Kennametal Inc (KMT) 2017 Q3 法說會逐字稿

Good morning.

I would like to welcome everyone to Kennametal's Third Quarter Fiscal Year 2017 Earnings Call.

(Operator Instructions) Please note that this event is being recorded.

I would now like to turn the conference over to Kelly Boyer, Vice President of Investor Relations.

Thank you, Kerry.

Welcome, everyone, and thank you for joining us to review Kennametal's Third Quarter Fiscal Year 2017 Results.

We issued our quarterly earnings press release yesterday evening, and it is posted on our website.

I'm Kelly Boyer, Vice President of Investor Relations.

Joining me on the call today are Ron DeFeo, President and Chief Executive Officer; Jan Kees van Gaalen, Vice President and Chief Financial Officer; Chuck Byrnes, President, Industrial Business Segment; Pete Dragich, President Infrastructure Business segment; Alexander Broetz, President WIDIA; Pat Watson, Vice President Finance and Corporate Controller.

Ron and Jan Kees will discuss the March quarter operating and financial performance as well as our outlook for fiscal year 2017, and will be referring to the slide deck posted on our website.

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

At this time, please direct your attention to our forward-looking disclosure statement.

Today's discussion contains comments that constitute forward-looking statements that involve a number of assumptions, risks and uncertainties that could cause the company's actual results to differ materially from those expressed in, or implied by, those statements.

These risk factors and uncertainties are detailed in Kennametal's SEC filings.

Also, we will be discussing non-GAAP financial measures on the call today.

Reconciliations to GAAP financial measures that we believe are most directly comparable can be found at the back of the slide deck and on our Form 8-K on our website.

With that, I would like to turn the call over to Ron.

Thank you, Kelly, and good morning, everyone.

We are webcasting our call today from our European corporate office, so good afternoon to our European listeners.

Thank you all for your interest in Kennametal today.

Also, I'd like to welcome Pat Watson, who has this quarter moved into the Corporate Controller role at Kennametal.

Pat has been with the company for 13 years.

Previously, he was the lead finance person for the Industrial segment.

Marty Fusco, who was Corporate Controller, has taken that role.

So please join me in welcoming Pat and thanking Marty and wishing them both continued success.

Let me begin on Page 2 of the slides that are posted on our website.

Our third quarter fiscal year '17 results exceeded our expectations in almost every measure.

Simply put, revenue increased and cost declined, reflecting continued progress on the initiatives that we began last year.

Overall, we posted year-over-year total company sales growth of 6% for the quarter, which -- of which 5% was organic.

Every segment reported increased sales.

Industrial, plus 6%; Infrastructure, plus 6%; and WIDIA, plus 10%.

In addition, every region posted positive growth.

It's clear that the market confidence is building.

I would like to talk a little bit more in-depth on that when I get into the next slide, but first, let me summarize the results on a total corporate basis.

The work that we are doing on growth, simplification and cost reduction is starting to show in our results.

Both our cost of sales on our operating expenses as a percent of sales were down in this quarter versus prior year.

Our adjusted operating margin improved 500 basis points to 12.8% this quarter when compared to prior year.

This reflects a 360 basis point increase in adjusted gross profit and a 120-point decrease in adjusted operating expense as a percentage of sales.

Our EBITDA margin increased 380 basis points over Q3 fiscal year '16 from 13.5% to 17.3%.

The reported GAAP EPS more than doubled in the quarter to $0.48 per share versus $0.20 in the prior year quarter.

Included in this quarter is $10 million of pretax restructuring charges, mostly related to the ongoing headcount reductions announced in mid-calendar year 2016.

Therefore, on an adjusted basis, earnings per share for the quarter increased to $0.60 per share versus $0.37 last year.

Let's turn to Slide 3 to look at organic sales growth.

In the third quarter of fiscal year '17, quarterly organic sales growth has continued to be positive.

It is the positive trend that actually started last quarter.

Overall, the organic sales growth increased to 5% versus 2% last quarter.

We have now posted 2 consecutive quarters of growth after 8 negative quarters of organic growth.

Although it might be early to call it a recovery, it certainly is a good start.

Monthly organic sales growth is posted on this graph, as well.

The trend throughout the quarter was positive after a slow start in January.

We're encouraged by the tone of the end markets, in addition to our progress on sales execution initiatives.

One additional point before I get into the segment review, with regard to our headcount reduction program, we are now targeting $90 million by the end of fiscal year '17.

And as I discussed in our last quarter's earnings call, the target of $100 million was to be reviewed in light of conditions in the end markets as they presented themselves.

With end markets now recovering, and in some cases quite quickly, in order to ensure that we continue to balance our cost-reduction and productivity goals with customer service and the ability to meet increasing demand, we believe the proper target is now $90 million.

As noted on the last call, we have already identified the actions associated with this level of reduction, although we're still making some modifications.

This reduction enforces a major accomplishment for Kennametal and is an important part of our strategy to achieve the overall margins we believe that are possible and necessary for us to compete.

Now turning to Slide 4 in the Industrial segment overview.

As in previous quarter call slides, we have included the revenue splits of the business by geography and end markets for the quarter at the top of the slides for your quick reference.

There's nothing unusual to know here.

As I mentioned in my opening comments, Industrial posted a quarterly year-over-year organic sales growth of 6% -- I'm sorry, total sales growth of 6%, of which 5% was organic.

This is the third consecutive quarter of organic growth for Industrial.

All regions showed revenue gains, with Asia leading at plus 17%, followed by Europe and then the Americas.

Adjusted operating margin increased by 390 basis points versus prior year to 15.1% in the quarter.

We saw strength in all of our end markets with the highest gains in energy at plus 18%, followed by General Engineering, Aerospace and Transportation.

Consistent with last quarter, we believe stock levels within our indirect channel seem consistent with end market demands.

The margins are beginning to show the impact of our productivity improvements and cost-reduction programs.

We are making significant progress in all 3 areas of focus: growth, simplification and cost reduction.

I will discuss each of these areas in order to -- in order but it is important to note that they can, and in many cases, do overlap.

In terms of growth and sales execution initiatives, Chuck Byrnes and his team have worked hard on improving our partnerships with distributors.

This is a critical and important initiative.

And we are dedicated to continuing to work together with our partners to improve our customer service levels.

Since we started this initiative last summer, we have transitioned approximately 2,600 customers that are best served through the indirect channel with no margin erosion.

Our multi-tiered customer segmentation work is also progressing, allowing us to spend more sales resource time on bigger customer targets.

In conjunction with this increase in sales resources, we have also focused on improving the use of our CRM tool.

This is for sales planning, not just management reporting.

And we are about an 80% adoption rate right now, a significant improvement over last quarter.

With regard to the second set of initiatives, namely simplifying the company, we are continuing to work on progress on product life cycle management and making good progress here.

This is a very important initiative since without good product discipline, manufacturing cannot be efficient.

To date, we have reduced our SKUs by approximately 15% and we are well on our way to achieving the goal we set for ourselves at our Analyst Day.

However, we are continuing our work on optimizing the number of SKUs and expect that this will be a consistent and continuing process.

In other areas of simplification, we've reduced the number of coatings on our products by over 40% and the number of powder formulations now by close to 60%.

Both of these are great numbers, and we feel good about the improvements we have been able to achieve.

Again, these feed into manufacturing efficiency and productivity, and therefore, improve cost control.

In keeping with this focus on margin improvement, we've implemented minimum manufacturing and order quantities and are at about the 80% level of our target implementation.

These are the types of changes that are driving margin improvements, both this quarter, and in quarters to come.

On the cost-reduction side, the headcount reduction initiatives are underway, and modernization and end-to-end initiatives are progressing.

Of course, the main benefits of these programs will be felt over the next 2 to 3 years.

For Industrial, the key to success lies in both our growth and margin improvement initiatives.

There is a lot of work to do and more opportunity.

Turning to Slide 5, WIDIA.

WIDIA posted a 10% quarterly sales improvement, with year-over-year quarterly organic growth at 9%.

Again, all regions reported positive numbers, with Asia leading at plus 14%; in this case, followed by the Americas at plus 11%; and EMEA at plus 3%.

We are quite pleased to note that WIDIA reported positive operating profit for the first time since being segmented as a separate business unit in the first quarter of this fiscal.

As we discussed at our Analyst Day in November last year, the decision to separate WIDIA on its own as a separate reporting segment was to allow better focus on the WIDIA brand.

To that end, we have implemented targeted regional strategies for WIDIA.

In America, the rebirth of the WIDIA-Hanita and WIDIA-GTD brands and the establishment of our channel partner programs are helping to grow sales.

In Asia-Pac, we are implementing new indirect channel partners.

In this quarter, we have successfully implemented a new national distributor in China.

In India, we were able to grow sales despite a flat market and are increasing our manufacturing capacity in output at our Bangalore facility, for both the Indian and global marketplace.

Finally, in EMEA, Europe, Middle East and Africa, we've been able to replace our German national distribution partner which we reported last quarter that had gone into bankruptcy, and we are seeing good growth also in Eastern European markets.

So all in all, we are encouraged with WIDIA's progress and are excited to continue focusing on, as Alexander Broetz often says, making the diamond shine again.

On Slide 6, we update our Infrastructure business.

As noted, this splits by geography in end markets for the third quarter are anticipated at the top of the slide.

Infrastructure reported quarterly sales growth over prior year of plus 6%, of which 4% was organic.

This is the first quarterly organic sales growth in over 2.5 years and the strongest organic growth in over 5 years.

Again, all regions posted positive sales growth with Asia leading, followed by the Americas, while Europe remained flat.

With regard to end markets, oil and gas activity is showing definite improvement.

With the average U.S. land rig count in the quarter up close to 40% versus prior year.

This improvement is starting to show in the numbers, with energy being the leading end market for infrastructure this quarter.

Mining is also showing some encouraging signs of improvement.

Adjusted operating margin increased 710 basis points to 12.3% this quarter versus 5.2% in the prior year quarter.

This is an excellent improvement in the results, and like last quarter, reflects the work Pete Dragich and the team are doing on a number of fronts.

Before I talk about the various sales and cost-reduction programs, I wanted to note the reorganization that Pete initiated when he took over as leader of Infrastructure, whereby he reorganized the team into 5 P&L-focused business lines.

This move has allowed the team to increase its focus on executing our plans and is the basis for the results that I'm reviewing.

First, we see lower raw material unit cost coming through not only from the work we are doing to strategically source materials, but also through improved product design as well as optimized material science usage.

We have now completed the 3 plant closures announced earlier this year and the cost savings are flowing through the P&L.

The headcount reductions in infrastructure are well underway, and we are seeing these cost reductions accelerating in the numbers this quarter.

Finally, we had a number of product launches, and we are seeing good volumes in both oil and gas frac seats, for fracking obviously as well as our new NS300 drum in road milling.

In summary, Infrastructure is making great progress.

We are obviously pleased with that the end markets are showing some improvement, but we are especially delighted with the productivity increase and improvements in cost structure.

Those are the improvements that will serve us well in the long run and the investments we're making in modernization will keep us on track to continue to improve our results.

Now I'd like to turn it over to Jan Kees van Gaalen, who will begin on Slide 7 with the details on our financial report.

Jan Kees?

Thanks, Ron.

Hello, everybody.

To highlight some of Ron's previous comments, though there is still much work to be done, our efforts to both drive growth and right size our cost structure continue to manifest in our quarterly results.

I will begin by reviewing the income statement starting with the quarterly results on Slide 7.

Sales in the March quarter were $529 million compared with $498 million in the same quarter last year, an increase of 6%.

5% of that increase is due to organic growth.

This is the strongest consolidated organic growth we had experienced since 2014.

More business days this year, due in part of the timing of the Easter holiday, also favorably impacted sales by 2%, but this was offset by 1% unfavorable currency exchange impact.

Sequentially, sales increased by $41 million or 8% from the second quarter fiscal 2017 sales of $488 million.

All end markets posted sequential sales increases, led by energy with 19% sequential quarterly growth followed by Transportation and then General Engineering, and to a lesser extent, Earthworks and Aerospace & Defense.

From a regional perspective, sales in dollar terms increased in all regions, led by the Americas, then Europe and then Asia.

Our adjusted gross profit margin improved in the current period to 35.5% versus 31.9% in the prior year due to organic sales growth, incremental restructuring benefits, higher fixed cost absorption along with improved productivity and favorable impact from business mix.

This was partially offset by negative impacts of foreign exchange and higher raw material costs.

Adjusted operating expense stayed flat at $116 million compared to prior period.

However, adjusted operating expense, as a percentage of sales, decreased 120 basis points when compared to the prior year and decreased 60 basis points when compared sequentially to the previous quarter.

Beyond reducing our cost structure, we are engaged in a delicate balance between constraining our operating expenses, while also ensuring that we serve our customers appropriately in the light of increasing demand.

Our adjusted operating margins increased significantly year-over-year to 12.8% in the current quarter, up from 7.8% in the prior year quarter.

For the third quarter of fiscal 2017, adjusted EBITDA was $91 million, up 36% versus $67 million in the prior year period.

I will review the details of cash flow later on in the call.

Adjusted EPS improved year-over-year to $0.60 per share in Q3 2017 fiscal from $0.37 in the third quarter fiscal 2016.

In order to gain a better understanding of the factors affecting adjusted EPS this quarter, please turn to Slide 8 for the EPS bridge.

In summary, the increase in adjusted EPS year-over-year reflects incremental restructuring benefits, organic sales growth, higher fixed cost absorption and productivity, and to a lesser extent, favorable mix; partially offset by higher performance-based compensation, a higher tax rate, unfavorable currency exchange of $0.02 per share and higher raw material costs.

The increase in the adjusted effective tax rate was driven primarily by the favorable impact in the prior year quarter related to a U.S. provision to return adjustment that did not repeat in the current year, partially offset by earnings in the U.S. that cannot be tax affected in the current year.

Turning now to the segment information on Slide 9. The Industrial segment reports positive news on all fronts this quarter, with solid operating -- overall operating performance compared to last year.

In percentage terms, sales grew year-over-year in all regions led by Asia, then Europe and the Americas.

Worldwide industrial sales were $289 million in third quarter, an increase of 6% from the prior year quarter sales of $274 million.

Organic growth was 5%, the highest quarterly level since September of calendar year 2014.

Industrial also benefited from more business days this year, translating to a 3% increase in sales.

However, these positives were partially offset by the unfavorable currency exchange effect of 2%.

Sequentially, Industrial segment sales increased $22 million or 8% from the second quarter fiscal 2017 sales of $267 million, with increases in all end markets.

On a year-over-year basis, for the Industrial segment, sales grew in all end markets led by Energy, then General Engineering, Aerospace & Defense and Transportation.

General Engineering sales benefited from growth in the indirect channel, due in part to the strengthening of oil and gas in the U.S. and growth in the Chinese automotive market.

Oil and gas in the Americas, likewise, contributed to overall growth in Energy, coupled with increases in power generation globally.

The Transportation market experienced growth in Asia with tiered suppliers and truck OEMs, offset by lower sales in the Americas.

Conditions continue to be favorable in the Aerospace sector, with engine growth being supplemented by increasing demand related to frames.

The WIDIA segment has continued on its path this year to outperform both the preceding quarter in this fiscal year, and the same quarter of the prior fiscal year.

Sales were $46 million in the third quarter, a 10% increase from $42 million in the prior year quarter.

This was driven by 9% organic growth, coupled with a favorable business day impact of 1%.

Growth is reported in all geographic regions, with Asia leading the pack at 14%, followed by 11% in the Americas and 3% in Europe.

Sequentially, WIDIA segment sales increased $3 million or 7% from the second quarter fiscal 2017 sales of $43 million.

Sales increased sequentially in the Americas and Europe, while sequential sales decreased slightly in Asia.

The Infrastructure segment, which has more exposure than our other segments due to cyclical oil and gas and coal markets, reported improving performance as well.

Third quarter sales of $193 million reflect an increase of 6% from $181 million in the prior year period, driven by organic growth of 4% and a favorable business day impact of 2%.

As Ron mentioned, this is the strongest organic growth improvement we've seen in 5 years.

From an end market perspective, energy increased 22%, while Earthworks and General Engineering increased 3% and 1%, respectively.

Sequentially, Infrastructure segment sales increased $16 million or 9% from the second quarter fiscal 2017 sales of $177 million.

With the exception of construction, sequential increases were reported in all markets, led by oil and gas and then industrial applications, processing and mining.

Now I will provide an update on our restructuring programs.

Details can be found on Slide 10 and 11.

As Ron mentioned and reported on the last earnings call, we have identified actions expected to translate to approximately $90 million in annualized savings.

With the increase in end market demand and in order to ensure we can maintain our high level of customer service, we are reducing the total program targets to this level.

Annualized savings in the third quarter were approximately $54 million.

We have incurred inception-to-date charges on this project of $42 million.

Our current expectations include at least an additional $18 million of future charges associated with the headcount reduction program.

However, as we have discussed on prior calls, please note that it is possible that there will be additional charges beyond this amount, as we move forward with the headcount cost reduction.

Our expectation for total program charges are now $60 million to $70 million, reduced from the initial estimate of $80 million to $95 million.

With regards to the other restructuring programs, benefits in the quarter amounted to $17 million, and we expect to achieve savings of approximately $63 million in the fiscal year 2017 with these programs.

At completion, we expect these programs to yield annualized savings of approximately $75 million to $90 million.

Inception-to-date charges of $83 million have been incurred, and we still expect total charges to be in the range of $105 million to $125 million.

The balance sheet is shown on Slide 12.

Our balance sheet reflects important strengths of conservatism for Kennametal.

Cash on hand at March 31 is $101 million as compared to $162 million last June.

Our current ratio was 2.4x on March 31, 2017, compared to 2.5x as at June 30, 2016.

As shown on Slide 13, primary working capital was $676 million as at March 31, 2017, an increase of $28 million from $648 million as at June 30, 2016.

Currency exchange decreased primary working capital by $11 million during this period.

On a percentage of sales basis, primary working capital decreased 200 basis points from 34.3% as at June 30, 2016, to 32.3% as at March 31, 2017.

The negative impacts of increases in inventories of $31 million and accounts receivable of $6 million were partially offset by an increase in accounts payable of $9 million.

As shown on Slide 14, third quarter free operating cash flow was $10 million, an improvement compared to Q2 fiscal year 2017.

Year-to-date, free operating cash flow is negative $10 million.

Consistent with our expected earnings and historical pattern, we anticipate the sequential quarterly improvement in free operating cash flow to continue into the last quarter of this fiscal year.

The year-to-date free operating cash flow of negative $10 million compares to positive $67 million in the prior year.

The decrease in free operating cash flow was primarily attributable to an increase in primary working capital and higher restructuring payments and capital expenditures, partially offset by higher cash earnings and lower tax and pension payments.

With regards to capital spending, net capital expenditures were $90 million year-to-date compared to $78 million for the prior year period.

Dividends paid out were $48 million, consistent with last year.

Our conservative capital structure and dividends are of key importance to Kennametal, and we continue our commitment to maintaining them.

Our debt and liquidity positions are shown on Slide 15.

At the end of March, our net debt was $595 million.

With no current outstanding borrowings on our revolver, we have no significant maturities until 2019.

Gross debt to adjusted EBITDA currently stands at 2.5x.

Now turning to Slide 16.

We are updating our outlook for the full fiscal year based on actual reported performance through March and our expectations for the rest of the year.

Our EPS outlook is now $1.50 to $1.60 per share on an adjusted basis compared to the previous outlook of $1.20 to $1.50 per share.

We expect increasing demand in our end markets to drive sales to be near the higher end of our previous outlook for fiscal 2017.

We are also expecting our tax rate to be slightly lower than initially expected due to changes in the jurisdictional mix of revenues.

Capital expenditures are still expected to be in the range of $125 million to $135 million.

However, higher working capital will be required to meet higher demand.

This is the primary reason why we are updating our free operating cash flow outlook to $60 million to $80 million, compared to the previous outlook we reviewed in February.

And with that, I will turn it back over to Ron.

Well, thank you, Jan Kees.

So our third Quarter results on Page 17 to be summarized showed progress on all fronts.

We're simplifying the organization for accountability as well as manufacturing efficiency and reduced bureaucracy.

We're improving our commercial execution in a number of ways.

We're no longer sitting back on our heels, but are actively making decisions that are enabling us to compete in the marketplace.

Finally, we really are laser-focused on getting cost out.

We made some really good progress on headcount reductions and have a good start on the modernization and end-to-end initiatives that will take us to the next level in the next several years.

Market forces are more positive today than a year ago in fact, frankly, than we thought just 6 months ago.

As I discussed with regard to the headcount initiative, for example, this is obviously a very welcome and positive development, but it adds some complexity to our decision-making regarding core and noncore processes.

Not really a bad problem to have.

We have the team in place to address these issues and are leaning into them aggressively.

We're building the foundation today, for sustainable improved performance over the next couple of years.

Now I'd like to open it up to your questions.

(Operator Instructions) Our first question comes from Ann Duignan of JPMorgan.

Could you just give us an idea of what you expect headcount charges to be in Q4?

You break out the other programs quite nicely so it's easy to back to the Q4 charges, but what are you anticipating on the headcount program?

Okay.

We'll try to gather that, and I -- for Q4, do you guys have that number?

Wait a second.

About $11 million.

Okay.

About $11 million.

Okay.

That's helpful.

And then Ron, on WIDIA and Industrial, can you just give us some color on when we might anticipate moving from kind of new distributor signups to kind of a same-store sales comparable, if you know what I mean?

Are we still in a process where we are signing up new distributors, particularly in WIDIA, and then when should we anticipate that we'd move to more stable -- like, kind of a same-store sales metric?

Yes, I think one of your concerns behind that question is, are we putting in a lot of pipeline inventory.

And I want to say at the beginning that we're really not.

When we sign up new distributors, there is obviously a little bit of inventory that goes in, but our real objective is to sell to retail demand.

But I don't think there will be a same-store sales calculation that will be easily made.

But I think WIDIA, I'll let Alexander comment and then Chuck, you can comment on Industrial.

Thanks, Ron.

Thanks, Ann, for the question.

We are still having some white spaces globally.

So those are areas where WIDIA has not been necessarily been present over the years.

So we will continue to sign up partners that we do want to grow in markets we have not been dealing in.

On the other hand, we are also not pushing significant amount of inventory in those distribution channels as we know that this is not sustainable.

We are helping them to start the initial -- servicing the initial demand, but we are not building massive inventories in those distribution partners.

And this is not a major initiative for the Industrial business.

In fact, we've got a net increase of 9 distributor partners in the Americas, 4 in EMEA and 3 in Asia.

It's not a large increase for us, overall.

So the real initiative in Industrial is moving many of the smaller customers that we would classify that should have been purchasing through distributors in the beginning, to have them buy through distributors.

Correct.

Okay.

And then just quick on the restructuring program.

Ron, is there any risk now, I mean, I know you noted that things are picking up faster than you anticipated, that organization and redesign is a complex.

Is there a risk that we cut too deep?

Or is there a risk that you will need to add back people sooner than you expected?

I mean, it's a nice problem to have, but I would imagine it's quite complex?

It is complicated, and that's why we weren't able to achieve the $100 million, because a lot of those cuts were predicated on flat overall revenue.

And if we reflect back on the market conditions that we thought existed 6 months ago, we were looking optimistic with our flat year-over-year revenue performance.

So now if we've got a plus 1% to 3% revenue performance expectation, that means a lot of little pieces are being made around some of our factories.

And so what we wanted to do is, we want to hold the direct headcount and work on productivity improvements in those factories and probably add a little bit of direct headcount where appropriate, though we still want to be aggressive on indirect headcount, staffing and all the associated cost that we believe have caused the company to be at bit bureaucratic and a bit bloated in some of its cost structure.

So I look at it and say, at the beginning, we set out a pretty aggressive target of $100 million.

That was pulled from the air, forced into the organization and now we are 9 months into it, and I feel really proud of being able to speak confidently of $90 million in a market that's now growing versus a business that was shrinking.

The next question comes from Sam Eisner of Goldman Sachs.

So just looking at the guide here, just a quick question.

Obviously, you're guiding to the high-end of the prior range.

I think that implies from a revenue standpoint about 4% organic, seems like a little bit of a decel.

So just curious, is that just being conservative?

Do you -- are you expecting a deceleration into the month?

And maybe you can talk a little bit about what the trends are that you are seeing in April?

Okay.

Well, Sam, I don't think we are guiding into the higher end of the old range.

We actually -- the old range is the bottom of our new guide, $150 million to $160 million.

And previously, we were $120 million to $150 million.

So it does actually reflect an increase.

But the net-net is a Q4 that's a little bit more conservative, perhaps.

And looking at it then, we hope will happen.

But we know hope is not always a productive thing to rely upon.

I think Chuck would say, in his business, it's 2.5 fewer business days.

And 2.5 fewer business days might not seem like a lot, but if you take the size of a company we are, divide by 230 days in a year, working days, it's over $20 million.

So that's an issue.

And if you look back in history, very few fourth quarters have actually been smaller than third quarters, but probably that's happened when there were fewer sales days.

But simultaneously, remember, end markets have turned around pretty fast.

They can soften up a little bit or at least pause a little bit.

And I'm not going to comment on April because April isn't even over yet, and -- but rather than to say that we are on the expectations that we've set for ourselves.

So I feel quite good about the fourth quarter, but I think I'm really beginning to lean into 2018 and just see how high, high can be in '18.

And that's what we are kind of concentrating on now.

That's helpful there.

And then, thinking about your Earthworks exposure plus 3 within the Infrastructure segment this quarter, it feels like data points that we are seeing across the mining sector are certainly better than 3%.

So curious if you can give a little bit more color on what you guys are seeing there, based on either what your customers are saying or what you are seeing is end market demand?

Yes, I'm going to turn that question over to Pete.

Thanks, Ron.

Thanks for the question, Sam.

You're right.

The end markets are doing better than the 3%.

The 3% represents our increase in overall Earthworks, globally.

Within that, obviously, is our mining portion of that.

And within the quarter year-over-year, it was actually up 15%.

Within that overall number, though, we've had mixed results in construction.

In last quarter update, I provided some feedback as far as what was happening in construction, particularly in the Middle East where we've seen significant year-over-year decline, primarily due to funding being put towards other areas instead of construction, also some challenges we've had in Japan.

Both of those cases, we expect that to return in the future.

So net-net, construction should be a good driver for our Earthworks business.

and we've got exposure to mining, a little bit less clear on what will remain for Appalachian coal for us, but we'll see.

That's helpful.

Maybe if I can just sneak one more in.

On the headcount reductions, I think you guys are -- or total cost savings, you're throwing out restructuring and program savings.

I believe the implied fourth quarter savings are around $18 million.

I'm curious if you can throw out a headcount savings number for that fourth quarter, given that you did about $13 million this quarter.

I recognize that you're targeting $90 million for the full year, but curious if you have a kind of point estimate that you guys are expecting for the fourth quarter for the headcount reductions?

Sam, I don't want to be that specific yet because there's a few things that are still up in the air, relative to exactly how we'll end the fiscal year.

But you're in a right ballpark.

The next question comes from Julian Mitchell of Crédit Suisse.

This is Ronnie Weiss on for Julian.

I just wanted to touch into Asia a bit.

Growth of double-digits cost all 3 segments.

On a macro level, what are you guys seeing there?

Was it one -- more of a one-off that you could -- saw this kind of strength?

Is this sustainable into the next quarter and the next few quarters?

Just any color there.

Okay.

I'm quite positive about Asia.

I think Asia is coming back.

I think it's encouraging for all industrial companies to see Asia and China, in particular, begin to come back.

It starts with the commodities and fundamental economic growth that we are seeing.

And I think we will see it across other regions of Asia, overall.

India is a little bit of a flat performer at this point in time, but I'm just -- I'm confident India will come back also.

So I think it's a good sign, because I'm old enough to have seen these things before.

And usually what happens is, with Asia improvement, it does bleed into other developing market improvements.

And if you look back at the period of 2002 to 2008, one of the things that really rocketed the industrial landscape was the fact that all developing markets have performed well.

Got it.

And then just one more from me.

On Slide 8, the EPS bridge of that first bar of $0.18, there's a lot of moving pieces in there.

So wondering if you could give a little more detail?

What the contribution was from volume price, raw mats mix, et cetera?

In that order of priority, both Jan Kees or Pat, do you want to take that?

In terms of sales volume, that was really the largest portion.

Then afterwards, at the gross profit line, we had, in order absorption, some productivity.

We have, obviously, some headcount savings.

We had restructuring in there, and this is again at gross profit level.

We had some mix and then we had a bit of price.

Negative price.

Negative price, yes.

The next question comes from Steve Volkmann of Jefferies.

I'll just start with a quick follow-up there.

Sorry, I'm drinking from a fire hose this morning, but I'm pretty sure price cost was negative, is what you're saying.

Do you expect that to continue?

I guess, you could take -- maybe get a little of that back over time?

Just how do we think about that?

I don't expect it to continue.

I think we'll get a little bit of that back over time, at least enough to offset raw material cost increases.

And -- but a lot of the price mix that was negative was in our Infrastructure business, which has contracts that were tied to the raw materials.

So most of our price deterioration was there.

It was not in the Industrial side.

Although we had a little bit of deterioration in Industrial, but the amount of volume more than offset that.

And Ron, one thing I hear from people is you expressed maybe a willingness, shall we say, to be more flexible on price than perhaps Kennametal was in the past.

And the concern is that, that erodes pricing broadly.

Can you just address that?

Yes, I think that's somebody's fear that assumes that we will be mavericks and just aggressively go out and take price down.

That, of course, is not the case.

But we are tired of being the company that people beat in the marketplace.

We've got great products.

We have a great brand.

We have a great sales organization.

And we're not going to give up for a couple of percentage points on products that have 40%, 50% margins.

So we're going to compete.

That does not mean that we're going to start a price war.

Okay.

Fair enough.

And then you mentioned you are starting to lean into 2018.

So if you don't mind, maybe I'll go there a little bit.

On Slide 11, you guys provided some estimates in terms of cost savings.

I want to ask you to forecast the market in '18, but as I read that, are the FY '18 and beyond estimates for savings are those -- should I read that as cumulative?

Or are those the amount of savings we'll actually expect in '18 and beyond?

And then if you could just maybe broadly give us a sense of how much of that might come in '18?

Those are really run rate savings.

Sorry, I think I missed that.

We're talking run rate savings here.

Run rate, okay.

So how much of that might we think -- would half of the 40 to 47 for Industrial, for example, would half of that come in 2018 or...

It will be probably be a little bit more than half of that, for sure, because we're further along.

But we're not really at a place where we can say precisely what percentage of that was going to fall in.

Because what we're going to make sure we are clear on is, what is the incremental piece in '18 versus what we've achieved in '17.

So what you see presented on Page 11 is the run rate for fiscal year '18 and beyond that estimate.

But what we haven't done is take out what is in a year-over-year comparison built into the base period.

And we're not going to do that here yet, Steve.

The next question comes from Joel Tiss of BMO.

I wondered is there any sense that you guys are winning back previously lost customers and gaining share.

Or is the volume growth that we're seeing just more a reflection of what's happening in the marketplace?

Yes, I'm going to let Chuck and maybe Alexander or Pete add on to that, because they are the guys on the firing line.

So Chuck?

Yes, Joel, the Industrial business had its third straight quarter of organic growth.

And although some of that did come from some stronger markets, most of that came from growing share at our key customers.

I've seen significant increases across Aero, our distribution channel and even our Transportation market globally has grown.

I'm particularly proud of the work that we've done among some of our big distribution and value-added resale partners.

We've taken a company that treated value-added resellers or distribution partners as a necessary evil.

And we took that and turned it 180 degrees and said, this is a tremendous opportunity for us.

And it's being reflected in the relationships.

So Alexander?

Yes, I want to stick for India.

India had a very difficult market environment.

And we have been consistently growing there.

So I would consider that as market share gain.

The growth of 11% India-Americas is also more than the industrial market has been growing.

So that would lead us to believe also that we are gaining market share.

In the EMEA, we are holding on to our own business and are slowly developing growth, but that's probably more within the growth of the market.

But in the Americas and in India, we're definitely growing in market share.

Yes, very similar situation for Infrastructure.

In particular oil and gas, obviously, we are benefiting from the volume increases there.

But during the downturn, we spent a lot of time working with those customers to expand what we sell to them.

And so that's allowed us to have, I think, disproportionate growth, as upturns in oil and gas.

In addition to that, I would say, as far as new customers and market share where we introduced new products, we tracked very closely the prior products and the number of customers that we've had.

And we had seen significant increase in number of customers we sell to for those new product introductions.

And the bottom line is, in each of these 3 businesses, the teams have big opportunities on the payable that they're working to bring home.

So this is not the Kennametal of your grandfather, okay.

This is a different Kennametal.

So...

I'm turning into a grandfather myself.

And just -- this is probably a little bit unfair, but I'm just going to ask it anyway.

Given how quickly we've seen the profitability snap back and knowing how much work is in front of you and kind of how early stages we are in this recovery, is it fair to think that the operating margins, say, on like a 5-year basis with a little bit of economic help could be in the low- to mid-20s?

Well, let's put it this way.

I don't think anybody here at Kennametal is interested in being second.

We looked at our big competitor in the Nordic region and saw their operating margin in the metalworking business, and we are still substantially below them.

There's no reason this company can't get the margins at that level.

There is no reason.

Whether on modernization initiatives, with the changes being made, absolutely, that -- we should not have any other goal, but to try and grow and to drive operating margins into the low 20s.

We need a good market for that.

That's not going to happen with a weak market, but a good market, absolutely.

The next question comes from Adam Uhlman of Cleveland Research.

I was hoping we can start with the working capital build that we were talking about earlier.

Again, it's a good problem to have that the market's coming back.

Could you talk about where the service levels are coming in now?

Where are the pinch points in certain businesses or regions?

And then any concerns that there might be share loss from service levels or availability being lower than expected or tighter?

Okay.

First of all, it is a delicate balance.

As Jan Kees and I have mentioned on our opening remarks.

Our service levels are solid.

They are good, but we like to see them better.

In a few instances, they are below our expectations, and we have a few factories that are underperforming on their service levels, for sure.

But I think with some targeted adjustments, I'm pretty confident we can address those.

I don't think we've had any meaningful share loss as a result of our service level issues.

We do periodically get a few complaints about service levels, but this certainly isn't new to Kennametal nor is it new to the category.

Obviously, the difference between 92% service level and 95% service level might be a lot of inventory.

And so you have to balance that.

We don't know quite what that real mix is going to be for us, because if you remember, we're taking 15% to 20% of our SKUs out.

So if you take 15% to 20% of your SKUs out, you're going to take some inventory that was either excess or obsolete or at a point in time where it was no longer effective inventory.

And so we're trying to find that right balance.

So net-net, I think we've got too much working capital in some of our inventory right now, but it's mostly powder related.

So I think we can get that down.

I think we should feel good about our percentage working capital number that Jan Kees mentioned at 32%.

That's a pretty good number for the company.

But I think our service levels are a little bit under pressure, but we're addressing that.

And that's one of the reasons why we wanted to moderate a little bit some of the headcount initiatives.

Okay.

Got you.

And then, secondly, it sounds like you've made some progress in the planning on modernization.

I'm wondering how much we should expect CapEx to grow next year, as you start to roll into that plan?

Yes.

I would say CapEx will grow a little bit next year, but it won't be massive increase in CapEx.

I think the thing that we're not going to do is, we're not going to spend CapEx on nice-to-do things and things likely we've done historically.

We have some of the best computer systems that are never been used.

So we are going to spend CapEx on things that are going to drive short-term profitability.

And we -- I don't think we are ready to give a specific CapEx forecast for next year yet though.

But I think the mantra really is to spend CapEx where we can reduce our cost structure, improve our productivity and efficiency on the manufacturing side.

And that is what we're going to focus the CapEx on.

Okay.

Have you lowered your targets that we discussed at the Analyst Day about how much you thought that you might need to invest to capture the savings from the modernization?

No, no.

We have not.

We have not.

Okay.

So it's probably just pushed out to 2019 a little more?

Yes, it's just a -- and also replacing some other CapEx that we just aren't going to spend on other things.

The next question comes from Steven Fisher of UBS.

Can you calibrate for us the progress on shifting customers, the indirect channel?

I think you said you migrated 2,600 customers so far.

Was the target there around 4,000 to 5,000?

And if that's right, what's the timing of the ramp up from the 2,600 you mentioned to get to that 4,000 to 5,000?

I think it was going from, like, 19,000 customers to less than 15,000?

Chuck, you want to deal with that?

Sure.

Steven, for the Industrial business moving additional 400 to 500 by the end of this fiscal year.

And I would say the pace or the expectation is as we find customers that are better served through our distribution channel, we'll continue to move them.

That was a directional 4,000 to 5,000.

And we could end up that high, but again, that's dictated by our distributor partners and the end-user determining there is a better value buying through the indirect channel and buying through the direct channel.

Was the 2,600, how does compare to what you thought you could achieve?

I guess, that's probably over about a year?

We kicked this initiative off about 8 or 9 months ago.

And I would say, we are on pace with the rate that I had expected to move.

At Analyst Day, we talked 12 to 24 months with that 4,000 to 5,000.

So we're pretty much right on schedule.

Yes, nobody really knows what the right answer to that is, because the customer gets the vote.

Right.

Sure.

Okay.

And then the press release mentioned some unfavorable mix headwinds in the Industrial segment.

Can you just discuss what drove that unfavorable mix?

This sounds like the overall mix generally was positive.

So what was the unfavorable mix in Industrial?

Okay.

Look, we obviously sell a very large portfolio of SKUs.

And it depends how the customers order, what kind of, how do you say, products they order from the portfolio.

There is some unfavorable mix in the quarter, but it's not so material I would say.

Yes, it's pretty small.

Yes.

The next question comes from Andy Casey of Wells Fargo Securities.

Question on -- couple of questions on the guidance.

If I'm doing the math correctly, maybe I'm not, it looks like it implies kind of mid-to-high 11% operating profit margin at the midpoint for the fourth quarter.

Can you -- if that's right, can you help us understand why you expect the operating margin to decrease sequentially from Q3?

Look, we've discussed the guidance in terms of -- in the context of the fewer working days, specifically on the Industrial side.

And in terms of the planning assumptions, we've targeted the 150 to 160 on the basis of that, how do you say, those business days in Q4.

Okay.

And then, on the -- so there's no kind of one-offs.

It's just top line-driven?

Well, let's put it this way.

I think I'd characterize it as a big conservative, at this stage.

But we are early on in the quarter.

It's the way the numbers played out.

It would seem premature to go past that, in terms of providing guidance.

And you've done an arithmetic calculation.

And what -- and I'm not saying that's wrong, Andy.

We just looked at it from an overall earnings per share, where do we think we're going to be?

And that's how we provided the guidance.

Okay.

Thank you, Ron.

And then, on the operating cash flow to get to that, the new guidance.

You need about -- I think it's around $70 million in the fourth quarter.

Is there any working capital drawdown anticipated in that?

I'm just wondering what the change is because the net income is kind of consistent?

Yes.

There will be a working capital drawdown that happens.

We have probably more powder inventory than we should ending the third quarter and that will be a meaningful number, and then coupled with some other things that's what's implied in the guidance.

I think we have developed with the segments targeted plans to work on the inventory numbers.

And we work also in terms of the payable side, whilst obviously maintaining the DSO or lowering it somewhat on the receivable side.

So there's a lot of detailed plans that have been developed by the teams to hit those targets.

Okay.

And then one last one if I could sneak it in.

Some companies that would generally have similar revenue profiles to Kennametal have kind of talked about demand getting better through the quarter, and you've illustrated that on Slide 3 with the organic growth trends.

I'm wondering if the orders actually kind of have shown a higher growth rate than what you've shown in the organic.

Is there any way you can comment on that?

Well, yes.

I mean, backlog has historically not been a critical thing for us to report.

But we probably have a little bit more backlog today than we have had historically.

Some of that might be pass-through deliveries and some of it might be real backlog.

Definitely, orders have been stronger than shipments.

And -- but if you were to look at where January started, following a quarter that did have organic growth, January was weak.

So -- but February and March were exceptionally strong.

So I think our view is, it's a recovering end-market business.

Yes, we're a shorter cycle company and that's a positive.

So trends are in the right direction and our order book is building, so that's a positive.

But we are a little conservative in our view that end markets could also take a brief pause here, because there's a lot of uncertainty out there regarding policy decisions.

So I think we want to be conscious of that.

The next question comes from Walter Liptak of Seaport Global.

I'll try and keep it brief.

I want to go back to price cost and understand a little bit more about what were your comments on Infrastructure.

And I wonder if you are directing them towards the Energy sector.

They are having trouble getting the pricing up in Energy.

And I wonder if that's just a timing issue?

Or if you've got agreements with customers already on pricing?

Wonder if we can get some more color there?

Pete, you want to answer that?

Yes, we do have agreements with our primary customers in oil and gas as indexed off of both APT and cobalt.

Cobalt, in particular, has risen quite significantly in recent months.

And we are able to recover that through pricing and according to the contracts we have.

Okay.

You guys bought that recycling business, tungsten recycler, a few years ago.

Is that having any benefits?

It is.

And this is primarily for the Infrastructure business.

And as Ron and J.K. went through this, we talked a bit about material savings that we are getting.

There's a variety of things that we're doing to get material cost down.

And starting with sourcing and who are buying from and using leverage there to get lower prices on what we buy.

But probably as important or more so, internally, what we've been able to do through product design is use less material for the products we sell without compromising performance.

But then the material science piece, and really leveraging that investment we made in recycling and using recycled product in the end items we sell, has been a significant benefit to us.

We've got into a multitude of projects that we are working on to even increase that going forward.

All right.

That sounds great.

And then last for Ron.

I wonder what your thoughts are, maybe philosophically, about M&A.

Kennametal is a company that's done a lot on M&A in the past.

Is that something that you think strategically fits for Kennametal, as we think about the next couple of years?

Well, at the appropriate time, I think it's always good to keep that option open.

But I just don't think this is the appropriate time.

I think we've got a lot of work to do in our own house, a lot of opportunities in our own house.

We haven't demonstrated we can do M&A particularly well.

So let's harvest the opportunities in front of us and then take a deep breath and somebody will look around and say, what's the right thing to do?

Probably won't be me.

Probably it'd be whomever follows me, but let's finish our job here.

The next question comes from Steve Barger of KeyBanc Capital Markets.

Two quick ones.

Ron, given the push into the indirect channel and just your comment about more fully appreciating the value-added resales -- resellers, I'm wondering what your view is or how your thinking has changed about Amazon business, as a distributor relationship?

Well, I don't think my view has changed a whole hell of a lot at this stage.

We've got some great distribution partners that know how to sell our products and know how to get them on the spindle.

And I think our focus is to help them be successful.

I think the Amazon channel will develop a small following over time, but it will never be -- well, I shouldn't say never, but right now, it doesn't look to be a huge business opportunity for us.

I don't know, Chuck, if you feel differently?

We've looked at it.

We've not taken any action to pursue that channel.

And it currently isn't being reviewed by the Industrial business.

Understood.

And last one, I know that this is always tough to gauge, but where do you think the channel is in terms of inventory?

Whether its distribution or end users?

Has there been a big restock?

Or is this more actual demand lift?

Steve, for the Industrial business, our sales are right in line with what see moving out of the point-of-sale data.

So we continue to be right in line on the inventory projection relative to our sales.

No increase or decrease.

And I think that's the same across the board for WIDIA and for Pete's business.

Absolutely.

It fits the same here.

In fact, particularly with oil and gas, we're struggling to keep up in some cases.

So it's not restocking.

So you think that -- just a one quick follow-up.

Do you think that channel's relatively lean then?

And if this persists without the pause that you said could happen that you would see more of an inventory build in the channel as well as demand?

You know I think we don't know.

My personal view is no.

Because my personal view is that our customers are smarter.

They have more tools.

And they are not going to want to build their inventory.

They are going to want to turn their inventory.

And's they're going to rely upon us to help them manage their assets better.

So I just think we are in a different world moving forward.

And many of our customers have very sophisticated systems.

This concludes the question-and-answer session.

I would now like to turn the conference back to Ron DeFeo for any closing remarks.

I just want to thank everyone for their interest in Kennametal today.

We appreciate it, and please follow up with the company on any specific questions you might have Kelly, Jan Kees, myself and/or others.

Thank you very much.

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