Kennametal Inc (KMT) 2013 Q3 法說會逐字稿

Good morning.

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

At this time, I would like to welcome everyone to Kennametal's third quarter and 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.

Thank you, Regina.

Welcome everyone.

Thank you for joining us today to review Kennametal's third quarter fiscal 2013 fiscal results.

We released our quarterly press release earlier today.

You may access via our website at www.kennametal.com.

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

It is also being broadcast live on our website, and the recording will be available on our site for replay through May 24th, 2013.

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

Joining for me for our call today are Chairman, President, and Chief Executive Officer Carlos Cardoso and VIce President and Chief Financial Officer Frank Simpkins.

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

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

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

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

Such forward-looking statements involve a number of assumptions, risks, and uncertainties that could cause the company's actual results, performance, or achievements to differ materially from those expressed in or implied by such forward-looking statements.

Additional information regarding these risk factors and uncertainties is detailed in Kennametal's filings with the Securities and Exchange Commission.

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

This enables us to discuss non-GAAP financial measures during this call in accordance with SEC Regulation G. This Form 8-K presents GAAP 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.

Good morning everyone.

Thank you for joining us.

Today, we are hosting this call from our Kennametal Europe office in Neuhausen, Switzerland.

Earlier this week, our Board of Directors and some members of the senior management team were in Milan, Italy to visit two of our manufacturing operations, a facility that produces metal-cutting tools and a satellite plant that makes investment casting components.

In addition, the team (inaudible) Switzerland to see our facility that provides customer solutions and services primarily for the energy markets.

Kennametal has strong brand recognition in Europe, and this region represents a key market for our Business.

During the March quarter, the economic conditions remained challenging globally, as persistent fiscal concerns and uncertainty affected customer demands for our served end-markets.

The US has slow growth, the Euro zone is still contracting somewhat, and certain emerging markets under performed.

As a result, global industrial production was negatively impacted as customers delayed spending and held back from inventory restocking.

As expected, the decline in customer demand reduced sales year over year.

However, we realized a sequential increase in revenues with 3.5% sales growth in the March quarter over the December quarter.

In addition, and very important, our daily order rates reflect sequential growth in each month since December.

Overall, we remain positive about Kennametal's long-term growth perspectives given our diverse served end-markets.

While infrastructure sectors such as mining and energy face near-term challenges, we expect road construction activity to ramp up with the arrival of warmer weather and continue into the summer and fall.

Regarding commercial markets, the transportation sector is beginning to see some improvement and commercial aerospace continues to show strength.

In addition, we expect that our general engineering business will experience a ripple-effect benefit when demand returns.

Last week, Kennametal participated in Bauma 2013 in Munich, Germany, which is a machinery and equipment tradeshow related to industries such as construction, mining, energy, and building materials.

The event had a record-breaking number of exhibitors as well as attendees.

There were approximately 530,000 attendees from more than 200 countries, and more than 200,000 of those were from outside of Germany.

This is the largest international representation in this event's history.

We believe the high-order activity reported by Bauma 2013 is an encouraging indicator of longer-term sentiment for the industry.

In the meantime, we continue to increase our addressable market through implementing our video brand challenge strategy as well as integrating our satellite acquisition to realize sales synergies long-term.

We will continue to invest in innovative technologies to differentiate Kennametal products in the marketplace and improve productivity for our customers.

Now, I would like to provide an overview of trends that we are seeing in the served end-markets.

In aerospace, production is going strong and many programs are increasing production rates with potentially more to come.

According to IHS Global Insight, worldwide commercial production is expected to grow approximately 14% in calendar year 2013.

In addition, Boeing recently announced that they have completed testing of the battery used in its 787 Dreamliner planes and is awaiting FAA approval.

Although this testing affected plane deliveries, the manufacturing activities are still maintained at a high level.

In general engineering, distributors continue to be cautious and are keeping inventory levels low.

Looking forward, business sentiment indicators are trending more favorably in the US, the Euro zone is still weak, and in emerging markets such as China, India, and Brazil, customer demand trends have moved up and down but have remained positive.

In transportation, auto production was lower in most geographic regions with a year-over-year decline of a 8.5% globally.

However, overall production levels for calendar year 2013 are forecasted to grow approximately 3%.

Currently, the average age of light vehicle fleets in the US has increased to a record 11 years.

This is proof of pent-up demands.

Eventually, aging vehicles need to be replaced.

Low interest rates and an improving housing market may influence some customers to borrow for big ticket purchases again.

For Western Europe, the outlook for 2013 will be challenging for manufacturers who are closely tied to Euro zone domestic markets.

Auto makers with broad geographic diversity and exposure to premium or export markets will perform better.

In China, a more favorable economic environment is expected as it is forecast to increase 10% year-over-year, reaching 20 million units in calendar year 2013 and surpassing Europe to become the leading manufacturer of light vehicles.

Moving to the energy market, the world rig count decreased by 5% year-over-year.

At the end of March, natural gas prices in the US steadily increased to around $4 per mmBTU, which is the first time at this level since September 2011.

Another favorable indicator is that the storage level of natural gas decreased 2% below the five-year average, which is a significant depletion from the prior month storage of 16% above the five-year average.

Natural gas from existing wells that have been capped will add to supply levels first, and then drilling activity will ultimately increase.

Longer term, pipeline construction remains robust as producers are expected to add 30 billion cubic feet per day of capacity by 2016.

Since 2012, more than half of this build has taken place in the Northeast region of the US, representing approximately $2 billion in capital investment.

Regarding the mining industry, coal production reflects further slowing worldwide.

US production is projected to contract approximately 2% for calendar year 2013.

It has been a challenging market with 87 mine closures over the past 12 months and additional closures are anticipated through the remainder of the calendar year 2013.

However, demand is expected to stabilize and modest growth of approximately 3% is forecast for calendar year 2014.

In the near term, the downturn in domestic production can be partially offset by overseas exports to China or increased production in countries such as Australia and South Africa.

Going forward, coal continues to be an important market for Kennametal, as it is a significant part of electricity generation, still production, and other manufacturing processes globally.

In the road construction and rehabilitation sectors, state governments in the US are focused on spending for maintenance work rather than new projects.

With funding available from Federal highway bill, quoting activity continues to build.

However, the construction season was delayed due to cold weather and winter storms extending into the end of March and through part of April.

In Europe, highway rehabilitation markets are expected to remain relatively challenging due to fiscal issues.

From a geographic perspective, the recent news on the US economy has been more positive and the fiscal trap of reaching a federal debt ceiling has been diffused.

However, the impact of spending sequesters remains and HIS Global Insight has estimated that a full sequester would cut 0.05% from real GDP growth in calendar year 2013.

In the Euro zone, recessionary forces are diminishing but significant growth is not yet in sight.

After contraction in the December 2012 quarter, the Euro zone economy expected to see flat activity through calendar year 2013 and will likely begin a slow recovery in 2014.

Fiscal austerity, high consumer debt levels, rising unemployment, and political uncertainty are all contributing to a subdued economic outlook.

In China, real GDP growth strengthened to 7.9% year-over-year in December 2012 quarter reflecting an increase from 7.4% in the September 2012 quarter.

This modest exploration, the first in seven quarters, was led by consumer spending and exports.

In the March 2013 quarter, however, China's economy grew 7.7%, so there is a continued caution due to the fragile nature of the recovery.

Kennametal has successfully managed through stronger headwinds in the past.

As always, our global team made business adjustments as needed, continued to execute our companies specific strategies to further strengthen our enterprise and deliver double-digit operating margin, even in a challenging macro environment.

We further streamlined our Business by employing lean initiatives, identifying outsourcing opportunities, and implementing cost containment measures for both manufacturing and operating expenses.

Those initiatives are in line with our corporate culture and will continue to position Kennametal for future growth.

We remain focused on balancing our global presence to generate revenues equally from North America, Western Europe, and the rest of the world markets.

We continue to diversify our mix of served end-markets to generate growth opportunities, lower volatility, and migrate risks to downsize exposure in cyclical industries.

In addition, I would like to mention that we celebrated two major milestones during the March quarter.

One is that we celebrated our 75th anniversary as an industrial technology leader with a record of delivery productivity and innovation worldwide.

The second milestone is that the Ethisphere Institute named Kennametal for the second consecutive year as one of the "World's Most Ethical Companies." This is a strong testament to our code of ethics, investment in innovation, and sustainable business practices, as well as activities designed to improve corporate citizenship.

Most importantly, it is a great honor and tribute to the Kennametal employees worldwide.

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

Frank.

Thank you, Carlos.

I will start with a summary of the March quarter followed by a review of the quarter details.

I will close with the current view on our outlook for the remainder of 2013.

As Carlos said, on balance, we delivered solid results with improved profitability from the December quarter, despite a mixed macro environment for our served end-markets.

Looking at our market analysis for sales by region, we experienced the most negative impact in North America.

This was mostly driven by infrastructure end markets where there was softness; in North America underground coal mining including additional mine closures, coupled with project delays in our Energy business.

General engineering results were down in North America as customers continued to operate at low inventory levels.

However, it is important to note that throughout the March quarter, both our industrial and infrastructure segments saw sequential growth in each month since December.

Also, a few other items to highlight, as we again delivered a double-digit EBIT margin of 11.2%, and excluding the Stellite acquisition, our margin was 11.8%.

We had strong free operating cash flow in the March quarter led by our inventory reduction initiative in which we reduced finished goods inventories by approximately $30 million.

Although this initiative lowered our EBIT margin by 110 basis points, it was consistent with our long-term strategy to maximize cash flow.

We further enhanced our liquidity and debt maturity profile by amending and extending our revolving credit facility at favorable pricing.

We completed the sale of 13% of shares in our India subsidiary, resulting in net proceeds of approximately $27 million, and I will touch on this in a bit more detail later.

Lastly, Stellite's acquisition was accreted to our results by to $0.02 per share despite the headwinds in its served markets.

Note that our proactive cost reduction measures as well as our more efficient organization structure helped us deliver double-digit adjusted operating margin of 12.1% despite the continued market challenges in our Company's inventory reduction efforts.

We continue to have cost-containment actions in place and are managing our business to market conditions while staying focused on near-term cash flow objectives as well as long-term growth strategies.

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

Sales for the quarter were $655 million.

This compares to $696 million in the same quarter last year.

Sales decreased by 6%, reflecting a 6% organic decline, a 5% decline from fewer business days, and a 1% unfavorable effect from currency exchange, partly offset by a 6% increase from Stellite.

That is two additional months in the quarter compared to last year, since we acquired Stellite on March 1st in the prior year.

Turning to the segment business review, our industrial segment sales of $374 million declined 11% from the prior-year quarter.

This was due to a 5% organic decline, a 5% decline from fewer business days and 1% unfavorable effect from currency.

On an organic basis, sales declined 12% in general engineering, 2% in transportation, and this was partly offset by sales growth of 14% in aerospace and defense.

General engineering was unfavorably impacted by lower demand levels as both direct and indirect customers continued to operate cautiously, maintaining lower than normal inventory levels.

Transportation experienced lower vehicle manufacturing rates in most geographic regions, in aerospace and defense sales continued to benefit from the increased in commercial aircraft production.

Regionally, sales in the industrial segment decreased by approximately 12% in the Americas, 10 in Asia, and nine in Europe.

Our infrastructure segment sales of $282 million increased 1% from the prior year quarter, driven by Stellite contributing 15% growth partially offset by in a percent sales decline in a 6% decline from fewer business days.

On an organic basis, sales declined 15% in energy, and 6% and in the Earthworks markets.

Energy customers continue to delay orders due to ongoing decline in the oil and gas rig count, primarily in North America.

Weaker underground coal demand in North America, as well as three additional mine closures during the quarter and a delay in the start of road construction season due to inclement weather in March affected our Earthworks business.

Regionally, including the one-month of Stellite organic growth, sales decreased by approximately 18% in the Americas, 6% in Europe, and remain relatively flat in Asia.

Now, I will recap on our operating performance.

Our gross profit margin was 31.8% compared to 35.4% last year.

The decline was due to decreased volumes and less absorption of manufacturing costs resulting from both lower sales as well as our inventory reduction efforts.

The inventory reductions had an unfavorable impact of approximately $6 million or 110 basis points on the gross margin for the base business.

This quarter's results also includes the effect of Stellite, which as I have said in the past is a lower gross margin business versus the Kennametal base business.

The current year gross margin benefited from -- the prior-year gross margin benefited from strong organic growth of 8% in the prior year.

Our operating expense declined $11 million year-over-year due to the containment of discretionary spending, lower employment and related compensation costs, and favorable foreign exchange.

Operating expense as a percent of sales was 19.6% for the quarter, down 30 basis points from the prior year of 19.9%.

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

Our operating income was $75 million compared to $103 million in the same quarter last year.

Our operating income included $2.9 million of Stellite operating income contribution for the quarter, and Stellite net operating loss, which included acquisition related costs, totaled $4.6 million in the prior year.

Operating income declined due to lower absorption of manufacturing costs related to the sales volume and our ongoing inventory reduction initiative, partly offset by lower operating expenses.

As I said earlier, our operating margin for the March quarter, excluding the acquisition of Stellite, was 12.1%.

Looking at the business performance by segments, the industrial segment's operating cost was $45 million compared to $71 million in the same quarter of the prior year.

Industrial's operating income decreased due to the lower absorption of manufacturing cost related to the sales volume in the ongoing inventory initiative to reduce inventory.

Industrial operating margin was 12% compared with 17% in the prior-year.

The infrastructure segment's operating income was $32 million compared with $34 million in the same quarter of last year.

Infrastructure's operating income benefited from the Stellite operating income of $2.9 million, and Stellite's net operating loss, as I said prior, totalled $4.6 million loss in the prior-year period.

Operating income decreased due to the effect of the organic sales decline in the lower absorption of the manufacturing costs.

Infrastructure's adjusted operating margin was 13.4% for the March quarter compared with 15.1% in the prior year.

Now, I'll walk through the rest of the income statements.

Despite higher average debt levels attributable to the Stellite acquisition, our interest expense decreased by $0.5 million year-over-year in the March quarter to $7.5 million.

This decrease was due to the favorable effects from the refinancing of our 7.2% notes that matured last June, which were replaced with a lower interest of 3.875% 10-year notes maturing in 2022.

Our effective tax rate was 18.5% for the quarter compared to 20.4% in the prior year.

The decrease was primarily driven by the extension of the credit for increasing research activities contained in the American Taxpayer Relief Act of 2012 that was enacted during the current quarter, partly offset by higher relative US earnings in the current year relative to the rest of the world.

Regarding the bottom line performance, the reported March quarter diluted earnings per share was $0.67 compared to $0.93 in the prior-year quarter.

As I said earlier, the current year earnings per share includes $0.02 per share accretion from Stellite while the prior year earnings per share included $0.05 per share of acquisition related costs.

Turning to cash flow, our year-to-date cash flow from operating activities was $150 million.

This compares with $164 million in the prior year.

Cash flow benefited from our ongoing inventory reduction initiative which reduced finished goods and WIP by approximately $40 million on a year-to-date basis.

Our net capital expenditures were $52 million compared to $56 million in the prior year and our free operating cash flow year-to-date was $98 million compared with $108 million in the prior year.

We continue to focus on further improving our cash flow metrics and are making significant progress towards achieving our goal of 100% conversion of net income to free operating cash flow.

In fact, on a discrete basis, our March quarter free operating cash flow was 144% of net income.

We remain committed to balancing our priority uses of cash during the March quarter.

We purchased 786,000 shares of our stock, totaling 2.1 million shares on a year-to-date basis.

We have approximately 6.5 million shares remaining available under the current stock buyback program.

Also, during the March quarter, we sold shares in our subsidiary in India in order to comply with the Securities and Exchange Board of India's stock exchange rules, which require a minimum 25% public float; prior to the sell down, we owned 88% of our India subsidiary.

In accordance with the rules, we sold 13% of our shares and received approximately $27 million as a result.

We now own 75% of the Indian subsidiary, and there was no P&L impact on the transaction except for the non-controlling interest going forward.

We continue to be confident in our strong cash flow generation and will stay consistent to our capital structure principles.

We have investment grade ratings and stable outlooks from all three ratings agencies and remain committed to maintaining them.

We continually strive to balance key priorities by prudently deploying cash and strategic growth investments and acquisition opportunities, returning excess cash to shareholders and reducing debt.

For the year to date period, we returned 81% of our net earnings to share owners.

The combined payout ratio reflects $78.5 million in share repurchases and $38.4 million in dividends.

Our net income before non-controlling interest was $144.7 million and combined share repurchases and dividends represent 119% of our year to date free operating cash flow of $98 million.

As always, we remain active on the acquisition front to identify and develop potential candidates.

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

Turning to the balance sheet, our balance sheet remains strong.

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

During the quarter, we reduced finished goods inventory, including WIP, by approximately $30 million.

This is in addition to the $17 million that we reduced in the December quarter.

At March 31st, 2013, we had just $47 million in short-term debt leaving availability of liquidity of more than $0.5 billion on our revolver.

Total debt was $751 million, and Kennametal had total cash of $322 million with the majority of this cash residing presently overseas.

Our net debt was $429 million at the quarter end, a decrease of $61 million versus the December quarter, due to strong free operating cash flow and approximately $27 million from the Kennametal India share sell proceeds, partly offset by share repurchases, and our March quarter dividend.

Our debt-to-capital ratio on March 31st was 30% compared to 25.3% at June 30th.

Our adjusted return on invested capital was 10.8%.

We continue to actively manage our pension plans and enjoy the benefits of our adoption of a liability-driven investment strategy over six years ago.

As a result, our US defined benefit plans remain 100% funded.

In April, we took additional steps to further enhance our liquidity and capitalize upon current market conditions to extend our debt maturing profile.

We amended our existing $600 million syndicated revolving credit facility to extend the maturity to April 2018.

We felt it prudent to move forward at this time to lock in current favorable pricing and reduce exposure to future market uncertainty.

This transaction closed on April 5th and represents the third event over a period of approximately two years in a series of key strategic financing initiatives which began with the refinancing of our $300 million10-year notes that matured last June.

We went to the bond market twice in the last four months and took advantage of the current low-interest rate environment to place attractive fixed rate debt issuances for Kennametal.

Our November $400 million 7-year 2.65% public note issuance significantly increased our liquidity and generates an attractive weighted average overall interest rate of 3%.

Kennametal's debt maturity profile has been effectively diversified and extended.

Our nearest debt maturity is now 2018.

Quick update on the acquisition of Stellite for you.

The integration of Kennametal Stellite continues to be on track.

The June quarter is an important period for the integration as we cut over four of the principal operating locations onto SAP.

The SAP implementation will accelerate future synergy opportunities in both cost and revenues.

During the June quarter -- or during the third quarter, Kennametal Stellite also experienced weakness in its core end-markets, particularly its energy in end-markets in North America, the construction market in Asia, and continued softness in the automotive in Europe.

We continue to manage operating and integration cost to partly mitigate the adverse effects on our operating results.

The delayed recovery in served end-markets for Kennametal Stellite is impacting its contribution in fiscal 2013.

And in the fiscal third quarter, Kennametal sales were $61 million and Stellite contributed $0.02 per share.

Now let me turn to the outlook for the remainder of the fiscal year.

We have revised our forecast in consideration of the global economic conditions and customer-made patterns that Carlos touched on.

So the assumptions that are included in our guidance include a benefit from two additional workdays in the June quarter compared to March in the prior-year quarter.

Weak conditions will likely persist in North America for underground coal mining; however, we expect increased activity in highway road construction, and slightly improving energy activity with drilling activity expected to remain flat in the June quarter.

Longer term, the industry is preparing for growth as natural gas prices rise and storage levels continue to be depleted.

Improving sales for transportation and general engineering with limited effects from destocking; now that customers have lowered inventory levels.

We believe destocking has slowed in the Americas and Asia is beginning to show positive signs.

Our non-controlling interest expense will increase due to Kennametal's India stock sale.

We now own 75% of our subsidiary compared to 88% previously.

Effective tax rate for the full year is now expected to be approximately 23%.

We're on track to reduce our finished goods inventory and WIP by approximately $60 million for the fiscal year.

We again expect to deliver strong free operating cash flow in the fourth quarter in excess of net income.

A positive note is that our monthly order rates reflect a sequential increase over prior quarter, and we expect continued modest improvement, particularly in our industrial end-markets.

As a result of these factors, we now expect our fiscal 2013 sales to decline in the range of 5% to 6% with organic sales decline ranging from 8% to 9%.

We're reducing our earnings per share guidance for fiscal 2013 to the range of $2.45 to $2.55 per share, and included in this outlook is the creative contribution of the Stellite acquisition, net of integration costs, which is now expected to be in the range of $0.05 per share to $0.10 per share.

We expect to generate cash flow from operations between $260 million and $280 million for the remainder of the fiscal year, and based on anticipated capital expenditures of $90 million to $100 million, we expect to generate between $170 million of $180 million of free operating cash flow for the full fiscal year.

Overall, we are managing the business very well for the factors that we can control or deal with and the near headwinds as needed.

We continue to focus on our many growth opportunities and the consistent execution of our strategies.

Now, I will turn it back to Carlos for some closing comments.

Thank you, Frank.

As we move forward, we will continue to execute the same strategies that have transformed Kennametal into a company that can deliver profitable growth throughout the economic cycle.

During this fiscal year, we have consistently delivered double-digit operating margin performance, despite the challenging market conditions that impact sales growth and lower cost absorption due to our inventory reduction efforts.

The results validate our company-specific initiatives to grow sales, invest in operational efficiencies, and maximize profitability.

In addition, we will continue to capitalize on our strong balance sheet to increase shareholder value.

Kennametal has a track record of generating strong cash flows and will remain disciplined in our capital allocation process to include stock buyback, acquisitions, capital expenditures, and dividends.

In summary, we will continue to serve customer demand by further balancing our served end-markets, business mix, and geographic presence.

We will remain focused on maintaining operational excellence throughout our Company.

Our goal is to drive profitability and returns while doubling revenues in five years and maximizing cash flows.

Thank you for your interest in Kennametal.

We will now take questions from you.

(Operator Instructions)

Your first question comes from the line of Julian Mitchell with Credit Suisse.

Thanks a lot.

I just wondered, on the issue of production versus sell-through -- the gross margin went up 30 bps sequentially in Q3.

Assuming a sort of flattish SG&A to sales ratio in Q4 sequentially suggests your guidance maybe has it up about 100 bps or so in Q4.

Is that roughly correct?

If you can give a broader update on production versus sell-through, and at what point you think that we should see the two match up again.

Yes, Julian.

This is Frank.

I think you are right, sequentially, Q2 to Q3.

We had originally anticipated taking out the remaining inventory reduction of about $47 million.

We did a little bit more in the March quarter, the $30 million.

Not that it was going to be equal last quarter of $20 million and $20 million, give or take; but I think the fourth quarter gross margin will be a little bit better.

We will have some additional benefits from the volume from the additional workdays.

It is less of a drag on the capacity utilization.

We will also experience slightly lower raw material costs now that we flushed through some of the higher costs in the fourth quarter.

It will be a slight bump up as well in my opinion, on the Stellite acquisition from some of the sales synergies and some of the integration activities that we started on previously.

I expect it to be up a little bit higher than what you anticipated in the fourth quarter.

Thank you.

And then, within the industrial business, the Americas seemed to see an accelerated decline in Q3.

I think they were down 12% organically year-on-year, versus down 8% year-on-year in the December quarter.

And yet, if you look globally and so on, the PMI is slightly better in the Americas versus other regions.

Maybe just give an update on industrial Americas.

Do you think that we should see that minus-12% improve much in the June quarter?

Yes, I think we will see it.

It was a little bit more pervasive with the de-stocking; I think that has somewhat subsided.

Even though it is in the industrial, the slowness in the energy also has a ripple effect on the general engineering side.

And I think some of the fiscal concerns and some of the caution in the third quarter as people get a little more comfortable with the payroll cut and the debt sequester, I think that we will see a little bit more activity going forward.

It was basically the same between our direct and indirect.

But we continue to see the daily rate in the industrial business gain a little bit of steam.

We see a strong correlation as well, as transportation starts to pick up a little bit.

The general engineering portion of our business tends to lag a couple of quarters.

We're starting to see a little bit more activity start to come through on that side as well.

I expect it to be a little bit better in the fourth quarter.

We do have a little bit easier comp in Q4.

Thanks.

Lastly, the cash balance -- I mean, your cash balance has trebled in six months -- just the gross cash.

Are you anticipating an accelerated buyback run rate from here?

I guess year-to-date you've been running at about 700,000 shares per quarter on average, year-to-date.

Are you anticipating an acceleration in that run rate?

I will answer it this way for you.

We committed to the beginning of the fiscal year to repurchase 2.5 million shares back.

We will do, at minimum, that amount.

Thank you.

I will remind everyone that we still have a 6.5 million authorization left.

We have flexibility.

Thank you very much.

Next question will come from the line of Eli Lustgarten with Longbow Securities.

Good morning, everyone.

Nice numbers and tough quarters.

Can you give me some idea of what is going on in end markets.

One clarification -- we had $13 million more of inventory to take out in the fourth quarter if you're going to get to $60 million -- you're at $47 million.

I will start on the inventory question.

Let me give you the numbers.

We said last quarter that we would take out $60 million, of which we did $17 million in the quarter.

And we did another $30 million.

The last two quarters, we did $47 million, but in the first quarter, inventory in those categories was up $7 million.

In the script I said year-to-date, we are at $40 million.

It would imply $20 million-ish in the fourth quarter.

The caveat there is that as we see some of the faster moving items, particularly in the industrial side, the A items, in turn, we will monitor our fill rates.

And if we think we need to increase for the second half any of the fast-moving items, we may not hit that; but the goal still remains to do the $60 million, of which $20 million will occur in Q4.

Eli, what was your question relative to the markets?

Just trying to get some character and color what is going on in the underlying markets.

The industrial markets are in a status quo, but the inventory seemed relatively low at this point, so you're just plodding along with current activity; That is what you would expect to happen until the market changed.

I guess my concern is the infrastructure, energy remains quite weak, and we have more inventory liquidation to be taken out in the end-markets and that part of the business.

Is that year-over-year comparison improvement delayed until sometime in the middle of fiscal 2014?

I think that we have seen the de-stocking really this month, this past month.

We have seen that activity sort of ends, as far as we can tell at this point.

One of the proofs is that we have seen the sequential in the daily [rack] rate, sequential growth At this point, we anticipate that the industrial will come back faster, maybe by a quarter or so.

The infrastructure to follow that.

What is driving the infrastructure is going to be around construction.

The construction was expected -- the activity to start, really, this quarter.

But because of the harsh weather -- again, we have the quotes.

I think the municipalities are ready to go.

I think that we will see that activity right now, in the next few weeks.

The only thing I would add on the energy side, I do not think there is a lot of inventory in the energy pipeline of any magnitude.

And it just varies -- summer -- how quickly this thing -- we see the gas prices, where they are, we know storage levels are down.

What could really be an inflection point -- if we have a hot summer -- because we had a normal winter -- if you get a normal summer, this thing could snap back a lot quicker, as you know.

Can we just get some commentary on what is going on in pricing in the industry?

Of course, is there any material change in pricing whatsoever, given the weakened industry conditions?

Maybe an update with what is going on with Fastenal in the video line, versus seeing some inroads from Amazon in the marketplace.

Yes, I would say that there has been no change in the pricing.

Obviously, we have a pricing -- the pricing that we are getting is the tail end of the pricing that we had in place last year.

We have not given pricing any areas I think that our Fastenal business continues to grow at a significant pace.

The base is small.

We are -- both myself and Will are very excited about the potential of this brand.

Amazon is not really going to affect this brand, because people need help in utilizing it, applying the principles of this brand.

You are going to see Amazon more in the high-speed steel and some of the more standard-type of products.

Your next question will come from the line of Ann Duignan from JPMorgan.

Good morning.

This is Damien Fortune on for Ann.

Can you expand on the sequential improvement in orders -- is most of it being driven by improvement from the OEMs?

Or is it more distribution?

It is really both.

We're seeing improvement all around in the daily order sequentially.

At the last call, we said that we believed that the bottom had been in November, December time frame?

We now have, basically, three months to validate that.

I can tell you right now that the current month seems to be going in the same path.

Okay.

Great.

Can you give us just a sense of what you're thinking over the cadence of orders over the next, call it six months or so?

We are not going to get into fiscal 2014, because we're going to be wrapping up our year.

I think you guys can look at the normal seasonal patterns.

As we go forward, as you know, the sales comps, as we get into fiscal 2014 will be relatively easy to compare to.

Some other items that we are contemplating going forward is, we should not have the inventory reduction issue next year.

We should continue to have a tailwind from some raw materials.

Stellite should pick up compared to this year from an integration contribution.

We expect to have a better mix as we get into the next fiscal year as we continue to be challenged this year with the destocking and the inventory burn.

All of those items should not necessarily recur in fiscal 2014.

But as far as the outline, you can look at all of the global GDP and industrial production numbers.

It is, in theory, setting up for a decent year, but we will be a little bit cautious and be able to update you when we get to the July call.

Your next question will come from the line of Adam Uhlman with Cleveland Research.

Good morning.

Good morning, Adam.

I am wondering -- you have done a good job pulling back your SG&A expenses as the demand has been pretty weak.

I am just wondering as we start to see some of the volumes recovering next year, what's your confidence level of holding that expense growth down as volumes improve?

I think traditionally we have been able to do that.

We have demonstrated that we did that in the last -- coming out of the last recession.

There is nothing that really would be abnormal and unusual.

By the way, in the last recovery, the recovery was higher and faster than I think it is going to be going forward.

I think that we have a better chance to do it -- it was more difficult to do it last time than it is going to be now.

Yes, Adam.

The one thing that I will add is as we continue to start going forward, you'll probably start seeing additions to the sales force.

We are going to make some investments, particularly in the Americas, to help us take some additional shares as we get into fiscal 2014.

As we stated, for the top line to grow faster, we're going to start making some investments to help accelerate the top line growth, particularly around the direct field sales organization and adding select distribution.

Okay, got it.

Actually, can you expand on that?

That comment, a little bit more, Frank?

The strategy for the last couple of years has been to expand the presence and distribution.

I think that seems to be a big change from what we had been hearing.

It is not a big change.

I think that our distribution is growing at a much faster pace than our direct sales.

It is going to continue to be that way.

It is still our strategy.

We did not change anything.

Sooner or later, as we get bigger and bigger, we have to head to the direct sales force, even though we are going to continue to grow in the record at a higher pace.

Nothing has changed.

Got it.

I think that I heard $6 million gross margin from the inventory reduction.

Could you clarify that?

That was just in the quarter?

Is that year-to-date?

And then, Frank, could you give us the impact of inventory reduction by business, perhaps?

The $6 million was basically the March quarter alone.

That is in addition to the $5 million that I called out last quarter.

I am not going to break it down overall by business, but there is probably a little bit more inventory reduction on the industrial side than there was on the infrastructure, because the infrastructure has a little bit more raw material content products in there, and the focus was really more on the industrial side.

This $6 million is in addition to the $5 million.

In the first quarter, we had a benefit of about $1 million and change.

That would put us basically at about $11 million year-to-date impact on the gross margin, with the bigger hits being in the December and March quarter.

Thank you.

Your next question will come from the line of Ross Gilardi with Bank of America.

Good morning.

Thank you.

Could you talk just a little bit about -- when you look at your different end-markets, the weakness in coal, I think, is well-understood.

But if you think about the year-to-date declines you have seen in demand, how much of that would you characterize as cyclical versus structural?

I guess when we think about getting back to a 15% margin at some point in the next couple of years, hopefully -- is there a detrimental impact on mix from some of these changes in the demand patterns that might inhibit you from getting back to that level of margin?

No.

I would say that the decline is due to the cyclicality of the business.

I think that as the supply chain is a lot tighter now.

I think it is going to take -- as we see, the IPI -- and you see the PMI getting better.

Then as the [surest] put inventory in their stock and so forth, we will see that coming back.

I would say that, even with the inventory reduction in place, we are hovering around 12%.

We have a lot of capacity.

As this thing comes back, we are going to experience a substantial incremental margin improvement.

We feel that we are very well-positioned for the growth.

What do you think is the risk, though, in some of the energy markets?

Some of the markets that we're talking about in Europe, in the transportation sector?

You are referring to a lot of destocking and restocking-type dynamics.

What is the risk of these markets?

These markets are just -- they are kind of dead for a while, from here.

I think if you look -- we are not anticipating that coal is going to come back soon.

I think that, as we said, for example, the automotive in the US, on average, 11 years is the life of a car.

There is a lot of pent-up demand that is going to come back.

I think really the only risk that we have that we can see of taking a while to recover is in the coal.

And the coal --I think it's probably primarily in the U S -- and I think that is a smaller percentage of our total sales.

I think that we can experience good growth starting this quarter or next quarter.

Yes.

The general engineering should get better as Fastenal gets a little bit more ingrained, particularly in North America.

We've expanded.

That is the sweet spot, with the good margin business.

Aerospace continues to have a long cycle, as you know.

That is going to grow, if it was a little bigger -- we continue to focus products in that area.

And then to your point, energy is a good market.

I think our focus strategy, just not to focus on the drilling, and taking all related aspects -- there is a much bigger sandbox that we can drive a lot more value to our customers with our full product portfolio, not just our industrial side.

So I think the risks are somewhat limited there, but I think the industrial will continue to grow stronger, and as Carlos said, mining is going to be what it going to be, but it is still a good market longer term.

Okay.

On Stellite, you gave some detail there, as to some of the dynamics with sales and profits.

Are the challenges that you have had with Stellite -- are they just purely demand and end-market related?

Is there anything going on operationally with the business or with distribution or products?

It is 100% market-driven, as a matter of fact, and the cost side of integration, we are actually ahead of plan.

We are really a year into this integration.

As I said, the Board visited one of their largest sites, and we are extremely excited about having Stellite as part of our family.

We could us a couple more.

And then lastly, your infrastructure segment -- your profits, at least, on a year-on-year basis, were fairly stable.

Almost flat despite the decline in sales.

I know that some of that was related to Stellite.

But do you think you can actually turn positive in the infrastructure segment this quarter on a year-on-year basis from a profitability standpoint?

That is a good question.

It is going to be close.

It will depend on how construction kicks in here sequentially.

If we do not get -- every time we say that we think mining has somewhat bottomed, we see some additional mine closures.

It will really depend on if we have less closures or no additional closures going forward, construction kicks in a little bit here.

Depending what happens with the energy side, we could potentially -- in a best case, we could definitely get there.

Thanks a lot, guys.

Thank you, Ross.

Your next question will come from the line of Joel Tiss with Bank of Montréal.

How are you, Joel?

All right.

It seems like a lot of people are dancing around this question.

How big is mining?

Can you give us a sense in terms of revenues or operating profits?

5% to 6% in the US.

Of revenues?

Right?

Yes.

That is the US.

Okay.

Then it's fair to still assume that is more profitable than the overall company?

No.

Not at all.

Okay.

Good.

Can you -- just two bigger-picture things.

Are you seeing anything changing on the competitive landscape front?

And can you give us your -- Frank gave us a little hint of capital allocation or reallocation.

Can you give us more of a sense -- do you think, in the next 12 months we are more likely to see acquisitions or share repurchase?

Or a combination?

(Laughter).

You would make a good prosecutor, Joel.

Yes.

I have been doing this too long.

I think the answer depends, obviously.

We can't forecast acquisitions.

We are constantly talking to people.

As I mentioned before, we negotiated for Stellite for over a year.

We thought that we were going to be closer.

Every time we were close enough, something happened, because we are very disciplined about our acquisitions.

The other question was relative to the market?

Yes.

About the competitive landscape.

Is anything changing there?

Nothing really changed.

We really do not see anything that is worthwhile noting, to be honest with you.

We continue to make inroads into the distribution and the indirect channel.

We're happy with that, and our partners are happy with that.

I think that, as the market calms, I think that we can accelerate the indirect sales more so than we did before, because we are better positioned with our indirect channels than we have ever been before.

Okay.

Thank you very much.

Thanks.

Next question will come from the line of Steven Fisher with UBS.

Good morning.

Good morning.

Now that you're starting to see some of these sequential increases in orders, I'm just wondering how you're thinking about cost reduction activities.

It sounded like your answer to Adam's question earlier was that you have now shifted to investment mode rather than cost reduction mode.

Is that the right way to think about it?

Yes.

We're going to continue to stay disciplined, obviously, until we see a better -- the incrementals are not exciting enough at this point for us to make some major shift.

But the reality is that we're going to continue to exercise the discipline that we have had, and we're going to start to make investments in the marketplace.

Steve, when we look at -- we're definitely going to make investments where we need it to be, in the sales-force related area.

As we have been saying along, the first thing we have to do internally, is we have to talk of about funding the S in the SG& A, with the G&A reductions.

So we continue to maintain that discipline as the underlying theme, where we try to trade-off dollar for dollar.

And if we feel that we have opportunities to launch some additional initiative -- the drive of top line, we're going to make some of those investments.

Okay.

And then it sounds like the US highway construction is off to a slow start, even through early April.

How long do you think it is going to take to really pick up to the full seasonal run rate?

What have you assumed for that for the June quarter?

We think it will maybe kick in, in late May, June-ish, in the timeframe there.

You have do you remember, too, that there is another factor there.

The longer they delay to repair the roads and the tougher the winters is, the more repairs they are going to need to make.

We are going to continue to monitor this -- I think we have gotten through most of the snow, with the exception of some of the -- like in Minnesota and a couple of those other areas.

We think that it should start to pick up here in May.

This will conclude today's question-and-answer session.

Thank you.

This concludes today's earnings call.

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

Thank you for joining us.

Today's call will be available for replay beginning at 12.00 pm Eastern time today and lasting through midnight Eastern time on May 25th, 2013.

The conference ID number for the replay is 28030042.

The number to dial for the replay is 855-859-2056 or 404-537-3406.

This concludes today's discussion.

Take you for your participation.

You may now disconnect.