the same period of last year and earnings per share increased 27.5%. 16
APPLIED INDUSTRIAL TECHNOLOGIES, INC. AND SUBSIDIARIES ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CAUTIONARY STATEMENT UNDER PRIVATE SECURITIES LITIGATION REFORM ACT Management's Discussion and Analysis and other sections of this Form 10-Q contain statements that are forward-looking, based on management's current expectations about the future. Forward-looking statements are often identified by qualifiers such as "expect", "believe", "anticipate", "should", "project", "forecast", "will", 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, many of which are outside the Company's control. Accordingly, actual results may differ materially from those expressed in the forward-looking statements, and the making of 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 industries; reduction in manufacturing capacity in the Company's targeted geographic markets due to consolidation in customer industries or the transfer of manufacturing capacity to foreign countries; changes in interest rates; changes in customer procurement policies and practices; changes in product manufacturer sales policies and practices; the availability of product and labor; changes in operating expenses; the effect of price increases or decreases in both procuring and selling products and services; the variability and timing of business opportunities including acquisitions, alliances, customer agreements and supplier authorizations; the Company's ability to realize the anticipated benefits of acquisitions and marketing and other business strategies; the incurrence of additional debt and contingent liabilities in connection with acquisitions; changes in accounting policies and practices; the effect of 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 expansion into foreign markets, including inflation rates, 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, war, natural events and acts of God, fires, floods and accidents). 17
APPLIED INDUSTRIAL TECHNOLOGIES, INC. AND SUBSIDIARIES ITEM 3: 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 and variable rate borrowings under its committed revolving credit agreement and interest rate swaps. The Company had no variable rate borrowings outstanding under its committed revolving credit agreement at December 31, 2003. The Company has no interest rate swap agreements outstanding, therefore, all of the Company's outstanding long-term debt is currently at fixed interest rates at December 31, 2003 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 of foreign-currency denominated debt. Hedging of the US dollar denominated debt used to fund a substantial portion of 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 because the Mexican activity is not material. The impact on the Company's future earnings from exposure to changes in foreign currency exchange rates is expected to be immaterial. 18
APPLIED INDUSTRIAL TECHNOLOGIES, INC. AND SUBSIDIARIES ITEM 4: CONTROLS AND PROCEDURES Management, under the supervision and with the participation of the Chief Executive Officer (CEO) and the Chief Financial Officer (CFO), has evaluated the Company's disclosure controls and procedures as of the end of the period covered by this report. Based upon that evaluation, the CEO and the CFO have concluded that the disclosure controls and procedures are effective in timely alerting them to material information about the Company required to be included in the Company's Exchange Act reports. Management has not identified any change in internal control over financial reporting occurring during the quarter ended December 31, 2003 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. 19
PART II. OTHER INFORMATION ITEM 1. Legal Proceedings. Applied Industrial Technologies, Inc. and/or one of its subsidiaries 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. ITEM 4. Submission of Matters to a Vote of Security Holders. At the Company's Annual Meeting of Shareholders held on October 21, 2003, the Shareholders (i) elected Thomas A. Commes, Peter A. Dorsman, J. Michael Moore, and Dr. Jerry Sue Thornton as Directors for terms expiring in 2006, (ii) ratified the appointment of Deloitte & Touche LLP as the Company's independent auditors for the fiscal year ending June 30, 2004, (iii) approved the Deferred Compensation Plan for Non-Employee Directors, and (iv) approved the Deferred Compensation Plan. Substantially the same information was previously reported in Part II, Item 5 "Other Information" of the Company's Form 10-Q for the quarter ended September 30, 2003. ITEM 6. Exhibits and Reports on Form 8-K. (a) Exhibits. Exhibit No. Description 3(a) Amended and Restated Articles of Incorporation of Applied Industrial Technologies, Inc., as amended on October 8, 1998 (filed as Exhibit 3(a) to the Company's Form 10-Q for the quarter ended September 30, 1998, SEC File No. 1-2299, and incorporated here by reference). 3(b) Code of Regulations of Applied Industrial Technologies, Inc., as amended on October 19, 1999 (filed as Exhibit 3(b) to the Company's Form 10-Q for the quarter ended September 30, 1999, SEC File No. 1-2299, and incorporated here by reference). 4(a) Certificate of Merger of Bearings, Inc. (Ohio) and Bearings, Inc. (Delaware) filed with the Ohio Secretary of State on October 18, 1988, including an Agreement and Plan of 20
Reorganization dated September 6, 1988 (filed as Exhibit 4(a) to the Company's Registration Statement on Form S-4 filed May 23, 1997, Registration No. 333-27801, and incorporated here by reference). 4(b) Private Shelf Agreement dated as of November 27, 1996, as amended on January 30, 1998, between the Company and The Prudential Insurance Company of America (filed as Exhibit 4(f) to the Company's Form 10-Q for the quarter ended March 31, 1998, SEC File No. 1-2299, and incorporated here by reference). 4(c) Amendment dated October 24, 2000 to 1996 Private Shelf Agreement between the Company and The Prudential Insurance Company of America (filed as Exhibit 4(e) to the Company's Form 10-Q for the quarter ended September 30, 2000, SEC File No. 1-2299, and incorporated here by reference). 4(d) Amendment dated November 14, 2003 to 1996 Private Shelf Agreement between the Company and The Prudential Insurance Company of America. 4(e) $100,000,000 Credit Agreement dated as of October 31, 2003 among the Company, KeyBank National Association as Agent, and various financial institutions. 4(f) Rights Agreement, dated as of February 2, 1998, between the Company and Computershare Investor Services LLP (successor to Harris Trust and Savings Bank), as Rights Agent, which includes as Exhibit B thereto the Form of Rights Certificate (filed as Exhibit No. 1 to the Company's Registration Statement on Form 8-A filed July 20, 1998, SEC File No. 1-2299, and incorporated here by reference). 10 First Amendment to the Company's Deferred Compensation Plan (September 1, 2003 Restatement). 15 Letter from independent accountants regarding unaudited interim financial information. 31 Rule 13a-14(a)/15d-14(a) certifications. 21
32 Section 1350 certifications. Applied will furnish a copy of any exhibit described above and not contained herein upon payment of a specified reasonable fee which shall be limited to Applied's reasonable expenses in furnishing the exhibit. Certain instruments with respect to long-term debt have not been filed as exhibits because the total amount of securities authorized under any one of the instruments does not exceed 10 percent of the total assets of Applied and its subsidiaries on a consolidated basis. Applied agrees to furnish to the Securities and Exchange Commission, upon request, a copy of each such instrument. (b) Reports on Form 8-K. The Company filed the following Report on Form 8-K with the Securities and Exchange Commission during the quarter ended December 31, 2003: 1. Filing on October 14, 2003 - the Company attached its press release of October 13, 2003, regarding first quarter earnings. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized. APPLIED INDUSTRIAL TECHNOLOGIES, INC. (Company) Date: February 9, 2004 By: /s/ David L. Pugh ---------------------------------- David L. Pugh Chairman & Chief Executive Officer Date: February 9, 2004 By: /s/ Mark O. Eisele ---------------------------------- Mark O. Eisele Vice President-Chief Financial Officer & Treasurer 22
APPLIED INDUSTRIAL TECHNOLOGIES, INC. EXHIBIT INDEX TO FORM 10-Q FOR THE QUARTER ENDED DECEMBER 31, 2003 EXHIBIT NO. DESCRIPTION 3(a) Amended and Restated Articles of Incorporation of Applied Industrial Technologies, Inc., as amended on October 8, 1998 (filed as Exhibit 3(a) to the Company's Form 10-Q for the quarter ended September 30, 1998, SEC File No. 1-2299, and incorporated here by reference). 3(b) Code of Regulations of Applied Industrial Technologies, Inc., as amended on October 19, 1999 (filed as Exhibit 3(b) to the Company's Form 10-Q for the quarter ended September 30, 1999, SEC File No. 1-2299, and incorporated here by reference). 4(a) Certificate of Merger of Bearings, Inc. (Ohio) and Bearings, Inc. (Delaware) filed with the Ohio Secretary of State on October 18, 1988, including an Agreement and Plan of Reorganization dated September 6, 1988 (filed as Exhibit 4(a) to the Company's Registration Statement on Form S-4 filed May 23, 1997, Registration No. 333-27801, and incorporated here by reference). 4(b) Private Shelf Agreement dated as of November 27, 1996, as amended on January 30, 1998, between the Company and The Prudential Insurance Company of America (filed as Exhibit 4(f) to the Company's Form 10-Q for the quarter ended March 31, 1998, SEC File No. 1-2299, and incorporated here by reference). 4(c) Amendment dated October 24, 2000 to November 27, 1996 Private Shelf Agreement between the Company and The Prudential Insurance Company of America (filed as Exhibit 4(e) to the Company's Form 10-Q for the quarter ended September 30, 2000, SEC File No. 1-2299, and incorporated here by reference).
4(d) Amendment dated November 14, 2003 to 1996 Attached Private Shelf Agreement between the Company and The Prudential Insurance Company of America. 4(e) $100,000,000 Credit Agreement dated as of Attached October 31, 2003 among the Company, KeyBank National Association as Agent, and various financial institutions. 4(f) Rights Agreement, dated as of February 2, 1998, between the Company and Computershare Investor Services LLP (successor to Harris Trust and Savings Bank), as Rights Agent, which includes as Exhibit B thereto the Form of Rights Certificate (filed as Exhibit No. 1 to the Company's Registration Statement on Form 8-A filed July 20, 1998, SEC File No. 1-2299, and incorporated here by reference). 10 First Amendment to the Company's Deferred Attached Compensation Plan (September 1, 2003 Restatement). 15 Letter from independent accountants regarding Attached unaudited interim financial information. 31 Rule 13a-14(a)/15d-14(a) certifications. Attached 32 Section 1350 certifications. Attached