The maintenance, repair, and overhaul (MRO) industry conjures up a vision of staid smokestack America -- of replacement parts for factories in the boondocks, and companies with quaint names like W.W. Grainger (NYSE:GWW) and McMaster Carr. The performance of some of the industry's stalwarts has been anything but staid, however; though the average company in this fragmented sector is around 80 years old, its overall record is one to be proud of. Applied Industrial Technologies (NYSE:AIT) is no exception, having lost money only once in the past 20 years. But the same factors that have lent the company its strength could eventually become its Achilles' heel.

Improving margins, better products
The company began as a bearings manufacturer, but Applied's lineup now includes linear, rubber, power transmission, and fluid power products, serving the pulp, paper, primary metals, mining, machinery, and automobile industries, among others.

Applied did an admirable job growing net profits at a compound annual growth rate (CAGR) of 14% over a 10-year period beginning in 1994. That's much faster than its smaller 5% CAGR in sales; the higher profit growth partly resulted from improved operating and net margins, which climbed from 3.5% to 5.1% and 1.6% to 3.2%, respectively. Top-line improvements in its fluid power segment, combined with a bit of operating leverage and a strong manufacturing environment, provided a welcome boost to margins previously weighted by poor performance from bearings products.

Competitive environment
Applied has a strong Internet-based inventory management and order interface for its customers, which should drive higher-margin Internet-based sales in future quarters. The Internet not only offers Applied an alternative sales channel but also helps its customers better organize their ordering and back-office processes. Moving online is critical, since the Internet was one of MRO distributors' fastest-growing sales channels last year. Rival MSC Industrial's (NYSE:MSC) annual Internet sales grew 42% over last year, accounting for 17% of its total revenues.

Applied does not break out its Internet sales, but among the top five MRO distributors, it easily has the largest number of services and product features on its website. Internet sales will become increasingly important as the company seeks to manage variable and fixed costs associated with physical locations and its sales force; currently, both contribute significantly to Applied's expenses.

Applied carries a whopping 2.3 million different products; it's second only to Motion Industries, the manufacturing arm of Genuine Parts (NYSE:GPC), which usually carries more than 3 million. The broad selection enables Applied to net a multitude of sales at a higher margin but also demands significant inventory, production, and potential obsolescence costs. The vast range of products only amplifies the cyclicality of Applied's results, boosting margins significantly in good times but dragging them farther down in bad ones.

Manufacturing drives 85% of Applied's revenues, compared with MSC's 72%. Strong manufacturing growth in the past three years has allowed Applied to improve cash flow, consolidate, and strengthen its position with acquisitions. But despite the company's strong and steady stream of maintenance revenue, the dependence on manufacturing makes Applied more vulnerable to an industrywide slowdown in such activity, especially if manufacturers delay purchases in to keep cash on hand until conditions improve.

Potential risks
At 3.6%, the company's trailing-12-month net profit margin ranks among the industry's lowest, compared to 6.3% for Grainger, 4.5% for Genuine Parts, and 10.4% for MSC (all figures on a trailing-12-month basis). Despite movements toward higher-margin businesses, Applied's product portfolio remains exposed to the cutthroat bearings business, which might make it difficult to maintain profit margins in a manufacturing downturn.

Unlike MSC and privately owned McMaster Carr, Applied's business model is driven more by stores and sales representatives, which hurts margins further. Keeping its 2.3 million parts in stock can also be a burden, especially compared to MSC's 550,000.

MRO distributors rarely have the luxury of planning ahead; most acknowledge that they often sell only a single item of a part or SKU during a given year. Many simply believe that more is best; if you have the product, you have the customer. Both Applied and MSC offer customers software to plan MRO needs and keep track of inventory, but it's unlikely that such programs will cut costs for MRO customers as significantly as supply-chain-management software has reduced manufacturing expenses.

Unfortunately, distribution and sales from bricks-and-mortar locations will likely remain a large part of this industry; Internet sales are growing, but it will likely take a while for them to significantly contribute to revenues. Until then, distributors following Applied's business model will be burdened with large inventories and more outlets.

Foolish final thoughts
Its enormous parts selection and dependence on manufacturing make Applied heavily dependent on strong manufacturing activity to drive performance. Times have been good for the past two years, with the Index of Supply Management currently in its 31st month of expansion. Most of Applied's margin and bottom-line improvements have appeared during this period; net income leapt from $20 million in 2003 to $55 million in 2005. But in 2002, net income was a paltry $2 million, down from $31 million in 2000.

That's my biggest concern about this company; over the past 10 years, I think Applied's performance has been too cyclical to warrant a valuation of 20 times trailing earnings. It's still a stellar company in a difficult, fragmented, low-margin industry, but its fortunes are too closely tied to manufacturing growth. In these booming times, Applied's shift toward a more diversified selection of higher-margin products has improved its performance. Still, its massive burden of fixed costs remains a significant risk. If something other than a serious operational misstep drives down Applied's shares, it will definitely be worth a look. Until then, Fools might want to steer clear.

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Fool contributor Bobby Shethia doesn't own shares of any of the companies mentioned in this story. He still believes in America's manufacturing strengths. The Motley Fool is investors writing for investors .