Item 7. Management’s Discussion and Analysis
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:
Index Reading
Month MCU PMI IP
June 2023 78.9 46.0 99.6
May 2023 79.4 46.9 99.9
April 2023 79.9 47.1 100.1
March 2023 79.5 46.3 99.1
December 2022 78.9 48.4 97.9
September 2022 80.8 51.0 100.6
June 2022 80.5 53.1 100.0
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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.
Year Ended June 30,
As a % of Net Sales Change in $'s Versus Prior Period
2023 2022 % Change
Net Sales 100.0 % 100.0 % 15.8 %
Gross Profit Margin 29.2 % 29.0 % 16.3 %
Selling, Distribution & Administrative Expense 18.4 % 19.7 % 8.6 %
Operating Income 10.7 % 9.4 % 32.2 %
Net Income 7.9 % 6.8 % 34.7 %
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.
Amounts in millions Amount of change due to
Year ended June 30, Sales Increase Acquisitions Foreign Currency Organic Change
Sales by Reportable Segment 2023 2022
Service Center Based Distribution $ 2,966.8 $ 2,565.6 $ 401.2 $ — $ (16.3) $ 417.5
Engineered Solutions 1,446.0 1,245.1 200.9 20.0 — 180.9
Total $ 4,412.8 $ 3,810.7 $ 602.1 $ 20.0 $ (16.3) $ 598.4
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.
Amounts in millions Amount of change due to
Year ended June 30, Sales Increase Acquisitions Foreign Currency Organic Change
Sales by Geographic Area 2023 2022
United States $ 3,860.4 $ 3,299.8 $ 560.6 $ 20.0 $ — $ 540.6
Canada 315.5 291.5 24.0 — (16.0) 40.0
Other Countries 236.9 219.4 17.5 — (0.3) 17.8
Total $ 4,412.8 $ 3,810.7 $ 602.1 $ 20.0 $ (16.3) $ 598.4
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).
Amounts in millions Amount of change due to
Year ended June 30, SD&A Increase Acquisitions Foreign Currency Organic Change
2023 2022
SD&A $ 813.8 $ 749.1 $ 64.7 $ 6.4 $ (4.3) $ 62.6
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.
Amounts in thousands Year Ended June 30,
2023 2022
Net Cash Provided by (Used in):
Operating Activities $ 343,966 $ 187,570
Investing Activities (60,833) (35,658)
Financing Activities (126,888) (223,029)
Exchange Rate Effect 3,317 (2,154)
Increase (Decrease) in Cash and Cash Equivalents $ 159,562 $ (73,271)
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):
Accounts receivable $ 94,460
Inventory $ 49,448
Accounts payable $ (15,915)
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):
June 30, 2023 2022
Revolving credit facility $ 383,592 $ 410,592
Trade receivable securitization facility 188,300 188,300
Series C Notes — 40,000
Series D Notes 25,000 25,000
Series E Notes 25,000 25,000
Other 356 603
Total debt $ 622,248 $ 689,495
Less: unamortized debt issuance costs 152 171
$ 622,096 $ 689,324
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):
June 30, 2023 2022
Accounts receivable, gross
$ 730,729 $ 673,951
Allowance for doubtful accounts
22,334 17,522
Accounts receivable, net $ 708,395 $ 656,429
Allowance for doubtful accounts, % of gross receivables
3.1 % 2.6 %
Year Ended June 30, 2023 2022
Provision for losses on accounts receivable
$ 5,619 $ 3,193
Provision as a % of net sales
0.13 % 0.08 %
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):
Total Period Less
Than 1 yr Period
2-3 yrs Period
4-5 yrs Period
Over 5 yrs Other
Operating leases
$ 113,251 $ 34,235 $ 44,995 $ 22,646 $ 11,375 $ —
Planned funding of post-retirement obligations
6,561 1,360 2,770 460 1,971 —
Unrecognized income tax benefit liabilities, including interest and penalties 5,900 — — — — 5,900
Long-term debt obligations 622,248 25,251 25,105 571,892 — —
Interest on long-term debt obligations (1)
68,000 22,300 34,000 11,700 — —
Acquisition holdback payments
810 684 126 — — —
Total Contractual Cash Obligations
$ 816,770 $ 83,830 $ 106,996 $ 606,698 $ 13,346 $ 5,900
(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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