Kennametal Inc (KMT) 2010 Q1 法說會逐字稿

Good morning. My name is Regina, and I will be your conference operator today. I would like to welcome everyone to Kennametal's first quarter fiscal year 2010 earnings call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions).

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

Thank you, Regina. Welcome, everyone. Thank you for joining us to review Kennametal's first quarter fiscal 2010 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 and prior quarterly conference calls, we've 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 November 28, 2009.

I'm Quynh McGuire, Director of Investor Relations for Kennametal. Joining me for our call today are Chairman, 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 quarter's financial performance. After their remarks, we will be happy to answer your questions.

At this time, I'd like to direct your attention to our forward-looking disclosure statement. The discussion we'll 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. Good morning, everyone. Thank you for joining us today.

Let me start by saying that I believe that sales levels have generally reached bottom and we have begun to see some positive trends in our order's rates. For September quarter, our sales increased sequentially by 6% from the June quarter. This was driven by higher industrial production activity and follows three consecutive quarters of sharp sequential decline during the global economic downturn.

Compared to the record level set for September quarter one year ago, sales were lower by 36%. The early order rates are showing that underlying business environment is improving globally. Also, it is important to note that customer inventories remain low, as they are still cautious and are buying only what they need for the short-term. Clearly, customers will need to replenish some of their inventories from direct and indirect channels as the recovery begins.

In the meantime, we continue to capitalize on value selling approach. Customers recognize the value proposition of our products, so we are holding pricing levels strategically. Overall, we exceeded our expectations and are encouraged by our performance for the September quarter. Sales, operating results, and earnings per share increased on a sequential basis.

In addition to the positive impact of higher sequential sales, results benefit from increased permanent cost savings from our restructuring programs. We also continue to focus sharply on generating strong cash flow and maintaining a solid financial position. Our September quarter performance demonstrates the positive effect and the future potential of the many difficult actions that we took during the global economic downturn.

From a macro perspective, I would like to discuss our view of certain end markets served. In the Transportation sector, the Cash for Clunkers program was a success. Over the next several months, we expect to see buying for inventory replacements. We are seeing some pullthrough at OEMs and integrators, as they are likely low on tooling inventory.

In aerospace, the market is still soft but passage of traffic is picking up in certain parts of the world. OEMs are starting to prepare for the upturn. Currently, the industry forecasts that demand is expected to rebound midyear calendar 2011. We could see a benefit six to nine months in advance for engineering components.

In the energy market, North American drilling rates are typically related to the gas industry. With the reduced rig counts and current high level of supply for liquefied natural gas, increased drilling rates is now expected until late in calendar year 2010.

Power generation suppliers have solid booked orders, but are reporting a slowdown of new orders due to some financing challenges. We continue to focus on equipment and component manufacturers, as well as various renewable energy projects.

In underground coal mining, production and demand for steam coal has been consistently decreasing. However, production in China has been robust. Steam coal represents 80% of the coal mined globally. Regarding metallurgical coal, production increases have been reported, as steel prices continue to increase.

In highway construction, we saw some benefit from stimulus plans in Asia, as the funds were released quickly. In the US, we experienced higher demand in the summer months, as contractors needed our products for the jobs they had won. However, customers are buying only what they need and remaining cautious. The road construction season is ending, but we may see some extended activity into November and December, depending on the weather.

During the September quarter, we continued to focus on permanently reducing costs through implementing our restructuring programs to reach our target of $125 million in annual cost benefits. As part of restructuring, we have closed seven facilities already and currently expect to close a total of nine manufacturing facilities to lower fixed costs.

By continually deploying lean, we have identified additional capacity in certain larger manufacturing facilities, which can absorb production from plants that are being closed. In addition, we have reduced our salaried workforce by 20% globally.

Also, we took additional cost reduction measures on a temporary basis. To adjust our production workforce and costs in line with demand, we made appropriate reductions in our hourly employment levels. Further, we have implemented short-time and reduced work-weeks in many areas. As a reminder, we implemented one week furloughs from March through June of 2009.

In fiscal year 2010, we have reduced salaries by 10% on average. We expect salary reductions to provide approximately $28 million in cost savings this fiscal year, although those costs will return when customer demand increases.

Regarding our portfolio management actions, we continued to divest non-core lower margin business over the past 18 months. We sold a high-speed steel bit operations in Europe and North America, and recently completed the sale of our gage product lines. Those included the divestiture of seven manufacturing facilities and generated approximately $50 million in net proceeds.

The combination of restructuring initiatives and divestitures will result in a permanent reduction of 16 facilities from our manufacturing footprint, and represent significant cost savings.

While we added facilities as part of our acquisitions, we will have reduced our base manufacturing footprint by more than 40% since fiscal year 2003. Those collective efforts will help position Kennametal to realize stronger operating levers in this coming upturn.

For fiscal year 2010 and over the near-term, we have two key objectives. Both are designed to help Kennametal further navigate through current economic conditions and position our Company for growth, as the recovery gains momentum.

Our first priority is to continue to reduce our cost structure and size the Company to operate profitably at a $2 billion in sales. And we believe that we can achieve double-digit EBIT margins at sales levels of $2.1 billion to $2.2 billion.

Our second priority is to leverage our existing infrastructure to be able to scale up to $3 billion in sales without adding much of our fixed cost base or making substantial additional capital investments. We believe that we have the manufacturing capacity to handle any upturn in volumes.

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

Thank you, Carlos. I'll provide further comments on our performance for the September quarter, then I'll move to the outlook for our December quarter and our 2010 year.

Some of my comments will exclude some of the special items that Carlos referred to, so please refer to the reconciliation schedules that we provided in our earnings release and related Form 8-K.

So to start, to summarize the September quarter, our sales were down year-over-year by 36% on an organic basis, but came in at the better end of our sales guidance of minus 35% to minus 40%. Furthermore, as Carlos mentioned, it's important to note that our sales did improve sequentially by 6% compared to the June quarter.

Our loss per share for September quarter was $0.04. It was ahead of our expectations, driven by better than anticipated sales, higher permanent savings from our restructuring programs, and ongoing cost discipline. We also had free operating cash flow of $9 million, driven by our operating performance and continued focus on our working capital and balance sheet.

The quarter also reflected the completion of our 8 million share equity issuance, which raised $120 million in proceeds; the amendment to our $500 million revolving credit facility; and the completion of the divestiture of our high-speed steel business. Additionally, as Carlos mentioned, on October 9, we also completed the sale of our gage business, further reducing our manufacturing footprint by two facilities.

Now I'll walk you through the key items in our income statements. Sales for the quarter came in at $409 million. This compared with $643 million in the September quarter last year. The change in sales represents a 36% year-over-year decrease and was driven by a 36% organic decline, a favorable 3% effect from acquisitions, and a 3% decrease from unfavorable foreign currency effects. The prior-year September quarter was a record quarter for Kennametal.

As I previously noted, sales for the September quarter were up sequentially from the June quarter by $23 million or 6%. And the last time this occurred was 25 years ago in fiscal 1984, as the economy was coming out of a recession in that period.

Looking at the performance of the business units, MSSG sales decreased by 43% from the prior-year quarter, and that was driven by organic sales decline of 39% and unfavorable foreign currency effects of 4%. On a regional basis, Europe and North America reported organic sales declines of 42% and 39%, respectively, while Latin America, India, and Asia-Pacific also experienced year-to-year declines of 31%, 25%, and 39%, respectively.

MSSG sales also increased sequentially by 6% from the June quarter, as global industrial production began to show some slight improvements. Sequential sales gains were made in North America, India, and Latin America, while sales in Europe and Asia-Pacific were near the same levels as the June quarter.

AMSG sales decreased 25% from the September quarter one year ago, and that was driven by a 30% organic decline and a 2% unfavorable impact from foreign currency effects, partly offset by the favorable impact of a prior acquisition of 7%. The organic decline was primarily driven by lower sales in the engineered products business, as well as reduced demand for energy-related products.

Sequentially, AMSG sales increased by 7% from the June quarter. All units in AMSG posted sequential growth with the exception of our surface finishing machines/capital goods business.

Turning to our gross profit margin, that came in at 29% for the quarter, as compared to 33% in the prior-year September quarter. And restructuring-related charges recorded in cost of goods sold in both periods were not material. Lower production levels and the related reduced capacity utilization continued to be the reason for the year-to-year decline in gross profit margin.

However, the increased run rate and benefits from our restructuring initiatives and other cost reduction actions continued to offset an increasing portion of the capacity utilization impact. In addition, our gross profit margin further benefited from continued positive momentum with price realization, as well as stabilization in our raw material costs.

Also helping to mitigate the impact of lower production levels during the quarter were one-time benefits from certain labor negotiations in Europe. This is all evidenced by the sequential improvement in our gross profit margin of over 200 basis points from the first quarter of fiscal 2010, which normally is our weakest period for us due to seasonality.

Our decremental margin for the September quarter came in at 24%, which was 200 basis points above the June quarter and improved by 1,000 basis points over the last two quarters. The margin performance validates our restructuring initiatives are delivering real, permanent cost savings.

Our operating expense decreased by 23% or $35 million to $116 million. The decrease is mainly attributable to lower employment costs as a result of the impact of our restructuring and cost management activities, lower incentive compensation, as well as the impact of foreign currency exchange rate fluctuations, other cost reductions, offset somewhat by an increase from acquisitions.

Now let me provide you an update on our restructuring programs. In the September quarter, we realized approximately $30 million in pretax benefits, most of which were incremental to the same quarter one year ago. We're now very close to our targeted run rate that will yield $125 million in annual, ongoing pretax savings.

During the quarter, we recorded pretax charges related to these initiatives of $9 million or about $0.06 a share. We now have recorded $90 million of the $115 million of pretax charges related to these programs. The remaining $25 million are expected to be incurred over the next six to nine months and all programs are on track or slightly ahead.

So to summarize, our permanent cost reductions from our combined programs show an investment of $115 million to realize $125 million of savings annually. This will represent the closure of seven manufacturing plants, lowering operating expenses and reducing salaried employment levels by 20% globally.

In addition, we have also been actively managing our product portfolio by divesting low-margin non-core businesses, as Carlos mentioned, such as our high-speed steel business and our gage business. These actions will also yield a reduction of an additional seven manufacturing plants. These actions combined will remove a total of 14 facilities to date from our manufacturing footprint and are permanent cost reductions.

And lastly, as Carlos mentioned, we took temporary cost reduction measures, including one week furloughs in the prior-year, as well as salary reductions in fiscal '10. The salary cuts in fiscal '10 will generate approximately $28 million in cost savings this year. These costs will come back as demand returns.

Our operating loss was $10 million for the current quarter compared to operating income of $52 million last year. Absent the restructuring-related charges recorded in both periods, the operating loss for the current quarter was $1 million compared to operating income of $61 million from the prior-year quarter. I believe that it bears repeating here that this is a sequential improvement in adjusted operating results from the June quarter.

Looking at the business unit performance, MSSG had an operating loss of $13 million for the September quarter compared to operating income of $42 million in the same period. Excluding restructuring-related charges recorded in both periods, MSSG's operating loss was $8 million compared with operating income of $49 million in the prior-year quarter.

The primary drivers of the decline in operating income were reduced sales volumes and the related unfavorable absorption of manufacturing costs. This was offset in part by restructuring benefits and other cost reduction actions, including the one-time savings of certain European labor negotiations as well as higher price realization. MSSG reduced its operating loss by almost 50% from the June quarter.

AMSG's operating income was $23 million in the quarter compared to operating income of $30 million in the same quarter the prior-year. Absent restructuring-related charges in both periods, AMSG's operating income was $24 million in the current quarter compared to $31 million in the prior-year quarter, and was up 35% on a sequential basis from the June quarter.

The decline in operating income was primarily due to lower sales and production volumes in the engineered products and energy-related businesses. However, a considerable portion of the sales decline was offset by a combination of restructuring benefits and continued cost reduction actions, as well as lower raw material costs.

As a result, AMSG again achieved a double-digit operating margin in the September quarter. This was also slightly higher than for the same quarter last year. This again demonstrates the importance of this business segment to our strategy and our overall product portfolio.

Corporate operating loss of $20 million was level with the same quarter a year ago and sequentially higher by $11 million from the June quarter. The sequential change was due to higher stock compensation expense related to our normal annual award process at this time of year, as well as increase in certain employee benefit costs and the fact that certain favorable items were recorded in the June quarter.

Our interest expense was $6.4 million and decreased by $700,000, or 10% compared to last year's comparable quarter. The decrease was due to lower borrowings, due in part to the July equity issuance, offset in part by higher interest rates related to the amended revolving credit facility.

The reported effective tax rate for the September quarter was 39.6% on a pretax loss. Excluding the impact of restructuring-related charges, the adjusted effective tax rate was a negative 41.8% on a pretax loss compared to 19% on pretax income in the prior-year quarter. The relatively high percentage of tax benefit on the pretax loss for the current quarter was driven by certain favorable tax settlements, which amounted to $1.5 million this year.

Additionally, we're on track with the wind-down activities related to our June 2009 divestiture of our high-speed steel business. During the current quarter, we recorded $2 million of pretax charges related to this divestiture, most of which were associated with employee severance. These charges, along with related tax effects, were recorded in discontinued operations.

We expect to incur the remaining pretax charges related to this divestiture of $2 million to $3 million over the next three to six months, and all cash proceeds related to the divestiture have been received.

Net loss was $10 million for the current quarter compared to net income of $35 million in the prior year. Absent the charges related to restructuring and divestiture, the net loss for the current quarter was $3 million compared to net income of $43 million in the prior-year quarter.

Lastly, reported fiscal 2010 first quarter diluted loss per share was $0.12 compared to the prior-year quarter EPS of $0.47. The adjusted loss per share was $0.04 compared to the prior-year quarter adjusted EPS of $0.57.

Turning to our balance sheet, we have a strong balance sheet to continuing weathering the current economic conditions, and we continue to invest in our business, shape our portfolio, and streamline our manufacturing footprint.

We have reduced our inventory for four consecutive quarters while maintaining high product availability and service levels. Specifically, we drew down our inventory by $17 million in the September quarter and by $80 million over the last 12 months. We also continue to remain extremely focused and diligent on receivable collections. Our capital expenditures were reduced [to] $9 million as compared to capital spending of $45 million in the same quarter one year ago.

And at September 30, 2009, our total debt was $367 million. That was down $119 million from the June 30, 2009 period. This was driven by the application of the proceeds from our equity issuance in July, as well as from the divestiture of our high-speed steel business.

Lastly, our debt to capital ratio at September 30, 2009 was 20.8, which is significantly improved from the 27.7% at June 30, 2009, and our US defined benefit pension plan remains over 100% funded.

Cash flow from operating activities from the current quarter was $17 million. This compares to $38 million in the prior-year quarter. As I previously mentioned, free operating cash flow for the current quarter was $9 million. This compares to an outflow of $5 million in the prior-year quarter. The year-over-year improvement is driven by a reduction of working capital and lower capital expenditures.

Looking ahead to our outlook, global industrial activity has recently exhibited some stability following the severe economic downturn and turbulence experienced during the previous fiscal year. However, the development at present is considerably uneven and does not yet entail broad-based momentum.

Certain market sectors and regions have begun to strengthen, while others look to remain flat or trend further downward in the short to medium-term. While there are some overall positive signs in the improving global economy remains difficult to predict with any certainty the timing, magnitude or duration of a sustainable recovery.

We presently believe that the global industrial activity and the corresponding demand for our products will continue to moderately improve through the remainder of the current fiscal year. Under these assumed conditions, we would expect our earnings per share for fiscal 2010 to be in the range of $0.50 to $0.70 per share, excluding restructuring and divestiture-related charges on sales that would be 5% to 10% lower year-over-year on an organic basis. And this 5% increase on EPS is from the midpoint that we provided back in July.

Cash flow from operations would be expected to be in the range of $65 million to $75 million for our fiscal year, as a considerable portion of the cash generated is expected to be needed to fund higher working capital requirements as business improves. Based on capital expenditures of approximately $60 million, free operating cash flow would be in the range of $5 million to $15 million for fiscal 2010.

For the second quarter of fiscal 2010, we expect organic sales to be 20% to 25% lower than the same quarter of the previous fiscal year, and expect EPS to be at or slightly above breakeven, excluding restructuring and divestiture-related charges.

At this time, I'll turn it back to Carlos for some closing comments.

Thank you, Frank. As Kennametal moves forward, our long-term strategies remain consistent. We are staying committed to our management operating system, the Kennametal value business system. We continue to balance our geographic presence to achieve sales of one-third each from North America, Western Europe, and the rest of the world.

We are also continuing to balance our business mix to generate sales equally from our metal working and advanced material segments. We also continue to strengthen our balance sheet by focusing on working capital and maximizing liquidity.

While we expect the first half of fiscal 2010 to continue to be challenging, we are well positioned. We also believe that we will see an upturn in the second half of fiscal year based on leading economic indicators. For Kennametal, we expect some recovery at the top line and we think we will benefit from better operating leverage that will result from permanent cost savings.

In summary, we are sizing Kennametal to operate profitably at $2 billion in sales. We can leverage the Company's existing infrastructure to be able to scale up to $3 billion in sales without adding much of our fixed cost basis or making substantial additional capital investments.

Thank you for your time and your interest in Kennametal. We will now take your questions.

(Operator Instructions). Adam Uhlman, Cleveland Research.

I guess first with a clarification, Frank. Could you talk about what the one-time labor negotiation benefit was in Europe?

Yes, the bottom line is we're able to get some further concessions with our European. And we had put that as an incremental amount from the guidance that we've provided of about $3 million.

Okay, great. Thanks. And then do you have any sense of how much your distributor partners have destocked their inventories through this downcycle? And what benefit Kennametal might be able to capture as you start to sell to the level of retail sales going forward -- have you been able to dimensionalize that at all?

We do not -- I mean, we know that the distribution channel has destocked. But we also know that the end-user, in other words, our customers have destocked even further. So we really have two opportunities in re-stocking -- one is in the distribution channel, the other one is at the customer themselves. But we can't quantify that at this point.

Okay, great. Thanks. I'll get back in the queue.

Ann Duignan, JPMorgan.

It's Ann Duignan. Could you talk a little bit about the $30 million in restructuring savings, where the lion's share of those savings have taken place? I'm trying to get a sense of what kind of volume the metal working business is going to need to return to profitability.

And then as a follow-up, could you talk a little bit about sequentially which business you'd expect to start to see positive organic growth year-over-year, as we go forward into the back half of the year?

Yes, Ann, as far as the restructuring, right now the bulk of it -- or I should say the majority of it, is in MSSG. Probably give or take two-thirds of it right now, because if you go back to the number of manufacturing facilities, we have more in MSSG as opposed to advanced materials. So two-thirds and one-third, ballpark, [right], but I expect that trend to continue to go as we go in the out periods or sequentially.

And then from an organic perspective, that's a tough one. I would expect probably advanced materials, given some of the mix in there to maybe be the first one that would show some organic as opposed to metalworking, given the guidance that we've talked about. The one area from an MSSG that's probably a little bit softer than what we provided in the month of July, I would say, would be Europe, which is a bigger component of MSSG.

And on the Advanced Materials side, the one area that I think we referenced is on the energy side. So that's obviously, a smaller part of the Company but they would be the drivers. And that's why I would say it would be probably first Advanced Materials as we see it going forward.

Yes, that's interesting. I might have expected MSSG to potentially show organic growth positive before Advanced Materials. So that's definitely interesting.

I think one of the reasons for that is we feel that the European recovery is running about a quarter behind than what we expected. And based on -- as planned, they would have been having organic growth first. It's going to be close; let me say it that way, Ann.

Okay. That's great color. And just a follow-up on that then, given those comments, would you expect MSSG to break even in fiscal Q2 or still lag?

I think it will lag a little bit. I think directionally, that's kind of where we're going for the whole organization, to be at breakeven. Obviously, both business units need to be in that trajectory. So we think we're moving towards that area.

Okay. I'll get back in line just in the interest of time. Thanks. Thanks for the color.

Andy Casey, Wells Fargo Securities.

Frank, on the tax rate for Q2, what are you expecting there within the guidance that you provided?

Yes, again, you know how that moves around, to be excluded -- I would say it's going to be about in the mid-30s. And then for the rest of the year, I'd probably put it around 25%, given how it's been moving. So, the second half will be in that 24%, 26% range.

I think we'll finish the year towards that 25%, then it will step down as we start getting a little bit more profitability out of our European business in the second half.

Okay. So with that are we looking at pretty much a breakeven operating profit line? And if so, that kind of brings your decrement year-over-year at the midpoint down to around 17%, 18% -- is that about right?

From a decrement -- is that --

Yes.

Say that again, Andy? I mean, you're close. Let me say it that way.

Okay. And then on the free cash flow guidance, the $5 million to $15 million, you pretty much got to the midpoint of that range in Q1. Are you looking at that? I know you talked about the inventory build in a recovery, but are you looking at that right now as being fairly conservative?

Yes, I would think that's safe. We'll probably have some strategic raw material, some input costs here in the second quarter, but nothing significant; but at this point, I would say that's a fair comment.

Okay. Thank you very much.

Eli Lustgarten, Longbow Securities.

Just a quick clarification -- corporate expense, which was 19 and change, does that continue at that rate for the rest of the year?

No, Eli, I'd put that around going forward about $15 million, give or take a little bit there. You know, because we won't have the annual granting of the stock option and some related costs like that. And we have some one-time costs in there in the quarter, so going forward, it should be in that range.

And the profitability improvement in AMSG was quite stark -- to see that strong double-digit. Was that sustainable? Can you talk about what really contributed to that, just all cost reduction? And how do we look at that for the rest of the year? Is that a sustainable number or is there some variability around it?

Yes, I would say it's obviously the cost reductions. And then I would say lower raw material costs on some of the areas there. And then it's just the ongoing discipline in the organization, I think. A couple of the business units that were dragging, I think we're seeing some improvements in the surface finishing business -- [Extrude Holland] and some of the industrial areas that in the past were tagging. So I think we've done a better job of looking at those businesses.

You should be able to sustain that profitability for the rest of the year at that level?

Yes. Yes, this is Carlos, Eli. We feel that the business is in really good shape for that.

Even with some seasonality in the second quarter?

Yes.

And can you tell me -- with raw materials starting to go the other way, are we going to see some pressures in MSSG in the second quarter? Or is that -- have your pricing built-in to offset the cost pressures that are building?

Yes, the pricing is built based on the pressures. And I continue to remind people that we suffered last year because we -- our standard costs reflected a higher price. We are benefiting -- it takes us about six months, so we have benefit of raw material there. We purchased a year ago and so forth, so that raw material price increase is not a big concern for us during this year.

Mark Zepf, Goldman Sachs.

What was the impact of currency on an APS basis in the quarter and what's the expectation for Q2 and 2010, as that swings to a positive?

We don't break it down to that level. Currency, as I said on the call, was a negative 3%, but it was probably a negative given our exposure in Europe. When you translate kind of the cost over there, it was a slight drag. We had some hedges in there that were a positive from a transaction perspective, but that was in the other income and deduction areas; but from an overall business perspective, it wasn't significant.

And does the balance of the weaker dollar versus the hedges swing to a benefit in Q2 and for the balance of the year? What's implied in the guidance?

Yes, it will be -- the guidance we provided was organic because it's always, obviously, tough to predict where the currencies -- with the big one for us being the euro, the euro was down year-over-year in our first quarter but we expect that to be up anywhere from 3% to 5% from where it was last year. So we'll get a slight benefit going forward.

Okay. And then just a follow-up on the cash flow. The inventories are down year-over-year, but not as much as the 36% organic decline in revenues. I guess it's not clear why the current inventory level is not sufficient to satisfy the early re-stock and uptick in demand. Are customers offloading any of the inventory risk on to you? Is there any change going on in that dynamic?

Can you talk about why the working capital build, even as inventories are only down 20% year-over-year, versus a 36% topline decline?

Well, we made an acquisition last year. And you have foreign currency, which are artificially inflating the absolute value of it. But I'm not talking about adding anything significant. We think we're balanced where we need to be at this point.

So you consider the 2010 level an appropriate level of working capital for the business, kind of thinking longer-term over the cycle?

I think longer-term over the cycle, we want to improve inventory turns; but at this inflection point of going from where we are at a $2 billion rate to a higher rate, I would say that in the next 12 months it's going to be difficult for us to make a major improvement in our inventory turns. We will, once we get at the full run rate.

Okay, thank you.

Alex Blanton, Ingalls & Snyder.

When you're looking at 2010, how do you currently think about the capital goods outlook for 2010? You said that the economy is recovering but is going to be very volatile and uncertain. Do you think there is a possibility of another leg down in the economy? Because inventory adjustments can take place despite the fact that final demand continues to fall, and then you have the potential for another inventory adjustment later.

Yes, again, we are talking calendar year. So we have a fiscal -- our fiscal year ends in the middle of calendar year 2010. So you have got to keep that in mind. But talking calendar year capital equipment, what we call machinery, we see from an IPI perspective we see calendar year '09 to be minus like 14%. And we see calendar year 2010 to go to 3.3 positive.

So is there a possibility there is going to be an inventory correction down the road in 2010? I mean we are not sure. I mean nobody knows that. But what we find right now is one of the positive things is that we have had an inventory depletion throughout all the industries that has been greater than ever before. So I think there is going to be demand coming out of there that is going to stay, number one.

And number two is I want to continue to emphasize because of the cost take-out in our business, we are not counting on a big growth, topline growth, for us to be able to deliver this promise that we made. We still are looking at a 5% to 10% negative year over year growth on a topline in our fiscal year 2010, which half of it is in calendar year 2010. So I think that from where we can see, I think we are in very good position.

Well, ultimately the demand for capital goods depends on consumption. So what I'm suggesting is that unless consumption turns around and goes up in 2010, it is hard to see any recovery in the capital goods market other than an inventory adjustment.

Alex, I mean who knows. And again, my point to you is that this is why we sized this business to be profitable at $2 billion. What if things don't turn around, we are in good shape. We also have the capability of getting this business to deliver $3 billion. And if that happens, I think that I certainly would be smiling myself here, but it would be a great story. (multiple speakers). We are positioned for either case at this point.

Yes. And how quickly can you raise production if things do turn around?

Today. Fast. Fast.

Very fast?

Yes.

Because I know that the OEMs like Caterpillar and others are concerned about the suppliers being able to respond to a recovery because of the very big inventory adjustments that have taken place. There could be some very big increases on the other side. Are you ready for that?

Yes, Caterpillar, John Deere, I think this is the whole essence -- the whole strategy that we deployed during this downturn is the fact that even though we closed a number of facilities to take this fixed cost, we did not remove capacity from our business, and this is another reason that instead of laying off further people we did the reduction in salary of 10%. So what we are doing is we have people in place to take at least the first wave of increased production.

Henry Kirn, UBS.

A quick question about stimulus expectations. What are you expecting -- when are you expecting that to start to hit? How big could it be for you guys?

Well, Henry, I mean I tell you what. We are not counting on the stimulus -- let me say it this way, we are not counting on the stimulus of the US. Okay? We have seen benefits from the stimulus elsewhere like China. We have not experienced really any positive growth from the stimulus program in the US, and we are not counting on it. So we are still looking for it. When we get it, it will be an upside to what we are providing to you. But we just cannot see what it is going to do for our business at this point.

Okay. And in terms of M&A, how are you thinking about strategic acquisitions as we get deeper through the downturn, and are there any more businesses that you are reviewing to see if they are non-core?

I mean we pretty much identified the major non-core businesses and have acted on it. You obviously need to continue to look at product lines. Whether I mean you are down or up, reviewing how strategic product lines are is I would say a normal course of business.

We, at this point until we see the upturn and we feel good about where we are going with a lot of certainty, are inclined not to make the any acquisitions. We are going to make sure we keep a strong balance sheet, manage cash flow and until we have a very good feel about the future, the economic future.

Chuck Murphy, Sidoti & Co.

I was just wondering your sales were pretty much in line with your guidance, but the net loss was not quite as bad. And I was just wondering if there was anything in particular that provided that upside?

I think it is the one item that we had a little bit of acceleration. The first question we had from Cleveland Research was an incremental $3 million --

The Europe stuff?

In Europe and I think the tax rate, obviously that $1.5 million that we talked about, but then it is basically kind of the restructuring programs delivering the permanent benefits and kind of the mindset and watching the cost in the business.

I need to continue to emphasize, I'm extremely pleased that we -- our progress on the cost reduction in this Company is ahead of our expectations. We were ahead last quarter. We are ahead this quarter, and that really validates our belief that these costs are gone, and we are going to really benefit from the upturn with very good leverage.

All right. And how should we be thinking about gross margins and operating expenses going forward? Are they kind of stable right now and just tick up with sales as the year goes by, or is there still something moving around in those items?

No, I think they will continue to improve as we go out, and we expect a much better leverage on the topline in our second half of the fiscal year where we have talked about leverage north of 40%, and we think we are on track to deliver that in the second half with a lot of the costs that we have taken out of the business.

Okay. And my last question was, can you just talk about the rationale for separating the Widia and the Kennametal brands and what you expect from the two going forward?

The fundamental view is that we are going to have a distribution brand for distribution with a value proposition that benefits from distribution, and we are going to make sure that the Kennametal brand is a direct brand and helps us with our values sale proposition. And I think that we have been very, very good in the direct sales arena, and we have been building the momentum with the distribution, and this is really the next step to grow our distribution. And this I think will allow us to grow the distribution channel at a higher rate.

Walt Liptak, Barrington Research.

Good quarter. In talking about the inventory build for this year, what sectors are you expecting that in? And specifically with Caterpillar's Power Up program that got alluded to earlier, have you talked to Caterpillar, and does that ripple through your customers inventory in a meaningful way?

Yes, I mean certainly Caterpillar, John Deere has just announced hiring another 600 people, I think close to 600 people. We would expect to see that ripple through our sales basically in the next quarter.

Okay. And what kind of leverage do you initially get on that inventory build?

I mean this is what we talk about, 40% plus in our incremental sales. I think we have experienced that this quarter, and we will continue to experience that plus going forward.

Okay. And with the $3 billion number that you talked about, I imagine if you go out a couple of years to get to the $3 billion leverage becomes less than the 40% plus?

Typically we get -- you know, if you look back historically we would get 35%, 30% to 35% leverage. 35% would be a good leverage. Again, I keep on saying that if you look at our 2008 results and take $125 million of our cost there, it puts us at a 16.4% EBIT margin. So we are well positioned going forward, obviously depending on economic turnaround, but we don't need a lot of top line growth.

Okay. And then I want to ask another -- you talked about the manufacturing footprint down 40% from '03, which is impressive. But I think you have got shareholders that have been I guess expecting that footprint was going to get reduced faster knowing the cost structure and the way especially the US is set up. What are the plans beyond -- I know you have done a lot of heavy lifting this year, and I don't want to take away from that -- but what are the plans beyond the $125 million of costs out to the plants, the 14 plants that you have taken out?

All I can tell you is that there continues to be opportunity for us to do that. But we need to see what the next year brings. I mean we need to see what the growth is. We need to see -- we need to start generating cash and so forth to be able to do those things. But that is something we are going to think about when we put our 2011 plan down the road. But clearly to me I would describe -- it depends on the topline obviously at a $2 billion -- $2.5 billion, I would say that we will probably have -- we are 60% there. If you have -- if you think about a $3 billion company, we probably are 70% or 80% done. So there is opportunity, but we need to understand what the topline is going to be in the out years. But we are not done by any means.

Andrew Obin, Bank of America/Merrill Lynch.

Most of my questions have been answered, but just if you could give us more color as to what you're seeing from distributors in terms of this inventory restocking? Can you talk about just the magnitude of sequential pickup you saw in September, and we are almost done with October. What are you seeing there?

It has been the growth between the distributors and the direct sales has been about even, and there it is for different reasons. I think the distributors are building up starting to have sales, especially the integrators that are associated with the order industry. They are beginning to see strong pool. And in the direct side, we have seen a lot of activity in special new programs and so forth that are being put in place. So it is really hard for us to be able to tell you exactly, not only because it is different things driving one channel versus the other. The other one is competitively we just don't typically disclose those numbers.

And what about just October versus September, any discernible difference between the two months?

All I can tell you is that as we look to our sales I think our sales are aligned with the guidance that we are providing.

And just in terms of thinking about steel costs and raw material costs that you are experiencing, how are you thinking about this versus first half of this fiscal year versus the second half? Any difference there given what is happening in the market?

At this point I would say nothing significant at this point.

Ant is that because --?

Our steel cost buy will be down because -- unlike a lot of the divestitures we did in those areas. So we would not have a significant impact on there. So we continue to watch tungsten trends, and the way we're looking out with our contracts we feel there's not going to be a significant change going forward at this point.

So you don't think that steel cost is going to be a big variance for the quarter for the annual results?

It is smaller in composition. Unless something gets way out of line, then we will have to react with price increases.

The way we see it right now with our visibility we should not -- we don't have a concern at this point.

Nico Dil, JPMorgan.

I was just wondering whether you could give us the applied organic growth you are looking for in the June period next year, so H2 2010 as far as I can understand.

Perhaps related to the first question that was asked on the conference call, but how much do you feel the implied growth here is due to an end to destocking and how much is due to an economic recovery?

Well, from an organic -- we gave in the press release, and let me just reiterate what the percents were. From an organic in the second quarter, we said negative 20% to 25% organic, and then for the full year, a minus 5% to minus 10% for the full year. So you have the first and the second, and we don't give it out by quarter. But you can imply with the second half would be some growth on the topline.

And your second question, I could not quite here it.

As far as (inaudible) the calculations, I get to about 25%, 30% or so for the second half 2010. I was wondering how much of that is due to destocking and how much is due to an economic recovery?

I would say for the most part I think the destocking is somewhat stabilized or a little bit behind us. So I don't think that is going to be a drag going forward. And then as Carlos said in his call, people are still a little bit cautious. So hopefully we are planning for the worst, and then if we get a little bit of an upside on the restocking, that will obviously fall to the bottom line, and you will see it in the organic order rates that we put out every single month.

My opinion is the growth that we have seen or the deceleration of decrease that we have seen is through demand. Because people are very cautious, they are buying what they need right now. I think, as we have built confidence going forward, I think that there will be a stocking portion.

So when I look at our second half, right now I would say that the majority of it is going to be demand. Because I don't think that people are going to start increasing their stocks this year, this calendar year, 2009 calendar year. I think that everyone needs to see a sustained growth for a longer period of time before they start building inventories.

Steve Barger, KeyBanc Capital Markets.

I had to hop off for a minute. Just tell me if you covered this. But you have done a good job on keeping or gaining price through the severity, the worst part of this downtime. Is that sustainable going forward, or do you think competitors may start seeking out increased market share to put through there? You know, everybody has got a smaller cost base now.

I think that we have come from a place where we were increasing prices during the most severe times, and I think that what we guided for this year is that we are going to basically be even. So we are now going to increase -- have price increases or decreases. And I think for our 2010 fiscal year I've think that is very achievable.

Okay. And Frank, you had talked about the idea that as you see sequential revenue increases, there is, given your cost initiatives and the fact that you are probably on top of raw material inflation, you should be able to get gross margin increases sequentially throughout your fiscal year, right?

Correct.

SG&A has bounced around a lot because of some of the cost-cutting initiatives. How should I think about the absolute level of SG&A in 2Q going forward? Is that up, down from 1Q plus or minus?

At this time I would say it is kind of up slightly going from the 116 base, and it will be the variable components that will drive up it. Because we continue to watch the restructuring programs. You know, we are at that run-rate. We will probably pick up a little bit there between cost of sales and OpEx. But it is maintained in that discipline. So it is not going to go up substantially. But you are right. When you go from the fourth quarter to the first quarter, when you have the furlough salary increase, that is the one anomaly period. But the salary cuts will be consistent for all periods going forward. So I don't expect anything significant.

Okay. And is the $6.4 million plus or minus the right interest expense number to think about for the next quarter or two given where interest rates are and the fact that you have paid some debt down?

Yes, I wouldn't -- I cannot see it going one way or the other for much significant -- it is not going to change that much. Let me say it that way.

Okay. So if you have improving gross margin from here on, rising revenue, flattish SG&A, flattish interest expense, is it fair to say you are taking a fairly conservative approach to 2Q EPS given what we know should be a lot better operating leverage going forward?

Well, I think you will definitely see the strong operating leverage in the second half, and it gets to the what is going to happen in December with the holidays and the plant shutdowns --

Right.

-- and I expect not everything is going to be exactly flat. There will be some increases. So -- but I think until we get further down the road, the other issue is kind of some of the mix of the business. I think with Europe being a little bit softer in some of the energy business, we do have somewhat of a mix in the, I will call it, different business units -- Europe and MSSG, energy and AMSG. So that will play a little part in it. And then in the second quarter, if you remember the first question that we had where we got that incremental $3 million benefit, that is not going to be in the next period. So that will be a little bit of a takeaway.

Okay. And just last question. Generally speaking from some of the comments you had, it seems like you have -- you are if anything ahead of schedule of where you expected to be given some of your cost takeouts. Anything other than some of the issues that you just talked about that should reverse that trend? Do you have a lot of positive momentum on these initiatives going into 2Q?

Yes, we do. Yes.

Joel Tiss, Buckingham Research.

I wonder do think that MSSG is going to be on the operating line? Do you think second quarter is when we get pretty close to breakeven?

Yes.

Okay. So that makes sense. And then the overall sales year-over-year to turn positive, it sounds like the third quarter is a reasonable guess.

From a year over year growth, yes.

Yes? Okay.

Don't forget there are very favorable comps.

Yeah, yeah. Well, the fourth quarter they get really, really favorable.

(multiple speakers). Exactly.

And then the swing in other income, I'm sorry I don't know if you covered that or not; maybe you did. The $3 million positive in other income, can you just give us what was in there?

Yes, are you year over year or sequentially?

The year over year?

Yes, that is some FX hedging gains that we have.

Okay. So that is -- is that a cleanup or --?

That goes back to another question from Steve Barger, and you will probably have a little less on a sequential basis there. That was some options that expired on our euro currencies.

Dana Walker, Kalmar Investments.

Boy, I hope I'm worth the effort and the wait. We have now been through a full cycle with a fairly full AMSG portfolio. Could you comment on how you believe that portfolio has performed against your expectations and how your effort to perhaps keep the price cost relationships more current on a more real-time basis might play assuming that that is possible?

You know, I will start that, and then Frank can add some color. But I would say that AMSG has not in the last 12 months has actually suffered from -- has not met their potential because they suffered from increased raw materials that take us typically a year to recover, and the markets were beginning to decline at the time that we needed to recover those raw material price increases.

So I would say that AMSG's profitability or margins or whatever you want to look at it from what perspective, are, as we always said, a great business that will have higher margins in metalworking, and we haven't in the last 12 months been at that point.

Yes, I would add I think I will call it our mining construction, Earthworks, I think those guys have done a phenomenal job with the Tricon acquisition. It has been right in their sweet spot and really leveraging that across the organizations.

The energy business, you know, sometimes it's down, sometimes it is up. We think that is a great business. We like it a lot, and that eventually will come back, and that is very profitable, as you know. And I think we have made some pretty good inroads with some of the industrial businesses or the engineered products related and with our surface finishing capital good side.

So I think we have come a long way. I think the good businesses have continued to do well and some of the units that were underperforming, I think we have made some hard decisions and we try to point them in the right direction.

Are you in a position, though, given that we have a new cycle unfolding unknown as to what shape it will take to try to gain price on a more real-time basis, or is it just what it is?

Well, I think that as what happens with the raw materials, at this point I think that if the energy part of that business is the question mark of when is that going to turn up. But we believe that business has tremendous upside opportunities from this point.

Another reflection question. What is your observation as to what has happened to competitive capability? I suspect the majors probably have not done much other than try to adjust their structural costs. But how would you comment about what the majors have done versus what the remaining smaller players in the market have done?

I think that we have taken costs out without taking capacity out, which is a benefit for us in the upturn, we believe, number one.

Number two is during this time we continue to invest in new product development. We introduced a number of new products like BEYOND that are outperforming and outpacing any competition at this point.

So to the event that companies' demands, our customers' demands go up, I think we have a very good opportunity for an upside from that perspective.

You know, I would say that Sandvik probably has done what they needed to do to cope with the costs. I don't think a lot has changed. I think that we will probably by the time this is over have seen some of the smaller competitors that probably have lost ground and will not be there during the upturn. They will not have enough working capital to stay in business.

Have you been able to take steps, though, that would enforce your customer relationships in a way that you don't believe the market has been able to keep pace with?

I think in some customers we have. But when you have a global business and we have 80,000 active customers, it is hard to make that assertion across the boards.

A final question for me. Late in the cycle you were taking steps to work the channel more than your direct business so that you would have some of both. How has your channel business performed versus your direct business, and how strongly do you feel about that today versus how you thought you might two years ago?

I still believe the strategy is the right strategy. I think that our indirect channel may have performed slightly better. But it is because those folks don't take -- they tend to carry inventory more than the end-users. The end-users I think did more of a destocking than the distributors. But everything is relative.

I mean we still believe it is the right strategy. We still believe that we are going to continue to invest in the distribution channel, and I think that long-term we are going to see a good uptick from that.

Thank you and good luck.

This concludes our question-and-answer period for today. I will turn the conference back to Ms. Maguire for any closing remarks.

This concludes our discussion. Please contact me, Quynh McGuire, at 724-539-6559 if you have any follow-up questions. Thanks for joining us.

Today's call will be available for replay beginning at 1:00 p.m. Eastern time today and will run through midnight on November 28, 2009. The number to dial to access the replay is 800-642-1687 or 706-645-9291. The conference ID number for the replay is 34761535.

This concludes today's call. Thank you for your participation. You may now disconnect.