Applied Industrial Technologies ("Applied," the "Company," "We," "Us" or "Our") is a leading industrial distributor serving MRO (Maintenance, Repair & Operations), OEM (Original Equipment Manufacturer) and government markets. Applied is an authorized source for a diverse range of products, including bearings, power transmission components, fluid power components and systems, industrial rubber products, linear motion components, tools, safety products, and general maintenance and mill supply products. The Company also provides customized shop services for mechanical, fabricated rubber and fluid power products, as well as services to meet storeroom management and maintenance training needs. We have a long tradition of growth dating back to 1923, the year our business was founded in Cleveland, Ohio. During the second quarter of fiscal 2013, business was conducted in the United States, Canada, Mexico, Puerto Rico, Australia and New Zealand from 524 facilities.

The following is Management's Discussion and Analysis of significant factors which have affected our financial condition, results of operations and cash flows during the periods included in the accompanying condensed statements of consolidated income, consolidated comprehensive income and consolidated cash flows. When reviewing the discussion and analysis set forth below, please note that the majority of SKUs we sell in any given period were not necessarily 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.

Overview
Consolidated sales for the quarter ended December 31, 2012 increased $19.1 million or 3.4% compared to the prior year quarter, with acquisitions contributing $25.3 million or 4.4% and a favorable foreign currency translation of $2.5 million increasing sales by 0.4%. Operating margin increased to 6.9% of sales from 5.8% for the prior year quarter largely driven by an increase in sales without a commensurate increase in SD&A costs. Net income of $27.0 million increased 29.2% compared to the prior year quarter. Shareholders' equity was $722.1 million at December 31, 2012, up from the June 30, 2012 level of $672.1 million. The current ratio was 2.7 to 1 at December 31, 2012 and 2.9 to 1 at June 30, 2012.

Applied monitors several economic indices that have been key indicators for industrial economic activity in the United States. These include the Industrial Production 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.

In the December quarter, Industrial Production increased at an annual rate of 1%. The MCU for December was 77.4, up from the September 2012 revised reading of
76.7. The ISM PMI averaged 50.7 in the December quarter, a slight decrease from 51.5 in the September quarter, and above 50 (its expansionary threshold).

The number of Company associates was 5,160 at December 31, 2012, 4,664 at June 30, 2012, and 4,682 at December 31, 2011. The number of operating facilities totaled 524 at December 31, 2012 and 476 at June 30, 2012 and 475 at December 31, 2011.

Results of Operations

Three months Ended December 31, 2012 and 2011

The following table is included to aid in review of Applied's condensed
statements of consolidated income.
                               Three Months Ended December 31,
                                  As a Percent of Net Sales          Change in $'s Versus Prior
                                   2012                2011              Period - % Increase
Net Sales                           100.0 %              100.0 %                             3.4 %
Gross Profit                         27.6 %               27.3 %                             4.8 %
Selling, Distribution &
Administrative                       20.8 %               21.4 %                             0.2 %
Operating Income                      6.9 %                5.8 %                            21.7 %
Net Income                            4.6 %                3.7 %                            29.2 %

During the quarter ended December 31, 2012, sales increased $19.1 million or 3.4% compared to the prior year quarter, with acquisitions accounting for $25.3 million or 4.4%, and foreign currency translation increasing sales by $2.5 million or 0.4%. There were 62 selling days in the quarter ended December 31, 2012 versus 61 selling days in the quarter ended December 31, 2011 which would approximate a 1.6% increase in sales. Offsetting these increases are slight overall declines in sales in our businesses not acquired in the current year.

Sales from our Service Center Based Distribution segment, which, operates primarily in MRO markets, increased $22.2 million or 4.8% during the quarter from the same period in the prior year, primarily attributed to acquisition related sales growth. Acquisitions within this segment increased sales by $24.1 million or 5.3%.

Sales from our Fluid Power Businesses segment, which operates primarily in OEM markets, decreased $3.0 million or 2.7% during the quarter from the same period in the prior year, primarily attributed to weakness within a few of our larger Fluid Power Businesses. Acquisitions within this segment increased sales by $1.2 million or 1.0%.

Sales in our U.S. operations were flat, with acquisitions adding $1.3 million or 0.3% . Sales from our Canadian operations increased $0.6 million or 0.9%, with acquisitions adding $5.7 million or 7.8% and a favorable foreign currency translation increasing Canadian sales by $1.9 million or 2.5%. The ongoing Canadian operations were impacted by some slowing of sales to resource industry, transportation and agricultural-OEM customers. Comparisons to the prior year period were also impacted by unique project sales in the prior year period which did not recur. Consolidated sales from our other country operations, which include Mexico, Australia and New Zealand, were $18.4 million or 98.5% above the prior year. Virtually all of this increase, relates to our new Australian and New Zealand operations. We also experienced a favorable foreign currency translation of $0.6 million in Mexico .

During the quarter ended December 31, 2012, industrial products and fluid power products accounted for 72.3% and 27.7%, respectively, of sales as compared to 70.9% and 29.1%, respectively, for the same period in the prior year.

Our gross profit margin for the quarter was 27.6%, as compared to the prior year's quarter of 27.3%. The increase can largely be attributed to the impact of higher supplier support for U.S. service centers, along with the impact of relatively higher margins from acquisitions.

Selling, distribution and administrative expense (SD&A) consists of associate compensation, benefits and other expenses associated with selling, purchasing, warehousing, supply chain management and providing marketing and distribution of the Company's products, as well as costs associated with a variety of administrative functions such as human resources, information technology, treasury, accounting, legal, and facility related expenses. SD&A was 20.8% of sales in the quarter ended December 31, 2012 compared to 21.4% in the prior year quarter. On an absolute basis, SD&A increased $0.2 million or 0.2% compared to the prior year quarter. In the prior year quarter we incurred approximately $4.4 million of non-recurring SD&A expense mostly pertaining to the curtailment loss pertaining to freezing our Supplemental Executive Retirement

Benefits Plan as well as certain one-time CEO transition related expenses. Adjusting for these items, SD&A expenses increased 3.8% during the quarter. Our ongoing operations experienced SD&A expense declines as this increase is entirely the result of acquisitions.

Operating income increased 21.7% or $7.2 million, and as a percent of sales increased to 6.9% from 5.8% during the prior year quarter. The quarterly increase in operating income primarily reflects the higher sales levels without an increase in SD&A expenses. The increase in the operating margin percentage is driven by an increase in sales of 3.4% as we lowered our SD&A as a percent of sales to 20.8% versus 21.4% in the second quarter of fiscal 2012.

Operating income as a percentage of sales for the Service Center Based Distribution segment decreased to 5.9% in the current year quarter, from 6.4% in the prior year quarter. This decrease is primarily attributable to an increase in the SD&A as a percentage of sales (representing 0.8% of the decrease) offset by improved gross profit margins, mostly as a result of acquisitions which operate at a higher gross margin (offsetting 0.3% of the decrease).

Operating income as a percentage of sales for the Fluid Power Business segment decreased to 7.9% in the current year quarter from 9.1% in the prior year quarter. This decrease is primarily attributable to a decrease in sales coupled with a slight increase in SD&A (representing 0.7% of the decrease) along with decreases in gross profit margin (representing 0.5% of the decrease)

Other income was $0.4 million in the quarter which included unrealized gains on investments held by non-qualified deferred compensation trusts of $0.1 million and net favorable foreign currency transaction gains of $0.3 million. During the prior year quarter other expense was $0.8 million which included net unfavorable foreign currency transaction losses of $1.0 million, offset by unrealized gains on investments held by non-qualified deferred compensation trusts of $0.4 million.

The effective income tax rate was 34.0% for the quarter ended December 31, 2012 compared to 35.7% for the quarter ended December 31, 2011. Lower effective tax rates in foreign jurisdictions favorably reduced our rate when compared to the U.S. federal statutory rate by approximately 0.6% in the quarter, along with reduced state and local taxes of 0.2% and other items which reduced the rate by 0.9%. We expect our full year tax rate to be in the 34.0% to 34.5% range.

As a result of the factors addressed above, net income increased $6.1 million or 29.2% compared to the prior year quarter. Net income per share was $0.64 per share for the quarter ended December 31, 2012, compared to $0.49 in the prior year quarter.

Six months Ended December 31, 2012 and 2011

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

                                Six Months Ended December 31,
                                  As a Percent of Net Sales          Change in $'s Versus Prior
                                   2012                2011              Period - % Increase
Net Sales                           100.0 %              100.0 %                             4.4 %
Gross Profit                         27.3 %               27.3 %                             4.2 %
Selling, Distribution &
Administrative                       20.2 %               20.7 %                             2.1 %
Operating Income                      7.1 %                6.7 %                            10.8 %
Net Income                            4.7 %                4.1 %                            19.6 %

During the six months ended December 31, 2012, sales increased $50.1 million or 4.4% compared to the same period in the prior year, with acquisitions accounting for $44.8 million or 3.9%, and foreign currency translation decreasing sales by $2.8 million or 0.2%. There were 125 selling days in both the period ended December 31, 2012 and the period ended December 31, 2011.

Sales from our Service Center Based Distribution segment, which, operates primarily in MRO markets, increased $56.1 million or 6.1% during the six months ended December 31, 2012 from the same period in the prior year, primarily attributed to acquisition related sales growth. Acquisitions within this segment increased sales by $43.6 million or 4.7%.

Sales from our Fluid Power Businesses segment, which operates primarily in OEM markets, decreased $6.1 million or 2.7% during the six months ended December 31, 2012 from the same period in the prior year, primarily attributed to weakness within a few of our Fluid Power Businesses. Acquisitions within this segment increased sales by $1.2 million or 0.5%.

During the six months ended December 31, 2012, sales in our U.S. operations were up $12.2 million or 1.3% with acquisitions adding $1.6 million or 0.2%. Sales from our Canadian operations increased $1.3 million or 0.9%, with acquisitions adding $10.5 million or 7.1% and an unfavorable foreign currency translation decreasing Canadian sales by $0.8 million or 0.6%. Consolidated sales from our other country operations, which include Mexico, Australia and New Zealand, were $36.6 million or 98.2% above the prior year, primarily driven by our new Australian and New Zealand operations. Mexican operations increased $3.8 million or 10.2% . This increase consisted of a $5.7 million increase in local currency sales partially offset by an unfavorable foreign currency translation of $1.9 million.

During the six months ended December 31, 2012, industrial products and fluid power products accounted for 72.2% and 27.8%, respectively, of sales as compared to 70.7% and 29.3%, respectively, for the same period in the prior year.

Our gross profit margin for the period was 27.3% consistent with the prior year. The consistency in gross profit margin is attributable to consistent increases in both sales and cost of sales of 4.4%.

Selling, distribution and administrative expense (SD&A) consists of associate compensation, benefits and other expenses associated with selling, purchasing, warehousing, supply chain management and providing marketing and distribution of the Company's products, as well as costs associated with a variety of administrative functions such as human resources, information technology, treasury, accounting, legal, and facility related expenses. SD&A was 20.2% of sales for the six months ended December 31, 2012 compared to 20.7% in the prior year period. On an absolute basis, SD&A increased $5.0 million or 2.1% compared to the prior year period. In the prior year period we incurred approximately $4.5 million of non-recurring SD&A expense mostly pertaining to the curtailment loss pertaining to freezing our Supplemental Executive Retirement Benefits Plan as well as certain one-time CEO transition related expenses. Adjusting for these items, the adjusted SD&A expenses would have shown a 4.0% increase over the prior year period. This increase in adjusted SD&A is entirely the result of acquisitions as our ongoing operations experienced SD&A expense declines.

Operating income increased 10.8% or $8.3 million, and as a percent of sales increased to 7.1% from 6.7% during the prior year period. The period increase in operating income primarily reflects higher sales levels. The increase in the operating margin percentage is driven by improved leverage of our SD&A expenses over a larger base, as we lowered our SD&A as a percent of sales to 20.2% versus 20.7% in the same period of fiscal 2012, all while maintaining a consistent gross margin.

Operating income as a percentage of sales for the Service Center Based Distribution segment decreased to 6.3% in the current year period, from 6.4% in the prior year period. The stability in operating income as a percentage of sales is due to an increase in sales coupled with commensurate increases in both SD&A and gross profit margin.

Operating income as a percentage of sales for the Fluid Power Business segment decreased to 8.6% in the current year period from 9.4% in the prior year period. The decrease is attributable to declining sales without a commensurate decrease in SD&A(representing 0.3% of the decrease) along with decreased gross profit margins (representing 0.4% of the decrease)

Other income was $0.9 million in the period which included unrealized gains on investments held by non-qualified deferred compensation trusts of $0.6 million and net favorable foreign currency transaction gains of $0.4 million. During the prior year period other expense was $2.7 million which included unrealized losses on investments held by non-qualified deferred compensation trusts of $1.0 million and net unfavorable foreign currency transaction losses of $1.6 million.

The effective income tax rate was 34.0% for the six month period ended December 31, 2012 compared to 35.9% for the six month period ended December 31, 2011. The impact of lower effective tax rates in foreign jurisdictions favorably reduced our rate when compared to the U.S. federal statutory rate by approximately 1.5% in the period, along with other tax items which reduced the rate by 0.4%. We expect our full year tax rate to be in the 34.0% to 34.5% range.

As a result of the factors addressed above, net income increased $9.3 million or 19.6% compared to the prior year period. Net income per share was $1.33 per share for the six month period ended December 31, 2012, compared to $1.11 in the prior year period.

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 December 31, 2012, we had $33.0 million in outstanding borrowings. At December 31, 2011, we had no outstanding borrowings. Management expects that our existing cash, cash equivalents, funds available under the revolving credit facility, cash provided from operations, and the use of operating leases will be sufficient to finance normal working capital needs, payment of dividends, acquisitions, investments in properties, facilities and equipment, and the purchase of additional Company common stock. Management also believes that additional long-term debt and line of credit financing could be obtained based on the Company's credit standing and financial strength.

The Company's working capital at December 31, 2012 was $442.5 million, compared to $435.6 million at June 30, 2012. The current ratio was 2.7 to 1 at December 31, 2012 and 2.9 to 1 at June 30, 2012.

In the first quarter, the Company acquired SKF's company-owned distribution businesses in Australia and New Zealand for cash consideration. The Company funded this acquisition from its available cash.

In the second quarter, the Company acquired Parts Associates Inc. based in Cleveland, Ohio. The Company funded this acquisition with funds drawn on the Company's revolving credit facility. The company also acquired Bearings & Oil Seals Specialists Inc. based in Ontario, Canada, as well as HyQuip Inc. based in Wisconsin. The Company funded these acquisitions from its available cash.

Net Cash Flows
The following table is included to aid in review of Applied's condensed
statements of consolidated cash flows; all amounts are in thousands.
                                            Six Months Ended December 31,
Net Cash Provided by (Used in):               2012                 2011
Operating Activities                    $       28,886       $       30,216
Investing Activities                           (72,469 )            (14,282 )
Financing Activities                            15,376              (34,344 )
Exchange Rate Effect                             1,610               (2,170 )
Decrease in Cash and Cash Equivalents   $      (26,597 )     $      (20,580 )

Net cash provided by operating activities was $28.9 million for the six months ended December 31, 2012 as compared to $30.2 million for the same period a year ago. Improved net income of $9.3 million was slightly more than offset by greater increases in working capital.

Net cash used in investing activities during the six months ended December 31, 2012 was $72.5 million; $6.8 million was used for capital expenditures (including capitalized costs associated with our ERP project) and $66.1 million for acquisitions. These uses of cash were partially offset by $0.4 million of proceeds from property sales. In the six months ended December 31, 2011, investing activities used $14.3 million including $1.2 million for acquisitions and $14.0 million for capital expenditures. These uses of cash were partially offset by $1.0 million of proceeds from property sales.

Net cash provided by financing activities was $15.4 million for the six months ended December 31, 2012. Financing activities included $17.7 million used to pay dividends, $1.8 million used to make acquisition holdback payments, offset by $33.0 million borrowed under the revolving credit facility, and $1.5 million from tax benefits from share based compensation. During the same period in the prior year, financing activities used $34.3 million of cash; repurchases of 644,100 shares of treasury stock used $19.0 million and dividends paid used $16.1 million.

ERP Project
In the second quarter of fiscal 2011, Applied commenced its ERP (SAP) project to transform the Company's technology platforms and enhance its business information and transaction systems for future growth. We have deployed our solution in a portion of our Canadian and U.S. operations. Deployments have continued in the second quarter with further deployments planned for fiscal 2013 and 2014.

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 and negotiated transactions, from time to time, depending upon market conditions. We did not acquire any shares of treasury stock in the six months ended December 31, 2012. At December 31, 2012, we had authorization to repurchase an additional 1,142,800 shares. During the six months ended December 31, 2011, we acquired 644,100 shares of treasury stock for $19.0 million.

Borrowing Arrangements
We have a $150.0 million revolving credit facility with a group of banks expiring in May 2017. There is $33.0 million outstanding under this facility at December 31, 2012. At December 31, 2012, unused capacity under this facility, net of outstanding letters of credit, was $107.8 million and is available to fund future acquisitions or other capital and operating requirements.

At December 31, 2012, we had an uncommitted long-term financing shelf facility enabling us to borrow up to $100 million with terms of up to fifteen years. This facility had no borrowings outstanding at December 31, 2012. In February 2013, prior to its expiration, the facility was extended to February 2016 and the available facility amount was increased to $125 million.

Accounts Receivable Analysis
The following table is included to aid in analysis of accounts receivable and
the associated provision for losses on accounts receivable:
                                                     December 31,              June 30,
                                                         2012                    2012
Accounts receivable, gross                     $              312,734    $          315,375
Allowance for doubtful accounts                                 8,106                 8,332
Accounts receivable, net                       $              304,628    $          307,043
Allowance for doubtful accounts, % of gross
receivables                                                       2.6 %                 2.6 %

                                                   For the six months ended December 31,
                                                         2012                    2011
Provision for losses on accounts receivable    $                  604    $            1,525
Provision as a % of net sales                                    0.05 %                0.13 %

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 46.5 at December 31, 2012 versus 45.2 at June 30, 2012. Accounts receivable decreased 0.8% this year, compared to a 4.4% increase in sales in the six months ended December 31, 2012. We primarily attribute the increase in DSO to higher sales to large contract accounts.

Less than 3.4% of our accounts receivable balances are more than 90 days past due. On an overall basis, our provision for losses from uncollected receivables represent 0.05% of our sales in the six months ended December 31, 2012. Historically, this percentage is around 0.15%. Management believes the overall receivables aging and provision for losses on uncollected receivables are at reasonable levels.

Inventory Analysis
Inventories are valued at the lower of cost or market, 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 current costs. The annualized inventory turnover for the period ended December 31, 2012 was 4.1 versus 4.6 at June 30, 2012. We believe inventory turnover will improve through our June year-end, although it will not reach the levels achieved in the fiscal 2012. This slight decline in inventory turns pertains to our current year acquisitions as well as additions to core inventory in support of our strategic objectives.

Cautionary Statement Under Private Securities Litigation Reform Act

Management's Discussion and Analysis and other sections of this report, including documents incorporated by reference, contain statements that are forward-looking, based on management's current expectations about the future. . . .