Kennametal Inc (KMT) 2006 Q3 法說會逐字稿

At this time, I would like to welcome everyone to the Kennametal third-quarter fiscal year 2006 earnings call.

All lines have been placed on mute to prevent any background noise.

After the speakers' remarks there will be a question-and-answer session. (OPERATOR INSTRUCTIONS).

I would now like to turn the call over to miss Quynh McGuire.

Ma'am, please go ahead.

Thank you, operator.

Welcome and thank you for joining us this morning to review Kennametal's third-quarter results and outlook for the remainder of 2006 fiscal year.

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

I am Quynh McGuire, Director of Investor Relations for Kennametal.

And I'm pleased to have joining me for the call President and Chief Executive Officer Carlos Cardoso, Executive Vice President and Chief Financial Officer Kathy Smith, and Vice President of Finance and Corporate Controller Frank Simpkins.

Carlos and Kathy will provide additional details on the quarter's operational and financial performance as well as our outlook for the remainder of the 2006 fiscal year.

After these remarks, we will answer your questions in the remaining time.

At this time, I would like to direct your attention to our forward-looking disclosure statement.

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 filings.

In addition, to be able to discuss non-GAAP financial measures during this call, in accordance with SEC Regulation G, the Company has furnished a Form 8-K to the SEC which is also now available on our website at www.Kennametal.com.

The 8-K 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 Carlos.

Thank you, Quynh, and good morning.

We're pleased with the third quarter results, which represent the ninth consecutive quarter of year-over-year growth.

Our team executed on our clearly defined strategic initiatives to deliver another quarter with strong sales, earnings per share, and return on invested capital.

I am particularly happy that we reached a record return on invested capital of 10.7% this quarter.

We will continue to focus on sustainable growth, portfolio enhancements, expanding margins and cash flow as evidenced by this quarter.

Our core business segments are showing consistently strong performance.

For metalworking, we continue to see healthy orders in North America, a modest increase in Europe, and strong growth in developing countries.

Advanced materials consistently reports very dynamic activities across the board in energy, mining and construction, and engineered products.

J&L, our distribution business, also reported solid results.

As shown by the performance of the third quarter, we have consistently achieved our goals.

We are cautiously optimistic that the outlook for our end markets for the remainder of the fiscal year remains favorable.

Despite difficult comparables, the global manufacturing forecast is consistent with our belief that the industrial sector will continue to show strength.

Our proven business model enables us to effectively deliver volume growth and price realization through disciplined process.

Therefore, we expect to continue to outperform the market.

In summary, our financial performance is confirmation of the value driving capability of our roadmap for growth, designed according to the disciplined process that is part of the Kennametal Value Business System, or KVBS.

Through our strong focus on customers, we have repeatedly demonstrated our market leadership by offering innovative technologies, end market balance, and global presence.

We will continue to gain market share globally and deliver strong financial results.

At this time, I will turn this discussion over to Kathy, who will review the details of this quarter's performance.

Kathy?

Thank you, Carlos, and good morning, everyone.

I will provide you further comments on the performance of the March quarter, and then move onto the outlook for the remainder of our fiscal 2006.

As many of you are aware, we've had quite a bit of activity this past quarter, so there are a number of special items reflected in the results.

I will walk you through these items in order to provide additional clarification, and you'll see that our performance reflects another strong operational quarter.

Fiscal 2006 third-quarter performance reflects the impact of recent divestitures, which is consistent with our Company's strategy of exiting noncore businesses.

Therefore, third-quarter results include a charge associated with the sale of our UK based high-speed steel net assets and transaction-related costs from the divestiture of J&L Industrial Supply.

The disposition of the UK high-speed steel assets was part of Kennametal's acceleration of its manufacturing rationalization, and is expected to improve future overall company EBIT margins by 10 to 20 basis points.

The divestiture of J&L is in line with Kennametal's strategy on focusing on our core manufacturing businesses.

This transaction will complete our planned exit from owned distributions, and will allow Kennametal to build new and growth existing distributor relationships.

Additionally, in the third quarter, a goodwill impairment charge of $0.13 per share was recognized for the small, high-speed steel consumer retail product line because the Company is pursuing strategic alternatives for this business.

Reported earnings per share for the third quarter of fiscal 2006 was $0.82.

Excluding the special items just mentioned, adjusted EPS was $1.17 for our third quarter.

The effective tax rate for the quarter was 37.4%.

Excluding special charges totaling $0.33 per share, for which there were no tax benefits, and other items, the effective tax rate was 31.1%.

This adjusted tax rate was lower than our expected tax rate of 35% due to favorable earnings mix and other items, which contributed $0.07 per share to the quarter.

Therefore, taking the $1.17 less the tax benefit, third quarter's operational performance was $1.10 earnings per share, which is at the high end of our guidance for the quarter.

Moving on to our overall results for the current quarter, Kennametal earned net income of $33 million compared to 31 million last year.

Adjusted earnings per diluted share of $1.17 is up 27% over last year's $0.92.

This includes $0.20 related to the sale of the UK-based high-speed steel business divestiture, $0.13 related to the goodwill impairment charge recognized at the Company's high-speed steel consumer product line, and $0.03 related to the J&L Industrial Supply divestiture related charges.

For the March quarter, consolidated sales increased 6% to $631 million.

The sales increase was driven by organic growth of 12%, offset by unfavorable foreign currency of 3%, as well as a 3% reduction due to the net of acquisitions and divestitures.

Reported gross profit margin of 34.4% decreased 100 basis points compared to the prior year.

The decline was primarily attributable to the high raw material costs and the charge for UK-based high-speed steel business divestiture of $7.4 million.

Excluding the effect of the UK-based high-speed steel business divestiture, gross profit margin would have been 35.6%, an increase of 20 basis points over the prior year.

Improved price realization and ongoing lean benefits drove the improvement.

As we have previously stated, our goal is to limit SG&A expense to no more than one-third of our topline growth.

Operating expenses increased $2 million or 1% to $148 million.

This increase is primarily attributable to increased employment costs, stock option expenses resulting from the adoption of FAS 123, pension expense, and the J&L Industrial Supply divestiture related charges.

These increases were offset by favorable foreign currency and lower employee compensation expense.

Excluding stock option, pension expense, and J&L Industrial Supply divestiture charges, operating expenses decreased 2% on the sales growth of 6%, consistent with our goal of limiting SG&A.

Adjusted EBIT was $77 million, up 20%.

The corresponding EBIT margin increased 150 basis points to 12.2% from the prior-year margin of 10.7%.

Adjusted return on invested capital, as Carlos mentioned, was up 160 basis points to 10.7%, a new Company high.

Interest expense increased $0.9 million to $8 million in the March quarter.

Interest rates on domestic borrowings of 5.7% are up from 4.8% last year, and average domestic borrowings decreased $31 million from the last year.

The effective tax rate for the March quarter was 37.4% compared to 37.1% in the prior year.

Excluding special charges, the effective tax rate was 31.1% versus an expected tax rate of 35%.

The lower adjusted tax rate for the quarter includes $0.07 per share tax benefit due to the favorable earnings mix and other items.

Net cash from operations was $42 million, including an outflow of $33 million for the funding of the UK pension plan versus $66 million in the same quarter last year.

Excluding the pension funding, cash flow from operations of $75 million increased 12% from the prior year.

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

MSSG continued to deliver strong growth, despite difficult comparisons to the strong quarter last year.

Growth in the metalworking business continues to outpace the growth in its addressed market, demonstrating the effects of price realization and further market penetration.

In the March quarter, MSSG sales were up 7% on volume and price, excluding acquisitions, divestitures, and foreign exchange.

North American cemented carbide and high-speed steel grew 9 and 6% respectively.

European sales were increased 8%.

The rest the world grew 6%.

North American consumer products declined 6%.

MSSG operating income excluding special charges was up 10% on 5% reported sales growth, and the operating margin of 15.7% was up 70 basis points excluding special charges, over the same period last year.

AMSG deliver significant topline growth in the current quarter, also despite difficult comparisons to the prior year.

The underlying markets in mining, construction, and energy remain strong for Kennametal.

Electronics is the only market showing year-over-year declines.

Despite this challenge, the overall AMSG segment continues to report considerable growth.

Overall market conditions, price realization, and market share penetration are primary factors to favorable results.

AMSG sales grew 24% on volume and price, excluding acquisitions divestitures and foreign exchange.

Mining and construction was up 22%, energy sales increased 56%, and engineered product sales grew 18%.

Electronics decreased 7%.

AMSG operating income grew 50% versus last year on 35% reported sales growth, with the operating margin increased 180 basis points to 18.2%.

J&L sales grew 12% on volume and price, excluding impact of foreign exchange, and operating income grew 19%.

Operating margins of 12.7% was up 90 basis points versus last year.

Now we will look ahead for the remaining quarter of our fiscal year 2006.

Global economic indicators forecast continued expansion through fiscal 2006 in North America and the rest of the world markets, and flat to modest growth in European markets.

Kennametal's organic sales growth for the fourth quarter of fiscal 2006 is expected to be 7 to 10% relative to very strong performance from the prior-year quarter.

Worldwide market conditions support our expectations of continued topline growth in the fourth quarter.

Consistent with year-to-date results and full-year guidance for fiscal 2006, we expect to finish the year with organic revenue growth in the 9 to 10% range, consistently outpacing worldwide industrial production rates by two to three times.

Kennametal anticipates the majority of its end markets to continue operating at high levels, with moderating growth rates for certain sectors.

We anticipate ongoing pressure on raw material prices as mentioned during the past year -- consistent with historical seasonal patterns, and reflecting confidence in our ability to maintain the strength of the year-to-date performance, forecasted earnings per share for the fourth quarter and full fiscal year 2006 are as follows.

As outlined in our press release, we have revised our projected fourth quarter and fiscal year 2006 guidance to reflect the impact of recently announced divestitures.

Reported EPS for the fourth quarter is expected to be in the range of $3.83 to $4.12.

Reported EPS for fiscal 2006 is now expected to be in the range of $6.31 to $6.60, including an approximately $0.25 negative impact on the combination of expensing stock options due to FAS 123 and the effects of the reduction in the discount rate applied to our domestic pension plans.

Fourth quarter 2006 is expected to reflect a gain ranging from $3.20 to $3.30 per share related to the divestiture of J&L Industrial Supply.

In addition, fourth quarter is expected to include a charge ranging from $0.45 to $0.50 per share associated with the sale of the Kemmer Praezision electronics business, as well as a charge of up to $0.04 related to the remaining cost of the disposition of the UK-based high-speed steel assets, consistent with our earlier announcement on these two divestitures.

Excluding the special items anticipated in the fourth quarter, adjusted EPS guidance for the fourth quarter is expected to be in the range of a $1.17 to $1.27 per share.

For the fiscal 2006, adjusted EPS guidance is expected to be in the range of $3.85 to $3.95 per share.

We have taken the midpoint of our guidance up $0.10 to reflect the strong recent quarter performance and continued confidence in the fourth quarter.

Operating margins and return on invested capital, or ROIC, are expected to continue improving for the fiscal year 2006, with ROIC on track to achieve its projected 10 to 12% range.

We will maintain our strong focus on the balance sheet and cash flow generation as well.

As a reminder, we previously disclosed in our quarterly SEC filings that the Company is evaluating options for cash repatriation and the corresponding tax impact under the American Jobs Creation Act of 2004.

The act provides for a special onetime tax deduction of 85% of foreign earnings that are repatriated to the United States.

We are considering repatriating an amount between zero and $200 million, which would result in an estimated tax cost between zero and $19 million.

We will complete our evaluation during the fourth quarter of our fiscal year 2006.

We anticipate cash flow from operations to be 190 to 210 million for the fiscal 2006 based on projected capital expenditures of $80 million.

We expect free operating cash flow of $110 to $130 million, including the $33 million funding of the UK pension plan in the third quarter.

This pension funding was a prudent business decision and a good use of our cash.

It reduces ongoing pension expense, brings our plan into conformity with recent changes in the UK pension regulations, and we largely avoid newly imposed pension insurance fees.

In summary, we are solidly on task to meet our targets for the fiscal 2006.

We continue to maximize growth by managing our product portfolio, maintaining operating expense discipline, and achieving price realizations.

We're on track for another quarter of strong performance.

At this time, we will be happy to take your questions.

Operator, we're ready to take the questions now.

(OPERATOR INSTRUCTIONS) Gary McManus.

Actually, this is [Phil Gresch] in for Gary McManus this morning.

So, my first question has to do with your operating cash flow projections.

You reduced them by 20 million versus your previous guidance.

Did that have to do with the UK pension plan?

Was that unexpected, or -- what was that related to?

The contribution to the UK pension was not forecasted.

So on a like-for-like basis, we actually would have increased our guidance by 13 million, so -- if you add that 33 million.

And then my second question has to do with the J&L divestiture.

You guys are losing roughly 30 million in annual profit with the divestiture, and getting roughly 225 million in cash.

So to get that profit back, you'd have to invest in something that would have roughly a 13% return on that 225 million.

So I'm wondering -- if you could walk us through your current thinking on the expected annual EPS impact of this divestiture moving forward?

Well, as you know, we'll give our FY '07 guidance at the next quarterly call.

So we won't be providing that guidance.

However, our prior uses of cash remain the same, and that is we'll continue to focus on acquisitions in the advanced materials space primarily.

We'll continue to look at the buyback of minority interest where it makes sense.

And those are the top priorities for uses of cash to return that earnings per share.

And obviously, we'll evaluate the other things -- additional share repurchase, dividends.

We are evaluating a pension contribution, etc.

Let me ask it another way.

If you can't find any acquisitions, are you going to remain patient and just keep the cash on the balance sheet, or would you do something else in the meantime?

I mean, what's the acquisition environment like right now?

Phil, this is Carlos.

First of all, I would like to remind you that of all the acquisitions we have made in the last 24 months are at a much higher EBIT percentage than J&L consistently.

So we have demonstrated that we can find properties out there in the AMSG space as we have been describing that can deliver those.

And relative to being patient about acquisitions, yes, we will be patient with acquisitions, because we are going to make the right acquisitions.

They have to be strategic.

And as you know, mergers and acquisitions is one of the six processes of our Kennametal Value Business System.

So there's a lot of discipline around that.

(technical difficulty) [Having] said that, there are properties available, and we do have a disciplined process.

We have at any one point in time anywhere from 10 to 15 companies in our pipeline.

So we're constantly looking at acquisitions that are strategic for the Company and meet our strategic goals.

As you know, it's very difficult to forecast acquisitions.

But at this point, we feel good about the environment.

Mark Koznarek.

FTN Midwest. (multiple speakers) A special hello to Frank Simpkins -- it's been awhile that you've been on one of these.

Hello, Mark.

Okay, question -- I just want to make sure -- this is more of a clarification.

None of these properties that you have announced that are going to be divested, there are -- nothing held as discontinued operations.

They all contributed to this quarter.

Is that correct?

That is correct.

Now would you mind going through, since a high-speed steel and the electronics are somewhat imminent, can you go through with us what kind of revenue deduction we should be making from our estimates?

And you know, you did comment on the impact of the absence of losses from high-speed steel.

Can you do the same thing with the electronics -- just to give us some benchmarks here?

Yes, magnitude and scope -- the UK high-speed steel business was not a positive contributor to our earnings.

And it was in the 10 million-ish range annually.

So it's very small.

And with regards to electronics, it was in the 30 million-ish range annually saleswise, so not significant there.

And it was also not a contributor to earnings.

Were they actually losses?

I mean, it seems like high-speed steel was, if it contributes to margin by its absence.

Yes, they were slightly.

Both of them -- okay.

Then second one is -- can you comment on the environment here for your key raw material, tungsten?

I noticed the spot price during the course of the quarter rose.

So far this quarter, it is falling back.

There has been some new supply that's coming into the market.

Can you make any kind of comments on tungsten for us?

This is Carlos, Mark.

You know the tungsten -- as you stated in your question is very volatile.

It's really hard to protect.

It has stayed in a 270, plus or minus $10.

And it has gone up and down.

So we still feel that there's an opportunity for the tungsten towards the summer to come down as new raw material is available and as the summer months come about.

We experience that every year.

So it's really hard at this point for us to predict what the raw material is going to do.

But you know, again, in our projections, we project the volatility that we have experienced so far year to date.

Okay, and then just a finer minor question here, hopefully, is what tax rate should we assume for the fourth quarter, given how it's been moving around during the year?

Yes, good guidance for fourth quarter would be 34%.

Joel Tiss.

I wonder -- can you be a little more specific on the return on capital?

And also maybe just stretch it out to longer-term?

There's a lot of changes going on; you're obviously aggressively reshaping the portfolio.

Can you give us a sense of maybe where can return on capital get to over the next five years?

And even with only one quarter left, you gave us a range of 10 to 12%.

It seems like you could be a little more precise than that at this point.

This is Carlos.

In the five years, obviously, we have been open and talked about that we have a goal of 12% return on invested capital by '07.

And I believe that in the next five years, we can get to 15% return on invested capital.

Relative to the quarter --

Yes, you know, we use a [five-point] moving average on ROIC.

So it's not going to move much at all this year.

And we'll provide good solid guidance into '07 when we provide guidance next quarter.

Can you also give us a sense why you're cautiously optimistic?

It seems like everyone else is just straight-up optimistic.

And I just wondered if you could give us a sense of what you're seeing in some of your end markets that would get the word "cautiously" to enter your sentence.

We feel very good about our end markets, as I said in my -- earlier on.

I think that as you know, our fiscal year is different than our calendar year.

So our guidance is just for this quarter.

But we feel very strongly about the end markets.

And we do have some volatility, as I talked earlier, in the tungsten.

And that's the level of -- if you sense -- any hesitation is based on those two elements.

We also -- as you have noticed, Europe has gone up and down.

We had a good third quarter in Europe.

But in the first half of the year, of our fiscal year, we didn't grow as much.

And if you looked at the latest estimates for '07, calendar year '07, they show a growth of 4%.

But again, the European market is one that we need to watch very closely and see what's happening there.

So that's -- by end markets, we feel very good about.

So there's nothing in April that would insert the word "cautiously"?

No.

No.

Eli Lustgarten.

(multiple speakers) clarification -- you did say fourth-quarter tax rate was 34%?

Correct.

Do you have any feel for what tax rate 2007 looks like?

Is there any reason it would be different than 34, 35%?

You know, we'll give all of our full guidance in our next quarter call for '07.

That will be the time to direct it there.

All right, [will the] foreign currency affect earnings in the quarter at all?

You know, our foreign currency hedging program is very good at protecting our earnings guidance ranges.

But we don't try to protect the year-over-year changes.

And so that's where you will see some movements, but we always contemplate that in our hedging program at the beginning of the year.

Were there any gains or losses on the programs in the quarter -- I mean, affected earnings at all (multiple speakers)?

We had a translation effect -- a negative FX translation effect -- small.

Okay.

And can you give us an idea what pricing was in the quarter in each of the divisions and with the retail gains and things?

How much was pricing [in each sector]?

Obviously, because of competitive concerns there, we're not going to give you by sector.

Overall, pricing continues to be very solid for us.

And we remain at the higher end of our ranges and expectations there.

I guess the question I was going to follow with is what kind of pricing carries over into 2007?

When do you anniversary most of these price increases? (multiple speakers)

We'll actually go into a good part of '07, because we just recently went into Europe.

We consciously [through] strategic pricing delayed our European increases to be consistent with the competitive space.

And so we won't lap full 100% pricing for -- gosh, until the same quarter next year.

Till January of next year.

Okay.

And what was the magnitude of your [European] price increases?

We don't do an average.

And we may not have shared that with you yet, Eli.

We do strategic pricing.

And so we don't do an average x percent across the board anymore.

We do our pricing literally based on customer, our market position, the tungsten content in that product, what the competitive landscape.

And then all of those factors determine -- we could go up a substantial amount, or we could stay flat on an individual product.

I think the fact that we do strategic pricing is one of the major elements of our success in pricing.

So we're very cautious about being very detailed about our strategic pricing, because it obviously has a lot of competitive implications, because we --

[I see].

And one final question -- can you talk about the levels of inventory, particularly at distributors at this point?

I guess I don't know what you're trying to get at.

I'm just trying to find out whether -- demand has been quite strong, (indiscernible) quite strong, there's plenty of product available in the field, both with direct sales and with distributors sales.

Are things relatively in balance?

Are things -- [in short], just give me some idea of what's going on in the (multiple speakers)

Eli, our distributors typically don't carry a lot of inventory.

They like to -- actually in some cases, they place orders with us, and we ship directly to their customers.

So I feel that the supply chain, if you want it call that, is pretty lean.

Walt Liptak.

The growth rate that you had in AMSG is pretty good.

And I realize it was price and volume.

I wonder if you could breakout how much is price, how much is volume?

Across the Company, we're about 60/40 -- so 60 price, 40 volume across the Company.

Okay.

And in the energy business, up 56% -- was there any special price initiative, or could you comment on the growth in your energy markets?

Our price initiative was across the board.

So it was consistent in all units.

And you know, the energy market segment is just doing very well.

So we continue to gain market share, and the market continues to be very good.

Okay.

And at this point, with the divestiture of J&L, we don't have a specific close date -- or do we know if it's going to happen mid quarter, towards the end of the quarter?

Our expectation right now is at the end of the quarter.

Okay, so all the revenue and profit will be in pretty much for the full quarter [other] in 2007?

Right, that's our expectation.

Okay, and when you commented on acquisitions, you mentioned that you're looking for advanced materials source of acquisitions with higher margins.

I think there were a couple of assets for sale in traditional metalworkings.

Are you saying that you wouldn't be looking at those as possible acquisitions?

Our strategy, Walt, is that we are going to focus on the advanced materials because our long-term strategy is to have advanced materials to be the same size as metalworking.

And so we're going to focus in that business.

However, in the metalworking business, we will do some bolt-on acquisitions that would help us be more competitive in the marketplace.

Andrew Casey.

Prudential Equity Group.

Just a follow-up question on Eli's, and just a little bit different.

Are you seeing any of your leadtimes extend or contract?

Leadtimes from what point of view, from --

Suppliers or customers?

Customers.

No.

I mean, there really hasn't been any change on that at all.

Okay.

And then in terms of the material costs, are you locked in for tungsten at the end of '05, or do you have some sort of index?

If you could remind me of that?

Yes, our tungsten -- we do buy the majority of our tungsten from a supplier that correlates with the index.

However, we buy it at a lower price than the index.

So we always guarantee two things.

One, we guarantee supply.

Number two is we guarantee that we are buying at lower than the market.

And that is a long-range contract.

It does not end in our fiscal year '05.

We also buy on the spot market a smaller portions, and we buy directly from China -- again, smaller portions.

At this time, there are no further questions.

Mr. Cardoso, please proceed with the closing remarks.

Thank you.

In closing, we are very pleased with our third-quarter performance.

This quarter, we delivered great results, while we worked on portfolio management to position this Company to continue to grow topline and deliver good financial performance in the future.

We feel confident of continuing this momentum into the remainder of the fiscal year 2006.

Thank you.

This will conclude our discussion.

Please contact me, Quynh McGuire, at 724-539-6559 if you have any follow-up questions.

Thank you for joining us today.

Thank you for participating in today's Kennametal third-quarter fiscal year 2006 earnings conference call.

This call will be available for replay beginning at 1 PM Eastern standard time today through 11:59 PM Eastern standard time on May 10, 2006.

The conference ID number for replay is 822-7641. (OPERATOR INSTRUCTIONS) The number to dial for the replay is 1-800-642-1687 or 706-645-9291.

You may now disconnect.