APPLIED INDUSTRIAL TECHNOLOGIES INC (AIT)

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS.

OVERVIEW

With approximately 6,500 associates across North America, Australia, New Zealand, and Singapore, Applied Industrial Technologies, Inc. ("Applied," the "Company," "we," "us," or "our") is a leading value-added distributor and technical solutions provider of industrial motion, fluid power, flow control, automation technologies, and related maintenance supplies. Our leading brands, specialized services, and comprehensive knowledge serve MRO (Maintenance, Repair & Operations) and OEM (Original Equipment Manufacturer) end users in virtually all industrial markets through our multi-channel capabilities that provide choice, convenience, and expertise. We have a long tradition of growth dating back to 1923, the year our business was founded in Cleveland, Ohio. At June 30, 2024, business was conducted in the United States, Puerto Rico, Canada, Mexico, Australia, New Zealand, Singapore, and Costa Rica from approximately 590 facilities.

The following is Management's Discussion and Analysis of significant factors that have affected our financial condition, results of operations and cash flows during the periods included in the accompanying consolidated balance sheets, statements of consolidated income, consolidated comprehensive income and consolidated cash flows in Item 8 under the caption "Financial Statements and Supplementary Data." When reviewing the discussion and analysis set forth below, please note that a significant number of SKUs (Stock Keeping Units) we sell in any given year were not sold in the comparable period of the prior year, resulting in the inability to quantify certain commonly used comparative metrics analyzing sales, such as changes in product mix and volume.

Our fiscal 2024 consolidated sales were $4.5 billion, an increase of $66.6 million or 1.5% compared to the prior year, with the acquisitions of Grupo Kopar (Kopar), Bearing Distributors, Inc. (BDI), Cangro Industries, Inc. (Cangro), Advanced Motion Systems Inc. (AMS), and Automation, Inc. increasing sales by $56.4 million or 1.3% and favorable foreign currency translation of $6.6 million increasing sales by 0.2%. Gross profit margin increased to 29.8% for fiscal 2024 from 29.2% for fiscal 2023. Operating margin increased to 11.1% in fiscal 2024 from 10.7% in fiscal 2023.

Our diluted earnings per share was $9.83 in fiscal 2024 versus $8.84 in fiscal 2023.

Shareholders’ equity was $1,688.8 million at June 30, 2024 compared to $1,458.4 million at June 30, 2023. Working capital increased $162.3 million from June 30, 2023 to $1,268.8 million at June 30, 2024. The current ratio was 3.5 to 1 and 3.0 to 1 at June 30, 2024 and at June 30, 2023, respectively.

Applied monitors several economic indices that have been key indicators for industrial economic activity in the United States. These include the Industrial Production (IP) and Manufacturing Capacity Utilization (MCU) indices published by the Federal Reserve Board and the Purchasing Managers Index (PMI) published by the Institute for Supply Management (ISM). Historically, our performance correlates well with the MCU, which measures productivity and calculates a ratio of actual manufacturing output versus potential full capacity output. When manufacturing plants are running at a high rate of capacity, they tend to wear out machinery and require replacement parts.

The MCU (total industry) and IP indices increased since June 2023. The ISM PMI registered 48.5 in June 2024, an increase from the June 2023 revised reading of 46.4. A reading above 50 generally indicates expansion. The index readings for the months during the most recent quarter, along with the revised indices for previous quarter ends, were as follows:

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RESULTS OF OPERATIONS

This discussion and analysis deals with comparisons of material changes in the consolidated financial statements for the years ended June 30, 2024 and 2023. For the comparison of the years ended June 30, 2023 and 2022, see the Management's Discussion and Analysis of Financial Condition and Results of Operations in Part II, Item 7 of our 2023 Annual Report on Form 10-K.

The following table is included to aid in review of Applied’s statements of consolidated income.

Sales in fiscal 2024 were $4.5 billion, which was $66.6 million or 1.5% above the prior year, with sales from acquisitions adding $56.4 million or 1.3% and favorable foreign currency translation accounting for an increase of $6.6 million or 0.2%. There were 251.5 selling days in fiscal 2024 and 252.5 selling days in 2023. Excluding the impact of businesses acquired and foreign currency translation, sales were up $3.6 million during the year. The modest increase over the prior year was driven by our Service Center Based Distribution segment reflecting positive demand for technical MRO products and solutions, internal sales initiatives, and price increases. This was offset by normalizing end-market demand as the year progressed, sales declines across our Engineered Solutions segment, and a decrease due to the change in sales days.

The following table shows changes in sales by reportable segment.

Sales in our Service Center Based Distribution segment, which operates primarily in MRO markets, increased $89.7 million, or 3.0%. Acquisitions within this segment increased sales by $36.4 million or 1.2% and favorable foreign currency translation increased sales by $6.6 million or 0.2%. Excluding the impact of foreign currency translation, sales increased $46.7 million or 1.6% during the year, driven by an increase of 2.0% from operations reflecting positive demand for technical MRO products and solutions, internal sales initiatives, price increases, cross-selling benefits, and new growth opportunities arising from our industry position. This was partially offset by a 0.4% decrease due to the change in sales days.

Sales in our Engineered Solutions segment decreased $23.1 million or 1.6%. Acquisitions within this segment increased sales $20.0 million or 1.4%. Excluding the impact of businesses acquired, sales decreased $43.1 million or 3.0%, driven by a 2.6% decline from operations primarily reflecting lower fluid power sales and, to a lesser extent, softer sales across our automation operations, as well as a decrease of 0.4% due to the change in sales days. The sales decline was partially offset by sales growth across our flow control operations.

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The following table shows changes in sales by geographical area. Other countries include Mexico, Australia, New Zealand, Singapore, and Costa Rica.

Sales in our U.S. operations increased $71.8 million or 1.9%, with acquisitions adding $50.0 million or 1.3%. Excluding the impact of businesses acquired, U.S. sales were up $21.8 million or 0.6%, driven by an increase of 1.0% from operations offset by a 0.4% decrease due to the change in sales days. Sales from our Canadian operations decreased $5.3 million or 1.7%. Unfavorable foreign currency translation decreased Canadian sales by $3.7 million or 1.2%. Excluding the impact of foreign currency translation, Canadian sales were down $1.6 million or 0.5%, driven by a 0.4% decrease due to the change in sales days along with a decrease of 0.1% from operations. Consolidated sales from our other countries operations increased $0.1 million or 0.1%, with acquisitions adding $6.4 million or 2.7%. Favorable foreign currency translation increased other countries sales by $10.3 million or 4.4%. Excluding the impact of businesses acquired and foreign currency translation, other countries sales were down $16.6 million or 7.0%, driven by a decrease from operations, primarily in Mexican sales due to decreased industrial activity.

Our gross profit margin increased to 29.8% in fiscal 2024 compared to 29.2% in fiscal 2023. The year over year increase primarily reflects benefits from ongoing margin initiatives, countermeasures in response to inflation dynamics, as well as a $21.2 million decrease in LIFO expense over the prior year, which positively impacted gross margins by 47 basis points. This was partially offset by unfavorable mix tied to sales declines across our Engineered Solutions segment and local customer accounts.

The following table shows the changes in selling, distribution, and administrative expense (SD&A).

SD&A consists of associate compensation, benefits and other expenses associated with selling, purchasing, warehousing, supply chain management, and marketing and distribution of the Company’s products, as well as costs associated with a variety of administrative functions such as human resources, information technology, treasury, accounting, insurance, legal, facility-related expenses and expenses incurred in acquiring businesses. SD&A increased $27.0 million or 3.3% during fiscal 2024 compared to the prior year, and as a percentage of sales increased to 18.8% in fiscal 2024 compared to 18.4% in fiscal 2023. Changes in foreign currency exchange rates had the effect of increasing SD&A by $0.7 million or 0.1% compared to the prior year. SD&A from businesses acquired added $16.7 million or 2.0%, including $1.8 million of intangibles amortization. Excluding the impact of businesses acquired and the unfavorable impact from foreign currency translation, SD&A increased $9.6 million or 1.2% during fiscal 2024 compared to fiscal 2023. Excluding the impact of acquisitions, total compensation increased $4.3 million during fiscal 2024 primarily due to annual calendar year merit increases and benefit costs partially offset by lower incentives and commission expense. All other expenses within SD&A were up $5.3 million.

Operating income increased $22.7 million, or 4.8%, to $495.8 million during fiscal 2024 from $473.2 million during fiscal 2023, and as a percentage of sales, increased to 11.1% from 10.7%, primarily due to gross profit margin expansion, inclusive of lower LIFO expense, volume leverage within our Service Center Based Distribution segment, and control of SD&A expense in fiscal 2024.

Operating income, as a percentage of sales for the Service Center Based Distribution segment increased to 13.1% in fiscal 2024 from 12.6% in fiscal 2023. Operating income as a percentage of sales for the Engineered Solutions segment increased to 14.5% in fiscal 2024 from 14.1% in fiscal 2023.

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Segment operating income is impacted by changes in the amounts and levels of certain supplier support benefits and expenses allocated to the segments. The expense allocations include corporate charges for working capital, logistics support, and other items and impact segment gross profit and operating expense.

Interest expense, net decreased $18.8 million during fiscal 2024 primarily due to reduced debt levels and greater interest income from higher cash balances and investment yields.

Other (income) expense, net, represents certain non-operating items of income and expense, and was $5.1 million of income in fiscal 2024 compared to $1.7 million of expense in fiscal 2023. Current year income primarily consists of unrealized gains on investments held by non-qualified deferred compensation trusts of $3.3 million, foreign currency transaction gains of $1.1 million and life insurance income of $0.9 million, offset by other periodic post-employment costs of $0.1 million and other expense of $0.1 million. Fiscal 2023 expense consisted primarily of foreign currency transaction loss of $3.3 million and other periodic post-employment costs of $1.5 million, offset by unrealized gains on investments held by non-qualified deferred compensation trusts of $2.2 million, life insurance income of $0.7 million and $0.2 million of other income.

The effective income tax rate was 22.6% for fiscal 2024 compared to 22.9% for fiscal 2023. The decrease in the effective tax rate is primarily due to changes in compensation-related deductions in fiscal 2024 compared to the prior year.

As a result of the factors discussed above, net income for fiscal 2024 increased $39.0 million from the prior year. Diluted net income per share was $9.83 per share for fiscal 2024 compared to $8.84 per share for fiscal 2023.

At June 30, 2024, we had approximately 590 operating facilities in the United States, Puerto Rico, Canada, Mexico, Australia, New Zealand, Singapore, and Costa Rica, versus 580 at June 30, 2023.

The approximate number of Company employees was 6,500 at June 30, 2024 and 6,200 at June 30, 2023.

LIQUIDITY AND CAPITAL RESOURCES

Our primary source of capital is cash flow from operations, supplemented as necessary by bank borrowings or other sources of debt. At June 30, 2024 we had total debt obligations outstanding of $597.4 million compared to $622.2 million at June 30, 2023. Management expects that our existing cash, cash equivalents, funds available under the revolving credit facility, and cash provided from operations, will be sufficient to finance normal working capital needs in each of the countries in which we operate, payment of dividends, acquisitions, investments in properties, facilities and equipment, debt service, and the purchase of additional Company common stock. Management also believes that additional long-term debt and line of credit financing could be obtained on commercially acceptable terms if necessary based on the Company’s credit standing and financial strength.

The Company’s working capital at June 30, 2024 was $1,268.8 million compared to $1,106.5 million at June 30, 2023. The current ratio was 3.5 to 1 at June 30, 2024 and 3.0 to 1 at June 30, 2023.

Net Cash Flows

The following table is included to aid in review of Applied’s statements of consolidated cash flows.

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The increase in cash provided by operating activities during fiscal 2024 is driven by changes in working capital for the year and by improved operating results. Changes in cash flows between years related to working capital were driven by (amounts in thousands):

Net cash used in investing activities in fiscal 2024 included $72.1 million used for the acquisitions of Kopar, BDI and Cangro and $24.9 million used for capital expenditures. Net cash used in investing activities in fiscal 2023 included $35.8 million used for the acquisitions of Automation, Inc. and AMS, and $26.5 million used for capital expenditures.

Net cash used in financing activities increased from the prior year period primarily due to an increase in treasury purchases as $73.4 million was used to repurchase 398,000 shares of common stock which were taken into treasury in 2024 compared to $0.7 million used to repurchase 8,000 shares of common stock which were taken into treasury in 2023. This was offset by the change in net debt activity, as there was $24.8 million of net debt payments in fiscal 2024 compared to $67.2 million of net debt payments in 2023. Further uses of cash in 2024 were $55.9 million for dividend payments and $16.3 million used to pay taxes for shares withheld. Further uses of cash in 2023 were $53.4 million for dividend payments and $12.9 million used to pay taxes for shares withheld.

The increase in dividends over the year is the result of regular increases in our dividend payout rates. We paid aggregate dividends of $1.44 and $1.38 per share in fiscal 2024 and 2023, respectively.

Capital Expenditures

We expect capital expenditures for fiscal 2025 to be in the $28.0 million to $30.0 million range, primarily consisting of capital associated with focused investments for growth and information technology equipment maintenance.

Share Repurchases

The Board of Directors has authorized the repurchase of shares of the Company’s common stock. These purchases may be made in open market or through negotiated transactions, from time to time, depending upon market conditions. At June 30, 2024, we had remaining authorization to purchase an additional 1,102,000 shares.

In fiscal 2024, we purchased 398,000 shares of the Company's common stock at an average price per share of $184.39. In fiscal 2023, we repurchased 8,000 shares of the Company's common stock at an average price per share of $89.46. In fiscal 2022,we repurchased 148,658 shares of the Company's common stock at an average price per share of $92.72.

Borrowing Arrangements

A summary of long-term debt, including the current portion, follows (amounts are in thousands):

In December 2021, the Company entered into a five-year revolving credit facility with a group of banks to refinance the existing credit facility as well as provide funds for ongoing working capital and other general corporate purposes. The revolving credit facility provides a $900.0 million unsecured revolving credit facility and an uncommitted accordion feature which allows the Company to request an increase in the borrowing commitments, or incremental term loans, under the credit facility in aggregate principal amounts of up to $500.0 million. In May 2023, the Company and the administrative agent entered into an amendment to the credit facility to replace LIBOR with SOFR as a reference rate available for use in the computation of interest. Borrowings under this agreement bear interest, at the Company's election, at either the base rate plus a margin that ranges from 0 to 55 basis points based on the net leverage ratio or SOFR plus a margin that ranges from 80 to 155 basis points based on the net leverage ratio.

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Available borrowing under this facility, without exercising the accordion feature and net of outstanding letters of credit of $0.2 million to secure certain insurance obligations, totaled $515.8 million and $516.2 million at June 30, 2024 and June 30, 2023, respectively, and were available to fund future acquisitions or other capital and operating requirements. The interest rate on the revolving credit facility was 6.24% and 6.11% as of June 30, 2024 and June 30, 2023, respectively.

Additionally, the Company had letters of credit outstanding with separate banks, not associated with the revolving credit agreement, in the amount of $4.0 million as of June 30, 2024 and June 30, 2023 in order to secure certain insurance obligations.

In August 2018, the Company established a trade receivable securitization facility (the “AR Securitization Facility”). On March 26, 2021, the Company amended the AR Securitization Facility to expand the eligible receivables, which increased the maximum availability to $250.0 million and increased the fees on the AR Securitization Facility to 0.98% per year. On August 4, 2023, the Company amended the AR Securitization Facility, extended the term to August 4, 2026, and reduced drawn fees to 0.90% per year. Availability is further subject to changes in the credit ratings of our customers, customer concentration levels or certain characteristics of the accounts receivable being transferred and, therefore, at certain times, we may not be able to fully access the $250.0 million of funding available under the AR Securitization Facility. The AR Securitization Facility effectively increases the Company’s borrowing capacity by collateralizing a portion of the amount of the U.S. operations’ trade accounts receivable. The Company uses the proceeds from the AR Securitization Facility as an alternative to other forms of debt, effectively reducing borrowing costs. In May 2023, the Company entered into an amendment to the AR Securitization facility to replace LIBOR with SOFR as a reference rate available for use in the computation of interest, therefore borrowings under this facility carry variable interest rates tied to SOFR. The interest rate on the AR Securitization Facility as of June 30, 2024 and June 30, 2023 was 6.35% and 6.16%, respectively.

At June 30, 2024 and June 30, 2023, the Company had borrowings outstanding under its unsecured shelf facility agreement with Prudential Investment Management of $25.0 million and $50.0 million, respectively. Fees on this facility range from 0.25% to 1.25% per year based on the Company's leverage ratio at each quarter end. The "Series D" notes carried a fixed interest rate of 3.21%, and the remaining principal balance of $25.0 million was paid in October 2023. The "Series E" notes have a principal amount of $25.0 million, carry a fixed interest rate of 3.08%, and are due in October 2024.

In 2014, the Company assumed $2.4 million of debt as a part of the headquarters facility acquisition. The 1.50% fixed interest rate note is held by the State of Ohio Development Services Agency and matures in November 2024.

In 2019, the Company entered into an interest rate swap which mitigates variability in forecasted interest payments on $384.0 million of the Company’s U.S. dollar-denominated unsecured variable rate debt. For more information, see note 7, Derivatives, to the consolidated financial statements, included in Item 8 under the caption “Financial Statements and Supplementary Data.”

The credit facility and the unsecured shelf facility contain restrictive covenants regarding liquidity, net worth, financial ratios, and other covenants. At June 30, 2024, the most restrictive of these covenants required that the Company have net indebtedness less than 3.75 times consolidated income before interest, taxes, depreciation and amortization (as defined). At June 30, 2024, the Company's net indebtedness was less than 0.3 times consolidated income before interest, taxes, depreciation and amortization (as defined). The Company was in compliance with all financial covenants at June 30, 2024.

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Accounts Receivable Analysis

The following table is included to aid in analysis of accounts receivable and the associated provision for losses on accounts receivable (all dollar amounts are in thousands):

Accounts receivable are reported at net realizable value and consist of trade receivables from customers. Management monitors accounts receivable by reviewing Days Sales Outstanding (DSO) and the aging of receivables for each of the Company's locations.

On a consolidated basis, DSO was 56.2 at June 30, 2024 versus 55.1 at June 30, 2023. Approximately 1.5% of our accounts receivable balances are more than 90 days past due at June 30, 2024 compared to 2.5% at June 30, 2023. On an overall basis, our provision for losses from uncollected receivables represents 0.00% of our sales for the year ended June 30, 2024, compared to 0.13% of sales for the year ended June 30, 2023. The decrease primarily relates to provisions recorded in the prior year for customer credit deterioration and bankruptcies primarily in the U.S. operations of the Service Center Based Distribution segment, as well as improved collections performance. Historically, this percentage is around 0.10% to 0.15%. Management believes the overall receivables aging and provision for losses on uncollected receivables are at reasonable levels.

Inventory Analysis

Inventories are valued using the last-in, first-out (LIFO) method for U.S. inventories and the average cost method for foreign inventories. Management uses an inventory turnover ratio to monitor and evaluate inventory. Management calculates this ratio on an annual as well as a quarterly basis and uses inventory valued at average costs. The annualized inventory turnover (using average costs) for the year ended June 30, 2024 was 4.3 versus 4.4 for the year ended June 30, 2023.

CONTRACTUAL OBLIGATIONS

The following table shows the approximate value of the Company’s contractual obligations and other commitments to make future payments as of June 30, 2024 (in thousands):

(1) Amounts represent estimated contractual interest payments on outstanding long-term debt obligations net of receipts under the terms of the interest rate swap. Rates in effect as of June 30, 2024 are used for variable rate debt.

Purchase orders for inventory and other goods and services are not included in our estimates as we are unable to aggregate the amount of such purchase orders that represent enforceable and legally binding agreements specifying all significant terms. The previous table includes the gross liability for unrecognized income tax benefits including

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interest and penalties in the “Other” column as the Company is unable to make a reasonable estimate regarding the timing of cash settlements, if any, with the respective taxing authorities.

CRITICAL ACCOUNTING POLICIES

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates at a specific point in time that affect the amounts reported in the consolidated financial statements and disclosed in the accompanying notes. The Business and Accounting Policies note to the consolidated financial statements describes the significant accounting policies and methods used in preparation of the consolidated financial statements. Estimates are used for, but are not limited to, determining the net carrying value of trade accounts receivable, inventories, recording self-insurance liabilities and other accrued liabilities. Estimates are also used in establishing opening balances in relation to purchase accounting. Actual results could differ from these estimates. The following critical accounting policies are impacted significantly by judgments, assumptions, and estimates used in the preparation of the consolidated financial statements.

LIFO Inventory Valuation and Methodology

Inventories are valued at the average cost method, using the last-in, first-out (LIFO) method for U.S. inventories, and the average cost method for foreign inventories. We adopted the link chain dollar value LIFO method for accounting for U.S. inventories in fiscal 1974. Approximately 14.9% of our domestic inventory dollars relate to LIFO layers added in the 1970s. The excess of average cost over LIFO cost is $225.9 million as reflected in our consolidated balance sheet at June 30, 2024. The Company maintains five LIFO pools based on the following product groupings: bearings, power transmission products, rubber products, fluid power products, and other products.

LIFO layers and/or liquidations are determined consistently year-to-year. See the Inventories note to the

consolidated financial statements in Item 8 under the caption "Financial Statements and Supplementary Data,"

for further information.

Allowances for Slow-Moving and Obsolete Inventories

We evaluate the recoverability of our slow-moving and inactive inventories at least quarterly. We estimate the recoverable cost of such inventory by product type while considering factors such as its age, historic and current demand trends, and the physical condition of the inventory, as well as assumptions regarding future demand. Our ability to recover our cost for slow moving or obsolete inventory can be affected by such factors as general market conditions, future customer demand and relationships with suppliers. A significant portion of the products we hold in inventory have long shelf lives and are not highly susceptible to obsolescence.

As of June 30, 2024 and 2023, the Company's reserve for slow-moving or obsolete inventories was $41.2 million and $42.6 million, respectively, recorded in inventories in the consolidated balance sheets.

Allowances for Doubtful Accounts

We evaluate the collectability of trade accounts receivable based on a combination of factors. Initially, we estimate an allowance for doubtful accounts as a percentage of net sales based on historical bad debt experience. This initial estimate is adjusted based on recent trends of certain customers and industries estimated to be a greater credit risk, trends within the entire customer pool and changes in the overall aging of accounts receivable. While we have a large customer base that is geographically dispersed, a general economic downturn in any of the industry segments in which we operate could result in higher than expected defaults, and therefore, the need to revise estimates for bad debts. Accounts are written off against the allowance when it becomes evident that collection will not occur.

As of June 30, 2024 and 2023, our allowance for doubtful accounts was 1.8% and 3.1% of gross receivables, respectively. Our (recoveries of) provision for losses on accounts receivable was $(0.2) million, $5.6 million, and $3.2 million in fiscal 2024, 2023, and 2022, respectively.

Goodwill and Intangibles

The purchase price of an acquired company is allocated between intangible assets and the net tangible assets of the acquired business with the residual of the purchase price recorded as goodwill. Goodwill for acquired businesses is accounted for using the acquisition method of accounting which requires that the assets acquired and liabilities assumed be recorded at the date of the acquisition at their respective estimated fair values. The determination of the value of the intangible assets acquired involves certain judgments and estimates. These judgments can include, but are not limited to, the cash flows that an asset is expected to generate in the future and the appropriate weighted average cost of capital. The judgments made in determining the estimated fair value assigned to each class of assets acquired, as well as the estimated life of each asset, can materially impact the net income of the

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periods subsequent to the acquisition through depreciation and amortization, and in certain instances through impairment charges, if the asset becomes impaired in the future. As part of acquisition accounting, we recognize acquired identifiable intangible assets such as customer relationships, vendor relationships, trade names, and non-competition agreements apart from goodwill. Finite-lived identifiable intangibles are evaluated for impairment when changes in conditions indicate carrying value may not be recoverable. If circumstances require a finite-lived intangible asset be tested for possible impairment, the Company first compares undiscounted cash flows expected to be generated by the asset to the carrying value of the asset. If the carrying value of the finite-lived intangible asset is not recoverable on an undiscounted cash flow basis, impairment is recognized to the extent that the carrying value exceeds its fair value determined through a discounted cash flow model.

We evaluate goodwill for impairment at the reporting unit level annually as of January 1, and whenever an event occurs or circumstances change that would indicate that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. Events or circumstances that may result in an impairment review include changes in macroeconomic conditions, industry and market considerations, cost factors, overall financial performance, other relevant entity-specific events, specific events affecting the reporting unit or sustained decrease in share price. Each year, the Company may elect to perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. If impairment is indicated in the qualitative assessment, or, if management elects to initially perform a quantitative assessment of goodwill, the impairment test uses a one-step approach. The fair value of a reporting unit is compared with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill of the reporting unit is not impaired. If the carrying amount of a reporting unit exceeds its fair value, an impairment charge would be recognized for the amount by which the carrying amount exceeds the reporting unit's fair value, not to exceed the total amount of goodwill allocated to that reporting unit.

Goodwill on our consolidated financial statements relates to both the Service Center Based Distribution segment and the Engineered Solutions segment. The Company has eight (8) reporting units for which an annual goodwill impairment assessment was performed as of January 1, 2024.  Based on the assessment performed, the Company concluded that the fair value of all of the reporting units exceeded their carrying amount as of January 1, 2024, therefore no impairment exists.

The fair values of the reporting units in accordance with the goodwill impairment test were determined using the income and market approaches. The income approach employs the discounted cash flow method reflecting projected cash flows expected to be generated by market participants and then adjusted for time value of money factors, and requires management to make significant estimates and assumptions related to forecasts of future revenues, operating margins, and discount rates. The market approach utilizes an analysis of comparable publicly traded companies and requires management to make significant estimates and assumptions related to the forecasts of future revenues, earnings before interest, taxes, depreciation, and amortization (EBITDA) and multiples that are applied to management’s forecasted revenues and EBITDA estimates.

Changes in future results, assumptions, and estimates after the measurement date may lead to an outcome where additional impairment charges would be required in future periods.  Specifically, actual results may vary from the Company’s forecasts and such variations may be material and unfavorable, thereby triggering the need for future impairment tests where the conclusions may differ in reflection of prevailing market conditions.  Further, continued adverse market conditions could result in the recognition of additional impairment if the Company determines that the fair values of its reporting units have fallen below their carrying values.

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CAUTIONARY STATEMENT UNDER PRIVATE SECURITIES LITIGATION REFORM ACT

This Form 10-K, including Management’s Discussion and Analysis, contains statements that are forward-looking based on management’s current expectations about the future. Forward-looking statements are often identified by qualifiers, such as “guidance”, “expect”, “believe”, “plan”, “intend”, “will”, “should”, “could”, “would”, “anticipate”, “estimate”, “forecast”, “may”, "optimistic" and derivative or similar words or expressions. Similarly, descriptions of objectives, strategies, plans, or goals are also forward-looking statements. These statements may discuss, among other things, expected growth, future sales, future cash flows, future capital expenditures, future performance, and the anticipation and expectations of the Company and its management as to future occurrences and trends. The Company intends that the forward-looking statements be subject to the safe harbors established in the Private Securities Litigation Reform Act of 1995 and by the Securities and Exchange Commission in its rules, regulations, and releases.

Readers are cautioned not to place undue reliance on any forward-looking statements. All forward-looking statements are based on current expectations regarding important risk factors, many of which are outside the Company’s control. Accordingly, actual results may differ materially from those expressed in the forward-looking statements, and the making of those statements should not be regarded as a representation by the Company or any other person that the results expressed in the statements will be achieved. In addition, the Company assumes no obligation publicly to update or revise any forward-looking statements, whether because of new information or events, or otherwise, except as may be required by law.

Important risk factors include, but are not limited to, the following: risks relating to the operations levels of our customers and the economic factors that affect them; continuing risks relating to the effects of the COVID-19 pandemic; inflationary or deflationary trends in the cost of products, energy, labor and other operating costs, and changes in the prices for products and services relative to the cost of providing them; reduction in supplier inventory purchase incentives; loss of key supplier authorizations, lack of product availability (such as due to supply chain strains), changes in supplier distribution programs, inability of suppliers to perform, and transportation disruptions; changes in customer preferences for products and services of the nature and brands sold by us; changes in customer procurement policies and practices; competitive pressures; our reliance on information systems and risks relating to their proper functioning, the security of those systems, and the data stored in or transmitted through them; the impact of economic conditions on the collectability of trade receivables; reduced demand for our products in targeted markets due to reasons including consolidation in customer industries; our ability to retain and attract qualified sales and customer service personnel and other skilled executives, managers and professionals; our ability to identify and complete acquisitions, integrate them effectively, and realize their anticipated benefits; the variability, timing and nature of new business opportunities including acquisitions, alliances, customer relationships, and supplier authorizations; the incurrence of debt and contingent liabilities in connection with acquisitions; our ability to access capital markets as needed on reasonable terms; disruption of operations at our headquarters or distribution centers; risks and uncertainties associated with our foreign operations, including volatile economic conditions, political instability, cultural and legal differences, and currency exchange fluctuations; the potential for goodwill and intangible asset impairment; changes in accounting policies and practices; our ability to maintain effective internal control over financial reporting; organizational changes within the Company; risks related to legal proceedings to which we are a party; potentially adverse government regulation, legislation, or policies, both enacted and under consideration, including with respect to federal tax policy, international trade, data privacy and security, and government contracting; and the occurrence of extraordinary events (including prolonged labor disputes, power outages, telecommunication outages, terrorist acts, war, public health emergency, earthquakes, extreme weather events, other natural disasters, fires, floods, and accidents). Other factors and unanticipated events could also adversely affect our business, financial condition, or results of operations. Risks can also change over time. Further, the disclosure of a risk should not be interpreted to imply that the risk has not already materialized.

We discuss certain of these matters and other risk factors more fully throughout our Form 10-K, as well as other of our filings with the Securities and Exchange Commission.

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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS.

OVERVIEW

With approximately 6,200 associates across North America, Australia, New Zealand, and Singapore, Applied Industrial Technologies, Inc. ("Applied," the "Company," "We," "Us," or "Our") is a leading value-added distributor and technical solutions provider of industrial motion, fluid power, flow control, automation technologies, and related maintenance supplies. Our leading brands, specialized services, and comprehensive knowledge serve MRO (Maintenance, Repair & Operations) and OEM (Original Equipment Manufacturer) end users in virtually all industrial markets through our multi-channel capabilities that provide choice, convenience, and expertise. We have a long tradition of growth dating back to 1923, the year our business was founded in Cleveland, Ohio. At June 30, 2023, business was conducted in the United States, Puerto Rico, Canada, Mexico, Australia, New Zealand, and Singapore from approximately 580 facilities.

The following is Management's Discussion and Analysis of significant factors that have affected our financial condition, results of operations and cash flows during the periods included in the accompanying consolidated balance sheets, statements of consolidated income, consolidated comprehensive income and consolidated cash flows in Item 8 under the caption "Financial Statements and Supplementary Data." When reviewing the discussion and analysis set forth below, please note that a significant number of SKUs (Stock Keeping Units) we sell in any given year were not sold in the comparable period of the prior year, resulting in the inability to quantify certain commonly used comparative metrics analyzing sales, such as changes in product mix and volume.

Our fiscal 2023 consolidated sales were $4.4 billion, an increase of $602.1 million or 15.8% compared to the prior year, with the acquisitions of R.R. Floody Company (Floody), Automation, Inc. and Advanced Motion Systems, Inc. (AMS) increasing sales by $20.0 million or 0.5% and unfavorable foreign currency translation of $16.3 million decreasing sales by 0.4%. Gross profit margin increased to 29.2% for fiscal 2023 from 29.0% for fiscal 2022. Operating margin increased to 10.7% in fiscal 2023 from 9.4% in fiscal 2022.

Our diluted earnings per share was $8.84 in fiscal 2023 versus $6.58 in fiscal 2022.

Shareholders’ equity was $1,458.4 million at June 30, 2023 compared to $1,149.4 million at June 30, 2022. Working capital increased $246.6 million from June 30, 2022 to $1,106.5 million at June 30, 2023. The current ratio was 3.0 to 1 and 2.7 to 1 at June 30, 2023 and at June 30, 2022, respectively.

Applied monitors several economic indices that have been key indicators for industrial economic activity in the United States. These include the Industrial Production (IP) and Manufacturing Capacity Utilization (MCU) indices published by the Federal Reserve Board and the Purchasing Managers Index (PMI) published by the Institute for Supply Management (ISM). Historically, our performance correlates well with the MCU, which measures productivity and calculates a ratio of actual manufacturing output versus potential full capacity output. When manufacturing plants are running at a high rate of capacity, they tend to wear out machinery and require replacement parts.

The MCU (total industry) and IP indices decreased since June 2022 correlating with an overall decrease in the economy in the same period. The ISM PMI registered 46.0 in June 2023, a decrease from the June 2022 revised reading of 53.1. A reading above 50 generally indicates expansion. The index readings for the months during the most recent quarter, along with the revised indices for previous quarter ends, were as follows:

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RESULTS OF OPERATIONS

This discussion and analysis deals with comparisons of material changes in the consolidated financial statements for the years ended June 30, 2023 and 2022. For the comparison of the years ended June 30, 2022 and 2021, see the Management's Discussion and Analysis of Financial Condition and Results of Operations in Part II, Item 7 of our 2022 Annual Report on Form 10-K.

The following table is included to aid in review of Applied’s statements of consolidated income.

Sales in fiscal 2023 were $4.4 billion, which was $602.1 million or 15.8% above the prior year, with sales from acquisitions adding $20.0 million or 0.5% and unfavorable foreign currency translation accounting for a decrease of $16.3 million or 0.4%. There were 252.5 selling days in both fiscal 2023 and 2022. Excluding the impact of businesses acquired and foreign currency translation, sales were up $598.4 million or 15.7% during the year, driven by an increase from operations reflecting resilient underlying demand across both segments, structural and secular tailwinds across legacy and new markets, and support from company-specific growth opportunities.

The following table shows changes in sales by reportable segment.

Sales in our Service Center Based Distribution segment, which operates primarily in MRO markets, increased $401.2 million, or 15.6%. Unfavorable foreign currency translation decreased sales by $16.3 million or 0.6%. Excluding the impact of foreign currency translation, sales increased $417.5 million or 16.2% during the year, driven by an increase from operations due to ongoing benefits from market position, sales process initiatives, solid growth across national strategic accounts, as well as benefits from cross-selling actions.

Sales in our Engineered Solutions segment increased $200.9 million or 16.1%. Acquisitions within this segment, primarily Automation, Inc., increased sales $20.0 million or 1.6%. Excluding the impact of businesses acquired, sales increased $180.9 million or 14.5%, reflecting positive underlying segment demand and driven by expanding technical and engineering capabilities, diverse end-market mix, and cross-selling initiatives, partially offset by slower order activity across the technology sector and ongoing supply chain constraints.

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The following table shows changes in sales by geographical area. Other countries include Mexico, Australia, New Zealand, and Singapore.

Sales in our U.S. operations increased $560.6 million or 17.0%, with acquisitions adding $20.0 million or 0.6%. Excluding the impact of businesses acquired, U.S. sales were up $540.6 million or 16.4%. Sales from our Canadian operations increased $24.0 million or 8.2%. Unfavorable foreign currency translation decreased Canadian sales by $16.0 million or 5.5%. Excluding the impact of foreign currency translation, Canadian sales were up $40.0 million or 13.7%. Consolidated sales from our other countries operations increased $17.5 million or 8.0% compared to the prior year. Unfavorable foreign currency translation decreased other countries sales by $0.3 million or 0.1%. Excluding the impact of foreign currency translation, other countries sales were up $17.8 million or 8.1% compared to the prior year, driven by an increase from operations, primarily an $11.5 million increase in Mexican sales due to increased industrial activity, mainly related to the automotive industry.

Our gross profit margin increased to 29.2% in fiscal 2023 compared to 29.0% in fiscal 2022. Gross profit margin expanded year over year primarily reflecting broad-based execution across the business and countermeasures in response to ongoing inflation and supply chain dynamics. The gross profit margin for the current year was negatively impacted by 18 basis points due to a $7.7 million increase in LIFO expense over the prior year.

The following table shows the changes in selling, distribution, and administrative expense (SD&A).

SD&A consists of associate compensation, benefits and other expenses associated with selling, purchasing, warehousing, supply chain management, and marketing and distribution of the Company’s products, as well as costs associated with a variety of administrative functions such as human resources, information technology, treasury, accounting, insurance, legal, facility related expenses and expenses incurred in acquiring businesses. SD&A increased $64.7 million or 8.6% during fiscal 2023 compared to the prior year, and as a percentage of sales decreased to 18.4% in fiscal 2023 compared to 19.7% in fiscal 2022. Changes in foreign currency exchange rates had the effect of decreasing SD&A by $4.3 million or 0.6% compared to the prior year. SD&A from businesses acquired added $6.4 million or 0.9%, including $0.9 million of intangibles amortization related to acquisitions. Excluding the impact of businesses acquired and the unfavorable impact from foreign currency translation, SD&A increased $62.6 million or 8.3% during fiscal 2023 compared to fiscal 2022. Excluding the impact of acquisitions, total compensation increased $47.3 million during fiscal 2023, as a result of annual calendar year merit increases and an increase in employee incentive compensation correlating with the improved company performance. Also, excluding the impact of acquisitions, travel & entertainment and fleet expenses increased $4.7 million during 2023, primarily driven by higher fuel costs and the return of travel activity in the current year after travel constraints in the prior year due to COVID-19. Additionally, excluding the impact of acquisitions, occupancy costs increased $5.3 million during 2023, primarily driven by increased building lease costs. All other expenses within SD&A were up $5.3 million.

Operating income increased $115.3 million, or 32.2%, to $473.2 million during fiscal 2023 from $357.9 million during fiscal 2022, and as a percentage of sales, increased to 10.7% from 9.4%, primarily due to gross profit margin expansion, volume leverage, and control of SD&A expense in fiscal 2023.

Operating income, as a percentage of sales for the Service Center Based Distribution segment increased to 12.6% in fiscal 2023 from 11.8% in fiscal 2022. Operating income as a percentage of sales for the Engineered Solutions segment increased to 14.1% in fiscal 2023 from 12.6% in fiscal 2022.

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Segment operating income is impacted by changes in the amounts and levels of certain supplier support benefits and expenses allocated to the segments. The expense allocations include corporate charges for working capital, logistics support and other items and impact segment gross profit and operating expense.

Other expense (income), net, represents certain non-operating items of income and expense, and was $1.7 million of expense in fiscal 2023 compared to $1.8 million of expense in fiscal 2022. Current year expense primarily consists of foreign currency transaction losses of $3.3 million and other periodic post-employment costs of $1.5 million, offset by unrealized gains on investments held by non-qualified deferred compensation trusts of $2.2 million, life insurance income of $0.7 million and other income of $0.2 million. Fiscal 2022 expense consisted primarily of unrealized loss on investments held by non-qualified deferred compensation trusts of $2.6 million and other periodic post-employment costs of $0.6 million, offset by life insurance income of $1.4 million.

The effective income tax rate was 22.9% for fiscal 2023 compared to 21.9% for fiscal 2022. The increase in the effective tax rate is due to changes in compensation-related deductions in fiscal 2023 compared to the prior year.

As a result of the factors discussed above, net income for fiscal 2023 increased $89.3 million from the prior year. Diluted net income per share was $8.84 per share for fiscal 2023 compared to $6.58 per share for fiscal 2022.

At June 30, 2023, we had approximately 580 operating facilities in the United States, Puerto Rico, Canada, Mexico, Australia, New Zealand, and Singapore at June 30, 2023, versus 568 June 30, 2022.

The approximate number of Company employees was 6,200 at June 30, 2023 and 6,100 at June 30, 2022.

LIQUIDITY AND CAPITAL RESOURCES

Our primary source of capital is cash flow from operations, supplemented as necessary by bank borrowings or other sources of debt. At June 30, 2023 we had total debt obligations outstanding of $622.2 million compared to $689.5 million at June 30, 2022. Management expects that our existing cash, cash equivalents, funds available under the revolving credit facility, and cash provided from operations, will be sufficient to finance normal working capital needs in each of the countries in which we operate, payment of dividends, acquisitions, investments in properties, facilities and equipment, debt service, and the purchase of additional Company common stock. Management also believes that additional long-term debt and line of credit financing could be obtained if necessary based on the Company’s credit standing and financial strength.

The Company’s working capital at June 30, 2023 was $1,106.5 million compared to $859.9 million at June 30, 2022. The current ratio was 3.0 to 1 at June 30, 2023 and 2.7 to 1 at June 30, 2022.

Net Cash Flows

The following table is included to aid in review of Applied’s statements of consolidated cash flows.

The increase in cash provided by operating activities during fiscal 2023 is driven by changes in working capital for the year and by increased operating results. Changes in cash flows between years related to working capital were driven by (amounts in thousands):

Net cash used in investing activities in fiscal 2023 included $35.8 million used for the acquisitions of Automation, Inc. and AMS and $26.5 million used for capital expenditures. Net cash used in investing activities in fiscal 2022 included $7.0 million used for the acquisition of Floody, $14.8 million million in cash payments for loans on company-owned life insurance and $18.1 million used for capital expenditures.

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Net cash used in financing activities decreased from the prior year period primarily due to a change in net debt activity, as there was $67.2 million of net debt payments in fiscal 2023 compared to $139.9 million of net debt payments in 2022. Further uses of cash in 2023 were $53.4 million for dividend payments and $12.9 million used to pay taxes for shares withheld. Further uses of cash in 2022 were $51.8 million for dividend payments, $8.1 million used to pay taxes for shares withheld, and $13.8 million used to repurchase 148,658 shares of treasury stock.

The increase in dividends over the year is the result of regular increases in our dividend payout rates. We paid dividends of $1.38 and $1.34 per share in fiscal 2023 and 2022, respectively.

Capital Expenditures

We expect capital expenditures for fiscal 2024 to be in the $27.0 million to $29.0 million range, primarily consisting of capital associated with additional information technology equipment and infrastructure investments.

Share Repurchases

The Board of Directors has authorized the repurchase of shares of the Company’s stock. These purchases may

be made in open market and negotiated transactions, from time to time, depending upon market conditions.

At June 30, 2023, we had authorization to purchase an additional 1,500,000 shares.

In fiscal 2023, we purchased 8,000 shares of the Company's common stock at an average price per share of $89.46. In fiscal 2022, we repurchased 148,658 shares of the Company's common stock at an average price per share of $92.72. In fiscal 2021,we repurchased 400,000 shares of the Company's common stock at an average price per share of $100.22.

Borrowing Arrangements

A summary of long-term debt, including the current portion, follows (amounts are in thousands):

In December 2021, the Company entered into a new revolving credit facility with a group of banks to refinance the existing credit facility as well as provide funds for ongoing working capital and other general corporate purposes. The revolving credit facility provides a $900.0 million unsecured revolving credit facility and an uncommitted accordion feature which allows the Company to request an increase in the borrowing commitments, or incremental term loans, under the credit facility in aggregate principal amounts of up to $500.0 million. In May 2023, the Company and the administrative agent entered into an amendment to the credit facility to replace LIBOR as a reference rate available for use in the computation of interest and replace it with SOFR. Borrowings under this agreement bear interest, at the Company's election, at either the base rate plus a margin that ranges from 0 to 55 basis points based on net leverage ratio or SOFR plus a margin that ranges from 80 to 155 basis points based on the net leverage ratio. Unused lines under this facility, net of outstanding letters of credit of $0.2 million to secure certain insurance obligations, totaled $516.2 million and $489.2 million at June 30, 2023 and June 30, 2022, respectively, and were available to fund future acquisitions or other capital and operating requirements. The interest rate on the revolving credit facility was 6.11% and 2.81% as of June 30, 2023 and June 30, 2022, respectively.

Additionally, the Company had letters of credit outstanding not associated with the revolving credit agreement, in the amount of $4.0 million and $4.7 million as of June 30, 2023 and June 30, 2022, respectively, in order to secure certain insurance obligations.

In August 2018, the Company established a trade receivable securitization facility (the “AR Securitization Facility”). On March 26, 2021, the Company amended the AR Securitization Facility to expand the eligible receivables, which increased the maximum availability to $250.0 million and increased the fees on the AR Securitization Facility to 0.98% per year. Availability is further subject to changes in the credit ratings of our customers, customer concentration levels or certain characteristics of the accounts receivable being transferred and, therefore, at certain

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times, we may not be able to fully access the $250.0 million of funding available under the AR Securitization Facility. The AR Securitization Facility effectively increases the Company’s borrowing capacity by collateralizing a portion of the amount of the U.S. operations’ trade accounts receivable. The Company uses the proceeds from the AR Securitization Facility as an alternative to other forms of debt, effectively reducing borrowing costs. In May 2023, the Company entered into an amendment to the AR Securitization facility to replace LIBOR as a reference rate available for use in the computation of interest and replace it with SOFR, therefore borrowings under this facility carry variable interest rates tied to SOFR. The interest rate on the AR Securitization Facility as of June 30, 2023 and June 30, 2022 was 6.16% and 2.60%, respectively. The Company classified the AR Securitization Facility as long-term debt as it has the ability and intent to extend or refinance this amount on a long-term basis. On August 4, 2023, the Company amended the AR Securitization Facility and extended the term to August 4, 2026.

At June 30, 2023 and June 30, 2022, the Company had borrowings outstanding under its unsecured shelf facility agreement with Prudential Investment Management of $50.0 million and $90.0 million, respectively. Fees on this facility range from 0.25% to 1.25% per year based on the Company's leverage ratio at each quarter end. The remaining principal balance on the "Series C" notes of the $40.0 million was paid in July 2022. The "Series D" notes have a remaining principal amount of $25.0 million, carry a fixed interest rate of 3.21%, and are due in October 2023. The "Series E" notes have a principal amount of $25.0 million, carry a fixed interest rate of 3.08%, and are due in October 2024.

In 2014, the Company assumed $2.4 million of debt as a part of the headquarters facility acquisition. The 1.50% fixed interest rate note is held by the State of Ohio Development Services Agency and matures in November 2024.

In 2019, the Company entered into an interest rate swap which mitigates variability in forecasted interest payments on $384.0 million of the Company’s U.S. dollar-denominated unsecured variable rate debt. For more information, see note 7, Derivatives, to the consolidated financial statements, included in Item 8 under the caption “Financial Statements and Supplementary Data.”

The credit facility and the unsecured shelf facility contain restrictive covenants regarding liquidity, net worth, financial ratios, and other covenants. At June 30, 2023, the most restrictive of these covenants required that the Company have net indebtedness less than 3.75 times consolidated income before interest, taxes, depreciation and amortization (as defined). At June 30, 2023, the Company's net indebtedness was less than 0.7 times consolidated income before interest, taxes, depreciation and amortization (as defined). The Company was in compliance with all financial covenants at June 30, 2023.

Accounts Receivable Analysis

The following table is included to aid in analysis of accounts receivable and the associated provision for losses on accounts receivable (all dollar amounts are in thousands):

Accounts receivable are reported at net realizable value and consist of trade receivables from customers. Management monitors accounts receivable by reviewing Days Sales Outstanding (DSO) and the aging of receivables for each of the Company's locations. The Company experienced a significant increase in accounts receivable during fiscal 2023 commensurate with the increase in sales.

On a consolidated basis, DSO was 55.1 at June 30, 2023 versus 55.7 at June 30, 2022. Approximately 2.5% of our accounts receivable balances are more than 90 days past due at June 30, 2023 compared to 3.4% at June 30, 2022. On an overall basis, our provision for losses from uncollected receivables represents 0.13% of our sales for the year ended June 30, 2023, compared to 0.08% of sales for the year ended June 30, 2022. The increase primarily relates to provisions recorded in the current year for customer credit deterioration and bankruptcies primarily in the Service Center Based Distribution segment. Historically, this percentage is around 0.10% to 0.15%. Management believes the overall receivables aging and provision for losses on uncollected receivables are at reasonable levels.

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Inventory Analysis

Inventories are valued using the last-in, first-out (LIFO) method for U.S. inventories and the average cost method for foreign inventories. Inventory increased throughout fiscal 2022 to meet increasing customer demand. Management uses an inventory turnover ratio to monitor and evaluate inventory. Management calculates this ratio on an annual as well as a quarterly basis and uses inventory valued at average costs. The annualized inventory turnover (using average costs) for the year ended June 30, 2023 was 4.4 versus 4.7 for the year ended June 30, 2022.

CONTRACTUAL OBLIGATIONS

The following table shows the approximate value of the Company’s contractual obligations and other commitments to make future payments as of June 30, 2023 (in thousands):

(1) Amounts represent estimated contractual interest payments on outstanding long-term debt obligations net of receipts under the terms of the interest rate swap. Rates in effect as of June 30, 2023 are used for variable rate debt.

Purchase orders for inventory and other goods and services are not included in our estimates as we are unable to aggregate the amount of such purchase orders that represent enforceable and legally binding agreements specifying all significant terms. The previous table includes the gross liability for unrecognized income tax benefits including interest and penalties in the “Other” column as the Company is unable to make a reasonable estimate regarding the timing of cash settlements, if any, with the respective taxing authorities.

CRITICAL ACCOUNTING POLICIES

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates at a specific point in time that affect the amounts reported in the consolidated financial statements and disclosed in the accompanying notes. The Business and Accounting Policies note to the consolidated financial statements describes the significant accounting policies and methods used in preparation of the consolidated financial statements. Estimates are used for, but not limited to, determining the net carrying value of trade accounts receivable, inventories, recording self-insurance liabilities and other accrued liabilities. Estimates are also used in establishing opening balances in relation to purchase accounting. Actual results could differ from these estimates. The following critical accounting policies are impacted significantly by judgments, assumptions and estimates used in the preparation of the consolidated financial statements.

LIFO Inventory Valuation and Methodology

Inventories are valued at the average cost method, using the last-in, first-out (LIFO) method for U.S. inventories, and the average cost method for foreign inventories. We adopted the link chain dollar value LIFO method for accounting for U.S. inventories in fiscal 1974. Approximately 14.2% of our domestic inventory dollars relate to LIFO layers added in the 1970s. The excess of average cost over LIFO cost is $215.3 million as reflected in our consolidated balance sheet at June 30, 2023. The Company maintains five LIFO pools based on the following product groupings: bearings, power transmission products, rubber products, fluid power products and other products.

LIFO layers and/or liquidations are determined consistently year-to-year. See the Inventories note to the

consolidated financial statements in Item 8 under the caption "Financial Statements and Supplementary Data,"

for further information.

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Allowances for Slow-Moving and Obsolete Inventories

We evaluate the recoverability of our slow-moving and inactive inventories at least quarterly. We estimate the recoverable cost of such inventory by product type while considering factors such as its age, historic and current demand trends, the physical condition of the inventory, as well as assumptions regarding future demand. Our ability to recover our cost for slow moving or obsolete inventory can be affected by such factors as general market conditions, future customer demand and relationships with suppliers. A significant portion of the products we hold in inventory have long shelf lives and are not highly susceptible to obsolescence.

As of June 30, 2023 and 2022, the Company's reserve for slow-moving or obsolete inventories was $42.6 million and $39.2 million, respectively, recorded in inventories in the consolidated balance sheets.

Allowances for Doubtful Accounts

We evaluate the collectibility of trade accounts receivable based on a combination of factors. Initially, we estimate an allowance for doubtful accounts as a percentage of net sales based on historical bad debt experience. This initial estimate is adjusted based on recent trends of certain customers and industries estimated to be a greater credit risk, trends within the entire customer pool and changes in the overall aging of accounts receivable. While we have a large customer base that is geographically dispersed, a general economic downturn in any of the industry segments in which we operate could result in higher than expected defaults, and therefore, the need to revise estimates for bad debts. Accounts are written off against the allowance when it becomes evident that collection will not occur.

As of June 30, 2023 and 2022, our allowance for doubtful accounts was 3.1% and 2.6% of gross receivables, respectively. Our provision for losses on accounts receivable was $5.6 million, $3.2 million, and $6.5 million in fiscal 2023, 2022, and 2021, respectively.

Goodwill and Intangibles

The purchase price of an acquired company is allocated between intangible assets and the net tangible assets of the acquired business with the residual of the purchase price recorded as goodwill. Goodwill for acquired businesses is accounted for using the acquisition method of accounting which requires that the assets acquired and liabilities assumed be recorded at the date of the acquisition at their respective estimated fair values. The determination of the value of the intangible assets acquired involves certain judgments and estimates. These judgments can include, but are not limited to, the cash flows that an asset is expected to generate in the future and the appropriate weighted average cost of capital. The judgments made in determining the estimated fair value assigned to each class of assets acquired, as well as the estimated life of each asset, can materially impact the net income of the periods subsequent to the acquisition through depreciation and amortization, and in certain instances through impairment charges, if the asset becomes impaired in the future. As part of acquisition accounting, we recognize acquired identifiable intangible assets such as customer relationships, vendor relationships, trade names, and non-competition agreements apart from goodwill. Finite-lived identifiable intangibles are evaluated for impairment when changes in conditions indicate carrying value may not be recoverable. If circumstances require a finite-lived intangible asset be tested for possible impairment, the Company first compares undiscounted cash flows expected to be generated by the asset to the carrying value of the asset. If the carrying value of the finite-lived intangible asset is not recoverable on an undiscounted cash flow basis, impairment is recognized to the extent that the carrying value exceeds its fair value determined through a discounted cash flow model.

We evaluate goodwill for impairment at the reporting unit level annually as of January 1, and whenever an event occurs or circumstances change that would indicate that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. Events or circumstances that may result in an impairment review include changes in macroeconomic conditions, industry and market considerations, cost factors, overall financial performance, other relevant entity-specific events, specific events affecting the reporting unit or sustained decrease in share price. Each year, the Company may elect to perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. If impairment is indicated in the qualitative assessment, or, if management elects to initially perform a quantitative assessment of goodwill, the impairment test uses a one-step approach. The fair value of a reporting unit is compared with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill of the reporting unit is not impaired. If the carrying amount of a reporting unit exceeds its fair value, an impairment charge would be recognized for the amount by which the carrying amount exceeds the reporting unit's fair value, not to exceed the total amount of goodwill allocated to that reporting unit.

Goodwill on our consolidated financial statements relates to both the Service Center Based Distribution segment and the Engineered Solutions segment. The Company has eight (8) reporting units for which an annual goodwill impairment assessment was performed as of January 1, 2023.  The Company concluded that all of the reporting units’ fair values exceeded their carrying amounts by at least 20% as of January 1, 2023.

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The fair values of the reporting units in accordance with the goodwill impairment test were determined using the income and market approaches. The income approach employs the discounted cash flow method reflecting projected cash flows expected to be generated by market participants and then adjusted for time value of money factors, and requires management to make significant estimates and assumptions related to forecasts of future revenues, operating margins, and discount rates. The market approach utilizes an analysis of comparable publicly traded companies and requires management to make significant estimates and assumptions related to the forecasts of future revenues, earnings before interest, taxes, depreciation, and amortization (EBITDA) and multiples that are applied to management’s forecasted revenues and EBITDA estimates.

Changes in future results, assumptions, and estimates after the measurement date may lead to an outcome where additional impairment charges would be required in future periods.  Specifically, actual results may vary from the Company’s forecasts and such variations may be material and unfavorable, thereby triggering the need for future impairment tests where the conclusions may differ in reflection of prevailing market conditions.  Further, continued adverse market conditions could result in the recognition of additional impairment if the Company determines that the fair values of its reporting units have fallen below their carrying values.

Income Taxes

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. As of June 30, 2023, the Company recognized $35.0 million of net deferred tax liabilities. Valuation allowances are provided against net deferred tax assets, determined on a jurisdiction by jurisdiction basis, where it is considered more-likely-than-not that the Company will not realize the benefit of such assets. The remaining net deferred tax asset is the amount management believes is more-likely-than-not of being realized. The realization of these deferred tax assets can be impacted by changes to tax laws, statutory rates and future taxable income levels.

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CAUTIONARY STATEMENT UNDER PRIVATE SECURITIES LITIGATION REFORM ACT

This Form 10-K, including Management’s Discussion and Analysis, contains statements that are forward-looking based on management’s current expectations about the future. Forward-looking statements are often identified by qualifiers, such as “guidance”, “expect”, “believe”, “plan”, “intend”, “will”, “should”, “could”, “would”, “anticipate”, “estimate”, “forecast”, “may”, "optimistic" and derivative or similar words or expressions. Similarly, descriptions of objectives, strategies, plans, or goals are also forward-looking statements. These statements may discuss, among other things, expected growth, future sales, future cash flows, future capital expenditures, future performance, and the anticipation and expectations of the Company and its management as to future occurrences and trends. The Company intends that the forward-looking statements be subject to the safe harbors established in the Private Securities Litigation Reform Act of 1995 and by the Securities and Exchange Commission in its rules, regulations, and releases.

Readers are cautioned not to place undue reliance on any forward-looking statements. All forward-looking statements are based on current expectations regarding important risk factors, many of which are outside the Company’s control. Accordingly, actual results may differ materially from those expressed in the forward-looking statements, and the making of those statements should not be regarded as a representation by the Company or any other person that the results expressed in the statements will be achieved. In addition, the Company assumes no obligation publicly to update or revise any forward-looking statements, whether because of new information or events, or otherwise, except as may be required by law.

Important risk factors include, but are not limited to, the following: risks relating to the operations levels of our customers and the economic factors that affect them; continuing risks relating to the effects of the COVID-19 pandemic; inflationary or deflationary trends in the cost of products, energy, labor and other operating costs, and changes in the prices for products and services relative to the cost of providing them; reduction in supplier inventory purchase incentives; loss of key supplier authorizations, lack of product availability (such as due to supply chain strains), changes in supplier distribution programs, inability of suppliers to perform, and transportation disruptions; changes in customer preferences for products and services of the nature and brands sold by us; changes in customer procurement policies and practices; competitive pressures; our reliance on information systems and risks relating to their proper functioning, the security of those systems, and the data stored in or transmitted through them; the impact of economic conditions on the collectability of trade receivables; reduced demand for our products in targeted markets due to reasons including consolidation in customer industries; our ability to retain and attract qualified sales and customer service personnel and other skilled executives, managers and professionals; our ability to identify and complete acquisitions, integrate them effectively, and realize their anticipated benefits; the variability, timing and nature of new business opportunities including acquisitions, alliances, customer relationships, and supplier authorizations; the incurrence of debt and contingent liabilities in connection with acquisitions; our ability to access capital markets as needed on reasonable terms; disruption of operations at our headquarters or distribution centers; risks and uncertainties associated with our foreign operations, including volatile economic conditions, political instability, cultural and legal differences, and currency exchange fluctuations; the potential for goodwill and intangible asset impairment; changes in accounting policies and practices; our ability to maintain effective internal control over financial reporting; organizational changes within the Company; risks related to legal proceedings to which we are a party; potentially adverse government regulation, legislation, or policies, both enacted and under consideration, including with respect to federal tax policy, international trade, data privacy and security, and government contracting; and the occurrence of extraordinary events (including prolonged labor disputes, power outages, telecommunication outages, terrorist acts, war, public health emergency, earthquakes, extreme weather events, other natural disasters, fires, floods, and accidents). Other factors and unanticipated events could also adversely affect our business, financial condition, or results of operations. Risks can also change over time. Further, the disclosure of a risk should not be interpreted to imply that the risk has not already materialized.

We discuss certain of these matters and other risk factors more fully throughout our Form 10-K, as well as other of our filings with the Securities and Exchange Commission.

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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS.

OVERVIEW

With approximately 6,100 associates across North America, Australia, New Zealand, and Singapore, Applied Industrial Technologies, Inc. ("Applied," the "Company," "We," "Us," or "Our") is a leading value-added distributor and technical solutions provider of industrial motion, fluid power, flow control, automation technologies, and related maintenance supplies. Our leading brands, specialized services, and comprehensive knowledge serve MRO (Maintenance, Repair & Operations) and OEM (Original Equipment Manufacturer) end users in virtually all industrial markets through our multi-channel capabilities that provide choice, convenience, and expertise. We have a long tradition of growth dating back to 1923, the year our business was founded in Cleveland, Ohio. At June 30, 2022, business was conducted in the United States, Puerto Rico, Canada, Mexico, Australia, New Zealand, and Singapore from approximately 568 facilities.

The following is Management's Discussion and Analysis of significant factors that have affected our financial condition, results of operations and cash flows during the periods included in the accompanying consolidated balance sheets, statements of consolidated income, consolidated comprehensive income and consolidated cash flows in Item 8 under the caption "Financial Statements and Supplementary Data." When reviewing the discussion and analysis set forth below, please note that a significant number of SKUs (Stock Keeping Units) we sell in any given year were not sold in the comparable period of the prior year, resulting in the inability to quantify certain commonly used comparative metrics analyzing sales, such as changes in product mix and volume.

Our fiscal 2022 consolidated sales were $3.8 billion, an increase of $574.8 million or 17.8% compared to the prior year, with the acquisitions of Advanced Control Solutions (ACS), Gibson Engineering (Gibson) and R.R. Floody Company (Floody) increasing sales by $34.1 million or 1.1% and favorable foreign currency translation of $2.4 million increasing sales by 0.1%. Gross profit margin increased to 29.0% for fiscal 2022 from 28.9% for fiscal 2021. Operating margin increased to 9.4% in fiscal 2022 from 6.3% in fiscal 2021.

Our earnings per share was $6.58 in fiscal 2022 versus $3.68 in fiscal year 2021.

Fiscal 2021 results included a $49.5 million pre-tax non-cash charge related to the impairment of certain intangible, lease, and fixed assets, as well as non-routine costs of $7.8 million pre-tax, which were the result of weaker economic conditions and business alignment initiatives across a portion of the Service Center Based Distribution segment operations exposed to oil and gas end markets. Total non-routine costs of $7.8 million pre-tax included a $7.4 million inventory reserve charge recorded within cost of sales, and $0.4 million related to severance and facility consolidation recorded in selling, distribution and administrative expense. These charges were offset in the prior year by non-routine income of $2.6 million. On a net basis, the fiscal 2021 non-routine items unfavorably impacted operating income by $54.7 million, net income by $41.7 million, and earnings per share by $1.06 per share.

Shareholders’ equity was $1,149.4 million at June 30, 2022 compared to $932.5 million at June 30, 2021. Working capital increased $91.0 million from June 30, 2021 to $859.9 million at June 30, 2022. The current ratio was 2.7 to 1 and 2.8 to 1 at June 30, 2022 and at June 30, 2021, respectively.

Applied monitors several economic indices that have been key indicators for industrial economic activity in the United States. These include the Industrial Production (IP) and Manufacturing Capacity Utilization (MCU) indices published by the Federal Reserve Board and the Purchasing Managers Index (PMI) published by the Institute for Supply Management (ISM). Historically, our performance correlates well with the MCU, which measures productivity and calculates a ratio of actual manufacturing output versus potential full capacity output. When manufacturing plants are running at a high rate of capacity, they tend to wear out machinery and require replacement parts.

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The MCU (total industry) and IP indices increased since June 2021 correlating with an overall increase in the economy in the same period. The ISM PMI registered 53.0 in June 2022, a decrease from the June 2021 revised reading of 60.9. A reading above 50 generally indicates expansion. The index readings for the months during the most recent quarter, along with the revised indices for previous quarter ends, were as follows:

RESULTS OF OPERATIONS

This discussion and analysis deals with comparisons of material changes in the consolidated financial statements for the years ended June 30, 2022 and 2021. For the comparison of the years ended June 30, 2021 and 2020, see the Management's Discussion and Analysis of Financial Condition and Results of Operations in Part II, Item 7 of our 2021 Annual Report on Form 10-K.

The following table is included to aid in review of Applied’s statements of consolidated income.

Sales in fiscal 2022 were $3.8 billion, which was $574.8 million or 17.8% above the prior year, with sales from acquisitions adding $34.1 million or 1.1% and favorable foreign currency translation accounting for an increase of $2.4 million or 0.1%. There were 252.5 selling days in both fiscal 2022 and 2021. Excluding the impact of businesses acquired and foreign currency translation, sales were up $538.3 million or 16.6% during the year, driven by an increase from operations reflecting positive growth across core end markets, including heavy industrial verticals, as well as ongoing pricing actions and our internal growth initiatives.

The following table shows changes in sales by reportable segment.

Sales in our Service Center Based Distribution segment, which operates primarily in MRO markets, increased $366.1 million, or 16.6%. Favorable foreign currency translation increased sales by $2.4 million or 0.1%. Excluding the impact of businesses acquired and the impact of foreign currency translation, sales increased $363.7 million or 16.5% during the year, driven by an increase from operations due to benefits from break-fix MRO activity, sales process initiatives, as well as incremental growth from heavy industry verticals, with the strongest growth from the metals, machinery, aggregates, mining, pulp & paper, rubber & plastics, energy, and lumber & wood end markets.

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Sales in our Fluid Power & Flow Control segment increased $208.7 million or 20.1%. Acquisitions within this segment, primarily Gibson and Floody, increased sales $34.1 million or 3.3%. Excluding the impact of businesses acquired, sales increased $174.6 million or 16.8%, driven by an increase from operations due to ongoing demand strength across technology verticals and automation, as well as end market growth across the metals, chemicals, refining, utilities, pulp & paper and mining end-markets, partially offset by supply chain bottlenecks.

The following table shows changes in sales by geographical area. Other countries include Mexico, Australia, New Zealand, and Singapore.

Sales in our U.S. operations increased $516.9 million or 18.6%, with acquisitions adding $34.1 million or 1.2%. Excluding the impact of businesses acquired, U.S. sales were up $482.8 million or 17.4%, driven by an increase from operations. Sales from our Canadian operations increased $36.2 million or 14.2%, while favorable foreign currency translation increased Canadian sales by $2.8 million or 1.1%. Excluding the impact of foreign currency translation, Canadian sales were up $33.4 million or 13.1%. Consolidated sales from our other countries operations increased $21.7 million or 11.0% compared to the prior year. Unfavorable foreign currency translation decreased other countries sales by $0.4 million or 0.2%. Excluding the impact of foreign currency translation, other countries sales were up $22.1 million or 11.2% compared to the prior year, driven by an increase from operations, primarily a $13.9 million increase in Mexican sales due to increased industrial activity, primarily related to steel operations.

Our gross profit margin increased to 29.0% in fiscal 2022 compared to 28.9% in fiscal 2021. Gross profit margin expanded year over year and sequentially primarily reflecting broad-based execution across the business and countermeasures in response to ongoing inflation and supply chain dynamics. This was offset by 72 basis points due to a $27.3 million increase in LIFO expense year over year.

The following table shows the changes in selling, distribution, and administrative expense (SD&A).

SD&A consists of associate compensation, benefits and other expenses associated with selling, purchasing, warehousing, supply chain management, and marketing and distribution of the Company’s products, as well as costs associated with a variety of administrative functions such as human resources, information technology, treasury, accounting, insurance, legal, facility related expenses and expenses incurred in acquiring businesses. SD&A increased $68.5 million or 10.1% during fiscal 2022 compared to the prior year, and as a percentage of sales decreased to 19.7% in fiscal 2022 compared to 21.0% in fiscal 2021. Changes in foreign currency exchange rates had the effect of increasing SD&A by $0.5 million or 0.1% compared to the prior year. SD&A from businesses acquired added $9.3 million or 1.4%, including $0.8 million of intangibles amortization related to acquisitions. Excluding the impact of businesses acquired and the unfavorable impact from foreign currency translation, SD&A increased $58.7 million or 8.6% during fiscal 2022 compared to fiscal 2021. The Company incurred $0.4 million of non-routine expenses related to severance and closed facilities during fiscal 2021. Excluding the impact of acquisitions and severance, total compensation increased $50.3 million during fiscal 2022, primarily due to cost reduction actions taken by the Company in fiscal 2021 in response to the COVID-19 pandemic, including headcount reductions, temporary furloughs and pay reductions, and suspension of the 401(k) plan company match. Also, excluding the impact of acquisitions, travel & entertainment and fleet expenses increased $9.0 million during 2022, primarily due to reduced travel activity related to COVID-19 in the prior year. All other expenses within SD&A were down $0.2 million.

During fiscal 2021, the Company determined that an impairment existed in two of its three asset groups within the Service Center Based Distribution segment that have significant exposure to oil and gas end markets as the asset

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groups' carrying values exceeded the sum of the undiscounted cash flows. The fair values of the long-lived assets were determined using the income approach, and the analyses resulted in the measurement of an intangible asset impairment loss of $45.0 million, as the fair value of the intangible assets was determined to be zero. The analyses of these asset groups also resulted in a fixed asset impairment loss and leased asset impairment loss of $2.0 million and $2.5 million, respectively, which were recorded in fiscal 2021. Combined, the non-cash impairment charges decreased net income by $37.8 million and earnings per share by $0.96 per share for fiscal 2021.

Operating income increased $152.4 million, or 74.2%, to $357.9 million during fiscal 2022 from $205.5 million during fiscal 2021, and as a percentage of sales, increased to 9.4% from 6.3%, primarily due to gross profit margin expansion and control of SD&A expense in fiscal 2022, in addition to the $49.5 million non-cash impairment charges recorded in fiscal 2021.

Operating income, before impairment charges, as a percentage of sales for the Service Center Based Distribution segment increased to 11.8% in fiscal 2022 from 10.2% in fiscal 2021. Operating income as a percentage of sales for the Fluid Power & Flow Control segment increased to 12.6% in fiscal 2022 from 11.8% in fiscal 2021.

Segment operating income is impacted by changes in the amounts and levels of certain supplier support benefits and expenses allocated to the segments. The expense allocations include corporate charges for working capital, logistics support and other items and impact segment gross profit and operating expense.

Other expense (income), net, represents certain non-operating items of income and expense, and was $1.8 million of expense in fiscal 2022 compared to $2.2 million of income in fiscal 2021. Current year expense primarily consists of unrealized loss on investments held by non-qualified deferred compensation trusts of $2.6 million and other expense of $0.6 million, offset by life insurance income of $1.4 million. Fiscal 2021 income consisted primarily of unrealized gains on investments held by non-qualified deferred compensation trusts of $4.0 million and other income of $0.3 million offset by foreign currency transaction losses of $2.1 million.

The effective income tax rate was 21.9% for fiscal 2022 compared to 18.2% for fiscal 2021. The increase in the effective tax rate is due to changes in compensation-related deductions and uncertain tax positions in fiscal 2022 compared to the prior year.

As a result of the factors discussed above, net income for fiscal 2022 increased $112.7 million from the prior year. Net income per share was $6.58 per share for fiscal 2022 compared to $3.68 per share for fiscal 2021.

We had a total of 568 operating facilities in the United States, Puerto Rico, Canada, Mexico, Australia, New Zealand, and Singapore at June 30, 2022 and June 30, 2021.

The approximate number of Company employees was 6,100 at June 30, 2022 and 5,900 at June 30, 2021.

LIQUIDITY AND CAPITAL RESOURCES

Our primary source of capital is cash flow from operations, supplemented as necessary by bank borrowings or other sources of debt. At June 30, 2022 we had total debt obligations outstanding of $689.5 million compared to $829.4 million at June 30, 2021. Management expects that our existing cash, cash equivalents, funds available under our debt facilities, and cash provided from operations, will be sufficient to finance normal working capital needs in each of the countries we operate in, payment of dividends, acquisitions, investments in properties, facilities and equipment, debt service, and the purchase of additional Company common stock. Management also believes that additional long-term debt and line of credit financing could be obtained based on the Company’s credit standing and financial strength.

The Company’s working capital at June 30, 2022 was $859.9 million compared to $768.9 million at June 30, 2021. The current ratio was 2.7 to 1 at June 30, 2022 and 2.8 to 1 at June 30, 2021.

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Net Cash Flows

The following table is included to aid in review of Applied’s statements of consolidated cash flows.

The decrease in cash provided by operating activities during fiscal 2022 is driven by changes in working capital for the year offset by increased operating results. Changes in cash flows between years related to working capital were driven by (amounts in thousands):

Net cash used in investing activities in fiscal 2022 included $7.0 million used for the acquisition of Floody, $14.8 million in cash payments for loans on company-owned life insurance and $18.1 million used for capital expenditures. Net cash used in investing activities in fiscal 2021 included $30.2 million used for the acquisitions of ACS and Gibson and $15.9 million for capital expenditures.

Net cash used in financing activities increased from the prior year period primarily due to a change in net debt activity, as there was $139.9 million of net debt payments in fiscal 2022 compared to $105.9 million of net debt payments in 2021. Further uses of cash in 2022 were $51.8 million for dividend payments, $8.1 million used to pay taxes for shares withheld, and $13.8 million used to repurchase 148,658 shares of treasury stock. Further uses of cash in 2021 were $50.7 million for dividend payments, $10.1 million used to pay taxes for shares withheld, and $40.1 million used to repurchase 400,000 shares of treasury stock.

The increase in dividends over the year is the result of regular increases in our dividend payout rates. We paid dividends of $1.34 and $1.30 per share in fiscal 2022 and 2021, respectively.

Capital Expenditures

We expect capital expenditures for fiscal 2023 to be in the $23.0 million to $25.0 million range, primarily consisting of capital associated with additional information technology equipment and infrastructure investments.

Share Repurchases

The Board of Directors has authorized the repurchase of shares of the Company’s stock. These purchases may

be made in open market and negotiated transactions, from time to time, depending upon market conditions.

At June 30, 2022, we had authorization to purchase an additional 315,960 shares. On August 9, 2022 the Board of Directors authorized the repurchase of 1.5 million shares of the Company's stock.

The Company repurchased 148,658 shares in fiscal 2022 at an average price per share of $92.72. In fiscal 2021, we repurchased 400,000 shares of the Company's common stock at an average price per share of $100.22 and in fiscal 2020, no shares were repurchased.

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Borrowing Arrangements

A summary of long-term debt, including the current portion, follows (amounts are in thousands):

In December 2021, the Company entered into a new five-year revolving credit facility with a group of banks to refinance the existing credit facility as well as provide funds for ongoing working capital and other general corporate purposes. This agreement provides a $900.0 million unsecured revolving credit facility and an uncommitted accordion feature which allows the Company to request an increase in the borrowing commitments, or incremental term loans, under the credit facility in aggregate principal amounts of up to $500.0 million. Borrowings under this agreement bear interest, at the Company's election, at either the base rate plus a margin that ranges from 0 to 55 basis points based on net leverage ratio or LIBOR plus a margin that ranges from 80 to 155 basis points based on the net leverage ratio. Unused lines under this facility, net of outstanding letters of credit of $0.2 million to secure certain insurance obligations, totaled $489.2 million at June 30, 2022, and were available to fund future acquisitions or other capital and operating requirements. The interest rate on the revolving credit facility was 2.81% as of June 30, 2022.

The new credit facility replaced the Company's previous credit facility agreement. The Company used its initial borrowings on the new revolving credit facility along with cash on hand of $98.2 million to extinguish the term loan balance outstanding under the previous credit facility of $540.5 million. The Company had no amount outstanding under the revolver at June 30, 2021. Unused lines under the previous facility, net of outstanding letters of credit of $0.2 million to secure certain insurance obligations, totaled $249.8 million at June 30, 2021. The interest rate on the term loan was 1.88% as of June 30, 2021.

The Company paid $2.0 million of debt issuance costs related to the new revolving credit facility in the year ended June 30, 2022, which are included in other current assets and other assets on the consolidated balance sheet as of June 30, 2022 and will be amortized over the five-year term of the new credit facility. The Company analyzed the unamortized debt issuance costs related to the previous credit facility under Accounting Standards Codification (ASC) Topic 470 - Debt. As a result of this analysis, $0.1 million of unamortized debt issuance costs were expensed and included within interest expense on the statements of consolidated income for the year ended June 30, 2022, and $0.5 million of unamortized debt issuance costs were rolled forward into the new credit facility and were reclassified from the current portion of long-term debt and long-term debt into other current assets and other assets on the consolidated balance sheet as of June 30, 2022, and will be amortized over the five-year term of the new credit facility.

Additionally, the Company had letters of credit outstanding not associated with the revolving credit agreement, in the amount of $4.7 million and $4.5 million as of June 30, 2022 and June 30, 2021, respectively, in order to secure certain insurance obligations.

In August 2018, the Company established a trade receivable securitization facility (the “AR Securitization Facility”) with a termination date of August 31, 2021. On March 26, 2021, the Company amended the AR Securitization Facility to expand the eligible receivables, which increased the maximum availability to $250.0 million and increased the drawn fees on the AR Securitization Facility to 0.98% per year. Availability is further subject to changes in the credit ratings of our customers, customer concentration levels or certain characteristics of the accounts receivable being transferred and, therefore, at certain times, we may not be able to fully access the $250.0 million of funding available under the AR Securitization Facility. The AR Securitization Facility effectively increases the Company’s borrowing capacity by collateralizing a portion of the amount of the U.S. operations’ trade accounts receivable. The Company uses the proceeds from the AR Securitization Facility as an alternative to other forms of debt, effectively reducing borrowing costs. Borrowings under this facility carry variable interest rates tied to LIBOR.

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The interest rate on the AR Securitization Facility as of June 30, 2022 and June 30, 2021 was 2.60% and 1.20%, respectively. The new termination date of the AR Securitization Facility is March 26, 2024.

At June 30, 2022 and June 30, 2021, the Company had borrowings outstanding under its unsecured shelf facility agreement with Prudential Investment Management of $90.0 million. Fees on this facility range from 0.25% to 1.25% per year based on the Company's leverage ratio at each quarter end. The "Series C" notes carried a fixed interest rate of 3.19%, and the remaining balance of $40.0 million was paid in July 2022. The "Series D" notes have a remaining principal amount of $25.0 million, carry a fixed interest rate of 3.21%, and are due in October 2023. The "Series E" notes have a principal amount of $25.0 million, carry a fixed interest rate of 3.08%, and are due in October 2024.

In 2014, the Company assumed $2.4 million of debt as a part of the headquarters facility acquisition. The 1.50% fixed interest rate note is held by the State of Ohio Development Services Agency and matures in November 2024.

In 2019, the Company entered into an interest rate swap which mitigates variability in forecasted interest payments on $409.0 million of the Company’s U.S. dollar-denominated unsecured variable rate debt. For more information, see note 7, Derivatives, to the consolidated financial statements, included in Item 8 under the caption “Financial Statements and Supplementary Data.”

The credit facility and the unsecured shelf facility contain restrictive covenants regarding liquidity, net worth, financial ratios, and other covenants. At June 30, 2022, the most restrictive of these covenants required that the Company have net indebtedness less than 3.75 times consolidated income before interest, taxes, depreciation and amortization (as defined). At June 30, 2022, the Company's net indebtedness was less than 1.3 times consolidated income before interest, taxes, depreciation and amortization (as defined). The Company was in compliance with all financial covenants at June 30, 2022.

Accounts Receivable Analysis

The following table is included to aid in analysis of accounts receivable and the associated provision for losses on accounts receivable (all dollar amounts are in thousands):

Accounts receivable are reported at net realizable value and consist of trade receivables from customers. Management monitors accounts receivable by reviewing Days Sales Outstanding (DSO) and the aging of receivables for each of the Company's locations. The Company experienced a significant increase in accounts receivable during fiscal 2022 commensurate with the increase in sales.

On a consolidated basis, DSO was 55.7 at June 30, 2022 versus 51.9 at June 30, 2021. Approximately 3.4% of our accounts receivable balances are more than 90 days past due at June 30, 2022 compared to 3.0% at June 30, 2021. On an overall basis, our provision for losses from uncollected receivables represents 0.08% of our sales for the year ended June 30, 2022, compared to 0.20% of sales for the year ended June 30, 2021. The decrease primarily relates to provisions recorded in the prior year for customer credit deterioration and bankruptcies primarily in the U.S. and Mexican operations of the Service Center Based Distribution segment. Historically, this percentage is around 0.10% to 0.15%. Management believes the overall receivables aging and provision for losses on uncollected receivables are at reasonable levels.

Inventory Analysis

Inventories are valued using the last-in, first-out (LIFO) method for U.S. inventories and the average cost method for foreign inventories. Inventory increased throughout fiscal 2022 to meet increasing customer demand. Management uses an inventory turnover ratio to monitor and evaluate inventory. Management calculates this ratio on an annual as well as a quarterly basis and uses inventory valued at average costs. The annualized inventory turnover (using average costs) for the year ended June 30, 2022 was 4.7 versus 4.3 for the year ended June 30, 2021.

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CONTRACTUAL OBLIGATIONS

The following table shows the approximate value of the Company’s contractual obligations and other commitments to make future payments as of June 30, 2022 (in thousands):

(1) Amounts represent estimated contractual interest payments on outstanding long-term debt obligations and net payments under the terms of the interest rate swap. Rates in effect as of June 30, 2022 are used for variable rate debt.

Purchase orders for inventory and other goods and services are not included in our estimates as we are unable to aggregate the amount of such purchase orders that represent enforceable and legally binding agreements specifying all significant terms. The previous table includes the gross liability for unrecognized income tax benefits including interest and penalties in the “Other” column as the Company is unable to make a reasonable estimate regarding the timing of cash settlements, if any, with the respective taxing authorities.

CRITICAL ACCOUNTING POLICIES

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates at a specific point in time that affect the amounts reported in the consolidated financial statements and disclosed in the accompanying notes. The Business and Accounting Policies note to the consolidated financial statements describes the significant accounting policies and methods used in preparation of the consolidated financial statements. Estimates are used for, but not limited to, determining the net carrying value of trade accounts receivable, inventories, recording self-insurance liabilities and other accrued liabilities. Estimates are also used in establishing opening balances in relation to purchase accounting. Actual results could differ from these estimates. The following critical accounting policies are impacted significantly by judgments, assumptions and estimates used in the preparation of the consolidated financial statements.

LIFO Inventory Valuation and Methodology

Inventories are valued at the average cost method, using the last-in, first-out (LIFO) method for U.S. inventories, and the average cost method for foreign inventories. We adopted the link chain dollar value LIFO method for accounting for U.S. inventories in fiscal 1974. Approximately 15.7% of our domestic inventory dollars relate to LIFO layers added in the 1970s. The excess of average cost over LIFO cost is $178.9 million as reflected in our consolidated balance sheet at June 30, 2022. The Company maintains five LIFO pools based on the following product groupings: bearings, power transmission products, rubber products, fluid power products and other products.

LIFO layers and/or liquidations are determined consistently year-to-year. See the Inventories note to the

consolidated financial statements in Item 8 under the caption "Financial Statements and Supplementary Data,"

for further information.

Allowances for Slow-Moving and Obsolete Inventories

We evaluate the recoverability of our slow-moving and inactive inventories at least quarterly. We estimate the recoverable cost of such inventory by product type while considering factors such as its age, historic and current demand trends, the physical condition of the inventory, as well as assumptions regarding future demand. Our ability to recover our cost for slow moving or obsolete inventory can be affected by such factors as general market conditions, future customer demand and relationships with suppliers. A significant portion of the products we hold in inventory have long shelf lives and are not highly susceptible to obsolescence.

As of June 30, 2022 and 2021, the Company's reserve for slow-moving or obsolete inventories was $39.2 million and $43.5 million, respectively, recorded in inventories in the consolidated balance sheets.

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Allowances for Doubtful Accounts

We evaluate the collectibility of trade accounts receivable based on a combination of factors. Initially, we estimate an allowance for doubtful accounts as a percentage of net sales based on historical bad debt experience. This initial estimate is adjusted based on recent trends of certain customers and industries estimated to be a greater credit risk, trends within the entire customer pool and changes in the overall aging of accounts receivable. While we have a large customer base that is geographically dispersed, a general economic downturn in any of the industry segments in which we operate could result in higher than expected defaults, and therefore, the need to revise estimates for bad debts. Accounts are written off against the allowance when it becomes evident that collection will not occur.

As of June 30, 2022 and 2021, our allowance for doubtful accounts was 2.6% and 3.1% of gross receivables, respectively. Our provision for losses on accounts receivable was $3.2 million, $6.5 million, and $14.1 million in fiscal 2022, 2021, and 2020, respectively.

Goodwill and Intangibles

The purchase price of an acquired company is allocated between intangible assets and the net tangible assets of the acquired business with the residual of the purchase price recorded as goodwill. Goodwill for acquired businesses is accounted for using the acquisition method of accounting which requires that the assets acquired and liabilities assumed be recorded at the date of the acquisition at their respective estimated fair values. The determination of the value of the intangible assets acquired involves certain judgments and estimates. These judgments can include, but are not limited to, the cash flows that an asset is expected to generate in the future and the appropriate weighted average cost of capital. The judgments made in determining the estimated fair value assigned to each class of assets acquired, as well as the estimated life of each asset, can materially impact the net income of the periods subsequent to the acquisition through depreciation and amortization, and in certain instances through impairment charges, if the asset becomes impaired in the future. As part of acquisition accounting, we recognize acquired identifiable intangible assets such as customer relationships, vendor relationships, trade names, and non-competition agreements apart from goodwill. Finite-lived identifiable intangibles are evaluated for impairment when changes in conditions indicate carrying value may not be recoverable. If circumstances require a finite-lived intangible asset be tested for possible impairment, the Company first compares undiscounted cash flows expected to be generated by the asset to the carrying value of the asset. If the carrying value of the finite-lived intangible asset is not recoverable on an undiscounted cash flow basis, impairment is recognized to the extent that the carrying value exceeds its fair value determined through a discounted cash flow model.

The Company has three asset groups that have significant exposure to oil and gas end markets. Due to the economic downturn in these end markets in the prior year, the Company determined during the second quarter of fiscal 2021 that certain carrying values may not be recoverable. The Company determined that an impairment existed in two of the three asset groups as the asset groups' carrying values exceeded the sum of the undiscounted cash flows. The fair values of the long-lived assets were then determined using the income approach, and the analyses resulted in the measurement of an intangible asset impairment loss of $45.0 million, which was recorded in the second quarter of fiscal 2021, as the fair value of the intangible assets was determined to be zero. The income approach employs the discounted cash flow method reflecting projected cash flows expected to be generated by market participants and then adjusted for time value of money factors, and requires management to make significant estimates and assumptions related to forecasts of future revenues, earnings before interest, taxes, depreciation, and amortization (EBITDA), and discount rates. Key assumptions (Level 3 in the fair value hierarchy) relate to pricing trends, inventory costs, customer demand, and revenue growth. A number of benchmarks from independent industry and other economic publications were also used. The analyses of these asset groups also resulted in a fixed asset impairment loss and leased asset impairment loss of $2.0 million and $2.5 million, respectively, which were recorded in the second quarter of fiscal 2021. Sustained significant softness in certain end market concentrations could result in impairment of certain intangible assets in future periods.

We evaluate goodwill for impairment at the reporting unit level annually as of January 1, and whenever an event occurs or circumstances change that would indicate that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. Events or circumstances that may result in an impairment review include changes in macroeconomic conditions, industry and market considerations, cost factors, overall financial performance, other relevant entity-specific events, specific events affecting the reporting unit or sustained decrease in share price. Each year, the Company may elect to perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. If impairment is indicated in the qualitative assessment, or, if management elects to initially perform a quantitative assessment of goodwill, the impairment test uses a one-step approach. The fair value of a reporting unit is compared with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill of the reporting unit is not impaired. If the carrying amount of a reporting unit exceeds its fair value, an impairment charge would be

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recognized for the amount by which the carrying amount exceeds the reporting unit's fair value, not to exceed the total amount of goodwill allocated to that reporting unit.

Goodwill on our consolidated financial statements relates to both the Service Center Based Distribution segment and the Fluid Power & Flow Control segment. The Company has eight (8) reporting units for which an annual goodwill impairment assessment was performed as of January 1, 2022.  The Company concluded that all of the reporting units’ fair values exceeded their carrying amounts by at least 25% as of January 1, 2022.

The fair values of the reporting units in accordance with the goodwill impairment test were determined using the income and market approaches. The income approach employs the discounted cash flow method reflecting projected cash flows expected to be generated by market participants and then adjusted for time value of money factors, and requires management to make significant estimates and assumptions related to forecasts of future revenues, operating margins, and discount rates. The market approach utilizes an analysis of comparable publicly traded companies and requires management to make significant estimates and assumptions related to the forecasts of future revenues, earnings before interest, taxes, depreciation, and amortization (EBITDA) and multiples that are applied to management’s forecasted revenues and EBITDA estimates.

Changes in future results, assumptions, and estimates after the measurement date may lead to an outcome where additional impairment charges would be required in future periods.  Specifically, actual results may vary from the Company’s forecasts and such variations may be material and unfavorable, thereby triggering the need for future impairment tests where the conclusions may differ in reflection of prevailing market conditions.  Further, continued adverse market conditions could result in the recognition of additional impairment if the Company determines that the fair values of its reporting units have fallen below their carrying values.

Income Taxes

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. As of June 30, 2022, the Company recognized $38.3 million of net deferred tax liabilities. Valuation allowances are provided against net deferred tax assets, determined on a jurisdiction by jurisdiction basis, where it is considered more-likely-than-not that the Company will not realize the benefit of such assets. The remaining net deferred tax asset is the amount management believes is more-likely-than-not of being realized. The realization of these deferred tax assets can be impacted by changes to tax laws, statutory rates and future taxable income levels.

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CAUTIONARY STATEMENT UNDER PRIVATE SECURITIES LITIGATION REFORM ACT

This Form 10-K, including Management’s Discussion and Analysis, contains statements that are forward-looking based on management’s current expectations about the future. Forward-looking statements are often identified by qualifiers, such as “guidance”, “expect”, “believe”, “plan”, “intend”, “will”, “should”, “could”, “would”, “anticipate”, “estimate”, “forecast”, “may”, "optimistic" and derivative or similar words or expressions. Similarly, descriptions of objectives, strategies, plans, or goals are also forward-looking statements. These statements may discuss, among other things, expected growth, future sales, future cash flows, future capital expenditures, future performance, and the anticipation and expectations of the Company and its management as to future occurrences and trends. The Company intends that the forward-looking statements be subject to the safe harbors established in the Private Securities Litigation Reform Act of 1995 and by the Securities and Exchange Commission in its rules, regulations, and releases.

Readers are cautioned not to place undue reliance on any forward-looking statements. All forward-looking statements are based on current expectations regarding important risk factors, many of which are outside the Company’s control. Accordingly, actual results may differ materially from those expressed in the forward-looking statements, and the making of those statements should not be regarded as a representation by the Company or any other person that the results expressed in the statements will be achieved. In addition, the Company assumes no obligation publicly to update or revise any forward-looking statements, whether because of new information or events, or otherwise, except as may be required by law.

Important risk factors include, but are not limited to, the following: risks relating to the operations levels of our customers and the economic factors that affect them; continuing risks relating to the effects of the COVID-19 pandemic; inflationary or deflationary trends in the cost of products, energy, labor and other operating costs, and changes in the prices for products and services relative to the cost of providing them; reduction in supplier inventory purchase incentives; loss of key supplier authorizations, lack of product availability (such as due to supply chain strains), changes in supplier distribution programs, inability of suppliers to perform, and transportation disruptions; changes in customer preferences for products and services of the nature and brands sold by us; changes in customer procurement policies and practices; competitive pressures; our reliance on information systems and risks relating to their proper functioning, the security of those systems, and the data stored in or transmitted through them; the impact of economic conditions on the collectability of trade receivables; reduced demand for our products in targeted markets due to reasons including consolidation in customer industries; our ability to retain and attract qualified sales and customer service personnel and other skilled executives, managers and professionals; our ability to identify and complete acquisitions, integrate them effectively, and realize their anticipated benefits; the variability, timing and nature of new business opportunities including acquisitions, alliances, customer relationships, and supplier authorizations; the incurrence of debt and contingent liabilities in connection with acquisitions; our ability to access capital markets as needed on reasonable terms; disruption of operations at our headquarters or distribution centers; risks and uncertainties associated with our foreign operations, including volatile economic conditions, political instability, cultural and legal differences, and currency exchange fluctuations; the potential for goodwill and intangible asset impairment; changes in accounting policies and practices; our ability to maintain effective internal control over financial reporting; organizational changes within the Company; risks related to legal proceedings to which we are a party; potentially adverse government regulation, legislation, or policies, both enacted and under consideration, including with respect to federal tax policy, international trade, data privacy and security, and government contracting; and the occurrence of extraordinary events (including prolonged labor disputes, power outages, telecommunication outages, terrorist acts, war, public health emergency, earthquakes, extreme weather events, other natural disasters, fires, floods, and accidents). Other factors and unanticipated events could also adversely affect our business, financial condition, or results of operations. Risks can also change over time. Further, the disclosure of a risk should not be interpreted to imply that the risk has not already materialized.

We discuss certain of these matters and other risk factors more fully throughout our Form 10-K, as well as other of our filings with the Securities and Exchange Commission.

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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS.

OVERVIEW

With approximately 5,900 associates across North America, Australia, New Zealand, and Singapore, Applied Industrial Technologies, Inc. ("Applied," the "Company," "We," "Us," or "Our") is a leading value-added distributor and technical solutions provider of industrial motion, fluid power, flow control, automation technologies, and related maintenance supplies. Our leading brands, specialized services, and comprehensive knowledge serve MRO (Maintenance, Repair & Operations) and OEM (Original Equipment Manufacturer) end users in virtually all industrial markets through our multi-channel capabilities that provide choice, convenience, and expertise. We have a long tradition of growth dating back to 1923, the year our business was founded in Cleveland, Ohio. At June 30, 2021, business was conducted in the United States, Puerto Rico, Canada, Mexico, Australia, New Zealand, and Singapore from approximately 568 facilities.

The following is Management's Discussion and Analysis of significant factors that have affected our financial condition, results of operations and cash flows during the periods included in the accompanying consolidated balance sheets, statements of consolidated income, consolidated comprehensive income and consolidated cash flows in Item 8 under the caption "Financial Statements and Supplementary Data." When reviewing the discussion and analysis set forth below, please note that a significant number of SKUs (Stock Keeping Units) we sell in any given year were not sold in the comparable period of the prior year, resulting in the inability to quantify certain commonly used comparative metrics analyzing sales, such as changes in product mix and volume.

Our fiscal 2021 consolidated sales were $3.2 billion, a decrease of $9.7 million or 0.3% compared to the prior year, with the acquisitions of Olympus Controls (Olympus), Advanced Control Solutions (ACS) and Gibson Engineering (Gibson) increasing sales by $44.1 million or 1.4% and favorable foreign currency of $16.5 million increasing sales by 0.5%. Gross profit margin was 28.9% for both fiscal 2021 and 2020. Operating margin increased to 6.3% in fiscal 2021 from 2.7% in fiscal 2020.

Our earnings per share was $3.68 in fiscal 2021 versus $0.62 in fiscal year 2020.

Fiscal 2021 results include a $49.5 million pre-tax non-cash charge related to the impairment of certain intangible, lease, and fixed assets, as well as non-routine costs of $7.8 million pre-tax. These items are the result of weaker economic conditions and business alignment initiatives across a portion of the Service Center Based Distribution segment operations exposed to oil and gas end markets. Total non-routine costs of $7.8 million pre-tax include a $7.4 million inventory reserve charge recorded within cost of sales, and $0.4 million related to severance and facility consolidation recorded in selling, distribution and administrative expense. These charges were offset in the current year by other non-routine income of $2.6 million. On a net basis, the fiscal 2021 non-routine items unfavorably impacted operating income by $54.7 million, net income by $41.7 million, and earnings per share by $1.06 per share. The prior year included a $131.0 million non-cash goodwill impairment charge recorded during fiscal 2020 related to the goodwill associated with the Company's FCX Performance, Inc. (FCX) operations within the Fluid Power & Flow Control segment. The non-cash goodwill impairment charge decreased net income by $118.8 million and earnings per share by $3.04 per share for fiscal 2020.

Fiscal 2021 ended on a positive note as underlying demand continued to strengthen across both segments during the fourth quarter reflecting sustained recovery in our core end-markets and momentum across our internal growth initiatives. We are managing inflation well and controlling costs, while benefiting from productivity enhancements. Fiscal 2022 is off to a positive start with organic sales through early August up by a high-teens percent over the prior year and customer indications signaling sustained demand momentum.

Shareholders’ equity was $932.5 million at June 30, 2021 compared to $843.5 million at June 30, 2020. Working capital increased $35.2 million from June 30, 2020 to $768.9 million at June 30, 2021. The current ratio was 2.8 to 1 and 2.7 to 1 at June 30, 2021 and at June 30, 2020, respectively.

Applied monitors several economic indices that have been key indicators for industrial economic activity in the United States. These include the Industrial Production (IP) and Manufacturing Capacity Utilization (MCU) indices published by the Federal Reserve Board and the Purchasing Managers Index (PMI) published by the Institute for Supply Management (ISM). Historically, our performance correlates well with the MCU, which measures productivity and calculates a ratio of actual manufacturing output versus potential full capacity output. When manufacturing plants are running at a high rate of capacity, they tend to wear out machinery and require replacement parts.

The MCU (total industry) and IP indices increased since June 2020 correlating with an overall increase in the economy in the same period. The ISM PMI registered 60.6 in June 2021, an increase from the June 2020 revised

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reading of 52.2. A reading above 50 generally indicates expansion. The index readings for the months during the most recent quarter, along with the revised indices for previous quarter ends, were as follows:

RESULTS OF OPERATIONS

This discussion and analysis deals with comparisons of material changes in the consolidated financial statements for the years ended June 30, 2021 and 2020. For the comparison of the years ended June 30, 2020 and 2019, see the Management's Discussion and Analysis of Financial Condition and Results of Operations in Part II, Item 7 of our 2020 Annual Report on Form 10-K.

The following table is included to aid in review of Applied’s statements of consolidated income.

Sales in fiscal 2021 were $3.2 billion, which was $9.7 million or 0.3% below the prior year, with sales from acquisitions adding $44.1 million or 1.4% and favorable foreign currency translation accounting for an increase of $16.5 million or 0.5%. There were 252.5 selling days in fiscal 2021 and 253.5 selling days in fiscal 2020. Excluding the impact of businesses acquired and foreign currency translation, sales were down $70.3 million or 2.2% during the year, driven by a 1.8% decrease from operations and a 0.4% decrease due to one less sales day. The decrease from operations is due to weak demand across key end markets from the impact of the COVID-19 pandemic, although sales improved as the year progressed.

The following table shows changes in sales by reportable segment.

Sales of our Service Center Based Distribution segment, which operates primarily in MRO markets, decreased $42.4 million, or 1.9%. Favorable foreign currency translation increased sales by $16.5 million or 0.7%. Excluding the impact of businesses acquired and the impact of foreign currency translation, sales decreased $58.9 million or 2.6% during the year, driven by a 2.2% decrease from operations and a decrease of 0.4% due to one less sales day. The decrease from operations reflects weaker industrial end-market demand from the impact of the COVID-19 pandemic, although sales improved as the year progressed.

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Sales of our Fluid Power & Flow Control segment increased $32.7 million or 3.3%. Acquisitions within this segment, primarily ACS and Gibson, increased sales $44.1 million or 4.4%. Excluding the impact of businesses acquired, sales decreased $11.4 million or 1.1%, driven by a 0.7% decrease from operations and by a decrease of 0.4% due to one less sales day. The decrease from operations is primarily due to ongoing soft demand across process-related end markets, offset by stronger demand across technology, off-highway mobile, life sciences, and chemical end markets, as well as automation-related sales.

The following table shows changes in sales by geographical area. Other countries includes Mexico, Australia, New Zealand, and Singapore.

Sales in our U.S. operations decreased $36.5 million or 1.3%, with acquisitions adding $44.1 million or 1.6%. Excluding the impact of businesses acquired, U.S. sales were down $80.6 million or 2.9%, driven by a decrease of 2.5% from operations and by a decrease of 0.4% due to one less sales days. Sales from our Canadian operations increased $6.8 million or 2.7%, while favorable foreign currency translation increased Canadian sales by $11.6 million or 4.7%. Excluding the impact of foreign currency translation, Canadian sales were down $4.8 million or 2.0%, driven by a decrease of 1.6% from operations and by a decrease of 0.4% due to one less sales days. Consolidated sales from our other country operations increased $20.0 million or 11.3% compared to the prior year. Favorable foreign currency translation increased other country sales by $4.9 million or 2.7%. Excluding the impact of foreign currency translation, other country sales were up $15.1 million or 8.6% compared to the prior year, driven by an increase of 9.2% from operations, primarily a $10.9 million increase in Australian sales due to increased demand in the mining industry, offset by a decrease of 0.6% due to less sales days.

The gross profit margin was 28.9% in both fiscal 2021 and 2020.

The following table shows the changes in selling, distribution, and administrative expense (SD&A).

SD&A consists of associate compensation, benefits and other expenses associated with selling, purchasing, warehousing, supply chain management, and marketing and distribution of the Company’s products, as well as costs associated with a variety of administrative functions such as human resources, information technology, treasury, accounting, insurance, legal, facility related expenses and expenses incurred in acquiring businesses. SD&A decreased $37.2 million or 5.2% during fiscal 2021 compared to the prior year, and as a percentage of sales decreased to 21.0% in fiscal 2021 compared to 22.1% in fiscal 2020. Changes in foreign currency exchange rates had the effect of increasing SD&A by $4.9 million or 0.7% compared to the prior year. SD&A from businesses acquired added $11.9 million or 1.7%, including $1.1 million of intangibles amortization related to acquisitions. Excluding the impact of businesses acquired and the favorable impact from foreign currency translation, SD&A decreased $54.0 million or 7.6% during fiscal 2021 compared to fiscal 2020. The Company incurred $0.4 million of non-routine expenses related to severance and closed facilities during fiscal 2021 compared to $5.1 million non-routine expenses related to severance and facility consolidation during fiscal 2020. Excluding the impact of acquisitions and severance, total compensation decreased $14.1 million during fiscal 2021, primarily due to cost reduction actions taken by the Company in response to the COVID-19 pandemic, including headcount reductions, temporary furloughs and pay reductions, and suspension of the 401(k) company match. All of the temporary cost reductions have been reinstated in the second half of fiscal 2021. Also, excluding the impact of acquisitions, travel & entertainment and fleet expenses decreased $12.2 million during 2021, primarily due to continued reduced travel activity related to COVID-19. In addition, bad debt expense decreased $7.5 million, primarily due to provisions recorded in the prior year for customer credit deterioration and bankruptcies primarily in the Service Center Based Distribution segment, offset by strong cash collections and an improvement in the overall credit profile of the

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accounts receivable portfolio in fiscal 2021. Further, excluding the impact of acquisitions, intangible amortization expense decreased $8.3 million during fiscal 2021 primarily due to the intangible impairment recorded during the year. All other expenses within SD&A were down $7.2 million.

During the second quarter of fiscal 2021, the Company determined that an impairment existed in two of its three asset groups within the Service Center Based Distribution segment that have significant exposure to oil and gas end markets as the asset groups' carrying values exceeded the sum of the undiscounted cash flows. The fair values of the long-lived assets were determined using the income approach, and the analyses resulted in the measurement of an intangible asset impairment loss of $45.0 million, as the fair value of the intangible assets was determined to be zero. The analyses of these asset groups also resulted in a fixed asset impairment loss and leased asset impairment loss of $2.0 million and $2.5 million, respectively, which were recorded in fiscal 2021. Combined, the non-cash impairment charges decreased net income by $37.8 million and earnings per share by $0.96 per share for fiscal 2021.

As a result of the Company's annual goodwill impairment test in fiscal 2020, the Company recorded a $131.0 million non-cash goodwill impairment charge related to the Company's FCX operations in the Fluid Power & Flow Control segment, primarily due to the overall decline in the industrial economy, specifically slower demand in FCX's end markets. The non-cash goodwill impairment charge decreased net income by $118.8 million and earnings per share by $3.04 per share for fiscal 2020.

Operating income increased $116.5 million, or 130.9%, to $205.5 million during fiscal 2021 from $89.0 million during fiscal 2020, and as a percentage of sales, increased to 6.3% from 2.7%, primarily as a result of the goodwill impairment expense recorded during fiscal 2020 offset by the intangible impairment recorded in fiscal 2021.

Operating income, before impairment charges, as a percentage of sales for the Service Center Based Distribution segment increased to 10.2% in fiscal 2021 from 9.4% in fiscal 2020. Operating income, before impairment charges, as a percentage of sales for the Fluid Power & Flow Control segment increased to 11.8% in fiscal 2021 from 10.9% in fiscal 2020.

Segment operating income is impacted by changes in the amounts and levels of certain supplier support benefits and expenses allocated to the segments. The expense allocations include corporate charges for working capital, logistics support and other items and impact segment gross profit and operating expense.

Other income, net, represents certain non-operating items of income and expense, and was $2.2 million of income in fiscal 2021 compared to $2.8 million of income in fiscal 2020. Current year income primarily consists of unrealized gains on investments held by non-qualified deferred compensation trusts of $4.0 million and other income of $0.3 million, offset by foreign currency transaction losses of $2.1 million. Fiscal 2020 income consisted primarily of unrealized gains on investments held by non-qualified deferred compensation trusts of $0.5 million and foreign currency transaction gains of $2.5 million offset by other expenses of $0.2 million.

The effective income tax rate was 18.2% for fiscal 2021 compared to 56.5% for fiscal 2020. The decrease in the effective tax rate is primarily due to the FCX goodwill impairment charge in the prior year, which increased the effective tax rate by 31.4% in fiscal 2020.

We expect our income tax rate for fiscal 2022 to be in the range of 22.0% to 23.0%.

As a result of the factors discussed above, net income for fiscal 2021 increased $120.7 million from the prior year. Net income per share was $3.68 per share for fiscal 2021 compared to $0.62 per share for fiscal 2020.

At June 30, 2021, we had a total of 568 operating facilities in the United States, Puerto Rico, Canada, Mexico, Australia, New Zealand, and Singapore, versus 580 at June 30, 2020.

The approximate number of Company employees was 5,900 at June 30, 2021 and 6,200 at June 30, 2020.

LIQUIDITY AND CAPITAL RESOURCES

Our primary source of capital is cash flow from operations, supplemented as necessary by bank borrowings or other sources of debt. At June 30, 2021 we had total debt obligations outstanding of $829.4 million compared to $935.3 million at June 30, 2020. Management expects that our existing cash, cash equivalents, funds available under our debt facilities, and cash provided from operations, will be sufficient to finance normal working capital needs in each of the countries we operate in, payment of dividends, acquisitions, investments in properties, facilities and equipment, debt service, 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.

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The Company’s working capital at June 30, 2021 was $768.9 million compared to $733.7 million at June 30, 2020. The current ratio was 2.8 to 1 at June 30, 2021 and 2.7 to 1 at June 30, 2020.

Net Cash Flows

The following table is included to aid in review of Applied’s statements of consolidated cash flows; all amounts

are in thousands.

The decrease in cash provided by operating activities during fiscal 2021 is driven by changes in working capital for the year offset by increased operating results. Changes in cash flows between years related to working capital were driven by:

Net cash used in investing activities in fiscal 2021 included $30.2 million used for the acquisitions of ACS and Gibson and $15.9 million used for capital expenditures. Net cash used in investing activities in fiscal 2020 included $37.2 million used for the acquisitions of Olympus and $20.1 million for capital expenditures.

Net cash used in financing activities included $131.9 million and $49.6 million of long-term debt repayments in 2021 and 2020, respectively, offset by $26.0 million of cash borrowings from the trade receivable securitization facility in 2021 and $25.0 million of cash borrowings under a unsecured shelf facility agreement with Prudential Investment Management in 2020. Further uses of cash in 2021 were $50.7 million for dividend payments, $10.1 million used to pay taxes for shares withheld, and $40.1 million used to repurchase 400,000 shares of treasury stock. Further uses of cash in 2020 were $48.9 million for dividend payments and $2.6 million used to pay taxes for shares withheld.

The increase in dividends over the year is the result of regular increases in our dividend payout rates. We paid dividends of $1.30 and $1.26 per share in fiscal 2021 and 2020, respectively.

Capital Expenditures

We expect capital expenditures for fiscal 2022 to be in the $18.0 million to $20.0 million range, primarily consisting of capital associated with additional information technology equipment and infrastructure investments.

Share Repurchases

The Board of Directors has authorized the repurchase of shares of the Company’s stock. These purchases may

be made in open market and negotiated transactions, from time to time, depending upon market conditions.

At June 30, 2021, we had authorization to purchase an additional 464,618 shares.

The Company repurchased 400,000 shares in fiscal 2021 at an average price per share of $100.22. In fiscal 2020 no shares were repurchased and in 2019, we repurchased 192,082 shares of the Company’s common stock at an average price per share of $58.10.

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Borrowing Arrangements

A summary of long-term debt, including the current portion, follows; all amounts are in thousands:

In January 2018, the Company refinanced its existing credit facility and entered into a new five-year credit facility with a group of banks expiring in January 2023. This agreement provides for a $780.0 million unsecured term loan and a $250.0 million unsecured revolving credit facility. Fees on this facility range from 0.10% to 0.20% per year based upon the Company's leverage ratio at each quarter end. Borrowings under this agreement carry variable interest rates tied to either LIBOR or prime at the Company's discretion. The Company had no amount outstanding under the revolver as of June 30, 2021 and June 30, 2020. Unused lines under this facility, net of outstanding letters of credit of $0.2 million and $1.9 million, respectively, to secure certain insurance obligations, totaled $249.8 million and $248.1 million at June 30, 2021 and June 30, 2020, respectively, and were available to fund future acquisitions or other capital and operating requirements. The interest rate on the term loan was 1.88% and 1.94% as of June 30, 2021 and June 30, 2020, respectively.

In August 2018, the Company established a trade receivable securitization facility (the “AR Securitization Facility”) with a termination date of August 31, 2021. In March 2021, the Company amended the AR Securitization Facility to expand the eligible receivables, which increased the maximum availability to $250.0 million and increased the drawn fees on the AR Securitization Facility to 0.98% per year. Availability is further subject to changes in the credit ratings of our customers, customer concentration levels or certain characteristics of the accounts receivable being transferred and, therefore, at certain times, we may not be able to fully access the $250.0 million of funding available under the AR Securitization Facility. The AR Securitization Facility effectively increases the Company’s borrowing capacity by collateralizing a portion of the amount of the U.S. operations’ trade accounts receivable. The Company uses the proceeds from the AR Securitization Facility as an alternative to other forms of debt, effectively reducing borrowing costs. Borrowings under this facility carry variable interest rates tied to LIBOR. The interest rate on the AR Securitization Facility as of June 30, 2021 and June 30, 2020 was 1.20% and 1.07%, respectively. The termination date of the AR Securitization is now in March 2024.

At June 30, 2021 and June 30, 2020, the Company had borrowings outstanding under its unsecured shelf facility agreement with Prudential Investment Management of $90.0 million and $170.0 million, respectively. Fees on this facility range from 0.25% to 1.25% per year based on the Company's leverage ratio at each quarter end. The "Series C" notes, which had an original principal amount of $120.0 million, carry a fixed interest rate of 3.19%. During fiscal 2021, two principal payments of $40.0 million each were made on the "Series C" notes and the remaining balance of $40.0 million is due in July 2022. The "Series D" notes have a remaining principal amount of $25.0 million, carry a fixed interest rate of 3.21%, and are due in October 2023. The "Series E" notes have a principal amount of $25.0 million, carry a fixed interest rate of 3.08%, and are due in October 2024.

The Company entered into an interest rate swap which mitigates variability in forecasted interest payments on $420.0 million of the Company’s U.S. dollar-denominated unsecured variable rate debt. For more information, see note 7, Derivatives, to the consolidated financial statements, included in Item 8 under the caption “Financial Statements and Supplementary Data.”

The credit facility and the unsecured shelf facility contain restrictive covenants regarding liquidity, net worth, financial ratios, and other covenants. At June 30, 2021, the most restrictive of these covenants required that the Company have net indebtedness less than 3.75 times consolidated income before interest, taxes, depreciation and amortization (as defined). At June 30, 2021, the Company's net indebtedness was less than 2.5 times consolidated income before interest, taxes, depreciation and amortization (as defined). The Company was in compliance with all financial covenants at June 30, 2021.

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Accounts Receivable Analysis

The following table is included to aid in analysis of accounts receivable and the associated provision for losses on accounts receivable (all dollar amounts are in thousands):

Accounts receivable are reported at net realizable value and consist of trade receivables from customers. Management monitors accounts receivable by reviewing Days Sales Outstanding (DSO) and the aging of receivables for each of the Company's locations.

On a consolidated basis, DSO was 51.9 at June 30, 2021 versus 55.9 at June 30, 2020. Approximately 3.0% of our accounts receivable balances are more than 90 days past due at June 30, 2021 compared to 4.6% at June 30, 2020. On an overall basis, our provision for losses from uncollected receivables represents 0.20% of our sales for the year ended June 30, 2021, compared to 0.43% of sales for the year ended June 30, 2020. The decrease primarily relates to strong cash collections and an improvement in the overall credit profile of the accounts receivable portfolio in the current year, compared to provisions recorded in the prior year for customer credit deterioration and bankruptcies primarily in the U.S. and Mexican operations of the Service Center Based Distribution segment. Historically, this percentage is around 0.10% to 0.15%. Management believes the overall receivables aging and provision for losses on uncollected receivables are at reasonable levels.

Inventory Analysis

Inventories are valued using the last-in, first-out (LIFO) method for U.S. inventories and the average cost method for foreign inventories. Management uses an inventory turnover ratio to monitor and evaluate inventory. Management calculates this ratio on an annual as well as a quarterly basis and uses inventory valued at average costs. The annualized inventory turnover (using average costs) for the year ended June 30, 2021 was 4.3 versus 3.8 for the year ended June 30, 2020. We believe our inventory turnover ratio in fiscal 2022 will be slightly better than our fiscal 2021 levels.

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CONTRACTUAL OBLIGATIONS

The following table shows the approximate value of the Company’s contractual obligations and other commitments to make future payments as of June 30, 2021 (in thousands):

(1) Amounts represent estimated contractual interest payments on outstanding long-term debt obligations and net payments under the terms of the interest rate swap. Rates in effect as of June 30, 2021 are used for variable rate debt.

Purchase orders for inventory and other goods and services are not included in our estimates as we are unable to aggregate the amount of such purchase orders that represent enforceable and legally binding agreements specifying all significant terms. The previous table includes the gross liability for unrecognized income tax benefits including interest and penalties in the “Other” column as the Company is unable to make a reasonable estimate regarding the timing of cash settlements, if any, with the respective taxing authorities.

CRITICAL ACCOUNTING POLICIES

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates at a specific point in time that affect the amounts reported in the consolidated financial statements and disclosed in the accompanying notes. The Business and Accounting Policies note to the consolidated financial statements describes the significant accounting policies and methods used in preparation of the consolidated financial statements. Estimates are used for, but not limited to, determining the net carrying value of trade accounts receivable, inventories, recording self-insurance liabilities and other accrued liabilities. Estimates are also used in establishing opening balances in relation to purchase accounting. Actual results could differ from these estimates. The following critical accounting policies are impacted significantly by judgments, assumptions and estimates used in the preparation of the consolidated financial statements.

LIFO Inventory Valuation and Methodology

Inventories are valued at the average cost method, using the last-in, first-out (LIFO) method for U.S. inventories, and the average cost method for foreign inventories. We adopted the link chain dollar value LIFO method for accounting for U.S. inventories in fiscal 1974. Approximately 19.8% of our domestic inventory dollars relate to LIFO layers added in the 1970s. The excess of average cost over LIFO cost is $151.9 million as reflected in our consolidated balance sheet at June 30, 2021. The Company maintains five LIFO pools based on the following product groupings: bearings, power transmission products, rubber products, fluid power products and other products.

LIFO layers and/or liquidations are determined consistently year-to-year. See the Inventories note to the

consolidated financial statements in Item 8 under the caption "Financial Statements and Supplementary Data,"

for further information.

Allowances for Slow-Moving and Obsolete Inventories

We evaluate the recoverability of our slow-moving and inactive inventories at least quarterly. We estimate the recoverable cost of such inventory by product type while considering factors such as its age, historic and current demand trends, the physical condition of the inventory, as well as assumptions regarding future demand. Our ability to recover our cost for slow moving or obsolete inventory can be affected by such factors as general market conditions, future customer demand and relationships with suppliers. A significant portion of the products we hold in inventory have long shelf lives and are not highly susceptible to obsolescence.

As of June 30, 2021 and 2020, the Company's reserve for slow-moving or obsolete inventories was $43.5 million and $42.9 million, respectively, recorded in inventories in the consolidated balance sheets.

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Allowances for Doubtful Accounts

We evaluate the collectibility of trade accounts receivable based on a combination of factors. Initially, we estimate an allowance for doubtful accounts as a percentage of net sales based on historical bad debt experience. This initial estimate is adjusted based on recent trends of certain customers and industries estimated to be a greater credit risk, trends within the entire customer pool and changes in the overall aging of accounts receivable. While we have a large customer base that is geographically dispersed, a general economic downturn in any of the industry segments in which we operate could result in higher than expected defaults, and therefore, the need to revise estimates for bad debts. Accounts are written off against the allowance when it becomes evident that collection will not occur.

As of June 30, 2021 and 2020, our allowance for doubtful accounts was 3.1% and 2.9% of gross receivables, respectively. Our provision for losses on accounts receivable was $6.5 million, $14.1 million and $4.1 million in fiscal 2021, 2020 and 2019, respectively.

Goodwill and Intangibles

The purchase price of an acquired company is allocated between intangible assets and the net tangible assets of the acquired business with the residual of the purchase price recorded as goodwill. Goodwill for acquired businesses is accounted for using the acquisition method of accounting which requires that the assets acquired and liabilities assumed be recorded at the date of the acquisition at their respective estimated fair values. The determination of the value of the intangible assets acquired involves certain judgments and estimates. These judgments can include, but are not limited to, the cash flows that an asset is expected to generate in the future and the appropriate weighted average cost of capital. The judgments made in determining the estimated fair value assigned to each class of assets acquired, as well as the estimated life of each asset, can materially impact the net income of the periods subsequent to the acquisition through depreciation and amortization, and in certain instances through impairment charges, if the asset becomes impaired in the future. As part of acquisition accounting, we recognize acquired identifiable intangible assets such as customer relationships, vendor relationships, trade names, and non-competition agreements apart from goodwill. Finite-lived identifiable intangibles are evaluated for impairment when changes in conditions indicate carrying value may not be recoverable. If circumstances require a finite-lived intangible asset be tested for possible impairment, the Company first compares undiscounted cash flows expected to be generated by the asset to the carrying value of the asset. If the carrying value of the finite-lived intangible asset is not recoverable on an undiscounted cash flow basis, impairment is recognized to the extent that the carrying value exceeds its fair value determined through a discounted cash flow model.

The Company has three asset groups that have significant exposure to oil and gas end markets. Due to the prolonged economic downturn in these end markets, the Company determined during the second quarter of fiscal 2021 that certain carrying values may not be recoverable. The Company determined that an impairment existed in two of the three asset groups as the asset groups' carrying values exceeded the sum of the undiscounted cash flows. The fair values of the long-lived assets were then determined using the income approach, and the analyses resulted in the measurement of an intangible asset impairment loss of $45.0 million, which was recorded in the second quarter of fiscal 2021, as the fair value of the intangible assets was determined to be zero. The income approach employs the discounted cash flow method reflecting projected cash flows expected to be generated by market participants and then adjusted for time value of money factors, and requires management to make significant estimates and assumptions related to forecasts of future revenues, earnings before interest, taxes, depreciation, and amortization (EBITDA), and discount rates. Key assumptions (Level 3 in the fair value hierarchy) relate to pricing trends, inventory costs, customer demand, and revenue growth. A number of benchmarks from independent industry and other economic publications were also used. The analyses of these asset groups also resulted in a fixed asset impairment loss and leased asset impairment loss of $2.0 million and $2.5 million, respectively, which were recorded in the second quarter of fiscal 2021. Sustained significant softness in certain end market concentrations could result in impairment of certain intangible assets in future periods.

We evaluate goodwill for impairment at the reporting unit level annually as of January 1, and whenever an event occurs or circumstances change that would indicate that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. Events or circumstances that may result in an impairment review include changes in macroeconomic conditions, industry and market considerations, cost factors, overall financial performance, other relevant entity-specific events, specific events affecting the reporting unit or sustained decrease in share price. Each year, the Company may elect to perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. If impairment is indicated in the qualitative assessment, or, if management elects to initially perform a quantitative assessment of goodwill, the impairment test uses a one-step approach. The fair value of a reporting unit is compared with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill of the reporting unit is not impaired. If the carrying amount of a reporting unit exceeds its fair value, an impairment charge would be

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recognized for the amount by which the carrying amount exceeds the reporting unit's fair value, not to exceed the total amount of goodwill allocated to that reporting unit.

Goodwill on our consolidated financial statements relates to both the Service Center Based Distribution segment and the Fluid Power & Flow Control segment. The Company has eight (8) reporting units for which an annual goodwill impairment assessment was performed as of January 1, 2021.  The Company concluded that seven (7) of the reporting units’ fair values exceeded their carrying amounts by at least 25% as of January 1, 2021. The fair value of the final reporting unit, which is comprised of the FCX Performance Inc. (FCX) operations, exceeded its carrying value by 14%. The FCX reporting unit has a goodwill balance of $309.0 million as of June 30, 2021.

The Company had eight (8) reporting units for which an annual goodwill impairment assessment was performed as of January 1, 2020. The Company concluded that seven (7) of the reporting units’ fair values exceeded their carrying amounts by at least 10% as of January 1, 2020. Specifically, the Canada reporting unit's fair value exceeded its carrying value by 12%, and the Mexico reporting unit's fair value exceeded its carrying value by 14%. The carrying value of the final reporting unit, which is comprised of the FCX operations, exceeded the fair value, resulting in goodwill impairment of $131.0 million. The non-cash impairment charge was the result of the overall decline in the industrial economy, specifically slower demand in FCX's end markets, which led to reduced spending by customers and reduced revenue expectations. If the Company does not achieve forecasted sales growth and margin improvements goodwill could be further impaired.

The fair values of the reporting units in accordance with the goodwill impairment test were determined using the income and market approaches. The income approach employs the discounted cash flow method reflecting projected cash flows expected to be generated by market participants and then adjusted for time value of money factors, and requires management to make significant estimates and assumptions related to forecasts of future revenues, operating margins, and discount rates. The market approach utilizes an analysis of comparable publicly traded companies and requires management to make significant estimates and assumptions related to the forecasts of future revenues, earnings before interest, taxes, depreciation, and amortization (EBITDA) and multiples that are applied to management’s forecasted revenues and EBITDA estimates.

Changes in future results, assumptions, and estimates after the measurement date may lead to an outcome where additional impairment charges would be required in future periods.  Specifically, actual results may vary from the Company’s forecasts and such variations may be material and unfavorable, thereby triggering the need for future impairment tests where the conclusions may differ in reflection of prevailing market conditions.  Further, continued adverse market conditions could result in the recognition of additional impairment if the Company determines that the fair values of its reporting units have fallen below their carrying values.

Income Taxes

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. As of June 30, 2021, the Company recognized $12.9 million of net deferred tax liabilities. Valuation allowances are provided against deferred tax assets where it is considered more-likely-than-not that the Company will not realize the benefit of such assets on a jurisdiction by jurisdiction basis. The remaining net deferred tax asset is the amount management believes is more-likely-than-not of being realized. The realization of these deferred tax assets can be impacted by changes to tax laws, statutory rates and future taxable income levels.

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CAUTIONARY STATEMENT UNDER PRIVATE SECURITIES LITIGATION REFORM ACT

This Form 10-K, including Management’s Discussion and Analysis, contains statements that are forward-looking based on management’s current expectations about the future. Forward-looking statements are often identified by qualifiers, such as “guidance”, “expect”, “believe”, “plan”, “intend”, “will”, “should”, “could”, “would”, “anticipate”, “estimate”, “forecast”, “may”, "optimistic" and derivative or similar words or expressions. Similarly, descriptions of objectives, strategies, plans, or goals are also forward-looking statements. These statements may discuss, among other things, expected growth, future sales, future cash flows, future capital expenditures, future performance, and the anticipation and expectations of the Company and its management as to future occurrences and trends. The Company intends that the forward-looking statements be subject to the safe harbors established in the Private Securities Litigation Reform Act of 1995 and by the Securities and Exchange Commission in its rules, regulations and releases.

Readers are cautioned not to place undue reliance on any forward-looking statements. All forward-looking statements are based on current expectations regarding important risk factors, many of which are outside the Company’s control. Accordingly, actual results may differ materially from those expressed in the forward-looking statements, and the making of those statements should not be regarded as a representation by the Company or any other person that the results expressed in the statements will be achieved. In addition, the Company assumes no obligation publicly to update or revise any forward-looking statements, whether because of new information or events, or otherwise, except as may be required by law.

Important risk factors include, but are not limited to, the following: risks relating to the operations levels of our customers and the economic factors that affect them; risks relating to the effects of the COVID-19 pandemic; changes in the prices for products and services relative to the cost of providing them; reduction in supplier inventory purchase incentives; loss of key supplier authorizations, lack of product availability, changes in supplier distribution programs, inability of suppliers to perform, and transportation disruptions; the cost of products and energy and other operating costs; changes in customer preferences for products and services of the nature and brands sold by us; changes in customer procurement policies and practices; competitive pressures; our reliance on information systems and risks relating to their proper functioning, the security of those systems, and the data stored in or transmitted through them; the impact of economic conditions on the collectability of trade receivables; reduced demand for our products in targeted markets due to reasons including consolidation in customer industries; our ability to retain and attract qualified sales and customer service personnel and other skilled executives, managers and professionals; our ability to identify and complete acquisitions, integrate them effectively, and realize their anticipated benefits; the variability, timing and nature of new business opportunities including acquisitions, alliances, customer relationships, and supplier authorizations; the incurrence of debt and contingent liabilities in connection with acquisitions; our ability to access capital markets as needed on reasonable terms; disruption of operations at our headquarters or distribution centers; risks and uncertainties associated with our foreign operations, including volatile economic conditions, political instability, cultural and legal differences, and currency exchange fluctuations; the potential for goodwill and intangible asset impairment; changes in accounting policies and practices; our ability to maintain effective internal control over financial reporting; organizational changes within the Company; risks related to legal proceedings to which we are a party; potentially adverse government regulation, legislation, or policies, both enacted and under consideration, including with respect to federal tax policy, international trade, data privacy and security, and government contracting; and the occurrence of extraordinary events (including prolonged labor disputes, power outages, telecommunication outages, terrorist acts, public health emergency, earthquakes, extreme weather events, other natural disasters, fires, floods, and accidents). Other factors and unanticipated events could also adversely affect our business, financial condition or results of operations. Risks can also change over time. Further, the disclosure of a risk should not be interpreted to imply that the risk has not already materialized.

We discuss certain of these matters and other risk factors more fully throughout our Form 10-K, as well as other of our filings with the Securities and Exchange Commission.

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