Kennametal Inc (KMT) 2008 Q2 法說會逐字稿

Good morning.

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

At this time I would like to welcome everyone to Kennametal's second quarter fiscal 2008 earnings conference call.

(OPERATOR INSTRUCTIONS).

I would now like to turn the call over to Quynh McGuire, Director of Investor Relations.

Ma'am, you may begin your conference.

Welcome everyone.

Thank you for joining us today to review Kennametal's second quarter fiscal 2008 results.

We issued our quarterly earnings press release earlier today.

You may access this announcement via our website at www.Kennametal.com.

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

It is also being broadcast live on our website, and a recording of this call will be available on our site for replay through February 22, 2008.

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

Joining me on our call today our Chairman, President and Chief Executive Officer, Carlos Cardoso; Vice President and Chief Financial Officer, Frank Simpkins; and Vice President of Finance and Corporate Controller, Wayne Moser.

Carlos and Frank will be provide details on the second quarter financial performance, as well as our outlook for the remainder of fiscal 2008.

After their remarks we will be happy to answer your questions.

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

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 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 will now turn the call over to Carlos.

Good morning everyone.

Thank you for joining us today.

Let's talk about the December quarter results.

We continued to make further progress during the December quarter in terms of EPS and ROIC.

Sluggish conditions in North America, along with lower demand in certain market sectors, provided a particular challenge in the quarter.

However, we grew our sales in several geographic regions and end markets, reflecting the strength and diversity of our global business.

Sales growth, while lower than we expected, represented 16 consecutive quarters of year-over-year organic growth.

We will remain focused on driving ongoing sales growth, while moving forward with additional initiatives to generate margin expansion and earnings growth in line with our long-term goals.

We can accelerate actions related to manufacturing rationalization, SG&A initiatives, and Lean projects to reduce our cost structure.

For the December quarter we achieved EBIT margin growth of 100 basis points on EPS growth on a comparable basis of 52%, despite raw material cost headwinds and a more challenging environment in North America and the effects of an ongoing plant outage mentioned last quarter.

In addition, our ROIC was up 120 basis points year-over-year on a comparable basis.

As we have stated previously, our priority uses of cash are a value creating combination of making strategic acquisitions, buying back our stock, and continually investing in our business.

During the December quarter we repurchased 1 million shares of Kennametal stock on a post split basis.

We will continue to repurchase our stock on an opportunistic basis.

During the past quarter we took additional actions designed to drive higher levels of profitability.

We continue to take steps to rationalize our manufacturing footprint.

As an example, in a plant closure of the Manchester Tool facility that was part of our acquisition of the Federal Signal cutting tool business in January of 2007.

We plan to relocate the manufacturing of this productline to other U.S.

facilities that currently have capacity.

We expect that this will result in cost savings of approximately $3.5 million annually.

Also, we are effectively managing our costs.

We lowered year-over-year operating expenses by 180 basis points.

This demonstrates the benefits of our actions to make structural changes to our business in order to improve the Company's overall margin performance.

During the quarter we continued introducing new technologies and developing new products, which represented 47% of our sales.

In addition, by aligning our brands with the appropriate channels, customers today have the choice of buying Kennametal products directly from us or from indirect channels, such as distributors who promote the sale of our products.

Our ongoing branding efforts stick to align the value proposition of our products, services and solutions in various industries with the appropriate sales channel, whether through direct or distribution.

Regarding the market conditions, North America economic environment continues to be challenging.

Manufacturing activity in December declined as reflected by the ISAM data.

Industrial production also flattened during December as manufacturing of housing sector goods and autos was down.

Industries driven primarily by domestic demand appear to be impacted more than others, while those involved in exports seem to be doing better.

In Europe a slight reduction in economic growth is anticipated in Germany.

We remain watchful of market conditions in that region.

At this time our expectations for Europe include some moderation, but still represents a reasonable good growth environment for Kennametal.

In our rest of the world market there seems to be ongoing strength.

In China the prediction is for strong GDP growth in calendar year 2008.

Japan's industrial production continues to reflect year-over-year growth.

In India the automobile industry in general shows signs of growth in December, as customers departed somewhat from a year-end pattern of postponing purchases until the New Year.

However, motorcycle sales declined in December.

Overall the prediction for India is for continued healthy demand.

Regarding some of our key end markets, aerospace continues to experience strong growth.

Travel demand and investment in the sector are generally fueled outside of North America.

The natural gas market continues to have high supply of prices -- and prices are low.

Natural gas in storage is currently 9% above the five-year average inventory level.

Temperatures in the lower 48 states have been warmer than normal so far this winter season.

The Baker Hughes Drilling Report shows that active rigs in North America have declined 1% year-over-year.

U.S.

rig count has increased by 5%; however, Canadian rig count is down 24%.

In underground coal mining prices began to improve in December quarter.

Metallurgical coal prices have been at record highs due to an increase in global steel production and higher global demand.

In road construction North America road milling activities has recently been somewhat lower year-over-year due to unusual high rainfall in regions where activity is normal normally robust at this time of the year.

At Kennametal our approach and mindset is to proactively address developments in the marketplace, seeking new ways to turn current challenges into long-term opportunities.

We have recently implemented price increases where warranted, and we will continue to make additional price such actions in a strategic manner.

On average, price increases take effect within several months after customers are notified, and we generally get full recovery of raw material costs within several quarters.

While we are experiencing some unfavorable impact from sales mix and softness in certain market, such as energy, we are capitalizing our strengths in the highway construction market, [metal] applications and general engineering.

We are taking steps to offset the weakness in North America economic environment by attacking opportunities in our diverse end markets and focusing on sectors that offers strong global growth, such as aerospace, machine-tools and general engineering.

While doing so, we are also leveraging our channel branding strategy to reach more customers through distributors.

In addition, we continue our strategy to balance our geographic presence.

At December 31, our international markets represented 54% of our sales, including 18% of sales from developing economies, what we refer to as the rest of the world markets.

We have made much progress and we credit this success to the talent and dedication of our global team.

The Kennametal team is collectively executed our strategy, and at the same time maintaining a sharp focus on improving operational excellence.

I will now turn the call over to Frank so he can discuss our financial results in a greater detail.

I will provide further comments on our performance for the December quarter, and then I will move to the outlook for the remainder of fiscal 2008.

Some of my comments will exclude the effect of special items recorded in the prior year quarter.

We had no special items in the current year December quarter.

To summarize, we had a solid quarter in terms of our overall financial results.

December quarter turned out a bit more challenging that in the past.

While we continue to make progress in many areas, the softness in our organic sales growth rate was greater than anticipated.

But despite the topline performance, we delivered a record December quarter for actual sales, EPS and ROIC.

Also during the quarter we completed our two-for-one stock split in the form of capital stock dividend to shareholders -- shareowners of record on December 4.

All earnings per share amounts have been restated to reflect the impact of the split.

Moving forward our reported diluted earnings per share for the second quarter of fiscal 2008 was $0.64 a share.

This represents a 68% increase over the prior year's quarter reported EPS of $0.38, and a $0.52 -- 52% increase over the prior year quarter adjusted EPS of $0.42.

Now I will walk through the key items of our operations.

For the December quarter our consolidated sales came in at $647 million, and this compared with $569 million in the same quarter last year.

Our sales were up 14% year-over-year and reflected 2% organic growth, 6% from acquisitions, and 6% from access FX.

Our organic growth rate of 2% was less than our guidance of 4 to 5% due to sluggish conditions in North America, lower demand in certain market sectors, and softer than expected sales in the month of December.

We expected somewhat less activity in the month of December, but it was a bit more significant as customers had extended shutdowns over the holiday period, and that was both in North America as well as Europe.

However, our sales grew in several geographic regions and market sectors, reflecting the strength and diversity of our global business.

Our gross profit margin came in at 34.1%.

That is 70 basis points lower than last year.

Our gross margin declined due to a drop in AMSG's margin as a result of higher raw material costs and unfavorable mix primarily due to lower sales of energy related products and the previously discussed effect of the ongoing plant outage that Carlos talked about earlier.

We anticipated that that facility would be running in December, but that did not occur.

An improvement in MSSG's margin partly offset the AMSG decline.

MSSG's margin will be further supported going forward by efficiencies gained through the plant closure of the Manchester Tool manufacturing facility and the relocation of the production of that productline to other Kennametal facilities.

We expect to have some period costs related to this closure in the March and June quarters.

Also, as Carlos pointed out, we did put in additional pricing actions that were implemented globally at the beginning of January to address the increase in raw material costs.

Our operating expense during the quarter increased year-over-year by 5%, or $8 million to $148 million.

The increase is mainly attributable to the impact of acquisitions, unfavorable foreign currency exchange effects.

And this was partly offset by decreased employment costs.

Operating expense as a percent of sales decreased 180 basis points to 22.8% from 24.6% in the prior year quarter.

The December quarter represents the eighth consecutive quarter in which we have made a year-over-year reduction in operating expenses as a percent of sales.

Amortization expense for the December quarter increased $2 million year-over-year to $4 million, and that is related to the acquisitions we did in the prior year.

And our operating income was $69 million for the quarter.

And this represents an increase of $14 million, or 24%, from the prior year reported earnings of $56 million.

The current quarter operating margin increased 90 basis points on a reported basis.

Our other income increased slightly from the prior year quarter, and that was driven mostly by favorable foreign currency translation results.

Interest expense was $9 million for the quarter.

That is up 17% from last year's comparable quarter.

This was the result of an increase in average domestic borrowings of $115 million, mostly offset by lower average interest rates on domestic borrowings of 6.6% compared to 7% last year.

The effective tax rate for the quarter was 17.3%.

The current quarter rate benefited from continued increase in earnings under the Company's Pan-European business strategy, the combined effects of other international operations and the tax benefit associated with the dividend reinvestment plan in China.

More than one-third of the tax benefit was driven by the Pan-European business strategy, with the remaining items being more of a onetime in nature.

The above were partly offset by a benefit recorded in the prior you quarter from the extension of the research development and experimentation tax credit.

We expect the effective tax rate for the second half of the fiscal 2008 to be in the 22.5 to 23% range.

Our balance sheet continues to remain strong, and we continue to generate healthy cash from operations.

This will afford us the opportunity to further restructure the business, make acquisition and repurchase stock.

Our adjusted return on invested capital is 12.3%.

That is up 120 basis points from 11.1 in the prior year quarter.

Our cash and cash equivalents finished the quarter at $63 million.

That is up $13 million from June 30, 2007.

Our primary working capital at December 31 was $742 million.

That is up $61 million from $681 million at June 30.

And about half that increase in the primary working capital is due to the effect of stronger foreign currencies.

The remaining increase is primarily attributable to higher inventory due to increased raw material prices and strategic raw material purchases, as well as our initiatives to enhance service levels.

We now have our inventory at a level that strengthens our ability to provide superior service to our customers.

We will take advantage of that as we move to the second half of the fiscal year, while focusing on further initiatives to improve our inventory turns going forward.

Cash flow from operating activities was $69 million in the first half, compared with $36 million in the prior year period.

With respect to free operating cash flow on an adjusted basis, we had an outflow of $4 million in the current quarter compared with an inflow of $78 million in the prior year.

Year-over-year change in adjusted free operating cash was primarily driven by a $35 million increase in CapEx for enhanced manufacturing capabilities and our geographic expansion, as well as changes in our overall working capital.

During the quarter, as Carlos said, we repurchased 1 million shares of our stock at a total cost of $40 million under our 6.6 million share repurchase program.

We have 4.3 million shares remaining to repurchase in this program.

We will continue to enhance shareholder value by buying back our stock on an opportunistic basis.

As we announced in our press release, our Board of Directors declared a regular quarterly dividend of $0.12 per share.

Turning to the business units.

From a geographic perspective Asia, India and our European markets remain strong, but the North America market declined slightly, while the Latin America market had positive growth compared to the prior year.

Worldwide we continue to see global growth in many sectors, [not included] general engineering, machine-tool and distribution.

We also saw growth in the construction, mining and engineered products businesses.

However, the automotive market weakened, and demand for energy related products was down.

For the December quarter MSSG sales were up 16% over the prior year quarter as a result of 4% organic growth, 7% foreign exchange and 5% from acquisitions.

India and Asia-Pacific organic sales were 15 and 11, respectively.

Latin America organic sales were up 9, and Europe's organic sales increased 6%.

North America organic sales declined 2% during the period.

MSSG's operating income increased by 37%, and the operating margin increased 220 basis points from the same quarter last year.

The current quarter results benefited from organic growth, continued cost containment, and the impact of acquisitions.

In addition, the prior year quarter included costs associated with the plant closure.

AMSG sales increased during the December quarter, and that was driven by the effect of acquisitions and FX.

Organic sales were lower due to softness in certain markets.

AMSG sales were higher by 9% compared to the prior quarter.

Of the year-over-year increase in the sales, 7 came from acquisitions, and 5 was from FX.

Organic sales were down 3% on lower sales of energy related products and surface finishing machines and services, offset partly by higher construction, mining and engineered products.

AMSG's operating income was down 20%, while the operating margin was also lower than the prior year quarter.

That is due primarily to the sales mix, higher raw material cost and the effects of the ongoing plant outage.

Corporate operating loss decreased 15% to $20 million from $23 million in the prior year quarter due to lower employment costs, lower pension and post-retirement benefits, partly offset by higher professional fees.

Now I will discuss the outlook for the remainder of the fiscal year and then turn it back to Carlos.

Worldwide conditions support our expectations for continued growth but somewhat lower topline for the balance of 2008.

We believe the softness in North America will continue to persist.

We also expect ongoing variability in the level of demand amongst certain individual market sectors.

We also believe that the European market will remain favorable, but it may not grow at the same level as we experienced in the past six months.

We expect that business conditions will continue to be very good in developing economies as well.

While there is some inherent and challenging uncertainties and risks with the current macroeconomic environment, it appears that the fundamental drivers will continue to provide a platform for ongoing growth.

We expect total sales growth in the range of 11 to 12% for the fiscal 2008, and organic growth of 3 to 4%.

The growth rate is slightly lower than previously expected in view of the outlook for more moderate expansion in global demand.

We have revised our adjusted EPS guidance for fiscal 2008 to a range of $2.71 to $2.77 from $2.80 to $2.85 due to the expectation for more moderate organic sales growth, as well as the outlook for sales mix, raw material cost and a lower overall effective tax rate.

This guidance represents 19 to 21% growth on an adjusted EPS compared with fiscal 2007 adjusted EPS of $2.28.

For the third quarter of fiscal 2008 we expect total sales growth to be in the range of 12 to 13%, including organic sales growth of 2 to 3%, and EPS to be in the range of $0.72 to $0.75 per share.

We also anticipate cash flow from operating activities to be approximately $250 million to $270 million for fiscal 2008.

Based on anticipated capital expenditures of $145 million to $155 million, and slightly higher working capital, we expect to generate between $105 million to $115 million of free operating cash flow for the remainder of the fiscal year.

At this time I would like to turn it back to Carlos for some closing comments.

As always, the Kennametal value business system remains an important tool in executing our strategy.

KVBS is our proven management operating system, and it guides all of the decisions we make related to strategic planning, product development, sales growth, talent development, mergers and acquisitions, and Lean enterprise strategies.

As Kennametal moves forward, we will continue to apply our disciplined growth strategy.

Delivering 15% EBIT margin and 14 to 15% return on invested capital for fiscal year 2009 remains our goal.

However, the softening in the North American economy, as well as a more moderate expansion in global demand may cause our achievement of those targets to be pushed out.

We continued to believe that we have the ability to deliver margin expansion, earnings growth, and strong cash flow over both the short and long term.

While we may be impacted by the cycle on a top line, we can accelerate certain actions.

We can further reduce our costs by restructuring our manufacturing footprint, implementing SG&A reduction initiatives, and continue to actively deploy Lean throughout our Company.

At the same time, we will prudently manage our cash flow to invest in those activities that increase shareholder value.

We have an active pipeline of acquisition candidates, but will remain stringent in our evaluation process.

We will continue to buy back our stock opportunistically.

We have a strong balance sheet and we continue to expect strong cash flow generation.

Whatever business conditions may be, we will stay focused and take advantage of the many opportunities we have to continually increase value for our shareholders.

We remain optimistic about the future growing and balancing our business.

Kennametal has a strong business portfolio, a broad geographic presence, and numerous platforms for growth.

We also have multiple levers, as we always said, to achieve our objectives.

We will continue to move forward with our strategy towards achieving our long-term goals.

By staying focused on that we believe that we will overcome what may perhaps be a more challenging economic environment in the near to medium term.

Thank you for listening to this call today.

I will be happy to now take your questions.

Thank you.

(OPERATOR INSTRUCTIONS).

Stephen Volkmann, JP Morgan.

A question, maybe Frank.

Is it possible to give us a sense maybe in terms of margin basis points on what this plant outage cost you in AMSG?

And then also if you could just update us on where that stands now and when that will be behind us?

We estimate it was 40 basis points on AMSG's margin in the December quarter, a slight impact in the first, but not the [major sub 40].

We expect that by the end of the month to be up and running.

That is in pretty good shape now, but it was it just took a little bit longer than we had anticipated.

Good.

That's kind of behind us.

Even backing that out, I guess I am surprised that the decremental margin there is as big as it is.

The other issues seem like they may take a little more time to get behind us.

Would you agree with that, or should I think about that?

Yes, I think the raw materials, we have stepped up some initiatives there to address, and that was a little bit more pervasive than we anticipated.

And then the highest margin businesses in that side of the Corporation were down, so the mix in the raw materials really brought that to where it came out.

Just to follow-up with Carlos.

You talk about accelerating some of the consolidations -- I don't want to put words in your mouth, but things in the manufacturing and SG&A space and so forth.

Should we be looking for additional restructuring here?

Is there any portfolio pruning possible?

Maybe if you could just elaborate a little on that, and specifically if there are going to be any costs associated with that that we should be mindful of.

The answer is yes.

We're looking at obviously taking opportunity of doing the things that we can do -- as pay-as-you-go as we have always done.

But as a result of the headwinds that we have, we are also looking at potentially doing some restructuring.

But that would not be in your numbers yet, I'm assuming?

No, they are not the numbers.

We are still in the planning process at this point.

Andrew Casey, Wachovia.

A couple of questions.

First on the guidance, I'm trying to understand the pattern that it seems to suggest for Q3 and Q4.

The midpoint of Q3 suggest about 11% growth, and then for Q4 the implied midpoint is around 18% growth.

Can you talk a little bit more about what you expect?

Is the growth rate change more related to lag pricing effect and timing of restructuring initiatives, or what are you seeing they there?

Part of it, it is some of the pricing initiative.

I think Carlos said it takes several quarters to get the full benefit of that.

Coupled with some additional introduction of products will help in the third, and then more particularly in the fourth quarter.

Then some of the end markets, particularly in the energy side will -- because some of the orders we have are longer, we see more of those type of products being released in the fourth quarter, given some of the demand that we have internally.

And our plant will obviously be at full runrate by the end of the third quarter.

On the inventories, could you first comment on what you're seeing at the distribution level, just in case things deteriorate further?

Then could you elaborate on -- I think you said you have a desire to take advantage of the strategically increased inventory level.

Does that mean you're placing a little bit higher premium on share gains, and how does that dovetail with the January pricing actions?

Relative to the distribution, our distributors carry very low inventory.

In many cases we have a 24-hour shipping history with our customers, including our distributors.

So typically our distributors don't carry much inventory.

In our business model that is not a big indicator for us or a big issue.

Relative to the inventory, last year we actually lost some sales as a result of our inability to deliver on time when the customer needed.

We put an effort -- we put more capacity into our facilities and purposely did some strategic inventory.

We're now at a very good fill rate.

So we have -- we feel we have an opportunity now to get some marketshare and get more customers to come to us.

Walt Liptak, Barrington.

My question is on the guidance.

With the reduction to your '08 outlook on an EPS only 3% and an operating basis it looks like about 5 to 7%, if you're adjusting for the tax rate.

Given the credit situations out there and the concern about Europe's slowing down, considerably, why is it that you didn't take a bigger cut to the EPS in the back half of '08?

And then as a follow-on, is the Pan-European tax strategy, is that tax rate that you mentioned, the 22, 23% sustainable as we get to 2009?

The tax rate, we think that at this level it is going to be in the low 20s going forward.

The China tax dividend was something we were hoping to get at the beginning of the planning process, it wasn't a guarantee.

That actually came in, and we have to spread that in through the rate accordingly.

We will have a good tax rate going forward, but at this time it will depend on how the business is on a global basis.

But the Pan-European strategy continues to help drive that tax rate down into the low 20s from where it has been in the past in the 30s.

Then you're looking at the out markets and the growth, we have looked at a couple of things.

I think we think the ISA facility will be up and running here as we go forward on the advanced materials side.

We did factor in the pricing in some of the end markets that we looked at.

And we try to take as realistic a approach in the second half of the fiscal year when we determined our guidance outlook.

And based upon the input and some of the insight that we have with our general managers globally, this is where we feel that this is the best estimate we have at this time.

I will only add two things.

Again, I continue to hear the tax rate as a result of the Pan-European is just a tax rate.

But the way to look at this is we made structural changes in our European business.

We invested to make those changes.

As a result of that our European business is performing way above market.

As we generate more revenue and more profit out of that in Europe -- European unit, because we made the structural changes, obviously we have a benefit from tax.

And we expect that performance to continue.

Relative to looking ahead of Europe, as I said in my discussion, we do anticipate a decelerating growth in Western Europe.

And basically we're looking at the GDP from 2.5 to 3% in 2007 to go to 2.1 to 2.3, approximately there.

So there is a decline.

There is a decline in our estimates going forward.

However, as a result of our performance, we have continued to do better in that marketplace and we anticipate that we will continue to do better.

Mark Koznarek, Cleveland Research.

I have got maybe a similar question to Walt with regard to thinking about the outlook.

Because as I try and work through some of the changes here, it looks like you have lowered the earnings, looking at the midpoint, by about $0.08.

Then that lower tax also contributes a further $0.08.

So you could really say your second half is $0.16 lower than what you originally anticipated.

Then if we consider your core revenue growth reduction, it looks like the second half you're thinking about the runrate is maybe about 2 points lower than what had previously would have been -- and that is around $30 million.

And what it suggest is that the operating income pretax is off more than half that amount, like $17 million or so.

It's seems that is pretty severe negative incremental margin.

I have heard you mention that you're taking some aggressive posture regarding expense reduction, but it seems like there is something else going on in the second half.

And I am just wondering are you expecting this mix to remain negative for the entire second half, and so these cost reductions are just matching the revenue reduction, you're not really getting ahead?

Can you discuss the moving parts here a little bit?

The cost reductions -- and Frank can add to my comments -- the cost reductions are in line with the reduction of the topline.

However, as we always talk about, the price increases, so to offset the raw material price increase typically takes a few months for us to recover.

Although typically we recover 100% of the cost of raw material, there is always a lag to that recovery.

As Frank talked earlier, raw materials is one of the major drivers in AMSG for our margin degradation.

Anything else you want to add, Frank?

I think the only thing I would add to that is the energy related sales, we don't expect them to come back, and they are a very profitable business.

So late in the fourth quarter, and we are seeing some volatility, as well on the capital equipment side some of the businesses that we have.

That is the main driver.

Then a follow-up for Carlos.

As we finished talking about the outlook you reiterated that you still have that 15% EBIT target that right now is slated for '09, but that target may be pushed out.

And I'm wondering what kind of things -- what will lead you to make a decision about ultimately whether you're going to keep that target in '09 or stretch it out, and when will that decision be made?

First of all, the decision will be made in the next few months.

The drivers for that is basically what we're working on -- how quickly and how much of manufacturing restructuring do we do during the third and fourth quarter of this year.

We have things like -- we see energy coming back at the end of this year.

So we are -- continue to look at sales growth, although at a lower rate.

And taking advantage of that leverage, as well as the typical SG&A and other levers that I have always -- the Company always talked about, that we have those levers and as leader we're going to pull them harder.

We are in the process of doing all of that.

We started 30 days ago looking at, as I have always said, these are plans that we have in place.

They have been in place.

it is just a matter of us pulling the trigger to execute.

By next quarter you would have a decision on this?

Yes.

(OPERATOR INSTRUCTIONS).

Joel Tiss, Lehman.

I wonder, it sounds a little bit, and I may just be hearing it wrong, it sounds a little bit like you're talking more quarter to quarter in the energy business.

I just wondered if you could take a step back and give us anything structurally that is changing one way or the other?

Okay, maybe it will bounce back in the fourth quarter, but over the next three years is there any sense that we're are sort of where we need to be, or is there still a lot of activity behind the scenes that is going to sustain that cycle longer term?

We believe that there is some activity behind.

I think that the short-term drivers are obviously the rig count, the weather, the demand.

But it is hard for us to see -- to look at what is going to be in the next two to three years.

Again, we continue to see signs that it is going to -- things in the fourth quarter in the energy business are going to be better.

We thought that they were going to be better in this quarter, and than we thought it was third quarter, and now we're looking at the fourth quarter.

So things have moved to the right.

But all the indications that we have at this point is that we should see a slight comeback in the fourth quarter -- in our fourth quarter.

But I really don't have any specifics more to share with you at this point.

That is helpful.

Also, we heard from some other companies recently too that there is sort of a little bit of inventory adjustment.

I don't mean specifically in your business, but in general going on that is going to hurt the first half of calendar '08.

Are you saying that at all?

You said the distributors don't have a lot of inventory, but are you seeing anything broader than just what your distribution is doing or --?

I think that we saw an unusual December of plant shutdown, which is basically for us the correction of inventories is at the customer level versus in distribution.

Some of our energy customers do have -- are burning down some of the industry inventory.

So we see that in the energy.

Overall as a business, December was really soft, a little bit of inventory correction.

And we got a little bit surprised by that, the December months.

But we do not see, like I said, through our distributors and through our customers at this point, other than in the energy business, we don't see that inventory correction.

Lastly for Frank, can you just talk a little bit more about the big drop in your free operating cash flow?

Is it pretty much all the factors you gave us before, the mix and the raw material cost increases, or is there anything else in there besides the CapEx that you mentioned?

The CapEx, and that is really FX related, and obviously the lower cash earnings and slightly on the working capital, those are the three drivers at this point.

Seaver Wang, Utendahl Capital Partners.

Most of my questions have already been asked.

But actually, I was hoping to get a little bit more color on the dividend reinvestment plan.

Tax benefits from China, how does that work exactly?

The China reinvestment, what that was we qualified for a technologically advanced enterprise based upon the new plant that we constructed over a year ago.

We didn't -- there are some legislation in China that these actual credits expire at the end of this calendar year, or the end of last calendar year.

We were able to take advantage of some of the equipment and some of the RD&E that actually qualified for deduction in China, hence our tax return.

We had a onetime benefit in there in that quarter related to the China situation.

That will be smoothing in the rate for the year, which won't recur in the following year.

You said low 20s for the full year this year, so maybe a little higher for next year because you don't have certain credits?

Yes.

It is tough to go and give a rate out for next year, given how the business mix comes into play, so I'm always hesitant on that.

But we expect to finish the year at 22.5 to 23%.

And than as we get towards year-end we will have a better idea going forward.

We don't expect the tax rate to go back to the '30s, as we have in the past and the near term.

Can you quantify the china tax benefit, the one-time, that was -- ?

Yes, it was a few million dollars.

Eli Lustgarten, Longbow Securities.

A couple of cleanup questions, and then I will ask something.

One, you had big currency benefits in the first half of the year, 5 to 7% by division.

Is that what you are assuming for the second half of the fiscal year in the quarterly numbers?

Are we still looking at 5 to 10 currency roughly?

Maybe not that high.

In the first half we did have some hedging programs in, so we didn't get a very favorable overall in the first half FX, because we did put some hedging programs at the beginning of July.

But we are a slight benefit from where we were at the end of the quarter.

The sales numbers of the 12 to 13%, half of it is currency again, so [you are] not going to report that to currency through the third quarter and fourth quarter?

Yes, because we are assuming organic growth rate is going to be in the 2 to 3%.

I am just wondering what your carryover of acquisitions is really what I'm getting to.

As we have talked in the past, the acquisition of Federal Signal anniversaries at the end of January.

And the last of two bigger acquisitions we did in the fourth quarter effective in May was ISA and KENCI in Europe.

They are the main drivers.

We will have some acquisitions in the third quarter and that tails off in the fourth.

The raw material cost, a big part of the impact, can you quantify how much of those raw material -- what is killing you in the quarter?

I think it hit us to about $0.05 to $0.06 this quarter.

It will take a couple of quarters to catch up, I assume is what you are saying.

Yes, yes, as usual.

That is the kind of the pattern.

You bought back 1 million shares in the quarter.

Was the average shares are lower than what we see for that, or is some share (inaudible)?

Just trying to get an idea of what share count we would be using for the rest of the year.

I think the share count, it will be about 78 million.

Okay, for the rest of the year.

Now when you look at the big drop to -- in the operating margin of (inaudible) 12.8%, is it fair to assume that we're going to be showing negative margins comparisons you have [got set] for the rest of the year, is what I'm assuming at this point?

Is that fair?

On a year over year basis, probably short-term that's correct.

The third quarter will be worse.

Can you catch up in the fourth quarter or do we have to wait until next year before you get some improvement?

Because your mix is not going to change radically probably in the next two quarters.

It is hard to tell.

You may see some in the fourth quarter, but most likely next year.

The improvement that we have begun to see in metalworking continues, and you had a step up in margins at the end of the year last year in the fourth quarter, can we assume that we're going to see the same sign of improving margins in metalworking for next few quarters?

Yes, for the rest of the year.

The real question is coming back, you should have put a little hedge clause in to 2009, because the market conditions was probably appropriate.

One of the thesis that we'll always heard is that if things go down there are lots of levers that you can pull.

You sort of alluded to them, but we really haven't got much input yet.

Should we be expecting a real rash of acceleration of actions over the next couple of months in preparation to meet the 2009 -- to take a shot at the 2009 goals?

Yes.

Yes.

But you're not ready to give us anything yet?

I'm not sure -- we're going to do them as we go.

I'm not sure that some of the plants, the manufacturing footprint, we cannot come out and announce that externally until we do it internally for obvious reasons.

Interest charges are going to stay where they are for the rest of the year, aren't they at this point?

What was that, I didn't hear it?

Interest charges.

Exactly, yes.

They don't change very much.

Thank you.

Steve Barger, KeyBanc Capital Markets.

I want to ask a conceptual question.

I went back and looked at the monthly order rates for the '01, '02, '03 timeframe, and there was an extended period of negative monthly order numbers.

But you were much more North American and metalworkings exposed that.

Now that you are kind of at the front end of North American cyclicality again, how are your internal models holding up relative to expectations versus actual results, purely on the operating margin performance side?

If you can give us any insight there?

I think from an internal they were actually holding up pretty good until we saw some deterioration on the energy related businesses.

That has been the major disconnect.

If you continue to get end market volatility, is it possible that your sensitivity analysis didn't capture fully -- I guess the question is are you really less cyclical than you thought as we go into to a weaker North American end market environment?

This quarter results is an example of that.

If you take the raw material prices out, and if you take the raw material price increases, and if you take the mix out of it, there is an example of where North America we grew in a negative rate, and as a Company we still had positive growth, and still have done well overall.

I want to emphasize with our new guidance at the end of the year on top of all the challenges that we have, we're still going to grow year-over-year by 20%.

And that is not too bad in a market environment as we are today.

So our models -- we will continue to do SG&A and so forth, so our models if you take those elements out, are very close to where we were before.

Was the moderation in North America, do you get the sense that you are down in-line with the market in those weak areas, or are any of your competitors getting more aggressive on price, or is your salesforce telling you that potentially you're losing share anywhere?

We believe that we're either number one or number two in every market that we play.

We believe that we are in many cases outpacing the market.

One last question.

Frank, in your comments you talked about strategic raw material purchases.

Are you trying to -- does that go of hedging of cobalt or steel?

Are you buying ahead in anticipation of price further increases?

A little bit.

[Raoul Federal], Goldman Sachs.

This is [Ralph Holmes] who is filling in for Terry Darling here.

Just a quick question regarding the raw material assumptions.

What prices are you obviously taking into the guidance for cobalt and tungsten going forward?

We don't -- you can see what the spot price is doing, and we don't expect that to change that much.

Now we have contracts with some of our suppliers, and we're not that liberty to disclose those.

But we don't see cobalt or steel coming down in the near term.

Just one more question.

In terms of the foreign exchange impact, the other day you had actually called -- in prior quarters you called out the exact EPS impact.

I am wondering for this quarter if you could call out what the EPS impact was, and what would be going forward?

Going forward -- again, I'm not sure how it is going to be with some of the hedging and what the currencies do.

But we're expecting a similar amount to what we had in the first quarter, which I think was less than $0.05.

So it would be about $0.03 per quarter and that would be the same it was this quarter?

Yes.

Yes.

Marty Pollack, NWQ Investment Management.

I just would like to get a little better understanding.

That $0.05 you're describing is over on the higher raw material -- is over the total Company's business, right?

But you indicate that as a factor primarily related to AMSG.

What is the overall impact of raw materials?

And certainly AMSG did extremely well here relative to expectations.

In fact, better margins -- I remember the last time they had better margins in Advanced.

Can you just comment on that first?

I think we gave both sides of the business.

MSSG and AMSG both use tungsten, steel and cobalt.

So when we're talking about AMSG has maybe a more higher material content then some products, but it varies by individual business, and we have a number of them.

When we're talking, we're talking in total.

With regard to just let's say the more carbon related steel, we have seen price increases now being implemented pretty much across January, February, March fairly aggressive.

And your raw material assumption, what is that content for you specifically?

And how are you -- are you pricing -- are you looking to price that through, or what is your flexibility?

Again, we don't obviously give out the content of steel in our product.

But we have gone up with prices in steel.

We did it in October.

We have done again as -- if our suppliers are going to increase ours, in most cases we will pass it on.

As far as structurally longer-term margins, is there any reason to assume there is any change there -- I mean AMSG, because having more 16 and 17 type percent margins historically, is that a margin level we should recover just most things normalized?

Is that the way to think about that?

We continue to believe that the AMSG margin is at least 200 basis points better than metalworkings, so we will expect the business to come back to the margins that we have enjoyed.

Again, it has to do with the mix.

It has to do with the raw materials, but we feel nothing in the business has fundamentally changes.

As far as the metalworking then what about those margins?

Clearly their performance has been very strong here.

Would you be expecting normalized margins there to be still a little bit lower than what they were in this quarter?

Our strategy is that we're going to maintain the marketing margins in metalworking, and we're going to reduce the cost of serve so that overall our EBIT margin improves, as has been our strategy and we have been implementing that strategy, and we will continue on that road.

Dana Walker, Kalmar Investments.

We have been hearing about price cost in the AMSG business not going quite the way you would like for several quarters.

Can you describe the role that raw materials are playing in your inability to get it where you want versus your ability to gain price?

Again, our cobalt, we have a phenomena last year that -- or the year before that tungsten was the big driver of the raw material pricing in the steel.

This year tungsten has remained flat but cobalt has increased basically every quarter.

Every time we have a price increase in cobalt we obviously have to go out to the marketplace and boost up prices, which is very, very difficult because two years ago we based our pricing on the tungsten.

So now we are introducing this cobalt.

In every quarter our cobalt, as you know, has gone up.

We had to -- that is a difficult thing to do, is when you have multiple price increases in a sequence quarter over quarter, to be able to recover.

And as I said, price increases typically lag a few months from the time that you announce it to the time that you recover the cost.

We typically recover 100%, however, we can't recover it in any one quarter.

That helps me understand far better.

Thank you.

The outage that you have with the recently acquired property that had a plant down, you have talked about 40 basis points of effect on your EBIT margin, what effect did that have on your revenue?

Let me take it there.

Probably less than 1%.

How costly is the processor bringing that plant up likely to be?

Most of that would have been covered by insurance, so most of that has already been captured.

Like I said earlier, I think it should be up and running here within a week or so.

We have just gone through some specs and classifications of certain things and we should be back to normal.

On a question you describe how you will be -- you focused on an additional location that you'll be taking out of operation.

I presume those restructuring costs are embedded in your second half guidance?

Yes.

Correct.

So the one from an acquisition, the initial cost from a purchase accounting, but I do have period cost that could be a couple of pennies in the next two quarters as we wind it up.

Glenn Primack, Broadview.

In the energy business what percent is land versus offshore, where you're quoting on a pipe and bearings and that type of stuff?

(multiple speakers).

I don't know that question.

If you can call later we can discuss that with you.

I will follow-up with our business leader from that business and get you additional detail.

But the bulk of it is coming from North America?

Yes.

I think from the first quarter you would probably start to anniversary the big drop-off in Canada.

And then it seems like just listening to a couple of your customers calls that North America is starting to abate a little bit.

That is what we have talked about earlier that we feel that by the fourth quarter we can see some improvement there, yes.

Are you able to tap into those customers and take the product offering internationally yet?

Because it seems like that is where the big international land is?

Our challenge is that we do sell to customers that are global customers.

And it is very hard for us, although the sales for us are recorded in North America, it is really hard for us to know where those sales -- those components are actually going.

But your product may be going to some of the other --?

We just cannot -- at this point we cannot trace it.

But when we talk to Schlumberger or customers like that, we really don't know where the product ends up being -- going.

Just systems, you feel pretty comfortable with being able to track North America inventories with your distributors, and theirs has been -- has there been any kind of conflict between people coming into calling direct versus --?

No, we have a Distributor Advisory Council, and we have a really close relationship with our distributors.

So we pretty much know was going on in the marketplace.

Andrew Casey, Wachovia.

I wanted to follow-up on the more macroeconomic inventory question I think Joel asked a little bit earlier.

Other than the energy customer inventory liquidation you talked about continuing, did you see any continuation of that December abnormal plant shutdown so far into January?

No.

No.

I caution everyone, because I have been -- we have been saying this.

We have a great month and then the next month is not so great and so forth.

We have been in this roller coaster now for the last 18 months.

For right now what we saw in December is -- we're not seeing it in January so far.

This concludes our discussion today.

Thank you for joining us.

As you have follow-up questions, please call me, Quynh McGuire.

My line is 724-539-6559.

Thank you.

Thank you for participating in today's Kennametal's second quarter fiscal 2008 earnings conference call.

This call will be available for replay beginning at 1 o'clock PM Eastern time today through 11.59 PM Eastern time on Friday, February 22, 2008.

The conference ID number for the replay is 30386679.

Again the conference ID number for the replay is 30386679.

The number to dial for the replay is 1-800-642-1687 or 706-645-9291.

Thank you.

You may now disconnect.