Kennametal Inc (KMT) 2018 Q3 法說會逐字稿

Good morning.

I would like to welcome everyone to Kennametal's Third Quarter Fiscal 2018 Earnings Conference 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.

Please go ahead, ma'am.

Thank you, Denise.

Welcome, everyone, and thank you for joining us to review Kennametal's third quarter fiscal 2018 results.

We issued our quarterly earnings press release yesterday evening.

And the release, along with the slide deck for today's call, is posted on our website kennametal.com.

This call is being broadcast live on that website and a recording of the call would be available for replay through June 2.

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

Joining me on the call today are Chris Rossi, President and Chief Executive Officer; Jan Kees van Gaalen, Vice President and Chief Financial Officer; Patrick Watson, Vice President of Finance and Corporate Controller; Pete Dragich, President, Industrial Business segment; Ron Port, President, Infrastructure Business segment; and Alexander Broetz, President Video Business segment.

Chris and Jan Kees will review the March quarter's operating and financial performance as well as our updated outlook.

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

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

Today's discussion contain comments that constitute forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995.

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

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

In addition, 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 From 8-K on our website.

And with that, I'll now turn the call over to Chris.

Thank you, Kelly.

Hello, everyone, and thank you for your interest in Kennametal.

On the call today, I'm going to go through a high-level review of our results both at a total consolidated level as well as the segment level.

After which, I'll turn the call over to Jan Kees, who will discuss the financial results in detail.

I'll close with some summary comments and then we'll open the call up for question-and-answer.

I'm really pleased to report that Kennametal had another strong operating quarter with both sales and margins improving again this quarter in line with our long-term goals.

As shown on Slide 2 of the slide deck posted on our website, total sales grew by 15% this quarter.

An 11% organic sales growth of no foreign exchange was responsible for $0.06 of the increase in sales, offset by 2% decrease in business days.

Late last quarter, all our business segments experienced double-digit growth over the prior year period.

With industrial and infrastructure both growing at 15% and Widia at 13%.

Also, like last quarter, all regions grew with Americas leading a 12%, followed by Asia Pacific at 8%, and EMEA at 5% excluding currency.

And finally, again, like last quarter, all end markets grew: aerospace, energy, general engineering, earthworks and transportation, they all reported continuing strong growth.

Margins continue to improve significantly this quarter versus prior year.

Our adjusted operating margin increased 150 basis points to 14.3%, which reflects an approximate 70 basis point increase in adjusted gross profit margin, plus approximately 70 basis point improvements in operating expenses as a percentage of sales.

Sequentially, the margin improved 210 basis points and we expect more margin improvement to comp.

Reported EPS was $0.61 for the quarter and adjusted EPS was $0.70 versus $0.60 in the prior year.

It's important to note that like last quarter, adjusted EPS was affected negatively, in this case by $0.07, due to the change in the US tax law.

Jan Kees will provide a detailed description of the tax effect in his section as well as an update on the toll tax estimate.

The quarter's results were affected by $0.05 of additional variable compensation, similar to last quarter due to higher than anticipated operating performance this year.

Also note that included in the reported and adjusted figures this quarter is $0.02 due to executive severance.

Jan Kees will go through the EPS bridge in some detail later on the call.

Our year-over-year quarterly organic growth of 11% is graphed on Slide 3. Organic growth remained in double-digit levels this quarter, even with the stronger comps this quarter versus prior year, and the Easter holiday falling in the last week of March this year versus the middle of April last year.

This is the sixth consecutive quarter of positive year-over-year growth, and we expect to see good market demand going forward.

Also it's important to note, that we have relatively high utilization levels in some of our facilities currently due to strong market conditions.

This affords us the ability to be more selective taking on certain sales, allowing us to liberate capacity to improve fill rates on our high-volume highest profit products.

Before I move on to the review -- the segment results, there are a couple of topics that have received a lot of focus during the quarter that I would like to discuss for a moment.

The first topic is pricing ability and general raw material cost increases.

I think most of you on the call know that the 3 main raw material costs for Kennametal are tungsten, cobalt and steel, in that order, with tungsten, by far, being the most important.

Raw material cost increases continued in the third quarter.

That said, like the first 2 quarters in the fiscal year, we've been able to cover raw material costs increases year today, and we expect that trend to continue through the fiscal year.

The second topic that I want to discuss is the effect of -- or rather, the possible effect of steel tariffs on Kennametal.

Let me remind you, steel is a relatively small portion of the company's raw material costs, and we source on a regional basis.

For those reasons, based on our understanding of the tariffs being discussed at this point, we expect that the proposed tariffs would have a very small effect on the company.

In fact, we estimate that the effect would be in the range of approximately $1 million.

Now let's review the segment operating results in more detail, starting with our industrial segment on Slide 4.

Industrial posted very strong quarterly year-over-year sales growth of 15%, on 10% organic growth with foreign exchange of 8%, offset partially by 3% negative impact of business days.

This is the seventh consecutive quarter of organic growth for industrial.

With regard to regional splits, in constant currency terms, the Americas led at a healthy 12% year-over-year growth rate, followed by EMEA at 7%, and Asia Pacific was flat this quarter versus last year due to unusual time in the sales in the prior year quarter.

We see growth in the region remaining strong.

In terms of end markets, excluding FX, we saw good strength in all of them, with both our largest, general engineering and transportation, continue to report good growth rate at 7% and 4%, respectively.

Aerospace posted another strong quarter as well at 13% year-over-year while energy grew at 4%.

Adjusted operating margin increased year-over-year to 16.2% from 15.1% in the prior quarter, reflecting our continuing progress on simplification and modernization.

Regarding our simplification actions, we continue to pursue our SKU, coatings and powder formulation reductions as well as the minimum order quantity program.

The majority of this work is well under way and is now just an ongoing part of the efficient management of the operations of the company.

Regarding our 3-year modernization plan, as mentioned during our Investor Day presentation, we have begun moving into the execution phase of these programs with the main benefits to be increasingly felt over the next few years.

In summary for industrial, we continue to see major improvements this quarter, despite the fact that we have additional variable compensation and some manufacturing inefficiencies, such as additional overtime in temporary help while we balance our modernization efforts with the current high levels of customer demand.

We continue to focus on the execution of our plans, and we expect more success to comp.

Turning to Slide 5, which summarizes Widia's results.

Widia reported 13% quarterly sales growth on year-over-year organic growth of 9%, with foreign exchange of 5% offset by a negative effect of business days of 1%.

This is the sixth consecutive quarter of growth for Widia.

Excluding FX, all regions again reported positive year-over-year quarterly numbers with Asia Pacific leading at 15%, followed closely by EMEA at 14% and the Americas at 1%.

Adjusted operating margin improved 90 basis points to 3.2% in the quarter versus 2.3% in the prior year, reflecting progress on both growth and cost.

Widia's strategy differs by region.

In Asia Pacific, the opening of new demand streams is starting to gain traction, and we are making good progress in the establishment of a brand channel for the entire Widia portfolio.

India posted really strong growth, and our work on modernizing our facility there is progressing quite well.

In EMEA, like last quarter, we continue to see strong growth due to improved effectiveness of our channel partners in Central Europe as well as the growth we are seeing in Eastern Europe.

In the Americas, we are continuing to work on establishing a strong and effective distribution partner network, the quarter was affected by a large non-repeating order in the prior year, but we expect growth in U.S. to remain strong.

Overall, I can see that we'll be pleased with Widia's growth performance and believe margin improvement will accelerate as we move forward.

On Slide 6, we update our Infrastructure business.

Infrastructure sales grew 15% over the prior year quarter, on year-over-year organic growth of 14%, with 3% due to foreign exchange offset by a negative 2% due to business days.

This is the fifth consecutive quarter of growth for infrastructure.

Excluding FX, Asia Pacific posted strong sales growth at 19%, followed closely by the Americas at 14%.

EMEA's growth declined 5% in the quarter due in part to accelerated sales in the prior year due to the anticipation of labor disruptions in South Africa.

With regard to end markets, all was positive during the quarter.

Excluding currency, general engineering lead its 16% growth for the quarter versus prior year.

Energy was up 14%, affected possibly by oil and gas and related process industries.

The average U.S. land rig count in the quarter was up approximately 30% year-over-year.

With the current level being at approximately 990 rigs.

Completion activity also remained strong.

Earthworks, which includes construction and mining, grew at 4% for the quarter, although construction activity in Americas with affected slightly by unusually cold weather conditions.

Adjusted operating margin increased to 14.6% for the quarter.

This is a significant increase of 230 basis points over the prior year, resulting from continuing execution on our initiatives.

With regard to growth initiatives, we are focused on new product launches as well as expanding the portfolio products sold through the partnership with Caterpillar.

On the cost side, with raw material costs increasing, we are working to lower raw material unit costs to improve product design, optimize material science as well as strategically sourced material.

Also, operational efficiencies from previous actions such as plant closures and headcount reductions continue to show in the numbers.

Overall, I'm very pleased with Infrastructure's progress.

We are ahead of schedule on our multi-year improvement plan.

We continue to make solid progress on our growth, simplification and modernization initiatives, which all translate into improved margins and will help keep infrastructure profitable throughout the entire cycle.

Before I hand it over to Jan Kees, let's turn to Slide 7 and look at some of the work that has been done today on modernization, which contributed $0.03 to EPS during the quarter.

There are 2 examples shown on the slide.

The first one is an example of modernization, which we highlighted at last year's Investor Day: the automation of insert inspection and packaging.

The photo on the top left of the slide shows the historical process, heavily dependent on labor.

The new automated machines are shown at the bottom left of the slide, with increased productivity higher than expected at greater than 80%.

We were able to accelerate the timeline for the new machines such that the initial benefits were felt this quarter.

There will be more benefits to come, of course, in FY '19 as we install the equipment in 6 more plants across the globe.

The photos on the right-hand side of the slide are examples of modernization and an infrastructure plan.

Both before the modernization initiative, our products were ground in 8 standalone grinding operations, each of which were manually fed.

The new process, shown on the bottom right of the slide, reduces the number of process steps through the use of automated feed systems and improved grinding technology, yielding a 50% efficiency improvement.

These are just 2 examples of modernization, but needless to say, we are very excited to see the modernization initiatives starting to take effect, and of course, the majority of the benefits are still to come.

With that now, I'll turn it over to Jan Kees, who will begin on Slide 8 with a detailed financial report.

Thank you, Chris, and good morning, everyone.

Let me walk you through the income statement on Slide 8 on both the reported and adjusted bases.

On a reported basis, EPS for the quarter was $0.61 per share compared to $0.48 per share in the prior year quarter.

Reported EPS for the current and prior year quarters includes restructuring and related charges of $0.01 and $0.12 per share, respectively.

Reported EPS in the current quarter also includes a discrete tax charge of $0.08 per share related to US tax reform.

Also, as Chris noted, the reported and adjusted EPS results include a negative $0.02 effect of executive severance in the industrial segment.

Sales in the March quarter increased 15% to $608 million with organic sales growth posting at 11%.

Currency tail winds favorably affected sales by 6%, partially offset by 2% impact of fewer business days.

As Chris mentioned, sales grew in every end market and every region.

Adjusted gross profit increased 17% to $220 million this quarter over the prior year quarter.

Adjusted gross profit margin Increased by 70 basis year-over-year to 36.2%.

The main drivers for expansion at the gross margin level were organic sales growth, favorable currency exchange benefits, incremental benefits from restructuring initiatives and favorable mix.

This is partially offset by higher raw material costs and decreased manufacturing efficiency due in part to modernization efforts in progress.

Adjusted operating expenses increased $129 million, on increased volume compared to $116 million in the prior year quarter.

$6 million of that $13 million increase is due to unfavorable currency effects.

On a percentage of sales basis, adjusted operating expenses improved by 70 basis points decreasing to 21.3%.

We continue to be pleased with the progress we're making on operating expenses, particularly given the strong end market environment, and we will continue to focus further improvements as we move forward.

The improvements in both gross profit margin and the operating expense margin contributed to adjusted operating income margin increasing year-over-year by 150 basis points to 14.3%.

For the third quarter of fiscal 2018, adjusted EBITDA was $111 million at 21% from the prior year period.

Our reported effective tax rate for the quarter of 31.2% includes a 1 -- an 8.3% effect, or $6 million in dollar terms, charge related to U.S. tax reform.

As discussed last quarter, the Tax Cuts and Jobs Act of 2017 requires a onetime toll tax on unremitted earnings of our foreign subsidiaries.

We recorded an additional $6 million expense in this quarter to adjust the estimated toll tax charge based on a regulatory guidance issued earlier during the quarter.

The amount is provisional, and we expect to finalize this in the calendar year.

The adjusted effective tax rate increased to 23.1% from 15.3% in the prior year quarter.

This was primarily due to U.S. income in the prior year quarter not being taxed effected and the current quarter U.S. income being tax effected now that the valuation allowance is no longer recorded on our U.S. deferred tax assets.

Adjusted EPS improved year-over-year to $0.70 in the third quarter of fiscal 2018 versus $0.60 in the prior year quarter.

A complete bridge of the factors affecting adjusted EPS this quarter versus the prior year quarter is presented in the EPS bridge on Slide 9.

Now let's examine some of these items in a bit of detail.

The effect of volume, price, raw materials, mix, absorption and productivity amounted to $0.13 this quarter versus prior year.

When I look through the operating results and consider the effects of items that don't level well like foreign exchange and pricing on raw material costs, we are satisfied with the underlying operating leverage, which we estimated to be in the range of 40-ish percent.

We are relatively pleased with that line.

It is worth noting, again, that the leverage number can move around each quarter due to segment mix, regional mix, and product mix.

But in general, we expected to be in that range.

With regards to the restructuring benefits of $0.10 in the quarter, this is the positive impact year-over-year of our fiscal 2017 headcount reduction and other restructuring initiatives.

These will continue to provide year-over-year benefits in the fourth quarter as well.

Like the first 2 quarters in fiscal year 2018, currency provided a tailwind this quarter as well, as opposed to the headwinds that we saw in fiscal year 2017.

As Chris mentioned, we're starting to see the benefits from simplification and modernization this quarter amounting to $0.03.

This will increase as we move further into our modernization plans.

As we noted last quarter, the strength of our end markets is providing an additional but welcome challenge for us while we moved to our modernization plan and can manifest itself in a need for additional overtime in temporary help in order to meet customer needs at the level we demand of ourselves.

In this quarter, debt amounted to $0.02, a slight decrease from the $0.03 in the previous quarter.

Our expectation going forward is that this will continue, and we will continue to use over time and temp help as needed until we complete our multi-year modernization plan.

Additional variable compensation this quarter of $0.05, like last quarter, is due to the stronger-than-expected operational performance.

The expectation is that this will continue in Q4 of this year.

Please note that the incentive plan resets each fiscal year.

Salary inflation of $0.05 is related to merit, and is simply a cost of doing business.

I've already explained the tax headwind we are facing this fiscal year.

The expectation for the longer term is that we have an effective tax rate in the low 20s.

All other items amounted to $0.02 this quarter.

The detail of our segment sales by region and end markets can be found on Slide 10.

For the Industrial segment, general engineering sales experienced growth from the indirect channel in the Americas and EMEA.

Transportation sales increased due to growth to tier suppliers and OEMs in EMEA and the Americas.

Conditions continue to be favorable in aerospace due to growth in sales in the Americas related to engines and freights.

Oil and gas sales in the Americas continue to provide growth in energy.

The Industrial segment expanded the adjusted operating margins by 110 basis points to 16.2% year-over-year, reflecting primarily organic sales growth, incremental restructuring benefits and favorable currency exchange impact, partially offset by increasing manufacturing inefficiencies while modernizing, and a higher variable compensation expense due to the better-than-expected operating results.

For Widia, strong sales in Asia Pacific were mainly driven by China and India followed by EMEA growth due to primarily increases in Eastern Europe and Germany.

Demand in the Americas was strong.

However, a large order in the prior year quarter did not repeat this year.

Thus, the sales growth was lower in the Americas relative to other regions.

Widia reported adjusted operating margins up 90 basis points to 3.2% year-over-year, reflecting primarily organic sales growth partially offset by unfavorable mix.

Infrastructure saw strength in all end markets during the quarter.

Favorability in general engineering is driven primarily by overall more robust activity in the general economy, particularly in the Americas.

Additionally, increases in process industries and oil and gas activity in the U.S. yielded strong growth in the energy end market.

Growth in earthworks was primarily driven by mining in Asia Pacific.

Infrastructure's suggested operating margin increased by 230 basis points to 14.6% due primarily to organic sales growth, favorable mix, favorable currency exchange impact and incremental restructuring benefits.

These were partially offset by higher raw material costs, decreased manufacturing efficiency from operating facilities while modernizing, and a higher compensation expense.

As shown on Slide 11, primary working capital was $728 million as of March 2017, an increase of $76 million from the previous fiscal year-end due to the higher activity-driven inventories and receivables, partly offset by increasing payables.

On a percentage of sales basis, primary working capital decreased 100 basis points to 13.4% as of March 31, 2018, from the June 2017 figure.

Slide 12 summarizes the cash flow statement.

Third quarter year-to-date free operating cash flow was $54 million as compared to negative $7 million for the prior year quarter.

The change in free operating cash flow is due primarily to higher cash from operations before changing -- changes in certain other assets and liabilities and lower restructuring payments, offset partially by higher working capital and capital expenditures.

Regarding capital expenditure, net capital expenditures were $127 million year-to-date compared to $90 million for the prior year-to-date period.

Dividends paid out were $49 million, and we remain committed to maintaining our dividends.

Turning to Slide 13 for a discussion of our balance sheet.

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

Cash on hand at March 31, 2018, increased to $222 million as compared $191 million last June.

At the end of March, our net debt was $476 million with no current outstanding borrowings on our revolver.

We have no significant maturities until November 2019.

Gross debts to adjusted EBITDA currently stands at 1.8x.

The full balance sheet can be found in the appendix of the slide deck.

We are confident in our balance sheet and liquidity positions, and we'll continue to work to maintain them as we execute on our modernization initiatives.

And with that, I'll turn it back over to Chris.

Thank you, Jan Kees.

Turning to Slide 14, the outlook for fiscal year 2018.

Our expectations for organic growth sales growth is to be at the top of the previously communicated range of 9% to 11%.

The effective tax rate is expected to fall in the range of 23% to 25%, a slight change from the previous guidance of 22% to 25%.

A rate in the midpoint and narrowing the range for adjusted EPS outlook to $2.55 to $2.65, and we expect to be at the lower end of the capital range of $210 million to $230 million.

Our outlook for free operating cash flow is also increasing the $60 million to $75 million, reflecting our improved operating results.

To summarize on Slide 15, we continue to show good progress on our initiatives in Q3.

Looking forward, we're very much focused on executing our improvement plans to create significant returns for our shareholders, great products and services for our customers and really great place for our team members to work.

Operator, with that, please open the call up for questions.

Your first question will come from an Ann Duignan of JPMorgan.

Just a couple of clarification questions.

First, could you tell us how much of your tungsten are you sourcing externally versus internally?

And then following that up, can you talk about pricing strategies by channels and when in the year might you be able to pass through price increases through maybe distribution versus OEM?

Okay.

Ann, in terms of the first question on tungsten, we do have a combination of internal and external sources.

We believe that the ability to manage that process is actually key to staying competitive in this business, but honestly, we don't want to disclose that type of level of detail, because we think it's competitive information.

But it is important to manage, and we feel like how we're managing that supply chain today actually puts us in good position to manage our cost going forward.

In terms of pricing, we've already had a few price increases that we've talked about in previous calls.

But every segment is focused on making sure that as the material costs change, that we try to stay ahead of that curve or pretty close to it, and then also, frankly, Ann, we realized that demand is very high, and we want to focus on pricing based on the demand that's out there.

But also recognizing that many of our products, we haven't had price increases for many years.

We've improved those products of delivering more value to customers, and we are not ashamed or bashful about going out and putting -- pointing it out to customers to push price.

So, so far, as you can tell, we've been able to stay ahead of the cost curve, and you have to be strategic about the pricing decisions, but, again, we're -- the markets are cooperating with us and so far, we feel pretty good about our strategy.

But in general, would you agree that it's probably easier to push through price increases through the distribution channel versus the OEM channel?

Would that be a fair assessment?

Yes.

I think the distribution channel, just by nature of that business, it's easier to raise the list prices.

But there still is a conversation you want to have with our distribution partners.

So you have to -- it's not -- I don't know if it's necessarily easier, maybe it's facilitated by the fact that they're going off the list price.

But the direct customers also require a conversation and a little hand holding through the process.

Okay.

And just a final question on that, on the list prices.

When normally do you publish new list prices?

I don't know what Kennametal's history has been, but because we're watching what's happening with the demand in the market and we're keeping an eye on the material cost, we typically will adjust those list prices as needed.

Now there may be some historical basis where they may have done it once a year, but it seems to me, Kennametal didn't do that for several years.

So you guys want to add anything to that, Pete or Alexander?

Well, normal history is annual basis typically, that would be in January, but as Chris said, we've had to adjust based on what's happening with material cost.

The same is true for Widia.

The next question will be from Steve Volkmann of Jefferies.

Maybe just stick with this price cost one more time.

Chris, I think you said -- so Chris, I think you said that things were positive this quarter, you expected to be positive for the remainder of the fiscal year, but of course, we're halfway through the fourth quarter already.

So I'm curious if there's anything we should be focused on with respect to timing, maybe as we get into the second half of the calendar year, relative to things like your inventory levels or your supply agreements, is there any reason to think that, that price cost dynamic would change as we get a couple of quarters further out?

Yes.

Steve, as we've talked about before, we monitor the situation closely and try to stay ahead of it, but at any point in time within a year, we may be a little behind, we might be a little bit ahead.

But given the dynamics of what we're seeing in the market, I don't -- I expect us to still be able to sort of manage next year, very similar to how we've managed this year.

Okay, good.

And then there's just a lot of balls in the air for us to keep track of relative to your headcount reduction, your SKU reduction, the shift to indirect, the modernization, the simplification and so forth.

Can you just talk broadly about kind of where we are relative to these?

And what I'm thinking about is, as we move into FY '19, what are going to be the key drivers of margin expansion amongst those various programs?

And can we, kind of, think about that 40% incremental as something we can hold through FY '19 as well?

Yes.

I think it should get easier for us to explain sort of the moving pieces because we've -- as we've -- we're now moving into the phase where we're going to execute the information we've presented at the Investment Day.

So we had the simplification initiatives, which are largely sourcing and sort of general productivity and some sales effectiveness type of things, and then modernization of the factory.

So we do plan on discussing this as sort of simplification and modernization and give you folks an update as we're moving through that process.

I'm sorry, what was the second part of the question?

What are going to be the key drivers of margin expansion?

Yes.

So those will be the key drivers of modernization and simplification, will be the key drivers, especially, as we walk through 2019, because all the benefits associated with prior restructurings are sort of falling off by then.

And the 40% incremental, was that something you think you can continue to do going forward?

Steve, the leverage moves around all these 3 quarter-by-quarter, depending on the segment, geographic and product mix.

But at the end of the day, that is the target that we set ourselves.

The next question will be from Julian Mitchell of Barclays.

Maybe just a question on that point on incremental margins.

Overall, I guess, on a clean basis, they were in the mid-20s in Q3, they guided to move up to maybe 45%, 50% in Q4.

Just maybe talk through the bigger moving pieces, I mean, I think, one would be just the anniversarying of that incentive comp from Q4 last year, that was very heavy.

Do you also think those manufacturing inefficiencies in industrial that you cited in Q3 start to fade as well and anything else that you think is driving that improvement?

Yes.

I think, first of all, the manufacturing efficiencies while modernizing that -- by definition, what modernizing means that those are, unfortunately, going to continue through the -- likely to continue through the cycle.

When we -- we're intensely focused on the leverage issue, and we believe that industrial, by way, is hit the hardest by, not only the variable comp and of course, the executive severance in the quarter, which is why their EBIT leverage, I think, was below what you would normally see.

But if you look at their EBIT leverage on Industrial for the third quarter and you adjust for the effects of this variable comp, which they tend to be hit with the harder piece because there's a big sales incentive piece to that.

The executive severance and FX were now in the 30%, kind of, leverage range, and then the manufacturing efficiencies sort of gets us back into where we think.

The other thing about industrial and what -- there's an opportunity here is the industrial margins, we believe, can be improved through a selectivity process.

A fair amount of our business is custom engineered and quoted to order, and we have a chance to actually control that process and decide and be selective on the orders that we take.

And so by favoring orders and customers that we want to improve service on and favoring orders that are more profitable, we're actually going to liberate some of our manufacturing capacity to improve our fill rates on the high-moving high margin standard products, which will also help to drive the leverage improvement and sort of mitigate some of these operational efficiencies while we're modernizing.

Julian, I think the Industrial business has been particularly impacted over the quarter by the foreign exchange, the strong euro versus the dollar.

And obviously, the raw material versus price impact.

So as that starts mapping, we should see some help coming out of these 2 or less impact on these 2 matters.

And then my follow up would just be more of a top line question.

So a lot of industrial companies have seen the automotive end market coming a bit light.

Your own transportation revenue growth in -- slowed from, I think, mid-teens in the second quarter to 4% in the third quarter.

So maybe just remind us how much of your transportation business is sort of light vehicle versus commercial vehicle, and whether you think that big slow down you saw was a blip?

How are you thinking about transportation revenue growth looking out the next 6 to 9 months?

Yes.

I think, in general, it's still a very strong market across the ball, Our end markets seem to be in good shape.

We don't really see anything that's going to concern us right now.

Transportation, you're right, the growth rate had slowed since Q2, but when we started to canvas the sales people and sort of the feet on the ground out there, we're not sensing that there's some macro event here that's going to slow down that sector.

And one of things you got to worry about with transportation -- not worry about it, you got to consider is, that the pace of sales doesn't necessarily dictate the supply chain and how they're producing the parts, which we're more tied to.

So I think, maybe, you need to just wait another few quarters to see what's going to happen, but our general sense -- and this is really the sense not just for transportation, but we can talk about all the end markets, even in Infrastructure and Industrial and Widia, we just -- we really don't see -- we don't see a lot of weakness out there.

The next question will be from Andy Casey of Wells Fargo Securities.

Your free -- I'm just trying to understand your free cash flow guidance for the last quarter.

It implies around -- at the midpoint, around $16 million free cash, $89 million OCF.

That's a down take from what you posted in Q3 despite the higher sales and margin that are implied in the guidance for the next quarter.

What is driving that?

Is it increased working capital intensity?

Or can you help us with that?

There's a little bit more cash -- capital expenditure foreseen Q4 in terms of pre-payments for fixed asset orders, that they're growing out.

We also have the inventories rolling this time once more.

And obviously, if the euro stays where it is, then maybe a little bit of FX in that forecast as well.

Okay.

And then if we go back to Slide 9, I just want to ask a pretty simple question.

The $0.02 severance, is that in the Other bucket?

Or is that included somewhere else?

Yes.

That's in the Other buckets -- bucket, sorry.

Okay.

And then the implied margin, if I assume a 5% to 6% benefit from currency and working days for the fourth quarter, on top of what seems to be about a 6% organic and then take everything else, it looks like the expected operating margin is about mid-15% to 16%.

First is, is that kind of in the ballpark?

And then second, I can get there, if I assume absence of the roughly $2 million of severance and then around a 40% incremental margin sequentially.

Is that about the right way to think about it?

Absolutely spot on.

The next question will be from Adam Uhlman of Cleveland Research.

Follow up on Andy's question on working capital, on cash flows, I'm start thinking about what fiscal '19 looks like.

Could you just talk about, like, kind of that medium-term plan of dealing with inventories, raw materials, finished goods?

Like, do we have to step that up in medium term to deal with inflationary pressures, the lead times, inefficiencies with the modernization program?

And then sense -- the CapEx outlook's kind of coming in at the low end of the range, we have another big step up next year.

I'm just trying to get to how we should think about the free cash flow outlook for next year broadly?

Adam, I'll just make a couple of general comments.

First, on the CapEx, we said that modernization was gonna sort of be $300 million spend over 3 years.

So you'll see another CapEx number similar to this year as next year, like we talked about in our Investor Day.

The -- generally though, as we move through next year, and I'll let Jan Kees add some details to this.

But generally, as we moved to last year, we expect -- we -- or next year and the following year, we expect this to -- generally, have free cash flow positive, and that's our model and that's our forecast.

So we sort of got all of that baked in but through this modernization period, we definitely will see positive free cash flow and it should increase year-over-year.

JK, do you want to add anything to that?

Thanks, Chris.

We typically don't provide guidance for 2019 fiscal on this call, but what we have been doing in terms of primary working capital is a multi-year plan in terms of working debt down, in terms of the percentage of revenue.

For the moment, I would expect that plan to continue.

In terms of the capital expenditure, we have quarters where the capital expenditure, maybe a little light and another quarters where the capital expenditures, maybe a little bit heavier, depending on the scheduling of the POs of the modernization equipment, and also our normal on-going capital expenditure with our suppliers.

Typically, I would expect the operating -- free operating cash flow to grow up in line with our operating results for next year.

Everything else being equal, obviously.

Okay.

Great.

And then just a nuance.

As we think about the fourth quarter margin performance, would we expect both segments to see sequential improvement?

Or are there some other issues that we should think about?

No.

No other Issues.

All the segments would see sequential improvement.

The next question will be from Samuel Eisner of Goldman Sachs.

Just going back to some of the variable compensation stuff.

When I look at the last 2 quarters, your restructuring benefit and modernization are barely positive relative to your variable compensation expenses in total, I think.

Net $0.03 positive in the second quarter, $0.01 positive in the fourth -- in the third quarter here.

So I'm curious what's the right way we should be thinking about that into the fourth quarter?

And then any early indications on 2019 of those 2 kind of larger buckets?

Yes.

I think -- well, I'm not going to give you an outlook for simplification and modernization other than FY '19 is the year when we start to ramp up.

So you should see that $0.03 improve over time, that would be logical to conclude.

The additional variable comp, that will go away.

That basically, this will reset itself when we set the plan for next year.

So that should largely go away.

And then I'll just also point out, in the salary inflation, because of the timing of the last rise to payroll, that will disappear in the fourth quarter also.

It's already baked into our forecast at that point.

Yes.

And Sam, remember last year, in the fourth quarter, we had a bit of a catch up.

And so this year, in terms of comparison year-over-year, it should be relatively flat.

Got it.

I guess, just to challenge on the variable comp, I think that was part of the kind of expectation coming into this year, that the variable compensation was going to be reset and that would be an easy comp, yet it's continued to be an issue.

So are you changing the way that you guys are thinking about setting plans for variable compensation relative to the guidance that you guys gave?

Maybe just kind of open up the kimono a little bit there to help us better understand the process going forward?

Yes.

I mean, the way we think about this is that, the variable comp plans are set based on the guidance that we provide you folks.

And if you remember, and that's what Kennametal did at the start of this year.

But I don't think they anticipated that the markets were going to recover quite as fast as they did.

So consequently -- and that's when we raise our guidance, so consequently, the people are being measured on the original plan, and now we're in sort of an elevated situation which is -- it's good for the folks but that's not -- that's not our normal philosophy how to run a plan.

That make sense?

Yes.

I guess, obviously, I think it's just the way the plans have been set up, is creating the issues here.

And maybe just last one.

Going back to your Slide 3, it looks like on a 2-year stack basis -- I'm looking at the quarterly organic growth chart, looks like in a 2-year stack basis, you actually saw a deceleration within either March or the overall March quarter.

How should we be thinking about kind of the 2-year stack going forward?

Should we anticipate that continuing into fall?

Have we kind of, dare I say, reached some level of kind of peak-ish type of 2-year stack growth rate?

Just any kind of color there would be great.

Yes, I think just a couple of comments on the sort of the overall cycle.

First, I've learned a long time ago not to try to predict these things because the only thing I know for sure is I'm going to be wrong.

And the other thing that I've learned is that 1 data point in a quarter doesn't actually equal a trend.

So it's hard to predict whether it's an inflection point here or not.

That being said, the anecdotal information that we get from our salespeople is that they're kind of looking at me, like, "Why are you asking the question, Chris?" The end market demand is very, very strong.

Okay?

So far of what's being reflected in Chart 3 is the comps are getting more difficult as we continue through this positive cycle.

But we're not really -- we're not sensing anything that they would suggest that the demand is tapering off or anything like that.

The next question will be from Walter Liptak of Seaport Global.

I wanted to ask about the infrastructure business, specifically for energy, and given the 3 buckets that you put the business into, how was the leverage with the 3?

And is there any one of them that's getting more pricing than the other?

And I guess, specifically in energy, are you able to pass along the price yet?

Yes, I think just a couple of comments on energy.

Then I'll let Ron, you can add something, if you like on the pricing topic.

Energy, generally, we see that it's sort of stabilized, like, kind of continues to take an uptick but it's kind of stabilized.

And that's the way we sort of projected it.

I know that there is opportunity to raise prices in that space but it's probably less due to -- there's just a huge amount of demand, and we can raise prices in that environment and more about the fact that we have excellent products.

They have a very strong value proposition, and we're really, I think, getting much better as a company at selling that and pushing prices in that area.

Ron, any color you want to add that?

The only other piece that we have is, with a lot of the key customers, we have long-term contracts when we work with them, which have pricing indexes based on raw materials cost.

Good point.

Okay.

And then if I could ask 2. Just about the overtime expense, have you figured out a way to do the modernization and kind of mitigate that overtime expenses or is that OT something that we're going to see ramping as you continue with the modernization plans?

Yes.

I don't know how much it'll necessarily ramp, okay?

It could go up in any given quarter, it could go down a little bit.

But the way we're -- the reason we're pulling it out is, by definition, it is as a result of doing the modernization.

And so it's going to continue through this cycle.

Now we tried to minimize it, of course.

But one of the reasons that we're sort of doing this is -- and also using temporary workers, which is a little less efficient process, there's higher turnover and people aren't as skilled as your permanent workers would be, is that we anticipate that our company is going to be able to run and produce more volume with less people.

And I don't really want to add a bunch of people only to have to lay them off again in the next 2 or 3 years.

So as you can imagine that's a specially challenging situation in some countries.

So we think the best strategy is to try to continue to focus on meeting customer demand and operating the facilities with overtime and temporary workers.

It is more inefficient, but once we get through the modernization phase, that inefficiency, it's going to come out.

That's the thought.

The next question will be from Steven Fisher of UBS.

Just a clarification on the capital spending.

I know you're going to be at the lower end of the range originally contemplated.

Is that lower CapEx a function of timing?

Or is it that certain things have been permanently removed from your modernization plan that you found more efficient ways of achieving it?

No.

I think the modernization number that you should still have in your head is that $300 million over 3 years.

It's really just a question of timing.

And I don't want to give the impression that we think we're behind or anything like that.

But these are -- there are -- and if you look at the detail of this thing, there's actually 700 or 800 little projects that all add up to big projects, and it's very complex.

We've got a good project management process in place to do this and as we get -- as we got more clarity and move through this thing, we're going to do a better job of sort of predicting that number.

But I wouldn't read anything into it terms of the amount being reduced, or in terms of our ability to deliver where we said we'd be.

Just to add to that, Chris, the question around becoming more efficient.

So it's how we spend capital, I think the teams are learning quite a bit as we go through and design our future state, and we're going to be pushing ourselves to be more efficient with the capital that we do spend, thus it will allow us to do more modernization in the company with the $300 million we're going to spend.

Okay, great.

And just related to Widia margins.

Can you just give us a sense of the trajectory that you expect to get from where you are around the 3% range on margins to the, say, 18% in 2021?

How confident are you in that 18% number at this point?

And how back-end loaded do you think it'll be?

Yes.

I think, first of all, when we look at the Widia margins in any given quarter, they -- as a percentage of sales, they can move around a lot because the numbers are so small, right?

That's one thing.

But Widia, what I think is important to remember is, Widia's not actually manufactured completely independent of the industrial manufacturing footprint.

So once we've modernize the industrial segment, okay, by definition, you're also modernizing Widia and that's where a lot of the improvement is coming from, is that the 2 are having simultaneously.

So for example, some of the equipment that we showed in our slide deck today, they're -- that stuff -- that equipment is packaging industrial Widia products.

So the 2 go kind of hand in hand.

But that's what's largely going to drive the Widia margin improvement.

And then the other thing is that Alexander and his team are committed to continue to grow that business and that's also a big driver of the margin improvement.

And ladies and gentlemen, this will conclude our question-and-answer session.

I would like to turn the conference back to Chris Rossi for his closing remarks.

Thank you, everyone, for your ongoing interest in Kennametal.

Please follow up with Kelly B. on any questions you might have.

And have a great day.

Thank you.

Thank you.

Thank you, sir.

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