Kennametal Inc (KMT) 2021 Q3 法說會逐字稿

Good morning.

I would like to welcome everyone to Kennametal's Third Quarter Fiscal Year 2021 Earnings Conference Call.

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

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

Please go ahead.

Thank you, operator.

Welcome, everyone, and thank you for joining us to review Kennametal's third quarter fiscal 2021 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 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 now turn the call over to Chris.

Thanks, Kelly.

Good morning, everyone, and thank you for joining us today.

I'll begin today's call with some general comments and a brief review of the quarter and Q4 expectations.

Damon will then review the quarterly financial results and Q4 assumptions for modeling purposes in more detail.

Finally, I'll make some summary comments before opening the call for questions.

Beginning on Slide 2 in the presentation, I'm encouraged by our third quarter results, which reflects strong sales and operating leverage, driving solid cash flow generation.

Q3 sales increased 10% sequentially, outpacing our mid- to high single-digit expectations, reflecting both market improvement and growth from our strategic initiatives.

On a year-over-year basis, organic sales declined 1% on top of a 17% decline in the prior year.

Transportation and general engineering continued to lead the end markets with positive year-over-year growth for the first time in 10 and 7 quarters, respectively.

Energy and aerospace continue to be challenged, but both are showing signs of improvement.

Regionally, we saw Asia-Pacific return to growth, while EMEA and the Americas are still negative on a year-over-year basis.

However, all regions improved sequentially.

Our margins improved 330 basis points sequentially on stronger sales and improved manufacturing productivity, despite the continued lifting of temporary cost control actions, which Damon will discuss in more detail.

Improvement in margins sequentially is really a testament to the structural cost savings we've made through simplification and modernization.

Operating expense as a percentage of sales remained flat sequentially at 22%, but was up year-over-year, as costs continue to come back into the business.

Our target for operating expense remains at 20%.

Adjusted EPS was $0.32 versus $0.46 in the prior-year quarter, reflecting the factors I just named.

So overall, we are pleased with our execution as market conditions have improved, and we expect markets to continue strengthening.

However, the effects of COVID-19 restrictions in some regions and customer supply chain challenges may temporarily suppress the recovery trajectory from what we saw in Q3.

Therefore, because of these uncertainties, we have estimated sequential sales growth in the mid-single digits, recognizing that our end markets may strengthen even more in Q4 if these uncertainties do not materialize.

But regardless of the shape of the recovery, we will stay focused on executing our operational and commercial excellence initiatives, aimed at driving share gain and improving profitability throughout the cycle.

For operational excellence, we continue to execute simplification modernization, posting $63 million in incremental savings year-to-date, on track for $80 million this fiscal year and $180 million since program inception, which is in line with the target originally set, despite much lower sales volumes.

For commercial excellence, I'm encouraged again this quarter by the results of our fit-for-purpose and other growth initiatives and believe progress will continue accelerating as COVID-19 restrictions are lifted and markets recover further.

In addition, we continue to execute a disciplined pricing process to reflect pricing based on value added, as well as changes in commodity costs, so our teams in both business segments are planning pricing actions in the fourth quarter reflecting the changes in raw material costs expected as markets recover.

We do not expect the recent increases in raw material costs to affect us until early FY '22.

As you know, historically, we have demonstrated an ability to offset raw material cost increases with price and expect to do so for this current economic cycle.

Finally, as I mentioned at the outset of the call, free operating cash flow was strong this quarter, particularly when compared to adjusted net income, reflecting improved productivity, strong working capital management, and lower capital spending.

Now let's turn to Slide 3 for an update on how we have performed this downturn relative to past downturns.

As a reminder, the last time the company experienced a sales decline close to the current one was during the Great Recession in 2009.

The slide shows trailing 12-month sales on the left chart and the corresponding adjusted operating margin on the right chart.

Starting with the left chart, see that the trough level of trailing 12-month sales is similar, at approximately $1.7 billion for the current and 2009 downturns.

Also of note is that the current downturn is more elongated, and we've been hovering around the $1.7 billion level for 2 quarters.

Now, looking at the profitability chart on the right, you can see that we have been able to maintain significantly higher levels of profitability throughout this downturn.

This quarter, there's roughly 600 basis points of adjusted operating margin improvement compared to the 2009 downturn, due to the structural improvements we've made and the timely aggressive cost control actions taken last year.

With regard to Q4 margins, we expect our adjusted operating margin to improve modestly both year-over-year and sequentially, which Damon will provide more detail on later.

In summary, I'm encouraged by our Q3 results and the underlying leverage demonstrated this quarter.

We've maintained higher profitability levels and are well positioned to outperform as markets recover further because of the initiatives we executed over the last several years.

And with that, I'll turn the call over to Damon, who will review the third quarter and Q4 outlook in more detail.

Thank you, Chris, and good morning, everyone.

I will begin on Slide 4 with a review of Q3 operating results on both a reported and adjusted basis.

As Chris mentioned, the sequential performance of our sales outpaced our expectations.

On a year-over-year basis, total sales were essentially flat, declining 1% organically, with FX contributing approximately 2% and business days negative 1% in the quarter.

Year-over-year margin comparisons in Q3 are difficult, given the timing of the pandemic, the temporary cost actions last year, and the ongoing effects on end markets like aerospace and energy.

Although adjusted gross profit margin of 31.6% was down 170 basis points year-over-year, and adjusted operating expenses as a percent of sales were up 190 basis points, these are not reflective of the continued underlying improvement in the business.

Given the magnitude of the decline last year from COVID-19 and the current pace of the economic recovery, it's better to evaluate our performance on a sequential basis, as shown on Slide 5.

The sequential walk better reflects our underlying business performance in a more normal, although still low-volume environment.

As you can see on the bridge, sales improved $44 million sequentially, including $10 million from foreign exchange, and adjusted operating income improved $19 million.

Continued lifting of temporary cost actions was a sequential headwind of approximately $10 million, but is fully reflected in Q3 and going forward.

The operations bar is reflective of the margin associated with the higher sales as well as manufacturing productivity and representative of what we would expect under more normalized conditions.

It's this type of performance that gives us confidence that our operational and commercial excellence initiatives are working and that we will continue to see improved profitability as sales continue to grow.

Turning to Slide 6, you can see the primary drivers affecting adjusted EPS on a year-over-year basis.

The effect of operations this quarter amounted to negative $0.33, comparing positively to negative $0.39 in the prior-year quarter.

The main factors contributing to the $0.33 were the year-over-year changes in compensation, less favorable mix related to softer end markets like aerospace and energy, lower production, and the lifting of temporary cost control actions that were in effect last year.

Remember, the timing of the onset of the pandemic last year resulted in several effects making the year-over-year comparison more challenging.

First, the costs of our variable compensation program were reset lower, starting in the third quarter last year.

Second, as the severity of the pandemic was not fully felt until Q4, the majority of our factories were still loaded at higher levels of production in Q3 last year, creating a year-over-year headwind this quarter.

Finally, the third quarter last year did not reflect the full reduction in aerospace and oil and gas activity due to the pandemic.

This effect was not fully evident until the fourth quarter.

Incremental simplification/modernization benefits year-over-year totaled $18 million, or $0.16, bringing the total cumulative savings this quarter to $164 million.

As Chris mentioned, our expectation continues to be that simplification/modernization benefits for the total year will be approximately $80 million and approximately $180 million of [cumulative] savings from the program by the end of this fiscal year, which is in line with our original target, despite lower volumes.

Slides 7 and 8 detail the performance of our segments this quarter.

Metal cutting sales in the third quarter were flat organically versus a 17% decline in the prior-year period.

Asia-Pacific sales increased 10% year-over-year, the first increase in 9 quarters.

EMEA sales were flat, and sales in the Americas were down 9%, consistent with the timing of the onset of the pandemic last year.

Sequentially, we saw improvement in all regions.

The performance in Asia-Pacific relative to other regions reflects more positive economic activity, led by the recovery in China, up over 20%; in India, up in the high teens year-over-year.

Note that despite the strong performance this quarter in India, we are monitoring closely the potential effects on consumer buying activity from the recent escalation of COVID-19 cases and the resultant lockdowns.

On a year-over-year basis, the best-performing end market was transportation, which returned to growth in the quarter, increasing 11%.

Transportation end market also grew 11% sequentially, despite global supply chain challenges, which had a greater effect on customers' assembly operations than on their metal cutting operations, like engine plants.

However, given the increased level of disruption from the supply chain challenges, we expect momentum in this end market to be dampened temporarily until customers are able to stabilize their semiconductor supply.

For the other end markets, general engineering also returned to growth, with sales up 1% year-over-year, and energy declining 16%.

Aerospace continues to be the most challenged end market, with sales down 34% year-over-year, as COVID-19 continues to affect production levels in air travel.

Although still at low levels, we did see aerospace improve 7% sequentially.

Adjusted operating margin of 8.2% was down 380 basis points year-over-year, but improved sequentially from 6.1% in Q2.

As with the consolidated numbers, the year-over-year decrease was driven primarily by increased compensation, lifting of other prior-year temporary cost controls, mix, and lower production, partially offset by incremental simplification/modernization benefits.

Turning to Slide 8 for infrastructure, sales declined 3% organically on top of a 17% decline in the prior-year period.

Other factors affecting infrastructure sales were a benefit from foreign exchange of 2%, partially offset by a negative 1% effect from fewer business days.

(inaudible), again, Asia-Pacific led with a 30% year-over-year increase, driven by the easing of the prior-year COVID-19 disruptions in China.

This follows growth of positive 1% last quarter.

The Americas declined year-over-year 11%, and EMEA declined 13%.

Sales improved across all end markets and regions sequentially.

Year-over-year, general engineering was the best-performing end market, with growth of 2% associated with the rebound in China, offset by declines in both earthworks and energy at negative 3% and negative 14%, respectively.

Adjusted operating margin of 10.1% was down 290 basis points year-over-year, due to similar factors that drove declines in the total company and metal cutting segment figures.

As expected, raw materials were effectively neutral this quarter, both year-over-year and sequentially.

Since the start of the calendar year, the price of tungsten has increased approximately 23%, to around $270 per metric ton.

Increase in raw material costs will begin to affect us in early FY '22.

And as Chris mentioned, we remain confident in our ability to offset these material cost increases over time with pricing actions.

In the fourth quarter, certain sales more correlated to tungsten market prices will create a modest margin benefit in infrastructure as we continue to recognize the lower-priced tungsten in our cost of goods sold for a period of time.

Now turning to Slide 9 to review our balance sheet and free operating cash flow, we continue to believe that a conservative financial profile is appropriate to ensure liquidity and the ability to continue to execute our strategy.

Having successfully completed the refinancing and repayment of our 2022 notes in the third quarter, our new debt profile is made up of 2 $300 million notes maturing in 2028 and 2031, as well as a USD 700 million revolver that matures in 2023.

Given the lower interest rate of the new bond versus the one recently repaid, we expect annualized interest expense to be approximately $28 million versus the historical run rate of around $32 million.

At quarter end, we had combined cash and revolver availability of approximately $784 million.

Primary working capital decreased year-over-year to $615 million, given our continued focus on inventory.

On a percentage of sales basis, primary working capital increased year-over-year to 36.7%.

This is above our target of 30%, as sales remain at depressed levels, but we remain committed to getting back to this level as sales increase.

Capital expenditures were $25 million this quarter and down $32 million from the prior-year period, as expected, given the spending on simplification/modernization is substantially complete.

Year to date, we've spent $94 million, and we expect capital expenditures for the year to be approximately $120 million.

Free operating cash flow for the quarter improved year-over-year to $47 million, up from $2 million in the prior-year quarter, due to the working capital management and lower CapEx.

Sequentially, free operating cash flow improved from $29 million last quarter, due to improved profitability.

Consistent with prior quarters, we paid the dividend of $17 million.

Full balance sheet can be found on Slide 14 in the appendix.

Before I turn the call back over to Chris, I want to spend a few minutes on our Q4 assumption for modeling purposes.

Turning to Slide 10, this slide summarizes how we expect key factors to affect Q4 EPS and free operating cash flow.

As already mentioned, we expect sales to be up mid-single digits sequentially and are confident that our underlying operating leverage of the business will continue within the expected range.

Simplification/modernization is expected to be approximately $80 million in FY '21, which implies approximately $17 million of incremental year-over-year savings in the fourth quarter.

Sequentially, there will be no headwinds related to the lifting of the temporary cost control actions.

However, on a year-over-year basis, temporary cost control actions will be a significant headwind of $40 million to $45 million, reflecting the elimination of incentive compensation and the aggressive cost control actions we took last year in the form of furloughs.

We expect our Q4 adjusted effective tax rate to be approximately 28%, compared to 20.6% this quarter and approximately 25% for the full year.

However, the Q4 tax rate could fluctuate, depending upon the ultimate geographic mix of earnings.

Other items that are not individually itemized on this slide include depreciation and amortization, which we expect to be slightly higher sequentially, and raw materials, which we do not expect to be materially different sequentially or year-over-year.

As Chris mentioned, rising raw material costs will not begin to affect us until early FY '22, and we're confident in our ability to offset these increases with both business segments initiating pricing actions in the fourth quarter.

In terms of free operating cash flow drivers, capital spending for the year is expected to be approximately $120 million, which implies around $25 million in Q4.

We continue to expect cash restructuring spend for the full year to be higher by approximately $20 million.

As such, cash restructuring payments will be around $5 million higher year-over-year, and around $5 million lower versus the approximately $17 million paid in Q3.

Given our strong inventory reductions year-to-date and continued improving market conditions, we expect working capital to be a modest sequential use of cash in Q4.

Free operating cash flow is expected to remain positive in Q4, albeit at a slightly lower level, both year-over-year and sequentially.

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.

I'm encouraged by our results this quarter.

We posted strong sales, manufacturing performance, and free operating cash flow, and most importantly, our underlying operating leverage is within the expected range.

Our commercial and operational excellence initiatives are progressing well to drive growth, market share gain, and improve profitability.

The benefits from these initiatives, which we began 3 years ago, are evident, as shown in the margin chart, with more benefits to come as volume increases.

This gives us confidence in our expectation to achieve adjusted EBITDA margin of 24% to 26% when sales reached the range of $2.5 to $2.6 billion.

And the strength of our balance sheet and cash flow will allow us to optimize future capital allocation while continuing to focus on improving profitability, customer service and share gain throughout the economic cycle.

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

(Operator Instructions) And today's first question comes from Steve Volkmann at Jefferies.

Maybe I'll just start, if it's okay, Chris, kind of short-term here.

You talked about a number of uncertainties in the fourth quarter and sort of intimated that things could be a little better if those things don't happen.

I guess I'm just wondering if you can flesh that out for us a little bit.

Those uncertainties, are they relative to your own operations or your customer operations?

And maybe you can give us some color on where and what those sort of uncertainties are for you.

Yes, Steve, they're principally with our customers.

So from a transportation perspective, it's obviously the chip issue that's driving that.

And then, as Damon mentioned in his prepared remarks that India has seen a nice recovery, and that's been driven by consumer buying behavior, especially in the transportation area.

And with these lockdowns and the situation there, we think that that's going to temporarily depress demand, and so they'll have to adjust production schedules accordingly.

That's really -- those are really the 2 things that are driving it.

And also EMEA, which has seen a nice recovery in transportation.

They also had some COVID issues and some lockdowns that could potentially dampen demand.

So that's really the basis of that.

And in fact, Steve, when we did our forecast for Q3, we had anticipated that some of these effects, other than we didn't know about India, but we had anticipated some of these effects, especially in the supply chain for automotive, we may have actually seen that in Q3, but we didn't really see much of it in Q3, but we're expecting that it could happen in Q4 because the situation has gotten worse.

Great.

And then just a quick follow-up.

You mentioned price cost a number of times in the prepared remarks.

It sounds like that's perhaps a little bit of a tailwind in the fourth quarter, and then you're expecting somewhat of a headwind in the first.

How does that play out in '22?

Is it a headwind in like the first half and then you get it back in the second half?

Or how are you thinking a little bit longer-term about that?

Well, I think the way to look at it for FY '22 or sort of any 12-month period is that we think the price will cover raws.

And as you know, Steve, at any point in the cycle, you can be a little bit ahead, a little behind.

So infrastructure, for example, we see that because of the contracts on certain materials and certain customers, the price adjusts.

But as Damon said, we still have some of the lower cost material running through our P&L, so that can provide a little bit of a tailwind in that regard.

And then as the situation changes and the prices come down, you have the reverse of that.

So I would -- I guess the way I would think about it is there's really not going to be much of a headwind or a tailwind that's material for Q4.

And frankly, for the first half or second half of next year, I think we'll just have to kind of wait and see how it plays out and make those comments as part of our FY '22 outlook.

Our next question today comes from Julian Mitchell of Barclays.

Maybe just a first question on the fourth quarter margins.

So I think in the third quarter, the sequential incremental margin was around about 40% or so, maybe a touch above.

When we're looking sequentially at Q4, is that roughly the same level of sequential operating leverage we should expect?

I fully understand that year-on-year, there's mix and temporary cost headwinds and all the rest of it.

But sequentially, is that the right way to think about it?

Yes.

What we talked about before, Julian, is that you have that sort of 40% number that you said, and that's what we would expect to see on incremental margins.

But we also said there'd be some fixed cost absorption on top of that.

So some of you on the phone have used a model of around 50% on the incremental sales for your models, and that seems reasonable to us.

So that's the way we would think about leverage on the incremental sales.

That's very helpful.

And then, if we look at full year '22, can we assume that the kind of simplification and modernization savings sort of are net neutral relative to temporary costs?

And so, when we're thinking about margins for next year, it's really a function of that base operating leverage number of sort of 40% and then whatever we want to assume from raw materials, including tungsten sort of beyond that?

Yes.

I think, Julian.

So we haven't given a specific outlook for simplification/ modernization.

This is wrapping up.

But to your point, we have about $25 million of temporary cost actions that will affect us in the first half of next year.

I think as we look at some of the actions we have done this year, coupled with the things still to be executed in the fourth quarter related to Johnson City, I would say they'll probably be close between the 2.

I would, though, caution you remember there is actual incremental inflation year-over-year that we will have to deal with in regard to wage inflation and other things on top of that temporary cost.

And so, I'm not sure that temporary plus inflation would be fully offset by the simplification/modernization savings.

Julian, so I mean, in terms of the technical modeling, we have to factor those things in that Damon said.

But I kind of look at FY '22 as something that we're all, as a management team, looking forward to seeing the volumes run through our modernized factories.

Now, we still are ramping up processes even in FY '22, but it's going to be, really, the first year that we're going to be able to operate with this new equipment.

And so, we're really excited about the opportunity for improved profitability, better customer service, and leveraging that footprint to gain share.

So it's kind of like a clean year from that perspective, if you will.

And our next question today comes from Ann Duignan with JPMorgan.

I've heard a lot of different pronunciations of my name, but that one was probably the most unique.

Thank you.

Can you just remind us, how big is India in terms of dollars of revenue, both metal cutting and infrastructure, if it is important in infrastructure?

I know you called it out in metal cutting, but if you'd please size that business for us.

Yes.

Ann, we don't -- we have not broken out India as a specific country.

What we have said is for the quarter, Asia-Pacific was about 24% of our overall revenue.

We've said China is the biggest country in there.

And directionally, it's about, call it, 10% plus or so of our overall revenue.

India would be #2 behind that, so again, slightly smaller than that than the China percentage.

But still quite sizable.

Yes.

Okay.

That's helpful.

And then, can you talk about other, than tungsten and chips, what other supply chain issues are you facing?

Are you facing any labor shortages?

And if you could, rank order the issues as you're seeing them today.

And I've spoken to a number of CEOs in the last couple of days who say, this is the worst they've ever seen it, and that's saying something.

So if you could just talk to us a little bit about what you guys are seeing on the supply chain side, and from your perspective, how bad is it out there, both from raw materials, from a cost, from labor and all the other issues that you're trying to deal with.

Yes.

Ann, well, the first supply issue, which is not the ability to supply the material, but from a cost driver perspective is the APT, and I think we addressed that in the script.

And as you know, we have the ability to adjust prices accordingly.

So that's probably our biggest cost driver perspective.

We do have the second -- I guess second important material is cobalt.

And again, we're not really seeing any delivery issues, but that price is also escalated.

But that's kind of a distant second to APT.

And then in terms of steel, that's really spiked, but steel is such a small part of our overall cost structure, it's not really material.

And again, in the case of all those raw materials, we believe that we can do the proper things from a pricing perspective to offset.

As far as labor shortages, from our perspective, we're not experiencing anything more than we normally would do.

As you know, we have plants in small towns, and sometimes we're competing with other companies, but it's not a situation where we can't get workers because they're all off an unemployment or something or they don't want to come back to work.

So that's not our situation.

And in terms of our customers, the fact of the matter is, as customers were always -- there was always sort of a high demand for experienced machine tool operators and technical people.

So I don't think the current dynamics created by COVID are affecting that situation.

That's always kind of been a challenge.

It's one of the reasons why a lot of companies like ours have been moving more towards automation.

So I sit on the Board of another company, and the types of supply chain issues they're seeing, we're not really seeing that type of thing where shortage of the steel or they can't get material from their suppliers because they're supply chain issues.

We're not really experiencing that in Kennametal, Ann.

Okay, that's helpful.

And having those small factories geographically spread out, I guess, helps in some occasions.

Just for modeling purposes, could you just remind us what the normal seasonal growth rate would be for Q4 versus Q3, and I'll leave it there?

Yes.

On a consolidated basis, the typical seasonality would be sort of 3% to 4%.

And our next question today comes from Joel Tiss with BMO.

So can you just help us a little more clarifying.

The -- you gave us a lot of pieces about 2020.

And I know you're not ready to give guidance and all that.

But when you look at sort of price cost, simplification, and some of the other costs coming back, can you give us a sense if maybe the first half, we won't see the kind of incrementals that you guys are going to do in a clean year coming through, and it will be more second half?

Or just sort of how do we think about that?

Yes.

I think, Joel, so a lot will depend on the volume, as we've talked about.

Again, if we continue to see continued improvement, we'll continue to see leverage that, I think as Chris alluded to, we saw in the third quarter that we're optimistic to see in the fourth quarter.

To your point, though, when you start to look at it year-over-year in the first half, there will be around $15 million of temporary cost headwinds related to the actions we did last year -- or this current year, excuse me -- and we'll have about another $10 million in Q2.

Everything else, I think, as Chris alluded to, we're not overly concerned about the timing of price versus raw materials.

We don't expect that to be material as we see it today, but we'll give you guys more updated information as we get to our fourth quarter call.

And in that same vein, how about free cash flow in sort of the first clean year, or the free operating cash flow?

You think we'll see sort of a run at a normal kind of $100 million to $150 million kind of run rate, or that's still going to depend on everything else on all the uncertainties?

Again, Joel, we're not going to give an outlook for 2022 just yet.

But what I would tell you is, from a primary uses of cash, we're behind -- the heavy lifting related, the simplification/modernization is behind us.

As you see, we're trending at around $120 million in capital this year.

I don't expect a material difference next year in 2022.

Working capital, obviously, we've done a great job.

The team has done a phenomenal job with inventory this year.

We'll see how receivables and payables pan out, again, assuming the markets recover, call it neutral, maybe a slight use on the AR side.

Everything else is relatively going to be influenced by that top line.

Okay.

And then last one, just for Chris, you mentioned that sort of oil and aerospace were passing the bottom.

Can you give us any little color one way or the other about some of the things you're seeing, not so much a forecast, just kind of some little trends that give you confidence?

I think on the energy side, we -- I think we were pleasantly surprised that the rig count has picked up as much as it did.

That was not really expected, or that wasn't what our view was going to be in Q2.

And in fact, it should turn positive year-over-year in Q4.

So as far as oil and gas for metal cutting and, of course, infrastructure in the Americas, we think that's going to continue to strengthen.

The aerospace, as Damon mentioned, it's still down considerably year-over-year, but we did see sequential improvement.

And the other thing that we've noticed is that some of our customers, when the COVID-19 first hit and aerospace went down, everyone was trying to predict, when is it going to come back, and how long is it going to take to get back to sort of pre covid levels?

And that's still maybe a few years out.

But I've noticed that their forecast is that, if they were predicting 2 years, they're now -- maybe it's 18 months, okay, or something less.

So the good news is that it's moving in the right direction, and I think there's some optimism that could recover even faster.

But that -- it was encouraging to see, on a sequential basis, it's starting to tick up, both from an energy, oil and gas and aerospace.

So we're encouraged by that.

And our next question today comes from Dillon Cumming with Morgan Stanley.

I actually I want to piggyback off of kind of Joel's question in that I think, Damon, you mentioned that energy and A&D was still kind of holding back the margin performance of the company, just given the kind of negative impacts of mix.

And I guess, thinking about next year, do you feel like you still have some kind of wood to chop in terms of footprint rationalization or saving initiatives, more targeted towards those end markets?

Are you kind of comfortable kind of holding some excess manufacturing capacity there until those end markets recover?

Yes, Dillon, I don't expect to do any sort of facility rationalization.

Many of the products that we make for these end markets are part of the -- our factories that will service many end markets.

And so, for us, it's more an absorption within that factory that we deal with rather than a facility itself being tied up.

So I don't expect anything significant in '22 related to the facilities.

Again, as we've said, we're at the end of simplification/modernization.

We're operationalizing the equipment.

As Chris said, we're ready to leverage that footprint here as volumes recover.

Okay.

Got it.

That's helpful.

And then maybe just wondering if you can kind of update us on the fit-for-purpose initiatives.

Now that things are reopening a bit, maybe you're able to get out in front of customers a bit more.

So just curious kind of what kind of traction you're seeing there.

And I guess going forward, now that you've been at this for a few quarters now, would you kind of ever consider breaking out the kind of different purpose revenues, just to kind of get a measure of how those initiatives are progressing?

Yes.

I think to answer your question about how is it going, we're getting very good traction in this space.

And also to your point that as the COVID-19 restrictions are lifted, that just becomes easier to talk with customers, interact with customers to convert them, whether that would be fit-for-purpose or any other kind of metal brand tooling.

So that's going to -- if we're getting good traction now, we should get even better traction as the COVID restrictions continue to lift.

In terms of your question about breaking that out separately, I don't think we're going to break it out as a separate sort of sales item.

But we are sort of at the early stages of thinking about how we can measure relative performance and talk to you about it without jeopardizing competitive information because I think you can appreciate that some of that granularity is actually information our competitors would like to have.

But let me just say that, in general, if you look at the fit-for-purpose area, general engineering market is where a lot of that is sold.

So one of the things we look at is our performance versus how that market is growing.

And again, it's one of the largest target markets for fit-for-purpose.

And thus far, we believe we're outpacing that market growth in this area.

And then the other thing we do is that we have this targeted account process, and we're approaching our customers with the attitude that we want a larger share of their wallet.

And so, we well understand what their complete tooling spend is today, and then we can measure how much of that we're getting in the future.

And as we look at that from our existing customers and then also adding new customers, again, in this application space called fit-for-purpose, we believe that we're gaining share.

So those are 2 directional indicators that allow us to feel comfortable that we're getting good traction in this fit-for-purpose space.

Our next question today comes from Steven Fisher with UBS.

I just wanted to follow-up on some of the mix-related impacts.

If you could just sort of confirm my understanding of the year-over-year profit headwind that you had from mix, by my calculations, it was somewhere around a $20 million headwind year-over-year, assuming there really wasn't much impact from the lower volume year-over-year.

Is that about right, what you had in your calculations?

Yes.

So Steve, we don't disclose or break out mix.

I would tell you, as I alluded to in my comments, so again, the factories were loaded at a higher level in Q3 last year than they were this year.

That obviously had a significant effect on the overall profitability, as you saw coming through this year.

That, coupled with the richer mix in aerospace and energy on metal cutting, and then some mix issues on infrastructure, so all of that together is sort of getting you to the delta that you're looking at.

Okay.

And have you seen, as we've gotten into the fourth quarter, the mix headwind getting smaller already on a year-over-year basis?

Yes.

Well, I was going to say that we think the headwind is, on a year-over-year basis, is near the bottom, both regionally and by end market, especially as we start to lap the COVID-19 effects.

And then you do see, for example, as I mentioned, the sequential growth in aero and energy, indicating they're coming off the bottom.

So I think going forward, it will be less and less of a conversation, if you will.

Okay.

And the volume -- you called out lower volumes year-over-year in the quarter.

Was that entirely in January and February?

And did you see that flip in March to the positive?

Or is that inflection still yet to come?

I'm not sure I'm understanding the question.

Do you know what he's asking, Damon?

Yes.

I think -- yes.

So I think, Steve, we don't really break out monthly sales or production.

But I think, as Chris alluded to, we have seen, given that we're giving you an outlook of mid-single-digit sequential growth, we saw improvement, I guess more as we moved through the quarter, would be the way to look at it.

Our next question today comes from Ross Gilardi with Bank of America.

I had a question on capital allocation.

I mean, you guys have done a lot of refinancing.

You think markets -- seem to think markets have bottomed.

You're essentially done with your restructuring.

And just how does that influence your thoughts on capital allocation?

I mean, is FY '22 potentially a year that you shift away from debt reduction and really protecting the dividend to something more on the offensive, be it M&A, dividend increases or buybacks or something like that?

And then I have a follow-up too.

Yes.

So I think for -- Ross, for us, obviously, we're still very focused on liquidity here in FY '21.

As we look at FY '22, as Chris alluded to, we're feeling good if the markets continue.

And as we've said in the past, we're going to take a holistic approach on capital allocation, now that we're at the back end of simplification/modernization.

You've heard us say before, we may look at some smaller-scale projects to improve efficiencies.

These will have to have their own high-return stand-alone returns against not part of simplification/modernization.

And these would be smaller in size, but we'll continue to look at that.

We have said that we will look at inorganic opportunities.

I think our indication will be more likely on the bolt-on type size businesses, where we can leverage either our footprint and access new markets that we feel we're under-indexed in, where we can price for the value that we bring to the customers.

And if we don't find things that meet the right returns in either of those, we're going to look directly, we're going to look back to the direct the shareholders.

And whether that's in the form of increasing the dividend or a share buyback, I don't know yet, but that's sort of the -- how we're looking at it, and we'll know more as we build our plan for FY '22.

Okay.

Great.

And then I just want to ask you about your commentary just longer-term on EBITDA margins and so forth.

I mean you guys have been unflinching in saying that you think you can still do 24% to 26% margins at $2.50 to $2.6 billion in sales.

I mean those are revenue numbers that you did back in fiscal '13 to '15.

In fiscal '18, you did just under $2.4 billion, at the peak.

But if we do the math, I mean, that implies over a 50% incremental EBITDA margin for you seem likely to finish in fiscal '21, even though your restructuring actions will be substantially completed this year.

So the first question is, how realistic do you think $2.50 to $2.6 billion is?

Or is it just sort of just a hypothetical number, given that aerospace, energy, and mining seem unlikely to get back to where they were in the '13, '15 time period?

And then just whatever the next peak revenue number is, or I don't even know if you call it peak, but whatever we want to assume, how should we think about incremental margins from here if the end markets that I just mentioned are a smaller portion of the mix than you would have initially envisioned back in late fiscal '17, when you came up with those targets?

Well, I'd say a couple of things in terms of the revenue, and then I'll let Damon comment on the sort of the profitability -- underlying profitability assumptions.

So when we set that $2.40 to $2.6 billion, you're right, we did have a focus on aero.

And I think aero, our expectation is aero is going to recover, and it's going to recover such that it doesn't affect our view of the $2.4 to $2.6 million.

I even think in energy, Ross, well, that's something that you may have to watch over the next maybe 10-year horizon.

I don't know about you, but I've been reading about the peak demand for oil for -- I was in that business for 30 years, and it kept moving out 20 years at a time.

So I think, as we look out a reasonable time frame in 5 years, we do think that we can still get in that $2.4 to $2.6 billion range, even with, I think, conservative estimates for what's happening with oil and gas.

And part of that is we have an offset, as we told you on infrastructure, is we're expanding into other mining adjacencies.

And fact of the matter is, as we build more green machines, the need for some of these minerals and that type of mining is going to actually increase.

So we feel like those sort of areas that you mentioned, energy and aerospace, are not going to prevent us from getting to this $2.4 billion and $2.6 billion.

The other thing is that, when I came into the company and sort of reiterated that guidance at our Investor Day way back in December 2017, and I don't -- I think our plan for the fit-for-purpose wasn't fully developed.

We had sort of WIDIA as a separate segment.

And if you might remember, it was kind of set up as a separate segment so we could kind of figure out what we want to do with it, shine a light on and see what we need to do to make that business more profitable and grow.

And I think our expectations for that sort of fit-for-purpose space, I think, are even greater than what we thought we could accomplish under the previous setup.

So again, from a revenue perspective, I think we can get there.

And I'll let Damon comment on the -- our profitability assumptions.

Yes.

I think, Ross, 2 comments.

I think the other comment I'd make on top line is, remember, we're also a fairly low share in aerospace, and we still see significant opportunities to gain.

So even if that market is slower from a growth standpoint, there is still opportunities for us to grow within that market that I think gives us confidence in aerospace and the long-term potential there.

But I think from a margin perspective, again, when we gave you the outlook in December of '17, right, what we talked about was simplification/modernization.

And what you hear us talking about this next wave is operational excellence, where we now have the new modern equipment there.

For us, it's about driving incremental productivity that, to the extent there may be some sort of a mix issue that we're not seeing at least today, we're looking to hopefully offset that with incremental productivity going forward.

So when we look at our long-term plan, we still feel an opportunity -- we see the opportunity to get to that 24% to 26%, which is why we reaffirm it on the calls because we do see it as achievable for us.

Our next question today comes from Joe Ritchie of Goldman Sachs.

So I have a near-term and a longer-term question on the auto business, maybe the near-term first.

You talked about it being your strongest-end market in your fiscal third quarter, and you've got a guidance out there for sequential growth for the entire portfolio, mid-single digits.

I guess, what's the implied growth rate for your auto business in the fourth quarter?

And then maybe, if you could just provide a little bit more color just around both India and the supply chain constraints, that would be great.

For the transportation metal cutting, again, the impact of the chip shortages are going to affect the Americas as well as in EMEA.

And then, of course, EMEA is also being hit by sort of the COVID wave, potentially.

So for Americas and EMEA in terms of transportation, from Q3 to Q4, we actually see and sort of factoring in, it can kind of be down a little bit, right, because of those effects.

And while transportation in China is -- should continue to get stronger, I think that's going to be offset by sort of India, for the reasons we talked about with the potential lockdowns and the effect on consumer buying activity.

So I would say transportation for Asia-Pacific, all things considered, from Q3 to Q4 is kind of flat, if you will.

Those 2 will net out.

That's the way we're looking at.

Okay.

Okay.

Yes, that's helpful, Chris.

And maybe just a longer-term question on transportation, and really just trying to understand how you guys are positioned longer-term for EVs.

I'm just curious, just maybe if you could just provide some examples.

I don't know if the right number is like a content per vehicle or CapEx intensity of metal cutting for EVs versus traditional ICE.

It'd be helpful to hear kind of like your perspective on how you think that end market is going to look for you in the next 5 to 10 years.

Sure.

Well, there's no question there's going to be changes in the mix of cars produced.

I think something around -- just over 90% of the cars produced are internal combustion engines today.

And of course, this is going to move towards greater vehicle production over the next decade.

However, we think that there will initially be a greater shift to hybrid vehicles and -- which have both internal combustion engine, as you know, in electric motor propulsion systems.

And we expect that the hybrids will account for about 75% of the market in 10 years.

And as you mentioned or alluded to, the hybrid vehicles actually consume more cutting tools than the current internal combustion engines, so we view that there may actually be an uptick in metal cutting tool demand during the transition to electric vehicles.

I think it's also worthwhile noting that, while EV vehicles require less metal cutting to produce than the ICE or the hybrids, the underlying demand for all vehicles in the globe is still growing.

So we expect sort of net of all these variables for demand for cutting tools and transportation to grow sort of in this 1% to 2% range over the next 10 years.

That's kind of our long-term view of that.

Our next question today comes from Steve Barger with KeyBanc Capital Markets.

This is Ken Newman on for Steve.

So for my first question, I was just curious if you guys could just talk to broad inventory levels or visibility that you have in the channel from your customers.

Specifically, I'm trying to get a better sense if you think that you've seen any kind of restock from customers to pull ahead of supply chain issues within this quarter.

And how do you think about the potential for pull ahead orders in your 4Q guide?

Yes.

Well, I would say, from a metal cutters perspective, that we're seeing gradual improvement in stocking orders.

But distributors and customers are still exercising care and are a little bit cautious about burning too much cash until I think the demand signal a little stronger.

So Q4, the price increase that we're putting through, that could lead to some pull ahead of orders with distributors in Americas and EMEA.

But for the most part, in those 2 areas, I think that the significant restocking is still ahead, and it's not clear that it's going to break loose in Q4, but I suppose that's possible.

We're not counting on that in our current guidance, so that, I think, is potential upside.

In terms of infrastructure, the customer inventory levels, we would say, appear to be normal to low across all end markets, including oil and gas.

So for the most part, they're normal, but there are still -- that are holding lower inventory levels, so there's still, I think, a tailwind there that could come on the infrastructure side.

Understood.

And then, just from a modeling perspective, obviously, you're kind of guiding operating margins up both sequentially and year-over-year.

Should we think that margins are up sequentially for both segments in the fourth quarter, just given how tough the comp or how difficult the comp was in 4Q of last year?

Year-over-year, Ken, I don't -- I mean, what we're saying is you got -- there'll be a significant amount of temporary cost headwinds that are probably more focused on -- sorry, on metal cutting versus infrastructure, given the amount of labor that they deal with there.

I will also tell you that on infrastructure, again, they -- because of the way that they price their products with raw material cost, you may see a slight benefit for them, year over year, as they're starting to recognize a little bit of the benefit pricing-wise from the tungsten increase.

And so, I would tell you, probably a little bit more disproportionately negative to metal cutting year-over-year versus metal versus infrastructure.

Got it.

And then last one for me, within infrastructure, Americas and EMEA were both down double digits.

Obviously, Asia-Pac was up 30%.

Notwithstanding all the issues kind of going on within India right now, would you expect positive growth in all 3 of the regions this coming quarter?

Yes.

It's hard to say what's going to happen with India.

But with the exception of that, we are thinking that we'll have good positive growth in the other regions.

India is a little bit of a kind of a wait-and-see.

And ladies and gentlemen, this concludes the question-and-answer session.

I'd like to turn the conference back over to Chris Rossi for closing remarks.

Thanks, operator.

Thanks, everyone, for joining the call today.

We really appreciate your interest and support.

We've made fundamental improvements to the company, and we're really excited about the opportunity to further demonstrate the benefits of these improvements and the investment in modernization, to not only drive higher returns for investors, but also our ability to improve customer service and facilitate our ability to take share.

If you have any follow-up questions on today's call, please don't hesitate call to reach out to Kelly.

Have a great day.

Thank you, sir.

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