UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

SCHEDULE 14A

(RULE 14a-101)

SCHEDULE 14A INFORMATION

 

Proxy Statement Pursuant to Section 14(a) of the Securities

Exchange Act of 1934 (Amendment No.     )

Filed by the Registrant þ

Filed by a Party other than the Registrant o

 

Check the appropriate box:

 

 

Applied Industrial Technologies Inc.

(Name of Registrant as Specified In Its Charter)

 

(Name of Person(s) Filing Proxy Statement)

 

Payment of Filing Fee (Check the appropriate box):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

APPLIED INDUSTRIAL TECHNOLOGIES, INC.
1 APPLIED PLAZA
CLEVELAND, OHIO 44115
(216) 426-4000
www.applied.com

 

NOTICE OF ANNUAL MEETING OF SHAREHOLDERS

 

Dear Shareholder:

 

We are pleased to invite you to the 2008 annual meeting of the shareholders of Applied Industrial Technologies, Inc. The meeting will be at our headquarters, 1 Applied Plaza, East 36th Street and Euclid Avenue, Cleveland, Ohio, 44115 on Tuesday, October 21, 2008, at 10:00 a.m., Eastern Time. The meeting will be held for the following purposes:

 

1. Electing four directors for a three-year term, and

 

 

Shareholders of record at the close of business on August 22, 2008, are entitled to vote at the meeting. The transfer books will not be closed. A list of shareholders as of the record date will be available for examination at the meeting.

 

The attached proxy statement describes the business of the meeting and other information about our corporate governance. After the meeting, we will report on our operations and other matters of interest.

 

Vice President-General Counsel

& Secretary

 

September 5, 2008

 

 

 

 

Important Notice Regarding the Availability of Proxy Materials for the
Shareholder Meeting to be Held on October 21, 2008.

 

 

The Proxy Statement and 2008 Annual Report to Shareholders are available at
www.applied.com/proxy

 

 

PROXY STATEMENT

 

TABLE OF CONTENTS

 

 

In this statement, “we,” “our,” “us,” and “Applied” all refer to Applied Industrial Technologies, Inc., an Ohio corporation. Our common stock, without par value, is listed on the New York Stock Exchange with the ticker symbol “AIT.”

 

What is the proxy statement’s purpose?

 

The proxy statement summarizes information you need to vote at our 2008 annual meeting of shareholders to be held on Tuesday, October 21, 2008, at 10:00 a.m., Eastern Time, at our headquarters, and any adjournment of that meeting. We are sending the proxy statement to you because Applied’s Board of Directors is soliciting your proxy to vote your shares at the meeting. The proxy statement and the accompanying proxy card are being sent to shareholders of record on or about September 5, 2008.

 

On what matters are shareholders voting?

 

 

Who may vote and what constitutes a quorum at the meeting?

 

Only shareholders of record at the close of business on August 22, 2008, may vote. As of that date, there were 42,326,469 outstanding shares of Applied common stock, without par value. The holders of a majority of those shares will constitute a quorum to hold the meeting. A quorum is necessary for valid action to be taken.

 

We have no class or series of shares outstanding other than our common stock.

 

How many votes do I have?

 

Each shareholder is entitled to one vote per share.

 

How do I vote?

 

The answer depends on whether you hold the shares directly in your name, or through a broker, trustee, or other nominee, such as a bank.

 

 

Votes submitted by telephone or online for shares held in the Retirement Savings Plan or Supplemental Defined Contribution Plan must be received by Thursday, October 16, 2008; votes by telephone or online for other shares must be received by Monday, October 20, 2008.

 

If you attend the meeting and vote in person, a ballot will be available when you arrive. If, however, your shares are held in the name of your broker, trustee, or other nominee, you must bring a valid proxy from that party giving you the right to vote the shares.

 

What if I don’t indicate my voting choices?

 

If Applied receives your proxy in time to use at the meeting, your shares will be voted according to your instructions. If you have not indicated otherwise on the proxy you submit, your shares will be voted as the Board of Directors recommends on the two matters identified above. In addition, the proxies will vote your shares according to their judgment on other matters brought before the meeting.

 

What effect do abstentions and broker non-votes have?

 

Brokers holding shares for beneficial owners must vote the shares according to instructions they receive from the owners. If instructions are not received, then brokers may vote the shares at their discretion, except if New York Stock Exchange (“NYSE”) rules preclude brokers from exercising discretion relative to a specific type of proposal — this is called a “broker non-vote.” Under NYSE rules, brokers will have discretionary authority to vote on Items 1 and 2, so there should be no broker non-votes.

 

The affirmative vote of a majority of the votes cast at the meeting is required to approve Item 2. In determining the votes cast on the item, abstentions will not count as votes cast and, accordingly, will not affect the vote’s outcome.

 

What does it mean if I receive multiple sets of proxy materials?

 

Receiving multiple sets of proxy cards usually means your shares are held in different names or different accounts. Please respond to all of the proxy solicitation requests to ensure all of your shares are voted.

 

May I revoke my proxy?

 

You may revoke your proxy before it is voted at the meeting by notifying Applied’s Secretary in writing, voting a second time by telephone or via the Internet, returning a later-dated proxy card, or voting in person. Your presence at the meeting will not by itself revoke the proxy.

 

Who pays the costs of soliciting proxies?

 

Applied pays the costs of soliciting proxies. We will also pay the standard charges and expenses of brokers or other nominees for forwarding these materials to and obtaining proxies from beneficial owners. Directors, officers, and other employees, acting on our behalf, may solicit proxies. We have also retained Morrow & Co., at an estimated fee of $7,000 plus expenses, to aid in soliciting proxies from brokers and institutional holders. In addition to using the mail, proxies may be solicited personally, and by telephone, facsimile, or other electronic means.

 

Who counts the votes?

 

Computershare Investor Services LLC will act as inspector of election and tabulate the votes.

 

Applied’s Code of Regulations divides our Board of Directors into three classes. The directors in each class are elected for three-year terms so that the term of office of one class expires at each annual meeting. At the 2008 annual meeting, the shareholders will elect directors for a three-year term expiring in 2011 or until their successors have been elected and qualified. Pursuant to Ohio law, the properly nominated candidates receiving the greatest number of votes will be elected.

 

The Board’s Corporate Governance Committee recommended, and the Board has approved, the nomination of four persons for election as directors: L. Thomas Hiltz, John F. Meier, David L. Pugh, and Peter C. Wallace. All are incumbents who were most recently elected at the 2005 annual meeting. The Board renominated them following the Corporate Governance Committee’s review and evaluation of their performance.

 

The directors serving for terms expiring in 2009 and 2010 will continue in office.

 

The proxies named on the proxy card accompanying the materials sent to shareholders of record intend to vote for the four nominees unless authority is withheld. If a nominee becomes unavailable to serve, the proxies reserve discretion to vote for any other person or persons who may be nominated at the meeting and/or to vote to reduce the number of directors. We are not aware of any existing circumstance that would cause a nominee to be unavailable to serve.

 

The Board of Directors recommends that the shareholders vote FOR the nominees.

 

Below we show information about the nominees and the directors continuing in office. Unless otherwise stated, the individuals have held the positions indicated for the last five years.

 

Nominees for Election as Directors with Terms Expiring in 2011

 

L. Thomas Hiltz

 

Director since 1981, member of Corporate Governance Committee

 

Business Experience. Mr. Hiltz, age 62, is an attorney in Covington, Kentucky and is one of five trustees of the H.C.S. Foundation, a charitable trust which has sole voting and dispositive power with respect to 600,000 shares (as of June 30, 2008) of Applied stock.

John F. Meier

 

Director since 2005, member of Executive Organization & Compensation Committee

 

Business Experience. Mr. Meier, age 60, is Chairman and Chief Executive Officer of Libbey Inc., a leading supplier of tableware products in the U.S. and Canada, in addition to supplying to other key international markets.

 

Other Directorships. Cooper Tire & Rubber Company, Libbey Inc.

David L. Pugh

 

Director since 2000, member of Executive Committee

 

Business Experience. Mr. Pugh, age 59, is Applied’s Chairman & Chief Executive Officer.

 

Other Directorships. Hexcel Corporation, OM Group, Inc.

Peter C. Wallace

 

Director since 2005, member of Corporate Governance Committee

 

Business Experience. Mr. Wallace, age 54, has served as President and Chief Executive Officer, and a director, of Robbins & Myers, Inc. since July 2004. Robbins & Myers is a leading designer, manufacturer,

and marketer of highly engineered, application-critical equipment and systems for the pharmaceutical, energy, and industrial markets worldwide. Prior to July 2004, Mr. Wallace was President and Chief Executive Officer of IMI Norgren Group, a manufacturer of sophisticated motion and fluid control systems for original equipment manufacturers.

 

Other Directorship. Robbins & Myers, Inc.

 

 

Continuing Directors with Terms Expiring in 2009

 

 

Thomas A. Commes

 

Director since 1999, member of Audit and Executive Committees

 

Business Experience. Until his retirement in 1999, Mr. Commes, age 66, was President and Chief Operating Officer, and a director, of The Sherwin-Williams Company, a manufacturer, distributor, and retailer of paints and painting supplies. His career included service as that company’s Chief Financial Officer.

 

Other Directorship. Agilysys, Inc.

 

Peter A. Dorsman

 

Director since 2002, member of Corporate Governance Committee

 

Business Experience. Mr. Dorsman, age 53, has served as Senior Vice President, Global Operations for NCR Corporation since October 2007. NCR is a global technology company providing assisted- and self-service solutions and comprehensive support services that address the needs of retail, financial, travel, healthcare, hospitality, gaming and public sector organizations in more than 100 countries. He joined NCR in April 2006 as Vice President and General Manager of its Systemedia business. He had been Executive Vice President & Chief Operating Officer (from 2000 to June 2004) of The Standard Register Company, a leading provider of information solutions for financial services, healthcare, manufacturing, and other markets worldwide.

 

J. Michael Moore

 

Director since 1997, member of Audit Committee

 

Business Experience. Mr. Moore, age 65, is President of Oak Grove Consulting Group, Inc. He was Chairman and Chief Executive Officer of Invetech Company, a distributor of bearings, mechanical and electrical drive system products, industrial rubber products, and specialty maintenance and repair products, prior to its acquisition by Applied in 1997.

 

 

Dr. Jerry Sue Thornton

 

Director since 1994, member of Corporate Governance Committee

 

Business Experience. Dr. Thornton, age 61, is President of Cuyahoga Community College, the largest multi-campus community college in Ohio.

 

Other Directorships. American Greetings Corporation, National City Corporation, RPM, Inc.

 

Continuing Directors with Terms Expiring in 2010

 

 

William G. Bares

 

Director since 1986, member of Executive and Executive Organization & Compensation Committees

 

Business Experience. Mr. Bares, age 67, was The Lubrizol Corporation’s Chairman until his retirement from that post in December 2004. He was also Lubrizol’s Chief Executive Officer until April 2004. Lubrizol is a premier specialty chemical company focused on providing innovative technology to global transportation, industrial, and consumer markets.

 

Other Directorship. KeyCorp

 

Edith Kelly-Green

 

Director since 2002, member of Audit Committee

 

Business Experience. Until her retirement in October 2003, Ms. Kelly-Green, age 55, was Vice President and Chief Sourcing Officer of FedEx Express, the world’s largest express transportation company and a subsidiary of FedEx Corporation.

 

Stephen E. Yates

 

Director since 2001, member of Executive Organization & Compensation Committee

 

Business Experience. Mr. Yates, age 60, joined KeyCorp, one of the nation’s largest bank-based financial services companies, as Executive Vice President and Chief Information Officer in September 2004. He had been President of USAA Information Technology Company until May 2004.

 

Subject to shareholder ratification, the Audit Committee has appointed Deloitte & Touche LLP to serve as independent auditors for the fiscal year ending June 30, 2009. The committee made the appointment after evaluating the firm and its performance. Deloitte & Touche has confirmed it is not aware of any relationship between the firm (and its affiliates) and Applied that may reasonably be thought to bear on its independence.

 

Deloitte & Touche, the member firms of Deloitte Touche Tohmatsu, and their respective affiliates billed the following fees, including expenses, to Applied for fiscal years 2008 and 2007:

 

 

Audit-Related Fees in 2008 were for acquisition due diligence ($35,000), and miscellaneous accounting research projects and reports ($18,500), and in 2007 were for acquisition due diligence ($5,100), and miscellaneous accounting research projects and reports ($10,000).

 

Tax Fees in 2008 were for tax compliance and return preparation ($65,300) and consulting ($150,400) and in 2007 were for tax compliance and return preparation ($65,000) and consulting ($82,400).

 

All Other Fees in 2008 were for an annual subscription to an accounting research tool.

The Audit Committee pre-approves the services performed by the independent auditors to assure that the provision of the services does not impair the auditors’ independence. If a type of service to be provided is not included in the committee’s general pre-approval, then it requires specific pre-approval. In addition, any services exceeding pre-approved cost levels require additional committee pre-approval. The committee has delegated pre-approval authority to its chair, provided that the committee reviews the chair’s action at its next regular meeting. The committee also reviews, generally on a quarterly basis, reports summarizing the services provided by the independent auditors.

 

Unless otherwise indicated, the accompanying proxy will be voted in favor of ratifying Deloitte & Touche’s appointment. Ratification requires the affirmative vote of a majority of the shares cast at the meeting. If Deloitte & Touche withdraws or otherwise becomes unavailable for reasons not currently known, the proxies will vote for other independent auditors, as they deem appropriate.

 

We expect one or more Deloitte & Touche representatives to be present at the meeting. They will have the opportunity to make a statement and we expect them to be available to respond to appropriate questions.

 

The Board of Directors recommends that the shareholders vote FOR ratifying the appointment of the independent auditors.

 

Applied’s Internet address is www.applied.com. The following corporate governance documents are available free of charge at the website’s investor relations area:

 

 

These documents are also available in print to any shareholder who sends a written request to our Vice President-Chief Financial Officer & Treasurer at 1 Applied Plaza, Cleveland, Ohio 44115.

 

Under the NYSE corporate governance listing standards, a majority of Applied’s directors must satisfy the NYSE criteria for “independence.” In addition to having to satisfy stated minimum requirements, no director qualifies under the standards unless the Board affirmatively determines the director has no material relationship with Applied. In assessing a relationship’s materiality, the Board has adopted categorical standards, which may be found in our website’s investor relations area.

 

The Board has determined that all the directors, other than Mr. Pugh, meet these independence standards.

 

During the fiscal year ended June 30, 2008, the Board had six meetings. Each director attended at least 75% of the total number of meetings of the Board and all committees on which he or she served.

 

Applied expects its directors to attend the annual meeting of shareholders, just as they are expected to attend Board meetings. All the directors attended last year’s annual meeting.

 

Applied’s non-management directors meet in executive sessions without management, typically at every regular Board meeting. Mr. Bares, the Executive Organization & Compensation Committee chair, serves as presiding director of the sessions.

 

The Audit, Corporate Governance, and Executive Organization & Compensation Committees are composed solely of independent directors, as defined in the NYSE listing standards and Applied’s categorical standards, and, in the case of the Audit Committee, under applicable federal securities laws.

 

The committee members’ names and number of meetings held in fiscal 2008 follow:

 

 

We briefly describe each committee below. Their charters, posted at the investor relations area of Applied’s website, contain more complete descriptions. The Board also has a standing Executive Committee which, during the intervals between Board meetings and subject to the Board’s control and direction, possesses and may exercise the Board’s powers. The Executive Committee met twice in fiscal 2008.

 

Audit Committee. The Audit Committee assists the Board in fulfilling its oversight responsibility with respect to the integrity of Applied’s accounting, auditing, and reporting processes. The committee appoints, determines the compensation of, evaluates, and oversees the work of the independent auditor, reviews the auditor’s independence, and approves permissible non-audit engagements to be undertaken by the auditor. The committee also reviews, with management and the auditor, annual and quarterly financial statements, the scope of the independent and internal audit programs, audit results, and the adequacy of Applied’s internal accounting and financial controls.

 

The Board has determined that each Audit Committee member is independent for purposes of section 10A of the Securities Exchange Act of 1934 and that at least one, Mr. Commes, is an “audit committee financial expert,” as defined in Item 407(d)(5) of Securities and Exchange Commission (“SEC”) Regulation S-K.

 

Please review “Audit Committee Report” on page 38 of this proxy statement.

 

Corporate Governance Committee. The Corporate Governance Committee assists the Board by reviewing and evaluating potential director nominees, Board and Chief Executive Officer performance, Board governance matters, director compensation, compliance with laws, public policy matters, and other issues. The committee also administers long-term incentive awards to directors under the 2007 Long-Term Performance Plan.

 

Executive Organization & Compensation Committee. The Executive Organization & Compensation Committee monitors and oversees Applied’s management succession planning and leadership development processes, nominates candidates for the slate of officers to be elected by the Board, and reviews, evaluates, and approves the executive officers’ compensation and benefits. The committee also administers incentive awards under the 2007 Long-Term Performance Plan, including the annual

Management Incentive Plan. In approving the officers’ compensation and benefits, the committee bases its decisions on a number of factors and considerations, including the following: the committee’s own reasoned judgment; peer group and market survey information and recommendations provided by the committee’s consultant, Hewitt Associates LLC; and recommendations from Mr. Pugh, Applied’s Chief Executive Officer, as to the other officers’ compensation and benefits.

 

Please review, on page 38, the committee’s report regarding the “Compensation Discussion and Analysis” portion of this proxy statement.

 

Shareholders and other interested parties may communicate with any director by writing to that individual c/o Applied’s Secretary at 1 Applied Plaza, Cleveland, Ohio 44115. In addition, they may contact the non-management directors or key Board committees by e-mail, anonymously if desired, through a form established in the investor relations area of Applied’s website at www.applied.com. The Board has instructed Applied’s Secretary to review these communications and to exercise his judgment not to forward correspondence such as routine business inquiries and complaints, business solicitations, and frivolous communications.

 

In identifying and evaluating director candidates, the Corporate Governance Committee first considers Applied’s developing needs and the desired characteristics of a new director, as determined from time to time by the committee. The committee then considers a candidate’s business, strategic, and financial skills, independence, integrity, and time availability, as well as overall experience in the context of the Board’s needs. The committee in the past has engaged a professional search firm (to which it paid a fee) to assist in identifying and evaluating potential nominees, and may do so again in the future.

 

The committee will also consider qualified director candidates recommended by our shareholders. Shareholders can submit recommendations by writing to Applied’s Secretary at 1 Applied Plaza, Cleveland, Ohio 44115. Shareholders must submit recommendations in a timely manner and include appropriate detail regarding the shareholder’s identity and the candidate’s business, professional, and educational background and independence. The committee does not intend to evaluate candidates proposed by shareholders differently than other candidates.

 

Applied’s Code of Business Ethics expresses the principle that situations presenting a conflict of interest must be avoided. In furtherance of this principle, the Board has adopted a written policy, administered by the Corporate Governance Committee, for the review and approval, or ratification, of transactions with related persons.

 

The related party transaction policy applies to any proposed transaction in which Applied is a participant, the amount involved exceeds $50,000, and any director, executive officer or significant shareholder, or any immediate family member of such a person, has a direct or indirect material interest. The policy provides that the Corporate Governance Committee will consider, among other things, whether the transaction is on terms no less favorable than those provided to unaffiliated third parties under similar circumstances, and the extent of the related person’s interest. No director may participate in any discussion or approval of a transaction for which he or she is a related person.

 

Only non-employee directors receive compensation for service as directors. Mr. Pugh, our Chief Executive Officer, does not receive additional compensation for serving as a director.

 

The Corporate Governance Committee reviews our directors’ compensation annually. The committee seeks to provide a competitive compensation program to assist with director retention and recruitment. If the committee believes a change is warranted to remain competitive considering the size and nature of our business, then the committee makes a recommendation to the Board.

 

In considering changes, the committee bases its decisions on a number of factors and considerations, including published survey data for similar companies and the committee’s own reasoned judgment. In general, the committee targets the median director compensation levels for comparably sized companies in similar industries, considering also the time commitments required of directors. A majority of the directors must approve any change.

 

The primary components of the director compensation program follow:

 

Quarterly Retainer. Directors earn an $8,125 quarterly retainer.

 

Meeting Fee. Directors earn a $1,500 fee for the first Board or committee meeting attended per day, and $500 for each additional meeting attended on the same day, up to a maximum of $2,500 per day. Directors may be similarly compensated if they attend other meetings or telephone conferences at the Chairman’s request. In addition, Applied pays directors $500 for any action taken by unanimous written consent or via telephone conference of less than 30 minutes.

 

Committee Chair Retainer. Committee chairs earn an additional $1,250 quarterly retainer, except for the Audit Committee chair, who earns $1,875.

 

Long-Term Incentives. Annually, after considering survey data, the Corporate Governance Committee considers long-term incentive awards to the directors. In 2008, the committee awarded each director 2,596 stock options and 1,042 restricted shares under the 2007 Long-Term Performance Plan. The stock options’ exercise price is the closing market price for Applied stock on the grant date. The options are exercisable immediately and expire on the tenth anniversary of the grant date. The restricted shares vest one year after the grant date, subject to conditions as to forfeiture and acceleration of vesting.

 

Deferred Compensation Plan for Non-Employee Directors. Pursuant to the Deferred Compensation Plan for Non-Employee Directors, and subject to Internal Revenue Code (“Code”) section 409A, a director may defer payment of future retainer and meeting fees. Deferred fees are deemed invested, at a director’s option, in a money market fund and/or Applied stock.

 

At the end of the quarter in which the compensation would otherwise become due and payable, Applied transfers the amount deferred, in either cash or treasury shares (depending on which option the director chooses), to a grantor trust. In general, distribution of a director’s account commences in the manner (lump sum or annual installments not to exceed 10 years) and at the time designated in the director’s election form. The plan prohibits acceleration of distributions and any distribution change must comply with section 409A.

 

If a director elects to have compensation invested in Applied stock, then Applied contributes an additional amount equal to 25% of the amount so invested. This matching provision will expire in October 2013. Applied contributed a total of 10,894 matching shares to directors’ accounts in the most recent three fiscal years.

 

Nine directors currently defer all their retainer and meeting fees and elect to have the fees invested in Applied stock.

Other Benefits. In addition to the items described above, Applied reimburses directors for travel expenses for attending meetings, as well as for expenses incurred in attending director education seminars and conferences. The directors also participate in our travel accident insurance plan and may elect to participate in our contributory health care plan.

 

Applied expects each non-employee director to maintain, within five years of joining the Board, ownership of Applied shares valued at a minimum of three times the annual retainer fees. Directors may hold the shares directly or indirectly, including shares deemed invested in the Deferred Compensation Plan for Non-Employee Directors. All the directors meet this guideline.

 

The following table shows information about each non-employee director’s compensation in 2008.

 

 

 

The following table shows beneficial ownership of Applied common stock, as of June 30, 2008, by (a) each person believed by us to own beneficially more than 5% of Applied’s outstanding shares, based on our review of SEC filings, (b) all directors and nominees, (c) the named executive officers included in the Summary Compensation Table on page 23, and (d) all directors, nominees, and current executive officers as a group.

 

 

 

 

This Compensation Discussion and Analysis provides details about the compensation program for Applied’s executive officers. It includes the company’s compensation philosophy and objectives, roles and responsibilities in making compensation decisions, descriptions of the compensation components, and the basis for adjustments, incentive payments, and long-term incentive grants made in fiscal year 2008.

 

Unless otherwise noted, references to years in the “Executive Compensation” section of this proxy statement mean Applied’s fiscal year ending on June 30.

 

When reviewing these pages and the other compensation information, please note that Applied achieved record financial results in 2008 and 2007. Most significantly, we earned net income of $95.46 million in 2008 and $86.02 million in 2007, compared with $72.30 million in 2006 and $55.34 million in 2005. In addition, our total shareholder return was approximately 183% for the five years ended June 30, 2008.

 

We have designed our compensation program to link executive and shareholder interests. Accordingly, a substantial portion of the compensation our executives earned in 2008 and 2007 – particularly payouts under annual Management Incentive Plans and three-year performance grants – reflects Applied’s performance exceeding goals set for those years.

 

As with our overall business, Applied’s primary goal in compensating our executive officers is maximizing long-term shareholder return. In pursuing this goal, we seek to design and to execute a program that will accomplish the following:

 

 

Applied is an industrial distributor in a mature market. The business is highly competitive, with many other companies offering the same or substantially similar products and services. In this environment, attracting and retaining talented executives is critical to our success. We compete for talent with our business competitors as well as with similarly sized companies outside our industry. For these reasons, we have designed Applied’s executive compensation program to be competitive both within our industry and in the broader marketplace.

 

Consistent with maximizing shareholder return, Applied believes it is important for executives to focus their efforts on both short-term and long-term performance. Accordingly, we provide annual and long-term incentive programs, all designed to align executives’ interests with those of shareholders.

 

Executive Organization & Compensation Committee. The Executive Organization & Compensation Committee (the “Committee”) of our Board is composed entirely of independent directors and is responsible for the executive compensation program’s design and implementation. The Committee’s duties include the following:

 

 

For every meeting where compensation items are to be discussed, the Committee receives a tally sheet displaying all material components of each executive’s compensation and benefits. This enables the Committee to make decisions with respect to each compensation element in the context of total compensation.

 

Independent Compensation Consultant. Hewitt Associates LLC serves as the Committee’s independent compensation consultant, assisting the Committee in the following:

 

 

Hewitt is engaged by and reports directly to the Committee. Hewitt directly interacts with the Committee chair between meetings and participates in meetings and performs assignments as requested. The firm submits its invoices to the chair for approval and payment by Applied. Hewitt performs no other work for Applied and receives no other compensation from Applied outside this engagement.

 

Management. While the Committee is responsible for the program’s design and implementation, management assists the Committee in several ways.

 

Mr. Pugh, our Chief Executive Officer, and other key executives attend portions of Committee meetings at its invitation. They make recommendations about program components and incentive plan goals, and regularly report on Applied’s performance. Mr. Pugh also reports on the other officers’ individual performance and makes recommendations regarding their base salaries and incentive awards. The Committee sets Mr. Pugh’s pay in executive session without management present.

 

Management does not have its own executive compensation consultant. Mr. Pugh and other executives do assist Hewitt by providing compensation data and other input and helping Hewitt understand Applied’s organizational structure, business plans, goals, and performance.

 

Structure. The compensation program for executive officers includes the following components:

 

 

The Committee sets salaries to be competitive with similar positions in companies in the Comparison Peer Group described below under “Competitive Benchmarking.” Annual incentive pay rewards the achievement of short-term objectives, and long-term objectives are promoted through performance-based incentive awards and stock-settled stock appreciation rights. The incentive plans target key company-wide performance measures including total shareholder return, earnings growth, sales growth, and return on sales.

 

Applied’s compensation practices reflect our pay-for-performance philosophy. The Committee places the majority of the compensation provided to the officers named in the Summary Compensation Table on page 23 (the “named executive officers”), including targeted incentive compensation, at risk and tied to company-wide performance. Moreover, incentive compensation generally makes up a greater share of the overall opportunity for executives in more senior positions.

 

Applied also believes that programs leading to equity ownership ensure that the executives’ interests are aligned with shareholders’. However, to avoid excessive dilution, the Committee manages the form of earned incentive awards to keep annual share utilization well below 2% of the shares outstanding. The Committee regularly reviews its share utilization in relation to market practices.

 

With these guideposts, the Committee establishes a mix among base salary, target annual incentive pay, and target long-term incentive pay, as well as a mix between cash and equity-based incentives, that are aligned with competitive market practices.

 

The following table shows the allocation of the opportunity provided in 2008 to the named executive officers employed at year-end, considering the primary elements of compensation – base salary, target annual incentive opportunity, and target long-term incentive opportunity (including the estimated present value of performance grants that will pay out at the end of 2010, if earned):

 

 

Overall, there are no material differences in the Committee’s application of compensation policies and practices among the named executive officers. Mr. Pugh, our Chief Executive Officer, does earn a higher

salary and higher incentive opportunities than the other executive officers, which is typical of companies in the peer groups described below. We believe this is appropriate in light of his responsibilities.

 

Competitive Benchmarking. At the Committee’s request, Hewitt prepares a target compensation study from its proprietary Total Compensation Measurement database in odd-numbered years. For years when the study is not solicited, such as 2008, Hewitt provides a general market pay adjustment factor to assist the Committee in adjusting base salaries.

 

In large part, however, 2008 compensation levels stood on the foundation of the Committee’s actions the prior year, supported by Hewitt’s 2007 target compensation study. The first step in preparing the 2007 study was the Committee’s selection from the database, with Hewitt’s input, of general market and industry comparison groups for evaluating compensation.

 

 

The Comparison Peer Group included the following members:

 

 

References in this Compensation Discussion and Analysis to “market” generally mean the Comparison Peer Group.

 

 

 

The Industry Peer Group members, plus two other companies whose size fell outside the Comparison Peer Group revenue range — Genuine Parts Company and Lawson Products, Inc. — serve as the peer group in the performance graph in Applied’s 2008 annual report to shareholders.

 

The Committee may determine in the future that it is appropriate to change the peer groups based on changes in companies’ size, business profile, and other factors.

 

After the Comparison Peer Group was identified, Hewitt prepared the study. The study’s goal was to provide benchmarking data to assist the Committee in setting base salaries and incentive pay targets. Hewitt identified market pay for each executive officer position at the 25th, 50th, and 75th percentile levels, as well as a 50th percentile value that was size-adjusted – some companies are larger than Applied and some are smaller, so the data was adjusted using regression analysis based on revenues and market capitalization. Hewitt also aged the data to the middle of the fiscal year. The aged, size-adjusted 50th percentile is referred to here as the “market median.”

 

Hewitt’s study included analyses, for each position, of base salary, target short-term incentive compensation, target total short-term compensation (base salary plus target short-term incentive compensation), target long-term incentive compensation, and target total compensation (target total short-term

compensation plus target long-term incentive compensation). To assist the Committee in benchmarking company performance, Hewitt’s study also compared Applied’s total shareholder return and earnings growth over one-and three-year periods with Comparison Peer Group and Industry Peer Group medians.

 

Using Hewitt’s study and other guidance, the Committee benchmarks each compensation element, by position, against the market with the objective of targeting total compensation at or near the position’s market median if Applied’s performance targets are met. By design, sustained performance below target levels should result in realized total compensation below market medians, and performance that exceeds target levels should result in realized total compensation above market medians.

 

Base Salary. The Committee observes a general policy that base salaries for executive officers who have been in their positions for at least three years and are meeting performance expectations should be at or near (generally, within +/- 10%) the market median for comparable positions. The Committee may, however, set a salary higher or lower to reflect individual performance and skills, long-term potential, tenure in the position, internal equity, and the position’s importance in Applied’s organization.

 

Salary adjustments are based on changes in market rates for equivalent positions, as well as the Committee’s subjective evaluation of such factors as the individual’s responsibilities, performance, and overall contribution.

 

As noted above, Hewitt prepares a target compensation study to assist the Committee in setting compensation in odd-numbered fiscal years. In the other years, Hewitt provides the Committee a general market adjustment factor, not specific to position. In 2008, after considering the adjustment factor and Mr. Pugh’s recommendations for the other officers, the Committee adjusted the salary for each named executive officer employed at year-end (except Mr. Mondics, who had been recently promoted and whose salary was well below the position’s market median) upward in a 3.8-4.0% range.

 

Annual Incentives. The Management Incentive Plan rewards executive officers, in cash, for achieving fiscal year goals. In general, the Committee seeks to pay total short-term compensation at or near the market median when Applied meets its annual performance goals, and to pay substantially above the market median when Applied substantially exceeds its goals. If Applied does not achieve the minimum performance level, then the executive officers do not earn annual incentive pay.

 

At the beginning of the fiscal year, after the Board reviews Applied’s annual business plan, the Committee reviews and discusses proposed Management Incentive Plan performance goals. For 2008, after considering the market outlook and the business plan, the Committee set goals based on Applied’s net income objectives. The Committee adopted net income growth as the sole performance measure because of its value as a proxy for annual growth in shareholder value.

 

Each year, the Committee sets goals it believes are attainable, but that require executives to perform at a consistently high level to achieve target award values. The Committee set the 2008 goals as follow:

 

 

Payouts were to be prorated on a straight-line proportional basis for net income results between the levels shown. In addition, the plan provided that goals were subject to the Committee’s review and equitable adjustment depending on circumstances occurring during the year.

 

The $92.05 million target goal, which was 7% above 2007’s net income, reflected prospective increases in operating profit percentage and sales.

 

As shown above, payouts for 2008 could have ranged from 0% to 200% (for stretch performance) of the executive officers’ target award values. The Committee established this range after considering Hewitt’s guidance as to market practices.

Then, after considering Hewitt’s most recent target compensation study, the Committee assigns an incentive target – expressed as a percentage of salary – to each executive officer. For 2008, the Committee used the same percentages as in 2007, which were generally in line with the 2007 market medians; however, the Committee set a lower percentage for the President & Chief Operating Officer because Mr. Mondics was new to the position. The 2008 incentive targets follow:

 

 

Applied’s performance dictates the amounts paid. In 2008, Applied earned net income of $95.46 million. This exceeded the target goal and was 11% above 2007. The executive officers earned incentive pay at 137.2% of target levels. Accordingly, total short-term compensation was above market median levels.

 

Management Incentive Plan payouts are a component of the “Non-Equity Incentive Plan Compensation” column of the Summary Compensation Table at page 23.

 

Long-Term Incentives. The 2007 Long-Term Performance Plan rewards executives for achieving long-term performance goals. Applied’s shareholders approved the plan, replacing the 1997 Long-Term Performance Plan (the “1997 Plan”), last October.

 

Earlier in the fiscal year, the Committee made long-term incentive awards to the executive officers, and adopted the 2008 Management Incentive Plan, under the 1997 Plan. Outstanding grants under the 1997 Plan remain effective subject to their terms.

 

The 2007 Long-Term Performance Plan authorizes long-term incentive awards in a wide variety of forms. The Committee typically makes awards annually, at its regular August meeting after the release of the previous fiscal year’s financial results.

 

As with the other primary compensation components, the Committee sets the awards’ value after considering Hewitt’s target compensation study. In general, the Committee seeks to provide awards with a targeted value at or near the market median for equivalent positions, with some variation based on individuals’ responsibility, tenure in the position, overall contribution to Applied, and other factors. The program is intended then to pay total long-term compensation at or near the market median when Applied meets its performance goals and substantially above when Applied substantially exceeds its goals. If goals are not met, then long-term compensation should fall below the market median.

 

For 2008, the Committee set the same approximate targeted values as in 2007, when the Committee last solicited a target compensation study. The Committee then awarded the targeted value approximately one-half in nonqualified stock-settled stock appreciation rights (“SARs”) and one-half in three-year performance grants. The Committee has maintained this mix in recent years after considering Hewitt’s input regarding market practices.

 

 

The Committee designs the performance grants to motivate performance over the three years. Each year, as a new three-year period begins, the Committee reviews the business plan and market outlook. Then, after considering management’s recommendations and Hewitt’s guidance as to market practices, the Committee determines the performance measures and ranges at which payouts will be earned. For consistency, each grant has used the same performance measures, although the Committee reviews and adjusts performance goals and payout targets for new grants.

 

Payouts can range from 0% to 200% of the target levels. The Grants of Plan-Based Awards – Fiscal 2008 table on page 25 shows the threshold, target, and maximum payouts for the performance grants awarded to the named executive officers in 2008.

 

The performance grants tie two-thirds of the target payout to achievement of average annual return on sales and average annual sales growth goals. This portion of the grants links various payout levels with multiple ranges of achievement for a combination of the two goals.

 

The other third is tied to three-year cumulative total shareholder return compared with 19 other companies in Applied’s and related industries. Payouts are determined based on absolute return and percentile ranking. A 100% payout is predicated on Applied stock achieving a three-year return at least at the 50^th percentile and greater than 12.49% on an absolute basis. If, however, the return is lower than the 45^th percentile or lower than 0% on an absolute basis, then the executive officers will not earn a payout for this portion of the grants.

 

The three-year performance grant payouts earned at 2008 year-end by the named executive officers for awards made in August 2005 are reflected as a component of the “Non-Equity Incentive Plan Compensation” column of the Summary Compensation Table. A combination of Applied’s three-year average annual sales growth exceeding 7% and average annual return on sales exceeding 4% resulted in a payout of 200% of target for that portion of the grants. Applied fell below the 45^th percentile on the total shareholder return goal, so no participant earned a payout on this portion.

 

Qualified, Nonqualified, and Welfare Plan Benefits. Through the plans described below, we seek to provide personal security and other benefits comparable to those available at similarly sized companies. The Committee and Hewitt review the executive-level benefits periodically and compare them with market survey information, considering executives’ positions and years of service.

 

 

Normal retirement benefits are payable upon separation from service on or after attainment of age 65 to participants with at least five years’ credited service as an executive officer. Reduced benefits are available to participants who separate from service with at least 10 years’ credited service with Applied, five of which are as an executive officer. The named executive officers’ accrued SERP benefits are more fully described in “Pension Plans,” at page 27.

 

 

 

Perquisites and Other Personal Benefits. Applied provides executive officers with perquisites and other personal benefits that Applied believes are reasonable and consistent with the objective of attracting and retaining superior employees for key positions. As with other compensation, the Committee periodically reviews and adjusts these benefits after reviewing guidance on market practices.

 

In 2008, the principal perquisites and other personal benefits made available included an automobile allowance, reimbursement and tax gross-up for financial planning and tax return preparation services, an annual executive physical examination, reimbursement and tax gross-up for spousal travel and child care tied to approved business trips, and five weeks’ annual vacation (other employees get five weeks when they accumulate 25 years of service). Applied provides some executive officers with club memberships for business purposes, which are available for personal use as well; the executive pays for expenses related to personal use. See the “All Other Compensation” column of the Summary Compensation Table at page 23.

 

Change in Control and Termination Benefits. Applied does not generally enter into employment contracts with its executive officers, nor does it have a formal executive severance policy. The Board and its Executive Organization & Compensation Committee retain discretion to determine the severance benefits (excluding vested benefits), if any, that will be offered if the company terminates an executive officer’s employment, other than in the circumstance of a change in control.

 

Applied has entered into change in control agreements with its executive officers. These arrangements are designed to retain executives and to provide continuity of management if an actual or threatened change in control occurs. The Board approved the agreements primarily for two reasons: it believes that the executives’ continued attention and dedication to their duties under adverse circumstances are ultimately in the best interests of Applied and its shareholders, and the agreements are consistent with competitive market practice.

 

The agreements provide severance benefits if an executive’s employment is terminated either by the officer for “good reason” or by Applied “without cause” (each as defined in the agreements) if the termination occurs within three years after a change in control. The executive, in turn, must not compete with Applied for one year following the termination. The Committee has periodically, including in 2008, reviewed and adjusted the agreements after considering outside advisors’ advice. We describe the agreements more fully on pages 31-32 of this proxy statement.

 

The Committee believes that members of executive management should accumulate meaningful equity stakes in Applied to align their economic interests with shareholders’ interests, thereby promoting the objective of increasing shareholder value. See “Beneficial Ownership of Certain Applied Shareholders and Management” on page 13 for the shares of Applied stock beneficially owned by each named executive officer.

Pursuant to Applied’s stock ownership guidelines, we expect executive officers not to dispose of stock unless their “owned” shares’ market value equals or exceeds the following base salary multiples immediately after the disposition:

 

 

“Owned” shares include those owned outright, those owned beneficially in Applied’s Retirement Savings Plan and other deferred compensation plans, and restricted shares (whether or not vested), but do not include unexercised stock options or SARs.

 

The guidelines are not mandatory in the sense that they do not require an executive immediately to acquire shares if his or her ownership is below the applicable guideline.

 

Management monitors compliance with the guidelines. The Committee periodically reviews the guidelines and compares them with market data reported by Hewitt and others. With the guidelines in place, the Committee has not adopted stock retention policies for equity-based grants.

 

Code section 162(m) limits the amount of compensation a publicly held corporation may deduct as a business expense for federal income tax purposes. That limit, which applies to the chief executive officer and the three other most highly compensated executive officers, is $1 million per individual per year, subject to certain exceptions. The law provides an exception for compensation that is performance-based.

 

In general, the Committee seeks to preserve the tax deductibility of compensation without compromising the Committee’s flexibility in designing an effective, competitive program. Applied intends for Management Incentive Plan awards, income from the exercise of stock options and SARs, and performance grant payouts to qualify as performance-based compensation.

 

The Committee reviews all the elements of Applied’s executive compensation program. When making a decision regarding any element of an executive officer’s compensation, the Committee takes into consideration the other elements.

 

Applied believes that each executive officer’s total compensation is appropriate and that the program’s components are consistent with market standards. The program takes into account Applied’s performance compared to the Comparison Peer Group and the Industry Peer Group, and appropriately links executive compensation to Applied’s annual and long-term financial results and to the long-term financial return to shareholders. We believe that the foregoing philosophy is consistent with Applied’s culture and objectives and will continue to serve as a reasonable basis for administering Applied’s total compensation program for the foreseeable future.

 

The following table summarizes information, for the years ended June 30, 2008 and 2007, about the compensation of Applied’s Chief Executive Officer, Chief Financial Officer, and the three other most highly compensated executive officers at June 30, 2008, plus one other person who was an executive officer during 2008 and would have been included as one of our three other most highly compensated executive officers if he had remained an executive officer at June 30, 2008.

 

 

 

 

 

 

 

The Executive Organization & Compensation Committee provided the following incentive opportunities and grants in 2008 to the named executive officers:

 

 

 

The following table lists the named executive officers’ outstanding stock options and SARs at June 30, 2008.

 

 

 

The following table provides information about the value realized in 2008 by the named executive officers on the exercise of stock options and SARs and the vesting of restricted stock awards.

 

 

 

The SERP, a nonqualified defined benefit plan, provides supplemental retirement benefits to executive officers named as participants by the Board or the Executive Organization & Compensation Committee. Each named executive officer is a participant. Applied maintains a section 401(k) plan (the Retirement Savings Plan) available generally to all employees, but does not maintain a qualified defined benefit plan for employees generally.

 

The SERP’s principal features follow:

 

Retirement Benefits. The annual normal retirement benefit, paid in a single life annuity form, is 45% of an eligible participant’s average base salary and annual incentive pay for the highest three calendar years of the last 10 calendar years of service with Applied. To receive a normal retirement benefit, a participant must separate from service with Applied at or after age 65, with at least five years of service as an executive officer. To receive an early retirement benefit prior to age 65, a participant must separate from service after reaching age 55 and completing at least 10 years’ service with Applied, of which at least five were as an executive officer.

 

Normal and early retirement benefits are reduced by 5% for each year that a participant’s years of service are less than 20, except that this reduction will not apply to Mr. Pugh if he is credited with at least 10 years’ service (he will reach 10 years in January 2009). In addition, early retirement benefits are also reduced by 5% for each year that the commencement of benefits precedes age 65.

 

Disability Benefits. If a participant with at least five years of service as an executive officer becomes disabled (as defined in regulations under Code section 409A), the participant will receive a monthly SERP disability benefit until the earlier of age 65 or death. The monthly benefit, when added to all other long-term disability benefits under Applied programs, will equal 1/12th of 60% of the average of the participant’s highest three calendar years of total compensation (base salary plus annual incentive pay) of the last 10 while employed by Applied.

 

Deferred Vested Benefits. Deferred vested benefits will be paid at age 65 to any participant who separates from service without cause prior to age 55 with at least 10 years’ service, at least five of which are as an executive officer. The benefits equal 25% of the participant’s accrued normal retirement benefits at the time of separation from service.

 

Payment Forms. Normal and early retirement benefits vested after 2004 are paid in the form designated by the participant pursuant to the provisions of section 409A. Available forms of payment include a single life annuity, various joint and survivor annuities, and substantially equal annual installment payments for a minimum of three years (five for any participant who is or was the Chairman or Chief

Executive Officer) up to a maximum of 10 years. Deferred vested benefits are payable in three substantially equal annual installments following attainment of age 65.

 

Death Benefits. If a participant dies before receiving any SERP benefit, the participant’s designated beneficiary will receive the accrued benefit’s present value in a lump sum or a series of installments, as the participant elects in advance.

 

Change in Control. If a change in control of Applied (as defined in the SERP) occurs, each participant will be 100% vested, regardless of age and service, in his accrued normal retirement benefit. In addition, the benefit will be increased because the participant will be credited with additional years of service and age equal to one-half the difference between the participant’s age at the time of the change in control and age 65, up to a maximum of 10 years. The benefit will be paid in a lump sum unless the participant previously elected a different payment option.

 

Non-Competition. Except if a change in control occurs, payment of SERP benefits is subject to the condition that the participant will not compete with Applied.

 

The following table shows the present value of accumulated benefits payable to the named executive officers and their years of credited service under the SERP.