Kennametal Inc. (KMT) Q2 2013 Earnings Report, Transcript and Summary

Good morning. I would like to welcome everyone to Kennametal's Second Quarter Fiscal Year 2013 Earnings Call. [Operator Instructions] I would now like to turn the call over to Quyhn McGuire, Director of Investor Relations. Please go ahead.

Thank you, Brad. Welcome, everyone. Thank you for joining us to review Kennametal's Second Quarter Fiscal 2013 results. We issued our quarterly earnings press release earlier today. You may access this announcement via our website at www.kennametal.com. Consistent with our practice in prior quarterly conference calls, we've invited various members of the media to listen to this call. It's also being broadcast live on our website, and a recording will be available on our site for replay through February 25, 2013. I'm Quynh McGuire, Director of Investor Relations for Kennametal. Joining me for our call today are our Chairman, President and Chief Executive Officer, Carlos Cardoso; Vice President and Chief Financial Officer, Frank Simpkins; and Vice President, Finance and Corporate Controller, Martie Bailey. Carlos and Frank will provide further explanation on the quarter's financial performance. After their remarks, we'll be happy to answer your questions. At this time, I would like to direct your attention to our forward-looking disclosure statement. The discussion we'll have today contains comments that may constitute forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve a number of assumptions, risks and uncertainties that could cause the company's actual results, performance or achievements to differ materially from those expressed in or implied by such forward-looking statements. Additional information regarding these risk factors and uncertainties is detailed in Kennametal's filings with the Securities and Exchange Commission. In addition, Kennametal provided the SEC with a Form 8-K, a copy of which is currently available on our website. This enables us to discuss non-GAAP financial measures during this call in accordance with SEC Regulation G. This 8-K presents GAAP financial measures that we believe are most directly comparable to those non-GAAP financial measures, and it provides a reconciliation of those measures as well. I'll now turn the call over to Carlos.

Thank you, Quyhn. Hello, everyone. Thanks for joining us today. In the December quarter, we continue to experience challenges similar to those of the prior quarter, which included lower sales volumes as demand slowed globally. Political and economic uncertainties led to spending deferrals and inventory destocking by customers. Those conditions resulted in a weaker-than-expected global investor production across certain end markets and geographies. In addition, our sales were unfavorably impacted as a number of customers who extended shutdowns year end holidays. This trend was more severe in Europe but it occurred in North America as well. Accordingly, we made further adjustments in our business as we expected those challenging conditions to continue for the near term. Even so, we still expect to realize sequential quarter-to-quarter improvement in the second half of our fiscal year. Although economic projections call for global industrial production to expand, it is likely to grow at a more modest rate than previously forecasted. What positioned Kennametal well is that we serve a diversified mix of end-market and geographies, which helps to lessen volatility over economic cycles. We remain highly focused on further growing and balancing our global presence to generate revenues in equal parts from North America, Western Europe and the Rest of the World's markets. In line with our geographic expansion strategy, we announced earlier in December quarter that we plan to invest in an advanced carbide recycling facility in U.S., while expanding tungsten cobalt blended partner operation in our China facility to serve the Asia-Pacific region. Both projects focus on strengthening our tungsten sourcing for both technology and cost perspectives, while increasing our access to raw materials. We remain encouraged by the long-term growth opportunities in our served end markets. On a global basis, demand for energy, power generation, vehicles, commercial development, new materials and increased requirements for customer productivity remain the key growth drivers in our industry. In addition, our WIDIA brand and general [ph] strategy is creating opportunities for us to grow our presence in industrial distribution. Our proven strategies enable us to effectively navigate economic headwinds and deliver our goal of driving profitable growth and doubling our revenues over the next 5 years. We have implemented contingency plans to reduce costs to match the current environment. During the December quarter, we further sharpened our focus on expense control in both manufacturing operations and administrative functions. Our team maintained the discipline that has long been part of Kennametal's culture to achieve additional savings, over and above permanent structural improvements made from prior initiatives. Importantly, we accomplished this without sacrificing ongoing development of talent and technologies that depreciate Kennametal in the marketplace. At this time, I would like to provide an overview of trends we are seeing in our served end markets. In aerospace, U.S. commercial firms continue to lead the way in growth. Boeing finished the year with 601 commercial jet deliveries, surpassing their projection of 590 units. Although its 787 Dreamline fleet was recently grounded, the issues do not seem to be related to manufacturing processes and production has not been negatively impacted at this time. Embraer recently released its forecast for Chinese markets during Airshow China in November. It predicts significant growth in the number of aircraft carrying 30 to 120 passengers from 125 today to more than 1,000 jets in 2031. In General Engineering, which primarily reflects trends in the indirect channel, the latest Industrial Supply Association economic report indicates that distributors are optimistic despite current headwinds. Distributors generally reported experience of steep declining businesses in the last 2 weeks of December. In addition, they noted that inventories remain relatively high in the channel, suggesting further destocking in the near term. In transportation, light vehicle production in North America is expected to decline over the next several months but should resume modest growth through the remainder of calendar year 2013. Based on that, OEMs and major tier suppliers continue to make investments to increase capacity. In Europe, the transportation sector declined 18% year-over-year in vehicle production, and lower levels are expected to continue for upcoming quarters. In China, 2013 production is expected to increase 9% over prior year to 20 million units. In India, vehicle production is forecast to grow 8.4% in calendar year 2013. Kennametal can provide productivity improvement for this market with our portfolio of standard products, as well as our highly-engineered customized solutions. In the energy market, continuous flowing in oil and gas drilling activity is reflected in a 5% decline in world rig count year-over-year. While oil prices have improved, they remain relatively low, and gas prices have stalled as well. Demand for natural gas is expected to rebound by year end of calendar year 2013 with investments being made globally, including land purchases in U.S.-based Marcellus shale and exploration reserves in the North Sea. In addition, renewable sources of power generation are projected to grow globally 5% per year, which increases Kennametal's addressable market opportunities. In mining, U.S. coal production was down nearly 7% in 2012, contracting most significantly in Central Appalachia, with the 16% year-over-year decline. As of December, coal prices seem to have stabilized in U.S. In Europe, coal demand increased year-over-year despite a sluggish economy and imports from South Africa, Russia, and U.S. typically favored over high-cost coal produced in the European Union. China's coal production declined due to weak economic conditions and government mandated shutdowns of small mines in preparation for the transition to the new political leadership. Longer-term, China plans to add significant coal-fired electricity generation capacity increasing current annual production of 4.9 billion tons to 7 billion tons annual by 2020. In road construction, the U.S. federal Highway Bill will allow some states to fund more highway rehabilitation in calendar year 2013, which should benefit Kennametal beginning in the spring, giving us strong leadership position in this market. In Europe, highway rehabilitation markets are expected to be flat, while modest growth is expected in other regions such as South Africa, Poland and Russia. On the whole, world growth is expected to stabilize in 2013, then hold steady at 2.6% according to IHS Global Insight. In addition, a modest declaration of growth is expected in the later part of calendar year 2013. This cautiously favorable outlook is based on the expectation that the monetary stimulus put in place in many key economies will have some positive effect on growth and uncertainties related to the U.S. and the eurozone and China will become less intense. Therefore, it's anticipated that the risks facing the global economy will be more balanced. Over the past 12 months, the risks were more skewed to the downside. Following the great recession, consumers and businesses have been cautious about spending. There is some evidence that this process may be winding down, especially in the U.S. and parts of Asia. Looking ahead, those are encouraging signs of a recovery, although it appears to be delayed by 1 to 2 quarters. Our global team remains agile, and we will -- we are very well-positioned to serve our customers when growth resumes. We have successfully managed through the much more severe downturn, and we are a stronger company today. We have a playbook to align our cost structure with current market demand. As always, our company-specific initiative enable Kennametal to protect our profitability and deliver a double-digit operating margin, even in a challenging macro environment. I will now turn the call over to Frank, who will discuss our financial results for the quarter in great detail. Frank?

All right, thank you, Carlos. I'll provide some comments on our performance for the December quarter and then I'll move to the revised outlook for the remainder of fiscal 2013. The December quarter was more challenging than we originally anticipated as most of our served end markets experienced weaker-than-expected demand. This panel was evident in our monthly order rates that we provided during the quarter. Continued soft demand in destocking plagued our General Engineering market, transportation was particularly slow in Europe due to extended plant shutdowns in December at automotive manufacturers, and customers further delayed their projects in the energy market. Our previous expectation assumed that activity would begin a rebound at the beginning of calendar year 2013. It now appears that the recovery has been deferred for at least 1, maybe 2 quarters. That said, I'll point out that we're managing that business very well, the factors we can control, and near-term headwinds do not overshadow strong future growth opportunities and the execution of our strategies. Further, despite the sales challenge in the near term, we again delivered double-digit operating margin, we also demonstrated exceptional cost control throughout the company and managed to reduce our finished goods and WIP inventory by approximately $17 million from September, despite a demand environment that was much softer than we had anticipated. Lastly, we enhanced our liquidity and strengthened our financial position by issuing $400 million of 2.65% bonds, due in 2019. Note that our proactive cost reduction measures, as well as our more efficient organization structure helped deliver double-digit adjusted operating margin of 10.7% for our base business despite the market challenges of the quarter, and our inventory reduction efforts. We have cost containment actions in place at all functions and are managing our business to market conditions while staying focused on our near-term cash flow objectives and long-range growth strategies. Now I'll walk through the key items in the income statement. Sales for the quarter were $633 million, this compares to $642 million in the same quarter last year. Sales declined by 1%, reflecting a 10% organic sales decline and a 1% unfavorable effect from currency, partly offset by 9% increase from Stellite, and a 1% increase for more business days. Industrial segment sales were $361 million and they declined by 12% from the prior year quarter. This was due to 10% organic decline and a 2% unfavorable effect from currency exchange. On an organic basis, sales declined 15% in general engineering and 8% in transportation, partly offset by sales growth of 10% in aerospace and defense. General engineering was unfavorably impacted by lower sales to the indirect channel due to further inventory destocking, while transportation experienced lower volume, lower vehicle production rates and extended plant shutdowns, particularly in Europe and Asia. Aerospace and defense sales benefited from the increase in commercial aircraft production. And regionally, sales in the industrial segment decreased by approximately 15% in Asia, 9% in Europe, and 8% in Americas. Turning to the infrastructure segment, our sales of $272 million increased 17% from the prior-year quarter, driven by Stellite contributing 26% growth, partly offset by an 8% organic sales decline and a 1% unfavorable effect from currency. On an organic basis, sales declined by 13% in energy, and 6% in the Earthworks market. Energy customers continue to delay orders due to ongoing decline in the North American oil and gas rig count, and weak underground coal demand in North America, as well as additional mine closures affected our Earthworks business. Regionally, sales decreased by 12% in the Americas, 3% in Asia and remained flat in Europe. Now turning to our gross profit margin. Our gross profit margin was 31.5% compared to 36.1% last year. The decline was due to lower volumes and lower absorption of manufacturing cost resulting from both the lower sales, as well as our inventory reduction efforts, as well as an unfavorable sales mix. The inventory reduction had an unfavorable impact of approximately $5 million or 100 basis points on gross margin. This quarter's results also includes the effect of Stellite, which has a lower gross margin versus the Kennametal base business. The prior-year gross margin benefited from strong organic growth, a favorable business mix and pricing, as well as absorption benefits of manufacturing cost. Our operating expenses declined $7 million compared to last year. Overall, lower employment and related compensation cost, containment of discretionary spending and favorable foreign currency exchange were partly offset by the Stellite acquisition operating expenses. Operating expense as a percent of sales was 20.2% for the quarter, down 80 basis points from the prior year of 21%. This represents ongoing cost discipline from our global team, coupled with the affect of Stellite, which has a lower SG&A percentage versus the Kennametal base business. Amortization expense was $5.2 million and that's up $3.3 million from last year and the increase is all due to the Stellite acquisition. Operating income of $66 million compared to $94 million last year, operating income included $5 million of Stellite operating income contribution for the quarter. Our operating income decreased as a result of lower sales volume, the unfavorable mix and lower absorption of manufacturing cost. The operating margin for the December quarter was 10.5%, an adjustment for the Stellite acquisition, our base business delivered an operating margin of 10.7%. Looking at the business segment operating performance, industrial segment operating income was $37 million compared with $63 million in the same quarter of the prior year. Industrial operating income decreased due to lower sales volume and lower absorption of manufacturing cost, and an unfavorable sales mix. Industrial's operating margin was 10.4% compared with 15.3% in the prior year. The infrastructure segment operating income was $31 million compared with $33 million in the same quarter last year. Infrastructure's operating income benefited from the Stellite operating income of $5 million, which was more than offset by the effect of the organic sales decline and lower absorption of manufacturing cost and an unfavorable sales mix. Infrastructure's operating margin was 11.5% for the December quarter compared with 14.4% the prior year. Excluding Stellite, the adjusted operating margin for the infrastructure business was 12.3% in the December quarter. Interest expense increased approximately $1.7 million year-over-year in the December quarter to $7 million due to higher debt levels attributable to the Stellite acquisition and our recent 7-year $400 million bond issuance, partly offset by lower bank revolving borrowing cost and a lower coupon rate. Our effective tax rate was 26.4% compared to 17.3% in the prior year. The increase was primarily driven by a valuation allowance adjustment in the prior year and lower current earnings outside of the United States. And regarding our bottom line performance, we reported December quarter diluted earnings per share of $0.52 compared with $0.91 in the prior year, and December's quarter earnings per share included $0.02 accretion of Stellite. Turning to cash flow, our year-to-date cash flow from operating activities was $54 million, and this compares with $71 million in the prior year. Net capital expenditures were $34 million compared to $33 million in the prior year, and our free operating cash flow year-to-date was $21 million compared with $38 million in the prior year. We also remain committed to our prior uses of cash during the December quarter. We purchased almost 600,000 of our shares totaling 1.3 million shares year-to-date, approximately 7.2 million shares remain available under our current share buyback program. We continue to be highly disciplined on our capital allocation process to ensure that we invest in initiatives with the highest shareholder returns. Our balance sheet also remains strong. Cash was $217 million, and we remain focused on improving our working capital. DSOs, ITOs and DPOs were at relatively similar levels in the December quarter compared to both September and June despite the substantial decline in economic activities. This demonstrates that our operating model has become more adaptable to the dynamic market environment. As we have previously stated, we remain committed to reducing approximately $60 million of inventory in fiscal 2013, primarily from finished goods and WIP inventory. As I said earlier, in November, we issued a new $400 million, 7-year 2.65% note to take advantage of favorable borrowing rates and proceeds from this new bond issuance were used to pay down our revolving credit facility. At December 31, 2012, our total debt was $707 million, up $141 million or 25% from June 30, due primarily to share repurchases of $47 million and the new bond issuance. That was up $399 million versus the prior year due primarily to the Stellite acquisition and our debt-to-capital ratio at December 31, 2012, was 28.8% compared to 25.3% at June 30, 2012. And our U.S. defined benefit pension plans remain 100% funded and our adjusted return on invested capital was 12.5%. A quick update on Stellite. The integration of Stellite continues to be on track, including the implementation of SAP. Four key operating locations are expected to be on our global ERP system in the June quarter. We expect to implement the remaining 3 Stellite locations in early fiscal '14. During the second quarter, Kennametal Stellite also experienced some softness in its core end markets, particularly in its energy end market in North America, construction market in Asia and continued softness in automotive in Europe. We also took aggressive cost control measures to be in line with the weaker commercial outlook. We expect the delayed recovery in critical end markets for Stellite will impact this contribution in fiscal 2013. In the second fiscal quarter, Kennametal Stellite sales were $60 million and Stellite contributed $0.02 per share to the Kennametal results. Now I'll turn to our revised outlook for the remainder of the fiscal year. As I previously noted, as well as Carlos, the December quarter proved more challenging than we had anticipated due to continued demand softness in general engineering, energy and transportation. We have revised our outlook to reflect the situation which include the following assumptions: In terms of general engineering, we assume now that the destocking will most likely end by the end of the June quarter; in terms of energy, our customer order books are building and activity is expected to pick up in our second half; and in transportation, we are projecting an increase in activity in Europe and Asia in the second half. And then a positive note is that our monthly order rates that we provide have -- remain steady during the past several months and it appears that we have reached the bottom. As a result, we have adjusted our full year outlook. We now expect fiscal '13 sales to be between negative 2% and negative 4% with organic sales ranging from negative 7% to negative 9%. Therefore, we're reducing our earnings per share guidance for fiscal '13 to a range of $2.60 to $2.80 per share. Included in this outlook is the accretive contribution of the Stellite acquisition, which is now expected to range between $0.10 and $0.15 per share, net of integration cost. We expect to generate cash flow from operations between $290 million and $325 million for fiscal '13 based on anticipated capital expenditures of between $90 million to $100 million, we expect to generate between $200 million to $225 million of free operating cash flow for the full fiscal year. Some additional factors to note include our expectation of sequential growth over the remaining 2 quarters of the fiscal year, with the strongest sequential growth coming in the June quarter. The March quarter will have 2 less work days this year due to the Easter holiday. The June quarter will have 2 additional workdays and we anticipate the rebound in activity to be more evident at this time. We now expect to generate approximately 60% of our earnings in the second half following a 40-60 split for the full fiscal year. We are on track to reduce our inventory, primarily finished goods and WIP by $60 million in fiscal 2013 despite the top line softness. And we expect this inventory reduction initiative to have an unfavorable impact on gross margin of approximately 100 basis points in the second half and full fiscal year. Overall, we're managing the business very well for the factors we can control to deal with the near-term headwinds as needed. And we continue to focus on our many growth opportunities and consistent execution of our strategies. Now I'll turn it back to Carlos for a few closing comments.

Thank you, Frank. As we advance into the second half of fiscal 2013, we'll continue to respond quickly to changing economic conditions. We will continue to follow our demonstrated playbook by maintaining and streamlining cost structure, adjusting manufacturing operations as needed and implementing ongoing contingency planning. As always, we'll weather the challenges to protect the profitability and deliver double-digit margin performance. In the meantime, we'll continue to execute our proven strategies that are consistent with the company's long-term growth goals of diversifying our business mix, expanding our addressable market and balancing growth around the world. As we have consistently demonstrated, Kennametal has generated steady cash flows throughout the economic cycle. We'll continue to leverage our strong balance sheet and remain disciplined with [ph] capital allocation process to build on our strong financial position. Thank you for your interest in Kennametal. And we'll now take questions.

[Operator Instructions] Your first question comes from the line of Ross Gilardi with Bank of America Merrill Lynch.

I just have a couple of questions. First, could you comment a little more on the pricing environment? Are you seeing intensifying price pressure in any of your weaker areas, in particular, if you could just comment on a few of the key end markets?

Obviously, there's always pricing pressure in this industry. However, we continue to stay strong with our pricing, and we are looking at strategic areas where we can actually still get some price and not give up any pricing or any other areas.

Overall, would you think this pricing going up or down?

I think -- will be flattish to slightly up.

Okay. And then on the free cash flow outlook, it seems like you reduced it by less than the earnings outlook. What's happening there?

Yes, Ross, primarily the second half, we typically -- if you go back, we always generate a lot more of our earnings in the second half, as well as the focus on the inventory reduction, particularly with the finished goods and WIP. And I'll comment with some additional focus on our working capital from both receivables, as well as payables. But the inventory is going to be the big driver in the second half.

And then just last one. In terms of cash flow prioritization so forth that you still got this 5-year objective of doubling sales. Does the slower outgrowth outlook mean that you've got to get more acquisitive to fulfill that objective?

When we look 5 years out, based on our presentation in New York a few months ago, I think we're still pretty consistent on -- we still feel that the balance between organic and acquisition is still the same. Majority of the growth is going to come from organic basis. But it's an opportunity to accelerate if we get the right timing.

Your next question comes from the line of Julian Mitchell with Crédit Suisse.

This is Charlie for Julian. I apologize if you've addressed this already, I've been between calls, but just a quick question. It seemed like the demand from Asia was weak in both segments, it has been weak. Some of the other companies we have been speaking with have seen a pickup in China. I'm just wondering why you guys haven't seen a pickup in China, or if anything's kind of changed in January?

So in generally -- so if you think about it in a sequential basis, we have seen an uptick in Asia. However, it's still, year-over-year, a negative growth. So I think it's consistent with what other companies are seeing. And we are -- we believe that Asia is going to generate a positive growth first before any other geography.

Yes. Charlie, the only thing I'd add is I think we're doing a little bit better in the Earthworks side of the business from some of the investments we made, both in Australia and China, particularly on the coal side and some opportunities with the construction, with the surface mining as well. So we did a little bit better there. And then we're starting to see a little bit of a pick up here in January, particularly with the domestic auto production because the aerospace will be fine. And then the general engineering will typically lag a little bit on the transportation. So if the transportation domestic stuff starts picking up, we'll see the pull forward as well, potentially with the general engineering.

Your next question comes from the line of Adam Uhlman with Cleveland Research.

Frank, can we go back to the inventory part? I believe you said it was $17 million reduction. That was 100 basis points of margin headwind in the quarter. When I look at the balance sheet, it's like $5 million of inventory that's lowered or something like -- an accounting difference there, but the big question is this $95 million, $100 million of inventory that's going to be coming out in the back half of the year. I'm wondering why that would be worth 100 basis points as well?

Well, it's underfinished. [ph] You don't have the currency or the raw material increase because raw materials are still up in the first half. They were up a lot more in, obviously, in the first quarter and they continue in the second half. So the $17 million -- the related upon inventory reduction impact on that in the quarter I said was about $5 million. And as we continue to go towards the $60 million in the second half, we're obviously going to have some additional impacts in the second half by pulling the inventory down coupled with the negative organic. So it makes it a little bit more challenging because overall, raw materials, I think, we're doing a better job of controlling that, but when your larger content material products in the Earthworks and energy had a slower point in the first half, we try to hit the brakes where we could on the raw materials. I think we've got a better handle on that for the second half and now it's really focusing on the finished goods and WIP inventory getting towards that goal of $60 million in addition to the $17 million that we had here on this last quarter.

Okay. So the $60 million starting point is from December?

Well, it's really from -- we said at the beginning of the year, we were going to reduce $60 million, it was flat in the first quarter, the finished good and WIP with the primary increase coming in the form of raw materials. Fast forward, we didn't come up with that goal, we took finished goods and WIP down to $17 million so we have the remaining what I'll call balance of that reduction initiative of 60-plus in the second half of the fiscal year. So it was really raw materials and we didn't get any progress in the first quarter.

Okay. And then on the guidance for the year, through the back half of the year, the organic revenue growth is expected to remain -- the decline is pretty similar to what we saw in the first half of the year, and you walk through some of the markets that you thought Europe and Asia might be getting better and orders are steady right now. I was just wondering if you could highlight the big pluses and minuses that keeps the decline at a similar pace to what we've seen recently.

Yes, going forward, I mean, to your point, we have a negative volume. And when you have -- you've got to factor in the mix there because our most profitable pieces of the company, the gen eng and energy were down the most. So you've got to count the double whammy, you got the regular decline and you got the mix coupled with the inventory reduction. So a lot of the stuff we believe is temporary. So I think we're moving in the right direction. But as we go forward, as I look at Earthworks, we're not anticipating anything significant on the undeground coal because you could look at Appalachia, but some of the international markets are doing well. We're seeing, as we anticipated, an uptick on the construction side, so we're starting to see some nice orders come in there and that's -- there's some housing-related effects here in the Americas and then we're well positioned on that in the international market. We feel the energy and the general engineering destocking. The good news, it does end. And based upon what happened in December, it looks like it got pushed because people shut down a little bit further. So we're anticipating a little bit of a pick up sequentially in the March quarter in general engineering, as well as energy. And we're watching the rig counts and with the cold weather that obviously will have some help there. And then by the fourth quarter, we think that this thing will pickup a little bit and we'll start seeing much stronger sequential growth and we're also trying to factor in the number of workdays with the Easter holiday being in here. Because the quarter, when you look at it with New Year's ending on a Tuesday, you kind of lost that first week. So it kind of spilled and pushed things a little bit to the right. And then with Easter towards the end of March, it's going to be a tight workday quarter and we think when business activity picks up in transportation in Europe and the couple other markets that I mentioned, I think we'll start seeing some nice growth or directionally, the growth in the fourth quarter compared to the March quarter.

Your next question comes from the line of Ann Duignan with JPMorgan. Ann P. Duignan - JP Morgan Chase & Co, Research Division: You noted that both in industrial and in infrastructure that you've experienced some unfavorable mix. Could you just talk about what the impact on mix was in each of those businesses? And then which -- should we expect any change in that mix going forward for seasonal reasons or anything like that?

Yes, if you look at the industrial, the real mix was the general engineering business. Because aerospace and defense, it's a good profitability and that's been relatively constant from a growth perspective. So yes, I don't anticipate anything. Transportation was okay in the Americas, a little bit softer in Europe and Asia, and I'll expect that to come back. But the real driver because, we're sown in to the small and medium accounts through distribution, we've done a good job on distribution, that continues to be the market in the industrial side that was down the most, you can look at the first quarter, the second quarter, the sequential change. And that's where the very profitable piece, as well as that goes down fast, that could come back just as quick. And I think we're trying to take a realistic assumption here looking at kind of our visibility. But as quick as the general engineering goes down, which is the most profitable piece, that can come back very strong in a relatively quick period. So we have the general engineering on the industrial side, which is the high-margin stuff. And conversely, if you look at the infrastructure side, the energy is the more profitable piece there compared to the underground coal mining and some of the IGT stuff that Stellite as that continues to come up, but we also feel that that's kind of temporary. So we haven't really experienced the energy and the general engineering piece of the company being down, both the same amount. But based upon the weather and the rig counts and some of the order book information that we're getting from our sales force, we think that, that energy should come back by the fourth quarter. So it's those 2 sectors.

I just want to add that the one that is affected the most was general engineering in the first half and followed by energy. And general engineering fell the quickest in the shortest period of time closer to the second quarter, we believe that general engineering is going to come back the fastest in the second half. And trailed by energy at its lower growth rates than general engineering. And those are the 2 areas that are most profitable for us. So that will be the mix change going to the second half. The real question is, how much of it is going to be in the third quarter, how much of it is going to be in the fourth quarter. Ann P. Duignan - JP Morgan Chase & Co, Research Division: Yes, that make sense, Carlos. And in terms of activity drives demand and distribution. Carlos, just a follow-up on that really, with the flash PMIs coming in pretty gosh darn strong this morning, both in the U.S. and China, that would support your pieces of perhaps we get a swing back in demand in general engineering. Are you seeing anything like that? I know you're obssessed over your daily order rates, et cetera but are you guys seeing any signs of improvement in -- either in the U.S. or in China in terms of just industrial activity or is it too early to tell?

Well, I'll tell you that so far this month, the orders are coming in per our revised guidance, and I can tell you that in a sequential basis, it's slightly positive. So it really is demonstrating and is being led by the general engineering as we spoke. I'll also give you a data point. I mean, we have data that was back 20 years that when the PMI hit 50 in this situation, which has hit about a few months ago and just recently, is about a 6-month lag before we see some really, really good growth. So historically, it validates -- so we see it and again, as we said, we think our second quarter came in at a 1 to 2 quarters delay. And so it's just a -- when is it going to come back within the third quarter or the fourth quarter and to the magnitude. If it comes back in the third quarter, then we'll have an even better fourth quarter. But that's... Ann P. Duignan - JP Morgan Chase & Co, Research Division: And the catalyst for that would be the general and industrial side, you think?

Yes, correct. Yes.

Your next question comes from the line of Andy Casey with Wells Fargo Securities.

I apologize if you already addressed this first point. Just a clarification, what tax rate do you expect for the year? And the gist of the question is weaker Europe so far, and then any impact from R&D?

Andy, last time I think we guided 25% because the first quarter was a little bit less than 21%, so we'd have a little bit higher about 26% for the remaining outquarters. Given the change, I think the tax rate is now going to be 24% versus the 25%. So we'll probably pick up 100 basis points. But the tax rate being a little bit softer or lower favorably in the third quarter and then a little bit higher in the fourth quarter. But we'll finish the year about 24%, I would expect it to be in the low 20s in the third quarter for the discrete catch up relative to the R&D credit and then a little bit higher in the fourth quarter just because of the jurisdictional mix even though we're going to get R&D credit, will be about 25% in the fourth.

Okay. And then if we could revisit a couple of things that have been touched on. The channel destocking in addition to the 100-basis-point gross margin headwind that you're expecting from the internal inventory initiatives, is there any way to quantify what that destocking is doing to your margins?

Well, I can try to help you in total because we don't -- to the point I made in the second quarter, the pure inventory reduction that we undertook to drive down the $17 million of finished goods and WIP, I said that was about $5 million, okay? Then I would say the related volume impact was about the same in the quarter. Combined, it was about a $10 million impact of the volume and the inventory reduction initiative at Kennametal.

And is there any way to look into the field and see what the destocking actually did?

No. I mean, we have -- I mean, we have point of sale and all stuff to the largest distributors. We're very, very much aligned with MSC and Fastenal and all that stuff. But then we have a lot of small distributors, it's really hard to tell. Because you'll have the Northeast from aerospace is doing well versus -- that depends on the sectors that they're serving. So it's just too hard to quantify.

Okay. And then, at some point the destock reverses, and I'm just trying to gauge if all of that comes back or if you're seeing any issues with any of your indirect distribution partners like market share erosion or something else that would limit a 1:1 return?

I would say that you guys can read that MSE script that was put out last week. I think our market share at MSE continues to increase. And so I think that will come back at least a 1:1, the distribution when they start stocking. And I just want to make a point of our strategy. Our WIDIA during this period, first half of the year, was slightly positive year-over-year. Which really -- and by the way, they've play primarily in the general industry, which was down almost 16%, they were slightly positive. Just shows you that our channel strategy is really working and again in -- when it comes back, we're going to have quite a bit of a tailwind.

Your next question comes from the line of Eli Lustgarten with Longbow Securities.

Let me just one clarification. We're still going to do $60 million of inventory reduction in the next 2 quarters, and how would that split between the 2 quarters?

Eli, so it would be $60 million for the full fiscal year, and $17 million out in the December quarter.

So we have $43 million to go?

Yes. That would be at minimum, $43 million, right. And if we can do a little bit better, we'll take advantage of it.

And it will evenly be split between the 2 quarters?

I would think it'd be a little bit stronger in the fourth quarter, but not much different.

Okay. And you're talking -- you had 60 -- 40-60 was the earnings for the year. Can you give us some idea of how you expect the third and fourth quarter split -- it looks like that's also going to split like 45-55 in the second half of the year, in the third and fourth quarter just on the basis of where your guidance is going.

Yes. Again, that's why I'd tried to give you with the workdays. It will be much stronger in the fourth quarter because we're going to pick up 2 additional workdays. So we're going to have flat -- the workdays are going to work out to be about the same, specifically in the December quarter. So about in the low-60s, and then we'll pick it up in the fourth quarter. So I would imagine the improvement will be nice sequentially but it will be much stronger in the fourth quarter, and then I'll calculate that and get it to you here shortly.

Okay. And incremental margins, we look to the second half of the year, we're still talking about with the somewhat better volume, the 30% plus incremental margins and we're really talking about profitability, which is in the low double-digits getting back to maybe close to the mid-double digits in the second half of the year, is it still an attainable target?

You're talking sequentially, it's not year-over-year, right?

Yes, right. I'm just talking about -- your profitability is in a little over 10%. Currently, 11% and 12% in the different quarters. Are we talking -- can we get margins in the second half of the year in both divisions close to mid-teens, that was question.

I would say by the fourth quarter, that's a true statement.

And so it's really -- it's all leveraged into the fourth quarter at this point or so. And in case [ph] of the tax rate, can you quantify how big the R&D tax credit benefit will [indiscernible] you guys?

Right now, it's about $3.5 million.

Your next question comes from the line of Stephen Volkmann with Jefferies. Stephen E. Volkmann - Jefferies & Company, Inc., Research Division: Just one quick cleanup question. You guys mentioned a couple of times in the presentation that you had done some business adjustments to get your cost under control and we didn't really quantify that, maybe it's just sort of the ongoing kind of stuff but I'm wondering in the spirit maybe of Andy's question, did some of that come back onto the cost structure as business starts to come back or what's the right way to think about that?

No. I mean, that's the regular stuff traveling and all discretionary. So yes, that portion of it will come back. The other part is the direct labor. I mean, obviously, we shed direct labor as our volume goes down and the direct labor will come back. But we'll expect high leverage with that, it's not a 1:1, right?

Have you done anything that is more permanent?

No. Our goal is we believe that the business is going to come back, and we are maintaining the capacity, which we've talked about, the $3 billion-plus capacity without Stellite. And that's where we really get the leverage as the business comes back.

Your next question comes from the line of Gregory Macosko with Lord Abbott. Gregory M. Macosko - Lord, Abbett & Co. LLC: Just one brief question regarding Stellite. What was the core growth that you talked about, the 20-plus percent? Give me some color on that core growth within that group.

The core group, Gregory, we didn't own the business until March of last year. So we don’t have -- it may divest [indiscernible] business on the year-over-year, but I'll tell you, sequentially, the sales growth was up a little bit from the first quarter, about 1%. But we're also starting to see some nice IGT orders, the industrial gas turbine, something we secured in the second quarter which are a little bit longer lead time. So we'll expect those to kick in earliest toward the end of the fourth quarter, and then beginning into fiscal '14. That's with the Alstoms, the Siemens. So we're starting to see some nice improvement with those areas there. And then we expect the fourth quarter, to give you an idea, we expect that, that will be up close to double-digit by the fourth quarter on a year-over-year base bid.

Our final question comes from the line of Walt Liptak with Barrington Research.

I wanted to ask about your thoughts on the return on invested capital, which we've had a pretty good drop in organic volumes and the returns are looking a lot better than they would have 4 or 5 years ago. And then kind of along those lines, I wondered, we're still seeing pretty big under absorption. And is there anything that you're doing on the factory floor to try and get more variable cost in there? Or try and reduce absorption when we get these sort of downdrafts in volumes?

Yes, I mean, I think, obviously, we continue to look at that. The balance that we have to make what, Walt, is the balance that one being prepared because we can see a very, very fast turned up, be prepared for us to have the ability to deliver and risk losing market share because we cannot deliver to the speed and the volume that is expected in the turnaround. So that's the balance we're trying to make.

Okay. Is there more that you can do to try and take cost out on the manufacturing floor, get more variable cost in?

Yes, yes. I mean, we continue to -- I mean, we have a lean program that takes on average 3% to 4% of cost out every year. So for every year that goes by, we continue to do this, and obviously, when we have low volume, it's a better opportunity for us to look at those things in a more focused way.

We have no further questions in the queue. I'd like to hand it back over for any closing remarks.

This is Quyhn McGuire. This concludes our discussion. Please contact me at (724) 539-6559 for any follow-up questions. Thank you for joining us.