Kennametal Inc (KMT) 2021 Q2 法說會逐字稿

Good morning. I would like to welcome everyone to Kennametal's Second Quarter Fiscal 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, Vice President of Investor Relations. Please go ahead.

Thank you, operator. Welcome, everyone, and thank you for joining us to review Kennametal's Second 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 statements. 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 start today's call with some general comments and a brief review of the quarter, and then discuss our expectations for Q3 and strategic initiatives. Damon will then go over the quarterly financial results in more detail. And finally, I'll make some summary comments before opening the call for questions.

Beginning on Slide 2 in the presentation. We recorded strong margin improvement and free operating cash flow this quarter despite ongoing year-over-year market headwinds. These solid results were driven by improving sequential sales, reflecting both market improvement and growth from our strategic initiatives as well as increasing benefits from simplification/modernization.

Sales this quarter increased sequentially by 10%, outpacing the 1% to 2% increase from Q1 to Q2 that we typically see. Transportation and general engineering end markets, although still declining year-over-year, continue to show the highest levels of recovery. As a reminder, those 2 end markets total more than 65% of our sales. Energy and aerospace, as you know, continue to be challenged.

On a year-over-year basis, organic sales declined 14% on top of a 12% decline in the prior year. However, through disciplined execution of our strategic initiatives and cost-control actions, we were able to improve profitability despite the drop in volume and associated under absorption. Adjusted EBITDA margin improved by 160 basis points to 13% versus 11.4% in the prior year quarter. The year-over-year improvement in EBITDA margin was driven by lower raw material costs, increasing benefits from simplification/modernization and effective cost-control actions. Operating expense as a percentage of sales increased year-over-year to 22% due to lower sales, however, in dollar terms decreased 9%. Our target for operating expense remains at 20%. Adjusted EPS of $0.16 was essentially flat versus $0.17 in the prior year quarter, reflecting the factors I just mentioned.

Looking ahead, visibility in this environment continues to be limited. However, there are some reasons for optimism, such as recent end market momentum and some modest indications of restocking as well as the early stages of the vaccine rollout. Nevertheless, with possible additional shutdowns being contemplated in some regions due to recent spikes in COVID-19 cases, it remains difficult to forecast how end markets and our customers will be affected. Therefore, similar to the last couple of quarters, we will not be providing a full year outlook for fiscal year '21. However, I will provide some color on what we expect in the third quarter.

Based on monthly sales in Q2, early indications from our January sales and assuming that there are no additional significant COVID-19-related shutdowns in the quarter, we expect Q3 sales to see mid- to high single-digit growth sequentially, with part of the sequential sales growth coming from FX. We expect the underlying organic growth, excluding the effect of FX, to be in the mid-single digits, which is modestly above our typical sequential growth pattern of 3% to 4%. But regardless of the pace and trajectory of the recovery, we will continue to focus on the things we can control, such as executing our operational and commercial excellence initiatives, to gain share and improve profitability levels throughout the economic cycle.

On the operational excellence side, simplification/modernization initiatives delivered $23 million this quarter, 117% year-over-year increase, and are on track to deliver approximately $80 million in benefits this year, as expected. As a reminder, we expect to complete our original footprint rationalization activities with the closure of the Johnson City, Tennessee, plant and downsizing the Essen, Germany plant by the end of this fiscal year. Total cumulative savings from inception of the program are expected to be $180 million by the end of this fiscal year, which is within the original target range we laid out in December 2017 and will be achieved despite much lower volume levels than originally planned. This is a major accomplishment and sets us up well for the recovery. Capital spending associated with simplification/modernization is essentially complete, and as such, will result in more normalized CapEx levels going forward.

Total CapEx is expected to be between $110 million and $130 million this year, a 50% reduction year-over-year. Free operating cash flow was $29 million for the quarter, bringing the year-to-date figure to approximately breakeven. This was excellent performance by the team as they remained focused on working capital without compromising customer service. Based on the year-to-date performance and current second half outlook, we now expect positive free operating cash flow for the second half and total year, which Damon will go into more detail on.

As you recall, at the end of fiscal year '20, we announced 2 important changes as part of our commercial excellence strategy: first, the combination of our 2 Metal Cutting business segments to better direct our commercial resources, products and technical expertise on capturing a larger share of wallet; and second, repositioning the WIDIA brand and portfolio to address the multibillion dollar fit-for-purpose application space within Metal Cutting that we had not previously focused on. This approach opens up a 40% increase in served market opportunity while offering better service and tooling options for our customers. Overall, progress on these initiatives is tracking with our expectations, and I'm very encouraged by the wins we are seeing in fit-for-purpose applications as we roll the program out globally.

Please turn to Slide 3. We presented this slide on the last earnings call and have updated the graphs to reflect this quarter's results. As a reminder, the last time the company experienced a sales decline close to the one we are currently experiencing was during the Great recession in 2009. Graphs show trailing 12-month sales on the left and the corresponding adjusted operating margin on the right. As you can see, we have been able to maintain significantly higher levels of profitability throughout this downturn. And in this quarter, the 12-month profitability level is approximately the same but on much lower revenue. This is due to the benefits of simplification/modernization that we've already captured, combined with stronger and more timely cost-control actions.

Two additional points to note. First, the present day numbers do not yet include the full run rate effect of simplification/modernization. We are anticipating an additional approximately $40 million in savings by the end of this fiscal year. And secondly, we have not yet exited the downturn. The previous downturn lasted about 5 quarters. This downturn has already lasted 7 quarters, and we are just now starting to see early signs of recovery.

In summary, I'm very encouraged by these results. We have maintained higher profitability throughout this downturn and are well positioned to outperform as markets recover due to the initiatives we've executed over the last several years.

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

Thank you, Chris, and good morning, everyone. I will begin on Slide 4 with a review of Q2 operating results both on a reported and an adjusted basis.

As Chris mentioned, the sequential performance of our sales outpaced our expectations and the typical seasonal pattern. On a year-over-year basis, total sales declined 13% and 14% organically. Foreign currency and business days each contributed approximately 1% and a business divestiture had a negative effect of 1% in the quarter.

Adjusted gross profit margin of 28.2% was up 140 basis points year-over-year. Adjusted operating expenses of $98 million were down $10 million or 9% year-over-year. Adjusted EBITDA margin of 13% was up 160 basis points from the previous year quarter. Sequentially, despite rolling back many temporary cost-control actions in the quarter, which had amounted to close to $10 million, our adjusted EBITDA margin improved by 170 basis points due to the improving market conditions and continued simplification/modernization savings.

Adjusted operating margin of 5.3% was up 50 basis points year-over-year and 240 basis points sequentially. The improved year-over-year performance in our margin was primarily due to the positive effect of raw materials, as expected, which contributed approximately 590 basis points; incremental simplification/modernization benefits; and temporary cost-control actions; partially offset by lower volumes and associated under absorption.

The adjusted effective tax rate in the quarter of 24.7% was lower year-over-year due to the effect of higher pretax income and geographical mix. Our current expectation is for the adjusted effective tax rate for the fiscal year to be approximately 30%. Longer term, we continue to expect our adjusted effective tax rate to be in the low 20% range as profitability levels increase beyond FY '21.

We reported a GAAP earnings per share of $0.23 versus an earnings per share loss of $0.07 in the prior year period. On an adjusted basis, EPS was $0.16 per share versus $0.17 in the prior year. The main drivers for our adjusted EPS performance are highlighted on the bridge on Slide 5. The effect of operations this quarter amounted to negative $0.20. This compares positively to both the negative $0.62 in the prior year quarter and the negative $0.28 last quarter. The largest factor contributing to the $0.20 was the effect of lower volumes and associated under-absorption partially offset by positive raw materials of $0.25 and temporary cost-control actions. The negative effect of operations this quarter was basically offset by $0.19 or $23 million of benefits from simplification/modernization, a significant increase from $0.10 in the prior year quarter.

This brings the cumulative benefits of simplification/modernization to $145 million since inception. As Chris mentioned, our expectation continues to be that simplification/monetization benefits for the total year will be approximately $80 million driven by actions already taken or announced, bringing the total expected cumulative savings to $180 million by the end of fiscal year 2021.

Slide 6 and 7 detail the performance of our segments in this quarter. Metal Cutting sales in the quarter declined 14% organically on top of a 10% decline in the prior year period. All regions posted year-over-year sales decreases, with the largest decline in the Americas at negative 20%, followed by EMEA at 12% and Asia Pacific at 6%. Sequentially, however, we saw improvement across all regions. The performance in Asia Pacific relative to other regions reflects more positive economic activity, led by China, which was flat year-over-year, and an improvement in India, which was down low single digits.

From an end market perspective, we experienced the best performance in transportation and general engineering, which declined 4% and 12%, respectively. Energy declined 18% year-over-year, with the declines in the oil and gas portion of the energy end market more than offsetting continued strength in renewable energy, mainly in Asia Pacific. Aerospace continues to be our most challenged end market with sales down 43% in Q2 as COVID-19 continues to affect production levels and air travel. Sequentially, the increase in Metal Cutting was mainly driven by the transportation and associated general engineering end markets.

Adjusted operating margin of 6.1% was down 280 basis points year-over-year but well above the 1% we experienced in the first quarter. The year-over-year decrease was primarily driven by a decline in volume and mix partially offset by incremental simplification/modernization benefits, temporary cost-control actions and raw materials that contributed 230 basis points.

Turning to Slide 7 for Infrastructure. Organic sales declined 14% on top of a 14% decline in the prior year period. Other factors affecting infrastructure sales were a divestiture of 1% partially offset by a benefit from business days of 1% and FX of 1%. Regionally, again, the largest decline was in the Americas at 18%, then EMEA at 12%, followed by 1% growth in Asia Pacific. By end market, the results were primarily driven by energy, which declined 24% year-over-year, due mainly to the roughly 60% decline in the U.S. land-only rig count. Sequentially, our sales in the energy end market improved as customers increased their orders with the increasing rig count. Earthworks was down 10% year-over-year, driven by underground mining and construction weakness in the U.S. General Engineering was down 7% year-over-year, an improvement from the 14% decline we experienced in Q1.

Adjusted operating margin of 4.4% was up 620 basis points year-over-year. This increase was mainly driven by favorable raw materials, which contributed 1,230 basis points as expected, simplification/modernization benefits and temporary cost control actions partially offset by lower volumes and associated under absorption. Our expectation is that raw materials will be neutral year-over-year for Q3 and Q4 given that tungsten prices have been relatively stable for around 6 quarters.

Now turning to Slide 8 to review our balance sheet and free operating cash flow. We continue to believe that maintaining a conservative financial profile is appropriate to ensure that the company has ample liquidity, particularly in this environment, as well as the ability to continue to execute on our strategy. Our current debt profile is made up of 2 $300 million notes maturing in February of 2022 and June of 2028 as well as a USD 700 million revolver that matures in June of 2023. At quarter end, we had $25 million outstanding on the revolver with combined cash and revolver availability of approximately $780 million, and we were well within our financial covenants.

Primary working capital decreased year-over-year to $638 million given our continued focus on inventory. On a percentage of sales basis, primary working capital increased to 37.3% as sales remained depressed. Our target primary working capital to sales ratio remains 30%.

Capital expenditures were $29 million, a decrease of $46 million from the prior year, as expected, as our capital spending on simplification/modernization is substantially complete. Year-to-date, we have spent $69 million and continue to expect capital expenditures for the year to be in the range of $110 million to $130 million.

Free operating cash flow for the quarter improved year-over-year to $29 million. Sequentially, free operating cash flow also improved due to lower CapEx and stronger profitability. Year-to-date, our free operating cash flow is approximately breakeven and $59 million more favorable compared to last year.

Consistent with prior quarters, we paid the dividend of $17 million. The full balance sheet can be found on Slide 13 in the appendix.

Before I turn the call back over to Chris, I want to discuss the FY '21 EPS and free operating cash flow drivers for the second half. Please turn to Slide 9. As a reminder, this slide details how we expect key factors to affect EPS and free operating cash flow. This slide has been updated to show how these factors will affect the second half on a year-over-year basis and highlights meaningful sequential differences, where appropriate.

Starting with simplification/modernization. As we already mentioned, we expect to achieve benefits of approximately $80 million in FY '21, which implies around $40 million of incremental year-over-year savings in the second half. Temporary cost-control actions, unlike in the first half, will be a significant year-over-year headwind of $50 million to $55 million, with $40 million to $45 million in the fourth quarter. These headwinds are reflective of the aggressive cost-control actions implemented last year that are not expected to repeat this year. Given the phaseout of cost control actions in the second quarter, Q3 will face a sequential headwind of approximately $10 million relative to Q2. Due to the significant level of temporary cost control actions in place last year in the second half, year-over-year leverage will be distorted and not accurately reflect the underlying improved operational performance.

Based on current material prices, particularly tungsten, we do not expect raw materials to have a material effect either year-over-year or sequentially in the second half. Although depreciation and amortization were only modestly higher year-over-year in the first half, we still expect them to be approximately $10 million higher for the full year as new equipment comes online.

Lastly, for the EPS drivers, we have lowered our adjusted effective tax rate expectations for fiscal year '21 to approximately 30% from our previous estimate of 33%, which was also the effective tax rate last year. This improvement is reflective of the higher pretax income and geographical mix.

In terms of free operating cash flow drivers, as Chris and I already mentioned, capital spending for the year is expected to be in the range of $110 million to $130 million. This implies lower CapEx, both year-over-year and sequentially in the second half. We expect cash restructuring to be slightly higher both year-over-year and sequentially in the second half. And we now expect the full year cash restructuring to be higher by $20 million to $25 million versus the approximate $40 million spent in FY '20. This represents a modest decrease versus our original expectation.

Given our strong inventory reductions year-to-date and continued improving market conditions, we now expect working capital to be a modest use of cash in the second half. With our focus on working capital, combined with the improved market conditions, we now expect free operating cash flow will be positive in the second half and the full year.

Finally, as it relates to Q3, as Chris mentioned, we expect sales to be up mid- to high single digits sequentially, with part of the sequential sales growth coming from FX. We expect the underlying organic growth, excluding the effect of FX, to be in the mid-single digits and above our typical sequential growth pattern of 3% to 4%.

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

Thanks, Damon. Turning to Slide 10, let me take a few minutes to summarize. I'm encouraged by our results this quarter despite the ongoing challenges in our end markets. Our commercial excellence initiatives are progressing well to drive growth and market share gain, and our operational excellence initiatives are on track with simplification/modernization nearing completion. As shown in the margin graphs earlier in the presentation, the benefits of these initiatives, which we began 3 years ago, are evident, with more benefits to come as volumes return, further reaffirming our expectation that we will meet our adjusted EBITDA target of 24% to 26% when sales reached a targeted range of $2.5 billion to $2.6 billion. The strength of our balance sheet and cash flow allows us to continue to optimize capital allocation while further improving profitability and customer service throughout the economic cycle.

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

(Operator Instructions) The first question today comes from Steve Volkmann of Jefferies.

So Chris, you talked a little bit about some modest restocking that you were seeing. And I think you also said something in your prepared remarks about how January had started off fairly well, but I don't want to put words in your mouth. I'm just hoping you could maybe give us a little bit more color on kind of what you're seeing sequentially through the quarter into January. And whatever restocking might be sort of poking its head up, would love to hear about that.

Sure, Steve. In terms of the stocking level in my comment, I said we saw a modestly -- modest evidence of that, and that was primarily in Asia Pacific and China where there was clearly some restocking going on. But as it relates to the Americas, we're just sort of seeing some month-over-month improvement in stocking orders. And in EMEA, we see -- we haven't really seen anything. So I think my key takeaway here is that we're starting to see modest restocking activity, but -- but Steve, frankly, customers still remain cautious. So I don't think it's really in a meaningful way other than what I said in China.

But as you know, regardless of the customer inventory levels, we're managing our inventory to be able to take share in this recovery by having the sort of high-value, high-mover parts in inventory. And then we've also moved to this sort of weekly sales and operation planning meeting to allow us to react quickly to any changes in the demand signals.

As it relates to sort of January activity, I think it's safe to say we've seen an uptick in sort of the average daily sales versus kind of the average that we saw in December, and it's consistent with the -- sort of that mid-single-digit that we told you, excluding FX for growth in the quarter.

Great. Okay. Appreciate that. And then just on the energy specifically, I mean, the rig counts look like they've kind of turned up a little bit. How long until that sort of flows through into your business, do you think?

Yes. As it relates to energy, the good news is we are seeing an uptick in the rig count. And that will equal some modest growth, but frankly, we're off such a low base in the Americas that we're thinking that we're going to see some growth there, but not a huge amount. So it might start to benefit us maybe in the fourth quarter, Steve, but maybe not so much in the third quarter. That's -- it takes maybe 3 to 6 months for that to kind of flow through to us, if you will.

The next question is from Julian Mitchell of Barclays.

Maybe just the first question, trying to understand in the Infrastructure business what happened with the margins. Just trying to understand, sequentially, those were down despite a modest revenue increase. So just wondered if you could help us understand sort of what the main headwinds were there sequentially. And then when we're thinking about the second half operating leverage in that business of the higher revenues, what kind of placeholder should we have for that?

Sure, Julian, I think I'll comment on the sequential decline. Then Damon, maybe you can focus on the operating leverage and add anything.

(technical difficulty)

But for -- as you pointed out, Infrastructure had a slight increase in sales sequentially, but as we -- Damon talked about these temporary cost actions that came off. That had a big effect as well as some of the variable comp elements. And frankly, there was a bit of a mix issue. The oil and gas is a profitable business, and as that declined even further from Q1 to Q2, that also drove some of that decline. And all of that was partially offset by better manufacturing performance, volumes and raw materials.

So we saw a decline, unlike we did in Metal Cutting because it was largely dominated by those temporary cost actions and a little bit of mix.

What I would add for Infrastructure for the quarter is we did have a slight increase in an environmental reserve that you'll see in our 10-Q, added probably about a, call it, a little bit over $1 million of cost in the quarter. So that would have influenced the margin a little bit as well.

To your question about second half leverage, Julian, as I alluded to in my call -- in my comments, I think looking at leverage in the second half is going to be very challenging as you think about the year-over-year changes of the temporary cost increases flowing back in. As we've said in the past, historically, our average leverage is around 40%. Metal Cutting usually is above that, Infrastructure is slightly below that, plus some fixed-cost absorption. But again, I would just sort of caution you as the second half here with all of these changes of the implemented cost-control actions last year, they really skew it when you try to do it on a year-over-year basis this year.

Got it. And maybe looking at Metal Cutting, perhaps that's a bit simpler in terms of that operating leverage point. When we're looking year-on-year in that piece, do you think we can get closer to that -- maybe the -- not 40% as such, but closer to sort of 30% year-on-year leverage as you see the revenues start to return to growth during the second half?

I think leverage in the second -- remember, we have $50 million to $55 million of cost headwinds, in theory, coming back in year-over-year. So as you think about even the improvements that we're referring to with the sequential sales growth from Q2 to Q3, and hopefully, we'll see that something -- improvement in Q4, it's still going to be distorted by these level of cost-control actions that won't repeat here in the second half. So I'm not optimistic that when you do the math on leverage year-over-year, you're going to see anything that's even really reflective of our prior sort of downturns or recoveries given what we did last year and the changes year-over-year.

So it's not to -- it's hard to give you a specific answer because I don't think they're going to look good when you look at them on paper given what we did last year to control cost.

And I might add, maybe an easier way to look at it is sequentially from.

(technical difficulty)

Sort of the way I think about the margins is they're going to be pretty similar to what we saw in Q2 because we've got this sort of mid-single-digit sequential growth, excluding FX, and you said if it levered at 50%, I think, was kind of your number, and we've got some additional simplification/modernization benefits, we got to take off that $10 million headwind on cost actions and there's a little bit more depreciation in the third quarter than we had in the second quarter. And so all that gets you sort of in the neighborhood of what we saw in Q2. That may be an easier way to look at it.

The next question comes from Ann Duignan of JPMorgan.

Yes. On Metal Cutting also, I think you said that mix was a negative, which surprises me given that automotive or transportation and general engineering are such a significant portion of your sales. So could you just talk about that? Is it also energy is higher margin? Or are either automotive or general engineering particularly low-margin businesses?

Ann, when I was talking about mix, I was talking about the Infrastructure business. The oil and gas business is higher profitability and nonmetal cut.

I think, Ann, our mix was a negative headwind for us year-over-year. If you think about the markets that were down the most, aerospace, which, as we've said, is one of our most profitable end markets, which is why we focused our growth there the last several years, was down 43% year-over-year. Transportation, which as you know, as part of our portfolio simplification years ago, that was one of the markets we sort of moved away from because it was on the lower end of that profitability, was the best performing.

So when you think about the year-over-year changes, it's definitely the lower aerospace. Energy, which is a higher profit margin business for Metal Cutting was also downward 18%. So that's -- there is a mix effect here in Metal Cutting, but it was more end market mix that was driving it.

Okay. That's helpful. Because it was specifically Metal Cutting in the opening remarks that you called out lower volume and mix. So I just wanted to make sure I understood that. And then China, sales flat year-over-year. There's really been no end market in China where we've seen flat year-over-year. And I think you said there was some restocking in the region, maybe, again, not specifically Metal Cutting. So could you address that? Are you losing market share? Is there anything we need to know about why your sales in China were flat?

Yes. In Asia Pacific -- China, in terms of transportation, we did see an uptake in transportation business there. And also energy, which is around wind turbines, was an increase. So when I was talking about flat, we think that, that is sort of driven to -- the market has recovered pretty well, but we're expecting it to maybe improve just a little bit better, but not significantly beyond what it's already done.

And again, Ann, I think, again, comparing every company is a little bit different. But the mix of what we have in Asia, as Chris alluded to, we did see good growth in automotive or transportation and energy. Aerospace, which is a good part of the business there in China, was down significantly, I think down a very high percentage. So again, for us, that was probably a negative mix issue in China, which led us to be about flat year-over-year.

The next question comes from Ross Gilardi of Bank of America.

I was just wondering if we could just talk about your capacity a little bit and just how you're thinking about the right amount over the next cycle. You talked about the EBITDA margin targets getting back to the -- being achieved. Your EBITDA margin targets being achievable when you get back to $2.5 billion to $2.6 billion in revenue, which was the peak in 2012, '15. I mean I think it's clearly debatable if some of your end markets get back to those levels, particularly on the Infrastructure side. So my question is really how much revenue do you think you're capacitized for on a normalized basis over the cycle? And if you come to conclusion at the next peak is going to be below that $2.5 billion to $2.6 billion, how would you address capacity?

Yes. So Ross, the way we're thinking about the capacity is, as you know, we've done a lot of footprint consolidation, resulted in about 7 plants as part of our original

(technical difficulty)

program. So size of the capacity at the low end of the volume, we think that because we've modernized the factories and have taken a huge amount of labor out, that, coupled with being able to do furloughs or using temporary workers in the U.S., we think that our capacity, as it sits today, is actually sized for what turns out to be one of the all-time cycle lows that we've seen. We've been able to actually do better in this down cycle than we have in the previous great recession, if you will.

So we feel pretty good about our sort of the low-end capacity and be able to flex with that. And then because a lot of this is automated, we also feel good about our ability to ramp up. So I think we've protected ourselves on the downside, and we're positioning ourselves to be able to ramp that capacity up at higher volume levels. That's the way I see the current footprint.

Okay. Got it. And then maybe you could just talk about raw material costs just a little bit beyond the second half? I mean you really didn't have a lot of visibility right now, but we've seen pretty dramatic spikes in a lot of industrial metals. And tungsten and cobalt are a little bit harder to follow from the outside. But what are you thinking there? And do you have the ability to stock up on additional raw material going into fiscal '22 in the event of a spike? And is that a potential risk to just the margin recovery beyond the second half of this year?

Yes. Let's see, just kind of a little background, the big material driver for us, especially on the Infrastructure side, not so much on the Metal Cutting, is the APT. Those prices have been sort of stable between this $210 to $240

(technical difficulty)

price over the last 6 quarters. I think in Q2, it averaged around $220.

So we expect to see a slight uptick in that, and that usually is indicative of what we're going to see, which is demand coming back, right? So that's a positive. And then when that happens, we've got a long history in the company in both the Infrastructure side and Metal Cutting to be able to manage the price raw calculation. Sometimes, we're ahead of the curve, sometimes behind. It changes by quarter, but overall, we've demonstrated a history that we can maintain the right balance there.

So I see APT prices going up as an indication of higher demand, and I'm very confident in our ability to sort of manage that cycle, whether we move these prices off to our customers. We don't do so much buying the raw material inventory in advance. In case of Infrastructure, there's a lot of the oil and gas contracts. There's an industry there, so we're covered as those prices go up. And like I said, we've been able to -- any changes in the APT price, we've been able to push that off to our customers. It's kind of what's expected in the industry.

The next question is from Walter Liptak of Seaport.

I wanted to ask about the temporary costs and make sure that we understand fully how these temporary costs are coming back. So I wonder if you can split the costs returning in the third quarter and fourth quarter. And then maybe talk about the first half of 2022 a little bit, are there more costs that are going to be coming back then?

Yes. Walt, so we said there'll be about $50 million to $55 million of incremental cost headwinds year-over-year, and about $40 million to $45 million of that would sit in Q4. So that, let's call it, about $10 million of the headwind in Q3. That's your year-over-year for the back half of this year.

As we look at the first half of FY '22, we will see, again, first half of FY '22 headwinds due to the first half cost actions that we had in place here in Q1 and Q2 of FY '21, and those are around $15 million or so per quarter. So I think it was around $15 million in Q1, and maybe just a little bit less than that as we started to roll off some of those temporary cost actions here in the second quarter. So let's call it -- we'll call it, $25 million or so of incremental cost headwinds in the first half of '22 versus the first half of '21. And then all else being equal, we should be neutral year-over-year in Q3 and Q4 of '22, assuming there's nothing that we do this -- balance of this fiscal year.

Okay. Great. And I wanted to switch topics and talk a little bit about Europe. And I think you made a comment in the opening remarks that Europe is still pretty down. I wonder if you can talk about some of the recent trends. And as they begin to reopen with vaccines coming out, what you're expecting for inventories and for production going up?

Yes. EMEA, like I said, overall, is flat. I think general engineering, we think that there could be an uptick in

(technical difficulty)

as things start to recover there. But you kind of hit it, Walt, there's still uncertainty about maybe potential shutdowns. But if that doesn't happen, we would start to see -- expect to see an increase from Q2 to Q3 in general engineering. But aerospace and energy would sort of be flat at their current levels. And I think transportation will stay flat at least through Q3.

The next question comes from Ronny Scardino of Goldman Sachs.

So just a clarifying question. If I heard you correctly, you mentioned 3Q in the neighborhood of 2Q. Was that a margin comment or an EPS comment?

Yes, margin comment.

Got it. And then are there any puts and takes we should just keep in mind in 3Q versus 2Q outside of what you already outlined on a temporary cost and material inflation side?

No. I think, as Chris said, we'll pick up incremental EBIT related to the volume that he's alluded to. So again, the mid-single digits, when you adjust for FX, improving the overall EBIT, but directionally speaking, that would be offset by the sequential increase in cost as these temporary cost actions have rolled off now at the end of the second quarter.

Next question is from Dillon Cumming of Morgan Stanley.

First, I just wanted to kind of frame some of the comments you made around fit-for-purpose. You mentioned the positive feedback from the distributor channel. But I guess more tangibly, it actually looks like you've managed to narrow the gap on organic growth versus one of your larger competitors. So I'm just wondering whether you think that's a result of some of the fit-for-purpose efforts or if there's some other kind of share dynamics going on there.

Yes. I think when you look at the share in any given quarter, I think you got to kind of look at it over a longer period of time, they can kind of move around, especially when you're coming out of this type of market situation. That being said, we are focused on this fit-for-purpose segment, which basically opens up about 40% of Metal Cutting segmentation that we've never really focused on before, and it happens to be right inside our existing customers. We've been -- a lot of our customers, especially those buying Kennametal tooling, were looking towards us for sort of high-performance tooling. And even though they had these sort of fit-for-purpose applications inside the same factories, they didn't really turn to us. So now that we've repositioned the WIDIA brand and we've put the two organizations together and are selling it as if we can cover their entire broad application base, we see that we're starting to win a lot of business. They're coming to us for things that they never came to us before.

We're very, very encouraged by some of the things that we're seeing as we roll this out globally. We're seeing some good opportunities in France and Spain with existing customers where they're now giving us these fit-for-purpose applications.

Concerning early wins with customers, as I said, that previously had looked to us for the high-performance stuff but not the fit-for-purpose. So when we see those type of things, we know we're getting a larger share of wallet. And so that's actually a pretty easy way to definitely indicate that you're picking up share because we know we've gained share with that particular customer.

So very good feedback from our distributors. I think that we -- this clearer brand strategy and positioning actually brings the full Kennametal portfolio to their customers. And net-net, it's a win for the channel and it's a net-net win for our customers. So we feel very good about the traction we're getting. And I would absolutely say that as you -- as the organic growth numbers come in, it's going to start to even more reflect this traction that we're getting in fit-for-purpose.

Okay. Got it. That's helpful color. And maybe just a market question to wrap up here. Just wanted to level set what you're seeing in earthworks between the underground mining business and construction. It feels like some of your construction customers have started to sound a bit more positive on kind of where calendar '21 is going to shake out. So first of all, I just wanted to kind of triangulate where the more acute pressure is within earthworks? And then on to that, you've mentioned before you wanted to start getting more into the international opportunities on the mining side. I'm just wondering if you can kind of update us on your efforts there.

Yes. I would just start with sort of broadly mining from Q2 to Q3, we expect to be sort of flat across all regions and construction flat across all regions. But let me just maybe make some deeper comments on construction.

Like I said, expected to be flat. The road continues to be affected basically by state budgets and COVID-19. So that is sort of putting a damper on some of the road projects. You can't physically get on site or the states are running out of budget. So that's what's kind of going on there, and that we think will persist at least through

(technical difficulty)

And in terms of mining, as you know, we're tied to metallurgical coal, which is more stable than thermal. And there does seem to be an uptick in global surface mining. Regionally, we think EMEA is fairly stable in this area. China has rebounded from COVID, but there is trade conflict with Australia and U.S., and that's affecting some of the market dynamics. And America has rebounded somewhat off the bottom. Appalachian coal was down, I think, around 19% year-over-year, and -- but it's expected to recover by Q4.

So those are sort of the high levels on the current business. And then as you said, we also wanted to move internationally. We continue to get some good traction in places like South Africa in that regard. And then also, we were expanding into mining adjacencies, and that actually is starting to get some good traction where we're trying to use our tooling portfolio that's well-suited for coal, if you will, with similar materials, such as potash. And we continue to get traction there.

The next question is from Adam Uhlman of Cleveland Research.

Yes, I wanted to go back to the discussion about working capital earlier. You mentioned it's going to be a use of cash in the second half of the year, I think, modestly. But beyond that, how should we think about working capital as we get further into a sustainable revenue recovery given all the investments that the company has made and the factories and processes? Any kind of metrics that you could share with us along those lines?

Yes. I would say our target is still to be somewhere in the ballpark of 30%. As Damon said, the second half is expected to be a modest use of cash. So until volumes return, we're going to probably be above that 30%. But we're constantly looking for ways to reduce the primary working capital further. And one of those ways is to rationalize our footprint. So the footprint reduction is going to help.

And also, we're still ramping up a lot of these modernized processes in factories. And as those become -- as those ramp up and we become more efficient, we think that, that will actually have an impact on the working capital, in particular on not only finished goods inventory because it takes us less time to manufacture things but also on the work in process.

So 30% is the target, but I believe with modernized factories, we should be able to do better than that. And that's what we're levering to do.

Okay. Got you. And then could you remind us how we should expect the cadence of modernization savings to kick in over the next year or 2? I know there's -- a big chunk of that is going to be dependent on volume, but I'm curious if you have any updated thoughts to share along those lines?

Yes. So I think, Adam, we've done just over $40 million, about $45 million year to date. What we said is will be just around another $40 million in here in the back half year-over-year. We haven't given any specific numbers for FY '22, but there is actions that we have put in place this year or that we are yet to put in place, like the closure of Johnson City, that will happen in the latter part of this year that will drive incremental savings in FY '22 and beyond.

And to your point, as volumes ramp up from where we are today, they will drive an incremental savings beyond just the plant closures and other actions that are currently in place. But we haven't given any specific numbers as to how big or what more that would contribute to the bottom line other than say, by the end of this year, we're going to be at $180 million. And we have given you a range of $180 to $220 million based on certain revenue. So you can start to see that there's probably more savings that'll come as volumes continue to pick up here, hopefully, in FY '22 and beyond.

The next question is from Steven Fisher of UBS.

Can you guys just remind us of how much of the general engineering market is driven by automotive end demand and the extent to which you're seeing any broadening of that market -- end market that's recovering really versus just automotive? It seems like automotive has been a nice big driver here, just is that broadening out with it in general engineering?

Yes, you're absolutely right. The increase in general engineering that we've seen is -- in large part, we think, is driven by transportation. So transportation saw a nice increase from Q1 to Q2. And most of the manufacturers have kind of returned to sort of pre-COVID levels, and they'll probably stay there for Q3.

We'll see some trickle-down effect continuing in general engineering, but so far, Steven, we haven't actually seen sort of a broader recovery in that space quite yet. And that's part of what's governing our expectations for Q3. We're hopeful that it's going to improve, especially as GDP starts to return and the economy starts to return to normal with the vaccine, but that's -- the timing of that is still a little bit uncertain.

But you're absolutely right, it's been largely driven by transportation. I'd have to see what happens in the broader sense.

Got it. And then just bigger picture here, longer term, obviously, volumes are a very critical factor to your model. So just kind of high-level, as we think about the potential for getting to that $2.5 billion or so of revenues that really drives the margin upside, how much do you think you can do from a growth perspective on company-specific initiatives versus what you're going to be relying on, on market growth for?

Yes. We -- I think the way I would look at it is -- I mean, of course, it depends on how quickly the markets would recover. But we -- when we do our strategic planning, we're sort of thinking of this thing as the market piece, we can't really control, and we've got all kinds of models as to how these businesses come out of these cycles. We're challenging ourselves to pick up share gain. So while we're focused on and happy to have the market rebound, it's really the share gain that we're going after. I wouldn't -- it wouldn't surprise me if that's a 50-50 split depending on the time frame we're talking about.

So that's where we're about coming to work every day is pick up that share gain and not just simply follow the markets up and follow the markets down. Now obviously, it is a cyclical business, and the markets do move, so that's going to affect our numbers, but we can help dampen that effect by picking up share, making sure that we have a higher share regardless of what point in the cycle we're at.

The next question comes from Steve Barger of KeyBanc Capital Market.

I know it's tough to call here in January, but when you look at the 4Q revenue comp of negative 37%, just in the context of the sequential improvements in end markets you're seeing, how are you thinking about 4Q growth? Just to help people calibrate, should we be thinking it's over 25%? Under 25%? What's your kind of thought on that?

When you say growth, you're talking about revenue growth?

Revenue growth in 4Q year-over-year, yes, against the negative 37% comp from last year.

Yes, got it. I think maybe what might be helpful to look at is the markets staying largely the way they are right now, this business would -- normally, we would see a seasonality, bunch of growth from Q3 to Q4 sort of in the 2% to 3% range. So you can make whatever assumptions you want if you want to take it higher than that because you think the recovery is going to accelerate, but I would think that you'd want to at least think about that normal seasonality of 2% to 3%.

Sequential?

Yes. Sequential.

Understood. Okay. And I know revenue is going to be a huge swing factor over the next few quarters, and it's really hard to gauge that. But just as I'm thinking about the margin conversation that we've had today, simplification/modernization versus costs coming back, just as a base case, are you thinking that 2 half EPS this year is above the $0.61 that Kennametal earned in 2 half '20?

We haven't -- we're not giving a specific EPS guidance. As we said, there's a lot of different variables thinking about the absorption and the volume. We're trying to -- we haven't even given you Q4. As Chris said, we've given you an indication of what historical seasonality would look like. So I think that, coupled with the fluctuation in the tax rate, we've given you the best we can right now. We haven't given any sort of full year guidance given the level of uncertainty that we're dealing with. So I think we're going to keep it at that right now and just give you the

(technical difficulty)

Understandable. I guess, I'll just try it one more way. If the 3Q operating margin looks similar to 2Q, would you expect a significant step-up in 4Q? Or that's not likely because of the $40 million to $45 million of incremental costs rolling back in, even if you have a better volume?

Well, again, Steve, I think it goes back to what is the incremental volume that we're going to see from 3Q to 4Q sequentially? From incremental cost going from Q3 to Q4, we don't see a significant or a material headwind in sequential cost. So all else being equal, if you see revenue growth, generally speaking, I think cost would be relatively flat sequentially, I would expect to see some sort of an EBIT growth related to that top line. Again, the $45 million to $55 million headwind is a year-over-year comment as well as sequential cost increases should be relatively muted from Q3 to Q4.

The next question is from Joel Tiss of BMO Capital Markets.

I appreciate you guys staying on to squeeze me in. I missed a little bit in the beginning, but I don't know if you talked at all about inventory levels at the distribution side. And any customer color about wanting to increase their inventory levels or kind of keep them about where they are now?

Yes. Joe, we had talked about some modest restocking activity. I made that in my opening remarks, and then there was a question. But what I said was that customers, I think, are pretty much remaining cautious, so not a meaningful increase in restocking that we're seeing. We did see that probably the most meaningful area was in China, which maybe doesn't surprise you because they're kind of ahead of the curve on the recovery. Otherwise, a little bit -- little indication in the Americas and maybe really nothing yet on the EMEA side.

What was...

And -- go ahead, sorry.

Go ahead, Joel. What was the other part of the question?

I just wanted to -- I was wondering if you could give us kind of a normal free cash flow maybe when we get past all this noise and just say maybe in your fiscal 2022, just sort of how you guys are thinking about it or how should we be thinking about it?

I think, Joel, we're not going to give the specific for 2022 because, again, a lot of uncertainty with how the markets are going to recover. But I think what we have said is as we've moved through the heavy investment here with simplification/modernization and our capital expenditures are now back into what we'll call more normalized range in this $110 million to $130 million, as these markets recover, we work through the working capital sort of rebuild of AR, we would expect cash flow to be about 100% of net income on an ongoing basis. That's sort of our long-term expectations. Whether we get there in 2022, we're not -- a lot will depend on how the markets move here, but that's our longer-term goal.

The next question is from Chris Dankert of Longbow Research.

I guess, just circling back to fit-for-purpose. I know it's still early days, but will there be a metric going forward that we can kind of track whether it national account signings, whether it's average sales per order bidding level? Is there a metric that we on the outside can look at to just kind of see what that traction is? Or is it just too difficult to peel apart?

Well, there's -- from an outside perspective, we'll have to figure out something that -- I think it would be harder for you guys to triangulate that on your own because, like I said, it's inside of -- it's already inside the current segments that we report externally. I think the way we're looking at it is we will be commenting on basically the growth rate that we're seeing in certain end markets. And then in the fit-for-purpose space, which is largely -- has a lot to do with general engineering, we can probably measure ourselves and plan to measure ourselves against the -- what the overall market growth rate is versus what we're -- how we're actually growing, so that will give us one indication.

And then we also -- a better indication, though, specifically by customer, we have the ability to sort of understand what the share of wallet is, and that's a better indication for us. But that is not something that we would necessarily discuss externally.

So I guess from an external perspective, we could -- you can look at IPI and sort of how fast we're growing and maybe the general engineering space versus that IPI market index. But we'll continue to give you guys commentary on how we're doing relative to what I said, which is measuring this sort of one client at a time.

Got it. No, that's helpful. And just the very last thing for me. I guess, in the slide deck, you guys mentioned the growth initiatives within Infrastructure are also driving share gains. I guess, maybe you could highlight what those growth initiatives inside of Infrastructure are? That'd be really helpful.

Yes. There's a few things going on there. We're focused on commercial excellence in Infrastructure. We brought in a new leader about a year ago. He's really brought a lot of discipline to the selling process, in particular value selling and increasing the number of customer interactions. So what we're finding is that with that increased coverage, we're going to customers that we haven't really called on in a long time, reminding them who we are and our great value proposition, and we're starting to get a larger share of their wallet just by being more disciplined with that sales process and focused on value selling.

And then we're also -- we've been doing simplification/modernization inside Infrastructure. And so our ability to ship on time and ship with better quality, we're leveraging that. In fact, we just got a large order from a customer in the supporting U.S. government business. And they gave us a huge order because they said, basically, you're the supplier that we can count on to ship on time with the right quality, and that's all a result of simplification/modernization. So I would say, leveraging commercial excellence and operational excellence are helping us to grow there. And then as I said, we're trying to expand in some adjacent spaces, such as potash and those type of things, and we continue to see traction.

So it is true that Infrastructure's markets are down and maybe are not growing as fast as other markets, but there still is opportunity for us to gain share and grow in those spaces with the right business processes around commercial excellence and operational excellence. And that's what we're doing, that's what we come to work every day to do.

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

Thanks, operator, and thank you, everyone, for joining the call today. We certainly appreciate your interest and support for Kennametal.

As you can tell from our Q2 results, our transformation is really well underway. We permanently improved the cost structure, as demonstrated by our higher profitability levels this downturn versus prior downturns. Remember that as volumes increase, we will continue to get incremental benefits from these initiatives. Improvements will serve us well as markets recover throughout the entire market cycle.

If you have any follow-up questions on today's call, please don't hesitate to call Kelly. Have a great day, everyone. Thanks.

A replay of this event will be available approximately 1 hour after its conclusion. To access the replay, you may dial toll-free within the United States (877) 344-7529. Outside of the United States, you may dial (412) 317-0088. You will be prompted to enter the conference ID: 10139097, then the pound or hash symbol. You will be asked to record your name and company.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines.