Kennametal Inc (KMT) 2015 Q4 法說會逐字稿

Good morning.

I would like to welcome everyone to Kennametal's fourth quarter fiscal year 2015 earnings call.

(Operator Instructions).

Please note this event is being recorded.

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

Thank you, Amy.

Welcome everyone.

Thank you for joining us to review Kennametal's fourth quarter and fiscal 2015 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 into this call.

It is also being broadcast live on our website and a recording of this call will be available on our site for replay through August 31st, 2015.

I'm Quynh McGuire, Director of Investor Relations for Kennametal.

Joining me for our call today are President and Chief Executive Officer, Don Nolan, and Vice President, Finance and Corporate Controller and Interim CFO, Marty Fusco.

Don and Marty will discuss the June quarter's financial performance and after their remarks we'll be happy to answer your questions.

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

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

Such forward-looking statements involve 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's provided the SEC with a Form 8-K, a copy of which is currently available on our website.

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

I'll now turn the call over to Don.

Thank you, Quynh.

Well, hello, everyone.

Thanks for joining us today.

We've been working hard to improve the business and are beginning to see some of the benefits.

Today we'll discuss our current quarter results and provide a forward view of fiscal year 2016.

We'll will talk about what we're seeing in the markets, where year performing, where we're falling short and what we're doing to address our issues.

At our Analyst Day, which is scheduled for December 15th in New York City, we'll be able to go into more detail and convey our strategy and financial goals.

Performance in the June quarter was better than we anticipated on several fronts.

We made progress on our cost reduction measures and made significant improvements in working Capital Management.

Although we did forecast a year-over-year sales decline, the demand environment was even more challenging than we expected.

Organic sales were down at the 10% from prior year and from a sergeant perspective, industrial sales decreased 4% versus last year, while infrastructure sales were down 16% year-over-year.

Despite this, we delivered adjusted earnings per share of $0.46 for the quarter and $2.02 for the fiscal year 2015.

Free operating cash flow was a record high $267 million compared to $156 million in the prior year.

The $111 million year-over-year increase reflects considerable improvement in managing our working capital.

June quarter results demonstrate that even in a very challenging market environment, our efforts to lower costs, improve efficiencies, and generate higher cash flows, are having a favorable impact.

We recognize that we have more work to do to get the company back on track, and we continue to take action.

We will control what we can and adjust our plans quickly when needed.

On portfolio simplification, we're making progress and have narrowed the range of potential divestitures to $150 million to $250 million of sales.

We believe that exiting these non-core businesses will be accretive to our operating margin when complete.

We're running an orderly process to maximize the value of these properties and will provide an update when we can.

While we don't have any current plans for additional divestitures, portfolio management will be ongoing to evaluate the returns on our assets.

We're getting our footprint right, and as previously stated, we plan to reduce our overall footprint by 20% to 25%.

This includes divestitures.

But is in addition to the current restructuring programs that we've announced.

To date, we've closed six facilities, divested another, and recently announced the rationalization of two additional facilities.

As we finalize the divestitures we expect there will be additional restructuring opportunities to eliminate stranded costs and further streamline our business.

We are aligning our cost structure and have decreased our global headcount by approximately 6% compared with the prior year.

In addition, we have bench marked our corporate functions against top performing companies and have plans in place to automate, simplify, and standardize the work we do.

These plans will reduce administrative costs and complexity while enabling a more effective deployment of resources.

We are improving working capital to deliver sustainable results throughout the cycle.

We've made progress by having more efficient inventory levels as evident in our ability to achieve record free operating cash flow in this past quarter.

Finally, we're strengthening our commercial capability and putting full support behind our teams to make it happen.

We have made changes in leadership and are driving better alignment between sales, marketing, and customer service.

We've also invested in information technologies, like a customer relationship management system, so our teams have visibility to data and metrics that will help them win.

Benefits from these actions will be visible in future years, and more specifics will be provided at our Analyst Day in December.

We're also thinking differently about investments.

We're shifting our emphasis from working capital to investing more capital in our plants.

This approach will drive productivity and profitability improvements in our manufacturing processes that have been successfully tested in various pilot programs.

For example, we're optimizing the grinding capability in many of our facilities and we estimate a 20% return or better from this invested capital.

Everyone knows that Rome was not built in a day.

Transforming Kennametal will take time but we're not resting until it's done.

We will do what it takes to build a winning team, drive world-class commercial capability, deliver excellent service and quality and introduce new products that change the dialogue with our customers.

Our path forward in fiscal 2016 remains focused on increasing margins through portfolio simplification, footprint restructuring, and reductions in our G&A costs.

At the same time we continue to invest in innovation to fuel organic growth.

All aimed at positioning Kennametal to be a premiere industrial company.

We've made notable strides in increasing our cash flow generation and will be relentless in our efforts to deliver meaningfully improved profitability.

Beyond fiscal 2016 we will expand our return on invested capital to the double-digit level as part of our long-term plan.

For fiscal 2016 we forecast earnings per share to be in the range of $1.70 to $2.00.

This includes $0.30 to $0.35 of exchange rate headwinds.

Put simply, our headwinds include currency, weekend markets, and some near term investments to support growth.

These factors are partially offset by the tail wind of our ongoing cost reduction measures.

Key assumptions include a projected year-over-year decline in organic sales of 1% to 3%.

While we continue to see some growth in the industrial segment, it's just not sufficient to offset the significant weakness in our infrastructure business.

Primarily due to the oil and gas and mining markets.

In addition, we expect foreign currency exchange to have a negative impact on sales of approximately 6%.

Year-over-year comparisons are anticipated to be unfavorable through December 2015 and we expect December quarter to be particularly challenging.

We have not included the impact of potential divestitures in fiscal 2016 guidance.

For the industrial segment, we expect approximately 4% organic sales growth in fiscal 2016.

Conditions in our served end markets are expected to remain favorable.

The transportation market remains healthy with projected auto builds of 90 million units globally, 3% higher than prior year.

U.S. auto build rates are estimated to be 12 million units, a year-over-year increase of approximately 4%.

We believe that demand in our general engineering business will be mixed but our continued focus on the indirect channel will more than offset weakness in the oil and gas activity.

In aerospace and defense, production activity is expected to increase, particularly in commercial aerospace.

Looking at industrial from a geographic perspective, we expect continued growth in the U.S. and it represents a key target area as we have opportunities to improve our market position.

In China, we still see moderate growth during the fiscal year despite a recent deceleration.

And western Europe is beginning to improve and we should see slight growth in that area.

For the infrastructure segment, we're projecting an organic sales decline of approximately 9%.

Market trends reflect further contraction in the near term, although at a decelerating pace.

We expect difficult conditions to persist in the oil and gas sector, with operating rates projected to remain at low levels through calendar 2015, and a very modest year-over-year increase beginning in calendar 2016.

Underground coal mining in the U.S. continues to face headwinds with production rates further weakening in the near term particularly in the Appalachian region.

In China, coal production has stabilized and has shown some improvement, while construction sales have been softer due to less project work globally and delays in global funding in the U.S., we see some improvement coming from an increased activities in road rehabilitation applications.

To date our restructuring programs are on track to deliver projected benefits and we anticipate that the combined after tax savings from all three restructuring programs to be between $115 million and $135 million on an annualized basis once fully implemented.

We've intensified our efforts on cash flow generation and we're beginning to see the benefits of improved working capital efficiencies.

We expect to generate $115 million to $135 million in free operating cash flow in fiscal 2016, net of anticipate capital expenditures of $160 million to $175 million.

As already discussed, we are scaling up programs that have been proven and reflect very attractive risk adjusted returns.

We believe that this level of investment in our core business is warranted to improve productivity in our manufacturing processes and further support innovation through new product introductions.

Further, on uses of cash, we will continue to reinvest in our business.

Our Board of Directors just recently approved a dividend increase of $0.02 per share or 11%, to $0.20 per share.

With recently completed overseas cash deployment and strong free operating cash flows, we have paid down much of our revolving bank debt.

The dividend increase, coupled with our significant debt reduction, illustrates the confidence in our long-term plan to drive shareholder value.

In addition, we'll continue to evaluate opportunities to buy shares of our stock as part of returning cash to shareholders.

We are working hard to simplify our business and realign our cost structure, while taking actions to support further growth.

We will also remain dedicated to innovation and introducing new products with speed and purpose in order to strengthen our product portfolio.

We'll continue to focus on execution, doing what we say and delivering on our commitments.

At the same time, also invest for the future to drive both our top line and bottom line.

Once we complete the divestitures, we'll have a reduced asset base and can more effectively focus on our core business.

Kennametal will be better positioned to drive margin expansion by leveraging our asset utilization and improving our return profile over the long term.

I'll now turn it over to Marty Fusco for additional details on the financials.

Thank you, Don.

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

Please see the non-GAAP reconciliations filed on Form 8-K and in the press release.

As Don mentioned the June quarter presented a challenging demand environment due to the current economic conditions in many of our end markets.

The impacts of these topline challenges were lessened by restructuring benefits and additional cost reductions realized during the quarter.

We continue to make progress with all three of our current restructuring programs, and realized benefits of approximately $17 million in the June quarter, of which $14 million was incremental to the prior year quarter.

We are on track to realize the expected total annual benefits for all three programs of $115 million to $135 million.

Federal charges for all programs are expected to range from $185 million to $205 million.

We delivered adjusted EPS for the quarter of $0.46, which was consisted with our guidance.

As Don also mentioned, our focus on working capital management enabled us to deliver record free operating cash flow of $267 million for fiscal 2015.

Now let me walk through the key items in the income statement.

Sales for the quarter were $638 million, compared with $772 million in the same quarter last year.

Sales decreased by 17%, reflecting a 10% organic decline, or 7% unfavorable impact from currency exchange, and a 1% decrease from a prior year divestiture, offset partially by a 1% favorable impact due to more business days.

Earnings for the sales performance by business segment, industrial segment sales of $358 million decreased 14% from $416 million in the prior year quarter due to unfavorable currency exchange of 10%, organic sales decline of 4%, and a prior year divestiture of 1%, partially offset by an increase of 1% due to more business days.

Excluding the impact of currency exchange, sales remained flat in general engineering, while sales decreased approximately 2% in transportation, approximately 7% in aerospace and defense, and approximately 22% in energy.

On a regional basis, sales decreased 6% in the Americas, 1% in Europe, and remained flat in Asia.

In the general engineering market, sales in the indirect channel grew, offset by weak demand in the energy market in all regions.

Sales in the transportation market were adversely affected by lower volumes in all regions, while aerospace and defense sales decreased due to the company exiting lower margin business, partially offset by production growth in aircraft planes and engines.

Industrial segment sales were also negatively impacted by direct energy end mark exposure despite the relative small size of energy to its overall portfolio.

Infrastructure segment sales of $280 million decreased 21% from $357 million in the prior year.

The decrease was driven by 16% organic sales decline and 6% unfavorable currency exchange, offset partially by an increase of 1% due to more business days.

Excluding the impact of currency, sales decreased by approximately 23% in energy, and by approximately 11% in earthwork.

The energy market was impacted by continuing weakness in oil and gas end markets, partially offset with some improvements in power generation and process industry sales.

Earthworks was impacted by continued weakness in underground mining, while highway construction sales improved in line with the road rehabilitation season.

On a regional basis, sales decreased 21% in the Americas, 17% in Asia, and 5% in Europe.

Moving to our consolidated operating performance, our gross profit margin was 29.6% compared with 32.7% in prior year.

Our adjusted gross profit margin in the current and prior period was 30.1% and 33.1% respectively.

The decline in our margin was due to the organic sales decline, lower absorption of manufacturing costs related to lower sales volume, and an inventory reduction initiative, unfavorable business mix in the infrastructure segment, and unfavorable currency exchange.

These impacts were partially offset by restructuring benefits.

The reduction of inventory impacted gross margin by approximately 150 basis points.

Operating expense, as a percentage of sales was, 20.5% compared with 20% in the prior year.

Adjusted operating expense as a percentage of sales was 20.1% for the current period and 19.7% in the prior year.

Adjusted operating expense declined $23 million year-over-year due to favorable foreign currency impacts, restructuring benefits, and lower incentive compensation.

Past reduction actions continue to be in place as we align our cost structure with the realities of current market conditions.

Operating income was $35 million for the quarter, compared with operating income of $78 million in the same quarter last year.

Adjusted operating income was $56 million, compared with $95 million in the same quarter last year.

Adjusted operating results in the current period were driven by organic sales decline, lower absorption of manufacturing costs related to lower sales volumes, and an inventory reduction initiative, unfavorable mix in infrastructure, and unfavorable currency exchange, offset partially by restructuring benefits and lower incentive compensation.

Adjusted operating margin was 8.8% in the current period, compared with 12.4% in the prior-year period.

Looking at operating income performance by business segment, the industrial segment operating income was $40 million, compared with $53 million in the prior year.

Adjusted operating income was $51 million compared to $64 million in the prior year quarter.

These results were driven by organic sales decline and lower absorption of manufacturing costs related to reduced sales volumes and an inventory reduction initiative.

Partially offset by restructuring benefits and lower incentive compensation.

Industrial adjusted operating margin was down 140 basis points, to 14.1% compared with 15.5% in the prior year.

The infrastructure segment operating loss was $4 million compared with operating income of $27 million in the same quarter of the prior year.

Adjusted operating income was $6 million compared to $32 million in the prior year quarter.

Adjusted operating income decreased primarily due to lower organic sales, lower absorption of manufacturing costs related to reduced sales volumes, and an inventory reduction initiative.

Unfavorable mix, and unfavorable currency exchange offset partially by restructuring benefits and lower incentive compensation.

Infrastructure adjusted operating margin was 2% compared with 9% in the prior year.

The reported effective tax rate was 24.8% in the current quarter, compared with 30.5% in the prior year quarter.

The decrease was primarily driven by prior year restructuring charges in tax jurisdictions where a tax benefit was not permitted.

Turning to cash flow, as a result of our commitment to improving working Capital Management, we generated strong operating cash flow of $351 million and we're $80 million above the prior year.

We generated a record $267 million of free operating cash flow, an increase of 71% compared with $156 million in the prior year.

We remain confident in our continued strong cash flow generation and committed to our capital structure principles.

Through prudent and balanced debt facility structuring, we were able to tax efficiently, deploy approximately $100 million in cash from overseas operations for debt reduction in the June quarter.

This initiative further enhanced our liquidity, enabled us to accelerate rating agency credit metric enhancement, and will result in $2 million in annual interest expense savings.

Record free operating cash flow and overseas cash deployment enabled us to reduce debt $310 million in fiscal 2015.

Our $600 million revolving credit facility, due April 2018, had available borrowing capacity of $557 million at June 30, 2015.

We have ample cushion under our financial covenants and an attractive debt maturity profile as our nearest maturity is in November 2019 when our $400 million of 2.65% senior unsecured notes are due.

Our cash balance was $105 million as of June 30, 2015, most of which presently resides overseas.

Additionally, we have increased the current quarterly dividend by $0.02 per share, from $0.18 to $0.20, effective with the August dividend.

We are confident in our ability to continue to grow our cash flow.

This 11% increase in the quarterly dividend is consistent with our capital structure principles objectives to return a portion of excess free operating cash flow to shareholders, consistently over time, while positioning for recurring increases commensurate with earnings and cash flow growth.

As previously stated, our priority use of cash is business reinvestment for profitable growth while balancing the return of a portion of excess cash to shareholders.

We evaluate our dividend regularly in terms of dividend yield and payout relative to peer industrial companies.

We enjoy investment grade ratings from all three agencies and remain committed to maintaining them.

Our debt to capital ratio at June 30, 2015, was 35.3%, compared to 35.1% at of June 30, 2014.

This slight increase was driven by infrastructure impairment charges recognized in previous quarters, largely offset by substantial debt reduction in the current fiscal year.

Now turning to our guidance for fiscal 2016.

Our outlook reflects ongoing market uncertainties as well as limited visibility related to customer demand trends.

As Don elaborated on earlier, we expect some growth in our industrial end market, although not sufficient to offset the weakness in our infrastructure end market.

The oil and gas industry is likely to remain challenging through December 2015, and underground coal mining activity will likely remain at low levels globally.

We expect organic sales decline to range from 1% to 3% and total sales decline between 7% and 9%.

Our fiscal 2016 outlook is based on the following assumptions.

We are projecting, as I said, 1% to 3% of organic decline.

We expect that demand will improve modestly in our industrial end market, led by general engineering and transportation.

In the first half of 2016, growth will be challenged in general engineering due to exposure to the energy markets and slight growth is expected in aerospace and defense.

Transportation is expected to show stable growth throughout.

On a regional basis, growth in all end markets is expected to be led by Asia and EMIA, with modest overall growth in the Americas.

For infrastructure, we face challenging end market conditions and expect a very modest year-over-year improvement in the second half of fiscal 2016.

Accordingly, rates of year-over-year decline are expected to improve throughout the fiscal year, with modest volume growth expected towards the end of the fiscal year.

The sales decline is expected across all regions, led primarily by performance in the Americas.

Pricing will be a headwind during the fiscal year, but is expected to be more than offset by lower raw material costs once higher cost inventory positions are worked through our operations.

We expect restructuring benefits to more than double in fiscal year 2016 and incremental savings to be higher in the first half of the year.

Foreign exchange is expected to be a significant headwind, which we estimate to be in the range of $0.30 to $0.35 per share.

This is mostly from the impact of continued strength of the U.S. dollar against the Euro.

We are seeing a significant impact on earnings from foreign exchange due to the strengthening of the U.S. dollar against our selling currencies overseas and while we enjoy a global operating footprint that helps mitigate this foreign currency effect on revenues, our major raw materials are purchased in U.S. dollars, resulting in gross margin compression on our international business.

Operating expenses are expected to decline in 2016 due to favorable currency effects, restructuring benefits, and cost reduction efforts.

These benefits are expected to be partially offset by the effects of general inflation.

Due to topline softness, we expect our operating expenses at 21% to 23% of sales.

I also want to point out that our guidance includes approximately $20 million to $25 million of higher incentive compensation than the prior year.

This assumes that incentive compensation will be fully restored levels in fiscal 2016.

Our effective tax rate for fiscal 2016 is forecast to be approximately 24% to 26%.

Additionally, we are expecting the first half will have a higher tax rate than the full year.

Year-over-year increase in our tax rate is partly driven by a continued unfavorable geographic mix of earnings in fiscal 2016 and the effect of expired U.S. Federal tax provisions.

We will continue to look for ways to minimize our tax rate.

Consistent with our capital allocation principles, we plan to reinvest back into the business with $160 million to $175 million of capital spending.

This is higher than our historical trends of spending 3% to 4% of sales on capital expenditures.

This additional investment is anticipated to improve our longer-term manufacturing productivity.

Based on these highlighted factors, we expect EPS to range from $1.70 to $2.00 in fiscal 2016.

Again, this guidance includes the benefits of restructuring program but does not include any cost of restructuring program or potential portfolio actions which could represent $150 million to $250 million of sales.

We expect to generate cash flow from operating activities ranging from $275 million to $310 million in fiscal 2016.

Based on anticipate capital expenditures of $160 million to $175 million, the company expects to generate between $115 million and $135 million of free operating cash flow for the fiscal year.

The primary driver of the planned decrease from free operating cash flow is increased capital expenditures.

As discussed earlier today, we continue to take aggressive actions to reduce costs, including streamlining our manufacturing footprint and continuing to accelerate our restructuring program.

As we finalize our portfolio review, there will likely be additional restructuring opportunities to take out stranded costs and further streamline the business.

Over a longer term, our capital allocation process will include value drive in capital investments in the business, as well as returning cash to shareholders through dividends and share repurchases.

We are focused on increasing our profitability, growing our topline, as well as maximizing our cash flows and returns.

We will remain focused on productivity of our core businesses and reviewing our portfolio.

At this time I would like to turn the call back over to Don for closing comments.

Thank you, Marty.

In summary, we believe the strength of our people, our highly recognized products and our geographic reach will keep Kennametal at the forefront of our industry.

While we expect to see headwinds in certain markets in fiscal 2016, we believe we are on the right path.

Our focus is to increase our profitability over the course of the cycle, resulting in improved returns for investors.

While we continue to optimize manufacturing efficiency and reduce our footprint, we're ensuring that we're not negatively impacting our overall manufacturing capability.

We are consolidating in a manner that ensures we leverage best practices and we can continue to meet customer demand as the cycle improves.

We continue to develop innovative technologies and nurture the talent within our organization.

While there is still much to be done, we believe that we have made significant progress in improving our operations in a difficult market and positioning Kennametal well to capitalize on a brighter future.

We continue to execute on our key priorities to simplify our portfolio, align our cost structure, and invest in our business to deliver core growth with an accountable customer focused culture.

These are all central to developing our path forward to drive organic growth, maximize profitability, and generate improved shareholder returns.

We'll now be happy to take your questions.

(Operator Instructions).

Our first question is from Julian Mitchell at Credit Suisse.

Hi, thank you.

Hi, Julian.

Hi.

Just a quick question.

I think you said that the savings increase, sort of, over two times year on year, so I just wanted to double-check, you know, I think your savings to date are around $37 million, so you saying that the savings imbedded in the guidance for 2016 is sort of $80 million plus or did I get that wrong?

No, Julian, you got that right.

Okay.

And how do we think about the seasonality of earnings?

I guess historically it was maybe sort of 45, 55 first half, second half last year was the inverse.

How are you thinking about this year?

So, from a sales perspective, Julian, historically we do about a 50/50 split.

We'll be roughly the same.

We're going to be a little lower first half on the topline than historical norm.

From an earnings perspective, you know, our normal 40/60 split is going to be compressed, so you're probably looking at, you know, more of a 30/70 split.

And I do want to point out that our Q1 sequential sales, going back to sales for a moment, Q1 sequential sales are expected to be lower than our norm, normal sequential decline.

In FY15 we declined Q4 to Q1 about 10%, you can expect a little bit more than that in fiscal 2016.

Then going back to earnings, Q1 in particular is expected to only be about mid single-digit operating margins.

Thank you.

That's very helpful.

And lastly, I just wanted to circle back on the FX hit again.

I guess I think it implies around a 20% to 25% kind of drop-through margin on the FX hits to revenues.

That's a lot higher, I guess, than I had thought.

Are you including some kind of price decline within the FX impact?

And then maybe just clarify, you know, the $0.30, $0.35 hit this year, what were the hits in EPS in 2015 as a whole?

I don't have the 2015 impact in front of me, Julian.

We will get that for you.

We've assumed $0.30 to $0.35 unfavorable impact in our guidance, and again that's primarily driven by the euro.

We'll keep you apprised as we move through the year on any changes in our assumptions, but we do have an added impact within margin or an exaggerated impact in our margins because of the extent to the drop of the euro this year, the FY15 average euro for us was about $1.21.

So that exaggerated drop in the euro as well as exaggerated declines in our raw material costs are causing a bigger, I would say a bigger impact than you might expect because our European operations, purchase raw materials from our U.S. companies that are U.S. dollar denominated.

So the $0.30 to $0.35 that we noted is purely FX driven.

Great.

Thank you very much.

You're welcome.

Your next question is from Adam Uhlman at Cleveland Research.

Hi, guys.

Good morning.

Good morning, Adam.

Hey, Don, you had mentioned investing in growth this year versus, you know, pulling back on working capital in the past.

Can you help me understand, is this all a CapEx, you know, effort with the CapEx going up a lot or is there some operating expense growth that you anticipate?

And then longer term, you know, when can we expect to get back down to CapEx being 3% or 4% of sales?

Is that, you know, is this a couple year process or is this just going to be like one year?

You know, I think, Adam, you know, I'll be really transparent in our process.

We looked at our forecast, looking at free operating cash flow for the year, and we were looking at, you know, we were going to run 130% to 140% of net income, and we looked at the list of projects that we had on our list that would increase productivity.

We used our hurdle rate of 20% or better.

And we just said it's a better use of cash.

Simply put.

So we decided our investment in our CapEx because we had some great opportunities to improve productivity and the returns on those investments were well above our hurdle rate.

Going forward, I think, by the time we hit Analyst Day here in December, we'll be able to provide a little bit more color on what we'll be looking at for the next three years.

Okay.

Gotcha.

Thank you.

And then in general, in terms of some of the market commentary that you folks had made, can you talk to the improvement in power gen and process industry trends that you guys saw, what specifically is getting better within those markets?

Well, I'm not sure, so we look out, to be frank, I think what was mentioned is that, as we look at our energy markets, heading, for the first six months we see a continued challenging market, we really don't see a whole lot of improvement.

What we're seeing is that the comps get a little bit easier as we head into our third and fourth quarter, and declines turn into very, very slight improvement year-over-year.

And, again, we're basing that based on forecasts of others, including our customers, and looking at that as, I would call it more elimination of the declines rather than as an improvement.

But a lot of it has to do with easier comps.

Okay.

Thank you.

Our next question is from Ross Gilardi at Bank of America.

Hey, good morning, thank you.

Good morning, Ross.

Hey, Don.

I'm just wondering if you'd give us a little more of your thoughts on the divestitures.

I think you said $150 million to $250 million, I think that might have chopped off the high end there, and should we expect to see anything between now and your investor day?

And you've obviously mentioned margin accretion if you move forward on the divestitures, but wondering, your tolerance for shorter external earnings dilution because presumably some of these assets you're thinking about selling still have got positive margin even if it's below average.

Yeah, so, you know, again, it's difficult because these are, it's not clear which will actually be sold and at what time.

So, you know, it would be difficult for me to give a lot more definition at this point.

We know the range, just to give you a little more clarity about how much we expect now to move the process.

It's quite efficient.

It looks like we will be successful, how's that, it's just the extent of our success.

And all I can say, I can keep you posted as we move forward.

Got it.

And then could you talk a little bit more about the weakness in U.S. industrial and the most recent quarter and what you're seeing there?

And are you actually seeing anything in your order book today to suggest that we'll get a pickup that you're assuming?

Yeah, I think in the last quarter, I suggested that we're not achieving our potential, I think was the way I put it last quarter.

And we had a core focus on improving performance in the U.S. We're still there.

A tremendous amount of focus on improving execution in the U.S. I think we're improving.

I think we're getting better.

You know, I think that we've still got opportunity there.

But in terms of the decline this quarter, could you just give a little more color on that?

Well, I think, you know, looking at the marketplace, I think, actually, that the market wasn't as good, I think, as it was in our third quarter.

So some of it was market and some of it was our own performance.

Got it.

Okay.

Thanks very much.

I could just add to that for you, Ross, just from an industrial perspective in the Americas, the exposure to energy on the industrial side, both through general engineering and then also a small portion of the portfolio that's direct, would be also a driver to the Americas performance within industrial.

Got it.

Thanks very much.

Your next question is from Andy Casey at Wells Fargo Securities.

Hi, Andy.

Thanks a lot and good morning, everybody.

On the quarter you reduced inventory by about $57 million in Q4 from Q3.

Did that have any impact on gross profit?

It did, and Andy.

The impact in the quarter was about 150 basis points unfavorable over prior year.

Okay.

Thank you.

You're welcome.

And then as you look forward into fiscal 2016, specifically on the $275 million to $310 million operating cash flow, do you expect any further decrease in working capital relative to sales, you know, to finish the quarter about 29.3 of trailing 12-month sales?

I'm just wondering if that should stay about constant or if that continues to go down.

Andy, from a dollar perspective, looking at working capital, we're expecting a similar impact on the cash flow for the full fiscal 2016 as we saw in 2015.

Okay.

Great.

And then on the capital investment, the $160 million to $175 million, I know you've gone through and mentioned projects that improved the productivity.

Is there any investment in facilities to, in terms of new facilities, to help with that productivity?

No.

We're investing in equipment here.

And our, most of that, certainly most of the incremental investment is all about productivity specifically.

Okay.

Thank you very much.

The next question is from Joel Tiss at BMO.

Hi, guys, how's it going?

Good.

Good morning, Joe.

Is there any rationale or any reason to want to want to put, to ring fence the stuff that you're thinking about divesting and put it into discontinued operations so you can clean out all the goodwill and sort of get everything behind you in the nearer term or is it better to just wait for the right timing to find a buyer?

Joel, from an accounting perspective and a GAAP perspective, we're not permitted to break that out as discontinued operations, and we're not far enough down the line that those operations would be considered held for sale at this point.

Okay.

And I just wanted to ask one longer-term question.

You know, now that you've been there for whatever it is, for six months or so, I just wonder if you could give us a sense of what Kennametal looks like in five years.

And I'm thinking all just from return, you know, free cash flow as a percent of net income, operating margins.

Like if you, you know what I mean?

Your vision, and you slim down to the core business, what kind of returns and operating margins and free cash flow do you think is like the longer-term target?

Yes, Joe, I've noted every one of your questions, and I look forward to seeing you in December.

You'll tell me in 2018, right?

You know, I think we'll we're spending a lot of time and energy thinking hard about the rate strategy, making sure we have the right footprint, making sure we have the right portfolio to maximize all the tremendous assets that we have at our disposal here at Kennametal.

And our intention is to lay that out on December 15th on Analysts Day.

Is it crazy to think that this could be a high teens business, you know, when everything is said and done longer term or it's just too early to say?

Yes, I think it's just too early for me right now.

All right.

Okay.

Thank you.

Great question, though.

Thank you.

Yes.

Your next question is from Walter Liptak at Global Hunter.

Hi, thanks, good morning.

Good morning, Walter.

I wanted to ask about the 2015 percentage of sales.

You know, I guess specifically, you know, on the infrastructure segment, what percentage of your sales are O&G and what percentage are coal or I guess mining?

Walt, this is Quynh.

I would say that what we said last quarter still holds true.

What we can account for directly to the oil and gas is around 8% to 9% of total company sales.

However, there's indirect sales that gets captured, you know, via general engineering and, you know, more secondary impact.

In terms of the coal, we actually report that under earthworks, and in round numbers, I would say earthworks is around 20% of total company sales.

Half of that is mining, and half is construction.

Okay.

Got it.

And I'm, on the oil and gas, during the quarter what kind of year-over-year decline rates did you experience?

We had much higher declines on oil and gas in the U.S. When you look at rig counts, rig counts are down about 50%, and certainly in the U.S. we had similar drops.

And you can pretty much align it with that around the world.

We follow rig counts pretty closely.

Okay.

So as you go into your fiscal first quarter, second quarter, are you expecting those declines to, you know, to accelerate or stay about the same?

Boy, I'm not sure I want to be in the business of forecasting rig counts here, Walt.

What we've done, we've built into our assumptions for the year, is that we would continue to have a challenging first half, I would call it, so we would continue to see year-over-year declines.

And then the comps get easier as you get into the second half.

We don't, you know, right now we've built in that rig counts will not drop significantly, we may even add a few.

That's where we're saying.

Okay.

Thank you.

Okay.

And you mentioned in your comments about pricing and I wonder if you could comment specifically about what your oil and gas customers, are they requesting price declines and, you know, are you succumbing to the price declines and what impact did that have on the business?

Yes, we are getting requests on pricing.

We've had some declines in raw materials.

And many of our customers are aware.

And it's, obviously we're also seeing declines in raw materials.

And we don't expect to have that, we expect those to offset and not have a significant impact on margins.

Okay.

Okay.

Great.

Thank you.

Your next question is from Samuel Eisner at Goldman Sachs.

Yes, good morning, everyone.

Good morning.

Good morning, Sam.

Can you talk a little bit about just the June month and how organic performance was throughout the month of June, and then any early reads on July?

I don't see the June numbers posted on the website so any help there would be great.

Yes, so I would say nothing inconsistent in June with the rest of the quarter, so there's nothing to note there.

Got it.

Anything on July that you're willing to talk about?

You know, I think we're going to have a pretty challenging, pretty soft quarter.

This is year-over-year.

And early indications are that this will be a challenging quarter.

Got it.

And then when you think about the footprint changes that are going on here, you know, I think one of the comments that you've made historically is that you're certainly looking at divesting a portion of that but also you're looking at kind of culling some of the existing manufacturing that you will end up keeping.

Can you talk a little bit about your ability to maybe move to a more is flexible manufacturing structure and being in that remaining business after the $150 million to $200 million of divestitures?

Yes, we are looking at reducing complexity, I think, taking, I would call it, products that don't create as much value as you'd hope given the complexity that they add to our operations.

That is a key driver for us.

So, and it may allow us to, it may help us drive further footprint reduction as we think about that next 25%.

So that's key.

But I'm not sure, does that answer your question?

I guess my understanding is that you have a pretty kind of fixed manufacturing footprint where, you know, it's difficult to make dissimilar products in multiple facilities, and I just wanted to understand if you're thinking about the overall manufacturing footprint becoming either more redundant in a sense or the ability to make different products in different facilities going forward?

Yes, so, with the new, next generation equipment, I guess is the way to say it, as some of the investments that we're making with this capital budget this year, we will have more agility.

Both to reduce batch size, to drive inventory, and to reduce cycle time.

So we're definitely enhancing the flexibility of operations with the investments we're making this year.

All right.

That's helpful.

And I guess just lastly, given the fact that you're already starting to record charges for Phase III in the current quarter but not gaining any savings there, can you maybe just talk about how the sequential increases throughout the course of fiscal 2016 kind of happen, for phases one, two, and three?

Thanks.

Sure, Sam.

They're relatively consistent with what we disclosed on last quarter's call.

So for Phase I, in 2016, we will get near our full run rate, reaching a full run rate of those savings in fiscal 2017.

From a Phase II perspective, we did realize about 15% of those benefits in fiscal 2015.

We expect to be roughly up to about 75%, 70%, 75% in the full year of 2016 and then be at the run rate in 2017.

And then for Phase III, you know, we didn't expect any benefits in 2015 and we expect some benefits in 2016, maybe a quarter, and the remaining be up to the run rates.

Well, about three quarters to three quarters in 2017, up to three quarters.

And then ongoing we'll hit our full run rate.

Great.

Thanks so much.

Our last question comes from Eli Lustgarten at Longbow Securities.

Good morning, everyone.

Good morning, Eli.

Can we talk a little bit about of how we should think about operating margins for the two sectors as we go through 2016, and I know this gets complicated with or without charges and all that, but, I mean, the numbers adjusted look like, I guess, industrial, something around [14.1] in the quarter but 13% for the year.

Are you expecting, despite whatever the volume number turned out, that we can improve operating margin in industrial?

I mean, that's a world class kind of business and probably some reasonable chance of operating profitability to go up.

And then, the negligible profitability that we're seeing in infrastructure, you talk about what we should expect, you know, in that kind of business.

I know that with divestitures and I know there's going to be a lot of noise but as an entity are (inaudible) what should we be thinking about for 2016?

And maybe some first half, second half or something because I know it's gonna be complicated.

Yes, well let me start out and then I'll turn it over to Marty.

So, first of all, the first thing to think about on margin impact is our portfolio simplification.

We expect to divest, as we said, a significant chunk of our infrastructure business and that will definitely improve margins on infrastructure business because we expect that to be accretive.

So I would start with that piece and then, Marty.

Sure.

From, just to give you a little color directionally, Eli, we did end the industrials about 13% operating margin.

We do expect improvements there driven by their organic growth, the restructuring benefits and cost reduction, so you can expect a little bit higher operating margin there.

We do expect, for industrial, a little more softer Q1 and Q2 than maybe you saw last year and then improvements in the second half.

From an infrastructure perspective, given the organic declines that are expects, (inaudible) pressures we're expecting to see from a pricing perspective, because raw material costs are dropping for us and we do expect more compression on pricing first half than second half and we expect raw material benefits to sort of materialize more in the second half once we have worked through our high cost materials.

So, from an infrastructure perspective you can expect some compression on the operating margin there and, again, the first two quarters are gonna be pretty low.

I mean, is it feasible that infrastructure, you know, (inaudible) excludes the divestitures before the simplification, is it possible to lose money in infrastructure in the first quarter, first half?

I don't think, you know, I don't think we can comment on that piece, Eli.

I think the one thing we can say is that we're heading in to a much more challenging first quarter and we think the challenge will be less in the second quarter and improve as we head through the year.

I think the one challenge, I would call a timing problem, as we have some high cost inventory to work through, it can effect our margins due to pricing declines.

But we'll overcome that as we head through the year.

And over all we do expect, sort of, a mid-single digit operating margin in Q1.

Overall for the company?

Correct.

Thank you very much.

Thanks, Eli.

Thanks, Eli.

At this time we will conclude the question and answer session.

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

This concludes our discussion.

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

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