Kennametal Inc (KMT) 2005 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the Kennametal first quarter 2005 earnings conference call.

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

Please go ahead.

Thank you, Tom.

Good morning and welcome thank you for joining us this morning to review our 2005 first quarter and our outlook for the remainder of the fiscal year.

Consistent with prior calls, members of the media have been invited to listen to this call and the call is being broadcast live at our website at www.Kennametal.com.

As Tom mentioned, I'm Beth Riley.

I'm also pleased to 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 Nick, I'd like to read our forward-looking disclosure.

This 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 Security and Exchange Commission filings.

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

The 8-K represents GAAP financial measures we believe are most directly comparable to nonGAAP financial measures, as well as a reconciliation there, too.

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

Thank you, Beth, and good morning.

We are very pleased to announce this morning a strong start to fiscal year 2005 and another quarter of top quartile performance.

We exceeded our guidance for this September quarter and produced record sales and near record earnings.

In fact, if for the for a higher tax rate, September EPS would have been a record.

I'd like to make a few comments about the quarter and outlook before I discuss the financial details.

The September quarter was the third consecutive quarter of double digit organic sales growth.

We believe that new management, our customer acquisition process, which is part of the Kennametal value business system, and new products have enabled us to gain market share over the past several quarters, principally in North America and developing countries.

We are also completing the conversion of our business model from a company that provides the best tooling to a company that helps our customers gain the best economics from the manufacturing process or operation.

For the September quarter, every business and geographic region within Kennametal delivered growth.

And our 15% volume growth compares very favorably to global industrial production growth of 4%.

We're also feeling much better about our European business, which generated growth for the first time in over a year.

Although the European economy continues to lag behind the U.S. economy, the combination of our new European management team, Widia integration benefits and improving economic indicators will drive even stronger performance during the balance of fiscal year 2005.

Our profit margins and return on capital metrics have begun to reflect the operating leverage in the business, despite significant increases in raw material costs.

The reduction of cost in working capital over the past three years has positioned us to move beyond historical highs in these metrics during this period of economic growth.

Compared to last year our EBIT margin increased about 250 basis points, and ROIC increased over 200 basis points.

We are confident that these metrics will reach double digit levels in the next few years consistent with our long range plan.

As you've seen, we've improved our earnings guidance for the full fiscal year by about 5% to a range of $2.80 to $3.00, which is up 30 to 40% versus last year, reflecting better than expected performance in the first half of our year.

We are maintaining our outlook for mid single digit sales growth during the second half of the fiscal year, due to the strong growth we experienced in the second half of fiscal 2004, which was about 15%.

Earnings leverage, however, should improve throughout the fiscal year as price increases catch up to inflation and raw material costs.

Our balance sheet metrics continue to improve and provide flexibility for investment with debt to capital approaching 30%.

Our working capital ratio to sales declined to a new low, and inventory turnover has reached a new high.

Now to the specifics for the quarter.

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

For the first quarter of fiscal 2005, Kennametal earned net income of $22.7 million, or 61 cents per diluted share, up 80% compared to 12.1 million, or 34 cents per share last year.

For the September quarter, consolidated shares increased 20% to $531 million.

The sales increase was driven by organic growth of 15%, and included a 3% benefit from foreign currency, and a 2% benefit from acquisitions.

Gross profit margin declined 50 basis points to 32.6% due mainly to the continued negative impact of raw material costs, which increased 7.5 million versus last year, somewhat more than expected.

This impact was partially offset by better pricing, improved capacity utilization and favorable currency effects.

Operating expense increased 11 million, or 9% to $131 million for the quarter.

On a constant currency basis, operating expenses grew at less than half the rate of sales, or about 6% versus volume growth of 15%.

We will continue to gain good leverage from our operating expense base for the balance of the year, contributing to a 200 basis point improvement in the EBIT margin for the full year.

EBIT was 43.4 million, up about 70%.

The corresponding EBIT margin was 8.2% and as mentioned earlier, about 250 basis points higher than last year.

Interest expense of 6.5 million, decreased 2% over the same quarter last year on lower debt levels.

Interest rates on domestic borrowings were 4.6%, up from 4.3% last year.

Consistent with previous guidance, the effective tax rate for the September quarter was 36%, compared to 32% last year.

ROIC was 7.6%, up more than 2 points over last year.

Free operating cash flow for the quarter was 17 million, debt to capital declined about 900 basis points to 31.6% from September of 2003, an annualized debt to EBITDA is around 2 times.

Turning to our business units, and all comparisons of sales will be in constant currency.

MSSG delivered growth in every business and every geography with nearly every business producing double digit growth.

New products as a percentage of sales have increased for each of the past three years, and in the September quarter orders for new products exceeded forecast by about 30%.

The business achieved record sales in milling products and home making products grew 50% faster than the market.

Widia products are delivering strong sales in the Americas with momentum continuing to build.

In the September quarter, MSSG sales were up 13%, North America, excluding high-speed steel, grew at 16%.

High-speed steel grew 21%, Europe grew 4, and the rest of the world grew 20%.

On 13% volume growth, MSSG EBIT was up 37%, and EBIT margin improved about 2 points to 12.4%.

AMSG also realized significant sales growth across its businesses, although profitability was dampened by increased raw material costs and some isolated operating inefficiencies, related to the rapid growth and demand for certain products.

Mining and construction delivered strong sales growth due to market share gains resulting from its customer acquisition process, new products, and a somewhat improved market environment.

Engineered sales increased with penetration of new markets and capitalizing on an improved U.S. market.

Energy growth benefited also from the customer acquisition process, new products and a strong oil and gas market.

Electronics continued to improve their cost competitiveness.

Overall AMSG sales grew 24%, mining and construction was up 14%, engineered sales were up 25%, and energy grew 18%.

And finally, electronics increased 7% against last year.

The sales growth impact on AMSG's EBIT was lower than expected as price realization lagged further increases in tungsten prices.

EBIT grew 22% versus last year, with EBIT margin declining 40 basis points to 12.4%.

J&L's exceptional performance continued as September sales increased 28%.

J&L's EBIT more than doubled, and the EBIT margin was 9.3%, up about 4 points versus last year.

For the September quarter, FSS sales were up 14% and the EBIT margin increased to 0.3 of a point.

Moving ahead to the outlook for fiscal year 2005.

The outlook is driven by continued broad-based optimism for the global environments.

Continued strong readings and leading indicators such as the ISM index, and the Manufacturing alliance composite index, support the view as to consensus estimates of 3 to 4% growth in global industrial production.

These forecasts, coupled with our expectation of further market penetration, yield an improved forecast for 8 to 10% organic growth at Kennametal during fiscal year 2005.

For the second quarter we expect organic growth of 13 to 15%.

In terms of EPS, the second quarter guidance is 60 to 65 cents per share, which would be up 75 to 90% versus last year.

This guidance includes two noteworthy items.

First, consistent with our previous guidance, we expect to recognize a one-time tax benefit during the quarter that will reduce the tax rate to about 20%, and provide a 9 cent per share benefit versus last year.

The benefit will be derived from a structural change in our European business, that will enable utilization of net operating losses associated with Widia.

Again, this is consistent with our guidance and we expect the tax rate for the year remains about 32%.

Second item for the quarter that I'll mention is that the improved outlook has provided flexibility for us to invest in high return manufacturing projects.

Therefore this quarter we are proposing to close a facility in the U.K. that manufactures microdrills for our electronics business.

The production will be consolidated into our facility in China, to further improve the competitiveness of this business.

The cash return on this project will be quite high while shutdown costs equivalent to about 6 cents per share will be recorded during the quarter.

These costs are included in our guidance for the quarter, and will not be classified as a restructuring charge.

For the full year, as mentioned earlier, EPS is expected to range between $2.80 and $3.00 a share up 30 to 40%, the original guidance that we provided in July was $2.65 to $2.85.

Free operating cash flow for the full year is anticipated to be in the range of 110 to 140 million and ROIC should improve 2 points from last year to about 9%, consistent with our previous guidance.

Like most companies, our outlook includes significant cost pressure from increased raw material prices, particularly tungsten and steel.

We expect a $30 million increase in raw material cost for FY05.

We expect to offset approximately 70% of these cost increases through a combination of price increases and surcharges.

The outlook for pricing also includes a 50 to 100 basis point price improvement across the business portfolio.

Additional guidance for the full year is as follows.

Capital spending should be approximately 70 to 80 million, up 30% from FY04, driven by significant investment in capacity in India and China.

Depreciation and amortization should be about 65 million.

Our PWC, primary working capital ratio to sales, should be 22 to 23%, down another 300 basis points from last year.

Debt to capital should be about 25%, and interest expense for the year should be up 2 million, as higher rates more than offset the impact of lower debt levels.

Included in our sales guidance are the following assumptions concerning the end markets for the next three months.

On balance we expect 3 to 5% growth in most of our major end markets, including vehicle, heavy machinery, light and general engineering and coal mining.

In addition we expect the energy sector to level off, and road construction and aerospace to gradually improve.

On a geographic basis, we expect industrial production in North America to remain strong, up 3 to 4%, and look for continued improvement in Europe, up about 1 to 2%.

In addition, demand should remain strong in Asia Pacific and Latin America, with each market up 5 to 7%.

I'll now open the line for any questions.

Tom, we're ready for questions.

Thank you.

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Our first question comes from the line of Joanna Shatney from Goldman Sachs.

Hi, it's Mercedes here.

How are you guys?

Hi, Mercedes.

Couple of questions.

The margin in Advanced Materials Solutions Group was a little bit lower than than what we were looking for.

I understand it was raw materials.

One, can we quantify that?

And two, is anything else going on?

Right.

I would say across the company the raw material costs for the quarter were 2 to 3 million higher than we expected, and most of that would be in Advanced Materials.

The high inflation this quarter was in tungsten products, which utilize much more heavily in Advanced Materials.

So I would say I don't know what you assume from the margin.

But from what our expectation was, the majority of that variance would be due to raw materials.

Right.

Let me ask you another question, and then I will get back into the queue.

For FSS, sales and margins a little bit lower than than our expectation.

Anything I should keep in mind when looking at sales?

No.

In fact, Mercedes, I would say that their results for the quarter were in line with our expectations.

We do expect them, as they typically do, to improve throughout the fiscal year.

There's nothing really notable in FSS.

I will get back in queue.

Thank you so much.

Our next question is from the line of Mark Koznarek with Midwest Research.

Please go ahead.

Hi, good morning.

Hi, Mark.

Couple of things, one is we started off the discussion about the revenue growth with some new product comments, milling and hole drilling.

I'm wondering if you can talk about what proportion now of sales those new product categories constitutes, versus where they were before, and maybe some idea of a longer term target, where you want those to be in terms of a percent of sales in MSSG.

Well, within MSSG, the new products as a percent of sales I think are around 40%, a little bit higher across the whole company, I think 42 or 43.

I think we feel that that's about where it should be, maybe it will increase a few points over time.

But we're pretty comfortable around 40% or so.

Now, those new products aren't necessarily just the milling and hole drilling, it can be more turning innovations and things like that too?

Right.

Of that, the milling and hole making, is that a sizable amount?

Is that sort of an area where you're really gaining traction or would you characterize it as really just one of many things that are working positively for you.

Mark, this is Markos.

You may recall about three years ago we decided to focus hard on milling and hole making.

Our global markets have been turning close to 40%.

We began both of those in the high single digits.

We've been getting heavy traction there.

I would say we have close to doubled our market share in those two areas in the last couple of years.

So for us to get the kind of growth we had in milling and hole making is actually phenomenal.

It is way above anything we had expected.

So it is a combination of the new technology.

But it's also the new business model that we have been executing in the last couple of years where we're really repositioning our entire go to market model around the customer acquisition process that Nick talked about and we've mentioned before.

We're really going heavily on the financial benefit by end markets, and leveraging global accounts, in a way we haven't done before, by really appointing global account managers to coordinate our activities after major accounts that have multiple sites around the world.

So it's a combination of the business mold, heavy emphasis on the new technology.

I tell you what, milling and hole making, the kind of growth we had last quarter is nothing short of phenomenal.

That's great to hear.

Second and last one I had for right now is for overall sales up 20 with the base business up 15%, could you further split that into how much volume was up and then how much price realization you got for the quarter?

Yeah.

Price, Mark, would have been about 1%.

Okay.

So volume, let's say, 14%.

Okay.

Then when we talk about price of 50 to 100 basis points for the year, does that assume further increases from the level we're at right now?

Yes, it does.

Okay.

Great.

Thank you.

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

Please go ahead.

How are you doing, guys?

Hi, Joel.

Can you give us a sense -- first of all, you mentioned taking share.

Can you give us a sense of who, in a competitive landscape, who you're taking the share from, maybe instead of naming names, whatever, just give us a sense.

Also, can you go through the pieces also that give you so much confidence around the outlook for 2005?

You know, looks like you're significantly outperforming the market and all those kinds of things.

Can you just build up some of the pieces for us?

Thank you.

With respect to market share, the visibility really is to an overall index.

And then there is one other public competitor that we have some visibility to.

In those markets, North America and the developing markets, we've seen three consecutive quarters of market share gains.

If you look at the outlook for the balance of the year, again, we'll grow top line about 15% or so in the first half.

Then with the more difficult comparisons up kind of 5, 6% in the second half.

And those forecasts are based mostly on industrial production growth, as well as some of the specific end market forecasts in oil and gas and automotive and mining and so forth.

So that tends to be what we look at overall.

Of course we build it up from the bottom as well and the sales force continues to be very optimistic as we look through the balance of the year.

Really, that growth is broad-based.

Every geography you saw, the return to growth in Europe, and every business unit is expecting solid growth for the balance of the year.

If you want to look at sector, if I can add something here, we begin to see some pickup in share, as far as we are concerned, Joel, in areas like the heavy truck and aerospace, which is starting to come back, aerospace is an area we've targeted.

In mining, where where we already have the leading market share, in the last couple of years we started moving heavily into surface mining and trenching and associated market segments, that's picking up traction.

In energy where we already have a very strong share in the oil sector, we have some new products and we have some associated applications.

And finally high-speed steel, you saw the numbers that nick quoted.

High-speed steel, we really feel very good about our performance in the U.S.

Growing more than 20% is no way the market is growing this way.

We are taking advantage we think of competitive weakness.

Not only picking up top line but actually performing very well profitability-wise.

Then J&L we think in the distribution business has done such a good job, that they are continuing double digit growth and operating margin improvement is also a reflection of further market share.

And they operate only in North America and the U.K.

So just to add a little more color in terms of segments and business units.

That's great.

Thank you very much.

Our next question is from the line of Walt Liptak with Keybanc.

Go ahead.

My question is regarding Europe and what your outlook is for I guess industrial production growth throughout the year, and then which sectors are you seeing the strength in?

Specifically discuss the automotive sector and Volkswagen.

Well, as indicated we expect industrial production in Europe to be up, say, 1 to 2%.

As we've discussed before, our strength tends to be in the engineering segments, which are doing better.

We have, as you know, increased our exposure to automotive with Widia, and automotive continues to be somewhat flat to maybe slightly down in Europe.

But the growth that we're seeing is mostly derived from the engineering segments where we have very high share.

Then also I'll say very high margins.

Okay, good.

So you probably mentioned this already but the tax rate for 2005?

32%.

Okay.

All right.

Thank you.

Our next question is from the line of Jay Aston representing Neuberger & Berman.

Please go ahead.

Morning, guys.

Morning Jay.

Another great quarter of execution.

Thank you.

Question with regard to acquisitions.

It's certainly something that we've always talked about.

I'll just be interested to get your take on what the acquisition landscape looks like, particularly with regard to opportunities and prices, where the market is pricing now and whether or not there are some opportunities out there.

Maybe if you'd also talk about the size a little bit, if it's changed at all from what you've talked about before.

We, as you recall, Jay, we talked about this in September at our meeting in New York.

We feel like we're very focused on the types of assets we're looking for, mostly within AMSG, and so-called engineered components.

So we're just working through the process of understanding what's available and what's affordable and so forth.

I think the size range is probably somewhat broad. 100 to 500 million, something in that range.

And we think the market is quite good.

We think that the acquisition multiples are reasonable, obviously the economic outlook is positive.

So I think we're optimistic that at some point we will find something that makes sense.

But at the same time, as we've discussed and as you know, this is a very disciplined management team, and we have some very high hurdles we think we need to clear financially for something to make sense.

And rest assured that we will maintain that discipline going forward.

And I'd say within MSFG, any acquisitions you'd see would be smaller bolt-ons or filling in geographic gaps in the business.

Okay.

And second follow-up, if I may, with regard to the international strategy, Markos, would you talk for a minute about how India and China look today and how you envision them looking a year from now, year to 18 months, maybe, from now?

Sure.

India today is -- the business that we purchased from Widia, together with a very small business we had, has gone extremely well.

They are now the leading supplier of metalworking products in India.

We are investing somewhere between another $10 million this year. 8 to $10 million of adding manufacturing capacity and expanding our operations.

And this is primarily for the Indian market and to a lesser extent for Asia, Asia Pacific.

So summary in India, going great, investing more, market leader, we feel pretty good going forward.

In terms of China, we have built a stronger infrastructure on the ground.

We already have two small manufacturing facilities.

We do not have the leading market share there.

That is a more fragmented market, not as easy to get ahold of data.

But we have put together a strong management team, and we will be investing to accelerate our capacity on the ground.

That will be exclusively for Chinese market growth.

We see that market continuing to do well.

We'll absorb any additional capacity we are going to be putting in.

This is simply to make sure we are there to support the growth, which primarily today is driven by foreign investment and capacity addition by western and Asian companies.

Then down the line, you'll see more -- as a phase 2, you'll see more Chinese companies.

Primarily that's what's absorbing the growth.

As I see it in the next couple of years, our goal is to double our business in each of those markets, more broadly.

We want in the next three to four years we want our sales from developing economies which now are close between 9 and 10% of total to double to about 20%.

Most of it will come from India, China, central Europe, and Latin America, primarily Brazil and Mexico.

Okay.

Of the Cap Ex guidance you mentioned about 10 going to India.

Geographically, how is the rest disbursed?

The rest of it could be allocated roughly evenly, Jay, between North America and Europe.

And how about China?

Yeah.

I think the China figure for the year is somewhat modest, a few million.

Okay.

Okay.

Thank you.

Thank you all.

Question from the line of Mark Koznarek with Midwest Research.

Please go ahead.

I just had one follow-up sort of leading from the China discussion we just had.

That is are you seeing any signs of moderation in growth over there based on these macropolicies?

Yeah, there is some moderation based on macropolicies as you said in the overall economy.

We still see very strong growth in the manufacturing sector.

Little bit of a slowdown from very high levels in automotive, to good levels in automotive.

So I think obviously it's a good thing, but it's driven primarily by administrative pronouncements rather than structural changes.

My personal view is the Chinese government is going to move on to the next level.

They still can expect change to pronouncement and then follow with structure.

Overall we seem to be pretty good.

It seems to be slowing down, which is generally a pretty good thing.

It sounds like, I don't want to put words in your mouth but it's not a dramatic slowdown, just a moderation in the degree of growth.

It's moderation, not a dramatic thing by any means.

Moderation at still high levels.

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Thank you, Tom.

Thanks again, everyone, for joining us.

And as always, I'll certainly be available during the day for any follow-up questions.

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