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5:56am EDT April 24, 2006

When David Pugh joined Applied Industrial Technologies in 1999 as president, he found a company that was committed to aggressive growth.

The industrial distributor had annual revenue of $1.2 billion at the time and had committed to reaching $3 billion by 2002 and becoming a global player. But not many people outside of Applied’s headquarters believed that was possible, as evidenced by the company losing two-thirds of its market capitalization value in less than a year.

The company’s leadership was saying the right things, but Pugh started to realize that there was a big gap between what the goals were and what the company was actually capable of achieving. So he started asking questions of people throughout the company. What is Applied Industrial Technologies? Do we have the capacity to change? Is there an urgency to change?

“As I went around this company, my job wasn’t to have all the answers, but it was to ask the right questions,” says Pugh, who became chairman and CEO in January 2000, moving up from the president and COO posts he’d assumed the year before. “I needed to be perceptive enough to ask the questions that would get people to think outside their comfort zones and maybe from a different perspective. I was working with people who had worked in this industry a long time and had plenty of reasons why you couldn’t do something.”

While he was asking questions, Pugh was also looking for something else. He knew that changes were coming, so he was looking for people who could help him get it done.

“I was looking for where the talent was,” says Pugh. “Who are the change agents? Who are the people who are leaders? Where was my intellectual talent? Who are the competitors who are going to win regardless of the situation?”

He asked about expectations and if the company was capable of achieving them. What he discovered was that the expectations were too high.

“I think we were enamored with some of the Jack Welch goals of growing 10 percent a year regardless of what’s out there,” says Pugh. “We were operating in a market that was growing 1.5 percent a year, maybe 2 percent at the most. To think that we were going to grow at 10 percent a year or grow from $1.2 billion to $3 billion — the message was espoused, but as I went through the company, I didn’t find many believers.”

Worse, he found outright confusion as to what the company’s goals actually were, and the emphasis on growth had resulted in an acquisition spree in the late ’90s when company valuations were at their highest point thanks to the dot-com boom. The acquisitions hadn’t fully been digested, and some were hurting the company’s financial health because they simply weren’t profitable.

“When I went up and took a look at what we had, the issue to me wasn’t growth,” says Pugh. “We had a motto to stress growth. As a highly capitalized manufacturing company, that theory might work where you can continue to build output on a fixed-cost basis, but we’re a high variable-cost company. Growth for growth’s sake wasn’t working. We needed to make sure it was profitable growth and really put the emphasis on profit.”

Too much money was being spent on inventory and marketing, all in the name of supporting growth — growth that just wasn’t there.

“We may have wanted to look like GE, but we had to be honest with ourselves; we weren’t GE,” says Pugh.

Only by changing the expectations for AIT with investors, customers and employees could Pugh maximize the company’s long-term potential.

Getting in shape
Give Pugh the option of taking the elevator or the stairs, and he’ll take the stairs — and he’ll be up two flights before you even realize what’s happened. And that’s exactly what he wanted Applied to be able to do. It needed to be a fit and nimble organization that could move quickly before the competition knew what hit it.

The starting point was taking the expectation off of 10 percent annual growth and putting it on something more realistic, and the first step was to be honest with the investment community. Pugh went to then-CEO John Dannemiller back in April 1999 to lay out his plan for Pugh’s first teleconference with analysts.

“I told him I want to say that not only are we not going to grow 10 percent a year, over the next 12 to 18 months, we’re not going to grow at all,” says Pugh. “We’re going to spend our time working on operating excellence rather than growth. We’re going to stress excellence, and the results will follow. We’ll tell the investment community that the top line will be somewhat stagnant for 12 to 18 months, but we’re going to drive earnings.

“Let’s make this a more fit company. Let’s really stress fitness.”

By the following year, he was CEO and fully implementing his new goal for the company to outperform the market and outperform Applied’s peers.

“We focused on getting the basics right,” says Pugh. “We were getting away from the growth picture. Some people say that is a gutsy move. I don’t think it was a gutsy move because we didn’t really have a road map that showed where that growth was going to come from.

“Even if we had gotten it, I was concerned that we didn’t have the internal capabilities to support that level of growth. To me, we were piling stuff on an egg that hadn’t been hard-boiled, and that egg was starting to crack. We have to hard-boil the egg.”

The previously stated strategy was focused on making Applied a global company that would grow forever. The new strategy is more limited — and realistic.

“Today, the stated strategy is we are going to grow profitably in North America in our current product domain, not in Asia, not as an electronics distributor and not growth for growth’s sake. The strategy tells us what we are going to do and what we are not going to do.

“Oftentimes the strength of a strategy is in saying what you are not going to do so you don’t lose focus and invest assets in things that are not going to be profitable.”

Pugh changed the company from operating on five platforms to two to regain focus. One platform was sold and two others were enveloped into existing ones.

“We had to make some tough decisions,” says Pugh. “We cut operations in the first year that represented over $200,000 a day in sales.”

Pugh had a list made that showed which locations hadn’t made money in three years.

“My assumption is, the ones that haven’t made money in the last three years are gone unless you have a really good story,” says Pugh. “When you identify a lack of success in that situation, it is time to pull the plug. There’s something to be said about giving up on a bad idea.”

The changes Pugh made yielded results. In the next fiscal year, Applied posted 2.9 percent sales growth but increased earnings more than 61 percent.

“It’s not that we weren’t growing at the same time; we were trading off losing assets for winning assets,” says Pugh. “It’s tough love. You have to have the guts to go and look at a situation that’s never going to win and be willing to trim it, both for the good of the company and the individuals who are sitting up there in that losing situation. The last thing you ever want to do is send a message either to the outside world, or more importantly, to your inside folks, that mediocrity is an acceptable level of performance.”

Creating decisiveness
Pugh had gotten rid of the flab at Applied, but he also needed to create the nimbleness and speed required to compete.

He listened to people and asked questions on how to maximize Applied’s potential. He needed people to start being more responsible for their own areas of control, so control was pushed down to the front-line operating level.

“Headquarters went from a control organization to a support organization,” says Pugh. “The majority of decisions today are made at the front line right at our service centers, where they are closest to the customer.”

Pugh also reorganized compensation plans to reward people with meeting the organization’s objectives to make sure everyone was striving for the same goals. Before, people were being rewarded for growth instead of return on assets.

“The No. 1 thing I did that unified our approach to getting profitability and growth was changing the senior management-level incentive program,” says Pugh. “Before, we had a lot of individual functional objectives that determined incentives at the officer level. If you looked at those, every one of the officers could win, but the company could still be going downhill, which is what was happening.

“Our closest proxy to total shareholder return is earnings per share. I said, ‘OK guys, there can only be one metric for all senior officers, and that’s growth in earnings per share.’”

Now everyone’s incentives are tied directly to that. If the shareholder doesn’t win, neither do the officers.

Incentives had also hurt the company’s focus at the lower levels. As it had diversified, it had set up incentive programs to try to drive sales in these new areas, so Pugh addressed that as well.

“We had lost the focus on our core business,” says Pugh. “Guys were out selling in areas they weren’t familiar with. There was a sense of fear and confusion. People were saying, ‘I don’t know what you want me to do when I get up in the morning.’ We had set up an incentive program where it made it more personally profitable to go sell over there rather than here where I’m really good.”

He also needed employees to be more decisive and to take the initiative to move the company forward at whatever level they were at. The solution was to give them power, permission and protection — the power to make decisions, the permission to move ahead with change and protection if they make a mistake along the way.

“Because of the conservative nature of the distribution industry, we really had some folks that were afraid to make a mistake,” Pugh says. “We had to eliminate that fear. We had to make sure they understood that the fear of certainty of what would happen if they didn’t move was greater than what might happen if they did.

“We gotta be moving; don’t fear movement. Along the way, if you move with speed, also be resilient. If we make a mistake, that’s OK as long as you recover from it quickly. A mistake is only a mistake if you live with it.”

Getting rid of unprofitable operations sent the immediate message that you had to have a plan for profitable growth. The rest of the message was laid out by Pugh and other senior executives in constant communication, including town-hall style meetings.

“To get our associates out of their comfort zones, we have to explain what the strategy is, why it has inherent value to them personally, and then present it in a way that they are compelled to follow,” says Pugh. “It’s an important thing for leaders to understand that you can just dictate and get people to follow, but managing by dictate gets you compliance. Compliance is the lowest level of effort and is not what we are looking for. We’re looking for commitment.

“We have to have an open atmosphere where they can challenge us, because we want them to believe in the way we are going.”

So employees heard a presentation outlining the company’s strategy, the rationale behind it and the things that had to be done at that particular location to implement it.

“I told them I would be disappointed if you locally can’t put more things on this list of things to do in order to achieve those objectives,” says Pugh. “I asked them if this plan was reality or did we just fly in from Mars. I think people like that, because they feel like they have a say in how this company is run.”

Strategies were changed as a result of these communications with employees, and it was clear that their voices made a difference, encouraging them to speak up again to contribute to the success of the company.

“We continue to have the communication process flowing up from the bottom and being acted on at the top to drive a dynamic strategy for the company,” says Pugh.

And with 85 percent of the employees owning stock in Applied, the early results of Pugh’s plan certainly gave them an incentive to become believers.

Training is part of the communication process and is used to make sure everyone has a full understanding of where they are expected to go to achieve the goals at their level of the organization and to give them the skillset they need to get there.

It also gets them to think in new ways. For example, 37 percent of product returns were shown to be a result of the customer ordering the wrong product.

“One person says, ‘We can’t do anything about that,’” says Pugh. “In our culture, are you sure? You think the customer comes to work wanting to order something in error and have to return it? What is it about our process, our literature or our communications that causes or contributes to a customer ordering in error? We have to look at the total perspective.”

Training helps build employees’ confidence in themselves and in the organization.

“If you are going to move forward, you have to have motion,” says Pugh. “They can’t see the end of the path we are going down, and that evokes the fear of the unknown. It gets back to the policy of protection: If you are asking folks to go down an unknown path past their comfort zone, they have to know if they stumble off the path, there will be a lot of people there to pick them up and not hold them down.”

This culture of support has earned Applied the NorthCoast 99 award as one of the best places to work in Northeast Ohio for six consecutive years.

“If we want to attract talent and improve our talent, that culture has to be supportive and protective,” says Pugh. “When you start here, you get a 10-month training program before you are sent to the wolves. You are trained before you face the unknown. Our turnover rate is below the industry average. Part of it is the way we treat our people, and part of it is our success.”

Green light for growth
Pugh says all this transformation was going on at a time when the economy was tough. He says he used a “yellow light” management mode, using short timelines and keeping a close eye on things to make sure incremental progress was being made.

EPS growth became a regular occurrence. In 2003, on 1.2 percent sales growth, earnings per share went up 36 percent. In 2004, sales went up 8.6 percent and EPS jumped 55 percent. Last year, sales increased 13 percent, and EPS went up 68 percent.

“The things we did to muscle build and hard-boil that egg paid off for us when the market turned back up in probably the second half of our fiscal 2004,” says Pugh. “We have come out of the yellow-light management. The growth opportunities are here again, the acquisition opportunities are here again, and we have the lowest debt balance in company history.”

While AIT has made significant strides, including hitting $1.72 billion in sales in fiscal 2005, Pugh still sees plenty of room for more improvement.

“As I look out today, the best-in-class in our industry is still operating at a higher operating margin than we are — and that’s the first milestone, to become best in class,” says Pugh. “Beyond that are the catalog houses that do similar things that we do ... and they have margins even beyond that. That’s my next level.”

Acquisitions have and will continue to be an important part of Applied’s long-term profitable growth.

“The acquisitions we have made in the last two to four years have all been accretive in the first year,” says Pugh. “I think we have the M&A process down very, very well.

“We are an industry that is highly segmented. The top three players in the industry only own a combined 15 percent of the market, and the top seven own 20 percent. There’s a lot of room for consolidation. We have the installed base, infrastructure, Web capability, capital structure and credit facility to be a consolidator in this industry. I feel the company has the proper culture and the proper vision of what quality processes should be.”

But through it all, leadership will continue to shape and maintain the culture necessary for profitable growth.

“The most effective way to move a company is through leadership,” says Pugh. “I can change a procedure in this company by writing a new policy, but I can’t change the culture by writing a new policy. Culture is changed by leadership. It requires constant, positive reinforcement of the direction we want to go.

“A leader is someone who will take people places they wouldn’t go themselves, either from lack of vision or lack of courage. For cultural change, you need effective leadership. They have to espouse where you are going, identify the skill gaps between where you are and where they need to be to get to the next level and get training to them to make up the difference. They have to sit down and listen to what their fears are and overcome those fears with them. If you change a culture, it’s through leadership.”

How to reach: Applied Industrial Technologies, www.applied.com or (216) 426-4000