Kennametal Inc (KMT) 2022 Q2 法說會逐字稿

Good morning. I would like to welcome everyone to Kennametal Second Quarter Fiscal 2022 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.

Thank you, operator. Welcome, everyone, and thank you for joining us to review Kennametal's second quarter fiscal 2022 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.

I'm Kelly Boyer, Vice President of Investor Relations. Joining me on the call today are Chris Rossi, President and Chief Executive Officer; and Damon Audia, Vice President and Chief Financial Officer. After Chris's 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 and, as such, 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 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 turn the call over to Chris.

Thanks, Kelly. Good morning, everyone, and thanks for joining us. For today's call, I'm going to start with some general comments on our continuing strong results and highlight some recent strategic wins, followed by comments on our expectations for Q3 and the full year. Damon will then go over the Q2 financial results and outlook in more detail. And finally, I'll make some summary comments before opening the call for questions.

Beginning on Slide 2 of the presentation. We posted strong results again this quarter by executing our commercial and operational excellence initiatives. Underlying demand continue to improve in all our end markets this quarter, with the exception of transportation. Our sales performance was within the range of our expectations as discussed on our last quarterly call, increasing 11% organically year-over-year and in line with our normal sequential seasonal trend despite challenges in transportation and China.

By end market, the strongest year-over-year performance was in Aerospace and Energy, both at 24% growth, followed by General Engineering at 14%. Transportation decreased by 10% year-over-year, which was worse than we expected. While we believe underlying demand remains strong in Transportation, supply chain availability is still an issue due mainly to chip shortages. And it's our expectation that chip shortages will likely continue through the balance of our fiscal year.

On a regional basis, we saw year-over-year growth in all our regions, led by the Americas at 16% and EMEA at 9%. Asia Pacific also grew but at a slower pace of 3%, reflecting weakness in China, mainly in transportation and energy related to wind turbines. The rest of Asia Pacific performed well during the quarter.

Despite these isolated end market and regional challenges, our commercial and operational excellence programs drove strong operating leverage once again this quarter. Adjusted EBITDA margin improved by 320 basis points year-over-year to 16.2%. Operating expense as a percentage of sales was effectively flat, as compared to the prior year, at 22%. Our target for operating expense remains at 20%.

Adjusted EPS improved significantly to $0.35 compared to $0.16 in the prior year quarter. And free operating cash flow was $22 million. We also bought back $23 million of shares this quarter, up from $13 million in the previous quarter, reflecting the confidence we have in our growth and margin improvement initiatives and free cash flow generation.

Looking ahead, we believe market demand is strong in all end markets. However, in transportation, while the underlying demand for vehicles remains strong, the majority of our customers' production continues to be affected to varying degrees by supply chain bottlenecks. And we believe this effect is likely to continue for the balance of our fiscal year.

Nevertheless, overall we expect Q3 sales to be up 3% to 7% year-over-year, which is above our normal sequential growth pattern of 3% to 4% and highlights the relative strength of our end markets outside of transportation. Inflation, supply chain bottlenecks and other uncertainties present some challenges to our own operations but, we believe, to a far lesser extent than some of our customers and other manufacturers.

In that regard, we benefit from our in-region, for-region local supply chain setup. In addition, our proactive pricing approach continues to dampen the effect of inflationary pressures. For example, we saw approximately a $12 million increase year-over-year in material costs but still maintained positive price versus raw in the quarter, which Damon will provide more details on later.

As always, we are focused on what we can control. And despite the market uncertainties, we remain confident in our ability to drive strong underlying operating leverage for the full year.

Now let's turn to Slide 3 for an update on our commercial excellence initiatives aimed at gaining share. Some of our recent wins are shown on this slide, underscoring that our initiatives are continuing to deliver results by leveraging our application engineering expertise, product innovations and improved customer service. We posted another major win with a large auto manufacturer in the EV space, further strengthening our leadership position.

We also saw excellent performance with an Aerospace supplier leveraging our product innovations and technical support to convert customers to Kennametal solutions. We continued to see share gain in the renewable space in wind energy due to our innovative products focused on increasing customer productivity.

And finally, in Infrastructure, we posted a large win in process industries. Our proprietary pelletizing die design and manufacturing technique beat the competition in supporting the customer's large expansion project. Those are just a few examples of how our product innovations and commercial excellence initiatives are driving share gain. Together with our operational excellence initiatives, we are confident we will continue to drive growth, strong operating leverage and improved margins.

And with that, I'll turn the call over to Damon, who will review the second quarter financial performance in more detail.

Thank you, Chris. And good morning, everyone.

I will begin on Slide 4 with a review of Q2 operating results on both a reported and adjusted basis.

As Chris mentioned, we continue to leverage our modernized footprint to drive strong results this quarter. Sales increased by 10% year-over-year and 11% on an organic basis, with business days contributing negative 1%. On a sequential basis, sales increased by 1%, in line with the normal Q1-to-Q2 trend despite more challenging conditions in transportation in China. Adjusted gross profit margin increased 360 basis points year-over-year to 31.8%. On a sequential basis, adjusted gross profit margin decreased 170 basis points, as expected, mainly due to higher raw material costs flowing into the P&L and the timing of merit increases.

Adjusted operating expense as a percent of sales was relatively flat at 22% compared to the prior year. Adjusted EBITDA and operating margins were up significantly by 320 and 390 basis points, respectively. The strong year-over-year margin performance was due to higher volume and associated absorption, price more than offsetting raw material increases; mix; as well as strong manufacturing performance, including some remaining simplification, modernization carryover benefits. These factors were partially offset by the removal of $10 million of temporary cost control actions taken in the prior year.

The adjusted effective tax rate in the quarter increased from 24.7% to 26.5% year-over-year. We reported GAAP earnings per share of $0.37 versus $0.23 in the prior year period. On an adjusted basis, EPS was $0.35 versus $0.16 in the prior year. The main drivers for our improved adjusted EPS performance are highlighted on the bridge on Slide 5.

The effect of operations this quarter were $0.18, including approximately $0.04 of simplification/modernization carryover benefits and a negative effect of approximately $0.09 from $10 million in temporary cost control actions taken last year. Factors contributing to the substantial improvement in EPS year-over-year are the same as the drivers of our strong margin performance this quarter that I just reviewed. Taxes affected the quarterly EPS year-over-year by negative $0.01. And there was no effect due to currency this quarter.

Slides 6 and 7 detail the performance of our segments this quarter. Metal Cutting sales in the second quarter increased 7% organically year-over-year versus a 14% decline in the prior year period. There was no effect due to currency. And business days amounted to negative 1%. Regionally, the Americas led with year-over-year sales growth of 11%, followed by EMEA at 8%. Asia Pacific posted a decline of 4%. This decline was concentrated in China due mainly to the effect of chip shortages and transportation and, to a lesser degree, reduced sales in renewable energy, reflecting the elimination of government incentives in wind energy last year.

Year-over-year, all end markets, excluding Transportation, posted gains this quarter, with Aerospace leading at 24%, General Engineering at 13% and Energy at 7%. Transportation declined by 10% year-over-year. As Chris mentioned, transportation was down more than expected due to continuing chip shortages and other supply chain challenges affecting our customers. We continue to believe underlying transportation demand remains strong, and as such, we expect that a recovery will follow the resolution of the chip shortage. Sequentially, Aerospace posted a 6% increase, General Engineering a 2% increase and Energy a 3%. Transportation was a 6% sequential decline.

Adjusted operating margin increased 270 basis points to 8.8%. The increase was driven by higher volume and associated absorption; favorable pricing versus raw material increases; and manufacturing performance, including benefits from simplification/modernization carryover; and mix, partially offset by temporary cost control actions taken in the prior year.

Our growth initiatives remain on track, including fit-for-purpose, with sequential increases outperforming General Engineering again this quarter. We are continuing our pricing actions to cover inflationary pressures in the current environment. Operational excellence is also on track as we continue to drive productivity and leverage our modernized facilities.

Turning to Slide 7 for Infrastructure. Organic sales increased by 18% year-over-year versus a decline of 14% in the prior year period. There was no effect due to business days and a foreign currency benefit of 1%. All regions were positive year-over-year, with Americas leading at 22%, EMEA at 15% and Asia Pacific at 14%. As in Q1, the strength in the Americas was driven mainly by improvement in the U.S. oil and gas market, as seen in the continued increase in the U.S. land-only rig count. By end market, energy was up 33% year-over-year. General Engineering was up 17%, and Earthworks was up 11%. All end markets were up sequentially.

Adjusted operating margins improved by 570 basis points year-over-year to 10.1%. This increase was driven by higher volume and associated absorption, mix and manufacturing performance, partially offset by temporary cost control actions taken last year. Price over raw material increases were effectively neutral this quarter, as expected, as material costs increased on a sequential basis.

As in the case of Metal Cutting, we remain on track with our commercial and operational excellence initiatives.

Now turning to Slide 8 to review our balance sheet and free operating cash flow. We continue to maintain a strong liquidity position, healthy balance sheet and debt maturity profile. At quarter end, we had combined cash and revolver availability of $793 million, and we're well within our financial covenants. Primary working capital decreased year-over-year to $620 million but increased by $12 million on a sequential basis due mainly to an increase in inventory. On a percentage-of-sales basis, primary working capital was 31.3%, a significant decrease on a year-over-year basis and an 80 basis point improvement sequentially.

Net capital expenditures were $20 million, a decrease of approximately $9 million from the prior year. We now expect fiscal year '22 capital expenditures to be in the range of $110 million to $120 million. Our second quarter free operating cash flow was $22 million versus $29 million in the prior year quarter, reflecting strong sales and operating performance this quarter, offset by an increase in working capital. We also paid the dividend of $17 million in the quarter. And finally, as Chris noted, we repurchased $23 million of shares during the quarter under our previously announced repurchase program and, since inception of the program, are at $35 million in total shares purchased. The full balance sheet can be found on Slide 14 in the appendix.

Now let's turn to Slide 9 to review the Q3 outlook. We expect sales to be up approximately 3% to 7% year-over-year and in the range of $500 million to $520 million. The sales range also implies sequential growth of 3% to 7% versus our normal seasonal trend of around 3% to 4%. This outlook reflects our belief in the underlying strength in the economy but also the continuing challenges in transportation in China. We do not expect supply chain disruptions to worsen and at the midpoint have assumed transportation sales will be relatively flat. Lastly, we aren't forecasting meaningful restocking since we believe customers will continue to maintain their cautious behavior.

Adjusted operating income is expected to be a minimum of $55 million, up 32% year-over-year, implying continued strong operating leverage year-over-year. Sequentially, as discussed on previous earnings calls, higher raw material costs are flowing through the P&L as expected. Lastly, for Q3, we expect the adjusted effective tax rate to be in the range of 26% to 28% and free operating cash flow to be positive.

Regarding the full year outlook on Slide 10. We still expect sales in the second half to exceed normal sequential patterns and strong year-over-year annual operating leverage despite temporary cost control headwinds from the prior year. In terms of the sequential cadence for the full year, the significant operating leverage we experienced in the first half will begin to normalize in the second half based on raw material increases. The fourth quarter will also be affected by the above-normal leverage we saw in the fourth quarter last year related to the timing of net price versus raw material benefits.

Nevertheless, we are committed to drive strong operating leverage for the full year while recognizing the unevenness that can occur in year-over-year operating leverage comparisons from quarter to quarter. This is why we believe that looking at leverage over a longer time frame such as a full year is a better measure of the underlying performance of the business.

Moving on to the other variables. We expect depreciation and amortization to be approximately $135 million, increasing approximately $10 million year-over-year; capital expenditures to be in the range of $110 million to $120 million; and primary working capital as a percentage of sales to trend towards our 30% goal by fiscal year-end. These assumptions together translate to free annual operating cash flow generation of approximately 100% of adjusted net income, in line with our long-term target.

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

Thanks, Damon. Turning to Slide 11, let me take just a few minutes to summarize. We posted another excellent quarter, as demonstrated by our strong operating leverage. Our product innovations and commercial and operational excellence initiatives are positioning us well to drive further share gains and improve margins as markets continue to recover.

Although supply chain bottlenecks and other uncertainties continue to affect the transportation end market and China is challenging to forecast, our other end markets are showing strong signs of improvement. Furthermore, although we have not yet seen significant restocking, we believe underlying demand is strong and that restocking remains upside for us in the future.

We continue to expect to exceed normal sequential quarterly growth patterns in the second half of fiscal year '22 and are confident in driving strong full year operating leverage. Our strong balance sheet and free operating cash flow allow us to have the flexibility to both continue investing in all our strategic initiatives and optimize a balanced capital allocation strategy. I remain fully confident we will meet our adjusted EBITDA profitability target of 24% to 26% when sales reach the range of $2.5 billion to $2.6 billion.

And with that, operator, please open the line for questions.

(Operator Instructions) The first question today comes from Stephen Volkmann with Jefferies.

Since transportation was kind of the standout, I apologize, but I'm going to start there. You talked about a sequential decline, I believe, of about 6%. And I'm just curious that, that's not really what we're hearing from the various transportation markets we look at, although I'm sure I don't see everything. But I'm wondering if this is kind of an inventory situation where some of these transportation companies are kind of getting product out the door that may have been actually produced in previous quarters or something. And so maybe they don't need you as much right now and therefore is somewhat temporary. Or do you think there's something more going on here?

Steve, I think that's probably a pretty good assessment. And we also know there's always a little bit of a lag. When they start their production, they will -- we'll see a little bit of lag in terms of when we start to see the consumables, so -- but I think your assessment is probably right.

And when you say transportation, are we really kind of talking about automotive? Or is there something else in there that might be...

It's really light vehicles.

And the final one there, and I'll pass it on. Are you fairly confident that there's nothing going on here from a sort of market share perspective?

Yes, we're absolutely confident. There's no question in my mind about it.

The next question comes from Tami Zakaria with JPMorgan.

So my first question is you said you expect to drive market share gains across regions. Where are the biggest opportunities? And how do you measure share gains in this environment?

Good questions. I think the biggest opportunities, I would say for example, are in Aerospace. Tami, you're -- I think you're new to following Kennametal, but part of our history was we had focused a lot of our engineering resources on automotive. And we've redirected that in the last few years to Aerospace customers. They require high-end, high-performance tooling, so we feel confident that we're getting traction there.

And the way we measure that is, since we had a reasonably low share and we have a process by which we target particular customers, we actually reward our salespeople based on the increase in share of wallet on those customers. So we have metrics that say this is how much business we have with the customer last year. This is what it is this year. And then we also account for any increase just due to normal market, so it's almost measured on a sort of project-by-project basis.

We also -- so we have a number of metrics that are sort of project-by-project basis. And that works well for somewhere like Aerospace, but then if you take General Engineering, which is much broader, we had a rebranding and moving our WIDIA product portfolio into what I would call fit-for-purpose. And that's basically tools that are just like they say, fit-for-purpose. They're not the real high-end specialized tooling, they're customized for particular applications, more broader based.

And in that case, the way we measure our success is we look at the overall General Engineering and what Metal Cutting is doing, and then we look at how we're growing in the fit-for-purpose. And sequentially I can say that, last quarter, for example, our growth in the fit-for-purpose was much larger than the General Engineering broader markets, so that gives us some confidence that we're moving in the right direction.

And then in many areas around the world, people do report, whether it be metal cutting or infrastructure-type business, they report their sales into associations, and we kind of measure our sales versus them. And then we also get good feedback from our distributors. Many of those agreements are actually written so that we have -- they have incentives to increase our share of wallet with them, and so that's something we also track.

So Tami, it's not -- it's kind of a complex question. It's a good question. It's one that we're focused on because we really believe that -- with the foundation of the simplification/modernization that we've done over the last few years, that this company is really poised for not only growth in accordance with the markets recovering, but we believe we're well positioned to take share. So it's something that we're absolutely measuring and holding ourselves accountable for.

The next question comes from Julian Mitchell with Barclays.

I just wanted to start out maybe with a question around your revenue guidance. So the guidance for the March quarter implies a slowdown into that sort of mid-, high single-digit organic growth range, so a very sharp slowdown from what you were seeing a couple of quarters ago. Maybe help us understand sort of what you're assuming for sort of Metal Cutting versus Infrastructure growth in the current quarter, any differences in pattern versus what we saw in December.

And then as you look further out in Metal Cutting, how are you thinking about that growth rate? Like do you think we're at a sort of a trend growth rate now in the mid-single digits? Or you think, no, there are some pieces that should push that either higher or lower.

So I guess the context is that the PMIs are coming down, but there's a lot of other short-cycle companies talking about re-acceleration maybe later in the year, so I just wondered about your perspectives.

Yes. I think just I'd say, broadly speaking, Julian, we talked about Transportation. So obviously -- I don't know if anyone on the phone here is trying to buy a car lately, but there's plenty of demand for cars. And so we think that, that is a pent-up demand situation. It's going to take time to replenish that required cars and get caught up with the demand.

So that's certainly an opportunity for us going forward, and that will also positively affect General Engineering. And so it's interesting. Even though the PMIs have come down in many countries, they're still in sort of the growth territory in most cases, with the exception of China. And so we think that the growth is going to continue.

And of course, Aerospace is still in a place where they're -- definitely it's more recovery to come. Now you also asked a question what's sort of happening between Metal Cutting and Infrastructure and how to think about that? I would say that the -- we talked about 3% to 7% sequential growth. I would say that Metal Cutting would be at the higher part of that and then Infrastructure will be closer to the lower sequential.

And if you think about Infrastructure, we had a nice increase and rebound in that business. And so Energy, for example, oil and gas, we expect that's going to continue to expand, but it's expanding off a much higher level. It's kind of rebounded. So we look forward to that growth. And we're also -- we also believe that, in terms of met coal and mining adjacencies, there's still going to be very good demand there. And those have recovered nicely; and we should see sort of more steady, continuous growth there.

That's helpful. And then just want to sort of circle back on the cash flow generation and uses of cash. So you talked about the inventory increase weighing on the working capital side of cash flow just now. Just wondered about the pace at which you think that inventory-to-sales ratio can come down. I think it's in the high 20s right now as a share of sort of trailing 12-month sales. How quickly can you liquidate that?

And on the uses of the cash, you do have the sort of the buyback program. You look at your main global peer. They have been using their cash to sort of upgrade the portfolio, put more money into softer acquisitions and sort of move away from traditional tooling. Just wondered how tempted you were, if at all, by that approach to cash usage.

What we said on the capital allocation is that we still believe there's plenty of internal investments that we can make in the company to either put us in a position to drive higher sales growth, like our digital platform and the investments we're making there. And then also there's plenty of good productivity initiatives, Julian, still to come. And so those projects sort of stand on their own and have to generate the right return.

The next thing that we're focused on and we've sort of activated over the last year or so are sort of our M&A function, but perhaps different than maybe how Kennametal viewed that in the past is we're very focused on the core business. And so we'll be looking, absolutely looking for opportunities to probably do more bolt-ons that are closer to the core business.

And again, they may be accelerators to growth. We're also maybe accelerating some new technologies that will be important in the future. So we're very much focused on that. And then of course, we've got the return to shareholders or invest the -- excuse me, share buybacks or the dividend. So those are the basic focuses. And then in terms of your inventory question, I'll let Damon answer that.

Yes. I think, Julian, to your point, inventory on the balance sheet is up given the cost of our raw materials has risen significantly, as you know. And I think, as we've said on some prior calls, we also have a little bit more inventory due to transit times for some of the ore coming out of Bolivia, safety stock given some of the disruptions in the supply chain. I think, when I look at the second half of our fiscal year, I don't see inventory as an absolute number really moving materially.

It will probably drop in the fourth quarter, as you know, which is our stronger selling quarter with Infrastructure, but as from a percentage-of-sales standpoint, what we've talked about is working capital continuing to trend down here from the second quarter. So if you remember Q1, we were just over 32%. Now in Q2 we're just over 31%. We'll continue to see that improvement as sales, hopefully, start to continue to pick up here in Q3 and Q4.

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

How much of revenue growth was price versus volume in the quarter? And you -- can you talk about that for 3Q as well just given the mid-single-digit kind of range? How much of that is price?

Yes, Steve, we're not going to sort of disclose that pricing information. As you can imagine, that's sensitive, but I guess I can just directionally I would say that the majority of it is market growth or share gain, but there is a substantial price piece. And in fact, you can gauge a little bit of that because we told you that there was $12 million of cost headwinds that we -- more than offset with price. So you'd get some kind of ballpark figure if you'd like to back into it.

But -- and I'm sorry if I missed this. You expect a similar kind of cost headwind in 3Q and 4Q, or is that moderating?

Yes. So from a sequential basis, Steve, the operational costs, the merits and other costs we talked about, those will effectively be flat from Q2 into Q3 and Q4. Material costs will continue to increase as we move through the fiscal year. The tungsten prices, as we've been talking for the last couple of quarters, have continued to increase. They're about $325 right now versus maybe about to $310 a couple of -- a quarter or so ago. So those will slowly continue to trickle into our costs here over the balance of the fiscal year.

But as Chris has said, our team has been very confident in raising prices to more than offset the raw material headwinds that we see, so again we feel very confident that price versus raws for the fiscal year (inaudible) positive for us now.

Got it. And for the organic growth rate in Metal Cutting, you said fit-for-purpose grew at a much higher rate. Can you quantify that a little more? Just is legacy Metal Cutting outside of Transportation still positive?

Yes, yes, it's definitely positive. I guess the way I was looking at is, if you look at sort of General Engineering as a segment, a lot of that fit-for-purpose tooling is geared towards that type of industry where you have sort of machine shops, regardless of the size, that are doing sort of broad-based applications. So our theory there, Steve, is that if the fit-for-purpose tooling -- which we can measure exactly what's happening because it's a specific portfolio. If those sales are increasing faster than sort of that broader market and what we'd see in the broader Metal Cutting, then that tells us we're picking up traction. That's the basic premise of the measure.

And can you just remind me real quick, does fit-for-purpose mix you down in the segment? Or is there much of a margin difference between some of the legacy product lines and the newer product lines?

The fit-for-purpose, since it was repositioning WIDIA, which did have a lower margin. So what we're talking about is obviously the blended margin, but it's still margin that's consistent with what the WIDIA portfolio was.

(inaudible) margins for the Kennametal branded under industrial is around 25%. WIDIA was around 18%, as we've repositioned fit-for-purpose. Into the fit-for-purpose segment of the market, we think that the margins will be relatively similar there.

The next question comes from Dillon Cumming with Morgan Stanley.

I guess, as a start, you mentioned that China kind of went the wrong way in the quarter. I think you mentioned both transportation and wind were a bit more challenged, but I think some of your peers have started to kind of lay out expectations for a back half calendar year recovery. I'm just curious if that's kind of consistent with what you're seeing there and if you'd kind of expect those markets to stabilize over the next few quarters.

Dillon, I had a lot of trouble hearing you. You're talking about energy and China being...

Yes. I'm sorry. Maybe just to repeat it, if you can hear me better now.

That's a lot better, Dillon. Thanks.

Okay, yes. Sorry about that. You just mentioned that China kind of went the wrong way in the quarter. And you were talking about both transportation and wind being a bit weaker than expected, but I think some of your peers have kind of started to lay out expectations for a back half kind of calendar year recovery. So just curious if that's kind of consistent with what you're seeing and if you would kind of expect those markets will stabilize over the next few quarters.

Yes. I think -- I mean our assumption on China is it's not going to get worse, but we took kind of a conservative view. And it's probably going to stay flat through the next 2 quarters. That's kind of our thought process.

That's helpful.

I've been hearing the same thing you -- there is potential that it will start to improve, so that's certainly upside, but that's the -- that's what we've baked into our forecast at this point.

Okay, makes sense. And maybe if I can switch back over to the EV side for a second. You kind of called out that major win from sort of kind of a major OEM customer. I'm just curious, if that win kind of crystallize any content nuances between EV and IC? You've been talking about that that's kind of changed the thinking there.

And actually, if I can just ask a related follow-up on that point, to Steve's question earlier, do you feel like any kind of mix shift at the OEM level between EV versus IC is actually driving any level of kind of underperformance in transportation as well?

No. I don't think there's an underperformance in transportation driven by that switch. I mean, the transition to EV is it's very early stages. I think that they might account for like 5% of the world's vehicles or something along that order of magnitude. And so the way we -- Dillon, the way we look at that, EV, is it's really an opportunity for us. And if you look out over the next 10 years, there's a couple of things going on.

First of all, the increase -- there's just a general increased demand for light vehicles. That's going to happen no matter what. And then as you probably noticed -- even if you're watching ads on TV, you see a lot more ads, I noticed, for hybrid vehicles. It turns out the hybrid vehicles actually have more Metal Cutting requirements than the internal combustion engines because they have all the equipment you need for EV but also they have an engine. So that is going to drive -- certainly, if we look out over the next 10 years, certainly within the next 5 years, we could actually see an increase and bump in Metal Cutting because of that.

And then the EV applications, it turns out customers are starting to ramp up lines and they're thinking about how to do that. And those are the wins that we're talking about. And so we're -- every one of those sort of sets you up for the future of EV and that's why they're critically important. And I can tell you we're winning these things not based on trying to beat the lowest price. This is -- these applications are such that you can actually deliver significant value to this future production line. That's the way we're looking at it. So this should be very good business. As there's a transition to EV, it should be a very good business for us. And it's business that we want and we're well positioned to win.

And in some cases, we've got -- even our additive manufacturing technology is allowing us to produce tools served in a prototype basis in months rather than the normal cycle of years, where -- and so that helps us -- that helps these companies that are starting up these new production lines get those lines up faster and prototype much quicker. So lots of ways that we're leveraging our innovation and our technology to put us in a position to win these early orders for EV because that's going to -- once you're in there, it's very hard to displace you. So that's the theory and that's our approach.

The next question comes from Chris Dankert with Loop Capital.

I guess, a bit more of a North America-centric question maybe, but just can you highlight what the impact of labor availability and absenteeism was just kind of on factory absorption in the quarter? And I guess, is that dynamic improving as we move into fiscal 3Q here?

Yes, it definitely had an impact in the quarter. I mean, if you look at the Metal Cutting margins, we expected them to come down. Obviously, with transportation down, the biggest driver there in terms of the margins coming down was the transportation volume coming down, but inside that we did see -- the Omicron did affect the factories, especially in the month of December. So we were working higher overtime.

And then the other thing is it also impacted our suppliers and freight shipments. And so we actually incurred higher premium freight charges than we thought we would. So it definitely had an impact, but it's -- I would say that it's starting to normalize back to the situation it was before.

And then the other part of this, I guess, the good news is that, those sort of factors in terms of those inflationary things, whether it's higher overtime or some of the disruptions, we factored that into our price increase which we just put in place in January. So as it relates to Metal Cutting going forward, we think we've got that covered. Damon, do you want to add anything to that?

I think, Chris, (inaudible) we're not immune to any of the issues you're reading out there. And so we have a lot of these costs, training costs as we're hiring workers in a lot of our factories. As you will guess, they're not as productive as some of our experienced workers, so we are dealing with some levels of inefficiency as we work to continue to serve customers' needs, but overall the team has done a phenomenal job in driving productivity to help offset that and manage through that.

So you're not quite seeing that in our P&L because of the good work the team is doing both on the pricing side and on the manufacturing side to help offset some of those challenges.

Got it. That's really great color. And then we touched on mix. I guess, as we move into the third quarter here, General Engineering, I think, probably the biggest driver of the softening in growth. I guess, is that -- are we contemplating negative mix in the guide at this point?

No, I wouldn't characterize it like that.

Okay, okay. So it's -- principally, at this point, it's, again, price/cost still staying positive on the raw side, but really mix is not a factor, okay.

This concludes the question-and-answer session. I would now like to turn the conference back over to Chris Rossi for any closing remarks.

Thanks, operator. And thanks, everyone, for joining us on the call today. I look at this quarter, and I think it's another proof point that our strategic initiatives are working. We're driving strong operating leverage and share gain and margin improvement.

As always, we appreciate your interest in the company and your support. And don't hesitate to call Kelly if you have any questions after today's call. Thanks, everybody, and have a great day.

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