Kennametal Inc. (KMT) Q4 2015 Earnings Report, Transcript and Summary

Good morning. I would like to welcome everyone to Kennametal's Fourth Quarter Fiscal Year 2015 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] I would now like to turn the conference over to Quynh McGuire, Director of Investor Relations.

Thank you, Amy. Welcome, everyone. Thank you for joining us to review Kennametal's Fourth Quarter and Fiscal 2015 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 process in prior quarterly conference calls, we've invited various numbers of the media to listen in to this call. It is also being broadcast live on our website and a recording of this call will be available on our site for replay through August 31, 2015. I'm Quynh McGuire, Director of Investor Relations for Kennametal. Joining me for our call today are President and Chief Executive Officer, Don Nolan; and Vice President, Finance and Corporate Controller and Interim CFO, Marty Fusco. Don and Marty will discuss the March quarter's or the June quarter's financial performance and after their remarks we'll be happy to answer your questions. At this time, I'd 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 involves 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's 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 Don.

Thank you, Quynh. Well hello, everyone. Thanks for joining us today. We've been working hard to improve the business and are beginning to see some of the benefits. Today, we'll discuss our current quarter results and provide a forward view of fiscal year 2016. We'll also talk about what we're seeing in the markets, where we're performing, where we're falling short and what we're doing to address the issues. At our Analyst Day, which is scheduled for December 15, in New York City, we'll be able to go into more detail and convey our strategy and financial goals. Performance for the June quarter was better than we anticipated on several fronts. We made progress on our cost reduction measures and made significant improvements in working capital management. Although we did forecast a year-over-year sales decline, the demand environment was even more challenging than we expected. Organic sales were down 10% from prior-year and from a segment perspective, Industrial sales decreased 4% versus last year, while Infrastructure sales were down 16% year-over-year. Despite this, we delivered adjusted earnings per share of $0.46 for the quarter and $2.02 for the fiscal year 2015. Free operating cash flow was a record high $267 million compared to $156 million in the prior-year. A $111 million year-over-year increase reflects considerable improvement in managing our working capital. June quarter results demonstrate that even in a very challenging market environment, our efforts to lower costs, improve efficiencies and generate higher cash flows are having a favorable impact. We recognize that we have more work to do to get the company back on track and we continue to take action. We will control what we can and adjust our plans quickly when needed. On portfolio simplification, we're making progress and have narrowed the range of potential divestitures to $150 million to $250 million of sales. We believe that exiting these non-core businesses will be accretive to our operating margin when complete. We're running an orderly process to maximize the value of these properties and will provide an update when we can. While we don't have any current plans for additional divestitures, portfolio management will be ongoing to evaluate the returns on our assets. We're getting our footprint right, and as previously stated we plan to reduce our overall footprint by 20% to 25%. This includes divestitures but is an addition to the current restructuring programs that we've announced. To-date, we've closed six facilities, divested another and recently announced the rationalization of two additional facilities. As we finalize the divestitures, we expect there will be additional restructuring opportunities to eliminate stranded costs and further streamline our business. We are aligning our cost structure and have decreased our global head count by approximately 6% compared with prior-year. In addition, we have benchmarked our corporate functions against top-performing companies and have plans in place to automate, simplify and standardize the work we do. These plans will reduce administrative costs and complexity while enabling a more effective deployment of resources. We are improving working capital to deliver sustainable results throughout the cycle. We've made progress by having more efficient inventory levels as is evident in our ability to achieve record free operating cash flow in this past quarter. Finally, we're strengthening our commercial capability and putting full support behind our teams to make it happen. We have made changes in leadership and are driving better alignment between sales, marketing, and customer service. We've also invested in information technologies like a customer relations management system so our teams have visibility of the data and the metrics that will help them win. The benefits from these actions will be visible in future years, and more specifics will be provided at our Analyst Day in December. We're also thinking differently about investments. We're shifting our emphasis from working capital to investing more capital in our plants. This approach will drive productivity and profitability improvements in our manufacturing processes that have been successfully tested in various pilot programs. For example, we're optimizing the grinding capability in many of our facilities and we estimate a 20% return or better from this invested capital. Everyone knows that Rome was not built in a day. Transforming Kennametal will take time but we're not resting until it's done. We will do what it takes to build a winning team, drive world-class commercial capability, deliver excellent service and quality and introduce new products that change the dialogue with our customers. Our path forward in fiscal 2016 remains focused on increasing margins through portfolio simplification, footprint restructuring and reductions in our G&A costs. At the same time, we continue to invest in innovation to fuel organic growth all aimed at positioning Kennametal to be a premiere industrial company. We've made notable strides in increasing our cash flow generation and we'll be relentless is our efforts to deliver meaningfully improved profitability. Beyond fiscal 2016, we will expand our return on invested capital to the double-digit level as part of our long-term plan. For fiscal 2016, we forecast earnings per share to be in the range of $1.70 to $2. This includes $0.30 to $0.35 of exchange rate headwinds. Put simply, our headwinds include currency, weak end markets and some near-term investments to support growth. These factors are partially offset by the tailwind of our ongoing cost reduction measures. Key assumptions include a projected year-over-year decline in organic sales of 1% to 3%. While we continue to see some growth in the industrial segment, it's just not sufficient to offset the significant weakness in our Infrastructure business primarily due to the oil and gas and mining markets. In addition, we expect foreign currency exchange to have a negative impact on sales of approximately 6%. Year-over-year comparisons are anticipated to be unfavorable through December 2015, and we expect December quarter to be particularly challenging. We have not included the impact of potential divestitures in fiscal 2016 guidance. For the Industrial segment, we expect approximately 4% organic sales growth in fiscal 2016. Conditions in our served end markets are expected to remain favorable. The transportation market remains healthy with projected auto builds of 90 million units globally, 3% higher than prior-year. U.S. auto build rates are estimated to be 12 million units, a year-over-year increase of approximately 4%. We believe the demand in our General Engineering business will be mixed but our continued focus on the indirect channel will more than offset weakness in oil and gas activity. In aerospace and defense production activity is expected to increase particularly in commercial aerospace. Looking at Industrial from a geographic perspective, we expect continued growth in the U.S. and it represents a key target area as we have opportunities to improve our market position. In China, we still see moderate growth during the fiscal year despite a recent deceleration and Western Europe is beginning to improve and we should see slight growth in that area. For the Infrastructure segment, we're projecting an organic sales decline of approximately 9%. Market trends reflect further contraction in the near-term although at a decelerating pace. We expect difficult conditions to persist in the oil and gas sector with operating rates projected to remain at low levels through calendar 2015 and a very modest year-over-year increase beginning in calendar 2016. Underground coal mining in the U.S. continues to face headwinds with production rates further weakening in the near-term particularly in the Appalachian region. In China, coal production has stabilized and has shown some improvement. While construction sales have been softer due to less project work globally and delays in global funding in the U.S. we see some improvement coming from increased activities in road rehabilitation applications. Today, our restricting programs are on track to deliver projected benefits and we anticipate that the combined after-tax savings from all three restructuring programs to be between $115 million and $135 million on an annualized basis once fully implemented. We've intensified our efforts on cash flow generation and we're beginning to see the benefits of improved working capital efficiencies. We expect to generate $115 million to $135 million in free operating cash flow in fiscal 2016. Net of anticipated capital expenditures of $160 million to $175 million. As already discussed, we are scaling up programs that have been proven and reflect very attractive risk adjusted returns. We believe that this level of investment in our core businesses warranted to improve productivity in our manufacturing processes and further support innovation through new product introductions. Further on uses of cash, we will continue to reinvest our business. Our board of directors just recently approved a dividend increase of $0.02 per share or 11% to $0.20 per share. With recently completed overseas cash deployment and strong free operating cash flows, we have paid down much of our revolving bank debt. The dividend increase coupled with our significant debt reductions illustrates a confidence in our long-term plan to drive shareholder value. In addition, we'll continue to evaluate opportunities to buy shares of our stock as part of returning cash to shareholders. We are working hard to simplify our business and realign our cost structure while taking actions to support further growth. We will also remain dedicated to innovation, and introducing new products with speed and purpose in order to strengthen our product portfolio. We'll continue to focus on execution, doing what we say and delivering on our commitments. At the same time, we'll also invest for the future to drive both our top line and bottom line. Once we complete the divestitures, we will have a reduced asset base and can more effectively focus on our core business. Kennametal will be better positioned to drive margin expansion by leveraging our asset utilization and improving our return profile over the long term. I'll now turn it over - I'll now turn it over to Marty Fusco for additional details on the financials.

Thank you, Don. Some of my comments are related to non-GAAP metrics. Please see the non-GAAP reconciliation filed on Form 8-K and in the press release. As Don mentioned, the June quarter presented a challenging demand environment to the current economic conditions in many of our end markets. The impacts of these top line challenges were lessened by restructuring benefits and additional cost reductions realized during the quarter. We continue to make progress with all three of our current restructuring programs and realized benefits of approximately $17 million in the June quarter of which $14 million was incremental to the prior-year quarter. We are on track to realize the expected total annual benefits for all three programs of $115 million to $135 million. Federal charges for all programs are expected to range from $185 million to $205 million. We delivered adjusted EPS for the quarter of $0.46, which was consistent with our guidance. As Don also mentioned, our focus on working capital management enabled us to deliver record free operating cash flow of $267 million for fiscal 2015. Now let me walk through the key items in the income statement. Sales for the quarter were $638 million compared with $772 million in the same quarter last year. Sales decreased by 17% reflecting a 10% organic decline, a 7% unfavorable impact from currency exchange, and a 1% decrease from a prior-year divestiture offset partially by a 1% favorable impact due to more business days. Turning to the sales performance by business segment; Industrial segment sales of $358 million decreased 14% from $416 million in the prior-year quarter due to unfavorable currency exchange of 10%, organic sales decline of 4% and a prior-year divestiture of 1% partially offset by an increase of 1% due to more business days. Excluding the impact of currency exchange, sales remained flat in General Engineering while sales decreased approximately 2% in Transportation, approximately 7% in Aerospace and Defense, and approximately 22% in Energy. On a regional basis, sales decreased 6% in the Americas, 1% in Europe and remained flat in Asia. In the General Engineering market, sales in the indirect channel grew, offset by weak demand in the energy markets in all regions. Sales in the transportation market were adversely affected by lower volumes in all regions while aerospace and defense sales decreased due to the company exiting lower margin business, partially offset by production growth in aircraft frames and engines. Industrial segment sales were also negatively impacted by direct energy and market exposure by the relatively small size of energy to its overall portfolio. Infrastructure segment sales of $280 million decreased 21% from $357 million in the prior-year. The decrease was driven by 16% organic sales decline and 6% unfavorable currency exchange, offset partially by an increase of 1% due to more business days. Excluding the impact of currency, sales decreased by approximately 23% in energy, and by approximately 11% in earthworks. The energy market was impacted by continuing weakness in oil and gas end markets, partially offset with some improvements in power generation and process industry sales. Earthworks was impacted by continued weakness in underground mining while highway construction sales improved in line with the road rehabilitation season. On a regional basis, sales decreased 21% in the Americas, 17% in Asia and 5% in Europe. Moving to our consolidated operating performance. Our gross profit margin was 29.6% compared with 32.7% in prior-year. Our adjusted gross profit margin in the current and prior periods was 30.1% and 33.1% respectively. The decline in our margin was due to the organic sales decline, lower absorption of manufacturing costs related to lower sales volume and an inventory reduction initiative, unfavorable business mix in the infrastructure segment and unfavorable currency exchange. These impacts were partially offset by restructuring benefits. The reduction of inventory impacted gross margins by approximately 150 basis points. Operating expense as a percentage of sales was 20.5% compared with 20% in the prior-year. Adjusted operating expense as a percentage of sales was 20.1% for the current period and 19.7% in the prior-year. Adjusted operating expense declined $23 million year-over-year due to favorable foreign currency impacts, restructuring benefits, and lower incentive compensation. Cost reduction actions continue to be in place as we align our cost structure with the realities of current market conditions. Operating income was $35 million for the quarter compared with operating income of $78 million in the same quarter last year. Adjusted operating income was $56 million compared with $95 million in the same quarter last year. Adjusted operating results in the current period were driven by organic sales decline, lower absorption of manufacturing costs related to lower sales volume and an inventory reduction initiative, unfavorable mix in infrastructure and unfavorable currency exchange offset partially by restructuring benefits and lower incentive compensation. Adjusted operating margin was 8.8% in the current period compared with 12.4% in the prior-year period. Looking at operating income performance by business segment, the Industrial segment operating income was $40 million compared with $53 million in the prior-year. Adjusted operating income was $51 million compared to $64 million in the prior-year quarter. These results were driven by organic sales decline, and lower absorption of manufacturing costs related to reduced sales volumes and an inventory reduction initiative partially offset by restructuring benefits and lower incentive compensation. Industrial adjusted operating margin was down 140 basis points to 14.1% compared with 15.5% in the prior-year. The Infrastructure segment operating loss was $4 million compared with operating income of $27 million in the same quarter of the prior-year. Adjusted operating income was $6 million compared to $32 million in the prior-year quarter. Adjusted operating income decreased primarily due to lower organic sales, lower absorption of manufacturing costs related to reduced sales volumes and an inventory reduction initiative, unfavorable mix and unfavorable currency exchange offset partially by restructuring benefits and lower incentive compensation. Infrastructure adjusted operating margin was 2% compared with 9% in the prior-year. The reported effective tax rate was 24.8% in the current quarter compared with 30.5% in the prior-year quarter. The decrease was primarily driven by prior-year restructuring charges in tax jurisdictions where a tax benefit was not permitted. Turning to cash flow, as a result of our commitment to improving working capital management, we generated strong operating cash flow of $351 million and were $80 million above the prior-year. We generated a record $267 million of free operating cash flow, an increase of 71% compared with $156 million in the prior-year. We remain confident in our continued strong cash flow generation and committed to our capital structure principle. Through prudent and balanced debt facility structuring, we were able to tax-efficiently deploy approximately $100 million in cash from overseas operations for debt reduction in the June quarter. This initiative further enhanced our liquidity, enabled us to accelerate rating agency credit metric enhancement and will result in $2 million in annual interest expense savings. Record free operating cash flow and overseas cash deployment enabled us to reduce debt $310 million in fiscal 2015. Our $600 million revolving credit facility due April 2018 had available borrowing capacity of $557 million at June 30, 2015. We have ample cushion under our financial covenants and an attractive debt maturity profile as our nearest maturity is in November 2019, when our $400 million of 2.65% senior unsecured notes are due. Our cash balance was $105 million as of June 30, 2015, most of which presently resides overseas. Additionally, we have increased the current quarterly dividend by $0.02 per share from $0.18 to $0.20 effective with the August dividend. We are confident in our ability to continue to grow our cash flow. This 11% increase in the quarterly dividend is consistent with our capital structure principles objective to return a portion of excess free operating cash flow to shareholders consistently over time while positioning for recurring increases commensurate with earnings and cash flow growth. As previously stated, our priority use of cash is business reinvestment for profitable growth while balancing the return of a portion of excess cash to shareholders. We evaluate our dividend regularly in terms of dividend yield and payout relative to peer industrial companies. We enjoy investment grade ratings from all three agencies and remain committed to maintaining them. Our debt-to-capital ratio at June 30, 2015 was 35.3% compared to 35.1% as of June 30, 2014. This slight increase was driven by infrastructure impairment charges recognized in previous quarters, largely offset by substantial debt reduction in the current fiscal year. Now turning to our guidance for fiscal 2016. Our outlook reflects ongoing market uncertainties as well as limited visibility related to customer demand trends. As Don elaborated on earlier, we expect some growth in our industrial end markets, although not sufficient to offset the weakness in our infrastructure end markets. The oil and gas industry is likely to remain challenging through December 2015 and underground coal mining activity will likely remain at low levels globally. We expect organic sales decline to range from 1% to 3% and total sales decline between 7% and 9%. Our fiscal 2016 outlook is based on the following assumptions. We are projecting, as I said, 1% to 3% of organic decline. We expect that demand will improve modestly in our industrial end market led by general engineering and transportation. In the first half of 2016, growth will be challenged in general engineering due to exposure to the energy markets and slight growth is expected in aerospace and defense. Transportation is expected to show stable growth throughout. On a regional basis, growth in all end markets is expected to be led by Asia and EMEA with modest overall growth in the Americas. For Infrastructure, we face challenging end market conditions and expect a very modest year-over-year improvement in the second half of fiscal 2016. Accordingly, rates of year-over-year decline are expected to improve throughout the fiscal year with modest volume growth expected towards the end of the fiscal year. The sales decline is expected across all regions led primarily by performance in the Americas. Pricing will be a headwind during the fiscal year but is expected to be more than offset by lower raw material costs once higher cost inventory positions are worked through our operations. We expect restructuring benefits to more than double in fiscal year 2016 and incremental savings to be higher in the first half of the year. Foreign exchange is expected to be a significant headwind, which we estimate to be in the range of $0.30 to $0.35 per share. This is mostly from the impact of continued strength of the U.S. dollar against the euro. We are seeing a significant impact on earnings from foreign exchange due to the strengthening of the U.S. dollar against our selling currencies overseas. And while we enjoy a global operating footprint that helps mitigate this foreign currency effect on revenues, our major raw materials are purchased in U.S. dollars resulting in gross margin compression on our international business. Operating expenses are expected to decline in 2016 due to favorable currency effects, restructuring benefits and cost reduction effort. These benefits are expected to be partially offset by the effects of general inflation. Due to top line softness, we expect our operating expenses at 21% to 23% of sales. I also want to point out that our guidance includes approximately $20 million to $25 million of higher incentive compensation than the prior-year. This assumes that incentive compensation will be fully restored levels in fiscal 2016. Our effective tax rate for fiscal 2016 is forecast to be approximately 24% to 26%. Additionally, we are expecting the first half will have a higher tax rate than the full year. The year-over-year increase in our tax rate is partly driven by a continued unfavorable geographic mix of earnings in fiscal 2016 and the effect of expired U.S. federal tax provisions. We will continue to look for ways to minimize our tax rate. Consistent with our capital allocation principles, we plan to reinvest back into the business with $160 million to $175 million of capital spending. This is higher than our historical trends of spending 3% to 4% of sales on capital expenditures. This additional investment is anticipated to improve our longer term manufacturing productivity. Based on these highlighted factors, we expect EPS to range from $1.70 to $2 in fiscal 2016. Again, this guidance includes the benefits of restructuring programs but does not include any cost of restructuring programs or potential portfolio actions, which could represent $150 million to $250 million of sales. We expect to generate cash flow from operating activities ranging from $275 million to $310 million in fiscal 2016. Based on anticipated capital expenditures of $160 million to $175 million, the company expects to generate between $115 million and $135 million of free operating cash flow for the fiscal year. The primary driver of the planned decrease in free operating cash flow is increased capital expenditures. As discussed earlier today, we continue to take aggressive actions to reduce costs, including streamlining our manufacturing footprint and continuing to accelerate our restructuring program. As we finalize our portfolio review, there will likely be additional restructuring opportunities to take out stranded costs and further streamline the business. Over a longer term, our capital allocation process will include value driving capital investments in the business as well as returning cash to shareholders through dividends and share repurchases. We are focused on increasing our profitability, growing our top line as well as maximizing our cash flows and returns. We will remain focused on productivity of our core businesses and reviewing our portfolio. At this time, I would like to turn the call back over to Don for closing comments.

Thank you, Marty. In summary, we believe the strength of our people, our highly recognized products and our geographic reach will keep Kennametal at the forefront of our industry. While we expect to see headwinds in certain markets in fiscal 2016, we believe we are on the right path. Our focus is to increase our profitability over the course of the cycle, resulting in improved returns for investors. While we continue to optimize manufacturing efficiency and reduce our footprint, we're ensuring that we're not negatively impacting our overall manufacturing capability. We are consolidating in a manner that ensures we leverage best practices and we can continue to meet customer demand as the cycle improves. We continue to develop innovative technologies and nurture the talent within our organization. While there is still much to be done, we believe that we have made significant progress in improving our operations in a difficult market and positioning Kennametal well to capitalize on a brighter future. We continue to execute on our key priorities to simplify our portfolio, align our cost structure and invest in our business to deliver core growth with an accountable, customer-focused culture. These are all central to developing our path forward to drive organic growth, maximize profitability and generate improved shareholder returns. We'll now be happy to take your questions. [Operator Instructions]

Our first question is from Julian Mitchell at Credit Suisse.

Hi. Thank you.

Hi, Julian.

Hi. Just a quick question, I think you said that the - the savings increased sort of over two times year-on-year, so I just wanted to double check. I think your savings to-date are around $37 million, so are you saying that the savings embedded in the guidance for 2016 are sort of $80 million plus or did I get that wrong?

No, Julian, you got that right.

Okay. And how do we think about the seasonality of earnings? I guess historically it was maybe sort of 45%/55% first half/second half, last year was the inverse. How are you thinking about this year?

So from a sales perspective, Julian, historically we do about a 50%/50% split. We'll be roughly the same. We're going to be a little lower first on the top line than historical norms. From an earnings perspective, our normal 40%/60% split is going to be compressed so you're probably looking at more of a 30%/70% split. And I do want to point out that our Q1 sequential sales, going back to sales for a moment, Q1 sequential sales are expected to be lower than our norm, normal sequential decline. In FY 2015 we declined Q4 to Q1 about 10%, you can expect a little bit more than that in fiscal 2016. And then going back to earnings, Q1 in particular is expected to only be about mid single-digit operating margins.

Thank you. That's very helpful. And lastly, I just wanted to circle back on the FX hit again. I guess, I think it implies around a 20% to 25% kind of drop through margin on the FX hits or revenues. That's a lot higher I guess than I'd thought, are you including some kind of price decline within the FX impact? And then maybe just clarify - the $0.30, $0.35 hit this year, what was the hit of EPS in 2015 as a whole?

I don't have the 2015 impact in front of me, Julian, and we will get that for you. We've assumed $0.30 to $0.35 unfavorable impact in our guidance and again that's primarily driven by the euro. We'll keep you apprized as we move through the year on any changes in our assumptions but we do have an added impact within margins - an exaggerated impact in our margins because of the extent to the drop of the euro this year. The FY 2015 average euro for us was about $1.21 which [ph] for that exaggerated drop in the euro as well as exaggerated declines in our raw materials costs are causing a bigger - I would say a bigger impact than you might expect because our European operations purchased raw materials from our U.S. companies that are U.S. dollar denominated. So the $0.30 to $0.35 that we noted is purely FX driven.

Great. Thank you very much.

You're welcome.

The next question is from Adam Uhlman at Cleveland Research.

Hi guys. Good morning.

Hi, Adam.

Hey Don, you had mentioned investing in growth this year versus pulling back on working capital in the past. Can you help me understand, is this all CapEx effort with the CapEx going up a lot or is there some operating expense growth that you anticipate? And then longer term, when can we expect to get back down to CapEx being 3% or 4% of sales? Is that - is this a couple of year process or is this just going to be like one year?

I think Adam, I'll be really transparent in our process. We looked at our forecast looking at free operating cash flow for the year and we were looking at - we were going to run 130 to 140% of net income. And we looked at a list of projects that we had in our list that would increase productivity. We used our hurdle rate of 20% or better and we just said it's a better use of cash, simply put. So we decided to up our cash, our investment in our CapEx because we had some great opportunities to improve productivity and the returns on those investments were well above our hurdle rate. Going forward, I think by the time we hit Analyst Day here in December, we'll be able to provide a little bit more color on what we are looking at over the next three years.

Okay. Got you. Thank you. And then in general, in terms of some of the market commentaries that you folks had made, can you talk to the improvement in Powergen and process industry trends that you guys saw? What specifically is getting better within those markets?

Well, I'm not sure - so when we look out, to be frank, I think what was mentioned is that as we look at our energy markets, heading in - for the first six months, we see continued challenging market. We really don't see a whole lot of improvement. What we're seeing is that the comps get a little bit easier as we head into our third and fourth quarter and declines turn into very, very slight improvement year-over-year. And again, we're basing that based on forecasts of others including our customers and looking at that as I would call it more elimination of the declines rather than - rather than improvement. But a lot of it has to do with easier comps.

Okay. Thank you. Operator Our next question is from Ross Gilardi at Bank of America.

Hey. Good morning. Thank you.

Good morning, Ross.

Hey, Don. I'm just wondering if you could give us a little more - your thoughts on the divestitures. I think you said $150 million to $250 million, I think that might have chopped off the high-end there and should we expect to see anything between now and your Investor Day? And you've obviously mentioned margin accretion if you move forward on the divestitures, but wondering you tolerance for shorter-term earnings dilution because presumably some of these assets you're thinking about selling still have got positive margin even if it's below average.

Yeah. So again, it's difficult because these are - it's not clear which will actually be sold and at what time. So it'd be difficult for me to give a lot more definition at this point. We know the range, just to give you a little more clarity over about how much we expect now to move. The process is quite efficient where it looks like we will be successful, how's that? It's just the extent of our success and all I can say is I can keep you posted as we - as we move forward.

Got it. And then could you talk a little bit more about the weakness in U.S. Industrial in the most recent quarter and what you're - what you're seeing there? And are you actually seeing anything in your order book today to suggest that we'll get a pickup that you're assuming?

Yeah. I think in the last quarter I suggested that we were - we're not achieving our potential I think was the way I put it last quarter and we had a core focus on improving performance in the U.S. We're still there. [ph] Immense amount of focus on improving execution in the U.S. I think we're improving. I think we're getting better. I think we've still got opportunity there.

But in terms of the decline this quarter, could you just give a little more color on that?

Well, I think looking at the marketplace, I think actually that the market wasn't as good. I think as it was in our third quarter. So some of it was market and some of it was our own performance.

Got it. Okay. Thanks very much.

I could just add to that for you, Ross. Just from an industrial perspective in the Americas, the exposure to Energy on the Industrial side both through General Engineering and then also a small portion of the portfolio that's direct would be also a driver to the Americas performance within Industrial.

Got it. Thanks very much. Operator The next question is from Andy Casey at Wells Fargo Securities.

Thanks a lot. Hi, good morning, everybody. On the quarter you reduced inventory by about $57 million in Q4 from Q3. Did that have any impact on gross profit?

It did, Andy. The impact in the quarter was about 150 basis points unfavorable over prior-year.

Okay. Thank you.

You're welcome.

And then as you look forward into fiscal 2016 specifically on the $275 million to $310 million operating cash flow, do you expect any further decrease in working capital relative to sales? You finished the quarter about [ph] 29.3 of trailing 12 month sales. I'm just wondering if that should stay about constant or if that continues to go down?

Andy, from a dollar perspective looking at working capital we're expecting a similar impact on the cash flow for the full fiscal 2016 as we saw in 2015.

Okay. Great. And then on the capital investment, the $160 million to $175 million, I know you've gone through and mentioned projects that improve the productivity. Is there any investment in facilities to - in terms of new facilities to help with that productivity?

No. We're investing in equipment here and our - most of it, certainly most of the incremental investment is all about productivity specifically.

Okay. Thank you very much.

The next question is from Joel Tiss at BMO.

Morning.

Hi, guys. How's it going?

Morning, Joel.

Good.

Is there any rationale or any reason to want to put to ring-fence the stuff that you're thinking about divesting and put it into discontinued operations so you can clean out all the goodwill and sort of get everything behind you in the nearer-term? Or is it better to just wait for the right timing to find a buyer.

Joel, from an accounting perspective and GAAP perspective we're not permitted to break to out as discontinued operations and we're not far enough down the line that those operations would be considered held for sale at this point.

Okay. And I just wanted to ask one longer-term question, now that you've been there for whatever it is, for six months or so, I just wonder if you could give us a sense of what Kennametal looks like in five years and I'm thinking all just from return - free cash flow as a percent of net income, operating margins like if you - you know what I mean? Your vision and you slim down to the core business, what kind of returns and operating margins and free cash flow do you think is like the longer-term target?

Yeah. Joel, I've noted every one of your questions and I will look forward to seeing you in December.

You'll tell me in 2018, right?

I think we'll - we're spending a lot of time and energy right now thinking hard about the right strategy, making sure that we have the right footprint, making sure we have the right portfolio to maximize all the tremendous assets that we have here at our disposal here at Kennametal. And our intention is to lay that out on December 15, at Analyst Day.

Is it crazy to think that this could be a high teen’s business when everything is said and done longer term? Or it's just too early to say?

Yeah. I think it's just too early for me right now.

All right. Okay. Thank you.

Thanks, Joel. Great questions, Joel. Thank you.

Your next question is from Walter Liptak at Global Hunter.

Hi. Thanks. Good morning.

Good morning, Walter.

I wanted to ask about the 2015 percentage of sales. I guess specifically in the Infrastructure segment, what percentage of you sales are O&G and what percentage are coal? Or I guess mining?

Walt, this is Quynh. I would say that what we said last quarter still holds true. What we can account for directly to the oil and gas is around 8% to 9% of total company sales. However, there's indirect sales that gets captured via general engineering and more secondary impact. In terms of the coal we actually report that under earthworks and in round numbers I would say earthworks is around 20% of total company sales, half of that is mining and half is construction.

Okay. Got it. And on the oil and gas during the quarter, what kind of year-over-year decline rates did you experience?

We had much higher declines on oil and gas in the U.S. When you look at rig counts, rig counts are down about 50% and certainly in the U.S. we had similar drops and you can pretty much align it with that around the world. We follow rig counts pretty closely.

Okay. So as you go into your first - fiscal first quarter, second quarter, are you expecting those declines to accelerate or stay about the same?

Boy. I'm not sure I want to be in the business of forecasting rig counts here, Walt. What we've done, we've built into our assumptions for the year is that we would continue to have a challenging first half, I would call it. So we would continue to see year-over-year declines and then the comps get easier as you get into the second half. We don't - right now we've built in that rig counts will not drop significantly, we may even add a few. That's where we're staying.

Okay. Right. Okay. Thank you. Okay. You mentioned in your comments about pricing and I wonder if you could comment specifically about what your oil and gas customers - are they requesting price declines and are you succumbing to the pressure of price declines and what - what impact does that have on the business?

Yeah. We are getting requests on pricing. We've had some declines in raw materials and many of our customers are aware. And it's - obviously we're also seeing declines in raw materials and we don't expect to have that - those two to - we expect those to offset and not have a significant impact on margins.

Okay. Okay. Great. Thank you.

The next question is from Samuel Eisner at Goldman Sachs.

Yeah. Good morning, everyone.

Good morning.

Good morning.

Can you talk a little bit about just the June month and how organic performance was throughout the month of June and then any early reads on July? I don't see the June numbers posted to the website so any help there would be great.

Yeah. So I would say nothing inconsistent in June with the rest of the quarter, so there's nothing to note there.

Got it. And anything on July that you're willing to talk about?

Yeah. I think we're going to have a pretty challenging, pretty soft quarter. This is year-over-year and early indications are that this will be a challenging quarter.

Got it. And then when you think about the footprint changes that are going on here, I think one of the comments that you've made historically is that you're certainly looking at divesting a portion of that but also you're looking at kind of calling some of the existing manufacturing that you end up keeping. Can you talk a little bit about your ability to maybe move to a more flexible manufacturing structure and being in that remaining business after the $150 million or $200 million of divestitures?

Yeah. We are looking at reducing complexity, I think taking, I would call it, products that don't create as much value as you'd hope given the complexity that they add to our operations. That is a key driver for us so - and it may allow us to - it may help us drive further footprint reduction as we think about that next 25%, so that's key. But I'm not sure, does that answer your question?

I guess my understanding is that you have a pretty kind of fixed manufacturing footprint where it's difficult to make dissimilar products in multiple facilities and I just wanted to understand if you're thinking about the overall manufacturing footprint becoming either more redundant in a sense or the ability to make different products in different facilities going forward?

Yeah. So with the new - next generation equipment I guess is the way to say it, as some of the investments that we're making with this capital budget this year, we will have more agility. Both to reduce batch size to drive inventory and to reduce cycle time. So we're definitely enhancing the flexibility of our operations with this - with the investments we're making this year.

All right. That's helpful. And I think that just lastly given the fact that you're already starting to record charges for Phase 3 in the current quarter but not gain a savings there. Can you maybe just talk about how the sequential increases throughout the course of fiscal 2016 kind of happen for Phases 1,Phases 2, and Phases 3? Thanks.

Sure, Sam. They're relatively consistent with what we disclosed on last quarter's call. So for Phase 1 in 2016, we will get near our full run rate reaching a full run rate of those savings in fiscal 2017. From a Phase 2 perspective we did realize about 15% of those benefits in fiscal 2015. We expect to be roughly up to about 70%, 75% in the full year of 2016 and then be at the run rate in 2017. And then for Phase 3 we didn't expect any benefits in 2015 and we expect some benefits in 2016, maybe a quarter and the remaining be up to the run rate. Well, about three quarters to three quarters in 2017, up to three quarters and then ongoing we'll hit our full run rate.

Great. Thanks so much.

Yep.

Our last question comes from Eli Lustgarten at Longbow Securities.

Good morning, everyone.

Morning, Eli.

Yep. Can we talk a little bit of how we should think about operating margins for the two sectors as we go through 2016? And I know it gets complicated with or without charges and all that. But I mean the number is adjusted to look like I guess Industrial something around [ph] 14.1% in the quarter but 13% for the year. Are you expecting - despite whatever the volume number turn out that we can improve operating margins in Industrial? I mean that's a world-class kind of business and probably some reasonable chance for operating profitability to go up. And then the negligible profitability that we're seeing in Infrastructure, can you talk a bit about what we should expect in that kind of business? I know there'll be divestitures and I know there's going to be a lot of noise but as an entity what we try to model, what should we be thinking about for 2016? And maybe some first half, second half or something because I know it's going to be complicated.

Yeah. Well, let me start out and then I'll turn it over to Marty. So first of all, the first thing to think about on margin impact is our portfolio simplification. We expect to divest as we said a significant chunk of our Infrastructure business and that will definitely improve margins on our Infrastructure business because we expect that to be accretive. So I would start with that piece. And then, Marty?

Sure. From - just to give you a little color directionally, Eli, we did end the Industrial at about 13% operating margin. We do expect improvement there driven by their organic growth, the restructuring benefits and cost reductions. So you can expect a little bit higher operating margin there. We do expect for Industrial a little more softer Q1 and Q2 than maybe you saw last year and then improvements in the second half. From an Infrastructure perspective, given the organic declines that are expected, [ph] any pressures we're expecting to see from a pricing perspective because raw material costs are dropping for us and we do expect more compression on pricing first half than second half and we expect raw material benefits to sort of materialize more in the second half once we have worked through our high cost materials. So from an Infrastructure perspective you can expect some compression on the operating margin there and again the first two quarters are going to be pretty low.

I mean is it feasible that Infrastructure - we know the guidance excludes these divestitures before the simplification. Is it possible to lose money in Infrastructure in the first quarter, first half?

I don't think we can comment on that piece, Eli. I think the one thing we can say is that we're heading into a much more challenging first quarter and we think the challenge will be less in the second quarter and improve as we head through the year. I think the one thing that - the one challenge that I would call a timing problem, because we have some high cost inventory to work through, it can affect our margins with pricing, due to pricing declines. But we'll overcome that as we head through the year.

And overall we do expect sort of the mid single-digit operating margin in Q1.

Overall for the company?

Correct. [indiscernible]

Thank you very much.

Thanks, Eli.

Thanks, Eli.

At this time we will conclude the question-and-session. I would like to turn the call back over to Quynh McGuire for closing comments.

This concludes our discussion. Please contact me, Quynh McGuire, at 724-539-6559 for any follow-up questions. Thank you for joining us.