Kennametal Inc (KMT) 2007 Q2 法說會逐字稿

Good morning.

My name is Shante and I will be your conference operator today.

At this time I would like to welcome everyone to the Kennametal second quarter fiscal 2007 earnings conference 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 will now turn the call over to Ms. McGuire.

Ma'am, you may begin your conference.

Welcome everyone.

Thank you for joining us this morning to review Kennametal's second quarter fiscal 2007 results and our outlook for the remainder of the fiscal year.

We issued our quarterly earnings Press Release this morning.

You may access this Press Release via our website at www.kennametal.com.

Consistent with our practice and prior quarterly conference calls, we have invited members of the media to listen to this call.

It is also being broadcast live on our website where the replay will be archived for ten business days for your convenience.

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

Joining me for our call today are President and Chief Executive Officer, Carlos Cardoso, Vice President and Chief Financial Officer, Frank Simpkins and Vice President Finance and Corporate Controller, Wayne Moser.

Carlos and Frank will provide details on the second quarter's operating and financial performance as well as our outlook for the remainder of the fiscal year.

After their remarks we will welcome your questions.

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

The discussion we will have today contains comments that may constitute forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995.

Such forward-looking statements involve a number of assumptions, risks and uncertainties that could cause the Company's actual results, performance or achievements 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 Kennametal's filings with the Securities and Exchange Commission.

In addition, Kennametal has provided the SEC with a Form 8-K, a copy of which is currently available on our website.

This enables us to discuss non-GAAP financial measures during this call in accordance with SEC regulation G. This 8-K presents GAAP financial measures that we believe are most directly comparable to those non-GAAP financial measures and it provides a reconciliation of those measures as well.

I'll now turn the call over to Carlos.

Thank you, Quynh, and good morning.

I would like to remind everyone of the appointment of Frank Simpkins to the position of Vice President and Chief Financial Officer.

As you know, Frank has held a range of increasingly senior financial posts with Kennametal over the past eleven years.

His most recent promotion is a clear evidence of Kennametal's exceptional bench strength as well as the success of our talent development program.

As you know, talent development is the key part of our management operating system for the Kennametal value business system.

Let's now turn our attention to Kennametal's solid performance in the second quarter of fiscal 2007.

I am pleased to report that we delivered on our commitment for sales growth and exceeded our expectations for earnings per share and return on investment capital.

This performance represented a record December quarter for sales and for adjusted EPS and ROIC.

With those collective results we extended our track record of consecutive quarterly growth, another notable achievement of which we are very proud.

We also had another quarter of strong cash flow generation.

We attribute those results to our focused strategies, which we implemented by applying the disciplined processes of KVBS or Kennametal Value Business Systems.

Our proven strategies will help us continue to grow over the long term.

As part of our strategy we continue to transform Kennametal into an enterprise that is well diversified in terms of overall business mix.

We believe that this transformation will lower our dependence on a single sector and reduce the impact of the economic cycles of our business.

We continue to make progress toward this goal during the second quarter by driving steady performance in our core Metalworking and Advanced Materials businesses and growing each segment to achieve more balanced portfolio.

At the same time, we continue to successfully diversify Kennametal's global footprint and customer base with the goal to reduce our reliance on a specific geography or customer.

We expect this diversification will enable us to tap into new opportunities in rapidly growing economies and help us to serve the needs of our globally expanding customers.

During the second quarter of fiscal 2007 we saw continuing moderation in the North American market, which was reflected in the ISM trends.

However, European markets trend nicely and there was solid growth in our rest of the world emerger markets such as India and China.

The fact that we are diversified both geographically and in the markets we serve clearly helps to offset the impact of sluggishness in certain sectors and regions of our business.

We also experienced continued growth in a number of served markets such as distribution, aerospace, energy, mining and general engineering.

Other sectors such as auto, heavy truck and road construction continue to be soft, as we had expected.

It's important to note that we achieved organic sales growth of 6% during the second quarter despite economic headwinds.

We also fully replaced the sales and earnings contribution from our recently divested J&L business unit just 7 months after the transaction closed, much sooner than the 12 to 24 months that we expected.

In addition, we grew adjusted earnings per share by 8% even after making further investments to streamline our manufacturing footprint and better position our business for future growth.

Those accomplishments demonstrate that Kennametal is strong and resilient enough to mitigate challenging market conditions and that our diversification strategy is working.

The fact that we are a fundamentally different Company than we were several years ago helps to assure our ability to deliver profitable growth.

During the quarter we also continued to lower our cost structure in a steady and disciplined way.

This resulted in lower operating expenses or SG&A on a year-over-year basis.

In fact, this is the fourth consecutive quarter of year-over-year lower operating expenses as a percentage of sales.

We also made much progress in our planned facility closure as part of our ongoing efforts to streamline our manufacturing operations.

This measure reflects our commitment to making strategic investments today to lower our costs and strengthen our business for the future.

In addition, we continue during the quarter to develop and deploy new technologies that drive sales from new products.

Our relentless focus on this effort enables us to grow our core business and create new markets.

Another top line drive is our channel and branding initiative, which is proceeding according to plan.

We are continually adding new distribution partners to increase the quality of coverage in the marketplace for Kennametal's products.

The recent announcement of our agreement to acquire Federal Signal's cutting tool business is a good example of our strategy to bring additional value to our businesses.

This transaction will simultaneously enhance our portfolio and strengthen our distribution coverage.

Although small, we expect this to add strategic value to our metalworking product offerings and to provide an opportunity for us to leverage those products globally.

In addition, it will further support our go-to-market strategy because much of the acquired business is currently sold through distribution channels.

Additionally our strong cash flow generation plays an important role in our transformation.

It allows us to invest in multiple ways in our Company's future.

We have the financial flexibility to make strategic acquisitions in our core businesses and to take advantage of opportunities to increase our ownership of affiliates in key markets, which presently have minority interests.

In summary, Kennametal continues to achieve strong overall growth and to deliver healthy top line results, earnings growth and substantial free operating cash flow on an adjusted basis.

Again, we attribute our success to our strategy to diversifying our business mix, geographies and end markets, proven strategies that have served Kennametal well over the past few years.

I'll now turn the call over to Frank so he can discuss our results in greater detail.

Thanks, Carlos, and good morning.

I'll provide further comments on our performance for the December quarter and I'll move on to the outlook on the remainder of the fiscal year.

Overall we had a big quarter in terms of growth with the focus on margin expansion including operating expense reduction, as Carlos had mentioned, and we continued to generate strong cash flow.

During the quarter we completed the divestiture of our Electronics business.

Included in our discontinued operations was an impairment charge of $3 million or about $0.08 a share related to a building that was owned by Electronics and not included in the original transaction.

This essentially completed the divestiture of the Electronics business and, therefore, we have finished with all of our planned divestiture activities that we embarked in last year.

Our remaining comments will exclude the impact of the Electronics charge for the December quarter, which relates solely to our divestiture activity.

Also, there were now special items in the prior year quarter and you can refer to the reconciliation schedules that we provided in our earnings Press Release or related 8-K for additional information.

So to summarize the quarter, reported diluted earnings per share for the second quarter of fiscal 2007 were $0.77.

Adjusted earnings per share, which excludes the impact of the Electronics divestiture, were $0.85 a share, an 8% increase over last year.

As we noted in our Press Release, the recently enacted extension of the research, development and experimentation tax credit contributed $0.04 per share of a tax benefit in the quarter.

The RD&E tax benefit was not considered in our earnings guidance for the quarter.

Now I'll walk you through the key items of our continuing operations in the income statement.

For the December quarter our consolidated sales were 569 million compared with 563 million in the same quarter last year.

Our sales grew 6% on an organic basis, offset by the net impact of acquisitions and divestitures, primarily the divestiture of J&L.

As a reminder, J&L sales were 65 million in the December quarter last year.

The 6% organic sales growth is in line with our prior guidance and represents the 38th consecutive month of organic growth.

Turning to the margins, our gross profit margin was 34.8% compared with 35% in the prior year quarter.

Costs related to a plant closure were 2.6 million, which reduced our gross margin by about 50 basis points.

In addition, we also experienced higher raw material costs in the current quarter.

Plant closure costs did not have a tax benefit and approximated $0.07 a share in the quarter.

In our previous guidance we had anticipated closure costs of approximately $0.10 per share in the December quarter.

We expect to incur the remaining closure costs of approximately $0.03 in the March quarter.

Similar to last quarter, the prior year gross margin still had some benefits from higher than expected price realization coupled with lower raw material costs and, as we said last quarter, the year-over-year change in raw materials is expected to dissipate and therefore lead to margin expansion in the coming quarters.

This has developed as expected and accordingly our margins were up 30 basis points year-over-year and improved sequentially from the first quarter by 80 basis points after adjusting for the plant closures.

Moving to operating expenses, as Carlos said that he actually decreased 2% or $2 million to $140 million, due primarily to the net impact of acquisitions and divestitures, partially offset by higher employment costs primarily driven by our SG&A initiatives and we had unfavorable foreign exchange effects also.

Operating expenses as a percent of sales decreased 80 basis points to 24.6% from 25.4% in the prior year quarter.

And, as Carlos said, this December quarter represents the fourth consecutive quarter of year-over-year improvement as a percent of sales.

Our amortization expense increased $0.5 million to $2 million in the current quarter due primarily to acquisition and our operating income was $56 million, up $3.3 million or 6% from the prior year quarter.

The corresponding margin was 9.8%, an improvement of 50 basis points from the prior margin of 9.3%.

The costs related to the plant closure unfavorably impacted our operating margin performance by 50 basis points as well and additionally J&L contributed $6 million in operating income in the prior year quarter.

Our other income decreased $500,000 from the prior year quarter as a result of unfavorable foreign exchange effects but this was partially offset by lower cost receivable securitization fees related to our priority uses of cash in the prior fiscal year.

Interest expense came in at $7 million.

That's down 9% from last year's comparable quarter.

Our interest rates on our domestic borrowings were 7%.

That's up from 5.2 last year but our average domestic borrowings were down by about $174 million.

And as reported, the effective tax rate for the quarter was 30.5% compared with 31.4% in the prior year quarter.

This reduction reflects the $0.04 per share tax benefit related to the extension of the RD&E tax credit, partially offset by the non-deductible plant closure costs.

But we also continue to reap benefits from our pan European business strategy.

Turning to our balance sheet, that continues to be good as well as our cash continues to be strong.

I'm also pleased to note that our adjusted return on invested capital increased 110 basis points to 11.1% from 10.0% last year.

Our cash and cash equivalents, we finished the quarter at about 114 million.

That's down 120 million from June 30th and that's primarily due to acquisition activity, share repurchase and tax payments related to the J&L sale and the American Jobs Creation Act.

Our primary working capital came in at $618 million, an increase of $21 million from $597 at the end of June and that was primarily attributable to higher inventory, lower accounts payable offset by lower accounts receivable, and there's obviously effects from the acquisitions in those numbers.

Cash flow from operations was $36 million for the first half of the fiscal 2007 compared with $76 million in the prior period.

Included in our fiscal 2007 first half cash flow from operations were income tax payments of $86 million primarily due to the gain on the sale of J&L and the cash we repatriated in 2006 under the American Jobs Creation Act.

So adjusted free operating cash flow excluding the effects of these income tax payments was $78 million versus $45 million in the prior year period, reaffirming our ability to generate very strong cash flow.

During the first half of fiscal 2007 we also invested $77 million for two acquisitions in AMSG.

We received cash proceeds of $10 million from the divestiture of J&L and $20 million from the MSSG divestiture of CPG.

Capital spending during the period was $45 million versus $31 million in last year's period.

In terms of acquisitions, we still expect the Federal Signal acquisition cutting tool business to close at the end of January for the previously disclosed purchase price of around $67 million.

During the December quarter we also repurchased an additional 252,000 shares at a total cost of $15 million and this brings our total repurchases for the first half of 2007 to 431,000 shares at a total cost of $25 million.

Additionally, as announced today as well, our Board of Directors declared a regular quarterly dividend of $0.21 per share.

Turning to the business units, and again all sales comparisons will be in constant currency and adjusted for the impact of acquisitions and divestitures, turning to MSSG they continue to deliver top line growth met by year-over-year expansion and distribution, aerospace and general engineering markets.

The North America market continued to moderate while conditions in the European market continued to improve and Asia Pacific and India delivered solid growth.

In the December quarter MSSG sales were up 5% on an adjusted basis.

Our European sales increased 11%.

North America sales were up 1 and Asia Pac and India grew 6 and 7% respectively.

MSSG's operating income was up 6%.

The operating margin of 12% was lower than the same period last year, due primarily to the cost associated with the plant closure and SG&A initiatives in the current quarter, partially offset by ongoing cost containment.

The costs related to the plant closure reduces MSSG's operating margin performance by approximately 70 basis points and additionally we did have some-- experienced higher raw material costs.

AMSG continued to deliver top line growth driven by favorable market conditions and the effect of acquisitions.

Strong growth in the energy and mining markets continued to contribute to AMSG's results.

AMSG sales grew 10% on an adjusted basis.

Energy product sales, including Conforma Clad, were up 35%.

Mining construction product sales were higher by 8 and Engineer products increased by 2%.

AMSG's operating income grew by 15% over last year, while the operating margin of 17% was lower due primarily to the higher raw material realized cost in the current quarter, partly offset by the effects of some acquisition and some new product introductions.

Now I'd like to look ahead to the remainder of the fiscal 2007 year.

Global market conditions support our expectations of continued top line growth during the balance of fiscal year 2007.

Based on the global economic indicators, we believe that the moderation in the North American market will persist in the near term.

We also believe that the European market will continue on a positive trend and that business conditions will continue to be strong in developing economies.

While there remains some uncertainties and risks related to the macroeconomic environment, fundamental drivers for growth demand appear to be stable.

We expect organic growth in the 6 to 7% range for the full fiscal 2007 year, which would further extend our track record of consistently outpacing worldwide industrial production rates by two to three times.

We anticipate that many of our end markets will continue to operate at favorable levels throughout the fiscal year with moderating growth rates for some region and market sectors.

For the third quarter of fiscal 2007 ongoing expansion around the globe supports our projection of 6 to 8% organic sales growth on top of strong performance in the prior year quarter.

We also expect a similar sales growth to occur in the fourth quarter.

Our guidance for adjusted EPS for the full fiscal year is in the range of $4.40 to $4.50.

We believe this earnings outlook reflects our confidence in our ability to continue delivering solid financial performance and on a comparable basis the fiscal 2007 guidance midpoint represents a 31% growth rate, a substantial increase over the prior year for adjusted EPS and continuing operations of $3.41.

We expect the third quarter 2007 earnings per share to be in the $1.25 to $1.30 range.

The third quarter 2007 guidance includes approximately $0.03 per share of cost related to the completion of the plant closure initiated in the December quarter, which is expected to have a pay back within the fiscal year.

We expect to achieve our goal of 12% EBIT margin and return on invested capital is also on track for the projected 11 to 12% range for fiscal 2007.

As we move forward we will maintain a strong focus on our balance sheet and cash flow generation.

We anticipate reported cash flow from operations of approximately $190 million to $200 million for fiscal 2007.

Included in this amount are the income tax payments of $86 million, as previously mentioned, so adjusted cash flow from operations is expected to be approximately $275 million to $285 million.

And based on anticipated capital expenditures of $90 million, we expect to generate between $185 million to $195 million of adjusted free operating cash flow for fiscal 2007.

At this time I'd like to turn the call back to Carlos for some closing comments.

Thank you, Frank.

We are pleased that we delivered a solid financial performance during the second quarter.

In doing so we demonstrated that we have strong operating leverage and effective cost control measures that enable us to deliver on our commitments for earnings per share, margin and return on invested capital.

Top line growth is just one component of our investment strategy.

We anticipate that we will be able to offset the effects of moderation in the North American market and we continue to expect that we can outperform industrial production by two times in developed markets and three times in developing economies.

As we have said before, we have multiple levers within our control that we can pull in order to achieve our goals.

If appropriate, we have the opportunity to implement certain cost initiatives faster depending on our business conditions.

The challenges that exist for the near term relate to factors that we cannot control.

Our proven strategy, however, is helping to lessen the impact of the cycle.

Even with some deceleration in growth, we still operate in an environment in which we can continue to gain share in the marketplace.

This is due to our ability to provide secure value to customers, a critical part of our competitive advantage.

We expect Kennametal's strong forward momentum to continue into the third quarter and throughout the remainder of fiscal 2007.

We are on track to achieve our goal of 12% EBIT margin and 11 to 12% return on invested capital by the end of this fiscal year.

Our next milestone will be 15% EBIT margin and 15% return on invested capital by the end of fiscal year 2009 and we are well positioned to achieve this long-term goal.

We will maintain a sharp focus on using cash specifically in ways that will increase shareholder value [inaudible] as [inaudible] through our share repurchase program.

However, we also expect to tap into our healthy acquisition pipeline in an opportunistic way seeking prospects that offer an excellent strategic fit, primarily in Advanced Material segments with some bolt ons in the metal working market.

We'll continue to take advantage of our strong cash flow generation, which provides us with the necessary financial flexibility to build our portfolio when appropriate opportunities arise.

As we move into the second half of fiscal '07, we are confident that we have what we need to execute our growth plan, transform our enterprise into an even more balanced diversified organization and deliver sustainable long-term growth.

Thank you for participating in the call today.

At this time, we would be happy to take your questions

[Operator Instructions] Your first question comes from the line of Mark Koznarek.

Hi, good morning.

It's [Adam Allman] filling in for Mark today.

The first question I had for you is on the revised guidance for the year, specifically the sales growth guidance outlook has been taken down from 7 to 10% growth to 6 to 7% growth and I was wondering if you could discuss what vertical end markets or geographies led to the downward revision and if you could also talk about the revenue growth outlook for some of your key verticals like automotive and heavy truck, coal and oil and gas?

Adam, this is Carlos.

We want to cover some of the markets that led to our outlook to go down from 7 to 10% to 6 to 7.

Auto is one of the markets that we see continue to be sluggish over the balance of our fiscal year.

Trucks and off roads will continue to decline and the construction part of our business will continue to decline.

So based on those factors and those markets we feel that we can still get pretty good growth, 6 to 7%, in spite of the headwinds that we have in overall North America economy.

But we feel very comfortable that we have other markets in other geographies that are going to offset our position to the point to where, again, we can obtain the 6 to 7%.

Any change in the outlook between Europe and North America?

You had mentioned that you expect North America to continue to moderate.

Are you looking for sales declines then in the second half?

No.

Relative to North America we aren't expecting, as we have done in the first half of the year, to continue to have growth but at a much lower level that we were experiencing in the past.

We anticipate that Europe is going to continue to be strong going forward at similar levels that we had in the first half and particularly in the third quarter.

And then Carlos could you talk about what you're seeing so far in the order book for January?

Has it continued at what you saw in the fourth quarter?

Are you seeing things pick up or slow down?

Adam, I apologize but we really cannot talk about the third quarter at this point.

Just remember the guidance of 6 to 8 basically reflects what we feel is going to happen for the quarter.

Understood, thanks.

The next question comes from the line of Joel Tiss.

I wonder two areas like the last question, can you dig a little deeper into the raw material cost picture, maybe a little bit on what's happened but more on what we're looking for going forward?

And also, can you get more specific on where the cost reductions are coming from and you alluded to having more cost savings up your sleeve, etcetera.

Can you just give us a little more sense on exactly where they're coming from and exactly what you guys are thinking about even over the next year or two?

Yes.

You know Joel from a raw material perspective going back to the year-over-year comparisons first, last year as we talked on the last call we got the additional price acceleration and we still had some lower raw material cost as we burned through our inventory.

We didn't get the full price effect built into it.

So last year in the first half we had some I'll call relatively easier comparisons on the raw material costs.

Those raw material costs increased in the third quarter and the fourth quarter of last fiscal year and where we're at now from a tungsten perspective it appears that the costs are somewhat stable.

They've been that way for the past four to five months at the 250 range for tungsten.

The only raw material, and this is a lot smaller component, that's up significantly on a year-over-year basis would be some cobalt.

But if you take the outlook for the raw materials on tungsten, which is the key driver, we expect that to be stable for the rest of the fiscal year.

And then kind of on the cost reductions I'll call it the plant closing is going as planned from a cost of goods sold perspective, but we continued to benefit on the-- I'll call it cost reductions on the SG&A side from both a channel shift perspective or go-to-market shift in some back office functions from both the European and a North America perspective.

So that's where we continue to consolidate some of the back offices and try to rationalize or realize some inefficiencies that we have and benefit from some of the acquisitions that we did late last year and the early part of this fiscal year.

So the raw material cost would be stable and we continue to focus on the SG&A and take advantage of our channel diversification model.

And Joel the only addition that I would make is that the fact that I've always talked about the fact that if we were growing in the upper end of the range that we gave you top line, obviously we couldn't pull the lever of cost reduction as hard.

As we look into a growth rate of 6 to 7% we now have the ability to look at our manufacturing footprint and our SG&A to be able to push that lever a little harder and that has been the strategy I have been communicating to you guys all along.

And then, Joel, the other small point I would add is we continue to leverage the lean benefits predominantly in the manufacturing arena, but as we start taking these concepts and principles into the-- I'll call it SG&A side, we're finding that we can do more with existing population and get additional benefits from utilizing lean through the Corporation's goal of greenbelts being about 3% of the population.

Okay and just to glue two more questions together on a follow-up, can you talk about why the inventories were up 7.5% in the quarter, well I guess the first half of the year?

And then can we get a little more specific on mining as well, what's happening there?

There's a lot of talk about a slowdown in coal.

Do we expect that to go closer to zero over the next 6 or 12 months as more mines are closed?

Thank you.

On the inventory side, Joel, we did Sintec the acquisition July 1st of the fiscal year and we did the Camco acquisition September 1st, so we actually had some acquisition effects in there, which is a good chunk of it, and the related part of it is valuation.

We have some foreign exchange impacts there as well.

Joel, relatively to the mining, we again expect that to moderate, but at this point we don't see it coming to zero.

We still see a moderate growth opportunity for the balance of the year for us.

Walt Liptak.

Congratulations on a nice quarter guys.

My question is first about guidance for the third quarter, for the March quarter.

If we take the mid point of the range, it's below where my numbers are and I think where the Street consensus is and it also means that to get to the mid point of your full year you would be at like $1.55 for the fourth, which would be about 35% of your total EPS for the year which is seasonally high.

I wonder if there's any incremental costs that you're expecting in the third quarter?

Are there costs related to the Federal Signal tool acquisitions or is it related to the North American slowing?

Walt, we've excluded the effect of-- I'll call it the acquisition, so the guidance is clean and we would appreciate accretion from that as we've said.

Remember in the third quarter we'll have the remaining costs associated with the Pachuca plant closure, which will not reoccur in the fourth quarter and, as we said, we'll start realizing a lot more benefits from the plant rationalization and as well as some of the SG&A initiatives that we started in the first half of the fiscal year will start to pay some benefits in the second half as well.

And if you look at from an apples to apples base, we grew the fourth quarter last year about the same percentage, so it is an impact from a seasonality point of view as well as the investment that we made in the second half of the year that we said that will be neutral for the year, we'll actually get some benefits in the fourth quarter.

So you're saying that the growth rate that you're looking for the fourth is similar to what you're looking for the third.

Is that the way you're looking at it?

Can you repeat that, Walt?

I'm not sure I understood your last comment.

Are you talking about the growth rate for the fourth quarter you're expecting it to be the same as in the third?

No, the earnings growth in the fourth quarter is very similar to the earnings growth of last year's fourth quarter.

So when you look at what is our ability to make the fourth quarter and why is 30%, as you said the growth, basically we did the same last year and this year we have a slight advantage because we made some investments in the first half of the year that will pay in the second half of the year.

What type of tax rate should we be using for the third quarter?

Tax rate, Walt, it's still in the 32 to 33% and that's basically where we finished.

We actually closed the second quarter if you take into consideration the benefit from the RD&E and the cost to close the plant which were non tax deductible we would have been right, almost right smack in the middle of that range, so I would use that as we go out.

So the tax rate's up a little bit sequentially.

And then going back to the question about inventory, I wonder people have been talking about the inventory build over the last four or five months.

Have you seen inventories build and getting reduced with your customers or within the distribution channel?

No.

As a matter of fact, Walt, let me answer that in two ways.

The distribution channel we're actually seeing that our distributors are looking to get more inventory from us at this point and because we do have a lot of distributors that came on line this year.

And from our customers' perspective we really have not-- I think they have done a good job in our second quarter of depleting their inventory, which leads us to believe that somewhere in the second half of the year we're going to see some benefits from that.

Eli Lustgarten.

I'm just going to go over some groundwork to make sure that I understand.

You reported $0.85.

There was $0.07 in it from the plant closing, so it was $0.92 less the $0.04 for the R&D tax credits, so it's really $0.88 number versus the previous guidance.

That's correct right?

Well, Eli, how we did it we provided guidance of $0.70 to $0.75 for the second quarter and we said that that included the closure costs related to the manufacturing facility.

So what we're saying is the adjusted is 85.

If you take out the electronics and you're going to consider how you ever do it with the taxes of a $0.04 benefit, but the Pachuca cost or the manufacturing cost related to the plant closure is already embedded in our $0.70 to $0.75.

We've never excluded that.

Yes.

I guess I want to make sure because the guidance that you're using versus an $0.85 number in the second quarter and an $0.82 number in the first quarter from what I gather because you have $1.67 for the first half adjusted.

That's correct?

Correct.

So they restated the first quarter up a couple of pennies by readjusting all these charges?

Yes and that's when we took the guidance up for the-- you know we started the year at a higher tax rate and that's when we took the tax rate down in the first quarter and we increased the guidance from 4.20 to 4.40 to the 4.30 to the 4.50.

Okay, so we've got that.

And the R&D tax credit is a one shot deal; you don't get it for the rest of the year for the 32 to 33% tax rate?

No.

We may get a penny, but you know it's so hard because to try to predict the tax rates.

If you think about the $0.04, that's for a full year because the results went back to the beginning and $0.04 if you divide it by four you get $0.01 per quarter, but there's stuff that could go both ways, so at this point I wouldn't dial everything in at this point.

Eli, I would look at the $0.04 as a one time hit.

Okay I just wanted to make sure.

Now, the third quarter you're guiding the essential is a little over volume, in your outlook do you have anything in your numbers for FSS, for the Federal Signal acquisition at all?

No, we didn't put that in.

Okay so the 6 to 7% is a pure organic kind of number and the difference because I guess the consensus would be more like around $1.38 for the quarter or high $1.30s and you're implying about $1.30 if you ex out the charge $1.31, so the difference is strictly North American weaker markets at this point?

Yes, we would adjust the carryover of the plant closure cost of $0.03 and then exactly to your point.

It's a little off timing Eli.

I mean it's the timing of all the initiative of we have and the payouts.

Can you give us some magnitude of what kind of benefit you expect out of SG&A initiatives in second half of the year and maybe some idea of where do you expect the SG&A as a percent of sales to wind up for the year or as a run rate or what kind of progress are we making on that lever?

Yes, I think our goal at the beginning of the year was to take 100 basis points off for the full fiscal year and we said in New York, as you know, we'd have a net $5 million cost impact in the numbers and we're going to continue to implement them whether it's in the third quarter or fourth quarter to make sure that we're benefiting for the next fiscal year.

But to really quantify it, that was built into the guidance that we provided, the 4.30 to 4.50 and it basically had about 100 basis point reduction and I think that's where we're at at this point.

So is there any change in the average shares outstanding in your calculation for the rest of the year?

Right now I would assume flat at the 39.2 and that's consistent with the first quarter, obviously down year-over-year, but I would just assume that.

Steve Barger.

It's Joe Botts on for Steve this morning.

I have a quick question about your MSSG business in China and India.

Can you give us some color on why revenue growth declined sequentially from a low teen percentage in 1Q to a mid single digit percentage in 2Q?

Yes, first of all let's talk about India first.

That was purely some timing issues.

We'll get that back in the third quarter.

You know we have some large packages that a key customer originally thought that they would need in the second quarter, which will basically happen in the third quarter, so that was a pure timing issue.

And then on a year-over-year basis the Asia Pac December quarter last year had a very good compensation with some automotive packages, particularly on the diesel side, so we had a very tough comp.

We expect that to get back to the double-digit growth in the third quarter, so nothing unusual our fundamentals, mainly on the timing side.

Joe, we feel extremely good about achieving double-digit growth for the year in India and China, so it is a timing issue as Frank expects, but we have a very high level of confidence in the high double-digit growth in those two markets.

Did you say that was for the year or just for the back half where you can achieve the double-digit growth?

For the back half and for the year.

Also, if you look at the EBIT goals for FY '07 taking into account the performance in the first half, it implies that you are assuming about a 14% EBIT margin in the back half.

Is that correct to assume and generally where is the confidence coming from?

Joe, if you go back and you understand the history of the Company from manufacturing, you know our second half margins always go up substantially on the gross profit side because of the number of work days and then we get the benefit in the manufacturing absorption, so historically that has always come into fruition plus with the lean benefits, the number of plant reductions we have, we feel very confident at the gross margin and the continued acceleration.

The only issue was last year from an anomaly where we had the significant benefits in the first half versus the second half, but when you go back and you look at Kennametal historically you get the full volume absorption benefit in the second half of the fiscal year.

That coupled with some initiatives that we have on our strategies get us to the numbers that you're kind of alluding to.

Yes, again, I continue to remind everyone this is the second year in a row that we make good investments in the first half of the year that have a 12 month payback, so it is actually a headwind for us in the first half of the year, but it also creates a much positive picture for us in the second half.

Can you also break out the price versus volume gains in both the MSSG and AMSG segments?

Price was less than 1% and that was pretty much across the units.

What about-- okay I can just back into the volume then.

That's all for me.

Dana Walker.

Good morning.

I was late on the call.

There are a lot of calls this morning.

Good numbers.

In what time frame would you expect your AMSG profit growth to once again be in line or to exceed AMSG revenue growth in that you've been impaired or impeded by raw materials for a couple quarters now?

The second half of the year.

We should begin to see that in the March quarter then?

Yes.

You may have talked about this in your presentation which I missed in the first half an hour or so of the call, but could you briefly summarize the health and the way that your acquisitions are being brought into fold?

Are they contributing the way that you would like to?

Yes.

Yes.

We have, again as we spoke before, our acquisition process is a very disciplined process and although we have a healthy pipeline on average we walk away from 75% of the companies we look at and that is because of our disciplined approach.

So every acquisition that we have made meets our expectations of being accretive to the overall Company's EBIT margins within 12 months and obviously we have some that have been I would say home runs.

The behavior though of the ones that you included in those six you would define as being--?

Being above our expectations.

Remind us.

Does Federal Signal-- has that closed already or is that yet to close?

It is scheduled to close at the end of this month.

Andrew Casey.

Congratulations, Frank.

A couple clarifications and then I want to go back to the third quarter guidance if I could.

First, I know it's small, but could you help me again with the numbers in the Press Release?

In the text for the quarter adjusted EPS is 85, but back in the financial statements it's 86.

What's the penny difference?

I think the continuing operations there's probably a penny in there or so from the remaining discontinued operations, so that the adjusted EPS you should assume is $0.85 and then adjust for the specific items as we highlighted in the call for electronics and the taxes.

And then, Frank, when you were going through the first half CapEx I couldn't scribble it down quickly enough.

What was that again?

And just so you know if you need it, it is in the Press Release.

The CapEx for the first half it's in the adjusted free operating cash flow.

We said it was 45 million and that compares to 31 million for the six months ended '05.

Okay and then back on the third quarter guidance, I just want to be clear there's no acquisition integration stuff in there for the upcoming Federal Signal acquisition at this point?

Yes, Andrew.

I mean we look at that as neutral.

In other words the benefits and the costs offset each other for this second half.

I understand the second half, but Q3 they offset each other too?

Yes and it will close at the end of January and we'll just be getting it integrated and I wouldn't expect anything significant in the month or so, so it will take a while.

Marty Pollack.

Great numbers and certainly excellent outlook.

If I may just on those targets you're talking about 50% ROIC and EBIT at 15%, if you had to sort of describe that mix of how you get there how much of that is essentially acquisitions driven that you can sort of project and how much of it is actually in the mix of Advanced Materials too?

I mean is that what you need, a much-- an effective robust improvement in both?

Yes, I mean Marty, we always talk about having multiple levers so we never talk specifically about one because, as I said, we can modulate in different ways, but our goal from an acquisitions perspective is that we like to acquire about $150 million worth of sales per year.

Now, you know that forecasting acquisitions is very difficult to do, but that's kind of our objective.

However, the other ways by which we get to the 15 by 15 is through our SG&A reduction, which includes our go-to-market strategy, is through our lean benefits and new product introducing to the market place that will have higher margin and quite honestly new markets that will develop from the Advanced Materials business, as we have been doing all along.

So I cannot go into a specific of one or the other because if I got everything to the extreme positive then we would have something that would not be achievable, so we're trying to moderate so that we feel a high level of comfort to get to the 15 by 15 with the different levers that we have.

At this time, there are no further questions.

Are there any closing remarks?

This does conclude our discussion.

If you have any questions, please contact me, Quynh McGuire, at 724-539-6559.

Thank you for joining us today.

Ladies and gentlemen, this concludes today's conference.

You may now disconnect.