Kennametal Inc. (KMT) Q3 2019 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen. I would like to welcome everyone to Kennametal's Third Quarter Fiscal Year 2019 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. At this time, I would like to turn the conference over to Kelly Boyer, Vice President of Investor Relations. Please go ahead, ma'am.

Thank you, operator. Welcome, everyone, and thank you for joining us to review Kennametal's third Quarter Fiscal Year 2019 Results. Yesterday evening, we issued our earnings press release and posted our presentation slides on our website. We will be referring to that slide deck throughout today's call and a recording of this call will be available for replay through June 6. I'm Kelly Boyer, Vice President of Investor Relations. Joining me on the call today are Chris Rossi, President and Chief Executive Officer; Damon Audia, Vice President and Chief Financial Officer; Patrick Watson, Vice President, Finance and Corporate Controller; Alexander Broetz, President, WIDIA Business segment; Pete Dragich, President, Industrial Business segment; and Ron Port, President, Infrastructure Business segment. After Chris and Damon's prepared remarks, we will open the line for questions. At this time, I would like to direct your attention to our forward-looking disclosure statement. Today's discussion contains comments that constitute forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve a number of assumptions, risks and uncertainties that could cause the company's actual results, performance or achievements to differ materially from those expressed in or implied by such forward-looking statements. These risk factors and uncertainties are listed on Slide 1 and detailed in Kennametal's SEC filings. We will also 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'll now turn the call over to Chris.

Thank you, Kelly. Good morning, everyone, and thank you for joining the call today. I'm pleased to report that we delivered strong results in Q3 FY19 on a total company basis, both in terms of sales and margins. Although total sales decreased by 2%, negatively affected by foreign exchange of 4% and business days of 1%, sales at an organic level increased by 3%. This is the 10th consecutive quarter of organic sales growth and is on top of 11% last year. Furthermore, we achieved organic sales growth in all three segments, with Infrastructure posting 6% growth, WIDIA 3% and Industrial 1%. Those are on top of tough comparables of 14%, 9% and 10% respectively. Furthermore, the strong sales performance included a slower than anticipated in March. We believe the macro issues circulating during the quarter, such as potential tariffs between the US and Europe and just general uncertainty around global and US economic growth, resulted in a slower March. Our initial read based on April however is that this seems to have been a temporary issue, and the underlying markets remain steady. From a regional perspective, both the Americas and EMEA posted positive numbers at 4% and 2% respectively. Asia-Pacific declined slightly in the quarter by 1%, driven mainly by the slowdown in China. However, we are seeing some positive signs in China more recently. So we're encouraged in that regard. In terms of margins, on a total company basis, our adjusted EBITDA margin is now at 19.4%, up from 18.2% in the prior-year quarter. We maintained our operating expenses at our target of around 20%. On an earnings per share basis, we posted $0.77 for the quarter, up 10% year-over-year from $0.70 prior-year quarter. We continue to drive increase in results from our simplification/modernization initiatives. This quarter, the benefits increased to $0.11. That compares to $0.10 sequentially and is on top of $0.03 achieved this quarter last year. In general, our multiyear simplification/modernization program is progressing well. In fact, as the next phase of this program we announced restructuring with expected annualized benefits ranging from $35 million to $40 million by the end of FY20. These are structural changes that reduce our breakeven point and further demonstrate our commitment to achieving the FY21 adjusted EBITDA objectives presented in our last Investor Day. Now let's review the segment results, starting with Industrial on Slide 3. Industrial achieved year-over-year organic growth of 1% this quarter, on top of 10% organic growth in the prior-year quarter. As expected, transportation was down again this quarter, posting a negative 8%, centered mainly in Asia and Europe, as it related to a decrease in auto production. While we have seen some recent encouraging news out of China, specifically in terms of auto, our expectation is that auto production will remain at current levels for a while longer. Energy, after several quarters of positive growth, was down 2% this quarter and reflects some end-market softness, mainly in power generation. Our expectation is that the market will remain flat to slightly positive in Q4 versus Q3. This biggest end-market in industrial, General Engineering, posted a healthy growth rate of 5% in the quarter, which represents the 11th quarter of consecutive year-over-year growth. Our expectation is this end-market will remain steady. And finally, Aerospace grew double-digits, again for the 5th consecutive quarter at 13%. This is the 12th consecutive quarter of year-over-year growth for the Aerospace end-market and reflects the success we are achieving with our growth initiatives. Our expectation is that the Aerospace end-market will remain strong. The adjusted operating margin in Industrial is now 18.3%, up significantly by 290 basis points year-over-year and reflects the continuing success associated with our simplification/modernization work. Turning to Slide 4 for the WIDIA overview, WIDIA posted 3% organic growth this quarter on top of 9% in the prior-year quarter. The margin this quarter was negatively affected by one-time costs associated with portfolio simplification. Excluding this effect, the margin would have increased year-over-year. Let's look at the results by region. EMEA's high growth rate of 6% reflects continuing success with our Aerospace initiatives. Asia Pacific's 3% growth rate continues to be strong. However, performance in the region was dampened compared to prior quarters due to the temporary disruptions in India related to the ongoing national election and the slowdown in automotive production as OEMs shift to vehicles meeting the upcoming new emission standards. Our expectation is that the growth levels will recover as these temporary issues abate. Americas showed a slight decline of 1% this quarter, as we continue the process of upgrading our distribution network. We believe this decline is not reflective of the underlying market conditions. On Slide 5, we summarize Infrastructure's results. Infrastructure achieved organic sales growth of 6% this quarter on top of 14% growth in the prior-year quarter. By region, EMEA led an 11% growth followed by the Americas at 5%. Asia Pacific posted a negative 1% rate for the quarter, driven by China. By end-market, General Engineering posted positive results of 16% and Energy grew at 2%. As part of our continuing growth efforts in the Energy end-market, we announced yesterday a distribution agreement with Gardner Denver, a market leader in the energy space for our counter-flow valves seats. Our proprietary seat technology delivers up to 10 times the life of steel seats, offering a substantial increase in productivity through reduced downtime. Earthworks posted a negative 3% year-over-year change. This decline was unexpected and due primarily to a single large customer whose forecasted sales did not materialize for them. Therefore, we do not believe the decline is reflective of the underlying market. In fact, as we entered the fourth quarter, we are encouraged with the initial level of activity in this end-market. Operating margin in Infrastructure increased sequentially, as expected, this quarter to 11.7%, primarily driven by lower material costs. On a full-year basis, given the unexpected sales decline in Earthworks, our expectation is that the full-year margin will be relatively flat year-over-year. As reported last quarter, the capital investment in our Rogers facility modernization is essentially complete with additional benefits to comp as we work to optimize the modernized production processes. Before I turn it over to Damon, I will walk through an example of monetization on Slide 6. This is a great illustration of how simplification/modernization is making a massive change in our manufacturing efficiency. Our before process was highly manual and very labor intensive. For example, to make a single part at this stage it requires 3 different machines, 3 different setups and 3 different employees operating the machines and physically moving the pieces between machines. Today, this stage is completed with one automated machine that performs all those actions. The machine also features robotic handling, which enables higher quality, more consistent parts with less scrap since manual intervention has been eliminated. This modernized process reduced labor by more than 50% and delivered an 80% improvement in efficiency while improving quality and delivery performance for our customers. This is another example of the significant benefits of our simplification/modernization plan, improving our flexibility and reducing the breakeven point of the company. And with that, I'll turn the call over to Damon.

Thank you, Chris, and good morning everyone. Turning to Slide 7, sales in the third quarter were $597 million with organic sales growth of 3%, offset by unfavorable effect of foreign currency headwinds of 4% and business days of 1%. This is the 10th consecutive quarter of organic sales growth, which reinforces that our focus on growth initiatives in General Engineering and Aerospace are delivering results. Adjusted gross profit margin decreased 70 basis points to 35%, driven primarily by unfavorable volume related labor and fixed cost absorption in certain facilities, in part due to simplification/modernization efforts in progress, higher raw material cost and unfavorable foreign currency, partially offset by organic sales growth. Adjusted operating expenses decreased $11 million to $120 million, due primarily to lower compensation expense, favorable effects from foreign currency and benefits from our simplification/modernization initiatives. On a percentage of sales basis, adjusted operating expenses improved by 140 basis points, decreasing to 20.1%, as we continue to have success in reducing cost. As we have now demonstrated for the last several quarters, we expect to maintain operating expenses as a percent of sales around this level, which is in line with our long-term outlook. Adjusted operating margin increased 70 basis points to 14.3%, which is the best third quarter performance since fiscal year 2012. As Chris mentioned, our adjusted EBITDA margin increased 120 basis points to 19.4%, driven by our simplification/modernization savings. The effective tax rate for the quarter on an adjusted basis was 19.8% versus 23.1% in the prior-year quarter. The decrease is primarily due to US tax reform. Adjusted EPS improved significantly year-over-year to $0.77 versus $0.70 in the prior year. Slide 8 illustrates the main drivers affecting adjusted EPS this quarter compared to the prior year. The biggest driver in the quarter was the favorable effect of our simplification/modernization initiatives of $0.11. The savings this quarter is incremental to the $0.03 delivered in the third quarter last year. Year-to-date we have now delivered $0.30 in simplification/modernization savings versus $0.09 in all of fiscal-year 2018. Operations which effectively reflect the day-to-day running of the business was negative $0.02 in the quarter. There were some key tailwinds and headwinds worth noting this quarter. First, price more than covered raw material cost inflation again this quarter, which is consistent with our historical performance. This is a testament of the team's ability to continue to price for the value of our products. Second, in preparation for product moves, further simplification efforts and facility rationalization, we are currently operating certain facilities at lower levels of utilization. To put that in a little more perspective, as you would expect, as we further implement our simplification/modernization plans, we are moving different product families to different facilities around the world to improve productivity and lower our costs. However, while doing this some facilities will temporarily operate at lower utilization levels. Although we can reduce the variable costs, including temporary workers and overtime, the fixed costs create a temporary headwind until we can address them. The effects of these types of actions will change quarter-to-quarter depending on the timing of projects such as the restructuring actions announced yesterday. The other items affecting the EPS this quarter versus prior year were a lower tax rate, which contributed $0.03, and currency which was a $0.04 headwind. Turning to Slide 9 and our quarterly segment sales and profitability performance; Industrial delivered $319 million in revenue with 1% organic growth. This growth was centered in the Americas, with strong performance in our two growth and markets of General Engineering and Aerospace. This strength more than offset the continued weakness in the Transportation end-market, which influenced the negative growth in both EMEA and Asia Pacific regions. Our focus in these growth areas coupled with the incremental simplification/modernization benefits expanded Industrial's adjusted operating margins by 290 basis points year-over-year to 18.3%. WIDIA delivered 3% organic growth in the quarter and continue to execute on strategic growth plans in key areas such as Aerospace in EMEA, which grew 6%. WIDIA's America business was down 1% year-over-year, as we continued to work through changes to upgrade our distribution network. WIDIA's adjusted operating margin of 1.3% was down a 110 basis points year-over-year, reflecting one-time cost associated with simplification efforts to streamline the product portfolio and drive improved profitability. As Chris said, excluding this one-time cost, WIDIA's adjusted operating margin adjusted operating margin will increase year-over-year. Infrastructure reported sales of $228 million. The strong growth in EMEA and the Americas helped deliver 6% organic growth. As expected, the adjusted operating margins increased sequentially to 11.7% versus 9.6% in the second quarter, mainly due to lower raw material cost. The 11.7% adjusted operating margin was down 210 basis points versus the third quarter last year, mainly due to higher raw material cost and the timing of customer raw material price index adjustments discussed last quarter. As material costs have now been relatively stable for a few quarters, our material cost will be better aligned with our customer prices in the fourth quarter. In addition to the price versus raw material variance, Infrastructure also saw incremental manufacturing expenses partially offset by organic sales growth and incremental simplification/modernization benefits. Turning the Slide 10, we continue to maintain a strong investment grade balance sheet. Primary working capital as a percentage of sales remained relatively flat from last March at 30.7% this quarter. We continue to expect to maintain primary working capital as a percentage of sales in this approximate range, but we'll nevertheless continue to look for opportunities to further improve. In dollar terms, primary working capital increased partially due to an increase in inventory. The year-over-year increase in inventory is reflective of the lower than anticipated sales in March, higher year-over-year commodity prices, increased strategic inventory on our high volume high profitability products for improved customer service, as well as a temporary increase in inventory related to product moves between facilities as part of simplification organization, partially offset by a stronger US dollar. Cash on hand at March 31 was $113 million versus $222 million in March the prior year, a decrease of $109 million, mainly due to primary working capital changes and increased capital expenditures. Free - operating cash flow in the quarter was $39 million, down from $72 million in the prior-year quarter, also due mainly to changes in primary working capital and increased capital spending. Net capital expenditures were $57 million in the quarter compared to $45 million in the prior-year quarter. As with previous years, we expect capital spending to increase further in the fourth quarter. Dividends paid were $16 million, consistent with last year. Turning the Slide 11 for our fiscal year 2019 outlook; based on the environment we see today, we are refining our estimate for FY19 adjusted EPS outlook within the previous range. We expect adjusted EPS to be in the range of $3 to $3.10 for the full year. It's worth noting that the midpoint of our current EPS outlook remains aligned with the midpoint of our original outlook despite $0.08 of foreign exchange headwind since then, increased tariff related costs, as well as the slower March we discussed. Overall, we remain pleased with our team's ability to execute throughout the year. Regarding our sales outlook, as we've discussed, the markets remain generally positive in the third quarter but softened in the month of March. Based on our year-to-date organic growth of 5% and the early positive indications in April, we now expect organic sales growth of approximately 5% for fiscal year 2019. Free operating cash flow is expected to be in the range of $120 million to $140 million, with capital expenditures of $200 million to $220 million. We've reduced our outlook for capital expenditures, mainly due to the timing of cash payments for certain equipment. Since we do not record equipment as a capital expenditure until payment has been made, timing of payments affects the capital expenditures recorded in any period. Based on our experience derived from our Rogers plant modernization effort, we have introduced more stringent factory acceptance testing for new equipment. Contract with suppliers include a provision where final payment is not made until testing is complete. While this may have an effect of delaying the recording of capital expenditures, we have learned that the additional testing helps to shorten the equipment start-up process in the plants. Therefore, on balance, the plan for deriving savings from the new equipment still remains on-track. With that, I'll turn the call back to Chris.

Thank you, Damon. We had a strong quarter with organic sales up 3% and adjusted EBITDA margins increasing by 5%. We're progressing well with our simplification/modernization initiatives, which is really the cornerstone of Kennametal's increased profitability in years to come. There's a lot of detailed work being accomplished and further benefits to be derived from this important work. This quarter, the benefits from simplification/modernization increased again. Our announcement yesterday regarding restructuring associated with these initiatives further demonstrates the progress that we're making. We are now narrowing the full-year guidance, staying within the previous EPS range. We anticipate end-markets generally consistent with the markets in the third quarter and remain focused on continuing to improve our operating results by lowering the breakeven point of the company. I look forward to report our full-year results and providing our full-year outlook for FY20 on our next earnings call in August. And with that, operator, let's open it up for questions.

Thank you, Mr. Rossi. [Operator Instructions] And the first question will be from Steve Walkman [ph] of Jefferies. Please go ahead.

Maybe let's kick it off with just a couple of those sort of margin headwinds that you mentioned. And I guess maybe starting with Infrastructure, I'm trying to understand - I think that was the one where you had the unintended customer issue. Can you just describe a little bit more about what that is? And specifically, I guess I'm just trying to figure out whether it continues in 4Q or in next year or just sort of how to think about that?

So Steve, the - as we said, the margins improved sequentially, I think it was 9.6% to 11.7%, and inside our forecast for Infrastructure, the nature of that business is there are certain large customers that actually give you a pretty good indication of what they're going to buy quarter-over-quarter. And in this particular case, the customer - and we're not exactly sure why, but they didn't meet their forecast that they had let us to believe was going to happen. In the conversations with them based on the feedback we've got from our sales people, we do not think that, that is reflective of the underlying markets. So they may have had some issue, we're not exactly sure. But as far as we're concerned, it's not an underlying market issue. And - so that was the basis of - on that volume differential that we were expecting. But I would characterize it is not - is unique to this particular customer and not something that's affecting the underlying market. Now as we progress through April, in this particular market segment, we actually saw very encouraging results. We didn't see anything that was going to indicate that we should have another surprise here in the month - in the fourth quarter. And so, we feel pretty good about that part of the business going forward.

I don't want to put words in your mouth, Chris, but does that mean that this customer issues seems to be passed or is it just not getting worse?

Yes, I think it's - I don't know the exact status of it but when we look at the incoming order flow in total for this part of the business; if they are potentially having continued issues the extent of the volume that's coming in other parts and from other customers is going to more than offset that.

And then maybe just on the cash flow, I guess we've - you've cut the CapEx and sort of held the overall cash flow guidance, so I guess that implies that the working capital build is going to stick around a little bit longer here. But just help us think through, does that reverse next year? I mean how do you think the trajectory there?

Yes, I think generally on working capital, we've been sort of trying to keep it around that 30% level. And some of the things that Damon had mentioned, there was an increase but as we've talked about in the past, Steve, we've simplified our portfolio. We're more focused on growth areas in General Engineering and Aerospace. And we've made a conscious decision to invest more in the higher moving inventory, what I would call strategic inventory for high volume, high profit skews to help us improve customer service and the fact that we've done that I think is helping to fuel a lot of the growth that we've seen on the General Engineering side. Now, we did see a little uptick in working capital because of the slower March naturally with lot less sale, that drove a little bit of it. So, that part should go away. And then, as Damon mentioned, we did consciously make some decisions to increase inventory and support product moves, as we start to rationalize the footprint, move things around. We want to make sure that we have a little buffer there to not disrupt customer service. So eventually, any given period of time that will go away or that might go up and down, but that should eventually go away in the long term because we will have completed modernization.

And just one quick one I'm going to sneak in. Any long-term changes in the targets that you've laid out for the company over the next couple of years?

Yes, we've - we haven't updated our guidance since the last Investor Day. So that $600 million to $675 million in EBITDA is still our latest view that's out there. I think, Steve, when we get to the fourth quarter here where we naturally talk about the FY20 numbers, that would be an appropriate time to give a little more granularity on what's going to happen in FY20 and that certainly sets the stage for FY21. But I'm going to stick with the - with what we've already presented at the last Investor Day.

And the next question will be from Julian Mitchell of Barclays. Please go ahead.

Maybe just a first question drilling into your more upbeat comments about demand in April. I heard what you said on Infrastructure regarding customer - one specific customer's orders and so forth. But beyond that, just maybe talk about Industrial and WIDIA, what regions or markets did you see the April improvement in?

Yes, I would say, in general most of the markets were positive except for Transportation, which - Julian, we sort of think that's kind of stabilized at the Q2 levels. There we saw - and that of course was down from the previous year. Energy did slow a little bit, but on the Industrial side, that's not - and WIDIA side, that's not a huge play for them. Really, the bright spot for General Engineering and Aerospace, they remain healthy and we saw 7% and 13% growth organically in - 7% General Engineering, 13% in Aerospace. So our view is that, especially in those two areas of focus, that we feel quite good about the outlook for both General Engineering and Aerospace and we think that's going to remain steady.

And then just secondly, I wonder if you had any perspectives on inventory levels with some of your distribution partners, several short cycle manufacturers have complained about destocking in recent months and still elevated inventory levels in the current quarter as well. Just wondered what your view was on that topic.

Yes. As it relates to the Industrial, WIDIA business, we really didn't see any destocking this quarter, at least from our bigger distributor partners. We do know that some of the factors that we talked about such as the potential tariffs between the US and Europe and kind of the general uncertainty that was - been existed on the US economic growth and also the global economic growth earlier in the quarter, that may have contributed to the slowdown in March. But as far as a big distribution partner, we didn't really see any destocking.

And the next question will be from Ann Duignan of JP Morgan. Please go ahead.

Could you just remind us, your Aerospace business, how much of that is exposures to Boeing build rates and what might the impact on your business be going into fiscal '20 of the slowdown in the 737 or even the 787 later, what impact may it have on your business?

Yes. Boeing is obviously a key customer of ours. I can tell you that what we've seen so far relative to the Boeing situation is really not much. We haven't seen any slowdown in the business, both from direct business from Boeing and of course there's a lot of business that flows to Tier 1 to Tier 2. So we haven't really seen any slowdown in that area. So, I don't know if that's going to continue. I understand that Boeing is still working through the issues, but as far as what we see right now, Ann, we just don't see it affecting very much. And there's a lot of other business inside of the Aerospace that's non-Boeing that continues to be strong. So, we still feel quite upbeat about Aero in general, okay but you won't be disproportionately leveraged to Boeing directly or indirectly in terms of build?

Yes, I don't believe that - I don't actually know what our percentage is relative to the overall Boeing's contribution is, It is significant but we have other business in that area, Ann, that we think would compensate for that. But I'm not going to - I'm not sure [ph] you want to talk about our specific share with Boeing as it relates to the overall pool.

Maybe I could switch gears and maybe you give us a little bit more color on the Phase II restructuring simplification and the cadence of the spend and what inning are we in? Is this the end of the spend and then we slide into fiscal 2021 with everything all done and all that disruption is behind us?

Yes, I think - let me just make some general comments about the overall program in terms of restructuring for simplification/monetization and Damon can maybe fill in the gaps in terms of how we see this thing playing out through 2020 and 2021. We're basically - as you know, the simplification/modernization, we're trying to really lower the break-even point of this company, improve its profitability and really enable growth by improving our customer service through these modern processes. I think the latest restructuring in my mind is just another indication that we're moving towards this sort of ultimately lower structural cost inside this company. As we talked about in Damon's section, we're moving products around, we're rationalizing the footprint to lower cost countries. And I think, frankly on the remaining footprint, as we modernize, it's just going to be less labor dependent and much more efficient. So unlike the old Kennametal which was very heavily labor dependent and whenever there was adjustment that needed to be made based on demand, they really had a lot of challenges in terms of the flexibility workforce. So we see this modernization and an overall rationalized footprint is putting us in a different place. Now relative to the restructuring in this specific case, this is just kind of a subset of the overall program. But I'll let Damon maybe make some more comments on how we see this thing going.

So I think as Chris alluded to, this is just the next phase as part of our overall restructuring efforts to deliver the FY21 objectives. As we said in the press release, the timing of this one - again the savings is $35 million to $40 million, I'll tell you, is primarily a cash related cost, that $55 million to $65 million of cost we talked about primarily will probably be cash. But that will be phased in between Q4 and through FY20 depending on the discrete actions that we have planned here over that next, call it, 12 months to 15 months. And so it will be a little lumpy and when this cash goes out and the corresponding saving kicks-in. So the point is, we've said in the release that we sort of expect the run rate as we go through into that fourth quarter of FY20 is when we start to expect all of the benefits related to this.

And just a real quick clarification; it does sound though that beyond all of this your working capital needs will be structurally higher if you're going to carry more inventory for General Engineering and Aerospace, is that correct?

The inventory currently reflects that - as Chris alluded to, think about the higher profitability, higher volume products that we've been talking about. Our current level of inventory does reflect that. So, I don't anticipate a significant change in those levels going forward as we have achieved - the fill rates where we've looked to target there. So again, trying to keep that primary working capital around that 30% range continues to be our goal.

The next question will be from Andy Casey of Wells Fargo. Please go ahead. Mr. Casey, your line is open on this side. Are you muted on your side?

Good morning. This is actually Patrick [ph] standing in for Andy Casey. Thanks for taking our question. Just - I wanted to follow-up a little bit more on the margin side. Can you remind us what segment you guys saw the facility under absorption head fund in the quarter due to the modernization initiatives? And then on the WIDIA business, you called out that excluding the one-time cost year-over-year margins adjusted basis would have been a little bit higher. There is like a 90-basis point delta that you guys would have needed to make up for that to happen. Just wanted to see what that would have been, what the - excluding the one-time cost, what the adjusted operating margin would have been for the WIDIA business?

Let me just take the operating leverage question first. The underlying leverage for both Industrial and WIDIA - I know you asked about WIDIA, we think it's actually quite good. And when we - without that charge, WIDIA on a constant currency basis, the operating leverage would have been over a 100%. So we feel pretty good about that. And that particular charge is part of simplification and trying to narrow our product portfolio to make sure that WIDIA is very focused on going into white space that the infrastructure portfolio is not quite suited for, that customers aren't quite suited for. And so, we want to make sure that the portfolio is very focused and therefore we're kind of cleaning up some legacy issues that existed on that. But overall, the operating leverage we feel quite good about. And as I said, without that adjustment it would have been about 100%. Now in terms of the specific factories, they largely were on the - under-utilization was largely on the Infrastructure - excuse me, on the Industrial side. And as Damon talked about on the bridge, we sort of have that operating - operations bucket of minus $0.02 of EPS. And when we look at just to sort of characterize the impact on this, if we sort of take out the under-absorption associated with the facilities that were involved in preparing for plant rationalization, that bar would have been positive. So we feel pretty good about the Industrial underlying net leverage. And we've talked about before, modernization at any given point in time can be disruptive as you're trying to transform the way we are. So, it's not unexpected but it also on last won't last forever.

And then, just one more follow-up your comments on the restructuring on the next phases; what segments is the next phase of restructuring going to be primarily focused on? I mean I would assume that it's probably pretty broad based, but is there any particular segments that's going to be a bigger focus for you guys in over the next 12 months to 15 months?

Yes, the restructuring - since we're doing simplification/monetization across all segments, it applies to all. I guess you could argue, it's a little bit more heavily weighted towards the Industrial segment, which also affects WIDIA because that has a larger manufacturing footprint and probably the greatest opportunity for modernization.

The next question will be from Ross Gilardi of Bank of America Merrill Lynch. Please go ahead.

I just want to ask about your free cash flow outlook. You guys need to do I think north of $100 million in fiscal fourth quarter to hit your guide. You implied net income will be up a little bit, but you've got this new restructuring program. And you said your CapEx is going up in the fourth quarter I think. So, I'm just trying to understand how you squeeze that much cash out of the business in the fourth quarter to hit your numbers?

Yes, Ross. Again, I think as we've done historically, we do generate a lot of our cash in the fourth quarter here. I think about where we were with capital spending last year, I think we spent around $65 million in the fourth quarter and if you look at the midpoint of our range, it's sort of in line with that. Generally what you'll see is, again we see the stronger fourth quarter seasonal selling, some little - and inventory reduction. So overall, as we looked at the numbers, we still think that we'll be able to get into that range of $120 million to $140 million.

I think also, Ross, the restructuring - how do you see the cash flows going, Damon, on the actual restructuring charge?

I think that the cash flows are going to be dependent upon the project, so again then of a large portion of that cash will go out in the 2020, just a small portion, depending on the activity, as we work through them, make a lot in the - in Q4 of FY19?

Can you just help us on any preliminary thoughts on the '20 free cash flow outlook given that a lot of that restructuring cost is going to be deferred to that year? And maybe could you explain again the capital spending thought, I mean just the deferral into next year and just generally speaking what I'm trying to get at is, is 2020 going to be another year of elevated CapEx and restructuring cost such that - like the real drop-through on the cash flow statement isn't really until 2021?

I think that's the right way to look at it, Ross, is if you think about what we've said on modernization-related spending, we said in our Investor Day a couple of years ago that we were going to spend around $300 million incremental to our normal traditional $120 million run rate. If you look at what we spent in FY18 related to modernization, that was about $50 million. If you look at the midpoint of what we're spending this year, that would put about another $90 million. So, that's about $140 million of that $300 million. So, the rational you've looking at, the balance of about $140 million sort of rolling into effectively FY20. So, you're going to see an elevated CapEx spend through - into FY20 with the benefits starting to flow through in FY21. And we've also talked about there are some restructuring actions; this is the next phase of those actions that we've announced. And so we would expect to continue to look for those opportunities and continue to implement the modernization and simplification. So again, there could be - or there may be further actions to come.

And then just lastly, I wanted to ask you a little bit more about that - the movement of products amongst different facilities. Why is that again and operationally, could this contribute at all to the reduction in the organic growth outlook or is that purely an external issue with demand?

Yes, I think the - in terms of our moving of the product and that type of thing, we don't think that has effect necessarily on customer service. And so therefore, it's - our belief is it's more a macro environment issue. And then, the company has a long history, Ross, of a lot of small manufacturing plants that were built up through acquisitions. And so, a big part of simplifying the footprint and modernizing the footprint is to rationalize it. And so, that's what we're getting on with the business to doing. And as we've talked about, this is probably for stuff that should have been done over the last 20 something years, but now is our opportunity to do it and we're committed to make it happen. And it's going to put us in a much more better place in terms of the company's profitability. And I also think simultaneously we are going to be better able to service customers because before we were maybe shipping product all around the world and that extends lead times, not only increases cost but I think we're going to be at a much better place with this rationalized footprint to better serve the customers too.

Your next question will be from Adam [ph] of Cleveland Research. Please go ahead.

I was wondering if we could go back to the infrastructure margins outside of the volume related headwinds. I think you mentioned that you had a lot of price cost headwind in the quarter. I was wondering if you could dimensionalize that and I think - I might have missed it, but I think you said that that improves in the fourth quarter; is that the material cost moderating for you or are you getting some incremental pricing? I'm just trying to think about sort of into the next fiscal year, should we expect new additional margin expansion in a normalized volume environment?

Yes, I mean what's going to drive the improvement in the fourth quarter is there is a significant volume piece of that. And then also, as we talked about and we saw in the third quarter, the fourth quarter we'll continue with price over raw material and that'll be a big driver as well. And then there was some manufacturing inefficiencies that we saw in the third quarter. But Ron and his team are - have addressed those and we believe that that's going to correct itself in the fourth quarter and it also sets the stage for future improvement. And then beyond that, the Infrastructure team is also focused on simplification and modernization and so we would expect that that's going to help improve margins going beyond fiscal year FY19. And in general, my assessment of the overall business is that the underlying performance is really quite good and I think we'll make it even better in FY20.

Okay, got you. And then in China, you had mentioned earlier that you're seeing more positive signs recently. I'm just wondering if you could expand on those comments. Is that within your own order rates or are these macro indicators that you're feeling better about? Thanks.

Yes, we sort of alluded to it, we're cautiously optimistic that things are actually improving in China. Recently in April, there was the China industrial Machine Tool Show and we got opportunity to talk to lot of customers and people in the industry. And in general, they are quite upbeat about things improving in China. And specifically around auto production, we heard things like that's expected to improve anywhere from 3% to 4% from Q3 and that was kind of the feedback from our top 27 Auto OEM customers. So that's the basis of some of the optimism. And then also, we know that the Chinese Government is implementing policies that are trying to change customer behavior, which is ultimately going to - excuse me, consumer behavior, which is ultimately going to drive I think more demand for auto production. So in general, those are the basic things that we're kind of hearing from our customers, that things might actually have been lifting up there. And we haven't really - it seems that the situation has stabilized, at least through the third quarter. So we're pretty encouraged that it may start to improve.

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

I want to ask a follow-up on the planned rationalization and just the timing of the costs and the benefits. So it sounds like we're going to get all the costs by the end of 2020 starting in this current quarter. And then the benefits, it's not clear to me, do we get some of the benefits or how much of the benefits do we get in 2020 and how much in 2021?

Yes, so Walter, the benefits will start to happen in the first part of FY20, but again there are multiple programs that are in this restructuring and so, as we haven't disclosed any of the specifics, they're going to phase in depending on discrete events over the course of Q4 of FY19 and FY20. So, you will see the full run rate benefit that we've talked about, that $35 million to $40 million, we'll start to see that full benefit as we exit FY20. But again, we would expect to seek some savings starting as soon as the first quarter of FY20.

And I wonder how you would handicap the - this phase of the restructuring. Modernization, you've got a lot of experience with that now. Is this next phase - it sounds like there's heavier lifting there, especially if you're relocating some of the factories. I wonder if you could talk about just the risks or - are these controllable risks or how they are compared to modernization.

Yes, I mean if we think about infrastructure modernization, that was - we had the opportunity to do a transformation of a very significant sized plant in the infrastructure business, that's the Rogers facility that we've talked about. And you can imagine, that was largely according to plan, In fact we were ahead of our internal schedule, but we learned a lot from it and things didn't go perfectly. And so, I think that they - given that experience, we've made adjustments that I believe while this next phase of modernization - any time you're shutting down plants or you're moving product around, you're absolutely right, it becomes a little more risky. But I believe that we - especially given the learning's that we had from Rogers that we have a good mitigation plan that can stay on top of that. An example of that is how we talked about - or Damon talked about the capital expenditure timing where we've really I think strengthened and improved our factory acceptance testing. That was kind of a lesson learned from Rogers, that if we make sure that the supplier is fully engaged and we do a much more robust testing of the equipment, that actually makes the ultimate start-up process go a lot easier. And so I feel pretty good that we understand what needs to happen, especially when you're doing these large plant transformations and even though it'll get more complex I think we've got the risk mitigated

And the next question will be from Chris Dankert of Longbow Research. Please go ahead.

I guess to kind of pull the thread a bit more here on the simplification/modernization, hopefully it's been the case, but we do see demand kind of slow down a bit into 2020, is there an opportunity to kind of lever up and deliver savings beyond that $14 million or we're kind of at a fairly fixed rate of how these projects progress?

Yes, I guess one of the challenges of this simplification/modernization program is you're fixing the airplane via flying it. So to the extent that there is a lower demand, that can actually make things little simpler. And I'll just give an example. In our Rogers facility, while we sort of beat our own internal schedule, there were times where we intentionally slowed the moving of manufacturing processes from one section of the plant to the other just because we had so much demand and we didn't want to disrupt customer service. So theoretically, it should get a little easier. But I wouldn't, I wouldn't expect a huge acceleration, but what I would tell you is that we believe that modernization and simplification, and this investment we're making is fundamental to the success of the company going forward. And so regardless of what happens with demand, that's what we're focused on. And that by far is the single biggest lever we have for self-improvement in terms of driving shareholder value.

Yes, makes sense.

Just to make sure - you made a comment, I want to make sure you understand. The $40 million that we spoke about in this restructuring is now what we're necessarily saying is going to be the savings for FY20, which I think is what, your comment was. Again if you think about - a lot of this is labor reduction. So to the extent we were to take labor out in the - at July 1, we would get the full year. To the extent we were to take that out in January 1, we'd only get a half-year benefit. And so, as we've said, the $35 million to $40 million of savings is going to be your Q4 exit run rate. So again, depending on when people come out, we'll have a different overall savings impact for FY20.

Well, then just to clarify I guess, in some of the savings the actions you took this year should also be impacting the first half of fiscal 2020, no?

Correct.

And then just a clarification on the third quarter; with the transportation business, I guess can you break out what - how much Automotive declined versus how much the heavy trucker or the performance in rail, just kind of size what Automotive did?

Yes, I'm not sure that we break it down like that.

Got it. Well, thanks so much, guys.

Chris, we know the heavy truck - again, if you read the markets, heavy truck demand is high right now. I think going through the balance of this year, there is a high demand for heavy - Class 8 heavy duty truck orders. But if you think about the Automotive, the light vehicle segment tends to be the weaker one both in the US and Europe, and specifically in China.

Right. I guess that was my concern, if heavy truck is kind of propping things up that would have been a big concerned with how much the whole transportation business was off, I guess.

I think the - I think what - the transportation is - for us is largely driven by Automotive smaller vehicles, and so we're not seeing some kind of offset that and we should see - and so we're expecting a further drop because I think our sensitivity is more on the Automotive side.

Got it. Thanks guys.

Now I understand your question. Sorry, go ahead. Did you have another one?

No, that's it from me. Thanks.

And the next question will be from Joel Tiss of BMO Capital Markets. Please go ahead.

I wonder can you give us any characterization or sense of where you're regaining your market share; maybe a little bit easier and where it's much more of a battle to try to get back to where you were before?

Yes, we're - as you can tell, we're very focused on General Engineering and Aerospace, and the company in the past, it seems to me, has been heavily focused on automotive and that is a space that is full of very fine customers that have very strong, supply chain management organizations. And so, it's an area that we feel like we are continuing to focus on, but our focus is more on having a great value proposition. A lot of the custom engineering work we do, we're the only company that can do it and we're getting - we're now getting paid for that additional value. But there are some parts of Automotive that we're going to shift - we're shifting our technical resources and now applying them to General Engineering and Aerospace, and that's something different than the company has done. So, we believe we're gaining share in General Engineering and Aerospace and we're getting the type of business that we want in the Automotive space.

And then, the - just a clarification; so the free cash flow at 120 to - free operating cash flow, sorry, at $120 million to $140 million, that's held back by roughly $90 million of restructuring and sort of transitory issues, is that right?

Damon, why don't you clarify that?

When you say $90 million of transitory issues...

Well, you mentioned somebody - else was asking, I can't remember, maybe it was Ross, was asking about the free cash flow and I'm trying to get - by 2021, It sounded to me like the more normalized run rate would be something with a two in front of it and I just wanted to be sure about that.

I think so. Our current guidance for FY19 would have had any - would - is based on the $120 million to $140 million guidance, assumes the improvements in the fourth quarter along with the capital spend. The question I think Ross was referring to is what does the FY20 outlook pertain to. And we're not going to give guidance on FY20 today, but what we were talking about is you do have an - maintaining a higher level of CapEx related to modernization. There is - there may be further restructuring opportunities that we - beyond this next phase that we've talked about today that may recall part of some cash. And as we move through those in FY20, we would expect to move more towards our goals of FY21 that we've talked about coming through the fourth quarter of FY20.

Okay. Yes, because I'm just like underneath it all is that for whatever 15 or 20 years Kennametal was a company that had between 6% and 12% operating margins, and roughly 125 million a year of free cash flow and they have 18, 19% operating margins and still $120 to $140 million of free cash flow. So I just kind of was wondering what the disconnect was and then, I'm done. Thank you.

Right now we're obviously have an increase a significant level of increased CapEx versus probably what we had in the past and as we've alluded to - but there is some inventory levels that we've increased based on strategic decisions to improved fill rates as well some of the temporary issues as we go through the product movement around the company here. So again, I think there are some understandable reasons why the cash was a little bit lower given how you just calculated [indiscernible].

The next question will be from Steve [ph] of KeyBanc Capital Markets. Please go ahead.

Just a quick modelling question, historical Kennametal earnings cadence was really heavily back-half weighted. This year more 45/55 [ph] as we think about moderating growth rate and timing of CapEx and benefit around modernization, would you expect a more balanced front half back half next year or are moving back to a heavier skew in the second half?

We're still working through the FY20 plan but based on what I see I would think it's going to follow - will closer to what we've seen this year. I don't - what was driving the historical numbers you're talking about but I don't see a change in markedly from what we saw this year.

Ladies and gentlemen, this will conclude our question-and-answer session. I would like to turn the conference back to Christopher Rossi for his closing remarks.

Thank you, operator and thanks everyone for joining the call today. We really appreciate your time and continued interest in our company, Kennametal. I feel like it's an exciting time to be part of this company, we've got a team here that's incredibly focused on transforming the company and making something different than it ever was before. If you have any questions, by all means, please reach out to Kelly, should be happy to answer them for you. Thank you.

Thank you, sir. A replay of this event will be available approximately one hour after its conclusion. To access the replay, you may dial toll-free within the United States 877-344-7529. Outside of the United States, you may dial 412-317-0088. You will be prompted to enter the conference ID 10126070, then the pound or hash symbol. You will be asked to record your name and company. The conference has now concluded. Thank you for attending today's presentation. At this time, you may now disconnect your lines.