Kennametal Inc (KMT) 2014 Q2 法說會逐字稿

Good morning.

I would like to welcome everyone to Kennametal's second quarter FY14 earnings call.

(Operator Instructions)

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

Thank you Denise.

Welcome everyone.

Thank you for joining us to review Kennametal's second quarter FY14 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 of this call will be available on our site for replay through March 3, 2014.

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, Marty Fusco.

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

After the remarks, we will be happy to answer questions.

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

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

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

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

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

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

I'll now turn the call over to Carlos.

Thank you Quynh.

Hello everyone.

Thank you for joining us today.

In the December quarter, we realized organic growth for the first time in six quarters.

On an organic basis, sales for our industrial segment increased 6% year-over-year, which was consistent with our expectations.

This was driven by higher activity levels in our transportation and general engineering business, which included double-digit sales growth from distribution customers.

Revenue growth in our aerospace unit was mixed depending on the geographic region.

We believe that it was related to certain project delays as the industry's 2013 backlog reflected a five-year high.

Regarding markets served by our infrastructure business, the energy sector has not rebounded and production levels are still weak for both underground and surface mining activities.

From a macro perspective, we are encouraged that global industrial production is gradually improving and the economic indicators remain positive.

This increase in manufacturing activity has been largely driven by inventory buildup consistent with business expectations for calendar year 2014.

Although the Appalachian mining industry continues to be under pressure, the rig counts for oil and gas remain slightly higher, and the oil and gas extracted per rig has been on the rise.

Also, the commercial aerospace industry remains strong and the light vehicle production market continues to expand.

While demand is increasing, it is important to note that customers have exercised continued caution in terms of spending over the past six months.

To a certain extent, the recovery seems to be delayed.

But considering that our order rates bottomed in December of 2012, business conditions are much better than a year ago.

Consistently we still expect to realize sequential quarter-to-quarter growth as well as year-over-year improvement in the second half of our fiscal year.

In the near term, we'll continue to make adjustments to our business as needed, depending on demand levels.

We'll streamline our cost structure through our ongoing deployment of Lean and Six Sigma initiatives.

We also seek to maximize our use of advanced technology.

Innovation is a quality that continues to be strongly linked to Kennametal.

We were recently named to the 2013 Information Week 500 list, making the second consecutive year that Kennametal has been ranked among the nation's most innovative technology users.

As always, our global team will execute company specific strategies to further strengthen our business.

For the December quarter, we reported solid profitability, although margin expansion lagged the rate of top line growth.

This was partially due to softer than expected demands in our infrastructure markets, in particular energy.

However, results for our industrial business reflect the resumption of growth, and accordingly we dedicated greater resources to serve customers.

This is a reversal from prior year where we aggressively tightened spending due to market contraction.

Since our forecast calls for continued demand momentum in the second half of FY14, we are ramping up for the right reasons.

Our goal is to ensure a sustainable growth, as well as expanded our true cycle margin levels just as we demonstrated during the prior growth cycle.

During December quarter, we completed the acquisition of ATIs Tungsten Materials Business, a leading producer of tungsten metallurgical powders, tooling technologies, and components.

The integration plan has been initiated and is expected to realize significant cost synergies.

Also, this acquisition has expanded our presence in the aerospace and energy end markets, further augmented our tooling portfolio and accelerated our plans for an advanced tungsten carbide facility.

We believe that this transaction represents a highly complementary fit in terms of product portfolio, strategic assets, and talent base.

We will continue to deliver productivity improvements and outstanding service to our customers, which now include those of the acquired business.

We are very excited about the prospects of our combined companies.

In addition, our WIDIA brand and channel strategy continues to further grow our presence in the industrial distribution markets.

Both proven strategies provide a firm foundation to weather economic headwinds and they deliver on the overarching goal of profitable growth.

Kennametal continues to be well-positioned because we serve a broad array of industries across a diverse geographic base.

The business mix helps to migrate volatility over the economic cycles.

As we move forward, we will execute our growth strategies to further balance our global presence with the goal to generate revenues equally from North America, Western Europe, and the rest of the world markets.

Now I would like to provide an overview of trends we are seeing in the marketplace.

In the aerospace industry, growing demands in emerging markets and fuel efficiency programs are driving new aircraft orders.

Strong order rates for the A320 and the 737 plane models have caused Boeing and Airbus to ramp up manufacturing activities.

In addition, production rates for the 787s have increased to meet delivery commitments.

Overall, demand is robust as global commercial production expanded by 10.2% in 2013.

On the other hand, production of military planes increased less than 1% and procurement of defense related applications is lower due to government budget constraints.

In general engineering, growth is expected to re-accelerate in 2014.

For the capital equipment market related to new orders of metal working machinery.

Distributors are benefiting from higher volumes throughout the manufacturing supply chain, including the automotive and aerospace sectors.

In addition, demand for multi-channel capabilities is expected to continue to increase.

More distributors have introduced e-commerce platforms which include computers, tablets, and mobile phones to serve this growing customer need.

In the transportation market, there have been unprecedented investments worldwide in technology.

This trend is being driven by the downsizing of internal combustion engines and the lightweightening of vehicle structures to meet current and future fuel economy and emission regulations.

Globally, light vehicle production was 84 million units in calendar year 2013, and year-over-year growth for 2014 is being forecasted at 3 million units or 3.6% increase.

Key growth drivers are low interest rates, and stable fuel prices in developed markets, as well as continued growth in emerging markets.

In earthworks, HIS Global Insight noted that coal production increased by 0.7% in 2013.

The first increase since 2011.

Furthermore, Central Appalachian production is predicted to expand in 2014 for the first time since 2008.

Regarding road construction, new legislation was recently proposed to phase in a $0.15 per gallon fuel tax over the next three years to generate new revenues for the Highway Trust Fund.

Also, McGraw-Hill Construction Industry Confidence Index, which measures sentiment in the US, was favorable for much of calendar year 2013.

Survey results indicated that participants expect the business environment to continue to improve.

In the energy sector, North America natural gas markets have had relatively high supply levels in 2013.

Although inventory has decreased below 2012, levels.

In fact, extremely cold temperatures in January have led to record high storage withdrawals.

This situation should drive up prices and eventually increase production.

Going forward supply growth will likely be driven by risen productivity, new pipelines, and expanding capacity in gas processing.

Overall the global economy is improving and world growth is projected to accelerate in 2014 according to HIS Global Insight.

In the US, recent data suggests a stronger economy and the Industrial Production Index or IPI is trending higher.

It is encouraging that the manufacturing component of the index has been strong.

In the Eurozone after a weak October, the November IPI rebounded at its strongest month-over-month pace of growth since 2010.

In China the economy has shown some recent weaknesses.

However, the central government seems to have shifted its policy stance to support growth.

Regarding the emerging markets, many economies have improved during the past several months.

But problems still remain in countries such as Brazil and India which are on the HIS Global Insight's watch list.

Will continue to closely monitor those economy trends and be ready to adjust our business accordingly.

Our global team continues to be agile and remain ready to serve our customers.

As the macro environment improves we continue to expect to realize greater leverage to further expand our profitability.

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

Frank?

All right.

Thank you, Carlos.

Consistent with my prior discussions I'll start by making some overall comments, and then I'll review our second quarter in more detail.

Some of my comments are related to the non-GAAP metrics.

So to summarize the December quarter, we delivered solid profitability while focusing on necessary actions to drive further customer service improvements.

In addition, we began to integrate our acquisition of ATI's Tungsten Materials Business.

Highlights of the quarter included, as Carlos pointed out, the trend of year-over-year sales growth that began in the month of September continued during the December quarter for the December quarter where we realized organic growth for the first time in six quarters.

Organic growth was led by improving demand in our transportation and general engineering businesses, which tend to grow faster earlier in the cycle.

Aerospace and defense was slightly lower due to delayed timing of orders.

Our industrial segment achieved 6% organic growth in the quarter.

In our earthworks business we are still experienced weak demand in underground mining, particularly in the US and in China.

In energy, order activity remains softer than anticipated, but it is showing signs of modest growth.

We completed the acquisition of the Tungsten Materials Business or TMB for $607 million and immediately initiated restructuring plans for the combined businesses.

And I will go into much greater detail in a few minutes.

We continue to generate strong free cash flow and we delivered adjusted earnings per share of $0.52.

As Carlos said, we will continue to balance investments related to improving the customers' experience with our shareholder return priorities.

And as always we continue to evaluate strategic investments to grow our long-term enterprise value.

Now I'm going to walk through the key items in the income statement.

Sales for the quarter were $690 million compared to $633 million in the same quarter last year.

Our sales grew by 9%, reflecting a 2% organic increase and a 7% increase from the TMB acquisition.

I want to point out that we completed the closing of the TMB transaction on November 4. This included two months of sales in our results with a shortened month in November due to the closing date.

In addition, compared to the rest of the year, as you know, November and December have fewer workdays due to the holiday period.

As we touched on earlier, the December quarter is the first time in six quarters where Kennametal realized organic sales growth.

We are seeing improved demand from customers in our industrial end markets, and distribution sales for the quarter reflected double-digit growth over the prior year.

Those factors are encouraging.

Looking at our sales performance by business segment, the industrial segment sales of $371 million increased by 10% from the prior year quarter due to a 6% organic growth and a 5% growth related to the TMB acquisition, partly offset by 1% decline due to fewer business days.

Industrial sales increased in all served markets this quarter.

Excluding the TMB acquisition, sales increased by 8% in transportation, 7% in general engineering, 5% in energy, and 2% in aerospace and defense.

Transportation benefited from increased demand in the light vehicle markets worldwide and general engineering increased due to improvements in demand from distribution channels.

Energy sales reflect increased activity in industrial applications.

Sales were up in all geographies.

Our regional base of sales increased 12% in Asia, 7% in Europe, and 2% in the Americas, and that excludes TMB.

On the infrastructure side, our sales came in at $319 million, which would increase 7% from the prior year, and that was driven by 10% organic growth or 10% growth related to the TMB acquisition, partly offset by a 2% organic sales decline and a 1% unfavorable impact from fewer business days.

Excluding the TMB acquisition, sales increased 1% in energy, 1% in general engineering, offset by decreases of 12% in transportation and 5% in earthworks.

Earthworks' sales decreased due to persistently weak underground coal mining markets in the US and China.

But this was partly offset by continued strength globally in highway construction sales.

Energy sales were slightly positive year-over-year reflecting some improvement in oil and gas drilling activity in the US, coupled with gains in production completion and process application.

On a regional basis, sales grew 8% in Europe offset by decreases of 7% in the Americas and 4% in Asia.

Now a recap of our operating performance.

Our gross profit margin was 30%, which included the impact of the acquisition of TMB and the acquisition related charges.

Excluding the impact of these items, our gross profit margin was 32% compared to 31.5% last year.

The margin benefited from lower raw material costs and organic sales growth in the industrial segment, but was partly offset by higher manufacturing spending.

Our operating expenses increased $21 million year-over-year, excluding $7 million of operating expense from the TMB acquisition and $2 million of acquisition-related charges, our operating expense was $11 million higher year-over-year.

The $11 million increase was driven by employment costs related to our annual employee merit increase, higher sales commissions, and additional headcount investments to further grow our businesses.

Operating expense as a percent of sales was 21.5%, which included the TMB acquisition, and was 130 basis points higher than the prior year.

Additional spending in the current year represents our investment in long-term growth and consistent with our sales aspirations of $5 billion to $6 billion.

Our operating income was $50 million compared with $66 million in the same quarter last year.

Excluding the TMB acquisition operating results, acquisition-related charges, and the restructuring charges our adjusted operating income was $62 million.

The decrease in adjusted operating income primarily reflects higher employment and related costs, partly offset by favorable effects of organic growth, and lower raw material costs.

Our operating margin was 7.2% and adjusted operating margin was 9.6% compared within our operating margin of 10.5% in the prior year.

Looking at the operating performance by segments, industrial segment's operating income was $33 million compared to $41 million in the same quarter of the prior year.

Industrial operating income included TMB operations and was lower due to purchase accounting, acquisition related charges, and restructuring charges.

Industrial adjusted operating margin was 11.6% compared with 12.1% in the prior year.

The infrastructure segment's operating income was $19 million, and this compares with $28 million in the same quarter last year.

Infrastructure's operating income also included the TMB operations and was lower due to purchase accounting, acquisition related charges, as well as restructuring items.

Infrastructure's adjusted operating margin was 7.8% compared with 9.4% in the prior year.

Our interest expense increased $1 million year-over-year in the December quarter to $8 million.

The increase was due to higher year-over-year borrowings for acquisitions and higher borrowing rate for the seven year 2.65% notes that we issued last year in November of 2012 versus the bank revolver.

Our overall liquidity remains strong and we had approximately $360 million outstanding on a revolver of our $600 million revolver as of December 31, 2013.

And as you know, our nearest maturity debt is April of 2018.

The effective tax rate for the quarter was 40.8% in the quarter compared to 26.4% last year.

The increase was primarily driven by a one-time tax expense of $7 million related to the repatriation of certain overseas cash.

The impact of this charge was partly offset by a low relative US current earnings contribution compared with the rest of the world, where tax rates are lower.

And as highlighted in the press release, our reported earnings per share were $0.30 and this included $0.09 for the impact related to the TMB purchase accounting, which primarily related to the inventory fair value step up, acquisition related charges of $0.02, restructuring and related charges of $0.02, and a tax repatriation expense of $0.09, resulting in an adjusted earnings per share of $0.52.

Turning to our cash flow, our year-to-date cash flow from operating activities was $85 million, an increase of 56% compared with $54 million in the prior year.

Net capital expenditures were $48 million, compared to $34 million in the prior year.

Free operating cash flow year-to-date was $36 million, compared with $21 million in the prior year, reflecting our continued focus on improving working capital efficiencies.

We remain diligent in our focus on generating strong cash flow and are committed to our capital structure principles.

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

Our balance sheet remains strong.

At December 31st we had $110 million of short-term debt and total debt was approximately $1 billion.

Our cash balance was $163 million, with the majority presently residing overseas.

Net debt was $982 million at December 31st compared to $370 million in the June quarter.

And the increase was due to the Tungsten Materials acquisition.

Our debt to cap ratio at December 31st was 37.6%, compared to 29.2% at June 30.

We remain vigilant in the management of our pension plans and continue to enjoy the benefits of our adoption of a liability driven investment strategy over seven years ago, and our US defined benefit pension plan remains over 100% funded.

Now let me give you a quick update on our acquisition of the Tungsten Materials Business.

Overall the Tungsten Materials Business acquisition is progressing well and in line with our integration plan.

As previously announced, we completed the acquisition on November 4.

We have established a full-time integration team that is working with the Tungsten Materials Business team to drive critical work streams to ensure a smooth transition.

Our day one activities were initiated across the organization to welcome the TMB employees and introduce them to the Kennametal culture.

The cost synergy plan activities are underway and are on track to be fully realized within the next few years.

Kennametal and TMB technology and marketing teams have evaluated the product portfolios and identified key synergies that will result in exciting new product platform launches in the very near future.

Initial focus of the integration has been on financial processes, purchase accounting, human resource processes, and maintaining key commercial relationships, including the successful assignment of all major contracts to Kennametal.

The impact of the TMB acquisition on the December quarter earnings per share was $0.09 dilutive, driven primarily by purchase accounting and acquisition related charges.

For FY14 the TMB acquisition is expected to be dilutive to reported earnings per share by approximately $0.32 to $0.36, and I'll provide more details in the outlook sections in a minute.

Also we previously outlined restructuring actions that will be implemented within the next three years.

We expect to incur pretax restructuring charges of approximately $40 million to $50 million related to these initiatives.

During the December quarter we incurred $2 million of restructuring charges.

We expect to generate annual savings of approximately $35 million to $45 million once these initiatives are fully implemented, and these initiatives consist of concentrating our footprint by consolidating operations and driving productivity improvements with standard processes, reducing administrative overhead, and leveraging the supply chain, including raw material costs, procurement, and streamline manufacturing and distribution.

Now I'll touch on the outlook for TMB.

Our guidance previously stated that we expect sales to range from $200 million to $220 million for the TMB acquisition and we are currently within this range.

Originally, we believed the acquisition would be EPS neutral.

However, based upon purchase accounting, more value has been assigned to inventory than originally anticipated.

This higher value inventory will be amortized over four turns, or in our case two quarters, compared with intangibles, which have a longer amortization period of 15 plus years.

The acquisition process was confidential and very competitive, therefore Kennametal had limited access until the transaction was closed.

Thus the purchase accounting step up for inventory was greater than expected and we are taking a step up over four turns, and it will be then behind us after the March quarter.

That said, the TMB base operations, including purchase accounting, will be accretive in the June quarter.

Our current EPS guidance for the Tungsten Materials Business, as noted in the press release, is we expect the TMB base operations to be between 10% to 15% accretive.

Inventory purchase accounting of $0.14, depreciation and amortization related to fixed and intangible assets accounting step up and acquisition related charges will be a deduction of $0.09 to $0.13.

Restructuring related charge of another $0.10 to $0.15 and the tax repatriation expense of $0.09 resulting with a net dilutive impact of $0.32 to $0.36 for FY14.

And that's highlighted in detail in our press release.

Now for the outlook of the remaining company.

We updated our full-year outlook for the full FY14 to reflect the results of the acquisition.

Also we lowered our organic sales growth forecast due to a slower than anticipated rebound in our served end markets globally, in the oil and gas markets, as well as still weak conditions in the underground mining in the US and in China.

However, we remain confident in regard to customer demand growth projected in served industrial and markets as well as distribution channels.

Based on our revised 2014 forecast we expect the industrial segment to continue to realize strong growth while sales volumes will remain weak in the industrial or the infrastructure segment.

Accordingly we now expect FY14 sales growth in the range of 12% to 13% with the TMB acquisition contributing 7% to 9% growth and organic sales growth ranging from 2% to 4%.

Previously we had projected total sales growth ranging from 5% to 7% with organic sales of 4% to 6%.

Based on these factors we now expect FY14 EPS to range from $2.60 to $2.75 compared with our previous outlook of $2.90 to $3.05.

These ranges exclude the TMB acquisition, acquisition related charges, restructuring, and related charges, as well as a tax repatriation expense.

As I said earlier, the TMB is estimated to have a net dilutive impact of $0.32 to $0.36 per share for FY14.

We also now expect to generate cash flow from operations between $280 million and $310 million based on anticipated capital expenditures of $130 million to $140 million.

And we now expect to generate between $150 million to $170 million of free operating cash flow for the full fiscal year.

We will continue to manage our business for the factors we can control to deal with and the near-term headwinds as needed.

We are focused on protecting our profitability as well as maximizing our cash flows and returns.

In addition, we will remain focused on many growth opportunities and the consistent execution of our strategies.

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

Thank you Frank.

Moving ahead, we'll continue to execute strategies consistent with our long-term growth goals, which include doubling revenues over the next five years.

Additionally, we will stay focused on maximizing growth in top line, earnings, and cash flows.

Furthermore, we will continually streamline our cost structure throughout the enterprise, including the recently acquired Tungsten Materials Business.

As we have previously discussed, we plan to align manufacturing processes, as well as functional services to realize significant cost synergies.

As always, we'll remained disciplined in our capital allocation process.

We will continually evaluate opportunities to further invest in our business, to best serve our customers' demands, make acquisitions, repurchase shares, and pay dividends.

In summary, our global team continues to focus on increasing shareholder value by delivering profitable growth in the existing and adjacent markets, demonstrating ongoing cost discipline, achieving improved profitability, and generating strong cash flows.

In addition, we are further balancing our served end markets, business mix, and geographic presence.

Kennametal is well-positioned for the future and we have an enterprise wide commitment to succeed.

Thank you for your continued support.

We will now take questions.

(Operator Instructions)

Ann Duignan, JPMorgan.

It's Damien on for Ann.

Can you guys talk about how order rates have progressed so far this quarter?

Yes.

January is in line with our new forecast.

However, due to cold weather, we are not sure how much -- we definitely lost some work days, but we're not sure at this point how many work days totally we lost.

But we anticipated some of that in our current forecast.

Okay.

Great.

And then just on the oil gas and weakness that you were talking about earlier, I know you said the US was a little bit better.

But can you talk about oil and gas regionally outside of the US?

I would say probably almost two-thirds, Damien, of our businesses reside in the US.

So that's obviously impacting our profitability, as well as our sales given the composition.

But outside of that, both the European, as well as the Asian platform, is doing well.

Okay.

Great.

Thank you guys.

Thank you, Damien.

Adam Uhlman, Cleveland Research.

Frank, you were talking about this $11 million of expense growth in the quarter; and you broke it down in the merit pay, the sales and then the headcount additions.

I was wondering if you could divide that up for us, and then also talk about what's in the outlook for the second half of the year.

And then just to build on that, if maybe you could talk about your expectations of payback from the headcount additions that you are making into the business.

Is this a short-cycle payback, or is this something that's going to take some time?

Yes.

First of all, you are right.

The increase, sequentially, I can't remember if you asked year over year; and year over year, we did obviously add some people and the base we're going off of -- I just want to ground everybody, and I think Carlos said this, last year we were clearly in a decelerating decline as far as the overall macro.

So we were watching everything.

We had stuff locked down very tight, so obviously we were able to maintain very strict cost controls last year.

As we go forward, we typically have our merit increases every October 1. We added some people; and then on the industrial side, we have some of the sales force because they were up obviously 6% in the quarter, so we are paying some sales commissions.

Adam, without getting too specific, I would say that it was probably an equal increase across those with the headcounts, the merit, and some of the sales commissions.

They are the main drivers.

But it's always like a Catch-22.

You can't wait until you have growth to start adding people, so we started adding people obviously towards the end of last year into the first quarter in both businesses.

I think you see a little bit quicker payback on the industrial side, given the early cycle; and I think we're looking at that closely, as well as some of the opportunities on the infrastructure side.

Now, that's a little bit softer, but they are a little bit longer projects so it takes a little bit longer -- you don't get a significant payback quicker.

So will see a little bit more about return faster on industrial side going forward, with a little bit maybe longer.

We still think we need the right investments as it relates to the infrastructure side of the house.

So the payback will be a little bit different.

It will be quicker on the early cycle than the later, but we think longer-term some of the bigger projects and the growth that's fragmented there will be opportunistic.

And then we'll see how the TMB acquisition can help fill some of those gaps going forward.

Adam, the only thing that I would add is that we've seen already in the second quarter some of that benefit on the top line which was -- the industrial business grew at 6%.

But I want to point out that in the month of December, the industrial business grew at double-digit rates, which is a really good leading indicator for our business.

Stephen Volkmann, Jefferies.

I wanted to drill in a little bit on infrastructure, and I had sort of a two-part question.

I will just give it all to you at one time.

I am just wondering, there's a lot of numbers being thrown around.

I'm just wondering if you can expand a little bit on the transportation driver there.

I think you said Fraco was down 11% or 12% or something, which was bigger than I think the decline you saw in earthworks; and I just thought that was sort of interesting.

So maybe a little bit of detail there.

And then the second part is just on the margin.

It was quite a bit lower in that segment, even adjusted for all the one-time items.

And how should we think about the impact -- what's impacting that margin and how that should look going forward?

Thanks.

Yes.

Steve, first on transportation, it is not like-for-like.

Obviously we serve different industries.

The lion's share of our transportation, the light vehicles in the industrial side, and I think that's reflective of what people are seeing from the automotive builders.

Then we have, it's very small, when we reorganized and kind of transferred a couple things, we have Extrude Hone.

We make some of these machines that are going into the automotive.

So they are a little bit spotty from an overall quarter.

But that number, even if it was plus 12, it's not going to be a significant driver on the profitability.

The infrastructure is still going to be driven by the energy, as well as the earth cutting.

So as far as the profitability of right energy, we had expected it to be a little bit stronger.

It's a little bit weaker in the industrial gas turbines that Stellite provides there.

I would say the underground mining continues to be challenging, but we don't expect it to get any worse from this period out.

Now, we will see a sequential lift because our December quarter for the infrastructure business is typically our weaker because of the construction and the holiday period.

So as we go into the March quarter, we'll start seeing a little bit of a pickup with the energy side, both coal as well as energy.

And then we'll start to see some of the orders start for the highway construction projects.

That typically kicks in in the March period.

And we will talk about that when we're out at CONEXPO, but we're looking forward to see what type of information we have going forward.

So we expect it to be a little bit stronger as we get into the second half, which is typically our best period and the seasonality impacts kick in.

But the challenge for us really in the quarter was the energy side on the infrastructure; and the 12%, the transportation is a small thing, so I wouldn't read too much into that.

Great.

Thank you very much.

Thank you Stephen.

Andy Casey, Wells Fargo Securities.

Just a few more margin questions.

Ex the TMB dilutive impact, it looked like you had about an 80-basis-point decline in margins, 1% core growth in the first half.

Is it fair to say that you expect second-half roughly 4% to 8% core growth and 14% plus or minus operating margins?

Yes.

I think, Andy, the second half we will definitely do a little bit better.

I think we got our inventory pretty much in line, to your point.

The year-over-year change, obviously we have additional labor; and we had some additional maintenance costs.

We're trying to get our fill rates up to our distribution partners, and it's a combination of higher costs there.

We did have the negative volume impacts associated with the infrastructure that was not completely offset on the industrial side.

Then last year we were still burning down inventory, particularly throughout the period; so particularly the December quarter -- or really, the big drop was in the March quarter of last year.

So we think our inventory is pretty much in line from that perspective.

And then from a raw materials we don't see much change from the current levels, but it may be up slightly on a year-over-year basis.

But, yes, we do expect the margins to improve in the second half compared to last year; and particularly in the March quarter last year, we had the significant inventory reduction of about $35 million.

Okay.

Thank you for clarifying.

And then just to play devil's advocate a little bit, if we get into the second half, we're all expecting improvement; but if for some reason that does not show up, do you have contingent structural cost plans in place to get to those higher margins?

Yes.

We started that obviously in the quarter.

And obviously with the acquisition and restructuring opportunities, we'll try to accelerate that even quicker or pull more opportunities into play.

So, yes, we think we have both normal contingency plans, as you would expect, on discretionary stuff; and then we also have structural stuff ready to go.

Okay.

Thank you.

Eli Lustgarten, Longbow Securities.

One quick question on the outlook.

With your 2% to 4% organic growth in the second half of the year, are you effectively extrapolating the trends that you saw in the December quarter into the second half of the year?

You are expecting mid-single digit growth in industrial and flat to down or -- I don't know if it was plus or minus in infrastructure.

Is that sort of the structural framework that you are looking at?

Yes.

I think that's fair.

So you're not expecting any changes.

And then your profitability -- your numbers are well below where you -- what we used to think of the profitability of the businesses.

And it's clear that industrial will be much more profitable then infrastructure for a while.

Can you give us some idea -- is pricing more competitive?

Are these costs for investments that you have also have some element of competitive response in the marketplace because demand is so slow that will limit margin recovery in the second half?

No.

Our pricing actually for the year and overall is going to be slightly positive.

There was no pricing moves taken at the beginning of the year?

No.

There was some in select markets on certain geographies, Eli.

Sintec went up in a couple areas.

We did as well.

But it's all positive.

Yes, more on the industrial side than the bigger material content side because raw materials on that side has been relatively flat.

And one follow-up question on the ATI acquisition, so you obviously had a big surprise at inventory that almost changed your whole look out for this year.

Can you talk a little bit about versus expectation?

Was inventory the only surprise?

And do we still talk about, not so much in 2014 -- that year we understand you gave us the restructuring impact -- but will 2015 still be the accretive in the 20% to 25% range, or 15% to 20%, whatever number you want to pick that you have sort of been talking about when you made the acquisition?

Yes.

Good question.

And I'll start off by saying, the base number that we put in there, Eli, the 10% to 15%, there is no restructuring benefits in there yet, even though we're starting.

But maybe we can do a little bit quicker in the fourth quarter.

But you're right; the major difference, when you take a step back, everything is pretty much on track.

We had limited access to get in there; and at the end of the day, the entire difference is solely related to inventory.

It was basically double what we had anticipated.

So if I take that out of the equation -- and I'd rather have more value assigned to a tangible asset than an intangible asset -- and given the turns that they have four, I'm glad that we have more inventory there, so more tangible assets that we can serve our customers.

It's going to be done by the March quarter.

So when I get to the June quarter, this business, the base business including purchase accounting, is accretive and relatively quick.

So that's why we feel pretty good about it.

And I'm not even talking about trying to accelerate any restructuring activities.

If we can do it.

Great.

We will do a little bit better.

But I like how the fact that we are trending the right way, no real surprises, the culture, we have the top leadership.

Carlos, myself, and two other EMC men, we visited all the US locations; and Carlos also visited the international.

And these guys are very, very happy to be part of Kennametal.

So I see a huge benefit.

And the one thing I will also remind everybody is we have no sales synergies at all built in.

And we think there are going to be some opportunities as we get into 2015 going forward.

So far as I'm concerned this thing is a great acquisition and everything is on track.

And the only thing I will add to that is that I think this is going to be, turn out to be the best acquisition we've made in the last 10 years.

We really are excited about this business.

Thank you.

Walter Liptak, Global Hunter.

I wanted to ask you about -- in one of the charts, you've got TMB base operating results; and the operating profit looks lower than I think we expected going into it.

It looks like a 4% operating profit margin.

I thought it was high single digits, closer to 10%.

Was there production cuts to reduce inventory that went on?

Why was that so much lower?

Well, first of all, they were on a 4-4-5 closing period under the prior owner, so right away we lost the first week in November.

Then we had to shut the place down to do the physical inventories, the fixed assets; and we lost another day there.

This is how we built it in, and then you had the holiday periods.

So when I take a step back, it was profitable to your point.

The worst two months maybe, they don't have as big a footprint as we do in Europe, but we have the worst two months of ownership right now; and we still made money.

But in May, I think everything is pretty much on track.

This is as expected.

And to your comment, the double-digit still there.

Okay.

So in the second half, what are you assuming for operating margin for TMB?

We haven't got it out, but you kind of alluded to what we think it's going to be.

And that's without restructuring, so this is kind of looking at the base, and the purchase accounting.

We're going to have a nice second half.

Let me leave it at that.

Okay.

With the ISM's picking up, and you've talked about general industrial looking better, are you seeing distribution or end-customer inventory build yet?

Or is it still too early?

Yes.

I don't think the inventory buildup is taking place yet.

I think that this is due to demand, everything that we see in our 6% organic growth; and as I said, double-digit in the month of December.

At least we feel we don't have -- we can't really, just like we couldn't tell how much of the decline was coming from the inventory reduction.

It would be hard for us to see all the way down, but our gut feeling tells us that there is no inventory buildup yet.

Okay.

But at some point we should see that, right?

Yes.

Not as much as in -- every year -- every time there's a downturn we always get more efficient, but yes.

Yes.

And that's why we talk to distributors out there.

That's why we've been focusing on the fill rates because we do expect that if you look at the global PMI, all the economic indicators, or if you just look at the US, obviously they are strong.

So we want to make sure we maximize our opportunity when it comes forward.

And this is why we added the cost in the first half of the year, is with the anticipation that the industrial business was going to come back strong in the second half.

Okay.

And then the last one, what tax rate are you using for the third quarter and fourth quarter?

Well, if you exclude everything out, I would use about 24%.

Okay.

Thanks guys.

Thank you.

Julian Mitchell, Credit Suisse.

It's actually John Schaffer for Julian.

I just wanted to check on industrial real quick.

It sounds like December was a good standalone month, up double digits and that Asia was kind of one of the strongest drivers of growth.

Is that 12% growth in Asia sustainable for the rest of the year?

I'm not sure that it's sustainable, but I think that we're going to see -- you're going to see an improvement in growth in North America versus where we have been right now.

And I think that Europe is going to continue to stay at a nice growth rate, especially in Germany where we have a large presence.

And I think the concern -- the only concerns that we have to watch is really Brazil and India, as I talked.

India is coming up for a national election, coming up things are not going to happen that much until that election takes place.

But we feel very good about our forecasted growth for the second half of the year.

And then just quickly on the infrastructure side, specifically to Earthworks, it sounds like there is now a bottoming in that market.

Is there any suggestion of when you could actually see revenue turn positive again?

Is that a kind of next year event or possibly at the end of this year?

Yes.

It's interesting, right, with this cold weather.

While it does have an impact, the cold weather obviously is good for the energy, whether you are doing oil and gas or coal.

So we'll watch how this thing plays out as we go forward.

Our Achilles heel has been obviously we have good market shares in Appalachia as well as China.

I would expect China to come back before Appalachia, but it may be slow.

The construction has been very good.

So while we had negative, and the mining's a little bit bigger than our construction, but our highway construction was low double-digit growth.

So the highway construction stuff continues to bode well.

And if we get a little bit of an improvement here in our second half -- we go into the highway season -- and if the weather stays cold and we see what kind of prices natural gas does, there could be a swing there.

But I think it's a little bit too early for us to get excited on it.

Got you.

Thanks a lot guys.

Thank you.

Samuel Eisner, Goldman Sachs.

Just a couple housekeeping items here.

You said that the inventory step-up on TMB was about double what you were expecting.

I'm just curious about with the $100 million sequential increase, how much of that is TMB and how much of that is actual base business?

Sorry.

I didn't follow you Sam-- what was that?

The step-up in inventory total inventory is about $100 million on a sequential basis.

How much of that is TMB, and how much of that is base business?

Yes.

The base business was about $4 million.

Okay.

Great.

Everything else was TMB.

Great.

And the timeline for the annual savings that you're doing from the restructuring, I think you called out about $35 million to $45 million.

So just curious when those start to flow in and how they do flow in over future periods.

We really have them coming in towards the end of the fourth quarter, when we will see how quick we can get those into the base business.

I'm not counting on a lot in the number I provided, the 10% to 15%; so if we can accelerate a couple of these because it does take some time moving things around.

But hopefully we can go a little bit quicker, and then it will start coming in in the June quarter.

But really we will start seeing it in 2015 in earnest.

And is there a way to get a basically utilization rate on the base business at the moment, ex TMB?

Well, if you -- I'll give you just a rule of thumb.

We said that we were capitalized for $3 billion on the upturn over the base business.

We bought Stellite after that and we now bought TMB.

Between Stellite and TMB the run rate of the business is about --

$3 billion?

Yes.

So our base business is still low the high levels that we were before significantly.

I would say they are below the two acquisitions.

So I would say that our business in general, the base business, is probably running at -- a guess about 70% to 75%.

Okay.

Great.

And then just lastly on the double-digit strength that you saw in the distribution market, is that primarily because of it easing comps?

Or are you actually seeing sequential growth?

I know you called out December was obviously up double digits in all of industrial.

Just curious how the industrial distribution piece is working.

Well, I think it's a combination of both and we really can't -- we don't know how to break that down, to be honest with you.

And I don't have a number actually.

I didn't look up the number for distribution; but obviously distribution is a big factor of driving that double-digit, and distribution always comes out first.

Okay.

I'll follow-up on it, thanks.

Comps are helping us and there is actual growth.

Great.

Thank you.

Holden Lewis of BB&T.

I just wanted to understand, I guess, the guidance a little bit more.

For revenues, you are sort of indicating the total sales growth is going to be 12% to 13%; that obviously includes the TMB contribution.

Right.

When you get to the bottom line of $2.60 to $2.75, that includes nothing from TMB -- no base ops, no depreciation and amortization step-up, nothing at all?

Right.

That's kind of like-for-like.

That is akin to the prior guidance that we had, the $2.90 to $3.05.

And really, when you take a step back, it's a combination of the top line being a little bit softer, some investments that we accelerated to grow the top line, and some of the manufacturing expenses that we had in the quarter.

It's all base-to-base.

Okay.

Got it.

Then when you look at the pieces, and obviously the inventory step-up will be done pretty quickly; that kind of seems like nonrecurring.

But the depreciation and amortization step-up you talked about, that's sort of a -- that's going to be with you for a long time.

That's just the standard, right?

Yes.

On an annual basis, I'd ballpark that $0.06 to $0.09 annually.

Okay.

So if we are looking to line up the EPS along with the revenue guidance so that it's truly like-to-like, where the revenues include the acquisition EPS is, we should probably be using the TMB base ops and the D&A step-up, which are kind of offsetting, I guess.

But is that the way that we should be looking at it in terms of trying to make the top line and the bottom line be apples to apples with the acquisition?

Yes.

I think that's about right.

Okay.

Excellent.

And then I guess the second question I had, and this kind of relates to your comment about being down 70% to 75% of peak level.

You talked about all of these new costs.

But as an organization, obviously you've been at a much higher organic revenue base; you have plenty of capacity; the recovery seems to be very early and a bit weaker than you anticipated.

Why are we ramping expenses now, given all of that?

Why don't we sort of farm the infrastructure a bit, be sure of the trends behind the end markets, and then kind of get ahead of getting to peak?

It just seems like it's premature to be adding these expenses so soon.

Well, the first thing that I'd tell you is that it takes a very experienced sales guy about six months before they can be productive.

And it takes a young junior salesperson about a year and a half before they can be efficient, for instance, just to give you an example.

So it's a trade-off.

Do you want to grow double digit in the month of December, or you trade-off some expenses and grow less than double digit and then lose market share in the process?

Okay.

But these sort of investments that you are making, these are kind of new to the story.

It's not something that we were aggressively doing one, two quarters ago.

It's kind of something you're stepping up now with your rising confidence?

Yes.

By the way, you also have to realize that in the year-over-year basis, last year we were taking some of these people that were not as efficient out with the understanding that we would have to replace them at the right time so that we can accommodate the accelerated growth.

Yes.

And if you go back to the July call, we try to highlight two facets, Holden.

One was about $0.10, we said were kind of some investments.

And then we said, hey, we are going to have another $0.20 coming back for incentive compensation.

All those types of programs connect; so some of that stuff is coming back, and we kind of had to build that in.

And then there are some investments.

We talk about NOVO; we talk about people.

But we think these are the right things longer term to help us grow the top line quicker.

Yes.

The bottom line is we've got to manage this business for the year, not for the quarter.

Okay.

All right.

Thank you.

Joel Tiss, BMO.

Everything's been answered.

I had just one kind of curious question.

Is there any chance that the build up in inventory in the acquisition resulted in higher revenues and operating profits during the period that you were looking at that might impact -- like it might impact the growth rate longer term or medium term?

No.

Okay.

So just more stuff came out of the ground, but it wouldn't flow through into the revenues and the earnings?

Yes.

It's just kind of the value.

We could not get in there, Joel, and do stuff.

These guys ran a tight auction, unfortunately.

Everything we had.

And the good news to me is, I'd rather have tangible than intangible, as I said earlier; and this is good stuff.

Yes.

It's all stuff you need anyway.

Exactly.

Exactly.

It's not cabbage.

All right.

Thanks very much for spending the time.

Thank you, guys.

Thank you, everyone.

Ladies and gentlemen, this will conclude our question and answer session.

I would like to turn the call back to Quynh McGuire for closing remarks.

This concludes our discussion.

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

Thank you for joining us.

To access a replay of today's conference, you may dial toll-free 877-344-7529 or 412-317-0088 and enter the conference number 10038411.

You will be asked to record your name and company.

The replay will be available in approximately one hour.

The Kennametal conference call has now concluded.

You may now disconnect.