Kennametal Inc (KMT) 2013 Q2 法說會逐字稿

Good morning.

I would like to welcome everyone to Kennametal's second-quarter fiscal year 2013 earnings call.

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

After the speakers' remarks there will be a question-and-answer session.

( Operator instructions )

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

Please go ahead.

Thank you, [Brian].

Welcome, everyone.

Thank you for joining us to review Kennametal's second-quarter fiscal 2013 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've invited various members of the media to listen to this call.

It's also being broadcast live on our website and a recording will be available on our site for replay through February 25, 2013.

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, Marti Bailey.

Carlos and Frank will provide further explanation on the quarter's financial performance.

After their remarks, we'll 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'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 will now turn the call over to Carlos.

Thank you, Quynh.

Hello, everyone.

Thanks for joining us today.

In the December quarter, we continued to experience challenges similar to those of the prior quarter, which included lower sales volumes as demand slowed globally.

Political and economic uncertainties led to spending deferrals and inventory destocking by customers.

Those conditions resulted in a weaker than expected global industrial production across certain end markets and geographies.

In addition, our sales were unfavorably impacted as a number of customers took extended shutdowns, year-end holidays.

This trend was more severe in Europe, but it occurred in North America as well.

Accordingly, we made further adjustments in our Business as we expected those challenging conditions to continue for the near term.

Even so, we still expect to realize sequential quarter-to-quarter improvements in the second half of our fiscal year.

Although economic projections call for global industrial production to expand, it is likely to grow at a more modest rate than previously forecasted.

What positions Kennametal well is that we serve a diversified mix of end markets and geographies, which helps to lessen volatility over economic cycles.

We remain highly focused on further growing and balancing our global presence to generate revenues in equal parts from North America, Western Europe, and the rest of the world market.

In line with a geographic expansion strategy, we announced earlier in the December quarter that we plan to invest in an advanced carbide recycling facility in the US while expanding Tungsten-Cobalt Blended Powder Operations in our China facility to serve the Asia-Pacific region.

Both projects focus on [straining] our Tungsten sourcing for both technology and cost perspectives while increasing our access to raw materials.

We remain encouraged by the long-term growth opportunities in our [served] end markets.

On a global basis, demand for energy, power generation, vehicles, commercial development, new materials, and increased requirements for customer productivity remain the key growth drivers in our industry.

In addition, our Widia brand and channel strategy is creating opportunities for us to grow our presence in industrial distribution.

Our proven strategies enable us to effectively navigate economic headwinds and deliver our goal of driving profitable growth and doubling our revenues over the next five years.

We have implemented contingency plans to reduce costs to match the current environments.

During the December quarter, we further sharpened our focus on expense control in both manufacturing operations and administrative functions.

Our team maintained the discipline that has long been part of Kennametal's culture to achieve additional savings, over and above permanent structural improvements made from prior initiatives.

Importantly, we accomplished this without sacrificing ongoing development of talent and technologies that depreciate Kennametal in the marketplace.

At this time, I would like to provide an overview of trends we are seeing in our served end market.

In aerospace, US commercial firms continue to lead the way in growth.

Boeing finished the year with 601 commercial jet deliveries, surpassing their projection of 590 units.

Although its 787 Dreamline fleet was recently grounded, the issues do not seem to be related to manufacturing processes and production has not been negatively impacted at this time.

Embraer recently released its forecast for Chinese market during Airshow China in November.

It predicts significant growth in the number of aircraft carrying 30 to 120 passengers, from 125 today to more than1,000 jets in 2031.

In general engineering, which primarily reflects trends in the indirect channel, the latest Industrial Supply Association Economic Report indicates that distributors are optimistic despite current headwinds.

Distributor Channel reported to experience a steep decline in business in the last two weeks of December.

In addition, they noted that inventories remain relatively high in the channel, suggesting further destocking in the near-term.

In transportation, light vehicle production in North America is expected to decline over the next several months.

It should resume modest growth through the remainder of calendar year 2013.

Based on that, OEM and major tier suppliers continue to make investments to increase capacity.

In Europe, the transportation sector declined 18 % year-over-year in vehicle production, and lower levels are expected to continue for upcoming quarters.

In China, 2013 production is expected to increase 9% over prior year to 20 million units.

In India, vehicle production is forecast to grow it 8.4 % in calendar year 2013.

Kennametal can provide productivity improvements to this market with our portfolio of standard products, as well as our highly-engineered customized solutions.

And the energy market continues flowing in oil and gas drilling activity is reflected in a 5% decline in world recount year-over-year.

While oil processes have improved, they remain relatively low and gas prices have stalled as well.

Demand for natural gas is expected to rebound by year-end of calendar year 2013.

With the investments being made globally, including land purchases in US-based Marcellus Shale and exploration reserves in the North Sea.

In addition, renewable sources of power generation are projected to grow globally 5% per year, which increases Kennametal's addressable market opportunities.

In mining, US coal production was down nearly 7% in 2012, contracting most significantly in Central Appalachia, with a 16% year-over-year decline.

As of December, coal prices seem to have stabilized in the US.

In Europe, coal demand increased year-over-year despite a sluggish economy.

And imports from South Africa, Russia, and the US typically favored over high-cost coal produced in the European Union.

China's coal production declined due to economic conditions and government-mandated shutdowns of small mines in preparation for the transition to the new political leadership.

Longer term, China plans to add significant coal-fired electricity generation capacity increasing current annual production of 4.9 billion tons to 7 billion tons annual by 2020.

In road construction, the US Federal Highway Build will allow some space to fund more highway rehabilitation in calendar year 2013, which should benefit Kennametal beginning in the spring, giving our strong leadership position in this market.

In Europe, highway rehabilitation markets are expected to be flat, while modest growth is expected in other regions such as South Africa, Poland, and Russia.

On the whole, world growth is expected to stabilize in 2013, then hold steady at 2.6 % according to IHS Global Insight.

In addition, a modest exploration of growth is expected in the later part of calendar year 2013.

This cautiously favorable outlook is based on the expectation that the monetary stimulus put in place in many key economies will have some positive impact on growth, and uncertainties related to the US and the euro zone and China will become less intense.

Therefore, it is anticipated that the risks facing the global economy will be more balanced.

Over the past 12 months, the risks were more skewed to the downside.

Following the Great Recession, consumers and businesses have been cautious about spending.

There is some evidence that this process may be winding down, especially in the US and parts of Asia.

Looking ahead, those are encouraging signs of a recovery, although it appears to be delayed by one to two quarters.

Our global team remains agile, and we are very well positioned to serve our customers when growth resumes.

We have successfully managed to the much more severe downturn, and we are a stronger company today.

We have a play book to align our cost structure with current market demand.

As always, our Company's specific initiatives enable Kennametal to protect our profitability and deliver double-digit operating margins even in a challenging macro environment.

I will now turn the call over to Frank who will discuss our financial results for the quarter in great detail.

Frank?

All right.

Thank you, Carlos.

I'll provide some comments on our performance for the December quarter, and then I'll move to the revised outlook for the remainder of fiscal 2013.

The December quarter was more challenging than we originally anticipated as most of our served end markets experienced weaker-than-expected demand.

This was pattern was evident in our monthly order rates that we provided during the quarter.

Continued soft demand in destocking plagued our general engineering market.

Transportation was particularly slow in Europe due to extended plant shutdowns in December at automotive manufacturers and customers further delay their projects in the energy market.

Our previous expectations assumed that activity would begin a rebound at the beginning of calendar 2013.

It now appears that the recovery has been deferred for at least one or maybe two quarters.

With that said, I will point out that we are managing that business very well with the factors we can control.

And near-term headwinds do not overshadow strong future growth opportunities in the execution of our strategies.

Further, despite the sales challenge in the near term, we again deliver double digits at operating margin.

We also demonstrated exceptional cost control throughout the Company, and managed to reduce our finished goods and whip inventory by approximately $17 million from September despite a demand environment that was much softer than we had anticipated.

Lastly, we enhanced our liquidity and strengthened our financial position by issuing $400 million of 2.65% bonds due in 2019.

Note that our proactive cost-reduction measures, as well as our more efficient organization structure, helped deliver double-digit adjusted operating margin of 10.7% for our base business despite the market challenges of the quarter and our inventory reduction efforts.

We have cost containment actions in place in all functions and are managing our Business to market conditions while staying focused on our near-term cash flow objectives and long-range growth strategies.

Now I will walk through the key items in the income statement.

Sales for the quarter were $633 million.

This compares to $642 million in the same quarter last year.

Sales declined by 1%, reflecting the 10% organic sales decline and a 1% unfavorable affect from currency, partly offset by a 9% increase from Stellite and a 1% increase from more business saved.

The industrial segment sales were $361 million, and they declined by 12% from the prior-year quarter.

This was due to 10% organic decline and a 2% unfavorable effect from currency exchange.

On an organic basis, sales declined 15% in general engineering and 8% in transportation, partly offset by sales growth of 10% in aerospace and defense.

General engineering was unfavorably impacted by lower sales at the indirect channel due to further inventory destocking, while transportation experienced lower volume, lower vehicle production rates, and extended plant shutdowns, particularly in Europe and Asia.

Aerospace and defense sales benefited from the increase in commercial aircraft production and regionally, sales in the industrial segment decreased by approximately 15% in Asia, 9% in Europe, and 8% in the Americas.

Turning to the infrastructure segment, our sales of $272 million increased 17% from the prior-year quarter, driven by Stellite contributing 26% growth partly offset by an 8% organic sales decline and a 1% unfavorable effect from currency.

On an organic basis, sales declined by 13% in energy and 6% in the earth works market.

Energy customers continue to delay orders due to ongoing decline in the North American oil and gas rig count and weak underground coal demand in North America, as well as additional mine closures affected our Earthworks Business.

Regionally, sales decreased by 12% in the Americas, 3% in Asia, and remain flat in Europe.

Now turning to our gross profit margin, our gross profit margin was 31.5% compared to 36.1% last year.

The decline was due to lower volumes and lower absorption of manufacturing costs resulting from both the lower sales, as well as our inventory reduction efforts as well as an unfavorable sales mix.

The inventory reduction had an unfavorable impact of approximately $5 million or 100 basis points on gross margin.

This quarter's results also includes the effect of Stellite, which has a lower gross margin versus the Kennametal base business.

The prior-year gross margin benefited from strong organic growth, a favorable business mix in pricing, as well as absorption benefits and manufacturing costs.

Our operating expenses declined $7 million compared to last year.

Overall lower employment and related compensation cost, containment of discretionary spending, and favorable foreign currency exchange was partly offset by the Stellite acquisition operating expenses.

Operating expenses of percent of sales was 20.2% for the quarter, down 80 basis points from the prior year of 21%.

This represents ongoing cost discipline from our global team coupled with the affect of Stellite, which has lower SG&A percentage versus the Kennametal base business.

Amortization expense was $5.2 million, and that's up $3.3 million from last year.

And the increase is all due to the Stellite acquisition.

Operating income was $66 million compared to $94 million last year.

Operating income included $5 million of Stellite operating income contribution for the quarter.

Our operating income decreased as a result of lower sales volume, the unfavorable mix, and lower absorption of manufacturing costs.

The operating margin for the December quarter was 10.5%, and adjusting for the Stellite acquisition, our base business delivered an operating margin of 10.7%.

Looking at the business segment's operating performance, industrial segment's operating income was $37 million compared with $63 million in the same quarter of the prior year.

Industrial operating income decreased due to lower sales volume, lower absorption of manufacturing costs, and an unfavorable sales mix.

Industrial's operating margin was 10.4% compared with 15.3% in the prior year.

The infrastructure segment operating income was $31 million compared with $33 million in the same quarter last year.

Infrastructure's operating income benefited from the Stellite operating income of $5 million, which was more than offset by the effect of the organic sales decline and lower absorption of manufacturing costs and an unfavorable sales mix.

Infrastructure's operating margin was 11.5% for the December quarter, compared with 14.4% for the prior year.

Excluding Stellite, the adjusted operating margin for the Infrastructure business was 12.3% in the December quarter.

Interest expense increased approximately $1.7 million year-over-year in the December quarter to $7 million due to higher debt levels attributable to the Stellite acquisition and our recent seven-year $400 million bond issuance, partly offset by lower bank revolving borrowing costs and the lower coupon rate.

Our effective tax rate was 26.4% compared to 17.3% in the prior year.

The increase was primarily driven by evaluation allowance adjustment in the prior year and lower current earnings outside of the United States.

Regarding our bottom line performance, we reported December quarter diluted earnings per share of $0.52 compared with $0.91 in the prior year and December's quarter earnings per share included $0.02 accretion in Stellite.

Turning to cash flow, our year-to-date cash flow from operating activities was $54 million, and this compares with $71 million in the prior year.

Net capital expenditures were $34 million compared to $33 million in the prior year.

And our free operating cash flow year-to-date was $21 million compared with $38 million in the prior year.

We also remain committed to our priority uses of cash.

During the December quarter, we purchased almost 600,000 of our shares totaling 1.3 million shares year-to-date.

Approximately 7.2 million shares remain available under our current share buyback program.

We continue to be highly disciplined in our capital allocation process to ensure that we invest in initiatives with the highest shareholder returns.

Our balance sheet also remains strong.

Cash was $217 million, and we remain focused on improving our working capital.

DSOs, ITOs, and DPOs were at relatively similar levels in the December quarter compared to both September and June despite the substantial decline in economic activities.

This demonstrates that our operating model has become more adaptable to the dynamic market environment.

As we have previously stated, we remain committed to reducing approximately $60 million of inventory in fiscal 2013, primarily from finished goods and whip inventory.

As I said earlier, in November, we issued a new $400 million seven-year 2.65% note to take advantage of favorable borrowing rates, and proceed from this new bond issuance we use to pay down our revolving credit facility.

At December 31, 2012, our total debt was $707 million, up $141 million or 25% from June 30, due primarily to share repurchases of $47 million and the new bond issuance.

Debt was up $399 million versus the prior year, due primarily to the Stellite acquisition and our debt-to-capital ratio at December 31, 2012 was 28.8% compared to 25.3% at June 30, 2012.

And our US-defined benefit pension plans remain 100% funded, and our adjusted return on invested capital was 12.5%.

A quick update on Stellite.

The integration of Stellite continues to be on track including the implementation of SAP.

Four key operating locations are expected to be in our global ERP system in the June quarter.

And we expect to implement the remaining three Stellite locations in early fiscal '14.

During the second quarter, Kennametal-Stellite also experienced some softness in its core end markets, particularly in its energy end market in North America, construction market in Asia, and continued softness in automotive in Europe.

We also took aggressive cost control measures to be in line with the weaker commercial outlook.

We expect the delayed recovery in critical end markets for Stellite will impact its contribution of fiscal 2013.

In the second fiscal quarter, Kennametal-Stellite sales were $60 million, and Stellite contributed $0.02 per share to the Kennametal results.

Now I'll turn to our revised outlook for the remaining of the fiscal year.

As I previously noted, as well as Carlos, the December quarter proved more challenging than we had anticipated due to continued demand softness in general engineering, energy, and transportation.

We have revised our outlook to reflect this situation, which include the following assumptions.

In terms of general engineering, we assume now that the destocking will most likely end by the end of the June quarter.

In terms of energy, our customer order books are building and activity is expected to pick up in our second half.

And in transportation, we are projecting an increase in activity in Europe and Asia in the second half.

And then a positive note is that our monthly order rates that we provide have remained steady during the past several months, and it appears that we have reached the bottom.

As a result, we have adjusted our full-year outlook.

We now expect fiscal '13 sales to be between negative 2% and negative 4%, with organic sales ranging from negative 7% to negative 9%.

Therefore, we are reducing our earnings per share guidance for fiscal '13 to a range of $2.60 to $2.80 per share.

Included in this outlook is the accretive contribution of the Stellite acquisition which is now expected to range between $0.10 and $0.15 per share, net of integration costs.

We expect to generate cash flow from operations between $290 million and $325 million for fiscal '13 based on anticipated capital expenditures of between $90 million to $100 million.

We expect to generate between $200 million to $225 million of free operating cash flow for the full fiscal year.

Some additional factors to note include our expectation of sequential growth over the remaining two quarters of the fiscal year, with the strongest sequential growth coming in the June quarter.

The March quarter will have two less work days this year due to the Easter holiday.

The June quarter will have two additional workdays, and we anticipate the rebound in activity to be more evident at this time.

We now expect to generate approximately 60% of our earnings in the second half following a 40/60 split for the full fiscal year.

We are on track to reduce our inventory, primarily finished goods and whip, by $60 million in fiscal 2013 despite this top-line softness.

And we expect this inventory reduction initiative to have an unfavorable impact on gross margin of approximately 100 basis points in the second half and full fiscal year.

Overall, we are managing the Business very well for the factors we can control to deal with the near-term headwinds as needed.

And we continue to focus on our many growth opportunities and consistent execution of our strategies.

Now I'll turn it back to Carlos for a few closing comments.

Thank you, Frank.

As we advance into the second half of fiscal 2013, we will continue to respond quickly to changing economic conditions.

We will continue to follow our demonstrated play book by maintaining end streamline cost structure, adjusting manufacturing operations as needed, and implementing ongoing contingency planning.

As always, we'll weather the challenges to protect our profitability and deliver double-digit margin performance.

In the meantime, we will continue to execute our proven strategies that are consistent with the Company's long-term growth goals of diversifying our business mix, expanding our addressable market, and balancing growth around the world.

As we have consistently demonstrated, Kennametal has generated steady cash flows throughout the economic cycle.

We will continue to leverage our strong balance sheet and remain disciplined in capital allocation process to build in our strong financial position.

Thank you for your interest in Kennametal, and we will now take questions.

Thank you.

( Operator instructions )

Your first question comes from the line of Ross Gilardi with Bank of America, Merrill Lynch.

Good morning.

Thanks very much.

I had a couple questions.

First, could you comment a little more on the pricing environment?

Are you seeing intensifying price pressure in any of your weaker areas in particular?

If you could just comment on a few of the key end markets?

Good morning.

Obviously, there is always pricing pressure in this industry.

However, we continue to stay strong with our pricing, and we are looking at strategic areas where we can actually still get the price and not give up any pricing quality in any other areas.

Overall, do you think is pricing going up or down?

The Company?

It would be flattish to slightly up.

OK.

And then on the free cash flow outlook, it seems like you've reduced it by less than the earnings outlook.

What is happening there?

Yes, Ross.

Primarily, the second half-- we typically, if you go back, we always generate a lot more of our earnings in the second half as well as the focus on the inventory reduction, particularly with the finished goods in whip.

And I will comment with some additional focus on our working capital from both receivables as was payables.

But the inventory's going to be the big driver in the second half.

And then just last one.

In terms of cash flow prioritization, so forth, you've still got this 5-year objective of doubling sales.

Does a slower out growth outlook mean that you have got to get more acquisitive to fulfill that objective?

When we look five years out, based on our presentation in New York a few months ago, I think we're still pretty consistent on -- we still feel that the balance between organic and acquisitions are still the same.

The majority of the growth is going to come from organic basis, so --

But it's an opportunity to accelerate if we get the right timing.

Thanks a lot.

Thank you.

Julian Mitchell with Credit Suisse

Hi, this is Charlie for Julian.

I apologize if you have addressed this already.

We have been hopping between calls.

Just a quick question.

It seemed like the demand from Asia was weak in both segments and has been weak.

Some of the other companies we've been speaking with have seen a pickup in China.

Just wondering why you guys haven't seen a pickup in China, or if anything, we've kind of changed in January.

In general, if you think about it in a sequential basis, we have seen an uptick in Asia.

However, it is still, year over year, a negative growth.

So I think it is consistent with what other companies are seeing.

And we believe that Asia is going to generate a positive growth first before any other geography.

Charlie, I only got to add is -- I think we are doing a little bit better in the Earthworks side of the Business from some of the investments we made, both in Australia and China, particularly on the coal side, and some opportunities with the construction with the surface lining as well.

We did a little bit better there.

And then we're starting to see a little bit of a pickup here in January particularly with the domestic auto productions.

The aerospace will be fine.

And then, the general engineering will typically lag a little bit on the transportation.

So if the transportation magic stuff starts picking up, we will see the pull forward as well, potentially with the general engineering.

Great.

Thanks.

Adam Uhlman with Cleveland Research.

Hi, guys.

Good morning.

Hey, Adam.

How are you doing, Adam?

OK.

Hey Frank, could we go back to the inventory part?

I believe you said it was $17 million reduction.

That was 100 basis points of margin headwind in the quarter.

When I look at the balance sheet, it's like $5 million of inventory that is lower, so there's probably an accounting difference there.

But the question is this [$9500 million] that's going to be coming out in the back half of the year.

I'm wondering why that would be worth 100 basis points as well.

You don't have the currency or the raw material increase.

Because raw materials are still up in the first half.

They were up a lot more obviously in the first quarter, and they continue in the second half.

So the $17 million, they're related -- I'll call it inventory reduction impact on that in the quarter, I said was about $5 million.

And as we continue to go towards the $60 million in the second half, we are obviously going to have some additional impacts in the second half by pulling the inventory down, coupled with the negative organics.

So it makes a little more challenging, because overall -- raw materials, I think we are doing a better job of controlling that.

But when your larger content material products in the Earthworks and Energy had a slower point in the first half, we tried to hit the brakes where we could on there.

Raw materials -- I think we got a better handle on that for the second half.

And now it's really focusing on the finished goods with inventory getting towards that goal of $60 million in addition to the $17 million that we had here in this last quarter.

OK.

So the $60 million starting point is from December?

We said at the beginning of the year we were going to reduce $60 million.

It was flat in the first quarter for finished goods in whip with the primary increase coming in the form of raw materials.

Fast forward, we did not come off that goal.

We took finished goods and whip down $17 million.

So we have the remaining call balance of that reduction initiative of $60 million-plus in the second half of the fiscal year.

So it was really raw materials, and we didn't get any progress in the first quarter.

OK, I got it.

And then on the guidance for the year, the back half of the year, the organic revenue growth -- the decline is pretty similar to what we saw in the first half of the year.

And you walk through some of the markets that -- and you thought Europe and Asia might be getting better, and orders our steady right now.

I was just wondering if you could highlight the big pluses and minuses that keeps the decline at a similar pace than what we've seen recently.

Going forward, to your point, we have the negative volume.

You've got to factor in the mix there, because our most profitable pieces of the Company, the jet engine energy were down the most.

So you've got kind of a double whammy.

You've got the regular decline and then you've got the mix coupled with the inventory reduction.

So a lot of this stuff, we believe, is temporary.

So I think we're moving in the right direction.

But as we go forward, if I look at Earthworks, we're not anticipating anything significant on the area around coal, because you could look at Appalachia, but some of the international markets are doing well.

We're seeing, as we anticipated, an uptick on the construction sites.

So we're starting to see some nice orders come in there.

There's some housing-related effects here in the Americas.

And we are well-positioned on that in the international markets.

But we feel the energy and the general engineering -- destocking, the good news, it does end.

And based upon what happened in December, it looks like it got pushed, because people shut down a little bit further.

So we're anticipating a little bit of a pickup sequentially in the March quarter in the general engineering as well as energy.

And we're watching the rig counts, and with the cold weather, that obviously will have some help there.

And then by the fourth quarter, we think that this thing will pick up a little bit and we start seeing much stronger sequential growth.

And we are also trying to factor in the number of workdays with the Easter holiday being in here.

Because the quarter, when you look at it with New Year's ending on a Tuesday, you've kind of lost that first week.

So it kind of spills and pushes things a little bit to the right.

And then with Easter towards the end of March, it's going to be a tight workday quarter.

And we think that when business activity picks up in transportation in Europe in a couple other markets that I mentioned, I think we'll start seeing some nice growth, directionally, the growth in the fourth quarter compared to the March quarter.

Great.

Thank you all.

I'll get back in line.

Ann Duignan with JPMorgan.

Hi.

Good morning, everybody.

You noted that both in industrial and in infrastructure that you experienced some unfavorable mix.

Could you just talk about what the unfavorable mix was in each of those businesses?

And should we expect any change in that mix going forward for seasonal reasons or anything like that?

If you look at the industrial, the real mix, it was the general engineering business.

Because aerospace and defense -- it's a good profitability, and that's been relatively constant from a growth perspective.

Yes, I don't anticipate anything.

Transportation was OK in the Americas, a little bit softer in Europe and in Asia.

And now we expect that to come back.

But the real driver -- because we're selling into the small and medium accounts through distribution.

We've done a good job on distribution.

That continues to be the market in the industrial side that was down the most.

And you can look at the first quarter and the second quarter, the sequential change.

And that's where the very profitable piece, as well as that goes down fast, that could come back just as quick.

And I think we're trying to take a realistic assumption here looking at kind of our visibility.

But as quick as the general engineering goes down, which is the most profitable piece, that can come back very strong and in a relatively quick period.

So we have the general engineering on the industrial side which is the high-margin stuff.

And conversely, if you look at the infrastructure side, the energy is the more profitable piece there compared to the underground coal mining and some of the IGT stuff like Stellite as that continues to come up.

But we also feel that is kind of temporary.

So we have not really experienced the energy and the general engineering piece of the Company being down both the same amount, but based upon the weather and the rig counts and some of the order book information that we're getting from our sales force, we think that energy should come back by the fourth quarter.

So it's those two sectors.

So I'll just add that the one has affected the most was general engineering in the first half, followed by energy.

And general engineering fell the quickest in the shortest period of time closest to the second quarter.

We believe that general engineering is going to come back the fastest in the second half and trail by energy at a slower growth rate than general engineering.

And those are the two areas that are most profitable for us.

So that would be the mix change going into the second half.

The real question is how much of it is going to be in the third quarter, how much of it is going to be in the fourth quarter?

Yes, that makes sense, Carlos, in terms of activity drives demand and distribution.

Carlos, just to follow up on that, really, with the flash PMIs coming in pretty gosh darn strong this morning both in the US and China, that would support your thesis of perhaps we get a swing back in demand in general engineering.

Are you seeing anything out there -- I know you obsess over your daily order rates, etc.

Are you guys seeing any signs of improvement either in the US or in China in terms of just industrial activity?

Or is it too early to tell?

Well, I will tell you that so far this month, the orders are coming in per our revised guidance.

And I can tell you that on a sequential basis it is slightly positive.

So it really is demonstrating and is being led by the general engineering, as we spoke.

I will also give you a data point.

We have data that goes back 20 years.

When the PMI hit 50 in this situation -- which has hit about a few months ago, and just recently -- it is about a six-month lag before we see some really, really good growth.

So historically, it validates.

So we see it.

And again, as we said, we think our second quarter came in at a one to two quarters delay.

When is it going to come back within the third quarter or fourth quarter and to the magnitude.

If it comes back in the third quarter, then we will have an even better fourth quarter.

But that's --

And the catalyst for that would be the general industrial side, you think?

Yes, correct.

Okay.

That's helpful, Carlos.

I will leave it there in the interest of fairness.

Thank you.

Andy Casey with Wells Fargo Securities.

Good morning, everybody.

I apologize if you already addressed this first point.

Just a clarification.

What tax rate do you expect for the year?

And the gist of the question is weaker Europe so far.

And then, any impact from R&D?

Andy, last time I think we got at 25%, because the first quarter was a little bit less than 21%.

And so we'd have a little bit higher, about 26% for the remaining [out of] quarters.

Given the change, I think the tax rates now will be 24% versus the 25%.

So we'll probably pick up 100 basis points.

With the tax rate being a little bit softer or lower, favorably, in the third quarter and then a little bit higher in the fourth quarter.

But we will finish the year about 24%.

I would expect it to be in the low 20s in the third quarter for the discrete catch-up relative to the RD&E.

And then a little bit higher in the fourth quarter just because of the jurisdictional mix, even though we're going to get some RD&E.

So we'll be about 25% in the fourth.

Okay.

Thank you.

Then, if we could revisit a couple things that have been touched done.

The channel destocking, in addition to the 100 basis point gross margin headwind that you are expecting from the internal inventory initiatives, is there any way to quantify what that destocking is doing to your margins?

I can try to help you in total, because to the point we made in the second quarter, the pure inventory reduction that we undertook to drive down the $17 million to finish with whip, I said that was about $5 million.

Then I would say the related volume impact was about the same in the quarter.

Okay.

Combined, it was about a $10 million impact of the volume and the inventory reduction initiative at Kennametal.

And is there any way to look into the field and see what the destocking actually did?

No.

We have point of sale and a lot of stuff to the largest distributors.

We are very much aligned with MFC and Fastenal and all that stuff.

Then we have a lot of small distributors.

It's really hard to tell.

Right, because you'll have the Northeast for [Nerospace] doing well versus -- it's depends on the sectors that they're serving.

So it's just too hard to quantify.

Okay.

And then at some point, the destock reverses.

And I'm just trying to gauge if all of that comes back or if you're seeing any issues with any of your indirect distribution partners like market share erosion or something else that would limit a one to one return.

I would say that you guys can read the MFC script that was put out last week.

I think that our market share at MFC continues to increase.

And so I think that we'll come back at least to one to one, the distribution when they start destocking.

And I just want to make a point of our strategy.

Our [Vidia] during this period, first half of the year, was slightly positive year over year, which really -- And by the way, they play primarily in the general industry, which was down almost 16%.

There were slightly positive.

It just shows you that our channel strategy is really working.

And again, when it comes back, we are going to have quite a bit of a tailwind.

Okay.

Thank you very much.

Thank you.

Eli Lustgarten with Longbow Securities.

Hi, everyone.

Let me just get one clarification.

We are still going to do $60 million of inventory reduction in the next two quarters?

Is there something itching that?

And how would that split between the two quarters?

Eli, I said it would be $60 million for the full fiscal year.

And we have $17 million out in the December quarter.

So we have $43 million to go?

Is that --

That would be at minimum.

$43 million, right.

And if we can do a little bit better, we will take advantage of it.

And it would be evenly split between the two quarters?

Or heavily weighted to the third?

I would think it would be a little bit stronger in the fourth quarter, but not much different.

And when you were talking, 40/60 was the earnings for the year.

Can you give us some idea of how you expect the third and fourth quarter split?

It looks like that's also going to split 45/55 in the second half of the year and in the third and fourth quarters just on the basis of where your guidance is going.

Yes.

Again, that's why I try to give you with the work days.

It will be much stronger in the fourth quarter, because we're going to pick up two additional workdays.

So we're going to have flat -- the workdays are going to work out to be about the same, typically in the December quarter.

So about in the low 60s.

And then we will pick it up in the fourth quarter.

So I would imagine the improvement will be nice sequentially, but it will be much stronger in the fourth quarter.

And I will calculate that and get it to you here shortly.

OK.

And incremental margins.

We look to the second half of the year.

We're still talking about -- with the somewhat better volume, the 30%-plus incremental margins.

And we're really talking about profitability, which is in the low double digits, getting closer to mid-double digits in the second half of the year?

Is that still an attainable target?

You're talking sequentially, because not year over year, right?

Right.

I'm just talking about your profitability is a little over 10%, currently 11% and 12% in the different quarters.

Can we get margins in the second half of the year in both divisions to avoid the mid-teens, is the question.

I would say by the fourth quarter, that is a true statement.

It's all into the fourth quarter at this point or so.

And I wanted a clarification of the tax rate.

Can you quantify how big the R&D tax credit benefit will be for you guys?

Right now it's about $3.5 million

All right.

Thank you very much.

Stephen Volkman with Jefferies.

Good morning.

Just one quick cleanup question.

You guys mention a couple times in the presentation that you had done some business adjustments to get your costs under control.

We didn't really quantify that.

Maybe it's just sort of the ongoing kind of stuff.

But I'm wondering, in the spirit, maybe, of Andy's question, does some that come back onto the cost structure as business starts to come back?

Or what's the right way to think about that?

No.

That is the regular stuff -- traveling and --

All discretionary.

All discretionary.

So yes, that portion of it will come back.

The other part is the direct labor.

Obviously, we shed direct labor as our volume goes down.

And indirectly, we will come back.

But we will expect high leverage with that.

It's not a one-to-one, right?

Have you done anything that is more permanent?

No.

Great.

That's great.

Appreciate it.

Our goal is -- we believe that the business is going to come back.

And we are maintaining the capacity, which we've talked about -- the $3 billion-plus capacity without Stellite.

And that's where we really get the leverage as the Business comes back.

That's great.

Very helpful.

Thank you.

Thanks.

Gregory Macosko with Lord Abbett

Yes, thank you.

Just one brief question regarding Stellite.

What was the core gross there?

You talked about the 20%-plus, but give me some color on the core growth within that group.

Gregory, we didn't own the Business until March of last year.

So we don't have -- made investments on business on a year over year.

Sequentially, the sales growth was up a little bit from the first quarter, about 1%.

But we're we are also starting to see some nice IGT orders, the [induster gas] turbine.

That's what we secured in the second quarter, which are a little bit longer lead time.

So we will expect those to kick in, earliest, towards the end of the fourth quarter and then beginning into fiscal '14.

And that's with the [Austrums, the cements].

So we're starting to see some nice improvements with those areas there.

And then we expect the fourth quarter -- to give you an idea, we expect that will be up close to double digits by the fourth quarter on a year over year basis.

Okay.

Thank you very much.

Our final question comes from the line of Walt Liptak of Barrington Research.

Thanks.

Good morning, everyone.

I wanted to ask about your thoughts on the return on invested capital, which we've had a pretty good drop in organic volumes.

And the returns are looking a lot better than they would have four or five years ago.

And then, kind of along the lines, I wondered -- we are still seeing pretty big under-absorption.

And is there anything that you're doing on the factory floor to try and get more variable costs in there?

Or try and reduce absorption when we get these sort of down drafts in volumes?

Yes, I think that, obviously, we continue to look at that.

The balance that we have to make Walt, is the balance that are being prepared, because we can see a very, very fast turned-up being prepared for us to have the ability to deliver and not risk losing market share, because we cannot deliver it to speed and the volumes that is expected in the turnaround.

So that is the balance we're trying to make.

Okay.

Is there more that you can do to try and take costs out on the manufacturing floor and get more variable costs in?

Yes.

We continue to -- we have a lean program that takes an average 3% to 4% of costs out every year.

So for every year that goes by, we continue to do this.

And obviously, when we have low volume, it's a better opportunity for us to look at those things in a more focused way.

Okay.

Thanks.

Thank you.

We have no further questions in the queue.

I'd like to hand it back over for any closing remarks.

This is Quynh McGuire.

This concludes our discussion.

Please contact me at (724) 539-6559 for any follow-up questions.

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Thank you.

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