Stockholders’ Equity, Comprehensive Income and Share-Based Compensation

Accumulated Other Comprehensive Income (Loss)

Changes in the components of AOCI, net of tax, were as follows:



	Unrealized Gain on Investments, Net			Unrealized Gain on Derivative Instruments Qualifying as Cash Flow Hedges			Defined and Postretirement Benefit Plans			Cumulative Translation Adjustments			Total
	(in millions)
Balance at October 27, 2013	$	25		$	2		$	(72	)	$	7		$	(38	)
Other comprehensive income (loss) before reclassifications	8			3			—			(1		)	10
Amounts reclassified out of AOCI	(9		)	(5		)	—			—			(14		)
Other comprehensive loss, net of tax	(1		)	(2		)	—			(1		)	(4		)
Balance at July 27, 2014	$	24		$	—		$	(72	)	$	6		$	(42	)

The effects on net income of amounts reclassified from AOCI for the three and nine months ended July 27, 2014 were not material.

Stock Repurchase Program

On March 5, 2012, Applied's Board of Directors approved a stock repurchase program authorizing up to $3.0 billion in repurchases over the next three years ending in March 2015. Under this authorization, Applied purchases shares of its common stock on the open market. At July 27, 2014, $1.6 billion remained available for future stock repurchases under this repurchase program.

Applied did not purchase any shares of its common stock during the three and nine months ended July 27, 2014. The following table summarizes Applied’s stock repurchases for the three and nine months ended July 28, 2013:



	July 28, 2013
	Three Months Ended		Nine Months Ended

	(In millions, except per share amounts)
Shares of common stock repurchased	3		15
Cost of stock repurchased	$	50	$	198
Average price paid per share	$	15.33	$	13.18

Applied records treasury stock purchases under the cost method using the first-in, first-out (FIFO) method. Upon reissuance of treasury stock, amounts in excess of the acquisition cost are credited to additional paid in capital. If Applied reissues treasury stock at an amount below its acquisition cost and additional paid in capital associated with prior treasury stock transactions is insufficient to cover the difference between the acquisition cost and the reissue price, this difference is recorded against retained earnings.

Dividends

In June 2014, March 2014 and December 2013, Applied's Board of Directors declared quarterly cash dividends in the amount of $0.10 per share, resulting in total dividends declared during the nine months ended July 27, 2014 of $365 million. Dividends declared during the nine months ended July 28, 2013 totaled $348 million. Applied currently anticipates that cash dividends will continue to be paid on a quarterly basis, although the declaration of any future cash dividend is at the discretion of the Board of Directors and will depend on Applied’s financial condition, results of operations, capital requirements, business conditions and other factors, as well as a determination by the Board of Directors that cash dividends are in the best interests of Applied’s stockholders.

Share-Based Compensation

Applied has a stockholder-approved equity plan, the Employee Stock Incentive Plan, which permits grants to employees of share-based awards, including stock options, restricted stock, restricted stock units, performance shares and performance units. In addition, the plan provides for the automatic grant of restricted stock units to non-employee directors and permits the grant of share-based awards to non-employee directors and consultants. Share-based awards made beginning in March 2012 under the plan may be subject to accelerated vesting under certain circumstances in the event of a change in control of Applied. Applied also has two Employee Stock Purchase Plans, one generally for United States employees and a second for employees of international subsidiaries (collectively, ESPP), which enable eligible employees to purchase Applied common stock.

During the three and nine months ended July 27, 2014 and July 28, 2013, Applied recognized share-based compensation expense related to stock options, ESPP shares, restricted stock, restricted stock units, performance shares and performance units. Total share-based compensation and related tax benefits were as follows:



	Three Months Ended				Nine Months Ended
	July 27, 2014		July 28, 2013		July 27, 2014		July 28, 2013

	(In millions)
Share-based compensation	$	44	$	40	$	132	$	121
Tax benefit recognized	$	12	$	11	$	37	$	34

The effect of share-based compensation on the results of operations for the three and nine months ended July 27, 2014 and July 28, 2013 was as follows:



	Three Months Ended				Nine Months Ended
	July 27, 2014		July 28, 2013		July 27, 2014		July 28, 2013

	(In millions)
Cost of products sold	$	13	$	13	$	40	$	37
Research, development, and engineering	16		14		49		39
Marketing and selling	6		5		17		15
General and administrative	9		8		26		25
Restructuring charge	—		—		—		5
Total	$	44	$	40	$	132	$	121

The cost associated with share-based awards that are subject solely to time-based vesting requirements, less expected forfeitures, is recognized over the awards’ service period for the entire award on a straight-line basis. The cost associated with performance-based equity awards is recognized for each tranche over the service period, based on an assessment of the likelihood that the applicable performance goals will be achieved.

At July 27, 2014, Applied had $261 million in total unrecognized compensation expense, net of estimated forfeitures, related to grants of share-based awards and shares issued under Applied’s ESPP, which will be recognized over a weighted average period of 2.6 years. At July 27, 2014, there were 177 million shares available for grants of share-based awards under the Employee Stock Incentive Plan, and an additional 37 million shares available for issuance under the ESPP.

Stock Options

Applied grants options to purchase, at future dates, shares of its common stock to employees and consultants. The exercise price of each stock option equals the fair market value of Applied common stock on the date of grant. Options typically vest over three to four years, subject to the grantee’s continued service with Applied through the scheduled vesting date, and expire no later than seven years from the grant date. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model. This model was developed for use in estimating the value of publicly traded options that have no vesting restrictions and are fully transferable. Applied’s employee stock options have characteristics significantly different from those of publicly traded options.

Stock option activity for the nine months ended July 27, 2014 was as follows:



	Shares		Weighted Average Exercise Price

	(In millions, except per share amounts)
Outstanding at October 27, 2013	6		$	9.12
Exercised	(4	)	$	7.87
Outstanding at July 27, 2014	2		$	10.78
Exercisable at July 27, 2014	1		$	5.88

Restricted Stock Units, Restricted Stock, Performance Shares and Performance Units

Restricted stock units are converted into shares of Applied common stock upon vesting on a one-for-one basis. Restricted stock has the same rights as other issued and outstanding shares of Applied common stock except these shares generally have no right to dividends and are held in escrow until the award vests. Performance shares and performance units are awards that result in a payment to a grantee, generally in shares of Applied common stock on a one-for-one basis if performance goals and/or other vesting criteria established by the Human Resources and Compensation Committee of Applied's Board of Directors (the Committee) are achieved or the awards otherwise vest. Restricted stock units, restricted stock, performance shares and performance units typically vest over four years and vesting is usually subject to the grantee’s continued service with Applied and, in some cases, achievement of specified performance goals. The compensation expense related to the service-based awards is determined using the fair market value of Applied common stock on the date of the grant, and the compensation expense is recognized over the vesting period.

Restricted stock, performance shares and performance units granted to certain executive officers are subject to the achievement of specified performance goals (performance-based awards). These performance-based awards become eligible to vest only if performance goals are achieved and then actually will vest only if the grantee remains employed by Applied through each applicable vesting date. These performance-based awards require the achievement of targeted levels of adjusted annual operating profit margin. For the fiscal 2013 and fiscal 2012 performance-based awards, additional shares become eligible for time-based vesting if Applied achieves certain levels of total shareholder return (TSR) relative to a peer group, comprised of companies in the Standard & Poor's 500 Information Technology Index, measured at the end of a two-year period.

The fair value of these performance-based awards is estimated on the date of grant and assumes that the specified performance goals will be achieved. If the goals are achieved, these awards vest over a specified remaining service period of generally three or four years, provided that the grantee remains employed by Applied through each scheduled vesting date. If the performance goals are not met, no compensation expense is recognized and any previously recognized compensation expense is reversed. The expected cost of each award is reflected over the service period and is reduced for estimated forfeitures.

A summary of the performance-based awards approved by the Committee is presented below:



	Number of Performance-Based Awards Granted		Percent of Performance-Based Awards Earned as of July 27, 2014*
Fiscal Year Granted	Performance Shares/Performance Units	Shares of Restricted Stock
	(in millions)
2013	3	—	0%
2012	3	1	29%
2011	2	0.1	100%

___________________

* subject to additional time-based vesting requirements

A summary of the changes in restricted stock units, restricted stock, performance shares and performance units outstanding under Applied’s equity compensation plans during the nine months ended July 27, 2014 is presented below:



	Shares		Weighted Average Grant Date Fair Value		Weighted Average Remaining Contractual Term

	(In millions, except per share amounts)
Non-vested restricted stock units, restricted stock, performance shares and performance units at October 27, 2013	38		$	11.11	2.4 years
Granted	10		$	16.35
Vested	(12	)	$	11.07
Canceled	(3	)	$	11.62
Non-vested restricted stock units, restricted stock, performance shares and performance units at July 27, 2014	33		$	12.45	2.5 years

At July 27, 2014, 1 million additional performance-based awards could be earned upon certain levels of achievement of Applied's TSR relative to a peer group at a future date.

Employee Stock Purchase Plans

Under the ESPP, substantially all employees may purchase Applied common stock through payroll deductions at a price equal to 85 percent of the lower of the fair market value of Applied common stock at the beginning or end of each 6-month purchase period, subject to certain limits. Based on the Black-Scholes option pricing model, the weighted average estimated fair value of purchase rights under the ESPP was $4.07 and $2.90 for the nine months ended July 27, 2014 and July 28, 2013, respectively. The number of shares issued under the ESPP during each of the nine months ended July 27, 2014 and July 28, 2013 was 3 million. Compensation expense is calculated using the fair value of the employees’ purchase rights under the Black-Scholes model. Underlying assumptions used in the model are outlined in the following table:



	Nine Months Ended
	July 27, 2014	July 28, 2013
ESPP:
Dividend yield	2.14%	2.94%
Expected volatility	25.3%	24.3%
Risk-free interest rate	0.08%	0.12%
Expected life (in years)	0.5	0.5