Kennametal Inc (KMT) 2003 Q4 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the Kennametal fourth quarter earnings conference call.

At this time, all participants are in a listen only mode.

Later we will conduct the question and answer session.

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As a reminder this conference is being recorded.

I would like to turn the conference over to Beth Riley, Director Investor Relations.

Please go ahead.

Thank you.

Welcome, everyone, thank you for joining us this morning to review our fiscal 2003 fourth quarter and our outlook for fiscal 2004.

Consistent with prior calls members of the media have been invited to listen to this call and the call is being broadcast live on our Web site at www.kennametal.com.

I'm Beth Riley, Director Investor Relations.

I'm pleased to have our Chairman, President and CEO, Markos Tambakeras, the VP and CFO, Nick Grasberger joining me for the call.

After some initial comments we will open the line for questions.

Before I turn the call over to Mark, I'd like to read our forward-looking disclosure.

This discussion contains statements that may constitute forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995.

Such forward-looking statements involve a number of assumptions with uncertainties that could cause actual results, performance or achievements of the company to differ materially from those expressed in or implied by such forward-looking statements.

Additional information regarding those risk factors is detailed in the SEC filings.

In addition, to be able to discuss non-GAAP financial measures during this call in accordance with new SEC Regulation G, the company's filed today a form 8 K with the SEC which is also now available on our Web site at www.kennametal.com.

That presents GAAP financial measures that we believe are most directly comparable to those non-GAAP financial measures as well as reconciliation thereto.

With that I'll turn the call over to Markos.

Thanks, Beth.

Good morning, everyone.

Fiscal 2003 was a challenging year during which we continued to significantly strengthen our foundation for sustainable growth and profitability.

As you well know, the manufacturing sector and due to potentially unprecedented period of negative pressure, approaching three years of declines in North America.

For a second year a much-anticipated recovery in the U.S. economy not only did not materialize but was also exacerbated by significant declines in the European economies.

Now against this difficult background we continue to manage the company prudently and we have much to feel good about.

We continue to fund strategic areas and to invest in the education of our employees to further enhance our competitiveness and our presence in the market.

We are proud of several significant investments and I will summarize a few.

We continue to make progress against our target to balance domestic and international exposure through strong international growth.

This was achieved above market growth in both Asia and South America and by the expansion of our footprint in Europe and India from the acquisition of Vidia .As a result we brought our international to domestic mix close to 50/50 by the end of the fiscal year and for the first time in the history of the company.

The success of acquisition and integration of Vidia was a big Plymouth for this organization.

As we have discussed the acquisition significantly enhanced our global reach and is now lined up to deliver unprecedented breadth of world leading tooling solution with successfully completed integration of the business ahead of an aggressive schedule and just five months after closing the deal.

More importantly, we are on track to meet or exceed our original synergy targets which will top $30 million fiscal 2005 and on track with fiscal '04 commitments.

We've confirmed our global technological leadership when we achieved the significant milestone of 40% of our sales from new products more than a quarter ahead of schedule.

We improved process efficiency and redoubled market focus which generated a record number of market winning products.

This achievement gives us strong momentum as we enter fiscal 2004 with some unique breakthrough products to be introduced later this year.

Fiscal 2003 was yet another year of very strong cash flow.

We generated in excess of $136 million of free operating cash flow despite investing more than $25 million in the Vidia integration.

This year presents our best performance since fiscal 2000 but in a much tougher environment now and is testament to our relentless focus on strict working capital management, the nature of our business, and our continued commitment to earn the right to grow.

As we promised at the beginning of fiscal 2003, we continued to develop our strongest assets, our employees, regardless of the environment.

Bench strength was enhanced through key new internal and external appointments and we continued investing in our people by spending more than 2% of sales on training and development.

Fiscal '03 also included the official launch of the Kennametal value business system OKBBS with KBBS we have crystallized and united a core set of six business processes which have been developed in the past four years that represent the execution of our strategy to create superior value for our customers and stake holders.

These processes include strategic planning, customer acquisition, ace product developments, process, lean deployment, mergers and acquisitions and talent development.

One notable KBBS success story in fiscal '03 came from the Kennametal lean enterprise where lean delivered more than $20 million in savings for the year.

Another, of course, was the achievement of 40% of sales coming from new products.

More importantly, we have the structure and systems in place to utilize lean and ace as our engines of potential, perpetual value creation and we have still only scratched the surface of opportunity.

Finally, in June, both SSS and J& L were awarded some major contracts validating the effectiveness of the new business models implementing by both units.

J and L received a contract from GSA, government services administration, valued annually at approximately $25 million.

The largest ever contract for J and L. .SSS had some major wins as well with annual values in excess of $40 million.

These contracts ramp up in the second half of fiscal year '04.

On balance through fiscal '03 I believe that we successfully managed multiple challenges, made progress towards mitigating some of the market pressures beyond our control and enhanced further our competitive position.

Entering fiscal 2004 we remain cautious regarding the timing and the extent of the recovery.

But very optimistic regarding Kennametal's operational leverage through an upturn.

Global economies continue to deliver mixed signals and we are expecting weak markets to continue to constrain revenues during the first half of fiscal 2004.

As we have discussed in the past, a number of recovery supporting factors have aligned, including a weaker dollar, low interest rates, strengthening of the stock market, tax stimulus, better cash availability.

When we combine those with modest improvement in more manufacturing specific indicators, including an ISM approaching although not yet over 50, improvement in industrial production and in durable goods orders, we are increasingly optimistic regarding the beginning of calendar 2004 which is the second half of our fiscal year.

Based on current European indicators, we're still anticipating Europe to lag the North American recovery by at least one to two quarters.

Apart from the global manufacturing market improvement we anticipate that profitability will be enhanced by prior efforts, including incremental synergies from the Vidia acquisition, the ongoing expansion of the breadth of our solutions and global reach, continuous product innovation, efficiencies from the Kennametal/Lean enterprise and incremental restructuring benefits from previously implemented initiatives.

Considering these internal factors in the context of our market expectation, our fiscal 2004 expectation are for organic sales growth of 1-3%, for earnings to improve to between $1.90 and $2.20 per share, and to, again, deliver free operating cash in excess of $100 million.

I will now turn the call over to Nick for a more detailed examination of the numbers.

Thank you, Markos, and good morning.

I'll step through our financial performance for the June quarter and conclude with the outlook for fiscal 2004.

For the fourth quarter FY 2003, excluding special items, Kennametal earned net income of $15.9 million or 45 cents per share, compared to $21.4 million or 67 cents per share last year.

A 33% decline in the in EPS.

Compared to last year, 9 cents of the earnings decline was due to Vidia dilution of four cents and lower pension income of five cents.

Consolidated sales increased 15% to $464 million.

The increased breaks down as follows, Vidia added 13% of the growth, foreign currency 5%, and fewer workdays reduced sales by 2%.

Netting these items, sales volume declined about 1%.Consistent with our expectations.

Of course profit margin excluding special charges in both periods was 32.5% a decrease of 160 basis points compared with the fourth quarter of fiscal 2002.

Negative pressures included lower absorption of fixed manufacturing costs related to our planned reduction and inventory, Vidia dilution, modest price pressure and a reduced pension income.

Lean benefits, again, offset inflation in manufacturing costs.

Operating expense for the quarter increased 19% to $120 million, excluding special charges.

Excluding $12 million in Vidia operating expenses, $8 million of unfavorable foreign currency adjustment and $2 million in decreased pension income, operating expense was 2% below last year.

EBIT, excluding special charges, was $31.8 million, down 20% from FY '02.

The EBIT margin was 6.9%, down from 9.8% for the same quarter last year.

Interest expense of $9.1 million increased 25% over the same quarter last year, reflecting the additional debt associated with the Vidia acquisition and higher average borrowing rates driven by the issuance of 10 year notes last June.

As expected the effective tax rate, excluding the electronics impairment charge was 30% compared to 32% in the June quarter last year.

The fourth quarter was another quarter of strong cash flow $55million, which was 30% above last year.

Inventory reductions provided approximately $25 million for the quarter and $40 million for the year.

The inventory reductions for the last half of the year exceeded our target established in March.

As of June 30, 2003, total debt was $526 million.

The Debt to capital declined over 400 basis points to 41.5% from the levels immediately following the close of the Vidia acquisition.

The figure would have been below 40% excluding the charges to equity due to the increase in the minimum pension liability and the electronics fixed asset impairment charge.

The performance of our operating businesses was as follows: for the metal working group, sales excluding Vidia were flat to prior year in constant currency.

Europe was up slightly.

North America, excluding high speed steel, declined 5%.

The high speed steel business in North America grew by 3%.

The rest of the world grew 9% in constant currency.

And including Vidia metal working sales were up 20%.

EBIT margin for MMS declined against the prior year at 11% versus 14.4% excluding special charges.

The decline is largely due to the expected dilution from Vidia, an unfavorable business mix.

We continue to expect Vidia to be accretive to MSSG margins as the synergy benefits are realized over the next 12 months.

Turning to our advanced materials group, sales were up 3% in constant currency.

Money construction was up 3% on a modest recovery in mining and market penetration in construction.

Engineer sales were up 1% and in constant currency and energy grew 5% on the strength of U.S. recovs.

Electronics increased 10% against the prior year.

The four special charges AMSGs EBIT margin was 12.3% versus 15.8% last year primarily driven by a 15% decline in electronics pricing.

J and L sales, excluding the strong tool divestiture declined 4% over the same period in fiscal year 2002.

Before special charges J and L's EBIT margin was 1.8% against 2.5% a year ago.

The EBIT included a $1.7 million charge to the balance sheet which equates to 3.5 points of margin.

Full service supply sales decreased 28% in the current quarter versus last year.

Before special charges FSS and EBIT margin was 90 basis points compared to 1.1% a year ago.

FSS continues to generate strong cash flow of approximately $15 million per annum as it disengages from accounts requiring large investments and working capital.

Turning to our FY 2004 outlook, in terms of sales, we are forecasting core volume growth of 1-2% plus up to an additional 1% from the recently secured contracts at J and L and FSS for total volume growth of 1-3%.

Including currency and the two additional months of Vidia sales for the year are expected to grow 4-6%.

For the first quarter, we are anticipating volume declines of 1-2% and total sales growth of 9-11%, including currency and Vidia.

In terms of EPS, excluding charges, the first quarter guidance is 30-35 cents and for the year $1.90 to $2.20 for the year.

These numbers include 4 cents Vidia increased in the first quarter, and 15-20 cents of accretion for the full year.

Above our original estimate of 10 to 15 cents.

As anticipated the acquisition plan, Vidia will be modestly accretive to margins and ROIC in FC '04.

The other key drivers of the change in EPS year over year largely offset each other.

The benefits from currency, lower interest expense and lower depreciation are balanced against additional costs from our pension fund and healthcare programs.

Pre operating cash flow for the full year is anticipated to be in the range of $100 million to $125 million.

As discussed in the release, the reduced depreciation FY 04 is due to an adjustment to the estimated useful life of certain assets.

As a result of evaluation of Vidia's tangible and intangible assets performed by Deloitte Touche, the company possesses an objective assessment of the assets deployed by Vidia in the production of carbide and high-speed steel tooling.

We reviewed these findings against the utilization and maintenance of Kennametal's assets and decided to revise the fixed asset policy to extend the useful life on machinery and equipment from 10 years to 15 years.

We believe that this is a prudent adjustment that will bring us more in line with industry standards.

To complete the Vidia integration we expect to spend approximately $25 million in FY 2004.

Bringing the total cash spend to just over $50 million in line with our original estimates.

Total charges for FY '04 are expected to be in the $10 to $15 million range, bringing the total to between $55 and $60 million, which is modestly below the original expectations.

Additional guidance for the full year is as follows: a tax rate of 32%, up from 30% in FY '03.

Capital spending of approximately $70 million which is up about 50% from FY '03.

Depreciation and amortization of about $70 million, down $15 million from last year as discussed earlier.

Debt to capital to be below 35% and ROIC will be approximately 7%, up about 150 basis points from last year.

And finally interest expense will be below $25 million.

Included in our current target are the following assumptions regarding outlook by end market for the next three months.

We now expect oil and gas to grow at high single digit rates and high single digit growth in construction.

Heavy engineering is expected to be flat to slightly down for the quarter with automotive to have low single digit declines.

Mid single digit declines in electronics, mining and tool and die makers are anticipated.

Low single digit declines are expected in aerospace and light and general engineering.

Over the next 12 months our year over year geographic expectations are based on the following assumptions: North America industrial production flat to up 50 basis points and European industrial production down 50 to 100 basis points.

For the next three months we anticipate end markets in North America to be flat to down 2%, Europe to be down 2 or 3%. and Asia to grow 4 to 5%.

I'll now open the line for questions.

Thank you, sir.

And ladies and gentlemen, if you wish to ask a question, please press star, then one on your touch-tone.

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Once again, if you have a question, please press star, one at this time.

One moment, please, for the first question.

And our first question comes from the line of Mark Koznarek with Midwest Research.

Please go ahead.

Good morning.

Just a detail here to start with which is what kind of earnings did we get from foreign exchange translation in the quarter?

For the quarter, it was about a nickel.

OK.

And then the major question I had was with regard to this change in accounting policy on the depreciable life 'cause, you know, you've explained it here as sort of a prudent adjustment.

But it seems like it would be more prudent potentially to keep the useful life where you had it and have the additional tax shield.

So it seems like you're giving up a certain amount of aftertax cash flow in order to, you know, generate some reported accounting earnings.

And I'm just wondering how you thought about that process.

Well, Mark, the tax accounting on depreciation is very different.

This does not affect cash flow at all.

There's no impact on how we -- we would take tax deductions for depreciation.

This is just book accounting, as opposed to tax accounting.

Oh, it's only book, OK.

And so you're saying it's got no tax impact at all, then.

That's right.

And how -- what kind of comparison did you use to, you know, evaluate whether this is a reasonable kind of adjustment to make or not in terms of the life?

Well, we engaged Deloitte Touche and Deloitte Touche did an analysis on Vidia's assets which assets are very similar to the ones we use in our manufacturing processes.

And they looked at the lives of those assets, the depreciation of those assets and they certainly looked at let's say industry benchmarks as well and they concluded that the -- a better estimate of the useful lives of those manufacturing assets would be 15 to 18 years.

And we selected 15 and thought that certainly within Kennametal we should be consistent.

And so we elected to change the depreciation methodology for Kennametal's assets as well.

OK.

All right.

That's all I have, thank you.

And our next question comes from the line of Gary McManus with JP Morgan.

Please go ahead.

Good morning, everybody.

Just looking at your first quarter guidance and comparing it to the full year, it looks like you've got, you know, much slower growth in the first quarter than you expect for all of fiscal '04.And I think you said, Nick, that you expect Vidia you know, accretion to be pretty evenly spread through the fiscal year.

That's right.

And you're not assuming any pickup in the economy, I see that with your end market outlook.

So can you talk on why you see earnings growth accelerating throughout fiscal '04?

Uh-huh, OK.

Let me talk about the sales split throughout the year first.

The -- we indicated that we expect the first quarter volume to be down 1 to 2%.

We're looking at kind of a flat first half, top line, and the second half being up, you know, it to 3%, OK, on a like for like basis.

In terms of the -- the phasing of earnings we're looking at between 35 and 40% of the EPS being in the first half of the year with the balance in the second half.

So there's really not what you might think of a significant hockey stick here in the second half of the year.

It's a very modest improvement in the second half versus the first half.

And that's our standard seasonality, that's our historical pattern.

But I'm looking year over year you're expecting 30 to 35 cents and you did 30 cents last year that's like 10% growth.

And if I assume, you know, $2 versus -- or, you know, midpoint or whatever you want to call it in your fiscal '04 that's like 40% growth so you're clearly, I mean, forgetting about the seasonality you're expecting year over year growth to improve quite a bit.

Yeah, the numbers I quoted excluded any benefits we might get from the Kennametal assets contracts which Markos mentioned would occur later in the year.

So we do have some assumption in there from earnings pickup from that in the second half of the year.

Could you talk about how material these contracts are, what kind of revenues or earnings impact would these contracts have?

Well, we're being fairly cautious.

Markos mentioned they would occur later in the year, I indicated that it could be up to another 1% of growth year over year derived from these contracts.

Now, let's say up to maybe 15 to $20 million.

The annualized rate is much higher.

But because these are recently awarded contracts and they're certainly a period of time over which they ramp up, the expectation is -- is more skewed toward the end of the year.

Just one question on the depreciation charge and pension, they're both about 30-cent impact.

Are they both evenly spread throughout the quarters?

Yes, they are.

OK.

And just getting back to the depreciation change, you know, I was kind of surprise -- I mean Vidia is what is a 15-20% of the company's revenues and you're only taking the useful life out from 10 to 15 years but this has an impact of taking depreciation down from 85 to 70 which is, whatever, 20, 25% impact.

I'm just curious on why that change has such a big impact to the depreciation number.

Like, for example, the write off of the electronics business, did that hurt the -- or impact depreciation or any other things that are, that you could account for that -- seems like a fairly big reduction in depreciation.

Yes, that's correct.

The write off of the fixed assets at electronics did help year over year as well by a few million.

But keep in mind this is a capital intensive business.

We have a lot of machinery equipment in our factories.

We have over 50 factories.

So -

Well, would depreciation be -- I mean, the fact you're under spending depreciation, would that -- I assume that also would have a factor as well.

I mean, I'm just wondering what -- the impact of moving the useful life from 10 to 15 years, how much of an impact is it?

Its not entirely $15 million is it?

It's about $15 million.

OK, OK, all right, thanks.

Yes.

Your next question will come from the line of Joel Tiss from Lehman Brothers.

Please go ahead.

How you doing, guys.

Fine, hi.

Just three questions.

One, can you give us a sense of what your operating rates are?

We're still in the 65 to 70% range.

OK.

And can you talk a little bit about what's going on with high speed steel versus carbide?

It's been a couple of quarters where it seems like you're growing in high speed and it sounds like you're I am applying you're shrinking a little bit in carbide.

Can you give us the dynamics what's going on there?

This is Markos.

The carbide is definitely not shrinking.

High speed steel in North America we have -- I'm talking about the market share, of course.

High speed steel, the results are market share pickup in North America.

We've been very successful with a distribution strategy and some new products that the fellas came up with and we are -- clearly we see that we're picking that up at the expense of the competition.

That's not because high speed steel as a total market is growing.

That hasn't changed.

So new products, better distribution model, more aggressive marketing, more success relative to the competition in high speed steel.

Market share changes, not much, even out over the year over the world on the carbide side.

OK.

And then also can you talk just generally about your increasing beauty of your balance sheet and if you're thinking at all, you know, I know you've got a lot of work left to do on Vidia but anything else left to do maybe in the next 12 months, how do you think about dividends, more acquisitions, etc.?

Thank you.

Nothing has changed from our position that we stated before, Joel, as you said, we want to make sure that we continue to bring along the Vidia operation.

Beyond that, we have -- we remain committed to getting back on firm footing on our investment grade rating and then the extra cash that's coming out of the improved balance sheet as we look at opportunities both on the acquisition front and also returning some to the shareholders.

We don't expect to be making any changes to the dividend policy.

Your next question will come from the Walter Liptak of McDonald Investments.

Please go ahead.

Good morning, Marcos and Nick.

Good morning.

As you ran through the sector assumptions, I didn't catch what your expectation was for auto and I wonder if you could drill down into that a little bit more versus North American.

Not much change maybe a little bit of a slowdown in the summer a little more than expected than usual in Europe.

They're talking about going to three-week shutdowns versus two.

In North America, there may be a little bit of slowdown through the summer but there's a general sense that we'll still probably end up around $16 million production.

That's the current view of the industry.

Which would be a pretty good year, actually.

And that's consistent with where we've been at on this.

So, you know, net-net that's about I think what -- what you're seeing generally.

OK.

And then I guess, you know, generally in North America and Europe, can you talk a little bit about what you're seeing on the pricing environment?

Obviously you'll be getting a little bit better pricing from the new products but what are you seeing overall?

Well, we think on balance pricing pressure continues while the -- the ability of the business to -- and the industry to manage through that probably as well as can be expected we think continues.

In terms of our assumptions for the fiscal year '04 we expect pricing to be in the metal working business to hold, although it will be tight.

And then you have some offsets, new products versus some existing product lines, kind of upsetting each other.

So let's say flat expectation for '04 and pricing in the metal working business, we think that on the advanced material side, particularly in sectors where we have a strong position and -- and good products like in the engineered business and in the energy business and even mining we think we -- we will be able to leverage some of that.

On the other hand, we continue to have the offset from the electronics side which are very strong.

So on balance, there again, you can say we're taking a conservative view of pricing outlook to be flattish for both units, major deals and metal working.

And a couple other things, the accretion, the incremental accretion that you're seeing in Vidia, is that related to synergies?

And if so, what are the synergies that you're seeing, are they operating synergies, more cost takeout or is it revenue synergies?

Yes.

Well, they are related.

The accretion is related to -- to -- to hire synergies.

And again, these are slightly above the original expectations.

And they're mostly on the cost side.

As we've indicated before, we really have very modest revenue synergies gulped into the model.

And with the J and L contract, can you -- those contracts, can you talk about which customers that would be with or at least which sectors those are coming from?

The J and L contract comes from the government services administration.

This is a central group.

And essentially it represents the forecast that purchases hundreds of their locations around the country.

While I have the opportunity to speak about this, the reason J and L won--very -- very substantial win it essentially comes down to two things.

One is they're repositioning their business model to be very focused on supply chain excellence in the catalog business and secondly the investments they've made in setting up best in class commerce and capability that will allow this whole purchasing process to be very high-tech in terms of ordering, acknowledging pricing so on and so forth.

So as I said this is going to start ramping up in the second half of our fiscal year.

And it's a pretty darned good evaluation overall for where J and L is going.

How do the margins look on the contract?

Pretty good, actually.

Markos Tambakeras The incremental margins, Walter, between 20 and 25%.

OK, OK, thanks for the clarity.

Very little incremental selling cost in this kind of a project.

OK.

Thank you.

Once again, if you do have a question or comment, please press star, 1'.We have a question from the line of Gary McManus from JP Morgan, please go ahead.

Yeah, hey just one follow-up.

What's your working capital assumption for fiscal '04, do you expect to get 100 to 125 of free operating cash flow do you expect further reduction in working capital in '04.

Yes, we do in FY '03 the reduction was about $60 million.

We're looking for $40 to $50 million in FY 04.

OK, great, that's all I had, thanks.

We have a question from Mark Koznarek from Midwest Research.

Please go ahead.

Yeah, I just had a couple odds and ends here.

We were talking about price a second ago.

What was actual price realization across the company in 2003?

It was down about 50 basis points, I believe.

Obviously there are a lot of pluses and minuses in there.

The most significant decline, even though it's a small business, electronics had a relatively significant impact on the company because the price were down about 15%.

If we just looked at metal working alone, what would that have been?

Largely flat.

OK.

And then you had mentioned foreign exchange added a nickel to earnings in the quarter.

What was that for the full year?

It was somewhere between 10 and 15 cents.

I don't have the exact number.

Uh-huh, OK, that's -- that's close enough.

And I guess that's it.

Thank you.

Once again, if you have a question or a comment, please press star one.

While we have everyone on the phone on the event, I do want to come back and -- and speak a little more to this depreciation question to make sure that we're very clear.

There was a very firm position taken in terms of the depreciation of the assets of Vidia and as a result of that it became very clear that we wanted to be consistent throughout the company with our depreciation policies.

We couldn't have two separate sets of depreciation policies.

And essentially the net effect of all this has been passed right through.

So there's no -- you know, there's no adjustment in any way except that it's been passed through and from now on it becomes a new level set.

So I don't want -- I don't want us to get too complicated over this one.

And the fact that it happens to be close to offsetting the increase in our pension costs, that's what the numbers turn out to be.

At this time we have no further questions in queue.

Please continue.

Thanks again, everybody, for joining us and please do give me a call with any follow-up questions.

Bye-bye.

Thank you.

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