Kennametal Inc. (KMT) Q3 2017 Earnings Report, Transcript and Summary

Good morning. I would like to welcome everyone to Kennametal’s Third Quarter Fiscal Year 2017 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] Please note that this event is being recorded. I would now like to turn the conference over to Kelly Boyer, Vice President of Investor Relations.

Thank you, Kerry. Welcome everyone and thank you for joining us to review Kennametal’s third quarter fiscal year 2017 results. We issued our quarterly earnings press release yesterday evening and it is posted on our website. I’m Kelly Boyer, Vice President of Investor Relations. Joining me on the call today are Ron DeFeo, President and Chief Executive Officer; Jan Kees van Gaalen, Vice President and Chief Financial Officer; Chuck Byrnes, President-Industrial Business Segment; Pete Dragich, President-Infrastructure Business Segment; Alexander Broetz, President WIDIA; and Pat Watson, Vice President Finance and Corporate Controller. Ron and Jan Kees will discuss the March quarter operating and financial performance, as well as our outlook for our fiscal year 2017, and we will be referring to the slide deck posted on our website. After their prepared remarks we will be happy to answer your questions. At this time please direct your attention to our forward-looking disclosure statement. Today’s discussion contains comments that constitute forward-looking statements that involve a number of assumptions, risks and uncertainties that could cause the company’s actual results to differ materially from those expressed in, or implied by those statements. These risk factors and uncertainties are detailed in Kennametal’s SEC filings. Also we will be discussing non-GAAP financial measures on the call today. Reconciliations to GAAP financial measures that we believe are most directly comparable can be found at the back of the slide deck and on our Form 8-K on our website. With that, I’d like to turn the call over to Ron.

Thank you, Kelly and good morning everyone. We’re webcasting our call today from our European corporate office, so good afternoon to our European listeners. Thank you all for your interest in Kennametal today. Also I’d like to welcome Pat Watson, who has this quarter moved into the Corporate Controller at Kennametal. Pat has been with the company for 30 years previously was the lead finance person for the Industrial segment. Marty Fusco, who was Corporate Controller, has taken that roll. So please join me and welcoming Pat and thanking Marty and wishing them both continued success. Let me begin on Page 2 of the slides that are posted on our website. Our third quarter of fiscal year 2017 results exceeded our expectations in almost every measure. Simply put revenue increased and cost declined, reflecting continued progress on the initiatives that we began last year. Overall we posted year-over-year total company sales growth of 6% for the quarter of which 5% was organic. Every segment reported increased sales, Industrial plus 6%, Infrastructure plus 6%, and WIDIA plus 10%. In addition every region posted positive growth. It’s clear that the market confidence is building. I would like to talk a little bit more in depth on that, I want to get into the next slide. But first let me summarize the results on a total corporate basis. The work that we’re doing on growth, simplification and cost reduction is starting to show in our results. Both our cost of sales and our operating expenses as a percent of sales were down in this quarter versus prior year. Our adjusted operating margin improved 500 basis points to 12.8% this quarter, when compared to prior year. This reflects a 360 basis point increase in adjusted gross profit and 120 point decrease in adjusted operating expense as a percentage of sales. Our EBITDA margin increased 380 basis points over Q3 fiscal year 2016 from 13.5% to 17.3%. The reported GAAP EPS more than doubled in the quarter to $0.48 per share versus $0.20 in the prior year quarter. Included in this quarter is $10 million of pre-tax restructuring charges, mostly related to the ongoing headcount reductions announced in mid-calendar year 2016. Therefore on an adjusted basis, earnings per share for the quarter increased to $0.60 per share versus $0.37 last year. Let’s turn to Slide 3 to look at organic sales growth. In the third quarter of fiscal year 2017, quarterly organic sales growth has continued to be positive. It’s a positive trend that actually started last quarter. Overall, the organic sales growth increased to 5% versus 2% last quarter, we have now posted two consecutive quarters of growth after eight negative quarters of organic growth. Although it might be early to call it a recovery, it’s certainly is a good start. Monthly organic sales growth is posted on this graph as well. The trend throughout the quarter was positive after a slow start in January. We’re encouraged by the tone of the end markets, in addition to our progress on sales execution initiatives. One additional point before I get into the segment review, with regard to our headcount reduction program we’re now targeting $90 million by the end of fiscal year 2017. And as I discussed on our last quarter’s earnings call, the target of $100 million was to be reviewed in light of conditions in the end markets as a percentage themselves. With end markets now recovering and in some cases quite quickly in order to ensure that we continue to balance our cost reduction and productivity goals with customer service and the ability to meet increasing demand, we believe the proper target is now $90 million. As noted on the last call, we have already identified the actions associated with this level of reduction, although we are still making some modifications. This reduction in force is a major accomplishment for Kennametal, and is an important part of our strategy to achieve the overall margins we believe that are possible and necessary for us to compete. Now turning to Slide 4 in the Industrial segment overview. As in previous quarter call slides, we have included the revenue splits of the business by geography and end markets for the quarter at the top of the slides for your quick reference. There is nothing unusual to note here. As I mentioned in my opening comments, industrial posted a quarterly year-over-year organic sales growth of 6% – I’m sorry, total sales growth of 6% of which 5% was organic. This is the third consecutive quarter of organic growth for industrial. All regions showed revenue gains with Asia leading at plus 17% followed by Europe and then the Americas. Adjusted operating margin increased by 390 basis points versus prior year to 15.1% in the quarter. We saw strength in all of our end markets with the highest gains in energy at plus 18% followed by general engineering, aerospace and transportation. Consistent with last quarter, we believe stock levels within our indirect channel seem consistent with end market demands. The margins are beginning to show the impact of our productivity improvements in cost reduction programs. We are making significant progress in all three areas of focus growth, simplification and cost reduction. I’ll discuss each of these areas in order to – in order, but it is important to note that they can and in many cases do overlap. In terms of growth and sales execution initiatives Chuck Byrnes and his team have worked hard on improving our partnerships with distributors. This is a critical and important initiative. And we are dedicated to continuing to work together with our partners to improve our customer service levels. Since we started this initiative last summer, we have transitioned approximately 2,600 customers that are best served through the indirect channel with no margin erosion. Our multi-tiered customer segmentation work is also progressing, allowing us to spend more sales resource time on bigger customer targets. And conjunction with this increase in sales resources we have also focused on improving the use of our CRM tool, this is for sales planning not just management reporting. And we are about an 80% adoption rate right now a significant improvement over last quarter. With regard to the second set of initiatives namely simplifying the company, we’re continuing to work on progress on product lifecycle management and making good progress here. This is a very important initiative since without good product discipline manufacturing cannot be efficient. To date we’ve reduced our SKUs by approximately 15% and we are well on our way to achieving the goal we set for ourselves at our Analyst Day. However, we are continuing our work on optimizing the number of SKUs and I expect that this will be a consistent and continuing process. In other areas of simplification, we’ve reduced a number of coatings on our products by over 40% and the number of powder formulations now by close to 60%. Both of these are great numbers and we feel good about the improvements we have been able to achieve. Again, these speed into manufacturing efficiency and productivity and therefore improved cost control. And keeping with this focus on margin improvement, we’ve implemented minimum manufacturing and order quantities and are at about the 80% level of our target implementation. These are the types of changes that are driving margin improvements both this quarter and in quarters to come. On the cost reduction side the headcount reduction initiatives are underway and modernization and end-to-end initiatives are progressing. Of course the main benefits of these programs will be felt over the next two to three years. For industrial, the key to success lies in both our growth and margin improvement initiatives. There’s a lot of work to do and more opportunity. Turning to Slide 5, WIDIA. WIDIA posted a 10% quarterly sales improvement with year-over-year quarterly organic growth at 9%. Again, all regions reported positive numbers, with Asia leading at plus 14%, in this case followed by the Americas at plus 11%, and EMEA at plus 3%. We’re quite pleased to note that WIDIA reported positive operating profit for the first time since being segmented as a separate business unit in the first quarter of this fiscal. As we discussed that our Analyst Day in November last year, the decision to separate WIDIA on its own as a separate reporting segment was to allow better focus on the WIDIA brand. To that end, we have implemented targeted regional strategies for WIDIA. In America, the reverse of the WIDIA-Hanita and WIDIA-GTD brands and the establishment of our channel partner programs are helping to grow sales. In Asia-Pac, we’re implementing new indirect channel partners and this quarter we’ve successfully implemented a new national distributor in China. In India, we were able to grow sales despite a flat market and are increasing our manufacturing capacity in output at our Bangalore facility for both the Indian and global marketplace. Finally, in EMEA, Europe Middle East and Africa, we’ve been able to replace our German national distribution partner, which we reported last quarter that have gone into bankruptcy and we are seeing good growth also in Eastern European markets. So all in all we are encouraged with WIDIA’s progress and are excited to continue focusing on as Alexander Broetz often says making the diamond shine again. On Slide 6, we update our infrastructure business. As noted, this splits by geography and end markets for the third quarter are anticipated at the top of the slide. Infrastructure reported quarterly sales growth over prior year of plus 6% of which 4% was organic. This is the first quarterly organic sales growth in over 2.5 years and the strongest organic growth in over five years. Again, all regions posted positive sales growth with Asia leading followed by the Americas while Europe remained flat. With regard to end markets, oil and gas activity is showing definite improvement. With the average U.S. land rig count in the quarter up close to 40% versus prior year. This improvement is starting to show in the numbers with energy being the leading end market for infrastructure this quarter. Mining is also showing some encouraging signs of improvement. Adjusted operating margin increased 710 basis points to 12.3% this quarter versus 5.2% in the prior year quarter. This is an excellent improvement in the results, unlike last quarter reflects the work Pete Dragich and the team are doing on a number of fronts. Before I talk about the various sales and cost reductions programs, I wanted to note the reorganization that Pete initiated when he took over as leader of infrastructure, whereby he reorganized the team into 5 P&L focused business lines. This move is allowed the team to increase its focus on executing our plans and it’s the basis for the results that I’m reviewing. First, we see lower raw material unit cost coming through not only from the work we’re doing to strategically source materials, but also through improved product design as well as optimized material science usage. We have now completed the three plant closures announced earlier this year and the cost savings are flowing through the P&L. The headcount reductions in infrastructure are well underway. And we are seeing these cost reductions accelerating in the numbers to score. Finally, we had a number of product launches and we are seeing good volumes in both oil and gas frac seats for fracking obviously, as well as our new NS300 drum in road milling. In summary, infrastructure is making great progress. We are obviously pleased with that the end markets are showing some improvement, we are especially delighted with the productivity increase and improvements in cost structure. Those are the improvements that will serve us well in the long run and the investments we’re making in modernization and will keep us on track to continue to improve our results. Now, I’d like to turn it over to Jan Kees van Gaalen will begin on Slide 7 with the detailed financial reports. Jan Kees?

Thanks, Ron. Hello everybody. To highlight some of Ron’s previous comments. Though there’s still much work to be done, our efforts to both drive growth and right size our cost structure continue to manifest in our quarterly results. I will begin by reviewing the income statement starting with quarterly results on Slide 7. Sales in the March quarter were $529 million, compared with $498 million in the same quarter last year, an increased of 6%, 5% of that increase is due to organic growth. This is the strongest consolidated organic growth we have experienced since 2014. More business case this year due in part to the timing of the Easter holiday also favorably impacted sales by 2%, but this was offset by 1% unfavorable currency exchange impact. Sequentially, sales increased by $41 million or 8% from the second quarter fiscal 2017, sales of $488 million. All end markets posted sequential sales increases led by energy with 19% sequential quarterly growth, followed by transportation and then general engineering and to a lesser extent earthworks and aerospace and defense. From a regional perspective, sales in dollar terms increased in all regions led by the Americas, then Europe and then Asia. Our adjusted gross profit margin improved in the current period to 35.5% versus 31.9% in the prior year, due to organic sales growth, incremental restructuring benefits, higher fixed cost absorption along with improved productivity and favorable impact from business mix. This was partially offset by negative impacts of foreign exchange and higher raw material costs. Adjusted operating expense stays flat at $116 million compared to prior period. However, adjusted operating expense as a percentage of sales decreased 120 basis points, when compared to the prior year, and decreased 60 basis points when compared sequentially to the previous quarter. Beyond producing our cost structure, we are engaged in a delicate balance between constraining our operating expenses. I’ll also ensuring that we serve our customers appropriately in delight of increasing demand. Our adjusted operating margins increased significantly year-over-year to 12.8% in the current quarter up from 7.8% in the prior year quarter. For the third quarter of fiscal 2017, adjusted EBITDA was $91 million up 36% versus $67 million in the prior year period. I will review the details of cash flow later on in the call. Adjusted EPS improved year-over-year to $0.60 per share in Q3 2017 fiscal from $0.37 in the third quarter fiscal 2016. In order to gain a better understanding of the factors affecting adjusted EPS this quarter, please turn to Slide 8 for the EPS Bridge. In summary, the increase in adjusted EPS year-over-year reflects incremental restructuring benefits, organic sales growth, higher fixed cost absorption and productivity and to a lesser extent favorable mix, partially offset by higher performance based compensation, a higher tax rate, unfavorable currency exchange of $0.02 per share, and higher raw material costs. The increase in the adjusted effective tax rate was driven primarily by the favorable impact in the prior quarter related to a U.S. provision to return adjustments that did not repeat in the current year, partially offset by earnings in the U.S. that cannot be tax affected in the current year. Turning now to the segment information on the Slide 9. The industrial segments report positive news on all fronts this quarter, with solid operating – overall operating performance compared to last year. In percentage terms, sales grew year-over-year in all regions led by Asia then Europe and the Americas. Worldwide industrial sales were $289 million in the third quarter, an increase of 6% from the prior year quarter sales of $274 million. Organic growth was 5% the highest quarterly level since September of calendar year 2014. And industrial also benefited from more business days this year translating to 3% increase in sales. However, these positives were partially offset by the unfavorable currency exchange effect of 2%. Sequentially, industrial segment sales increased $22 million or 8% from the second quarter fiscal 2017 sales of $267 million with increases in all end markets. On a year-over-year basis, for the Industrial segment sales grew in all end markets led by energy, then general engineering, aerospace and defense, and transportation. General engineering sales benefited from growth in the indirect channel due in part to the strengthening of oil and gas in the U.S. and growth in the Chinese automotive market. Oil and gas in the Americas, likewise, contributed to overall growth in energy coupled with increases in power generation globally. The transportation market experienced growth in Asia with tiered suppliers and truck OEMs offset by lower sales in the Americas. Conditions continue to be favorable in the aerospace sector, with engine growth being supplemented by increasing demand related to frames. The WIDIA segment has continued on the spot this year to outperform both the proceeding quarter in this fiscal year and the same quarter of the prior fiscal year. Sales were $46 million in the third quarter, a 10% increase from $42 million in the prior year quarter. This was driven by 9% organic growth coupled with a favorable business day impact of 1%. Growth is reported in all geographic regions, with Asia leading the back at 14% followed by 11% in the Americas and 3% in Europe. Sequentially, WIDIA segment sales increased $3 million or 7% from the second quarter of fiscal 2017 sales of $43 million. Sales increased sequentially in the Americas and Europe, while sequential sales decreased slightly in Asia. The Infrastructure segment, which has more exposure than all other segments to the cyclical oil and gas and coal markets, reported improving performance as well. Third quarter sales of $193 million reflect an increase of 6% from $181 million in the prior year period, driven by organic growth of 4% and a favorable business day impact of 2%. As Ron mentioned, this is the strongest organic growth improvements we’ve seen in five years. From an end market perspective, energy increased 22%, while earthworks and general engineering increased 3% and 1% respectively. Sequentially, Infrastructure segment sales increased $16 million or 9% from the second quarter of fiscal 2017 sales of $177 million. With the exception of construction sequentially increases we’re reported in all markets led by oil and gas and then industrial applications, processing and mining. Now, I will provide an update on our restructuring programs, details can be found on Slide 10 and 11. As Ron mentioned, and reported on the last earnings call, we have identified actions expected to translate to approximately $90 million in annualized savings. With the increase in end market demand, and in order to ensure we can maintain our high level of costumer service, we are reducing the total program targets to this level. Annualized savings in the third quarter were approximately $54 million. We have incurred inception to take charges on this project of $42 million. Our current expectations include at least an additional $18 million of future charges associated with the headcount reduction program. However, as we have discussed on prior calls, please note that it is possible that there will be additional charges beyond this amount as we move forward with the headcount cost reductions. Our expectation for total program charges are now $60 million to $70 million reduced from the initial estimate of $80 million to $95 million. With regards to the other restructuring programs, benefits in the quarter amounted to $17 million and we expect to achieve savings of approximately $63 million in the fiscal year 2017 with these programs. At completion, we expect these programs to yield annualized savings of approximately $75 million to $90 million. Inception to-date charges of $83 million have been incurred, and we still expect total charges to be in the range of $105 million to $125 million. The balance sheet is shown on Slide 12. Our balance sheet reflects important strengths of conservatism for Kennametal. Cash on hand at March 31 is $101 million, as compared to $162 million last June. Our current ratio was 2.4 on March 31, 2017, compared to 2.5 times as at June 30, 2016. As shown on Slide 13, primary working capital was $676 million as at March 31, 2017, an increase of $28 million from $648 million as at June 30, 2016. Currency exchange decreased primary working capital by $11 million during this period. On the percentage of sales basis, primary working capital decreased 200 basis points from 34.3% as at June 30, 2016 to 32.3% as at March 31, 2017. The negative impacts of increases in inventories of $31 million and accounts receivable of $6 million were partially offset by an increase in accounts payable of $9 million. As shown on Slide 14, third quarter free operating cash flow was $10 million, an improvement compared to Q2 fiscal year 2017. Year-to-date free operating cash flow is negative $10 million, consistent with our expected earnings and historical pattern. We anticipated sequential quarterly improvement in free operating cash flow to continue into the last quarter of this fiscal year. The year-to-date free operating cash flow of negative $10 million compares to positive $67 million in the prior year. The decrease in free operating cash flow was primarily attributable to an increase in primary working capital, and higher restructuring payments and capital expenditures, partially offset by higher cash earnings and lower tax and pension payments. With regards to capital spending, net capital expenditures were $90 million year-to-date, compared to $78 million for the prior year period. Dividends paid out were $48 million, consistent with last year. Our conservative capital structure and dividends are of key importance to Kennametal and we continue our commitment to maintaining them. Our debt and liquidity positions are shown on Slide 15. At the end of March, our net debt was $595 million. With no current outstanding borrowings on our revolver, we have no significant maturities until 2019. Gross debt to adjusted EBITDA currently stands at 2.5 times. Now turning to Slide 16. We are updating our outlook for the full fiscal year based on actual reported performance through March and our expectations for the rest of the year. Our EPS outlook is now $1.50 to $1.60 per share on an adjusted basis, compared to the previous outlook of $1.20 to $1.50 per share. We expect increasing demand in our end markets to drive sales to be near, the higher end of our previous outlook for fiscal 2017. We’re also expecting our tax rate to be slightly lower than initially expected due to changes in the jurisdictional mix of revenues. Capital expenditures are still expected to be in the range of $125 million to $135 million. However, higher working capital will be required to meet higher demand. This is the primary reason why we are updating our free operating cash flow outlook to $60 million to $80 million, compared to the previous outlook we reviewed in February. And with that, I’ll turn it back over to Ron.

Thank you, Jan Kees. Our third quarter results on Page 17 to be summarized showed progress on all fronts. We’re simplifying the organization for accountability as well as manufacturing efficiency and reduced bureaucracy. We’re improving our commercial execution in a number of ways. We’re no longer sitting back on our heels, but are actively making decisions that are enabling us to compete in the marketplace. Finally, we really are laser focused on getting costs out. We’ve made some really good progress on headcount reductions and have a good start on the modernization and end-to-end initiatives that will take us to the next level and the next several years. Market forces are more positive today than a year ago, in fact frankly, than we thought just six months ago. As I discussed with regard to headcount initiative for example, this is obviously a very welcome and positive development, but it adds some complexity to our decision making regarding core and non-core processes. Not really a bad problem to have. We have the team in place to address these issues and are leading into them aggressively. For building the foundation today for a sustainable improved performance over the next couple of years. Now, I’d like to open it up to your questions.

[Operator Instructions] Our first question comes from Ann Duignan of JPMorgan. Please go ahead.

Hi, guys. How are you?

Good Ann, thank you.

I think, I’ll change my last name again. Anyway, could you just give us an idea of what your expected count charges to be in Q4? You break as the other programs quite nicely so it’s easy to back into the Q4 charge, but what are you anticipating in the headcount program.

Okay, we will try together that Ann I – for Q4, do you guys have that number? Wait a second.

About $11 million.

Okay, about $11 million.

Okay, that’s helpful. Thank you. And then Ron, on WIDIA and Industrial, can you just give us some color on, when we might anticipate moving from kind of new distributor sign ups, to kind of same-store sales comparable. If you know that means, are we still in a process, where we’re signing up new distributors particularly in WIDIA. And then when should we anticipate that would move to more stable – like, kind of same-store sales metric.

Yes, I think one of your concerns behind that question is are we putting in a lot of pipeline inventory. And I want to say, at the beginning that we’re really not. When we sign up new distributors there’s obviously a little bit of inventory that goes in. But our real objective is to sell to retail demand. But I don’t think there will be a same-store sales calculation that will be easily made. But I think WIDIA, I’ll let Alexander comment and then Chuck you can comment on Industrial.

Thanks, Ron. Thanks, Ann for the question. We are still having some white space, it’s still believe. So those are areas where WIDIA has not been necessarily been present over the years. So we will continue to sign up partners that we do want to grow in markets we have not been dealing in. On the other hand we’re also not pushing significant amount of inventory in those distribution channels, as we know that this is not sustainable, we are helping them to start the initial – servicing the initial demand. But we are not building message inventories in those distribution partners.

Ann, this is not a major initiative for the industrial business. In fact, we’ve got a net increase of 9 distributor partners in the Americas, 4 in EMEA and 3 in Asia. It’s not a large increase for us overall.

So the real initiative in Industrial is moving many of the smaller customers that we would classify – that should have been purchasing through distributors since beginning to have them by through distributors.

Okay. Thanks, Ron. And then just quite on the restructuring program. Ron, is there any risk now, I mean I know you noted that that things are picking up faster than you anticipated that organizational and we design it’s the complex. Is there a risk that we come to deeper or is there a risk that you’ll need to have back people sooner than you expected, I mean it’s a nice problem to have. But I would imagine it’s quite complex.

It is complicated. And that’s why we weren’t able to achieve $100 million. Because a lot of those customer predicated on flat overall revenue, and if we reflect back on the market conditions that we saw existed six months ago we were looking optimistic with our flat year-over-year revenue performance. So now if we’ve got a plus 1% to 3% revenue performance expectation that means a lot of little pieces are being made around some of our factories. And so what we want to do is we want to hold the direct headcount and work on productivity improvements in those factories. And probably add a little bit of direct headcount where appropriate, but we still want to be aggressive on indirect headcount, staffing and all the associated costs that we believe have caused the company to be a bit bureaucratic and a bit bloated in some of it’s cost structure. So I look at it and say at the beginning we set that a pretty aggressive target of $100 million. That was pulled from the air, forced into the organization and now we’re 9 months into it, and I feel really proud of being able to be confidently $90 million in a market that’s now growing versus a business that was shrinking.

Got you, Ron. Thanks. I will get back in line then in the interest of time. Thank you.

The next question comes from Sam Eisner of Goldman Sachs. Please go ahead.

Yes, good morning everyone.

Hi, Sam.

So just to looking at the guide here, just a quick question obviously, you’re guiding to the high end of the prior range I think that implies from a revenue standpoint about 4% organic. It seems like a little bit of a decel. So just curious, is that just being conservative. Do you – are you expecting a deceleration into the month. And maybe you could talk a little bit about, what the trends that you’re seeing in April.

Yes, okay. No Sam, I don’t think we’re guiding into the higher end of the old range. We actually, the old ranges is – the bottom of our new guide, $150 million to $160 million and previously we were $120 million to $150 million. So it does actually reflect in increase, but the net-net is a Q4 that’s a little bit more conservative perhaps in looking at it then, we hope will happen, but we know hope is not always a productive thing to rely upon. I think Chuck would say in his business is 2.5 to your business days. And 2.5 to your business days and might not seem like a lot, but if you take the size company we are divided by 230 days in a year working days, it’s over $20 million. So that’s an issue and if you look back in history very few fourth quarters have actually been smaller than third quarters, but probably that’s happened when there were fewer sales days. But simultaneously, remember end markets are turned around pretty fast. They can soften up a little bit or at least pause a little bit and I’m not going to comment on April, because April isn’t even over yet and but other than to say that we’re on the expectations that we set for ourselves. So I feel quite good about the fourth quarter, but I think I’m really beginning to lean into 2018 and just see how high I can be in 2018. And that’s what we’re kind of concentrating on now.

That’s – excuse me, that’s helpful there. And then, thinking about your earthworks exposure, plus 3% within the Infrastructure segment this quarter. It feels like data point that we’re seeing across the mining sector are certainly better than 3%. So curious, if you can give a little bit more color on what you guys are seeing there based on, either what your customers are saying or what you’re seeing the end market demand.

Yes, I’m going to turn that question over to Pete.

Thanks, Ron. Thanks for the question, Sam. You’re right. The end markets are doing better than the 3%. The 3% represents our increase in overall earthworks globally. Within that obviously, is there mining portion of that and within of the quarter year-over-year was actually up 15%. Within that overall number though, we’ve had mixed results in construction in last quarter update provided some feedback as far as what was happening in construction, particularly in the Middle East, where we’ve seen to significant year-over-year decline, primarily due to funding – look towards other areas instead of construction also some challenges we’ve had in Japan. Both of those cases we expect that’s a return in the future. So on net-net, construction should be a good driver for earthworks business and we’ve got exposure to mining, a little bit less clear on what are remain for Appalachian call for us, but we’ll see.

That’s helpful. Maybe if I can just sneak one more in on the headcount reductions I think you guys, our total cost savings you’re throwing out restructuring and program savings I believe the implied fourth quarter savings around $18 million. I’m curious if you can provide a headcount savings number for that fourth quarter given that you did about 13 this quarter. I recognize that you’re targeting 90 for the full year, but curious if you have a kind of point estimate you guys are expecting for the fourth quarter for the headcount reductions. Thanks.

Sam, I don’t want to be that specific yet, because there’s a few things that are still up in the air relative to exactly how will end and the fiscal year, but you’re in the right ballpark.

Helpful, thank you so much.

The next question comes from Julian Mitchell of Credit Suisse. Please go ahead.

Thank you. Good morning guys, Ronnie Weiss on for Julian.

Hi, Julian. Okay, no it’s not Julian.

Ronnie Weiss on. I just want to touch into Asia a bit growth of double-digits across all three segments. On a macro level, what do you guys seeing there, was it one – more of one off that you could saw this kind of strength. This is sustainable into the next quarter and the next few quarters. Just any color there.

Okay. I’m quite positive about Asia. I think Asia is coming back. I think it’s encouraging for all industrial companies to see Asia and China in particular begin to come back. It starts with the commodities and the fundamental economic growth that we’re seeing, and I think, we will see it across other regions of Asia overall. India is a little bit of a flat performer at this point in time, but I’m just – I’m confident, India will come back also. So, I think it’s a good sign, because I’m old enough to have seen these things before. And usually what happens is with Asia improvement it does believe into other developing market improvements. And if you look back at the period of 2002 to 2008, one of the things that really rocketed the industrial landscape was the fact that all developing markets performed well.

Got it, thank you. And then just one more from me. On Slide 8, the EPS Bridge of that first bar of $0.18, there’s a lot of moving pieces in there. I just wondering if you could give a little more detail what the contribution was from volume, price, raw mats, mix, et cetera.

In that order of priority, but Jan Kees or Pat, do you want to take that?

In terms of sales volume that was really the largest portion. Then afterwards at the gross profit line we had in order absorption and some productivity. We obviously some headcount savings, we have restructuring in there and this is again at gross profit level. We had some mix and then we had a bit of a price.

Negative.

Negative price, yes.

Price was negative. Okay, great. Thanks guys.

The next question comes from Steve Volkmann of Jefferies. Please go ahead.

Hi, Steve.

Hi guys, I’ll just start with a quick follow up there. Sorry, I’m drinking from a fire hose this morning. But I’m pretty share price cost was negative as what you’re saying. If you expect that to continue, I guess you could take maybe a little of that back over time. Just how do we think about that?

I don’t expect it to continue. I think we will get a little bit of that back over time, at least enough to offset raw material cost increases. And – but a lot of the price mix that was negative was in our infrastructure business, which has contracts that were tied to the raw materials. So most of our price deterioration was there it was not in the industrial side. Although, we had a little bit of deterioration in the industrial, but the amount of volume more than offset that.

And Ron, one thing I hear from people is you’ve expressed maybe a willingness so we say it could be more flexible on price than perhaps Kennametal was in the past. And the concern is that erodes pricing broadly. Can you just address that?

Yes, I think that somebody’s fear that assumes that we will be mavericks and just aggressively go out and take price down, that of course is not the case. But we’re tired of being the company that people beat in the marketplace. We got great products, we have a great brand, we have a great sales organization, and we’re not going to give up for a couple of percentage points on products that have 40%, 50% margins. So we’re going to compete that does not mean that we’re going to start a price for.

Okay, fair enough. And then you mentioned you were staying to lean in to 2018. So if you don’t mind maybe I’ll go there a little bit. On Slide 11, you guys provided some estimates in terms of cost savings I want to ask you to forecast the market in 2018, but as I read that, are the FY2018 and beyond estimates for savings are those should I read that as cumulative or are those the amount of savings will actually expect in 2018 and beyond. And then if you could just maybe broadly give us a sense of how much of that might come in 2018.

Those are really run rate savings.

Sorry I can’t understand.

We’re talking run rate savings here.

Run rate, okay. So how much of that might we think, what half of the $40 million to $47 million for industrials, for example. What half of outcome in 2018 or…

It will probably be a little bit more than half of that, for sure, because we’re further along. But we’re not really at a place where we can say precisely what percentage of that is going to fall in. It because what we going to make sure we’re clear on is, what is the incremental piece in 2018 versus what we achieved in 2017. So what – you see presented on page 11, is the run rate for fiscal year 2018 and beyond that estimate for what we’re – we haven’t done is then take out what is in a year-over-year comparison built into the base period.

Yes.

And we’re not going to do that here yet, Steve.

Okay, great. Thank you.

Thank you

The next question comes from Joel Tiss of BMO. Please go ahead.

Hi, guys.

Hello, Joe.

Looks like you make a lot of great progress here, is very exciting. I wondered is there any sense that that you guys are winning back previously lost customers and gaining share or is the volume growth that we’re seeing just more a reflection or what’s happening in the marketplace.

I’m going to let Chuck and maybe Alexander or Pete on for that because they’re the guys on the firing line. So Chuck?

Yes, Joel. The industrial business had its third straight quarter of organic growth. In all of those someone of that did come from some stronger markets most of that came from a growing share at our key customers. I’ve seen significant increases across aero, our distribution channel, and even our transportation market globally that’s grown.

I’m particularly proud of the work that we’ve done among some of our big distribution and value added resell partners. We’ve taken the company that treated value added resellers or distribution partners as a necessary evil. And we took that and turned it’s a 180 degrees and said this is a tremendous opportunity for us and it’s being reflected in the relationship. So, Alexander?

Yes, I want to speak for India. India had a very difficult market environment and we have been consistently growing there. So I would consider that as market share gain. The growth of 11% in the Americas is also more than the industrial market has been growing. So that would lead us to believe also that we’re gaining market share. In EMEA, we are holding on to our own business and are slowly developing grows, but that’s probably more within the growth of the market. But in the Americas and in India, we’re definitely growing in market share.

Yes, very similar situation for infrastructure in particular oil and gas. Obviously, we’re benefiting from the volume increases there. But during the downturn, we spent a lot of time working with those customers to expand what we sell to them. And so that’s allowed us to have, I think disproportionate growth as up turns in oil and gas. In addition to that, I would say as far as new customers and market share, where we’ve introduce new products, we tried very closely the prior products, and number of customers that we’ve had. And we have seen significant increase in number of customers we sell to for those new product introductions.

And the bottom line is in each of these three businesses the teams have big opportunities on the table that they’re working to bring home. So this is not the Kennametal of your grandfather. Okay this is a different Kennametal. So…

I’m turning into a grandfather myself and just…

Am already one, on – this is probably a little bit unfair but I’m just going to ask it anyway. Given how quickly we’ve seen the profitability snap back and knowing how much work is in front of you and kind of how early stages we are in this recovery. Is it fair to think that the operating margins, say on like a five year basis with a little bit of economic help could be in the low to mid-20s.

Well, this put at this way, I don’t think anybody here at Kennametal is interested in being second. We look at our big competitor and the Nordic region and saw their operating margin in the metal working business. And we’re still substantially below that. No reason this company can’t get the margins at that level. There is no reason. Our modernization initiatives with the changes being made, absolutely that we should not have any other goal, but the try and grow and to drive operating margins and the low-20s. We need a good market for that that’s not going to happen with a weak market, but a good market, absolutely.

That’s great. Thank you so much.

Yes

The next question comes from Adam Uhlman of Cleveland Research. Please go ahead.

Hi, Good morning, everybody.

Hi, Adam

Hopefully, we can start with the working capital build that we’re talking about earlier. Again it’s a good problem in the half with the markets coming back. Did you talk about where the service levels are coming in now, where are the tinge points the certain businesses or regions. And then any concern that there might be share loss from service levels or availability being lower than expected or tighter.

Okay. First of all, it is a delicate balance. As Jan Kees and I mentioned on our opening remarks. Our service levels are solid, they’re good, but we’d like to see them better. In a few instances they’re below our expectations and we have a few factories that are underperforming on their service levels for sure. But I think with some targeted adjustments I’m pretty confident we can address those. I don’t think we’ve had any meaningful share loss as a result of our service level issues. We do periodically get a few complaints about service levels. But this certainly isn’t new to Kennametal nor is it new to the category. Obviously, the difference between 92% service level and 95% service level might be a lot of inventory and so you have to balance that. We don’t know quite what the real mix is going to be for us, because if you remember, we’re taken 15% to 20% of our SKUs out. So if you take 15% to 20% of our SKUs that you’re going to take some inventory that was either excess or obsolete or at a point time, where it was no longer affected inventory. And so we’re kind of find that right balance. So net-net I think we’ve got too much working capital and some of our inventory right now, but it’s mostly powder related. So I think we can get that down. I think we should feel good about our percentage working capital number that Jan Kees mentioned that 32%. That’s a pretty good number for the company. But I think our service levels are a little bit under pressure, but we’re addressing that. And that’s one of the reasons why we wanted to moderate a little bit, some of the headcount initiatives.

Okay, got you. Thank you. And then secondly, it sounds like you’ve made some progress in the planning on modernization, I’m wondering how much we should expect CapEx to grow next year, as you start to roll in to that plan.

Yes, I would take CapEx have grow a little bit next year, but it won’t be massive increase in CapEx. I think the thing that we’re not going to do is we’re not going to spend CapEx on nice to do things and things like we’ve done historically. We have some of the best computer systems that are never been used. So we’re going to spend CapEx on things that we’re going to drive short-term profitability and we – I don’t think we’re ready to give a specific CapEx forecast for next year yet though.

But I think that month I really is to spend CapEx where we can reduce our cost structure and improve our productivity and efficiency on the manufacturing side. And that is what we’re going to focus to gave back some.

Okay. Have you lowered your target that we discussed at the Analyst Day about how much you thought that you might be to invest to capture the savings from the modernization.

No we have we have not.

Okay, probably just pushed out 2019 little more.

Yes. It’s just an also replacing some other CapEx that we just aren’t going to spend on other things.

Okay, thanks very much.

Yes.

The next question comes from Steven Fisher of UBS. Please go ahead.

Thanks, good morning. Can you calibrate for us the progress on shifting customers the indirect channel I think is that you have migrated 2,600 customers so far. Was the target there around 4,000 to 5,000, and is that’s right. And what’s the timing of the ramp up from the 2,600 you had mentioned to get to that 4,000 to 5,000. I think, it was going from like 19,000 customers to less than 15,000.

Chuck you want to deal with that.

Sure. Steven for an industrial business moving to additional 400 to 500 by the end of this fiscal year. And I would say the phase through the expectation is as we find customers that are better served through our distribution channel continue to move them. That was a directional 4,000 to 5,000 and we could end up that high. But again that’s dictated by our distributor partners and the end user determining there’s a better value buying through the indirect channels and buying through the direct channel.

Was the 2,600 – how did that compared to what you thought you could achieve, I guess that’s probably over about a year.

We kick this finished it off about eight or nine months ago. And I would say we’re on phase with the rate that I had expected to move. At Analyst Day, we talk 12 to 24 months with that 4,000 to 5,000. So we’re pretty much right on schedule.

And nobody really knows what the right answer to that is, because the customer gets the vote.

Right

Sure. Okay, and then the press release mentioned some unfavourable mix headwinds in the Industrial segment. Can you just discuss what drove that unfavourable mix? This sound like the overall mix generally was positive. So what was the unfavourable mix to industrial?

Look at what we obviously sell a very large portfolio of SKUs, and it depends how the customer’s order what kind of – how do you say products they order from the portfolio. There is some unfavourable mix in the quarter, but it’s not the material I would say.

That’s pretty small.

Yes

Okay, thank you.

Okay. Thanks, Steven.

The next question comes from Andy Casey of Wells Fargo Securites. Please go ahead.

Thanks. Good afternoon over there.

Hi, Andy.

Question on – couple questions on the guidance, if I’m doing the math correctly, maybe I’m not. It looks like it implies kind of mid to high 11% operating profit margin at the midpoint for the fourth quarter. Can you – if that’s right, can you help us understand why you expect the operating margin to decrease sequentially from Q3?

Look, we’ve discussed the guidance in terms of – in the context of the fewer working days, specifically on the industrial side. And in terms of the planning assumptions we’ve targeted at 150 to 160 on the basis of that how you say those business days in Q4.

Okay and then, on the – so there’s no kind of one offs, it’s just top line driven.

Well, let’s put it this way. I think I characterize that it is a bit conservative at this stage, but we’re early on in the quarter, that’s the way the numbers played out would seem premature to go past that in terms of providing guidance and you’ve done an arithmetic calculation and I am not saying that’s wrong Andy. We just looked at it from a overall earnings per share, where do we think we’re going to be and that’s how we provided the guidance.

Okay Thank you Ron and then on the operating cash flow to get to that the new guidance you need about I think it’s around $70 million in the fourth quarter, is there any working capital drawdown anticipated in that I’m just wondering what the change is because the net income is kind of consistent.

Yes, there will be a working capital drawdown that happens. We have probably more powder inventory. Than we should ending the third quarter and that would be a meaningful number and then coupled with some other things that’s, what’s implied in that guidance.

Okay thanks.

I think we have developed with the segments targeted plans to work on the inventory numbers. And we work also in terms of the payable side, whilst obviously maintaining the DSO or lowering it somewhat, on the receiving side. So there’s a lot of detailed plans that have been developed by the teams to hit those targets.

Okay thanks and then one last one, if I could sneak it in some companies that would generally have similar revenue profiles to Kennametal have kind of talked about demand getting better through the quarter and you’ve illustrated that on Slide 3, with the organic growth trends I’m wondering if the orders actually kind of have shown a higher growth rate than what you’ve shown on in the organic. Is there any way you can comment on that.

Well, yes I mean backlog has historically not been a critical thing for us to report, but we probably have a little bit more backlog today than we have had historically. Some of that might be passed through deliveries and some of it might be real backlog, definitely orders have been stronger than shipments and but if you were to look at where January started following a quarter that did have organic growth January was weak. So but February and March were exceptionally strong, so I think our view is it’s a recovering end-market business, yes we’re a shorter cycle company and that’s a positive. So, trends are in the right direction and our order book is building so that’s a positive but we are a little conservative in our view that end-markets could also take a brief pause here because there’s a lot of uncertainty out there regarding policy decisions. So I think we want to be conscious of that.

Okay thank you very much.

Yep

The next question comes from Walter Liptak of Seaport Global. Please go ahead.

Hi, thanks for getting my question in. Well I’ll try and keep it brief. I wanted to go back to the price cost and understand a little bit more about what were your comments on infrastructure and I wonder if you are directing them towards the energy sector, they are having trouble getting pricing up in energy and I wonder if that’s just a timing issue or if you’ve got agreements with customers already on pricing, wonder if we can get some more color there.

Pete you want to answer that

Yes we do have agreements with our primary customers in oil and gas that’s indexed of off both APT and cobalt. Cobalt in particular has risen quite significantly in recent months and we’re able to recover that through pricing and according to the contracts we have.

Okay you guys bought that recycling business Tungsten recycler a few years ago is that having any benefits.

It is and this is primarily for the infrastructure business and as Ron and JK went through this we talked a bit about material savings that we are getting there’s a variety of things that we’re doing to get material costs down and starting with sourcing and who we’re buying from and using our leverage there to get lower prices on what we buy but probably has important or more so internally what we’ve been able to do through product design and is in use less material for the products when you sell without compromising performance. But in the material science piece and really leveraging that investment we made in recycling and using recycled products in the end items that we sell has been a significant benefit to us where we’ve got an multitude of projects that we’re working on to even increase that going forward.

Alright this sounds great, and then last for Ron, I wonder what your thoughts are maybe philosophically about the M&A kind a – a company that has done a lot of M&A in the past, is that something that you think strategically fits for Kennametal as we think about the next couple of years.

Well at the appropriate time I think it’s always good to keep that option open but I just don’t think this is the appropriate time. I think we’ve got a lot of work to do in our own house, a lot of opportunities in our own house. We haven’t demonstrated we can do M&A particularly well. So let’s harvest the opportunities in front of us and then take a deep breath and then somebody will look around and say what’s the right thing to do, probably won’t be me probably be whomever follows me but let’s finish our job here.

Okay fair enough thank you.

The next question comes from Steve Barger of KeyBanc Capital Markets. Please go ahead.

Hi good morning everyone thanks for getting me in, just two quick ones.

Hi Steve

Ron given the push into the indirect channel and just your comment about more fully appreciating the value added resellers I’m wondering what your view is or how you’re thinking is changed about Amazon business as a distributor relationship.

Well I don’t think my view has changed a whole hell of a lot at this stage we’ve got some great distribution partners that know how to sell our products and know how to get them on the spindle and I think our focus is to help them be successful. I think the Amazon channel will develop a small following over time. But it will never be – well I shouldn’t say never but right now it doesn’t look to be a huge business opportunity for us – I don’t know if so, if you feel differently.

We’ve looked at it we’ve not taken any action to the pursue that channel and it currently isn’t being reviewed by the Industrial business.

Understood and last one I know that this is always tough to gage but where do you think the channel is in terms of inventory whether it’s distribution or end users has there been a big restock or is this more actual demand lift.

Steve for the industrial businesses our sales are right in line with what we see moving out of the point of sale data, so we continue to be right in line on the inventories projection relative to our sales no increase or decrease.

And I think that’s the same across the board for video and for Pete’s business.

Absolutely it fits the same here, in fact particularly with oil and gas we’re struggling to keep up in the some cases it’s not restocking.

So you think that.

Go ahead

I just got one quick follow up, yes do you think that channel is relatively lean then and if this persists without the pause that you said could happen that you would see more of an inventory build in the channel as well as demand.

I think we don’t know my personal view is no, because my personal view is that our customers are smarter. They have more tools and they’re not going to want to build their inventory, they’re going to want to turn their inventory and they’re going to rely upon us to help them manage their assets better. So I just think we’re in a different world moving forward and many of our customers have very sophisticated systems.

Thanks very much for the time gentleman.

Okay Steve thank you.

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

I just want to thank everyone for their interest in Kennametal today. We appreciate it and please follow up with the Company on any specific questions you might have, Kelly, Jan Kees, myself and all others. Thank you very much.

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