Kennametal Inc (KMT) 2019 Q3 法說會逐字稿

Good morning, ladies and gentlemen.

I would like to welcome everyone to Kennametal's Third Quarter Fiscal Year 2019 Earnings Call.

(Operator Instructions)

Please note that this event is being recorded.

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

Please go ahead, ma'am.

Thank you, operator.

Welcome, everyone, and thank you for joining us to review Kennametal's third quarter fiscal year 2019 results.

Yesterday evening, we issued our earnings press release and posted our presentation slides on our website.

We will be referring to that slide deck throughout today's call, and a recording of this call will be available for replay through June 6.

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

Joining me on the call today are Chris Rossi, President and Chief Executive Officer; Damon Audia, Vice President and Chief Financial Officer; Patrick Watson, Vice President, Finance, and Corporate Controller; Alexander Broetz, President, Widia business segment; Peter Dragich, President, Industrial business segment; and Ron Port, President, Infrastructure business segment.

After Chris and Damon's prepared remarks, we will open the line for questions.

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

Today's discussion contains 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 listed on Slide 1 and detailed in Kennametal's SEC filings.

We will also 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'll now turn the call over to Chris.

Thank you, Kelly.

Good morning, everyone, and thank you for joining the call today.

I'm pleased to report that we delivered strong results in Q3 FY '19 on a total company basis, both in terms of sales and margins.

Although total sales decreased by 2%, negatively affected by foreign exchange of 4% and business days of 1%, sales at an organic level increased by 3%.

This is the tenth consecutive quarter of organic sales growth and is on top of 11% last year.

Furthermore, we achieved organic sales growth in all 3 segments with Infrastructure posting 6% growth, Widia 3% and Industrial 1%.

Those are on top of tough comparables of 14%, 9% and 10%, respectively.

Furthermore, this strong sales performance included a slower-than-anticipated March.

We believe the macro issues circulating during the quarter, such as potential tariffs between the U.S. and Europe and just general uncertainty around global and U.S. economic growth, resulted in a slower March.

Our initial read based on April, however, is that this seems to have been a temporary issue, and the underlying markets remain steady.

From a regional perspective, both the Americas and EMEA posted positive numbers at 4% and 2%, respectively.

Asia Pacific declined slightly in the quarter by 1% driven mainly by the slowdown in China.

However, we are seeing some positive signs in China more recently, so we're encouraged in that regard.

In terms of margins, on a total company basis, our adjusted EBITDA margin is now at 19.4%, up from 18.2% in the prior year quarter.

We maintained operating expenses at our target of around 20%.

On an earnings per share basis, we posted $0.77 for the quarter, up 10% year-over-year from $0.70 prior year quarter.

We continue to drive increasing results from our simplification/modernization initiatives.

This quarter, the benefits increased to $0.11.

That compares to $0.10 sequentially and is on top of $0.03 achieved this quarter last year.

In general, our multiyear simplification/modernization program is progressing well.

In fact, at the next phase of this program, we announced restructuring with expected annualized benefits ranging from $35 million to $40 million by the end of FY '20.

These are structural changes that reduce our break-even point and further demonstrate our commitment to achieving the FY '21 adjusted EBITDA objectives presented in our last Investor Day.

Now let's review the segment results starting with Industrial on Slide 3. Industrial achieved year-over-year organic growth of 1% this quarter on top of 10% organic growth in the prior year quarter.

As expected, transportation was down again this quarter, posting a negative 8%, centered mainly in Asia and Europe as related to a decrease in auto production.

While we have seen some recent encouraging news out of China specifically in terms of auto, our expectation is that auto production will remain at current levels for a while longer.

Energy, after several quarters of positive growth, was down 2% this quarter and reflects some end market softness mainly in power generation.

Our expectation is that the market will remain flat to slightly positive in Q4 versus Q3.

The biggest end market in Industrial, general engineering, posted a healthy growth rate of 5% in the quarter, which represents the 11th quarter of consecutive year-over-year growth.

Our expectation is this end market will remain steady.

And finally, aerospace grew double digits again for the fifth consecutive quarter at 13%.

This is the 12th consecutive quarter of year-over-year growth for the aerospace end market and reflects the success we are achieving with our growth initiatives.

Our expectation is that the aerospace end market will remain strong.

The adjusted operating margin in Industrial is now 18.3%, up significantly by 290 basis points year-over-year and reflects the continuing success associated with our simplification/modernization work.

Turning to Slide 4 for the Widia overview.

Widia posted 3% organic growth this quarter on top of 9% in the prior year quarter.

The margin this quarter was negatively affected by onetime costs associated with portfolio simplification.

Excluding this effect, the margin would have increased year-over-year.

Let's look at the results by region.

EMEA's high growth rate of 6% reflects continuing success with our aerospace initiatives.

Asia Pacific's 3% growth rate continues to be strong.

However, performance in the region was dampened compared to prior quarters due to the temporary disruptions in India related to the ongoing national election and the slowdown in automotive production as OEMs shift to vehicles meeting the upcoming new emission standards.

Our expectation is that the growth levels will recover as these temporary issues abate.

Americas showed a slight decline of 1% this quarter as we continue the process of upgrading our distribution network.

We believe this decline is not reflective of the underlying market conditions.

On Slide 5, we summarized Infrastructure's results.

Infrastructure achieved organic sales growth of 6% this quarter on top of 14% growth in the prior year quarter.

By region, EMEA led at 11% growth, followed by the Americas at 5%.

Asia Pacific posted a negative 1% rate for the quarter driven by China.

By end market, general engineering posted positive results of 16% and energy grew at 2%.

As part of our continuing growth efforts in the energy end market, we announced yesterday a distribution agreement with Gardner Denver, a market leader in the energy space for our KennaFlow valve seats.

Our proprietary seat technology delivers up to 10x the life of steel seats, offering a substantial increase in productivity through reduced downtime.

Earthworks posted a negative 3% year-over-year change.

This decline was unexpected and due primarily to a single large customer whose forecasted sales did not materialize for them.

Therefore, we do not believe the decline is reflective of the underlying market.

In fact, as we entered the fourth quarter, we're encouraged with the initial level of activity in this end market.

Operating margin in Infrastructure increased sequentially as expected this quarter to 11.7% primarily driven by lower material costs.

On a full year basis, given the unexpected sales decline in earthworks, our expectation is that the full year margin will be relatively flat year-over-year.

As reported last quarter, the capital investment in our Rogers facility modernization is essentially complete with additional benefits to come as we work to optimize the modernized production processes.

Before I turn it over to Damon, I will walk through an example of modernization on Slide 6. This is a great illustration of how simplification/modernization is making a massive change in our manufacturing efficiency.

Our before process was highly manual and very labor intensive.

For example, to make a single part at this stage, it required 3 different machines, 3 different setups and 3 different employees operating the machines and physically moving the pieces between machines.

Today, this stage is completed with 1 automated machine that performs all those actions.

The machine also features robotic handling, which enables higher quality, more consistent parts with less scrap since manual intervention has been eliminated.

This modernized process reduced labor by more than 50% and delivered an 80% improvement in efficiency while improving quality and delivery performance for our customers.

This is another example of the significant benefits of our simplification/modernization plan, improving our flexibility and reducing the break-even point of the company.

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

Thank you, Chris, and good morning, everyone.

Turning to Slide 7. Sales in the third quarter were $597 million with organic sales growth of 3% offset by an unfavorable effect of foreign currency headwinds of 4% and business days of 1%.

This is the tenth consecutive quarter of organic sales growth, which reinforces that our focus on growth initiatives in general engineering and aerospace are delivering results.

Adjusted gross profit margin decreased 70 basis points to 35% driven primarily by unfavorable volume-related labor and fixed cost absorption in certain facilities in part due to simplification/modernization efforts in progress, higher raw material cost and unfavorable foreign currency partially offset by organic sales growth.

Adjusted operating expenses decreased $11 million to $120 million due primarily to lower compensation expense, favorable effects from foreign currency and benefits from our simplification/modernization initiatives.

On a percentage of sales basis, adjusted operating expenses improved by 140 basis points, decreasing to 20.1% as we continue to have success in reducing cost.

As we have now demonstrated for the last several quarters, we expect to maintain operating expenses as a percent of sales around this level, which is in line with our long-term outlook.

Adjusted operating margin increased 70 basis points to 14.3%, which is the best third quarter performance since fiscal year 2012.

As Chris mentioned, our adjusted EBITDA margin increased 120 basis points to 19.4% driven by our simplification/modernization savings.

The effective tax rate for the quarter on an adjusted basis was 19.8% versus 23.1% in the prior year quarter.

The decrease is primarily due to U.S. tax reform.

Adjusted EPS improved significantly year-over-year to $0.77 versus $0.70 in the prior year.

Slide 8 illustrates the main drivers affecting adjusted EPS this quarter compared to the prior year.

The biggest driver in the quarter was the favorable effect of our simplification/modernization initiatives of $0.11.

The savings this quarter is incremental to the $0.03 delivered in the third quarter last year.

Year-to-date, we have now delivered $0.30 in simplification/modernization savings versus $0.09 in all of fiscal year 2018.

Operations, which effectively reflects the day-to-day running of the business, was negative $0.02 in the quarter.

There were some key tailwinds and headwinds worth noting this quarter.

First, price more than covered raw material cost inflation again this quarter, which is consistent with our historical performance.

This is a testament of the team's ability to continue to price for the value of our products.

Second, in preparation for product moves, further simplification efforts and facility rationalization, we are currently operating certain facilities at lower levels of utilization.

To put that in a little more perspective, as you would expect, as we further implement our simplification/modernization plans, we are moving different product families to different facilities around the world to improve productivity and lower our costs.

However, while doing this, some facilities will temporarily operate at lower utilization levels.

Although we can reduce the variable cost, including temporary workers and overtime, the fixed costs create a temporary headwind until we can address them.

The effects of these types of actions will change quarter-to-quarter depending on the timing of projects such as the restructuring actions announced yesterday.

The other items affecting the EPS this quarter versus prior year were a lower tax rate, which contributed $0.03; and currency, which was a $0.04 headwind.

Turning to Slide 9 and our quarterly segment sales and profitability performance.

Industrial delivered $319 million in revenue with 1% organic growth.

This growth was centered in the Americas with strong performance in our 2 growth end markets of general engineering and aerospace.

This strength more than offset the continued weakness in the transportation end market, which influenced the negative growth in both EMEA and Asia Pacific regions.

Our focus on these growth areas, coupled with the incremental simplification/modernization benefits, expanded Industrial's adjusted operating margins by 290 basis points year-over-year to 18.3%.

Widia delivered 3% organic growth in the quarter and continued to execute on its strategic growth plans in key areas such as aerospace in EMEA, which grew 6%.

Widia's America business was down 1% year-over-year as we continued to work through changes to upgrade our distribution network.

Widia's adjusted operating margin of 1.3% was down 110 basis points year-over-year reflecting onetime costs associated with simplification efforts to streamline the product portfolio and drive improved profitability.

As Chris said, excluding those onetime costs, Widia's adjusted operating margin would increase year-over-year.

Infrastructure reported sales of $228 million.

The strong growth in EMEA and the Americas helped deliver 6% organic growth.

As expected, the adjusted operating margins increased sequentially to 11.7% versus 9.6% in the second quarter mainly due to lower raw material cost.

The 11.7% adjusted operating margin was down 210 basis points versus the third quarter last year mainly due to higher raw material cost and the timing of customer raw material price index adjustments discussed last quarter.

As material costs have now been relatively stable for a few quarters, our material costs will be better aligned with our customer prices in the fourth quarter.

In addition to the price versus raw material variance, Infrastructure also saw incremental manufacturing expenses partially offset by organic sales growth and incremental simplification/modernization benefits.

Turning to Slide 10.

We continue to maintain a strong investment-grade balance sheet.

Primary working capital as a percentage of sales remain relatively flat from last March at 30.7% this quarter.

We continue to expect to maintain primary working capital as a percentage of sales in this approximate range but will nevertheless continue to look for opportunities to further improve.

In dollar terms, primary working capital increased partially due to an increase in inventory.

The year-over-year increase in inventory is reflective of the lower-than-anticipated sales in March, higher year-over-year commodity prices, increased strategic inventory on our high-volume, high-profitability products for improved customer service as well as a temporary increase in inventory related to product moves between facilities as part of simplification/modernization partially offset by a stronger U.S. dollar.

Cash on hand at March 31 was $113 million versus $222 million in March the prior year, a decrease of $109 million mainly due to primary working capital changes and increased capital expenditures.

Free operating cash flow in the quarter was $39 million, down from $72 million in the prior year quarter also due mainly to changes in primary working capital and increased capital spending.

Net capital expenditures were $57 million in the quarter compared to $45 million in the prior year quarter.

As with previous years, we expect capital spending to increase further in the fourth quarter.

Dividends paid were $16 million, consistent with last year.

Turning to Slide 11 for our fiscal year 2019 outlook.

Based on the environment we see today, we are refining our estimate for FY '19 adjusted EPS outlook within the previous range.

We expect adjusted EPS to be in the range of $3 to $3.10 for the full year.

It's worth noting that the midpoint of our current EPS outlook remains aligned with the midpoint of our original outlook despite $0.08 of foreign exchange headwinds since then, increased tariff-related costs as well as the slower March we discussed.

Overall, we remain pleased with our team's ability to execute throughout the year.

Regarding our sales outlook, as we've discussed, the markets remained generally positive in the third quarter but softened in the month of March.

Based on our year-to-date organic growth of 5% and the early positive indications in April, we now expect organic sales growth of approximately 5% for fiscal year 2019.

Free operating cash flow is expected to be in the range of $120 million to $140 million with capital expenditures of $200 million to $220 million.

We've reduced our outlook for capital expenditures mainly due to the timing of cash payments for certain equipment.

Since we do not record equipment as a capital expenditure until payment has been made, timing of payments affects the capital expenditures recorded in any period.

Based on our experience derived from our Rogers plant modernization effort, we have introduced more stringent factory acceptance testing for new equipment.

Contracts with suppliers include a provision where final payment is not made until testing is complete.

While this may have an effect of delaying the recording of capital expenditures, we have learned that the additional testing helps to shorten the equipment startup process in the plant.

Therefore, on balance, the plan for deriving savings from the new equipment can still remain on track.

With that, I'll turn the call back to Chris.

Thank you, Damon.

We had a strong quarter with organic sales up 3% and adjusted EBITDA margins increasing by 5%.

We're progressing well with our simplification/modernization initiatives, which is really the cornerstone of Kennametal's increased profitability in years to come.

There's a lot of detailed work being accomplished and further benefits to be derived from this important work.

This quarter, the benefits from simplification/modernization increased again.

Our announcement yesterday regarding restructuring associated with these initiatives further demonstrates the progress that we are making.

We're now narrowing the full year guidance, staying within the previous EPS range.

We anticipate end markets generally consistent with the markets in the third quarter and remain focused on continuing to improve our operating results by lowering the break-even point of the company.

I look forward to report our full year results and providing our full year outlook for FY '20 on our next earnings call in August.

And with that, operator, let's open it up for questions.

(Operator Instructions) And the first question will be from Steve Volkmann of Jefferies.

Maybe let's kick it off with just a couple of those sort of margin headwinds that you mentioned, and I guess maybe starting with Infrastructure.

I'm trying to understand -- I think that was the one where you had the unintended customer issue.

Can you just describe a little bit more about what that is?

And specifically, I guess I'm just trying to figure out whether it continues in 4Q or in next year or just sort of how to think about that.

Yes.

Okay.

So Steve, the -- as we said, the margins improved sequentially.

I think it was 9.6% to 11.7%.

And inside our forecast for Infrastructure, the nature of that business is there are some large customers that actually give you pretty good indication of what they're going to buy quarter-over-quarter.

And in this particular case, the customer, and we're not exactly sure why, but they didn't meet their forecasts that they had led us to believe was going to happen.

In the conversations with them and based on the feedback that we've got from our salespeople, we do not think that, that is reflective of the underlying markets.

So they may have had some issue.

We're not exactly sure.

But as far as we're concerned, it's not an underlying market issue.

And so that was the basis on that volume differential that we were expecting.

But I would characterize it as not -- is unique to this particular customer and not something that's affecting the underlying market.

Now as we progress through April in this particular market segment, we actually saw very encouraging results.

We didn't see anything that was going to indicate that we should have another surprise here in the month -- or in the fourth quarter.

And so we feel pretty good about that part of the business going forward.

I don't want to put words in your mouth, Chris, but does that mean that this customer issue seems to be past?

Or is it just not getting worse?

Yes.

I think it's -- I don't know the exact status of it, but when we look at the incoming order flow in total for this part of the business, if they are potentially having continued issues, the extent of the volume that's coming in our other parts and from other customers is going to more than offset that.

Okay.

All right.

That's helpful.

And then maybe just on the cash flow.

I guess we -- we've -- you've cut the CapEx and sort of held the overall cash flow guidance.

So I guess that implies that the working capital build is going to stick around a little bit longer here.

But just help us think through.

Does that reverse next year?

I mean how do you think about the trajectory there?

Yes.

I think generally, on working capital, we've been sort of trying to keep it around that 30% level.

And some of the things that Damon had mentioned, there was an increase.

But as we've talked about in the past, Steve, we simplified our portfolio.

We're more focused on growth areas in general engineering and aerospace.

And we've made a conscious decision to invest more in the higher-moving inventory, what I would call strategic inventory for high-volume, high-profit SKUs, to help us improve customer service.

And the fact that we've done that, I think, is helping to fuel a lot of the growth that we've seen on the general engineering side.

Now we did see a little uptick in working capital because the slower March naturally was less sales.

That drove a little bit of it.

So that part should go away.

And then as Damon mentioned, we did consciously make some decisions to increase inventory in support of product moves.

As we start to rationalize the footprint, move things around, we want to make sure that we have a little buffer there to not disrupt customer service.

So eventually, at any given period of time, that will go away or that might go up and down, but that should eventually go away in the long term because we will have completed modernization.

Okay.

And just one quick one I'm going to sneak in.

Any long-term changes in the targets that you've laid out for the company over the next couple years?

Yes.

We've -- we haven't updated our guidance since the last Investor Day.

So that $600 million to $675 million of EBITDA is still our -- the latest view that's out there.

I think, Steve, when we get to the fourth quarter here, where we naturally talk about the FY '20 numbers, that would be an appropriate time to give you a little more granularity on what's going to happen in FY '20, and that certainly sets the stage for FY '21.

But I would stick with the -- with what we've already presented at the last Investor Day.

And the next question will be from Julian Mitchell of Barclays.

Maybe just the first question drilling into your more upbeat comments about demand in April.

I heard what you said on Infrastructure regarding a customer -- one specific customer's orders and so forth.

But beyond that, just maybe talk about Industrial and Widia.

What regions or markets did you see the April improvements in?

Yes.

I would say in general, most of the markets were positive except for transportation, which, Julian, we sort of think that's kind of stabilized at the Q2 levels that we saw.

And that, of course, was down from the previous year.

Energy did slow a little bit.

But on the Industrial side, that's not -- in Widia's side, that's not a huge play for them.

Really, the -- and bright spots were general engineering and aerospace, they remain healthy, and we saw, I think, 7% and 13% growth organically in -- 7% general engineering, 13% in aerospace.

So our view is that -- especially in those 2 areas of focus, that we feel quite good about the outlook for both general engineering and aerospace, and we think that's going to remain steady.

And then just secondly, wondered if you had any perspectives on inventory levels with some of your distribution partners.

Several short-cycle manufacturers have complained about destocking in recent months and still elevated inventory levels in the current quarter as well.

Just wondered what your view was on that topic.

Yes.

As it relates to the Industrial and Widia business, we didn't really see any destocking this quarter, at least from our bigger distributor partners.

We do know that some of the factors that we talked about, such as the potential tariffs between the U.S. and Europe and kind of the general uncertainty that was -- that existed on the U.S. economic growth and also the global economic growth earlier in the quarter, that may have contributed to the slowdown in March.

But as far as our big distribution partners, we didn't really see any destocking.

And the next question will be from Ann Duignan of JPMorgan.

Could you just remind us your aerospace business?

How much of that is exposure to Boeing build rates?

And what might the impact on your business be going into fiscal '20 of the slowdown in the 737 or even the 787 later?

What impact may it have on your business?

Yes.

Boeing is obviously a key customer of ours.

I can tell you what we've seen so far relative to the Boeing situation is really not much.

We haven't seen any slowdown in the business, both from direct business from Boeing and, of course, there's a lot of business that flows to Tier 1s and Tier 2s.

So we haven't really seen any slowdown in that area.

So I don't know if that -- I don't know if that's going to continue.

I understand that Boeing is still working through the issues.

But as far as what we see right now, Ann, we just don't see it affecting very much.

And there's a lot of other business inside of the aerospace that's non-Boeing that continues to be strong, so we still feel quite upbeat about aero in general.

Okay.

But you wouldn't be disproportionately leveraged to Boeing directly or indirectly in terms of build?

Yes.

I don't believe that -- I don't actually know what our percentage is relative to the overall Boeing's contribution as it is -- it is significant, but we have other business in that area, Ann, that we think would compensate for that.

But I'm not going to -- I don't really want to talk about our specific share with Boeing as it relates to the overall pool.

Okay.

I appreciate that.

Maybe if I could switch gears and maybe you'll give us a little bit more color on the Phase 2 restructuring simplification and the cadence of spend.

And what inning are we in?

Is this the end of the spend and then we slide into fiscal 2021 with everything all done and all the disruption is behind us?

Yes.

I think -- let me just make some general comments about the overall program in terms of restructuring to support simplification/modernization, and Damon can maybe fill in the gaps in terms of how we see this thing playing out through '20 and '21.

We're basically -- as you know, with the simplification/modernization, we're trying to really lower the break-even point of this company, improve its profitability and really enable growth by improving our customer service through these modern processes.

I think the latest restructuring in my mind is just another indication that we're moving towards the sort of ultimately lower structural cost inside this company.

As we talked about in Damon's section, we're moving products around, rationalizing the footprint to lower-cost countries.

And I think, frankly, on the remaining footprint, as we modernize it's just going to be less labor dependent and much more efficient.

So unlike the old Kennametal, which was very heavily labor dependent and whenever there were adjustments that needed to be made based on demand, they really had a lot of challenges in terms of the flexibility of the workforce.

So we see this modernization and an overall rationalized footprint as putting us in a different place.

Now relative to restructuring in this specific case, this is just kind of a subset of the overall program, but I'll let Damon maybe make some more comments on how we see this thing going.

Yes.

And so I think, as Chris alluded to, this is just the next phase as part of our overall restructuring efforts to deliver the FY '21 objectives.

As we said in the press release, the timing of this one, again, the savings is $35 million to $40 million.

I would tell you it is primarily cash-related cost.

That $55 million to $65 million of costs we talk about will primarily be cash, but that will be phased in between Q4 and through FY '20 depending on the discrete actions that we have planned here over that next, call it, 12 to 15 months.

And so it'll be a little lumpy on when this cash goes out and then the corresponding saving kicks in to the point, as we've said in the release, that sort of expect the run rate as we go through into that fourth quarter of FY '20 is when we start to expect all the benefits related to this.

Okay.

And then just a real quick clarification.

It does sound, though, that beyond all of this, your working capital needs will be structurally higher if you're going to carry more inventory for general engineering and aerospace.

Is that correct?

The inventory currently reflects the -- as Chris alluded to, if you think about the higher-profitability, higher-volume products that we've been talking about, our current level of inventory does reflect that.

So I don't anticipate a significant change in those levels going forward as we have achieved the fill rates we're -- we've looked to target there.

So again, trying to keep that primary working capital around that 30%-ish range, and this continues to be our goal.

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

This is actually Patrick Lowe standing in for Andy Casey.

Just wanted to sort of follow up a little bit more on the margin side.

Can you remind us what segment you guys saw the facility underabsorption hit from -- in the quarter due to the modernization initiatives?

And then the Widia business, you called out that excluding your onetime costs, year-over-year margins adjusted basis would have been a little bit higher.

There's like a 90 basis points delta that guys would have needed to make up for that to happen.

Just wanted to see what that would have been, what the -- excluding the onetime costs, what the adjusted operating margin would have been for the Widia business.

Yes.

Let me just take the operating leverage question first.

The underlying leverage for both Industrial and Widia, I know you asked about Widia, we think is actually quite good.

And when we -- without that charge, Widia on a constant currency basis, the operating leverage would have been over 100%.

So we feel pretty good about that.

And that particular charge is part of simplification and trying to narrow our product portfolio, make sure that Widia is very focused on going into whitespace that the Infrastructure portfolio is not quite suited for or what customers aren't quite suited for.

And so we want to make sure that the portfolio was very focused.

And therefore, we're kind of cleaning up some legacy issues that existed on that.

But overall, the operating leverage, we feel quite good about.

And as I said, without that adjustment, it would have been about 100%.

Now in terms of the specific factories, they largely were -- on the -- underutilization was largely on the -- or, excuse me, on the Industrial side.

As Damon talked about on the bridge, we sort of have that operating -- operations bucket of minus $0.02 of EPS.

And when we look -- and just sort of characterize the impact on this, if we sort of take out the underabsorption associated with the facilities that were involved in preparing for plant rationalization, that bar would have been positive.

So we feel pretty good about the Industrial underlying leverage.

And as we talked about before, modernization at any given point in time can be disruptive as you're trying to transform the way we are.

So it's not unexpected, but it also won't last forever.

Great.

And then just one more to follow up your comments on the restructuring, the next phases.

What segment is the next phase of restructuring going to be primarily focused on?

I mean I would assume that it's probably pretty broad-based, but is there any particular segment that's going to be a bigger focus for you guys in -- over the next 12 to 15 months?

Yes.

The restructuring -- since we're doing simplification/modernization across all segments, that it applies to all.

I guess you could argue it's a little more heavily weighted towards the Industrial segment, which also affects Widia because that has the larger manufacturing footprint and probably the greatest opportunity for modernization.

And the next question will be from Ross Gilardi of Bank of America Merrill Lynch.

I just want to ask about your free cash flow outlook.

I mean you guys need to do, I think, north of $100 million in fiscal fourth quarter to hit your guide.

Your implied net income will be up a little bit, but you've got this new restructuring program, and you said your CapEx is going up in the fourth quarter, I think.

So I'm just trying to understand how you squeeze that much cash out of the business in the fourth quarter to hit your numbers.

Yes.

Ross, again, I think as we've done historically, we do generate a lot of our cash in the fourth quarter here.

Think about where we were with capital spending last year.

I think we spent around $65 million in the fourth quarter.

And if you look at the midpoint of our range, it's sort of in line with that.

Generally, what you'll see is, again, we see the stronger fourth quarter seasonal selling.

So there will be an inventory reduction.

And so overall, when we looked at the numbers, we still think that we'll be able to get to that range of $120 million to $140 million.

I think also, Ross, the restructuring -- how do you see the cash flows going, Damon, on the actual restructuring charges?

Yes.

I think that the cash flows are going to be dependent upon the projects.

So again, that -- a large portion of that cash may go out in 2020.

Just a small portion, depending on the activities as we work through them, may go out in the FY -- in Q4 of FY '19.

Okay.

And can you just help us on any preliminary thoughts on the '20 free cash flow outlook given that a lot of that restructuring cost is going to deferred into that year?

And maybe you could explain again the capital spending cut.

I mean is this a deferral into next year?

And just generally speaking, what I'm trying to get at is, is 2020 going to be another year of elevated CapEx and cash restructuring costs such that like the real drop-through on the cash flow statement isn't really until 2021?

Yes.

I think that's the right way to look at it, Ross, is if you think about what we've said on modernization-related spending, we've said at our Investor Day a couple of years ago that we were going to spend around $300 million incremental to our normal or traditional $120 million run rate.

You look at what we spent in FY '18 related to modernization, that was about $50 million.

If you look at the midpoint of what we're spending this year, that will put about another $90 million.

So that's about $140 million of that $300 million.

So directionally, you're looking at the balance of about $140 million sort of rolling into effectively FY '20.

So you are going to see an elevated CapEx spend through -- into FY '20 with the benefit starting to flow through in FY '21.

As we've also talked about, there are some restructuring actions.

This is the next phase of those actions that we've announced.

And so we would expect to continue to look for those opportunities as the team implements the modernization and simplification.

So again, there could be or there may be further actions to come.

Okay.

Got it.

And then just lastly, I want to ask you a little bit more about that, the movement of products amongst different facilities.

Why is that again?

And just operationally, could this have contributed at all to the reduction in the organic growth outlook?

Or is that purely an external issue with demand?

Yes.

I think the -- in terms of our -- moving of the product around and that type of thing, we don't think that has an effect necessarily on customer service.

And so therefore, it's our belief that it's more a macro environment issue.

And then the company has a long history, Ross, of a lot of small manufacturing plants that were built up through acquisitions.

And so a big part of simplifying the footprint and modernizing the footprint is to rationalize it.

And so that's what we're getting on with the business of doing.

And as we've talked about, this is probably the stuff that should have been done over the last 20-something years, but now is our opportunity to do it, and we're committed to make it happen.

And it's going to put us in a much more -- a better place in terms of the company's profitability.

And I also think simultaneously, we're going to be better able to service customers.

Because before, we were maybe shipping product all around the world, and that extends lead times; not only increases costs.

But I think we're going to be in a much better place with this rationalized footprint to better serve the customers, too.

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

I was -- I wonder if we could go back to the Infrastructure margins outside of the volume-related headwinds.

I think you mentioned that you had a sort of price/cost headwind in the quarter.

I was wondering if you could dimensionalize that.

And I think I might have missed it, but I think you said that, that improves in the fourth quarter.

Is that the material costs moderating for you?

Or are you getting some incremental pricing?

And I'm just trying to think about the setup into the next fiscal year.

Should we expect additional margin expansion in a normalized volume environment?

Yes.

I mean what's going to drive the improvement in the fourth quarter is there is a significant volume piece of that.

And then also, as we talked about and we saw in the third quarter, the fourth quarter will continue with price over raw material.

That will be a big driver as well.

And then there was some manufacturing inefficiencies that we saw in the third quarter, but Ron and his team are -- or have addressed those, and we believe that that's going to correct itself in the fourth quarter.

And it also sets the stage for future improvement.

And then beyond that, the Infrastructure team is also focused on simplification and modernization, and so we would expect that that's going to help improve margins going beyond fiscal year FY '19.

In general, my assessment of the overall business is that the underlying performance is really quite good, and I think we'll make it even better in FY '20.

Okay.

Got you.

And then in China, you had mentioned earlier that you're seeing more positive signs recently, and I'm just wondering if you could expand on those comments.

Is that within your own order rates?

Or are these macro indicators that you're feeling better about?

Yes.

We -- I kind of -- we've sort of alluded to it.

We're cautiously optimistic that things are actually improving in China.

Recently in April, there was the China [Industrial] Machine Tool Show, and we got an opportunity to talk to a lot of customers and people in the industry.

In general, they are quite upbeat about things improving in China.

And specifically around auto production, we heard things like that's expected to improve anywhere from 3% to 4% from Q3, and that was kind of the feedback from our top 27 auto OEM customers.

So that's the basis of some of the optimism.

And then also, we know that the Chinese government is implementing policies that are trying to change customer behavior, which is ultimately going to -- or, excuse me, consumer behavior, which is ultimately going to drive, I think, more demand for auto production.

So in general, those are the basic things that we're kind of hearing from our customers that things might actually be [heating] up there.

And we haven't really -- it seems that the situation has stabilized, at least through the third quarter, so we're pretty encouraged that it may start to improve.

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

I wanted to ask a follow-on, on the plant rationalization and just the timing of the costs and the benefits.

So it sounds like we're going to get all the costs by the end of 2020, starting in the current quarter.

And then the benefits, it's not clear to me.

Do we get some of the benefits?

Or how much of the benefits do we get in 2020 and how much in 2021?

Yes.

So Walt, the benefits will start to happen in the first part of FY '20.

But again, there are multiple programs that are in this restructuring, and so we haven't disclosed any of the specifics, they're going to phase in depending on discrete events over the course of Q4 of FY '19 and FY '20.

So you'll see the full run rate benefits that we've talked about, that $35 million to $40 million, we'll start to see that full benefit as we exit FY '20.

But again, we would expect to see some savings starting -- as soon as the first quarter of FY '20.

Okay.

And I wonder how you would handicap the -- this phase of the restructuring.

Modernization, you've had a lot of experience with that now.

Is this next phase -- it sounds like there's heavier lifting there, especially if you're relocating some of the factories.

I wonder if you could talk about just the risks.

Or are these controllable risks?

Or how they are compared to modernization.

Yes.

I mean if we think about Infrastructure modernization, that was -- we had the opportunity to do a transformation of a very significant size plant in the Infrastructure business.

That's the Rogers facility that we've talked about.

And as you can imagine, that went largely according to plan.

In fact, we were ahead of our internal schedule.

But we learned a lot from it.

Things didn't go perfectly.

And so I think that they -- given that experience, we've made adjustments that I believe, while this next phase of modernization -- any time you're shutting down plants or you're moving product around, you're absolutely right, it becomes a little more risky.

But I believe that we -- especially given the learnings that we had from Rogers, that we have a good mitigation plan, we can stay on top of that.

And an example of that is how we talked about -- or Damon talked about the capital expenditure timing where we've really, I think, strengthened and improved our factory acceptance testing.

That was kind of a lesson learned from Rogers that if we make sure that the supplier is fully engaged and we do a much more robust testing of the equipment, that actually makes the ultimate start-up process go a lot easier.

And so I feel pretty good that we understand what needs to happen, especially when you're doing these large plant transformations.

And even though it'll get more complex, I think we've got the risk mitigated.

And the next question will be from Chris Dankert of Longbow Research.

I guess to kind of pull the thread a bit more here on the simplification/modernization.

Hopefully, this isn't the case.

But if we do see demand kind of slow down a bit into 2020, is there an opportunity to kind of lever up and deliver savings beyond that $40 million?

Or are we kind of at a fairly fixed rate of how these projects progress?

Yes.

I guess one of the challenges of this simplification/modernization program is you're fixing the airplane while you're flying it.

So to the extent that there is a lower demand, that can actually make things a little simpler.

I'll just give you an example.

In our Rogers facility, while we sort of beat our own internal schedule, there were times where we intentionally slowed the movement of manufacturing processes from one section of the plant to the other just because we had so much demand that we didn't want to disrupt customer service.

So theoretically, it should get a little easier.

But I wouldn't expect a huge acceleration.

But what I would tell you is that we believe that modernization and simplification and this investment we're making is fundamental to the success of the company going forward.

And so regardless of what happens with demand, that's what we're focused on.

And that, by far, is the single biggest lever we have for self-improvement in terms of driving shareholder value.

Yes.

Yes.

Makes sense.

And...

And Chris, let me just add just to make sure.

You made a comment -- I want to make sure you understand what the -- the $40 million that we spoke about in this restructuring is not what we're necessarily saying is going to be the savings for FY '20, which I think is what your comment was.

Again, if you think about -- a lot of this is labor reduction.

So to the extent we were to take labor out in the -- at July 1, we would get the full year.

To the extent we were to take that out in January 1, we'd only get a 0.5-year benefits.

And so as we've said, the $35 million of $40 million of savings is going to be your Q4 exit run rate.

So again, depending on when people come out, we'll have a different overall savings impact for FY '20.

I wanted to clarify, I guess.

And some of the savings and actions you took this year should also be impacting the first half of fiscal '20, no?

Correct.

Okay.

Okay.

And then just a clarification on this third quarter.

Within transportation business, I guess, can you break out what the -- how much automotive declined versus how much the heavy truck -- or the performance in rail?

Just kind of size what automotive did.

Yes.

I'm not sure that we break it down like that.

We knew that it was weak, Chris.

So we know the heavy truck -- again, as you read the markets, heavy truck demand is high right now.

And then going through the balance of this year, there's a high demand for the heavy Class 8, heavy-duty truck orders.

But if you think about the automotive or the light vehicle segment, it tends to be the weaker one both in the U.S. and Europe and specifically in China.

Right.

I guess that was my concern, if heavy truck is kind of propping things up.

That would have been a big concern with how much the whole transportation business was off, I guess.

I think the -- I think what -- the transportation is -- for us is largely driven by automotive -- smaller vehicles.

And so we're not seeing some kind of offset, and we should see -- and so we're expecting a further drop because I think our sensitivity is more on the automotive side.

Now I understand your question, sorry.

Go ahead.

Did you have another one?

No.

no.

That's it for me.

And the next question will be from Joel Tiss of BMO Capital Markets.

I wonder, can you give us any characterization or sense of where you're regaining your market share maybe a little bit easier and where it's much more of a battle to try to get back to where you were before?

Yes.

We're -- as you could tell, we're very focused on general engineering and aerospace.

And the company in the past, it seems to me, has been heavily focused on automotive, and that is a space that is full of very fine customers that have very strong supply chain management organizations.

And so it's an area that we feel like we are continuing to focus on, but our focus is more on having a great value proposition.

A lot of the custom engineering work we do are -- we're the only company that can do it, and we're getting -- we're now getting paid for that additional value.

But there are some parts of automotive that we're going to shift -- we're shifting our technical resources and now applying them to general engineering and aerospace, and that's something different than the company has done.

So we believe we're gaining share in general engineering and aerospace, and we're getting the type of business that we want in the automotive space.

Okay.

It makes a lot of sense.

And then the -- just a clarification.

So the free cash flow at $120 million to 100 -- free operating cash flow, sorry, at $120 million to $140 million, that's held back by roughly $90 million of restructuring and sort of transitory issues, is that right?

Damon, why don't you clarify that?

When you say $90 million of transitory issues, Joel...

Well, you mentioned -- somebody else was asking.

I can't remember who.

Maybe it was Ross who was asking about the free cash flow, and you -- and I'm trying to get -- by 2021, it sounded to me like the more normalized run rate would be something with a 2 in front of it, and I just wanted to be sure about that.

Yes.

I think -- so our current guidance for FY '19 would have had -- I mean, would have -- is based on the $120 million to $140 million guidance assumes the improvements in the fourth quarter along with the capital spending.

The question, I think, Ross was referring to is what is the FY '20 outlook pertaining to.

And we're not going to give guidance on FY '20 today, but what we were talking about is you do have an -- maintaining a higher level of CapEx related to modernization.

There may be further restructuring opportunities that we -- beyond this next phase that we've talked about today that, you may recall, -- may require some cash.

And then as we move through those in FY '20, we would expect to move more towards our goals of FY '21 that we've talked about coming through the fourth quarter of FY '20.

Okay.

Yes.

Because just like underneath it all is that for, whatever, 15 or 20 years, Kennametal was a company that had between 6% and 12% operating margins and roughly $125 million a year of free cash flow.

And now you have 18%, 19% operating margins and still $120 million to $140 million of free cash flow.

So I just kind of was wondering what the disconnect was.

And then I'm done.

Yes.

Well -- yes.

I mean right now, we're -- obviously, we have an increased -- a significant level of increased CapEx versus probably what we had in the past.

And as we've alluded to, Joel, there is some inventory levels that we've increased based on strategic decisions to improve fill rates as well as some of the temporary issues as we go through the product movement around the company here.

So again, I think there are some understandable reasons why the cash flow is a little bit lower given how you just calculated the percents, the earnings.

The next question will be from Steve Barger of KeyBanc Capital Markets.

Just a quick modeling question.

Historical Kennametal earnings cadence was really heavily back-half weighted.

This year, more 45-55.

As we think about moderating growth rate and timing of CapEx and benefit around modernization, would you expect a more balanced front half/back half next year or moving back to a heavier skew in the second half?

Yes.

I -- we're still working through the FY '20 plan.

But based on what I see, I would think it's going to follow something that's a little closer to what we've seen this year.

I don't know necessarily what was driving the historical numbers you were talking about, but I don't see it changing markedly from what we saw this year.

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

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

Thank you, operator, and thanks, everyone, for joining the call today.

We really appreciate your time and continued interest in our company, Kennametal.

I feel like it's an exciting time to be part of this company.

We've got a team here that's incredibly focused on transformation the -- transforming the company and making it something different than it ever was before.

If you have any questions, by all means, please reach out to Kelly.

She'll be happy to answer them for you.

Thank you.

Thank you, sir.

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