Kennametal Inc (KMT) 2004 Q3 法說會逐字稿

Ladies and gentlemen thank you for standing by.

Welcome to the Kennametal third quarter earnings conference call.

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

Later we will conduct a question and answer session.

Instructions will be given at that time.

Should you require assistance during the call, please press star and then zero.

As a reminder, this conference is being recorded.

I would now like to turn the conference over our host for today, Director of Investor Relations, Ms. Beth Riley.

Please go ahead.

Thank you Jeremy.

Welcome and thank you for joining us this morning to review our fiscal 2004 third quarter and our outlook for the remainder of our fiscal year.

Consistent with prior calls, members of the media have been invited to listen to this call.

The call is being broadcast live on our website at www.kennemetal.com.

As Jeremy mentioned I am Beth Riley.

I am pleased to also have our Chairman, President and Chief Executive Officer Markos Tambakeras, and Vice-President and Chief Financial Officer Nick Grasberger joining me for the call.

After some initial comments we'll ask for questions.

Before I turn the call over to Markos, 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, risks and 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 these risk factors and uncertainties is detailed in the company's Securities and Exchange Commission's filings.

In addition, to be able to discuss non-GAAP financial measures during this call, in accordance with the SEC regulation G, the company has furnished a form 8-K to the SEC, [which is also] now available on our website.

The 8-K presents GAAP financial measures that we believe are most directly comparable to those non-GAAP measures as well as a reconciliation thereto.

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

Thank you Beth.

Good morning everyone.

Obviously we were very pleased with our third quarter earnings in what is still a developing manufacturing recovery in North America and Europe.

Our earnings per share of 66 cents represents 74% year-over-year earnings growth on higher sales or about 144% increase on an as-reported basis.

In addition to benefiting from the improving North American economy, we believe that we outperformed many of our end markets in the quarter delivering overall performance better than the change in industrial production when excluding technology.

Compared to our 6% volume increase we believe that global industrial production increased around 2% to 2.5%.

My view is that our strong performance reflects the benefits of our extensive efforts over the past several years to reposition Kennametal and increase the competitiveness of our company and prepare for exactly the kind of environment we are facing today.

The development and standardization of the six processes that are crucial to the execution of our strategy, which we have formalized as the Kennametal Value Business System or KVBS, with very strong implementation by the Kennametal employees, drove our performance.

Also I am particularly pleased in this past quarter with the out-performance of our Advanced Materials business in virtually every aspect and with the impressive turnaround of our J&L distribution business.

As usual the quarter also included strong cash generation, prudent management of capital expenditures, and tight administration of working capital.

Our consistent performance on these contributed to a 540 basis-point improvement in debt-to-capital ratio versus the March 2003 including the acquisition of Conforma Clad, which was completed in the third quarter.

The economic forecasts support our expectations of further strengthening in the June quarter even though traditionally this quarter is not as strong as the March quarter.

Our expectation in the fourth quarter is for strong volume growth of about 6% to 8% on global industrial production excluding technology forecasted to grow at about 3%.

Most of our businesses are well positioned to continue to perform better than the market.

Our EPS should increase by about 55% in the quarter.

In conclusion we continue to feel good about the remainder of fiscal 2004.

Our outlook is based on the continuation of the North American economic recovery also on the expectation that Europe will stabilize at around current levels, while the developing markets will continue to be robust as well, of course, in our confidence in our ability to execute our strategies and leverage the benefits of that growth.

Finally, and perhaps most importantly, we continue to generate strong cash flow and reduce debt.

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

Thank you Markos.

Good morning.

I'll provide a few additional details on our performance for the March quarter and then on the outlook for the June quarter.

There were no special items in the March quarter and my comments will exclude the special items from the March quarter of last year for a better comparison of results.

For the third quarter of fiscal year 2004 Kennametal earned net income of 24.1m or 66 cents per share compared to 13.3m or 38 cents per share last year.

The current quarter included three cents of accretion from the Widia acquisitions.

Consolidated sales increased 14% to 524m.

About six points of the growth was derived from the impact of the weaker dollar versus a year ago.

Gross profit margin improved about 50 basis points to 33.5%.

Gross margin benefited from continued cost reduction from our lean (ph.) programs, improved capacity utilization, and favorable currency effects partially offset by higher raw material costs, slightly lower pricing, and unfavorable mix.

Operating expenses for the quarter increased 9% to 132m.

The increase of 11m is attributed mostly to unfavorable foreign exchange and inflation and employee benefit programs.

EBIT was 42.5m, up 14m versus last year.

The EBIT margin of 8.1% was about two hundred basis points above last year's margin.

Interest expense of 6.3m decreased 30% over last year on reduced debt levels and lower interest rates.

The average interest rate of 4.5% was about 100 basis points lower than last year.

As expected the effective tax rate for the March quarter was 32%.

Last year's rate was 30%.

Free operating cash flow for the quarter was in line with expectations and exceeded last year by over 50%.

As of March 31, 2004 total debt was 494m.

Debt-to-capital has declined about 400 basis points since the beginning of the fiscal year to now 37.5%.

Moving on to the business groups, starting with the metalworking group, metalworking sales were up 3% in constant currency.

On a similar basis, North America grew 7%, Europe declined 4%, high-speed steel grew 5%, and the rest of the world increased 15%.

The EBIT margin for MSSG increased about 250 basis points to 11.6% versus last year.

Turning to our Advanced Materials Group, sales grew 19% in constant currency.

Likewise mining and construction was up 25% on a modest recovery in mining and market penetration in construction.

Engineered sales were up 2% and energy grew 26% on the strength of US rig counts.

Electronics increased 6%.

AMSG's EBIT margin increased over 200 basis points to 13.6%.

J&L sales increased 15% over the same period last year.

J&L's EBIT margin of 10.7% was up 660 basis points as lean benefits and higher operating efficiencies generated strong operating leverage.

Full service supply sales were up 13% compared to last year and their EBIT margin was up to 1.1% from breakeven a year ago.

OK, let's look ahead to the remainder of fiscal 2004.

As Markos noted, we expect the June quarter to be sequentially stronger than the March quarter, which is contrary to historical trends.

For the fourth quarter we are anticipating sales volume to increase 6% to 8% with reported sales growth of 10% to 12% including currency effects.

For the full fiscal year volume should grow 3% to 4%.

With the additional two months of Widia and the impact of the weaker dollar, reported sales growth for the year should be in the 10% to 11% range.

In terms of EPS, the guidance is now 70 cents to 80 cents for the June quarter and $2.05 to $2.15 for the fiscal year.

We anticipate no special items in our fourth quarter.

These numbers include approximately three cents of Widia accretion in the fourth quarter and 12 cents for the full year.

On a year-over-year basis, Widia should add 27 cents per share benefit consistent with the original expectation.

Free operating cash flow for the full year is still anticipated to be in the range of 100m to 125m.

Additional guidance for the full year remains largely unchanged.

The effective tax rate will be 32%.

Capital expenditures will be about 55m.

Depreciation and amortization will be between 65m and 70m.

Interest expense should be about 25m.

The outlook for the June quarter is based on the following market assumptions.

Demand for metalworking products in North America is expected to accelerate to around 10% year-over-year driven by continued growth of industrial activity and sales of Widia brand products.

Demand for metalworking products in Europe is expected to be relatively flat year-over-year due to continued weakness in consumer durable goods offset by strong demand for machine tools and other capital goods.

Demand for engineered and mining products in Europe is showing strength.

Demand is expected to remain strong in Asia at about plus-15% and South America at about plus-30% fueled by rapid growth in the key end markets and Kennametal's strong market positions in Brazil, China, and India.

Automotive is expected to grow about 8% led by strong demand for heavy-duty trucks and off-road vehicles and easier comparisons with a year ago.

We believe that aerospace bottomed out in the March quarter after declining in each of the past two years.

We are seeing upward signs of activity.

Light and general engineering should increase about 10% driven by solid growth in a broad range of industrial markets and machine shops.

Energy remains strong driven by oil and gas prices and the increased rig count and is expected to grow about 15% in the current quarter.

Finally mining and construction is expected to grow 4% to 5% driven by highway projects and increased coal mining activity.

I'll now open the line for any questions.

Ladies and gentlemen if you wish to ask a question at this time, press the star followed by one on your touch-tone phone.

You will hear a tone indicating you have been place in queue and may remove yourself at any time by pressing the pound key.

Our first question comes from the line of Mark Koznarek from Midwest Research.

Please go ahead.

Good morning.

Nick, last quarter you went through a good review of your raw material exposure.

It seemed like you were potentially under some significant pressure.

You have managed to offset that substantially.

Could you revisit the raw material question versus price, how the company is balancing that, and what the outlook is?

I think what we said last quarter was that we expected raw material price pressure to reduce EBIT by about 5m for the whole second half of the year-in the third and fourth quarters.

We're basically on pace with that.

We had about 3m of incremental cost in raw materials in the third quarter, no price offset.

We have announced price increases.

We will begin to see some of that benefit in the fourth quarter.

Overall the impact of the second half will be about 5m.

In terms of the individual raw materials, the issue continues to be cobalt where prices doubled in a very short period of time back in December and January.

Even though we have seen in the marketplace higher steel prices, they have not yet flowed through to Kennametal.

It has not been an impact and we don't expect it to be an impact in the fourth quarter.

The same with tungsten.

Tungsten prices are beginning to trend up a little bit.

We don't expect it to be an issue this quarter.

We are becoming a bit concerned about steel and tungsten prices in fiscal year '05.

It will not be an issue in this quarter.

OK.

When you talked about the overall company performance-the first few comments of your prepared remarks, you talked about higher raw materials and lower price realization as being negative issues.

It seems like your gross margin improvement is all from lowered cost because even mix you've commented as unfavorable.

Can you talk about this cost reduction?

What actually happened?

Is this something that can persist?

This part of the margin improvement was a surprise to me at least.

I would say the cost improvement in the quarter was nothing that we haven't been experiencing the past several quarters.

The lean programs and manufacturing continued to generate positive results for us.

Currency helped us a bit in terms of margin in the quarter as well.

We are very pleased with the cost reduction that we're seeing in the manufacturing operations.

Currency helped by how much?

It was about 30 basis points, I believe.

OK, great.

I'll get back in queue.

Thank you.

The next question is from the line of Walter Liptak from KeyBanc.

Please go ahead.

Thank you.

Good morning.

Along the lines of the previous question, how much-it sounds like in the fourth quarter you are going to have higher costs, but then you are going to-just like you had in the third quarter, but it's going to be offset by pricing.

Could you provide a little more granularity?

How big of an issue could tungsten prices be in fiscal year '05?

We do expect margins to improve substantially Q4 versus Q3.

The sales level for the quarter should be about where it was in Q3, but based on the guidance you can tell that we expect higher earnings.

A part of that would be price realization mostly in mining and construction and in energy to offset some of the raw material price increases.

Yes, we certainly do expect pricing to be one contributor to sequentially higher margins in the fourth quarter.

In terms of looking at tungsten in '05, we are beginning our planning process and starting to look at what the impact might be.

I don't have a number to give you.

That's fine.

In the comments in the press release you talk about the KVBS and the positive impacts.

I presume a lot of that is on the gross margin level.

Are we to assume that things are moving along better than we thought on lean and that, rather than just offsetting costs in '05, we may see positive earnings benefit?

I think you can certainly assume that the benefits of KVBS across the board are taking hold and are helping us across the business.

Lean without a question is an area where we are getting cost efficiencies both at the operating expense level, but also at the manufacturing level.

To add to what Nick was saying before, there is a lead in the lag on the raw material pricing.

We are going to get some of that back in this quarter.

We also expect overall pricing in the industry to start firming up consistent with previous cycles.

You add those two to continuing benefits from efficiencies that we built into the company as the volume begins to go up now and capacity utilization goes up.

You can see the increasing combined effect on the margins.

Its a combination of recovery of raw material, firmer pricing, and continuing better utilization with the associated productivity improvement and leverage on the manufacturing side.

OK, great.

There is a follow-up.

Your rising costs for raw material - we'll wait and see what the tungsten impact could be.

Are there any other rising costs-health care, or any changes in pension for fiscal year '05 that we should be thinking of?

As you know, we've made some changes recently to our pension program.

We have made some changes to our health care programs as well.

The goal of those would be to mitigate the normal inflationary impact that those have had over the past few years.

I would expect them to be higher in '05, although somewhat behind the pace that we've seen in the past couple of years.

OK, great.

Thank you.

The next question is from the line of Joanna Shatney from Goldman Sachs.

Please go ahead.

One moment.

Go ahead please.

Can you hear me?

OK, great.

I think you mentioned this in your previous remarks.

I don't think I got all the details.

I would like to spend some time on this one.

If I look at the year-on-year volume growth for the global metalworking for the quarter-I would like to do this for the fourth quarter as well.

And maybe we can talk about that for '05.

Can you help us understand how this volume growth is split between high-speed steel and the rest of metalworking?

We are experiencing higher growth in the core carbide metalworking business than the high-speed steel business.

North American business, excluding high-speed steel, was up 7%.

High-speed steel was up about five.

We would expect that trend to continue in the fourth quarter.

OK.

Any update on the uses of cash-how are you looking [at it]?

No.

As you saw, we made what we believe to be a very attractive acquisition during the quarter.

We spent $65m.

In general we've been paying off debt with additional cash flow.

OK.

Thank you.

The next question is from the line of Joel Tiss from Lehman Brothers.

Please go ahead.

How you doing?

Can you give us a sense of what the source of the strength was in the margins at J&L for the quarter?

There is a lot of leverage that has been built up in that business.

We've taken significant cost out.

We've been restructuring that business.

We think the cost structure is about where it should be.

Perhaps it can go somewhat lower.

It's very scalable.

What you saw is, with 15% growth with expenses down year-over-year, it gave us tremendous leverage.

I would expect to see that going forward for the next several quarters.

OK.

To finish up on that, you've also said that 10% is a reasonable target for that business longer term.

Is there any reason to think that that number needs to be revised a little bit?

I think longer term, it's more like 11 to 12.

The March quarter was above 10%.

This quarter should be above 10%.

I think as we model it out longer term, we think 11 to 12 is achievable.

OK.

Last I heard in your comments that mining and construction - it sounds like you expect it to be up about mid single digits in the fourth quarter.

Right.

Can you give a sense why such a small growth rate?

It seems like both those industries are ramping up quickly.

Right.

You saw that we grew at 25% in the March quarter.

We're a little concerned that there was some pre-buying.

We've announced some price increases in mining and construction.

We saw a very, very strong month of March.

The price increases were effective in April.

We think there was some pre-buying.

The extent of that is difficult to say.

Perhaps we're being a bit cautious.

OK, Thank you.

As a reminder, if you do have a question, press the star followed by one.

We have a follow-up from Mark Koznarek.

Please go ahead.

Yes, just a couple follow-ups, Thank you.

Building on that last question on J&L, you did hold down those big contracts.

You just said that you expect the cost structure to continue-I think you said continue to decline or maybe stay flat.

It would seem like you would need to build up some sort of infrastructure to handle those things.

Am I not thinking about that correctly?

Less than you would think.

Clearly with 15% volume growth and hopefully strong performance going forward, there is likely going to be some very modest increases in their operating expenses and in the cost structure.

It would be nowhere near at the rate of the top line growth.

We think the cost structure is very scalable.

One of the real attractive benefits of this government program is that we did not need to add a lot of cost.

A lot of this business is being conducted electronically through systems.

OK, great.

Last quarter you made mention of some growth relative to market and talked about some underperformance in Europe, I believe.

How would you characterize that in this quarter?

We would say-I feel good about how we ended up the March quarter in Europe.

We feel that despite this continuing challenging environment, we had a good quarter in March.

Going forward, as that economy begins to come back-as we had hoped - and as we begin to get some traction now with the combined operations, even though our expectations are relatively modest, I think looking ahead I feel good about Europe.

Let me say a couple of other things that came up.

Don't be unduly alarmed about the tungsten prices.

Obviously we are working on these.

We don't know how this will work out.

I do want to say something on the high-speed steel business.

We are very pleased with the performance of the high-speed steel business.

Certainly relative to that kind of industry, we think we are underperforming.

The fact that tungsten carbide is growing faster than high-speed steel is also good for our margins because it is a more profitable business.

That is consistent with the model of the company.

Looking ahead, we feel we have a good tailwind.

The company overall is on track as to the way we have predicted and we have positioned it to be.

OK.

I have a final one.

There is going to be-you had spoken about some resolution of the electronics business by year end.

That is looming pretty close.

Any comments on that?

The electronics business has been stabilized based on the things we have done cost-wise in the last 12 months.

That industry is turning up strongly.

It's still not a stellar business to be in.

Relatively speaking, it is performing quite well.

Does that mean it's going to remain part of the portfolio-the status quo from here on out?

I think it's an area where visiting strategic options from time-to-time is something that we would do.

OK, Thank you.

We have a follow-up from Joanna Shatney.

Please go ahead.

Thank you.

If I look at incremental margins for the AMS business, they were a little bit lower than what I was expecting.

Is there anything that I should be looking at?

The issue really is the raw material issue.

Most of the raw material price pressure that we experienced during the quarter was in the AMSG business.

That would be the major driver.

How much of the incremental cost was in this business?

Of 3m, it was probably two or 2.5.

It was the vast majority.

Great, Thank you.

We have a follow-up from Joel Tiss.

Please go ahead.

Can you give us a little bit of a sense of how you are looking at the auto industry for 2005?

This was a 2005 question, Joel.

I know.

I think we said the auto industry is an interesting one to predict.

We feel good about it this coming quarter.

The heavy truck industry, in particular, looks good for the rest of the calendar year.

We think Europe is going to start showing some signs of life - stronger than we've had before.

If I were to look at the signs today overall in the automotive industry for the rest of the calendar year, I think they are more encouraging than we've had a few months ago.

OK.

Is there any sense that the 8% growth for this year, which is probably a little bit better than expected, has borrowed anything from the future?

No.

I think if you look at that 8% growth in the fourth quarter, last year's June quarter auto production declined - I think mid-to-high single digits so the comparison is easier.

I don't think we can take that number and extrapolate that into '05.

OK.

If we try to aggregate the price increases-I am sure they are different across all the different lines and all that - can you give us a sense of where we should be thinking?

It's mostly mining and construction and in energy.

Likely we'll not see any price increases in metalworking again.

They are not as affected by the cobalt issue.

It would be in those two segments.

Then if we aggregate for the whole company, if we guessed 1% to 2% would that be reasonable?

You mean for the quarter?

For going forward.

You put them in place in the beginning of your fourth fiscal quarter, so as they blend in in the future.

I think it is going to depend upon what the trends continue to be in raw material pricing.

Typical in a recovery cycle, 50 to 100 basis points.

OK, thank you.

Last, you made some comment quickly about unfavorable mix in the quarter.

Can you elaborate on that a little bit more.

Give us a sense of how it is looking going into the fourth quarter.

It was mostly an end market mix issue with respect to-I am sorry, channel mix - more sales through distribution in North America than direct.

That would be the predominant mix issue.

OK, Thank you.

At this time there are no further questions in queue.

Alright.

Thank you everybody for joining us.

I am certain we will follow up with any questions.

Have a good day.

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