Kennametal Inc (KMT) Q2 2020 Earnings Call Transcript

Good morning. I would like to welcome everyone to Kennametal's Second Quarter Fiscal 2020 Earnings Conference 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. 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. Ms. Boyer, please go ahead.

Thank you, operator. Welcome, everyone, and thank you for joining us to review Kennametal's second quarter fiscal 2020 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 the call will be available for replay through March 5th. 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 up 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 detailed in Kennametal’s SEC filings. In addition, we will be discussing non-GAAP financial measures on the call today. Reconciliations to GAAP financial measures that we believe are most directly comparable can be found at the back of the slide deck and on our Form 8-K on our website. And with that, I’ll now turn the call over to Chris.

Thank you, Kelly. Good morning, everyone. And thank you for joining the call today. Let me begin by making some general comments before reviewing the quarter. Though we're currently experiencing a downturn across all our end markets, we remain focused on the things that we can control. We are seeing results from the simplification and modernization actions completed to date. These actions, as well as those still to be completed, will drive improved profitability and leverage when our end markets begin to strengthen. Starting on Slide 2 in the presentation deck, organic sales declined by 12% in the quarter versus 4% growth in the second quarter last year. This is the second consecutive quarter of double-digit organic decline and highlights the weakened state of our end markets. While we had expected end markets in the second quarter to decline sequentially, a few countries, specifically the U.S., Germany, and India, declined more significantly than we had anticipated. Furthermore, the challenges in the aerospace end market related to the 737 MAX and the trickle-down effect in the supply chain exacerbated the already weak market conditions. Adjusted EBITDA margin decreased 740 basis points to 11.4%, but improved 50 basis points sequentially despite lower sales this quarter. Adjusted EPS decreased to $0.17 versus $0.71 in the prior year quarter. The decreases in margin and EPS were the result of three main factors. First, the decline in volume was a significant contributor as all our end markets declined year-over-year. Second, the negative volume effect and the associated under-absorption were magnified by manufacturing inefficiencies related to the recent plant closures from our simplification and modernization efforts. That said, the disruptive effect of plant closures is expected to decrease in the second half of this fiscal year. Third, as we discussed on our last earnings call, raw material headwinds continued to temporarily depress our margins in the quarter. Although as expected, the magnitude of the effect improved sequentially from the first quarter, it still represented 130 basis points of the year-over-year decline in our margins or $0.07 of EPS. This situation will reverse in the second half since the higher cost raw material inventory will work through the P&L in the first half of fiscal year '20. Our expectation is that the full year effect will be roughly neutral. These negative factors were partially offset by the progress we are making on simplification and modernization, which contributed an incremental $0.10 of EPS year-over-year. This quarter, we achieved an incremental $11 million in savings from simplification and modernization and $19 million year-to-date, bringing the total since inception of the program to $69 million. As a reminder, we still expect our full year savings this fiscal year to be modestly higher than the $40 million achieved last year, reflecting increased savings in the second half from footprint rationalization and manufacturing modernization. We closed two manufacturing facilities in the second quarter. The savings from these closures are part of the fiscal year '20 restructuring actions, which are expected to deliver $35 million to $40 million in run rate annualized savings by the end of fiscal year '20. We also remain on track with our fiscal year '21 restructuring actions that are expected to contribute an additional $25 million to $30 million of annualized run rate savings by the end of fiscal year '21. We now expect to achieve these savings at a lower cost. We've decided to downsize the Essen operation rather than closing it after reaching a compelling agreement with local employee representatives to improve profitability driven by increased required work hours per week and lower operating costs. We are also evaluating the acceleration of other facility closures as part of our ongoing restructuring activities. As I said before, in an unpredictable market environment such as this one, it's important to stay focused on the things that we can control, such as disciplined cost management. Our adjusted operating expense of 21.3% represents a decrease of 6% year-over-year in dollar terms. We will continue to look for opportunities to reduce costs, especially in the current market environment. Looking ahead, the lower end market demand we experienced in Q2, as well as our current expectations for further weakness through the remainder of the fiscal year have necessitated a reduction in our total year outlook. Let's turn to Slide 3 to discuss some of the changes since our last earnings call that have lowered our expectations. As you can see on this slide, many macroeconomic indicators for our key end markets have changed significantly over this last quarter, versus what was forecasted at the end of the first quarter. U.S. manufacturing production was positive in the first quarter but unexpectedly turned negative in the second quarter. Similarly, India was indicating signs of recovery with September industrial production forecasted to be positive 4%. However, actual performance was negative 4% and consistent with the further deterioration that we saw in Q2. The transportation end market continued to weaken further than expected in the quarter with a decrease in German industrial production of negative 5% versus the forecast of negative 3% at the start of the quarter. The developments with the 737 MAX affected our second quarter and full-year outlook as well. At the time of our last call, Boeing’s actual monthly production levels were 42, and they were forecasting an increase to 52 by fiscal year-end. Of course, the subsequent production also affected the associated supply chain. Finally, the energy end market was significantly lower, as seen in the drop in the U.S. land-only rig count, which was forecasted to stabilize around 850 at the time of our last call, and is now around 800 and expected to stay at approximately these levels for the balance of the fiscal year. Despite these challenges across our end markets, we continue to improve our long-term profitability, as seen on Slide 4. Part of simplification and modernization is reduction in our manufacturing footprint to reduce structural costs, as well as leveraging our modernized manufacturing processes for improved productivity. Since the start of this journey, we've reduced the footprint by 5 and require considerably fewer employees to operate the business. Note that the reduction in footprint does not include the significantly downsized Essen operation or other facility closures currently under evaluation. These actions to date are reflected in the improvement in our cash flow from operations as shown in the chart comparing the first half of this year to a similar revenue period. As you can see, there's a significant improvement in our cash flow as we’re focused on simplification and modernization, including simplifying value-based pricing, our product portfolio and services, improving productivity through automation and modernized manufacturing processes, and removing structural costs through footprint rationalization. Overall, we are making good progress. To date, we’ve reduced our footprint by 5 versus the December 2017 Investor Day projection of 5 to 7 and expect to spend approximately 90% of the incremental $300 million in modernization CapEx by the end of this fiscal year. This will complete the $300 million of incremental capital spend required for our simplification and modernization program, except for approximately 10%, which we expect will be needed to add capacity once markets recover. It's important to note that much of the productivity improvements from the modernization capital are still to come. As we’ve discussed, the plant closures would happen towards the end of our simplification and modernization program, and we are on track with that. The productivity of the modernized processes that enable consolidation of entire plants into a smaller footprint are significant. And these benefits of modernization are still ahead of us as we bring the new processes online and complete the transfer of products throughout fiscal year '20 and '21. So in summary, I remain confident that we will deliver the savings needed to achieve our adjusted EBITDA target of 24% to 26% once our sales are within the $2.5 billion to $2.6 billion range. Before I turn the call over to Damon, I'd like to discuss the executive changes announced last week. Ron Port, who is currently leading our Infrastructure business segment, has moved into the newly created role of Chief Commercial Officer for our metal cutting businesses. In this new role, Ron will drive best practices across our metal cutting segments to improve sales and marketing effectiveness and accelerate growth with target customers by leveraging the company's full metal cutting portfolio. Franklin Cardenas is joining our team as of February 10th and will lead the Infrastructure business segment. He comes to us from Donaldson Company where he held various business and general management positions with responsibility for commercial and operations. He was most recently VP of Asia-Pacific. Welcome Franklin to the Kennametal team. And with that, I'll turn it over to Damon.

Thank you, Chris. And good morning, everyone. I will begin on Slide 5 with a review of our operating results on both the reported and adjusted basis. As Chris mentioned, demand trends deteriorated more significantly than previously expected across our end markets. These trends were magnified by recent headwinds in the aerospace end market following changes to 737 MAX production. This resulted in sales declining 14% year-over-year or negative 12% on an organic basis to $505 million. Foreign currency had a negative effect of 1% as well as a divestiture that contributed another negative 1%. Adjusted gross profit margin of 26.8% was down 710 basis points year-over-year. The year-over-year performance was largely a result of the effect of lower volumes and higher priced inventories still working its way through the P&L. The negative effect of raw materials this quarter was roughly 130 basis points, down from 360 basis points in the first quarter. The effect of higher priced inventory will reverse in the second half of the year and be roughly neutral for the full year. Adjusted operating expenses were down 6% year-over-year and represented 21.3% of sales, an improvement of 70 basis points sequentially. Taken together, adjusted operating margin was 4.8%, down 900 basis points year-over-year against tough margin comparisons. Reported loss per share was $0.07 versus positive EPS of $0.66 in the prior year period. There are one-time items in the reported loss per share of this quarter that I'd like to highlight. First, discrete tax benefits accounted for $0.18 due primarily to transitioned provisions of Swiss tax reform. Despite this change, we do not expect a material change in our long-term adjusted tax rate. Second, we recorded pre-tax non-cash Widia intangible asset impairment charges of $15 million this quarter as a result of deteriorating market conditions, primarily in general engineering and transportation applications in India and China, in addition to overall global weakness in the manufacturing sector. The after-tax effect on EPS was negligible. This action does not change our view of Widia but is simply reflective of the current weak macro environment. Third, we completed the divestiture of a non-core specialty alloys business in Infrastructure for $24 million in cash proceeds as part of simplification and modernization, which amounted to $0.03 per share. On an adjusted basis, EPS was $0.17 per share versus $0.71 per share in the previous year. The main drivers for our adjusted EPS performance are highlighted on Slide 6. The effect of operations this quarter amounted to negative $0.62. The largest factor contributing to the $0.62 was the effect of significantly lower volumes. Also reflected within the operations category is the temporary effects of higher raw material costs of approximately $0.07. This was down from negative $0.19 last quarter and expected to reverse in the second half to be roughly neutral for the full year. Another factor was the temporary manufacturing inefficiencies related to our plant closures. Although improving, these headwinds continued as expected this quarter. We expect this to diminish as we proceed through the year. Simplification and modernization contributed $0.10 in the quarter, up from $0.07 last quarter, $0.03 of which is from restructuring actions. As Chris mentioned, we expect these benefits to increase as we progress through the second half of the fiscal year. Slides 7 through 9 provide detail on the performance of our segments this quarter. Industrial sales in Q2 declined 11% organically on top of 3% growth in Q2 of the prior year. From a regional standpoint, the largest decline was in EMEA at negative 14%, followed by the Americas and Asia Pacific down 10% and 4%, respectively. From an end market perspective, the weakness in demand remains broad-based with the biggest challenges in transportation and general engineering down 13% and 10%, respectively. This was primarily driven by decelerating global manufacturing and auto production activity, as well as extended holiday plant shutdowns by customers. Sales in the aerospace end market fell short of expectations affected by the ongoing developments surrounding the 737 MAX and the corresponding effects of the supply chain. Adjusted operating margins came in at 10.7% compared to 18.6% in the prior year. The decrease was primarily driven by the decline in volume. The effects of higher raw material costs represented approximately 70 basis points of the year-over-year decline. However, on a sequential basis, the adjusted operating margin increased approximately 90 basis points on roughly flat sales. Turning to Slide 8 for Widia. Sales declined 8% organically against a positive 4% in the prior year period. Widia faced similar macro challenges as the Industrial segment during the quarter. Regionally, both EMEA and the Americas were down 6% year-over-year with the largest decline this quarter in Asia Pacific down 17%. It should be noted that the decline in Asia-Pacific was due primarily to the significant slowdown in India, specifically in the transportation sector. That slowdown is also affecting the general engineering end market as well. Adjusted operating margin for the quarter was a loss of 2.4%. Similar to the other business segments, higher raw material costs affected Widia's operating margin by approximately 230 basis points this quarter, down from 430 basis points last quarter, and those headwinds will reverse in the second half. Turning to Infrastructure on Slide 9. Organic sales declined 14% against a positive 4% in the prior year period. Regionally, sales were up 2% in EMEA, while Asia Pacific and the Americas were down 5% and 22%, respectively. By end market, these results were primarily driven by energy, which was down 33% year-over-year, reflecting significant declines in the U.S. land-only rig count. General engineering and earthworks were down 6% and 3%, respectively. Infrastructure recorded an operating margin loss of 1.8% this quarter compared to a profit of 9.6% in the prior year period. Remember, Infrastructure is significantly more sensitive to changes in raw material costs in two ways. First, raw materials are a larger percentage of Infrastructure’s cost of goods sold. Second, certain customer prices adjust based on spot market prices of materials and create a temporary timing difference, further affecting operating margins. This higher raw material cost affected margins by approximately 180 basis points year-over-year. Again, this was down sequentially from 660 basis points last quarter and will reverse, such that we expect to see an improvement in Infrastructure’s profitability in the second half. Furthermore, as part of the simplification and modernization initiative, we expect to see additional benefits in Infrastructure margins following the recent closure of our Irwin, Pennsylvania facility, as well as the divestiture of our New Castle business. Now, turning to Slide 10 to review our balance sheet and cash flow. Primary working capital decreased both sequentially and year-over-year to $660 million. On a percentage of sales basis, our primary working capital was 32.7%. The slight increase year-over-year is the result of more modest inventory reductions compared to the sales decline in the quarter. Net capital expenditures increased to $75 million compared to $43 million in the prior year period. As Chris mentioned, our simplification and modernization spending and results are on track. Our second quarter free operating cash flow was negative $15 million consistent with normal seasonal patterns. This represents a year-over-year decline of $24 million on increased net capital expenditures of $32 million and increased cash restructuring cost. In the context of our updated outlook, we expect our free operating cash flow to improve in the second half, resulting in roughly breakeven free cash flow for the full year. Our cash balance remains strong, and in the quarter at $105 million, and we remain well positioned with our debt and overfunded U.S. pension plans. We had no borrowings on our $700 million revolver at quarter-end and have no significant debt maturities until February 2022. Dividends were approximately flat year-over-year at $17 million, and we remain committed to our dividend program. Overall, I'm confident in the strength of our balance sheet. Our cash position and unutilized revolver, coupled with our cash flow generation, allows us to drive forward with our simplification and modernization initiatives, which will improve our financial performance and cash flows throughout the economic cycle. The full balance sheet can be found on Slide 15 in the appendix. Turning to Slide 11 for our fiscal year '20 outlook. Our updated outlook reflects the change in several factors since our last call, many of which Chris mentioned. First, we are now assuming further end market deterioration in the second half. Secondly, our outlook encompasses the recent developments of the 737 MAX and the related effect on the supply chain. Also, the U.S. land-only rig count has declined more rapidly than expected, and the projections have been reduced affecting the results across all business segments. Together, these headwinds are expected to steer our second half revenues off the course of normal seasonality, which is what we had assumed in our prior outlook. Our revised organic outlook is now in the range of negative 12% to negative 9%, down from negative 9% to negative 5%. Our adjusted effective tax rate is expected to increase to be in the range of 25% to 28%. The increase in our adjusted effective tax rate is a result of lower taxable earnings and geographic mix. There are two additional points related to this that I'd like to highlight. First, the current outlook is reflective of lower taxable earnings, and we would expect a more normalized adjusted effective tax rate in the low 20s as profitability improves. Second, the change in this rate is not expected to have a material effect on the amount of cash taxes paid in fiscal year '20. In fiscal year '19, we paid approximately $50 million in cash taxes and expect to pay a modestly lower amount in fiscal year '20. Given these changes, we are updating the adjusted EPS outlook to $1.20 to $1.50. Moving on to free operating cash flow. As Chris mentioned, we are proceeding with our simplification and modernization plans and maintaining our prior capital spending forecast of $240 million to $260 million. Our updated outlook assumes free operating cash flow to be roughly breakeven for the year reflective of our lower earnings expectations. Remember, this reflects the current weak demand environment, but it's also inclusive of CapEx that is $120 million to $140 million higher than historical levels and significant cash restructuring charges. Our expectation is that cash flow conversion will be 100% once we are through the simplification and modernization initiatives. And with that, I'll turn the call back over to Chris.

Thank you, Damon. Turning to Slide 12, let me take a few minutes to summarize the quarter and the fiscal year '20 outlook. As we discussed already, the slowdown across our end markets and recent developments in aerospace have affected our quarterly results and were not anticipated in our prior outlook. Nevertheless, we continue to focus on what we can control and expect profitability to improve in the second half, driven by the progress we're making in simplification and modernization and the improvement in raw material costs. With continuing focus on strong execution, combined with our emphasis on improving customer service, I remain confident in achieving our adjusted EBITDA target on sales reached the range of $2.5 billion to $2.6 billion. And with that, operator, let's open it up for questions.

The first question today comes from Stephen Volkmann with Jefferies. Please go ahead.

Maybe Chris, can I go back to something you said in your opening comments about how your incremental margins would be sort of well positioned when things started to get better. And I guess I have been surprised that how large the decrementals have been, even adding back the raw materials. So I don't know if there's a way for you to maybe put some brackets around what you would expect for incremental margins when things actually turn it up that would be helpful?

Yes. Regarding the decremental margins, as we analyze the situation and exclude the impact of material costs, we find that they are consistent with our expectations across all segments. They are slightly higher due to manufacturing efficiencies tied to plant closures and similar factors. However, once we account for those issues, we believe the longer-term decremental margins align with what we anticipated. Additionally, we are optimistic about our progress in simplification and modernization. We are on track to meet our targets as volume increases. So far, we have achieved about $69 million in savings. Our restructuring actions in FY '20 and FY '21 are part of the modernization effort. Much of the significant work involved in this was related to plant closures, which are currently underway. We are in the process of transferring products from the closed facilities to lower-cost locations. This transition will continue, and we anticipate seeing benefits from simplification and modernization starting in the second half of FY '20, with additional benefits to follow in FY '21. Overall, we believe we are prepared and just awaiting a return in volume.

And then maybe switching just a little bit. Is it possible to put maybe Damon question, any numbers around the MAX? How much is your exposure to the MAX? And how much do you think that was actually a factor in the guide down in the second half?

Yes, Steve, I'm not going to go into specifics regarding any particular customer. However, I can share that the changes in our outlook were influenced by what we anticipated in the overall supply chain during the second half of the year.

If I could just add to that. It was, as Damon said, there was an impact on the full year and also the second quarter. But part of our strategy has been to grow in aerospace and it's a big market, including all the sub-tier suppliers beyond the 737 MAX. And I think we've been very successful since the start of FY '18 to redirect our engineering resources that have been really servicing the transportation industry quite well. We redirected a lot of those resources to aero. And we feel like given the number of new customers we've added, and across the board, across the supply chain, whether it be Tier 1, Tier 2, and actually with the direct OEMs, that we are gaining market share in the space and feel pretty good about being able to grow in aero. So just wanted to add that.

The next question comes from Ann Duignan with JP Morgan. Please go ahead.

Let me just ask you along those lines, you talked about gaining share in aerospace, but have you been losing market share anywhere regionally or by segment as you go through all of this simplification, and just the disruption that it's having to your businesses?

We don't believe so. Where you're at in terms of market share at any given point is a challenge to measure. But when we look at, for example, our competitors where we have publicly available data sort of like with Sandvik, as we look at their drop in revenue over the last two years, it’s very consistent with where we are. And then the only area I would say that we actually have lost share would be in transportation but as we talked about, Ann, that was by design. There’s a lot of that business that wasn't very profitable for us and we want to shift those resources to more profitable segments. So when we look at the data and peel back the onion, we don't believe we're losing share at all. Our volumes have come down commensurate with our competitors. And also where we are actually keeping track of new customers, we’re adding in in the segments that we’re targeting, so it’s general engineering and aero, just based on the fact we're adding new customers and not losing business with the existing ones, that gives us confidence that we're gaining share.

Yes, I would suggest that maybe going forward Sandvik is not the only competitor, there may be new competitors out there. But I’ll just take that offline. My follow-up question is really, I may have asked this before but on Infrastructure, how did you end up in a situation whereby you are repricing based on spot prices? I mean generally even in automotive you may be repricing to spot but with a lag given that everybody understands you have inventory. So, I'm just curious how your business ended up in a situation where you're giving up pricing coincident with raw material changes?

I think, Ann, you're honing in at one part of our business in Infrastructure. I think we have our traditional business which we price for the value of the products that we're selling, in components and other parts. We do have index-based pricing for some of our oil and gas customers and that does lag. It depends on the individual customers. I think the specific point you are referencing is our powder business where we do sell powders into the marketplace. And again, that piece is adjusted based on current market prices. And so we do deal with our inventory cost versus where the spot price, but it's only a subset of our overall Infrastructure business.

The next question comes from Joe Ritchie with Goldman Sachs. Please go ahead.

So just a few clarifying questions. I think the first one on just the MAX. Are you guys assuming zero in revenue in your fiscal second half?

Our assumption in the second half is that production is not going to come back online. I guess that's the simplest way to say it.

So production not coming back online. And having a full impact on your revenue base, or is there still some potential incremental revenue coming from the MAX in the second half?

Yes, considering the various uncertainties in the current macro environment, any potential upside from the MAX's startup is challenging to predict, particularly when it comes to when this will lead to increased chip orders and ultimately more tool sales from us. Therefore, I advise caution when identifying positives in any one area amid these uncertainties. We've made our best attempt to provide an outlook for the second half, taking all these factors into account. My guidance is that while there may be some potential positives in this environment, they could easily be offset; thus, we have adopted a balanced perspective on our current outlook.

Okay, that's fair Chris. And I guess as I kind of think about the puts and takes of like the midpoint of your second half guide versus what transpired in the first half, clearly you guys have called out raw material headwinds abating say it’s roughly, $0.26. You've got incremental simplification and modernization benefits, which I have kind of in that like call it $0.05 to $0.07 type range. I guess given that the backdrop is still expected to be pretty muted in the second half, I guess how am I bridging then to the call it $0.70 plus that is necessary to get to better second half profitability versus the first half?

Let me walk you through my thought process. Our EPS guidance indicates an improvement between $0.86 and $1.16 for the second half. Starting with the $0.34 we've achieved in the first half, you're right that raw material costs account for $0.26. The benefits from increased simplification and modernization should be slightly higher than last year's $40 million, estimated at around $0.11 to $0.15 in EPS. Additionally, our volume expectations could remain steady or increase, contributing up to $0.28 driven by volume. We're also implementing various cost control measures, such as salary furloughs in the U.S. and similar actions in Europe, which provide extra benefits. Keep in mind that some manufacturing efficiencies tied to plant closures will start to diminish in the second half. Lastly, there are several factors that will help offset potentially higher taxes and related issues. Overall, the net benefit from our cost control actions could be around $0.15. That’s the framework for how we arrive at our projections.

The next question comes from Julian Mitchell with Barclays. Please go ahead.

Maybe a first question around sort of inventory levels. I guess in terms of how you assess inventories at your channel partners and customers right now, what sort of destocking if any you’re assuming happens in the second fiscal half? And also your own inventories moved down sequentially a fair amount. Do you see any need for underproduction in the second half in your own plant to get inventories out or do you think those are at a reasonable level?

Let me begin by discussing the external perspective. We observed further destocking from our customers in the second quarter, and I believe our customers will remain cautious moving forward. While there have been some positive signs in the U.S. recently that suggest a potential improvement, my conversations with customers indicate they are likely to stay careful throughout the remainder of the year. This behavior is quite consistent with what we've experienced during previous downturns. Regarding our internal inventory, we experienced a significant decline from the first quarter to the second quarter. I’ll let Damon provide insight on how we will be managing plant operations from this point onward.

Yes, Julian, I think as you alluded to, we did make improvement in the first quarter to the second quarter. I think as we look at the back half of the year, we’ve tried to right-size the production based on the outlook. But as we’ve said in the past, we're going to be very fluid or flexible based on market demands here. We don't want to compromise customer service. I think as we look at the balance of the year, I think what you will see is a more modest reduction in inventory in the back half of the year versus what you saw here in the first half.

And then my second question just around the manufacturing inefficiencies aspect. Realize that they shrink in the second half versus the first half. But wonder if there was any way to frame at all their magnitude in the first half. For example, how much smaller were they relative to that raw material cost headwind, for example, is there any help you could give us sizing the inefficiency?

Yes. We really haven't sort of given that detailed information out. And I just assume not to do that, Julian. I understand it'd be helpful for you. But I think that's a little too much detail than I'd like to present in this format.

Fair enough. I guess I'm trying to think about, once your sales return to growth, do you get some kind of catch-up impact against those inefficiencies? Or do you think that you run the risk that once sales recover, there's some inefficiencies because you're juggling recovering volumes with modernization?

I'm glad you asked your follow-up question. Now I see where you're going with this. The inefficiencies we are experiencing are temporary and primarily operational in nature. As we shut down plants and relocate equipment, particularly with the closures we made in the second quarter, we expect most of this disruption to be resolved by the time we begin fiscal year 2021. However, the Essen operation has been significantly downsized, and production is shifting to lower-cost countries. This will be part of the restructuring in fiscal year 2021 and will continue into next year. While we anticipate significant reductions, some inefficiencies will remain in fiscal year 2021. As volumes increase, I don't foresee major additional disruptions, though there is a possibility. Overall, I believe that the majority of these issues will be resolved by the end of fiscal year 2020, with a few lingering into the first half of fiscal year 2021. Even with a return to higher volumes, I don't expect significant changes to this pattern.

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

At the beginning of the call you mentioned again, and it's been asked a little bit around this, but about the need and the desire to add back capacity as demand comes back. And I guess I'm just wondering how we should be thinking about the magnitude of those costs as revenues come back to your targeted range? Is this relatively modest and minor amount of cost? Or is this something we should be thinking as more significant?

Yes, the comments around adding capacity were relative to the CapEx. So if you go all the way back to our Investor Day, incremental CapEx spending for modernization and simplification was $300 million. We will have spent 90% of that by the end of FY '20. The balance is just adding more capacity to modernize processes. So for example, if, in some plants, we went from 16 presses with 16 operators down to 4 presses with one operator. At some point, the volume is such that you're going to need to add a fifth press, for example or sixth press. So, I wouldn't look at these as higher costs or expenses as volume comes up. As we were just simply commenting on the CapEx that we may need to add a few more presses, they'd be modernized presses with better productivity associated with modernization.

And then quick review that the cash flow outlook again for the second half, the key drivers to working capital coming back and I think you mentioned that you'll get back to 100% conversion of net income that next year and that is long-term comment, right?

That's right. I think Damon can provide more insight here, but the significant positives moving from the first half to the second half, as we anticipate reaching breakeven for the year, include a notable improvement in EBIT for the second half. Capital expenditures are also decreasing significantly from the first half to the second half. Additionally, our usual cash outlay, particularly regarding bonuses, was front-end loaded. These three factors will contribute to an improvement. However, we should also consider the higher restructuring charges, and working capital will provide some support for the incremental improvement we observed in the first half. Taking all of this into account, we should reach the breakeven cash point. Damon, would you like to add anything to that?

Yes. I would like to mention that, as Chris pointed out, there are positives regarding EBIT and capital. For the first half, the working capital was approximately positive $60 million, and we do not expect that full amount to be repeated. As I mentioned, there will be a modest reduction in inventory, which will provide some sequential improvement, along with the other positives Chris mentioned contributing to the net positive $60 million for the second half.

Your next question comes from Joel Tiss with BMO Capital Markets.

Alright, just a little more color on some of the end markets. Can you just run through a couple where you feel like the worst is behind you and a couple of other ones just to highlight where you feel like maybe there is not going to be any improvement for the next couple of months or quarters?

Yes, let me start by discussing metal cutting. We expect to see continued softness in the second half, and it's likely that all regions may experience year-over-year sales declines. We're taking a rather pessimistic view on all the end markets, which are anticipated to be down. Although we've mentioned the softness in aerospace due to the 737 MAX, there are some regions, particularly in aerospace in EMEA and Mexico, where we believe we can achieve growth based on earlier discussions. As for China, it seemed to be stable with some recovery signs until the Coronavirus outbreak. Unfortunately, it's hard to predict how that situation will evolve. On the Infrastructure side, specifically in general engineering and energy, we observed a more significant decline from Q2 to Q3 than we anticipated, but we think it won’t worsen significantly for the remainder of the year. Concerning our earthworks segment, we believe it's stable and will likely follow its usual seasonal trends.

Okay, that's great. Can you take a step back? Much of what you're discussing seems a bit defensive. Could you share some of the initiatives you're working on internally that are more proactive? For example, you mentioned shifting transportation to focus more on aerospace. Please talk about some of the proactive initiatives that you have in place to drive growth, especially in the long term.

Sure, I'd be happy to. We continue to invest in research and development. In the last few calls, we've shown you some of the technology, which is primarily focused on aerospace but also encompasses general engineering. Kennametal has concentrated on transportation and general engineering, a significant business segment. We have now segmented the market in detail and identified where we believe our product portfolio can effectively penetrate, especially in the U.S. We have organized ourselves to focus on this area. One of the initiatives discussed during the recent executive changes involves Ron Port assuming the role of Head of Commercial for the Metal Cutting segments. Ron will drive best practices across commercial operations. We view our investment in commercial operations as a strategic investment rather than an expense, akin to capital investment, with a strong focus on enhancing productivity and the entire sales process. There are common best practices and tools, such as CRM, along with digital customer experience platforms that we are investing in to better connect with our customers. With the market segmentation in general engineering, we realize that there are customers with high-end performance needs suited for the Kennametal tooling portfolio, which is mainly sold through the Industrial segment. Additionally, there are customers looking for a broader portfolio, which fits the Widia offering. We have Ron working on integrating the commercial process to ensure customers can benefit from both the Kennametal and Widia portfolios. This approach gives us confidence that we can drive growth in general engineering. It’s about leveraging technology and organizing ourselves to meet diverse customer needs. In aerospace, it's all about focus. While we have a strong reputation as a tooling supplier who meets technology demands, we haven't approached it with enough discipline as a company. Overall, we feel optimistic about these strategies, and I appreciate your question, Joel, and the chance to discuss some of these exciting developments. Thank you.

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

I wanted to ask about the dividend. I know you're committed to it, and you have sufficient liquidity with the revolver, but let's go over some numbers. You have $105 million in cash on the balance sheet, while the dividend requires about $65 million to $70 million annually. I assume you want to maintain that cash cushion in case we enter a deeper downturn or need to undertake additional restructuring, especially with a significant maturity coming up in two years. So, is it truly right to sustain the dividend considering your business may need more investment for automation, restructuring, or other factors, especially when you’re not generating free cash flow right now?

We are spending $250 million on capital this year, which is the highest amount the company has ever spent. This will significantly decrease next year. In the latter half of the year, we expect to generate $60 million in cash. We started with surplus cash on our balance sheet, which currently has an investment-grade rating from all three agencies, and none have raised any concerns. At this time, I don't see the need to cut the dividend due to an economic downturn, which we anticipate will eventually turn around. Historically, prior recessions have shown that conditions do improve. Therefore, we don't find it necessary to consider a dividend cut given our current situation. Additionally, we have $700 million available on our revolver at any time, providing us with additional financial flexibility. Our balance sheet is robust, and we remain committed to maintaining the dividend. As for the restructuring we've factored into our free operating cash flow, we expect it to be less in fiscal year '21. Thus, this is not a topic of internal discussion for us at this moment.

Damon, regarding the capital expenditures, you have clearly indicated that you anticipate a significant decline next year, and I understand that. However, your margins appear to be only half of your competitors', who are operating more efficiently and not facing the same challenges. How do you feel about returning to maintenance capital expenditures when your competitors seem to be extending their advantages by investing significantly more in research and development? Why is the $300 million target so crucial? You established that figure three or four years ago, and why wouldn't this business need increased capital expenditures to bring margins back to where they should be to be more in line with global competitors?

Well Ross, it's obviously on mix and we've said from the beginning that the 25% long-term margins are to get us to what we think is competitive. When you look at us versus others, there are portfolio differences, there are economies of scale with how they run their factories or the size of the factories they have. The $300 million is what we believe we need to modernize our factories. We'll continue, as I've said from a capital allocation standpoint, longer-term, we'll continue to look at further investment but those investments have got to have their own stand-alone return. So as we think about more smarter factories or further automation, those are going to have to have returns that are incremental or justifiable on a stand-alone basis as we think about that future capital. But as we sit today, again looking at what we're able to achieve and you've seen some of the examples of what we've been able to achieve in areas like Rogers, what we're doing with some of our other industrial factories, we feel very good about where we're heading.

Is your footprint rationalization, I mean I realize you're moving stuff into your lower production and to your lower-cost facilities. But is it done at this point? I mean, do you need to close additional factories? You have the chart on where you were and where you are now. But is there a chance you've got to do additional factory closures and spend more on cash restructuring than you anticipate right now? I mean given you I guess had to cut the outlook twice pretty hard in the last four months. I mean you don't have a lot of visibility on when demand is going to turn, so I'm just a little bit confused on what gives you the confidence that the cash restructuring charges to turn this business around are really kind of all accounted for at this point.

Ross, as mentioned in our opening comments, we are currently reviewing additional plant closures, which are already included in the FY '20 and FY '21 restructuring plans we announced. Moving beyond FY '21, I assure you that as long as I am the CEO, this company will always focus on modernizing its manufacturing operations. We will continuously seek opportunities for footprint rationalization if it makes sense. As Damon mentioned, we will consider necessary investments in line with ongoing business operations. Before Kennametal, I observed that our maintenance capital was only about fixing things without any significant improvements. With the upgrades we have made, we will not just focus on repairs. The maintenance investments going forward can yield legitimate returns, unlike before when it was merely about keeping operations running. There is an opportunity within that maintenance capital for continued advancement. However, I am not making projections for the period beyond FY '21. I can confidently state that our simplification and modernization program positions us well for when volumes increase. Regarding restructuring charges next year, we believe we have made appropriate estimates.

The next question comes from Walter Liptak with Seaport Global.

I want to revisit your comment during the Q&A regarding your outlook for second half EPS compared to the first half. Considering your previous mention of the disruptions caused by plant closures, it seems we might be underestimating the impact of those disruptions. Could you provide more details about the extent of those disruptions so we can gain a better understanding? Additionally, it appears that most of the planned closures, particularly in Europe and Germany, have been completed. Can you confirm that those disruptions will not affect your fiscal third quarter? Thank you.

I believe that in my analysis of the EPS, I identified around $0.15 related to cost control measures and reduced inefficiencies from plant closures. The inefficiencies linked to these closures fall within that $0.15 range. For context, I would estimate that we are currently seeing less than half of that potential improvement. Looking ahead, once we move past the remainder of this year, a significant portion of the disruption should diminish, particularly due to the restructuring actions from fiscal year '20, which included the closure of the plant in Germany and another in the U.S. In fiscal year '21, we are downsizing the Essen facility, and I anticipate that this will continue to cause disruptions at least through the first half of next year. Additionally, we have discussed further plant closures, and by then, we will have more clarity on that. While those are part of our ongoing restructuring efforts, there may be other disruptions that we haven't addressed yet, which I cannot discuss in detail at this time, but I want to emphasize that we are actively managing additional factors.

The next question comes from Chris Dankert with Longbow Research.

Appreciate there is a lot of uncertainty around Asia and China specifically right now, but can you give us a little bit of a bracketing of what range of scenarios is kind of assumed in the revised guide as far as kind of how India and China could be down in the back half of the fiscal year here?

Yes, regarding India, we believe that conditions are unlikely to improve and may even deteriorate slightly. If this holds true, it will bring us closer to the lower end of our guidance. As for China, we did not include the potential impact of the Coronavirus in our latest outlook, as it is a new and evolving situation. We're currently working on assessing the effects, but we do not have a specific figure at this time. This uncertainty has not been accounted for in our current guidance.

Yes, Chris, one of the challenges we are facing right now is the publicly available information from China and whether the situation is temporary or if there will be a longer-term impact. We are also considering the long-term consequences, and as Chris mentioned, it's a very fluid environment that we are monitoring closely.

Got it, that's very helpful. Thank you for the information. I wanted to ask if there is any additional SKU rationalization or pricing for value changes beyond just process improvement.

I want to talk a little about our simplification efforts. As we've mentioned before, a significant portion of the $69 million we've achieved so far is related to simplifying and streamlining our portfolio. We're now more focused on value pricing, which is driving benefits for us. It's important to note that while there have been headcount reductions and adjustments to our footprint as part of structural costs, we're also making considerable capital expenditures to modernize our processes. Not all of these savings are accounted for in the specific restructuring categories. This is about the increased productivity we gain from the equipment installed as we handle higher volumes. Therefore, although headcount may not fluctuate dramatically, the enhanced capacity and volume from our modernized processes will significantly improve our leverage.

The next question comes from Steve Barger with KeyBanc. Please go ahead.

Chris, I want to go back to Joel's question. Kennametal has been talking about CRM and digital going back through multiple management team. So can you just expand on what best practices means? And do you have to spend money on this or is this just getting the sales force into a more disciplined process using what's already there?

Yes, regarding the CRM, there isn't any additional financial commitment required; it's about being more disciplined in our approach. We've been making progress, and CRM has been an area where many other companies have advanced, leaving Kennametal somewhat behind in adopting best practices. We have made improvements and I want to highlight this as an example of a best practice that we need to share and utilize across our two segments. It's important to ensure that both segments are leveraging these best practices effectively. In terms of the digital platform, Kennametal has established some strong engineering tools, but previously, the focus was not on how to effectively market these tools, ensure customers understand their value, and drive revenue from them. This is an area that will require further investment, and we will communicate with you about when that occurs. It's crucial for us to justify the returns on this investment. While I don’t view this as a major modernization effort that would require significant capital expenditure, there will still be some necessary investment. As Damon mentioned, once we complete the modernization process, we anticipate generating substantial cash, and these are the kinds of investments we want to pursue. To put it in perspective, Kennametal has been focused on addressing structural issues, and now that we are moving beyond simplification and modernization, we can concentrate on opportunities that will help us expand our market share and grow the business. We are transitioning from a phase of fixing to a phase of growth, and I am open to making necessary investments to achieve that. As Damon noted, we're excited to invest as these initiatives are expected to yield significant returns.

So just thinking about that sales conversion for the competitive deals that you're not winning right now, what are the common threads, are they around product or pricing, what do you have to overcome here to get back on the plus side on sales and market share?

Yes, I believe that the key is focusing on the ability to target customers and understanding the value proposition we want to deliver to them. For instance, our product portfolio is tailored to meet the needs of high-end customers with specific cutting requirements for particular metals in certain applications, as well as more general tooling applications. Not all customers should be treated the same way. Therefore, our goal is to ensure that we appropriately address the needs of different customers and do not hinder the process of delivering our value proposition to the right ones. This approach exemplifies a best practice in understanding our customers and engaging with them in a manner that maximizes value, rather than treating all customers equally. This is one area of improvement. Additionally, to effectively achieve this, we need to go beyond a broad focus on general engineering and instead segment our efforts according to the various industries and specific customer needs, which is fundamental for a best-in-class company in terms of commercial excellence. This represents the next opportunity for Kennametal's enhancement, which is why I am appointing an executive with relevant experience to lead this initiative. I believe that having a dedicated executive in this area will accelerate performance improvements, which is the rationale behind our recent organizational change.

Well, I guess it's going to depend on the source. With Industrial, we leverage above our average of 40%. If you consider where Industrial is leveraging and deleveraging in the current environment, excluding raw materials, I would say the potential upside is likely to be similar.

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

Thank you all for joining the call today. We sincerely appreciate your interest and the questions asked. If you have any follow-up inquiries, please reach out to Kelly. Thank you very much.

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