Kennametal Inc (KMT) 2019 Q4 法說會逐字稿

Good morning.

I would like to welcome everyone to Kennametal's Fourth Quarter Fiscal 2019 Earnings Conference Call.

(Operator Instructions) Please note 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.

Thank you, operator.

Welcome, everyone, and thank you for joining us to review Kennametal's fourth quarter and fiscal 2019 results as well as our fiscal 2020 outlook.

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 the call will be available for replay through September 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; Pete Dragich, President Industrial business segment; and Ron Port, President Infrastructure business segment.

After Chris and Damon's prepared remarks, we will open the line up 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 detailed in Kennametal's SEC filings.

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 Form 8-K on our website.

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

Thank you, Kelly.

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

We have a lot to cover today, so I'd like to begin with an overview of the agenda.

I will start with a review of the full year results, followed by an overview of the fourth quarter and an update on our end markets.

From there, Damon will review the Q4 financial results in more detail and the FY' 20 outlook.

Finally, I will discuss FY' 20 in the context of the financial targets outlined at our last Investor Day in December of 2017.

Starting on Slide 2 of the presentation deck, on a total year basis, the company reported organic sales growth of 3% on top of organic growth of 12% last year.

The organic growth was muted by FX of negative 3% this year, resulting in sales being basically flat year-over-year at $2.4 billion.

All segments reported positive organic growth for the year with Infrastructure at 5%, Widia at 3%, and Industrial at 2% on top of tough comparables last year of 15%, 9%, and 11%, respectively.

Also all regions were positive with the Americas leading at 5% and both EMEA and Asia-Pacific posting 2% growth.

We maintained our adjusted operating expenses at our target of 20%, adjusted EBITDA margin for the total year increased significantly by 180 basis points to 19.6% from 17.8% in the prior year.

This performance is driven by our simplification/modernization initiatives.

We are modernizing our factories, simplifying our product portfolio, which reduces complexity and allows us to redirect capacity to our most profitable products and pricing our products based on value to customers.

This year we also introduced new products like the HARVI Ultra 8X targeting aerospace customers and the KenTIP FS for general engineering.

These types of innovative products will continue to help drive growth in key end markets.

In fact our growth in general engineering and Aerospace more than offset the year-over-year decline in the challenged transportation end market.

Turning to Slide 3 for a comparison of the results to our expectations.

During our last earnings call, we had tightened our projected organic sales growth to around 5%, recognizing softening in some of our end markets, especially transportation, as well as the general uncertainty in the macro environment surrounding trade disputes.

We ended the year at an organic sales growth rate of 3%, below our projection due to greater than expected softening in transportation and energy within the quarter.

The weakness in both these end markets also began to influence general engineering.

Nonetheless, even with these volatile market conditions, we were able to improve adjusted EPS by 14% to $3.02, which was within our outlook range despite headwinds due to FX of $0.13 and increased tariffs.

This improvement in EPS was due primarily to simplification/modernization actions, which I will discuss further during the review of the segment results.

To put these numbers into context of our multiyear plan to improve the profitability of the company, please turn to Slide 4. This graph shows our sales and adjusted EBITDA from FY '16, which was the starting point for simplification/modernization to FY '19.

As you may recall, in FY '17, the company was mainly focused on reorganizing in the P&L reporting segments, reducing headcount to rightsize the company and starting growth in simplification/modernization initiatives.

These initiatives including reducing the number of coatings and powder formulations as well as instituting economic and minimum order quantities to improve operating efficiencies and designing new end-to-end manufacturing processes.

In FY '18, we continue to get traction on growth and simplification and started to recognize the benefits of modernization, including the automation of certain processes and plants such as the Rogers, Arkansas facility.

In FY '19, we continued our growth initiatives, including purposely redirecting the company's considerable product and engineering capabilities and success in transportation to the general engineering and aerospace end markets, and we prepared for significant facility rationalization.

Our results this year show simplification/modernization benefits increasing $0.40 over last year, well above the $0.09 achieved in FY '18.

Put this year's results in perspective, the last time the company had sales of around $2.4 billion was in FY '15.

And at that time, our adjusted EBITDA margin was only around 15% compared to approximately 20% we posted this year.

This is a testament to the structural costs we have taken out of the business as a result of the simplification/modernization work already accomplished.

Over the 4-year time period shown, adjusted EBITDA has increased at a 24% CAGR with sales growth of 6% CAGR.

This resulted in EPS growth over that same time period of 40% CAGR.

We are on a good trajectory and there is more to come.

Remember, at this point we've not yet experienced the full effect of the modernization of our plants or savings associated with the future plant closures announced in July.

We expect the benefits will continue to accelerate throughout FY '20 and FY '21.

Now let's look at the fourth quarter results for the total company on Slide 5, and talk about the current state of our end markets.

As I mentioned, in the fourth quarter, we saw continued softening in most of our end markets still led by a decline in transportation, but now also encompassing energy and general engineering.

Total company organic sales declined 2% on top of quarterly growth of 10% in the prior year quarter.

Like the previous 3 quarters, FX headwinds continued this quarter at 4%, and business days were also a headwind of 1%.

By segment, Infrastructure posted a positive organic growth rate of 1%, and Widia and Industrial posted negative organic growth rates of 3% and 4%, respectively.

In constant currency, all regions posted negative growth rates with the Americas at 2%, EMEA at 3% and Asia-Pacific at 4%.

This is the first quarter of negative year-over-year quarterly growth for the Americas and EMEA since the first half of fiscal year '17, with transportation, general engineering, and energy all softening.

Our adjusted operating expense margin for the quarter improved to 19.2%.

Going forward, we would expect this to be approximately 20%, in line with our target.

Despite the softening markets, I am pleased to say our quarterly adjusted EBITDA margin increased significantly to 21%, a 130 basis point increase versus 19.7% in the prior year.

Adjusted EPS for the quarter was $0.84 compared to $0.87 in the prior year quarter, a strong result given the FX and tariff headwinds, but also given the volume declines and the plant inefficiencies created as a result of the complex work currently underway preparing for plant closures.

Now let's take a look at the results by segment, beginning on Slide 6 with Industrial.

In the fourth quarter, Industrial organic sales declined by 4% versus growth of 11% in the prior year quarter.

FX and business days were headwinds of 4% and 1%, respectively.

Each region posted a decline in sales this quarter with the Americas at 1%, EMEA at 5%, and Asia-Pacific at 8%.

In terms of our end markets, aerospace was a bright spot for us again posting year-over-year growth of 12% on top of 14% in the fourth quarter last year.

This is the sixth consecutive quarter of double-digit growth for aerospace.

As you know, aerospace is the key area of focus for us, and we continue to see excellent results.

Looking forward, we'd expect the underlying end market in aerospace to remain strong.

Excluding aerospace, as I mentioned earlier, uncertainty in the macro environment is affecting most other end markets.

And in fourth quarter, we saw sales decline in general engineering, energy and transportation of 2%, 4% and 13%, respectively, with general engineering now being influenced by the weakness in transportation and energy.

Nevertheless, despite the slowdown in the majority of our end markets, we were able to increase Industrial's adjusted operating margin by 40 basis points to 18.3% from 17.9% in the prior year quarter.

This is the fourth consecutive quarter of adjusted operating margins in excess of 18% and reflects the continuing success of our simplification/modernization initiatives, partially offset by unfavorable volume-related absorption and plant inefficiencies as we prepare for the announced plant closures.

We continue to manage price to exceed raw material cost inflation as expected.

We also saw continued success with our focus on improving the availability of our high-volume, high-margin products, which grew 6% year-over-year this quarter.

A major step in our simplification/modernization plan was announced in July with the intended closures of 2 high cost plants and a distribution center in Germany.

While this is a very difficult time for our team, and particularly those affected, it is a necessary and critical step in achieving our stated goals.

Given this announcement, we expect plant inefficiencies will be heightened in the first half of fiscal year '20 and will begin to abate in the second half as certain plants close.

We will discuss this in more detail later when we review the outlook chart.

Turning to Slide 7 for Widia's results.

For the quarter, Widia posted negative 3% organic growth, headwinds of FX and business days were 3% and 2%, respectively.

Regionally, EMEA reported positive year-over-year growth at 3% and both the Americas and Asia-Pacific posted negative growth at 4% and 13%, respectively.

Adjusted operating margin in the quarter decreased by 150 basis points year-over-year to 1.8%, reflecting unfavorable buying and regional mix partially offset by price realization.

Looking at the regional results for Widia in more detail.

In EMEA the team has been successful capitalizing on opportunities in aerospace.

In the Americas, the negative growth rate reflects a weaker demand environment and continuing portfolio simplification.

At the same time, we continue to make progress strengthening our distribution network and selectively exiting portions of the portfolio.

And in Asia-Pacific, the sales decrease mainly reflects the steep decline in transportation.

This decline was felt both in China as expected, but also in India and was partially offset by success in new demand streams in aerospace.

On Slide 8 we summarize the fourth quarter results for our Infrastructure business.

Organic sales increased by 1% for the quarter on top of 9% growth in the prior year period.

Asia-Pacific and EMEA reported positive growth in the quarter at 7% and 5%, respectively, and the Americas reported a decline of 3%.

End markets in the quarter were mixed.

General engineering stayed strong at a 12% growth rate, reflecting success with new products in the Americas and EMEA.

Earthworks, which includes construction, trenching and mining, declined 4% in the quarter, and energy declined by 6%.

The underlying oil and gas end markets softened unexpectedly in the fourth quarter with the average U.S. land rig count decreasing 5% versus the third quarter and 5% versus the prior year period.

Adjusted operating margin increased 80 basis points year-over-year to 15.5% this quarter, and increased significantly sequentially from 11.7% in the third quarter.

Although this was short of our expectations, as a result of the unexpected increased weakness in oil and gas during the quarter, this was still the best adjusted operating margin performance in 7 years.

We announced our intention to close the Irwin plant in the U.S. with the majority of the product expected to move to the newly modernized Rogers facility.

Our ability to make this change is another example of the benefits of simplification/modernization.

Not only is the Rogers facility performing well post modernization, the increased productivity allows us to consolidate these products further leveraging our lower cost and highly automated facility.

In summary, the collective actions taken by the segments in FY '19 demonstrate the progress we are making to improve the profitability of the company.

And the good news is there are still more benefits to come as we continue to execute our multiyear improvement plan.

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

Thank you, Chris, and hello, everyone.

The full year EPS bridge can be found on Slide 9. As you can see on the graph, the main driver of the 14% increase in EPS was the positive benefit of our simplification/modernization program, which increased significantly year-over-year by $0.40 compared to the $0.09 last year.

The net effect of organic sales growth mix and fixed cost absorption in aggregate, labeled operations, amounted to $0.12 for the year.

Those positives were offset by unfavorable currency effect of $0.13.

Taxes amounted to $0.05 for the year.

Overall, the team executed well and our performance improved even with the macro headwinds that escalated throughout the year.

The summary table for the full year results can be found on the Slide 18 in the appendix.

The summary of the quarterly results is shown on Slide 10.

Given the challenges Chris mentioned, sales in the fourth quarter decreased 7% to $604 million with organic sales growth at a negative 2%.

Unfavorable currency exchange effects negatively affected sales by 4% and fewer business days amounted to negative 1%.

This quarter, our adjusted gross profit decreased 8% to $215 million from the prior year.

Adjusted gross profit margin decreased by 40 basis points year-over-year to 35.6%.

The main factors of this decline were unfavorable volume-related labor and fixed cost absorption in certain facilities, inefficiencies related to announced plant closures and unfavorable currency exchange effects, partially offset by the benefits of our simplification/modernization actions.

Adjusted operating expenses decreased by 10% to $116 million, and as a percentage of sales, improved 80 basis points to 19.2%.

As Chris mentioned, we expect adjusted operating expenses as a percentage of sales at approximately 20% over the longer term.

Adjusted operating income was $95 million or 15.8% of sales.

Although down $4 million year-on-year, margin improved by 40 basis points.

Adjusted EBITDA was relatively flat at $127 million, and in margin terms, increased significantly by 130 basis points to 21%, reflecting progress on simplification/modernization and other cost out actions.

Incremental pretax benefits from restructuring initiatives in the quarter were approximately $3 million.

We recorded pretax restructuring and related charges of $10 million or $0.11 per share.

The charges are net of a $5 million gain from the sale of the Madison Alabama manufacturing facility, which was previously closed as part of our simplification/modernization program.

Adjusted EPS for the quarter decreased slightly year-over-year by $0.03 to $0.84 in the fourth quarter.

Slide 11 shows the complete bridge of the factors affecting adjusted EPS this quarter versus the fourth quarter of the prior year.

Operations this quarter were negative $0.08 and were affected by the under absorption related to lower volumes as well as plant inefficiencies related to the announced plant closures.

Price increases continued to cover raw material cost increases, which is consistent with our past results and our expectations.

Benefits from simplification/modernization amounted to $0.10 this quarter over the same quarter last year.

And as Chris described earlier, benefits are expected to increase as we move further through the execution of our simplification/modernization plan.

Taxes were a slight tailwind for us this quarter at $0.01 and currency continued to be a headwind at $0.05.

The details by segment, region and end market are listed on Slide 17 in the appendix.

Slide 12 presents our balance sheet and cash flow highlights.

Primary working capital totaled $739 million as of June 30, an increase of $34 million from the prior period.

On a percentage of sales basis, primarily working capital increased to 180 basis points from June 30, 2018, to 31.4%.

This is slightly above our target of 30% and mainly due to an increase in inventory as sales fell short of our expectations in the fourth quarter due to softening end markets.

In addition, as we've discussed in previous earnings calls, there were a few factors that played this year regarding inventory.

First, we made the strategic decision to increase inventory on our high volume, high profit products to improve availability in support of our growth initiatives.

Also, while we were in the process of rationalizing the footprint, we expect the inventory to be slightly elevated reflecting increased safety stock to minimize customer disruptions.

Our expectation is that primary working capital will be approximately 30% in the coming year.

Capital expenditures increased to $66 million in the quarter, an increase from $65 million in the prior year quarter.

On a total year basis, capital expenditures were $212 million, which was within our outlook range, and an increase of $41 million over fiscal '18.

Fourth quarter free operating cash flow was $84 million, an increase of $18 million from $66 million in the prior year quarter.

Our expectation is that free operating cash flow will continue to remain positive through the entire modernization plan, which is a goal that we've been successful in achieving to date.

The cash balance at year-end was $182 million, and our net debt was $411 million.

We continue to be very well positioned with no contributions required to our overfunded U.S. pension plans, and no significant maturities until February 2022.

Dividends paid out were $16 million in Q4, and $66 million for the full year, consistent with last year.

The full balance sheet can be found on Slide 19 in the appendix.

Turning to Slide 13 for our FY '20 outlook.

As we think about the FY '20 outlook, on the surface, it looks similar to FY '19.

There are several components, however, that are quite different, which I would like to elaborate on.

With our end market softening throughout the fourth quarter and continuing uncertainty in the macro environment, we are projecting full year organic sales growth between negative 2% and positive 2%.

At this time, while we effectively expect flattish organic sales for the full year, it's important to understand our expectations for the pattern of sales through the year.

We expect the end-market weakness to persist through the first half of FY '20.

The market challenges in transportation and energy will likely remain and continue to impact the general engineering end market.

In addition, like last year at this time, the recent rapid decline in tungsten prices will affect the Infrastructure segment as certain customer contracts adjust relative to tungsten spot prices.

Currently, we expect organic sales growth to resume in the second half predicated on transportation, energy end markets returning to modest growth.

Our effective adjusted tax rate is expected to be in the range of 21% to 23%.

Adjusted earnings per share is expected to be in the range of $2.80 to $3.20.

Like sales, I think it's important to understand our expectations on the cadence of earnings and the primary drivers.

Fiscal 2020 is a year of significant transition related to simplification/modernization.

As such, we expect a heavier weighting of our earnings in the second half.

It's our expectation that earnings would be around 1/3 in the first half and 2/3 in the second half versus our more traditional pattern of around 45-55.

This shift is driven by several items adversely affecting the first half of fiscal 2020.

First, as I mentioned a moment ago, we are expecting continued market weakness in the first half of the fiscal year and a recovery in the second half.

Given this lower level of market activity, we expect to drive inventory down commensurate with demand resulting in lower utilization in certain facilities.

Second, given the lag time of our inventory versus market spot prices for tungsten, we will need to work through our higher cost inventory during the first half of the year assuming no further price declines.

Third, there will be a significant amount of activity related to our simplification and modernization efforts, which will change the run rate of earnings between first quarter and the fourth quarter.

In that regard, first half costs will continue to be burdened by inefficiencies at facilities we intend to rationalize.

Many of these costs will start to abate in the second half of fiscal 2020.

We expect simplification and modernization savings in FY '20 to be modestly higher than FY '19.

However, based on the projected timing of these actions, the savings will be back end loaded as many are tied to plant closure actions.

While we will not see the full savings from these actions in FY '20, they will set us up well for increased profitability in FY '21.

Even with simplification and modernization being modestly higher year-over-year, the net effect on earnings is offset by increased transition expenses.

As a result, we expect earnings to be relatively flat in FY '20.

For example, as we move forward with simplification and modernization, we will incur transitional expenses for things like equipment moves and tooling related to the ramp-up of new equipment.

So as I said, on the surface, FY '20 looks similar to FY '19, but based on the significant structural cost we are starting to remove during this transition year, we expect to be well positioned for increased profitability in FY '21 and beyond.

Moving on to free operating cash flow chart we expect free operating cash flow to be in the range of $75 million to $100 million given our projected level of capital expenditures, cash payments related to our announced restructuring actions and primary working capital improvements.

Capital spending is currently forecast to be in the range of $240 million to $260 million.

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

Thank you, Damon.

Turning to Slide 14, let me take a few minutes to provide perspective on the FY '20 outlook in the context of the multiyear improvement plan we outlined at the December 2017 Investor Day.

The current market environment is quite different from the positive end-market environment we were experiencing at that time.

And these softer end markets obviously changed the trajectory of revenue growth from what we originally projected.

For the FY '20 sales outlook now essentially flat from FY '19, this shift in revenue and timing is illustrated on the right-hand chart.

Based on this change, and coupled with the uncertainty inherent in the current macroeconomic environment, it is challenging to predict when market conditions will improve, such that sales will reach the targeted range of $2.5 billion to $2.6 billion.

Instead, I'd like to discuss the things we can control, namely executing the simplification/modernization initiatives, they are in large part of improving profitability and removing structural costs to continue to lower the breakeven point of the company.

The good news is that we are on track with our initiatives such that with sales in the target range, we believe we will be within the range of our original adjusted EBITDA targets.

As you know, we cannot control the macro environment, so we remain highly focused on executing the things we can control such as our cost out and growth initiatives.

This approach has served us well since the start of our multiyear improvement plan in FY '16.

We've made considerable progress with adjusted EBITDA margins improving from 12% of sales in FY '16 to approximate 20% of sales in FY '19.

And I have every confidence in the Kennametal team members to well execute the balance of our improvement plan.

So to summarize on Slide 15, I'm encouraged by the strong results for the year and the progress we continue to make on our growth and margin expansion initiatives.

We posted strong fiscal year '19 results, increasing our adjusted EBITDA margin to around 20% even with the slowdown in the fourth quarter and the continuing headwinds of FX and tariffs.

I see fiscal year '20 as a transition year as we execute some of our most complex simplification/modernization projects.

I'm pleased to see the team working hard to execute this critical phase of our plan.

We're actively managing the business through this period of volatility, and are focused on delivering our plan so that we will be well positioned to achieve our adjusted EBITDA goals when the markets return.

The difference from where we began our journey to where we are now is impressive.

We have a more simplified and profitable product portfolio.

We have significantly improved the daily operation and management of the business.

And we've lowered the breakeven point of the company with more improvement opportunity to come as we continue to execute on simplification/modernization.

With that, operator, let's open the line for questions.

(Operator Instructions) Our first question comes from Julian Mitchell of Barclays.

Maybe just the first question.

Looking at your adjusted EPS bridge for fiscal '19 on Slide 9, maybe just talk through those main sort of 4 or 5 moving parts for fiscal '20, what's embedded in that overall flattish EPS trajectory?

Which slide you're looking at, Julian?

Slide 9. So you have those 5 pieces of EPS accretion or dilution year-on-year from fiscal '18 to '19.

So I'm just trying to understand, as you look fiscal '19 to fiscal '20, how we should you think about each of those pieces?

For example, simplification/modernization, it sounds like it is maybe $0.05, $0.10 of increase in '20, FX, presumably there's another small headwind just looking at the spot rates.

Any color you could provide, as I said, on those 5 pieces?

Yes.

I think you -- first of all your summary of the first 2 is right.

We said on simplification/modernization that we expect that to be modestly higher.

And then I think you're accurate on the FX comment.

The key here is on the operations side, while I'm not going to give you the exact EPS sense, but that is where in the first half we're going to be experiencing some headwinds.

Julian, as you know, we're making some considerable changes here in terms of our footprint and closing plants of significance.

And as you do that, there's a little disruption.

So that operations piece is where you're going to see that inefficiency captured in the overall earnings bridge.

And so as we exit the year, in terms of FY '20, the simplification/modernization savings that we -- the run rate towards the tail end of the year is going to be higher than the beginning of the year, but we're not going to quite experience the full year benefit of those until FY '21 because they are back end loaded.

So you've got a headwind on the operations side due to these inefficiencies of moving plants and products around, and then we're setting ourselves really up for FY '21, which is why we are characterizing FY '20 as a transition year.

Okay.

And then maybe my second question around just organic sales trends.

So you just had a 2% decline in the quarter on organic sales, maybe help us understand how much of a decline in the first half of fiscal '20 you're expecting?

And tied to that, how has demand trended, I guess, in the last couple of months in particular?

Yes.

Normally we would have a sales split of around 48%, 52%.

And yes, I think we'll be reasonably close to that, but it will be -- tend to be a little more back end loaded than what you -- than you -- what you might see.

As we said, we saw softening in the fourth quarter, and we expect that to continue through certainly sequentially from Q4 to Q1 we expect most markets to be softening with the exception of aerospace.

And that's kind of across the board in all regions.

A little more softening in Q2, and then we're assuming that we'll have a pickup towards the back and second half of the year.

Now in a macro environment, it's got uncertainty, it's difficult to predict exactly what's going to happen, but we do use third parties to give us at least their best guess of what's going to happen to overall industrial production and things like light vehicle production, and based on those sort of forecasts and then conversations we have with our customers, gives us the basis for our recovery that we're starting to see in the second half of FY '20.

Our next question comes from Ann Duignan of JPMorgan.

If you could just step back there again to the outlook.

Are you forecasting at this point that your end markets will actually recover in the back half versus the -- at the end of the first half run rate?

And if you're forecasting a recovery, how much visibility do you have into any kind of recovery, especially in oil and gas given well completions, given CapEx by your customers, given the rig counts, given everything that's going on the oil and gas space?

Yes.

I would say in oil and gas, what we're talking about is we think sort of sequentially Q4 to the first half is going to be sort of flat, okay?

And then when we talk about a recovery, we're thinking it'll be only about -- to about 50% of the strength we saw in the first half of FY '19.

So not a full recovery on the energy side again.

And more broadly, please?

Sure.

If we're talking about -- on the metal cutting, if we look at the Americas, again, we see some weakening in the first half, but the second half we expect that to recover to about the Q4 FY '19 levels.

In terms of EMEA, transportation, that's going to continue to weaken from the first half.

And we think that it would probably just get back to the Q4 FY '19 levels by the end of the year, and recognize those Q4 FY '19 levels are already significantly down from the peak that we saw at the start of FY '19 and FY '18.

China is -- that's -- we're expecting that there'll be some recovery, that market has been down for at least -- if you go through the first half of next year, have been down significantly over the last 5 quarters prior to that.

And we are starting to see some indication in the month of June that sales for automobiles has also picked up.

And on that basis, some of the recovery we see in the forecast on vehicle production is it will tail up at the end of the year.

But it's not going to recover to the levels that it was at that we saw, for example, the start of FY '19.

Anything else you'd like to give me some color on or...

No.

If I could ask a follow-up on the cost side.

Could you expand a little bit on what's going on with the tungsten costs?

Is that just you had inflation clauses and now they've become deflation clauses?

Yes.

Some of the contracts that are inside the Infrastructure business are indexed to the APT prices, and so as those prices come down we're required to pass on a commensurate price reduction.

So Ann, I think you would've saw this similar to last year when APT prices declined rapidly as well.

We're still working through the inventory we had at the higher cost.

And what we've said is, generally, there is a 3- to 6-month lag as the time we work through our inventory.

So in addition to those oil and gas customers that Chris mentioned, we also do sell powder to third parties, and that powder that we sell is based off of the current market price.

So again, we have higher cost inventory, but the market price is going to require us to reduce the price there.

So we're going to deal with the contraction in margin for the first half with APT currently where it is.

Our next question comes from Joe Ritchie of Goldman Sachs.

Maybe following on that comment around tungsten.

What are you embedding in the first half of your guide for the impact of tungsten on Infrastructure margins?

Yes.

The -- we have the lower APT price in our forecast.

The dynamic in the first half is that we carry raw material inventory that was bought at a higher price level.

And so that inventory needs to work through our system through the fourth quarter -- or excuse me, through the first quarter and part way into the second quarter.

And that'll put a drag on margins, even though the new price that we're paying for APT would be at the lower price.

So you'll see that phenomena reverse when you -- when we get to the second half of the year.

Okay.

And I guess the way to think about it then for Infrastructure is that we can try to quantify, I guess, what the number is on our own.

But like, I guess, the way to think about margins then in the first half of the year is that there'll be a drag here, some volume deleverage, and so on a year-over-year basis you should see negative margins year-over-year, the declining margins?

Yes.

So Joe, you're going to see that the revenue come down as we mentioned for both the powder and oil and gas and the material cost is not going to go down commensurate with the current spot prices of tungsten.

So you're going to see that margin contraction in the first half and likely will be down year-over-year.

Given we're...

Got it.

And then maybe just one last one on margins, if I think about Industrial and Infrastructure, your 2 largest segments, how are you guys thinking about, sort of full year, whether you're able to expand the margins in either segments this year just given the dynamics as a guide?

Yes.

I think for Infrastructure, Joe, I think it will be a challenge given the first half of the year.

I think if you look at the second half in isolation, you're going to see continued improvement as a result of the modernization and simplification efforts and some of the cost out related to the plant closures that we've already announced.

But again, for the full year, I guess, I don't want to give you any sort of reflection of how well it's going to -- how much it's going to be able to pass through the system with material cost.

And I think on the Industrial side, as Chris talked about, we are going through a fair amount of simplification/modernization efforts with a lot of churn inside the factories in the first half of the year.

The second half run rate will be significantly different as we go through the plant closures and execute on these restructuring actions that we've been talking about really driving the improvements more to that third quarter and even more importantly in that fourth quarter as we exit FY '20.

Our next question comes from Michael Feniger of Bank of America.

I believe on average like earnings just seasonally declined from the fourth quarter to the first quarter around 35% or so.

Do you think for fiscal year 2020, could you just help us like what type of seasonal decline -- is it going to be much greater than you guys typically see?

Just trying to get a gauge of even the Q1 and Q2, how that splits up.

Yes.

I think the way to think about is, we're going to see a normal seasonal decline, but it's going to be -- it's going to actually be worse than that for the reasons that we've talked about.

On the Infrastructure side, you've got this higher APT cost that you got to work your way through.

Plus you have prices coming down ahead of that on some of that volume.

And then on Industrial and Widia, again, we've got -- because this is a transition year, we've got -- sort of the way to think about this is we've got a lot of upfront expenses and investments to effect the next level of change associated with modernization.

And those are going to be significant in the first half.

And then as we start to close plants, they start to abate in the second half so the margins should start to improve.

So normal seasonality, but then you've got to factor in that we've got these other headwinds that we mentioned that I call them sort of transitional cost to effect the change in modernization, they eventually go away, but we are going to see them in the first half versus the second half.

Yes.

And Michael just putting in a little bit more context.

As we said on the call, generally, our earnings is -- are 45-55, and if you look at that, the first quarter, it's usually lower than the second quarter, and what we're telling you for this year, we expect about 1/3, 2/3 in the first half versus the second half.

But again, I would expect the same first quarter lower, getting a little bit higher in the second quarter and then moving into the back half.

Okay.

And then you guys mentioned your inventories a little elevated.

How about just with your customer base?

Have you seen any changes there with your customers on the inventory levels, particularly in the Industrial segment?

Yes.

We saw some destocking this quarter really in all regions across the -- what I would call the metal cutting businesses, which is Industrial and Widia.

And we're expecting that will likely continue for the next few quarters.

So we have saw -- we have seen some destocking.

And lastly, just help us understand, I think on the flat organic growth outlook, how much is -- are you thinking pricing -- are you embedding pricing in there versus volume?

Yes.

I'm not going to comment exactly on the pricing that we're contemplating, but I would say that this is -- given the uncertainty environment, we do price based on the value proposition we have but you also have to recognize that there is less demand, there is -- that can put pressure on pricing.

But right now we don't see that we're going to have relinquish any pricing other than the stuff that's indexed APT.

But we're also not thinking that this is an environment that we're going into where we can be aggressive on pricing.

So we've kind of got it, I would just say, we're sort of flat on the pricing equation as it looks -- as it relates to our outlook with the exception of the changes that we've contemplated in Infrastructure due to the APT index.

Our next question comes from Walter Liptak of Seaport Global.

Want to do a follow on with the inventory question.

In the past when things slowed down, there was -- the customers went through inventory correction.

It wasn't just your distributors, but it was also like your distributor's customers cut inventories and so it got exacerbated.

And I wonder if you -- as your business started slowing, how deeply did you look into kind of the inventory levels and your customers and your customer's customers.

And how much is factored into that slowing in the first half?

Yes.

I mean the good news is that we have a strategic relationships with our distributors.

So not only do we have insight into what the distributors are doing but also into their end customers.

So as I said there is -- I think we got a pretty good idea that part of what's driving the lower volumes in the first half is that people are working down their inventory.

On the oil and gas side on Infrastructure, you can have a more detailed conversation with those companies in terms of their capital spend and those type of things.

And there's no question that they -- during the last oil and gas downturn, they learned that they really need to pay attention to managing their cash flow.

So they told us that in the first half they're going to -- they're definitely trying to take down some of their inventory and manage that process.

And as I said, they're also the same customer that said that probably you will start to see a pickup in the second half of our calendar year.

And the way it actually happens, my experience is that when the pickup happens, it's actually pretty rapid.

They -- you see it like sort of spike in orders and then it kind of levels off.

That would be true also on the -- on recoveries in the metal cutting space for Industrial and Widia.

Okay.

Great.

And if I could ask also on the simplification and modernization.

It was helpful to see that $0.40 number and the nice pickup in fiscal year '19 versus '18.

What's your assumption for simplification and modernization benefits before you have these offsets from the plant inefficiencies and tungsten prices and things like that?

What's the expectation that a year from now the net-net on simplification will look like?

Yes.

I think, as we said, in FY '19 we had a nice pickup from FY '18, it went from $0.09 to I think $0.40 EPS driven by modernization and simplification.

And as Damon said, we expect that $0.40 will be modestly higher in FY '21 -- or excuse me, FY '20, but it's going to be important to realize that the actual run rate that will lead the year is greater than that because a lot of that full year run rate benefits won't be seen until FY '21.

The other thing to keep in mind is that there is still more plant rationalization actions that are under consideration, which we have not announced for obvious reasons.

That are part of the overall simplification and modernization plan.

And then the other thing to think about is that we continue to ramp up more and more modernized processes, which increases the benefits.

So what you're going to see in FY '20, well, that may be a moderate increase or a modest increase over FY '19, you'll see a step-up in benefits in FY '21 for the reasons that we said.

So that's why we look at the numbers and how we've laid the plan out, we're confident that we're going to be able to achieve those structural cost savings to hit our EBITDA profitability targets that we laid out back in December of 2017

Okay.

And just a follow on to the inefficiencies.

Did something happen after you announced the restructurings of those German plants?

Or was that always part of the plan that there'd be some inefficiencies?

Because I thought you were setting things up with extra inventory and moving machines prior to making the announcement.

Yes.

We're already setting up extra inventory and that's largely to make sure that we don't disrupt our customers.

But if you think about these plants, we're not just closing the plant and exiting parts of the business, we're trying to do quite the opposite.

We're trying to close the plants and not lose any business.

And so that necessitates literally in any point in time during this transition, we could have the same capability in a couple of plants that are going to take over the load of the one plant that we are exiting plus we still have the capability of the one plant that we're exiting.

So in both places, you have sort of this underutilization situation.

Then you also have things like expenses, they're are not capitalized like the tooling associated with the new equipment.

There's equipment moves and there is commissioning expenses with suppliers and all those types of things.

So during this transition period there is necessarily some, what we're calling, inefficiencies that are cost -- they were expected.

And when we did our -- when we generated our return on investment of the $300 million that we're spending on simplification/modernization, we factored that all that in.

And it's just part of the process that we have to go through, and that's why, again, we're calling FY '20 the sort of the transition year.

Our next question comes from Andy Casey of Wells Fargo.

On the fiscal 2020 guidance, it implies back half rough cut about 24% earnings growth.

Again, rough cut $0.40 increased compared to this year's second half, I mean, fiscal '19.

I'm trying to understand the drivers of that?

If I assume taking somebody else's numbers from earlier $0.05 to $0.10 of modernization/simplification benefit that implies roughly $0.30 to $0.35 by other sources.

If that's about right, how reliant is the expected second half growth on the end market?

Or will these first half things that you got to work through like the tungsten reprice and inventory reduction, will that drive above market growth for the company in the second half?

Yes.

The tungsten -- well, there is a couple of things going on.

There is the growth side of the equation.

And we have given you our assumptions on sort of this recovery, and then we also are continuing to execute our growth initiatives where we are expecting to continue pickup share in aerospace and even general engineering while it's softening.

We actually are doing a much better job of penetrating that space and we'll continue to do so.

I remember one of the investments we made last year was in the high profitability and high-volume moving inventory, and those components are consumed in the general engineering space.

And that's really helped us to pick up share.

So we're expecting to do that even in the face of maybe some softening markets in the first half.

In terms of the margin expansion, you're absolutely right, once the APT prices clear out due to the higher material cost, that's going to significantly give us a pop in the second half in terms of margins, especially on the Infrastructure side.

Damon, would you like to add something?

Yes.

I think, Andy, just to make sure to clarify on the simplification/modernization savings, if you look at what we saved this year, it was $0.40 and it was somewhat spread evenly over the 4 quarters.

And what we've said is, so the bridge for FY '20 is actually going to show something north of 40% -- or $0.40, excuse me, of incremental savings.

So we said modest increase.

So I think somewhat through the -- I think earlier said $0.45 to $0.50.

What you would see is that $0.45 to $0.50 using that example would be much more in the second half because as Chris and I alluded to, we're going through the inefficiencies in the first half whilst the plant closures are starting, and once we actually shutter facilities, we'll then start to pick up significant savings.

So that second half bridge is going to show a significant step-up in simplification and modernization versus this year or the FY '19 second half, which was about $0.21.

That helps a lot.

Then the second question is a little bit longer term.

You talked about the potential push out of the 2021 targets?

If volumes really don't come back, is there any way that you can accelerate structural cost removal to offset that potential lower than expected revenue generation?

Or do you think incremental cost reduction above what you alluded to, some actions that you're not going to announce today, would that potentially affect your future organic growth?

Well, first of all, let's just talk about the speed of what -- which we can move.

We said we're trying to repair the airplane while we fly it.

So theoretically, with a little less volume running through the system makes it a little bit easier.

But Andrew, frankly, the things that are driving a large chunk of the savings over the next couple of years are these plant closures and they are complex things to do.

And so for example, if you're going to shut a plant down that's making a 1,000 different components, you still have to move all 1,000 components to the new plant even though you might be making less of them.

So it's a little harder to go faster, but we're always challenging ourselves to do exactly that.

As volumes come down, we're going to continue to look for opportunities to make the appropriate adjustment like we would with any business.

So we feel like we can take the cost out of the system that we said we would in FY '21 so that when volumes do return, we are going to be able to fully leverage that capability and hit the profitability targets that we set.

If volumes stay down for a protracted period of time or whether volumes go up to allow us to get to the $2.5 billion to $2.6 billion, we're always going to -- as a company, we're always going to look for what's the next thing that we can do beyond this initial $300 million investment.

And that could equal even more footprint rationalizations and those type of things.

So we're going to do all of the things that a normal business would do beyond that.

And frankly, we've learned a lot about modernization and what we're capable of doing and how we can change our operating footprint that I look forward to, sort of, what we're going to do as an encore regardless of what the volumes do and the macro environment, which -- as you know, we can't control.

Our next question comes from Joel Tiss of BMO.

I just wondered, can you give us any sense of how far along you are in shifting the company away from the lower margin and slower growth end markets.

Yes.

We initiated that process, I would say, at the sort of the tail end of FY '18.

We've made really good progress through FY '19.

But as we talked about in some of the Widia results or -- and even Industrial, we still are looking for ways to simplify the portfolio and extract ourselves from that sort of lower profit business.

So I would say that it's -- the majority of it's kind of complete through FY '19.

We're sort of set the stage for the higher-margin products running through in FY '20.

But there's still a little bit more to do in FY '20.

And is there any way underneath all of this -- there's a lot of change going on and certainly structural.

Is there any way to tell sort of the customer support and the underlying market share gain that you guys are getting just like a little more qualitative sense of how much support you're getting from your customers?

Yes.

I think qualitatively, we're -- as we talked about, we -- a lot of this work where it wasn't very profitable was in the transportation space.

And so frankly in that space, we work with our customers to say this is the stuff we don't want to make any more for you.

We can continue if we can charge this price, and if not, we're happy to transition to work with someone else.

So in automotive we've actually exited some parts of that business.

But there's other parts that we do quite well that we're going to actually continue to grow.

On the aerospace side, that's an area of focus for us.

And we have a pretty good share.

But there's a lot more opportunity there.

We're clearly going there and our growth rates, in my mind, are faster than what we think the underlying market is doing.

And I said, in general engineering the company has focused in that area but never to the extent that we have today where we're bringing sort of the technology that we brought to the transportation industry, and we're now focusing on general engineering and bringing that same capability.

So I feel like we're picking up market share there.

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

Earlier this reporting season, we heard some distributors talk about pushing back on price increases if they felt they weren't justified and also wanting to see vendor invest more in sales programs.

Have you seen more contentious conversations with distributors about either price or support levels you provide?

I would say that not anything out of the ordinary.

No customers likes to have a price increase.

But the other thing I would say too is that many of our distributors are actually were not exclusive to Kennametal, and it seems to me in the conversations we've had, we've had to admit that our competitors have done similar price [increases].

So we feel like we've got the right balance there.

There was another part to your question, I'm sorry I don't remember what it was.

It was either price or support levels that you provide?

Yes.

So on the support level because we have this concept of being a strategic partner with them.

There are agreements where you do want to do joint marketing and try to grow.

And to the extent that the distributors are asking for more in that area, we usually tie that to some kind of a growth clause, that if we make the investment and it's going to yield more growth, we're happy to make the investment, but we kind of do that together.

So again, it's not -- it doesn't seem contentious to me.

It's -- these are very open conversations, and it's more of an approach where, look, we've got to ultimately have the right pricing, we've got to have the right support, the right marketing information, and if we do that together in a collaborative way, it's going to drive growth for both of us.

So that's the approach.

Okay.

And then you addressed some of this in Joel's question, but any change in how you're addressing the direct sales strategy given softer demand levels, any other opportunities in the market that you feel like that you have the time to go after now?

Yes.

We do have the direct sales force to the extent that there is softening in different end markets, we're going to continue to shift those resources to areas where we can grow like aerospace and even general engineering, while it's covered -- small customers are covered with largely through distribution, there is a direct sales portion of sales support, support function of that.

And so we will sort of redeploy those resources in those areas.

And also frankly, we're always looking to improve the productivity of our sales investment, and we're going to continue to do that, not just drive productivity in our factories, but drive productivity in our sales expense.

This concludes our question-and-answer session.

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

Thank you, operator, and thank you, everyone, for joining us on the call today.

We certainly appreciate your interest and support.

And please, by all means, reach out to Kelly, if you have any follow-up questions.

Thank you very much.

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