Kennametal Inc (KMT) Q4 2020 Earnings Call Transcript

Good morning. I would like to welcome everyone to Kennametal's Fourth Quarter Fiscal 2020 Earnings Conference Call. Please note that this event is being recorded. I would now like to turn the conference over to Kelly Boyer, Vice President of Investor Relations.

Thank you, operator. Welcome, everyone, and thank you for joining us to review Kennametal's fourth quarter and 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. 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; Franklin Cardenas, President, Infrastructure business segment; Pete Dragich, Chief Operating Officer in the Metal Cutting business segment; and Ron Port, Chief Commercial Officer, Metal Cutting business segment. After Chris and Damon's prepared remarks, we will open the lineup 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. With that, I'll now turn the call over to Chris.

Thank you, Kelly. Good morning, everyone, and thank you for joining the call. For today's call, I will start with some general comments on the year, followed by a quick overview of the fourth quarter. After that, I will discuss fiscal year ‘21 and our strategic agenda that will well-position the company as markets recover. From there, Damon will review the quarterly financial results in more detail. Finally, I'll make some summary comments before opening it up for questions. Beginning on Slide 2, I would describe our fiscal year 20 as a year of significant challenge, but also a year of significant progress on our strategic growth and profitability improvement initiatives. As you recall, we began the year in what was already considered an industrial downturn. The 737 MAX production halt and the significant decline in the price of oil followed soon after. Last but certainly not least, COVID-19 specifically affected end markets in all regions in the second half of our fiscal year, especially in Q4. As a result, organic sales declines occurred throughout the year and got worse as the year progressed. However, we focused on the things we could control by implementing aggressive cost control actions, staying the course to advance our strategic agenda, including positioning the company for profitable growth in the gain share, as markets recover. These actions resulted in strong decremental margin performance in the second half, as well as substantially completing our planned simplification and modernization capital spend. I'm pleased with how our team came together to tackle the challenges. COVID-19 protocols we successfully implemented continue to allow us to operate safely and serve customers globally. While all our facilities operated throughout the fourth quarter, with the notable exception of our Bangalore, India plant, which was closed for approximately six weeks due to a government-mandated lockdown. Some examples of our cost control actions are the acceleration of planned structural cost reductions associated with our simplification and modernization program, and further temporary cost control actions to mitigate COVID-19 headwinds, such as increased furloughs, salary and variable compensation reductions, and reduced production schedules. These measures help align our costs more closely with demand and finish the year on a strong liquidity position despite the challenging environment. In addition, we continued to make significant progress on our strategic initiatives. Yesterday we announced our intention to close a plant in Johnson City, Tennessee, as part of our simplification and modernization program. This brings the total number of plant closures to six since the inception of the program, and is in line with our original target of five to seven plant closures. That does not include the significant downsizing of the Essen, Germany facility. We expect the Johnson City closure to be substantially complete by fiscal year-end, with production consolidated into other newly modernized Kennametal facilities. We are also substantially complete with the spending on simplification and modernization capital, which marks a significant milestone in our journey to fundamentally reduce our cost structure through financial performance throughout the economic cycle and improved customer service to enable share gain. As we navigate through another challenging fiscal year, we will see the benefits from simplification and modernization increase. This is driven in part as we recognize full-year run-rate savings from fiscal year ‘20 actions, bring additional modernized processes online and recognize the benefits from accelerating the simplification and modernization structural cost actions. Also, of course, as buyers return, the savings will grow from increased utilization of our modernized processes and rationalized footprint. In addition to simplification and modernization, we continue to advance our strategic growth initiatives, including launching new high-value-added products and preparing to expand our reach into a large segment of Metal Cutting that we previously had not focused on. I will talk more about these growth initiatives in a minute. But first, let me quickly review on Slide 3, the fourth quarter results, which as you know, like other industrial manufacturing companies, we experienced significant headwinds due to COVID-19. In Q4, the company reported an organic sales decline of 33% on top of the 2% decline in the prior year quarter, which is the worst quarterly organic decline since the Great Recession in 2008. All segments reported negative organic growth for the quarter with Industrial declining by 36%, Widia down 32%, and Infrastructure at 29% compared to negative 4%, negative 3%, and 1% growth in the prior-year quarter respectively. Also, all regions were negative, with the Americas posting a 39% decline, EMEA 34%, and Asia Pacific 24%. Remember that Asia Pacific saw COVID-19 related declines earlier than EMEA, followed by the Americas. Our operating expenses declined 18% reflecting our cost control measures. These actions in the quarter, combined with benefits from our simplification and modernization program, significantly mitigated the effect of lower volumes on operating leverage. Adjusted EBITDA margin for the quarter was 17.7%, a decrease of 330 basis points from 21% in the prior year. Turning to Slide 4, due to COVID-19 it remains difficult to forecast how our customers as well as our end markets will be affected. As a result, we will not be providing an annual outlook for fiscal year '21. However, I would like to provide some color on what we might expect, especially in the first quarter. Based on our July sales and the month-to-month sequential sales pattern throughout Q4, market demand in Q1 would seem to be stable or modestly improving from Q4 levels for many end markets and regions. However, the company typically sees an approximate 10% seasonal decline in revenues from Q4 to Q1 on average. So as customers continue the reopening process in Q1, the resulting improvement in demand may not be sufficient to fully offset the normal seasonal pattern. Also note that there can be a lag of a few months from when customers increase production to when we see a corresponding increase in demand. Beyond Q1, it's helpful to consider customer sentiment, which seems to be that while there are signs of improvement from Q4 to Q1, there is still a lot of uncertainty due to COVID-19 about how these signs would translate to Q2 and beyond. So while many customers are hopeful for a continued improvement, they feel cautious due to the uncertainty of COVID-19, planning for demand to be stable or only modestly improving through the end of calendar year 2020. Regardless of how end market demand unfolds in fiscal year '21, we will continue our cost control actions to protect margins and liquidity. Regarding capital expenditures for fiscal year '21, capital spending will be significantly reduced by over $100 million to be in the range of $110 million to $130 million for the full year. The reduction is as expected, given we are substantially through the capital spend for the simplification and modernization program. The benefits of these investments will continue to increase in fiscal year '21, bringing savings since inception to approximately $180 million at fiscal year-end, including total company headcount reduced by approximately 20% and a rationalized footprint with six fewer plants and more production moving to lower-cost countries. So we are successfully managing through the current environment, while still advancing simplification, modernization and our other strategic initiatives to drive growth and share gain as markets recover. For example, on Slide 5. In fiscal year '20, we continued to launch new products with great value propositions for customers in end markets. As you can see from the customer feedback, they speak of the incredible versatility and performance of Kennametal products. We are creating tremendous value for our customers and differentiating ourselves from the competition. These types of innovations fueled growth. For example, in fiscal year '20, we won a five-year strategic supplier agreement with a leading aircraft OEM and a complete tooling program from a leading wind power bearings manufacturer. These are just a few examples of how creating value for customers is driving new business growth. We've also continued to advance our commercial excellence initiatives to gain share when markets recover. As you can see on Slide 6, we announced yesterday that as of July 1st, we combined Industrial and Widia into a single Metal Cutting organization. This move will enable us to more effectively direct our commercial resources, products, and technical expertise toward capturing a larger share of the wallet, in addition to executing a new brand strategy. Previously, Widia operated to serve a customer needs segment within Metal Cutting that significantly overlapped the Kennametal brand positioning. Our new approach is to reposition the Widia brand and portfolio to serve a multibillion-dollar segment within Metal Cutting that we had previously not focused on. We expect that this approach will open up a 40% increase in served market opportunity while offering better service and tooling options to our customers. More specifically, and speaking with our customers, we know they need technical support and high-performance tooling optimized around specific applications. But they also have a need for high-quality fit-for-purpose tools that are readily available and have the versatility to offer performance across a broad range of applications. It is this part of the customers’ Metal Cutting share of wallet that we are targeting by repositioning the Widia brand and product portfolio, which will leverage our newly modernized manufacturing capabilities for improved delivery and cost performance. Built from a customer perspective, and this is true across all markets, we are providing customers access to the company's full Metal Cutting suite through both direct and indirect channels, in effect, a one-stop-shop model to cover a broader range of their Metal Cutting needs. And with that, I'll turn the call over to Damon.

Thank you, Chris. And good morning, everyone. I will begin on Slide 7, with a review of our Q4 operating results on both the reported and adjusted basis. As Chris mentioned, demand trends already at depressed levels from the industrial downturn deteriorated significantly in Q4, driven by the effects of COVID-19. For the quarter, sales declined 37% year-over-year, in line with the decline seen in April or negative 33% on an organic basis to $379 million. Foreign currency had a negative effect of 2%, and divestiture contributed another negative 2%. Adjusted gross profit margin of 27.7% was down 790 basis points year over year. The year-over-year performance was primarily due to the effect of lower volumes and associated absorption, partially offset by cost control actions, including furloughs, increasing benefits from simplification and modernization, and the positive effect of raw materials, which amounted to approximately 140 basis points. Adjusted operating expenses of $68 million were down 41% year over year, and decreased to 18% as a percentage of sales. Although much of this decrease is temporary, it reflects our aggressive approach to managing costs in this environment. EBITDA margin was 17.7%, down 330 basis points from the previous year quarter. Taken together, the adjusted operating margin of 8.8% was down 700 basis points year-over-year. The adjusted effective tax rate in the quarter was significantly higher at 51.2% due to the combined effects of geographical mix, changes in our taxable income, as well as the magnified effect of guilty on the effective tax rate as we finalize actual full-year taxable income versus estimates. It's worth noting that our adjusted effective tax rate for the full year was approximately 33%. We reported a GAAP earnings per share loss of $0.11 versus earnings per share of $0.74 in the prior-year period, which reflects the reduced volume and higher tax rate partially offset by our cost control actions coupled with restructuring items. On an adjusted basis, EPS was $0.15 per share in the quarter versus $0.84 in the prior year. The main driver for our adjusted EPS performance are highlighted on the bridge on Slide 8. Effective operations this quarter amounted to negative $0.68. This compares to negative $0.08 in the prior-year period and negative $0.39 in the third quarter. The largest factor contributing to the $0.68 was the effect of significantly lower volume and associated under absorption. This was partially offset by cost control actions including lower variable compensation, as well as positive raw materials of $0.08. Simplification and modernization contributed $0.14 in the quarter on top of the $0.10 in the prior year. This brings the total FY20 simplification and modernization savings to $0.46. As Chris mentioned, our expectations for FY21 is that the simplification and modernization benefits will be in the range of $0.80 driven by actions already taken or announced. Remember, restructuring is a subset of our simplification and modernization program. In terms of benefits from our restructuring program, the savings from our FY20 restructuring actions delivered approximately $33 million in run-rate annualized savings at the end of FY20. FY21 restructuring actions are expected to contribute an additional $65 million to $75 million of annualized run-rate savings by the end of FY21. The total year results in detail and the EPS bridge can be found in the appendix. Slides 9 through 11 detailed performance of our segments this quarter. Industrial sales in Q4 declined 36% organically on top of a 4% decline in the prior year period. All regions posted year-over-year sales declines with the largest decline in the Americas at negative 40%, followed by EMEA at 38% and Asia-Pacific at 27%. The slightly better performance in Asia-Pacific reflects more mixed results in the region, with growth in wind energy and improvement in China, slightly offsetting significant contraction in other countries such as India. From an end market perspective, the weakness in demand remains broad-based with significant declines in transportation in general engineering down 45% and 32% respectively. This was primarily driven by the demand effects of COVID-19 as well as related customer shutdowns that continued throughout Q4. Sales in aerospace also experienced a significant decline both year-over-year and sequentially driven by the associated effects on demand in the supply chain from COVID-19. Adjusted operating margin came in at 7.7% compared to 18.3% in the prior-year quarter. The decrease was primarily driven by the decline in volume and associated under absorption, partially offset by reduced variable compensation and other cost control actions, increased simplification and modernization benefits, and then a 90 basis point benefit from raw materials. On a sequential basis, adjusted operating margin decreased 540 basis points as lower volume was partially offset by aggressive cost control actions and lower variable compensation. Turning to Slide 10 for Widia. Sales declined 32% on top of a negative 3% in the prior-year period. Regionally, the largest decline this quarter was in Asia-Pacific, down 41%, the Americas down 31%, and EMEA down 28%. The decline in Asia-Pacific was mainly driven by India, with its country-wide COVID-19 shutdown for approximately half of the quarter. Adjusted operating margin for the quarter was negative 2.9% due to volume declines partially offset by lower variable compensation and other cost control actions or raw material benefit of 220 basis points and increased simplification and modernization benefits. Turning to Infrastructure on Slide 11. Organic sales declined 29% versus positive 1% in the prior-year period. Other items that negatively affected Infrastructure sales included a divestiture of 4%, FX of 2% and fewer business days of 1%. The large decline was in the Americas at 39%, then EMEA at 22%, and Asia-Pacific at 14%. By end market, these results were primarily driven by energy which was down 47% year-over-year given the extreme drop in oil prices, and the corresponding decline in the U.S. land-only rig count. General engineering and earthworks were down 31% and 17% respectively. Adjusted operating margin of 12.7% remains relatively stable sequentially but decreased 280 basis points from the prior-year margin of 15.5%. This decrease was mainly driven by lower volumes and associated under absorption, partially offset by reduced variable compensation and other cost control actions favorable raw materials that contributed 200 basis points and benefits from simplification and modernization. Now turning to Slide 12 to review our balance sheet and free operating cash flow. Before I review the numbers like I did last quarter, I would like to emphasize that we view liquidity as extremely important, particularly in these uncertain times. We will remain conservative to ensure the company has ample liquidity to weather the current environment as well as continue to execute our strategy. Our current debt maturity profile is made up of $200 million to $300 million notes maturing in February of 2022 and June of 2028, as well as a $700 million revolver that matures in June of 2023. At fiscal year-end, we had combined cash and revolver availability of approximately $800 million. At quarter end, we were also well within our covenants. Primary working capital decreased both sequentially and year-over-year to $596 million. On a percentage of sales basis, it increased to 35.4%, a reflection of the significant decline in sales in the quarter. Net capital expenditures were $38 million, a decrease of approximately $20 million from the prior year, bringing the total capital spend for the year to $242 million as expected. Our fourth quarter free operating cash flow was $39 million and represents a year-over-year decline, reflecting lower income due to volume and increased cash restructuring costs. Total free operating cash flow for the full year was negative $18 million. As mentioned on our last call, while we expected positive cash flow in the fourth quarter, free operating cash flow for the full year was projected to be slightly negative given the level of capital expenditures and cash restructuring charges. In addition, we paid the dividend of $17 million in the quarter. The full balance sheet can be found on Slide 20 in the appendix. Before I turn the call back over to Chris, I wanted to spend a couple of moments providing some additional thoughts regarding FY21 for modeling purposes. Turning to Slide 13. This slide shows how certain factors are expected to affect EPS and free operating cash flow during each half of FY21 on a year-over-year basis. As I mentioned earlier, we expect increased simplification and modernization benefits of approximately $80 million in FY21. The accumulated benefits will increase as we move through the year. As we think about the temporary cost control actions that we've announced in June, they will generate a savings of $10 million to $15 million per quarter in the first half of FY21, relative to the first half of FY20. However, as we look at the second half of FY21, the temporary cost control actions implemented in FY20 and the reversal of variable compensation, which we currently do not expect to repeat will create a year-over-year headwind. As you'd expect from us, we will remain diligent in managing our costs, and we will take the appropriate actions if markets continue to be challenging. Based on current tungsten spot prices, raw materials will be a positive in the first half, due to the headwinds we face in the beginning of FY20 and will be roughly neutral for the rest of the year. Depreciation and amortization will step up to a range of approximately $130 million to $140 million compared to approximately $120 million in FY20. We currently expect our full-year tax rate in FY21 to be similar to the 33% adjusted effective tax rate we saw in FY20, but fluctuate significantly in any given quarter depending on the effects of geographical mix and the sensitivity to lower pretax income. However, should trends in earnings begin to improve in the second half, particularly in the U.S., our tax rates should improve. As we get back to a more normalized environment, we still expect the long-term effective tax rate to be in the low 20s. Regardless of the effective tax rate, we expect cash taxes in FY21 to be approximately $10 million less than the $37 million paid in FY20. In regard to free operating cash flow, capital expenditures will be significantly lower versus last year, as Chris mentioned, by approximately $120 million. However, I want to note that the total spend for the year will be weighted to the first half, mainly due to the timing of cash payments associated with machine deliveries. Primary working capital will depend in part on how market conditions evolve over the next several quarters. For the first half of FY21, although we will reduce inventory levels based on current market conditions, the net accounts receivable and accounts payable will likely still be a working capital use. In the second half, assuming market conditions improve, we would expect working capital to be used as well, given the significantly depressed accounts receivable balance in Q4 of FY ‘20 and reduced accounts payable from decreased capital spending in FY21. We will continue to be diligent and inventory while ensuring that we do not compromise on customer service, which is essential for our high volume, high margin products. Lastly, cash restructuring charges are expected to be a negative factor year-over-year in both the first half and second half due to our accelerated restructuring activities announced in June. We currently expect cash restructuring charges to be $25 million to $35 million higher in FY21, with the majority of this increase in the first half. And with that, I'll turn the call back over to Chris.

Thanks, Damon. Before we open up for questions, I'd like to make some closing remarks. Please turn to slide 14. Looking ahead to fiscal year 2021, we will continue to focus on the things that we can control, so that we manage through the current market headwinds and prepare the company to outperform during the recovery. We'll continue our approach to aggressively manage costs and aligning production to demand while operationalizing our modernization investments for incremental benefits. Second, we are committed to maintaining solid liquidity with a focus on optimizing cash flow through lower capital spend, working capital management, and cost control actions. Finally, we'll continue to pursue our strategic growth initiatives so that we can position the company for profitable growth and share gain as and when markets recover, and to achieve our adjusted EBITDA profitability target when sales reach a topline range of $2.5 billion to $2.6 billion. With that, operator, please open the line for questions.

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

Hey, good morning, everybody.

Good morning, Steve.

So I guess just a lot of moving pieces as we try to get our head around ‘21 and recognizing volume is probably the most important one, which none of us can forecast. But there's a number of things I think we started to lay out relative to ‘21. So I guess you should get a sense of benefits from modernization in ‘21. That's the number, not the run rate, correct?

That's correct.

And can you say how much you benefited in ‘20 from these temporary cost reductions that will come back?

Yes, we can, Steve. In fiscal year 2020, that was around $0.40 to $0.45, which included furloughs, lower incentive compensation, reduced travel, and austerity measures. This positive impact of about $0.40 to $0.45, as Damon pointed out in his remarks, is expected to become a challenge in fiscal year 2021, particularly in the second half of the year.

Right, but not in the first half, right, because you're going to get that $10 million to $15 million per quarter of continued benefit.

That's correct.

That's correct.

Okay. And then finally, the restructuring, I think one of you said $65 million to $75 million run rate in ‘21. What's the ‘21 number ballpark?

So, Steve, that would be embedded in the $80 million of simplification and modernization savings. So what we're getting as part of this restructuring through FY21 is going to flow into that $80 million.

Got it, okay. And is any of the cadence of that sort of more second half loaded for just as you worked through this stuff maybe?

What I want to convey, Steve, is that the announcement in June regarding the 10% headcount reduction will occur over the first half, depending on the location. I want to emphasize that the full annualized savings will be more apparent in the second half of FY21.

Okay, that makes sense to me. All right, thank you. I will pass it on. I appreciate it.

Thanks, Steve.

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

Hi, good morning. Maybe just the first question, you've talked in sort of dollars and cents around some of the margin for EBIT puts and takes. Just wanted maybe to look at it from a margin rate standpoint just to understand what kind of decremental margin you’re managing the business to? So, you did in the last six months an overall decremental margin around the mid-20s, understanding that included tailwinds from tungsten prices. So when we roll together all the bits and pieces on Slide 13, should we assume that as long as sales are falling, the decremental margin is around that mid-20s weight of the balance of the new fiscal year?

Yeah, I mean, I think, just I’ll lay the foundation here and Damon maybe he can provide some details inside this. But, you're right. Decremental margins were in that mid-20s kind of percent. If you back out raw materials and then also the incentive comp and all these temporary cost control actions, we’re looking at decrements that are pretty consistent with what we would expect with this business including contribution margin and of course, that we have to cover some fixed costs. So, it looks to me like, that's going to be very consistent with we've seen before. Damon, if you want to add anything to that to dig inside those numbers, please do.

I believe that in the first half of FY21, our decreases were likely to be better than our average rates due to two main factors. First, we experienced a favorable shift in raw material costs, which we mentioned earlier, and second, we implemented temporary cost actions that should contribute to slightly above-average results. However, much of the outcome for the second half will rely on actual sales performance. Generally, we anticipate returning to our typical decrease patterns. As Chris indicated, we usually operate around a 40% leverage on average, plus some fixed cost absorption, which should remain unchanged barring any significant operational changes in the second half.

Thanks. And on that point Damon, looking at temporary costs in aggregate for fiscal ‘21, we should assume that they were slight negative for the year as a whole year-on-year, is that fair?

The way I see it, Julian, as Chris mentioned, we achieved savings of $0.40 to $0.45 in the fourth quarter, and if we also consider the savings from the third quarter when we began implementing furloughs, combined with some variable compensation, it brings us slightly above $0.50 for the latter half of the year. Currently, our temporary measures are estimated to save between $10 million to $15 million each quarter, so roughly $25 million for the first half, along with some additional savings from travel and other expenses. Overall, it will still present a challenge for the entire year.

That's really helpful. My second topic is regarding working capital. On slide 12, I noticed you ended the year with a primary working capital to sales ratio in the mid-30s. Given that, I was surprised to see on Slide 13 that working capital is a headwind in the first half. I would have expected that 30s ratio to decrease back towards 30% or so, especially since there's still a double-digit revenue reduction. Could you help us understand why working capital isn't acting as a cash tailwind in light of those two factors?

Yeah, I think Julian, so what we're looking at here in the first half is a couple of moving pieces. So one is we do expect inventory to come down in the first half of the year. However, as we talked about, we're going to see a significant reduction in the payables, given the reduced level of capital expenditures that will go through here in the first half. So the payables from your end of FY20 through the first half of FY21 is going to be a significant to reuse. And then if you look at the receivables given where we finish fiscal year ‘20 at, if you look at what Chris alluded to for the first quarter plus any sort of seasonal pattern, we would see in Q2, we would expect the receivables to be a use of cash. So between the AR and the AP, our expectations are that would offset the reduction in inventory we're seeing. So I would call it more of a modest use of cash in the first half based on that.

Great, thank you.

Our next question comes from Steven Fisher with UBS. Please go ahead.

Thanks. Good morning. The follow up on the temporary cost savings, how definite would you say is the transition from those being a savings in the first half to a headwind? And how confident or how definite is the timing around that? Curious on what the signals and triggers you need to see to bring those temporary costs back? And how long you need to kind of see those signals sustained.

It's going to basically be triggered by what we see the end market demand doing. If it gets worse, for any number of reasons we're all thinking about COVID-19 and those kinds of disruptions, if it starts to get worse that would be something that will trigger us to again, make sure that we're focusing on preserving our decremental margin performance and also liquidity. So it's really going to be largely dependent on how our end market demand materializes as we go through the first six months of the year.

Okay, that's helpful. And then on the new Widia strategy. I'm curious, what has changed that redirects customers' focus to make this work? And why is now the right time to do this?

Let me start with the current situation. When we examine the fit-for-purpose segment within Metal Cutting, we see that it's consistent among customers in areas such as aerospace, transportation, and general engineering. We have a strong market presence with customers using Kennametal tooling, primarily for specific high-performance applications where we can customize the tooling for maximum productivity. However, there are numerous applications within the same facilities where customers often overlook us for these fit-for-purpose tools, even though we offer them in our portfolio. Widia can serve this portfolio, but many customers are not considering us for these opportunities. Fortunately, with one organization, we have the capability to coordinate and collaborate, providing customers with the complete portfolio they require. We don’t need to reach out to entirely new segments as there's plenty of business within our existing customer base. However, to offer fit-for-purpose tools, we need to ensure high performance in aspects such as availability, consistency, and quality. Prior to modernization, we were lagging in these areas, which is one reason for the modernization initiative. Now, we believe our upgraded manufacturing process enables us to achieve the operational performance needed to target this market effectively. Additionally, given the current low demand, it’s an opportune time to approach customers who are preparing to ramp up, as they are all gearing up at the same time. Having Kennametal as an additional supplier to meet not just high-performance demands, but all their tooling needs, presents a significant opportunity for us to gain market share in the fit-for-purpose sector.

And so how quickly do you think this could start to have a material impact on flowing through the financials?

If we look at the voice of the customer, there are a lot of near-end opportunities that we can target. We have some refinement to do our product portfolio, but that will happen over time, but the existing product portfolio can actually bring us these opportunities right now. And one of the things we started to move in this direction when I put Ron Port in charge of commercial excellence for Metal Cutting. And that was really a way to take two organizations that are operating separately and bring them together at a point where we could actually go and target some of these customers. So we've actually already started with certain customers offering this capability. So we feel we can gain traction pretty quickly.

Our next question comes from Ann Duignan with J.P. Morgan. Please go ahead.

Hi, good morning, everyone. Regarding the video and Industrial strategy, when those businesses were separated, there were many questions about the strategic rationale behind it. I'm curious if Widia can truly compete on its own. Are you admitting today that this was a flawed strategy, and are you hoping to regain lost market share rather than trying to increase market share from scratch?

Thank you for the question. I would describe the situation this way. When Ron De Feo joined, he recognized some important factors. He assessed the technology behind the Widia portfolio and its brand recognition, and after speaking with customers, he saw significant potential. His approach was to establish a profit and loss framework and allocate resources to grow the brand and understand its dynamics. Now, we've transitioned to a strategy that combines the work done by the Widia team, who identified this fit-for-purpose opportunity. This is a logical progression from our previous evaluations of how to position this brand for growth. Initially, we were focused on avoiding competition between the two brands and identifying new opportunities. However, through this process, we've realized that rather than just one opportunity, there are actually two distinct ones available. I believe we might not have arrived at this strategy had we not started with our earlier assessments. Looking ahead, I see a 40% increase in opportunities compared to any targets we've set before. Many customers are eager for us to pursue this, even if they may have thought we weren't focused on it.

Our next question comes from Dillon Cumming with Morgan Stanley. Please go ahead.

Hey, good morning, guys. Thanks for the question. I guess starting off as you kind of released the channel inventory at the customer level, kind of curious who’s gotten a good sense across our end market mix as to where production rates are settling relative to pre-COVID levels? And I guess whether you’re kind of baking in any under production or de-stocking activity here in the first half of the year?

I think in terms of production levels, whether it be automotive or aero or really just about any end market, we haven't seen anyone return I guess yet to the pre-COVID production levels. And so, as a result of that, we also feel like some de-stocking will certainly continue. I think generally there's as we talk to customers, they may start to see demand, they start to see things through but they're really not necessarily going to go out and order a bunch of inventory or restock the inventory in the channels until I think they get a little bit further into this thing and see how it plays out. So we could see some more de-stocking for sure in the first quarter. And we’ll have to wait and see what happens in the second quarter and it could start to improve or it could be that they're just going to use that period of time to sort of stabilize their inventory and then decide what to do.

Okay, got it. Thanks Chris. And then maybe just to wrap it up, that's going to relate to the energy organic growth in the quarter. Obviously, no surprise business was going on with the recount, but I guess as we think about kind of post-COVID trends, is that a business that you see as more kind of structurally challenged going forward or the expectation that you can eventually grow that business back to pre-COVID levels? And I guess kind of related to that, it seems like you have some maturity and then when recently you called out, is there any potential there to kind of offset some of the legacy of oil and gas business share gains elsewhere?

Yeah, I think there are a couple of moving pieces. First of all, as it relates to Infrastructure and energy, we've been at this game for a long time. And we understand how to run the business in this sort of cyclical environment. A lot of the modernization products and things we've done, have helped to really lower the breakeven point of that business. So that we're in a better position to sort of weather the cyclicality. The other thing is that I think and we've talked about this on previous calls is, our energy exposure and Infrastructure is really in the U.S. And we brought in a new executive, Franklin Cardenas, who has a lot of expertise in running businesses internationally. And he's identified many opportunities I think to grow outside the U.S. and we're setting ourselves up to focus on that. And one example is in mining. We have a lot of exposure to Appalachian coal and that's all gone, a lot of that has been permanently reduced. But we can use that same tooling technology in other mining adjacencies and they happen to be outside the United States. So there's opportunity to grow there. And then, I would also say one of the technologies that we mentioned was in the earthworks area for road rehabilitation and road construction. So there are opportunities to grow some of the other spaces around this to give us some diversification if you will. And then, I think energy, as I said it's been largely focused in the U.S. but there are opportunities to grow in other regions. But I think the bigger opportunity is, we still have technology to bear in that space. There's still plenty of business there. A lot of the oilfield services companies are our biggest customers and they're still expecting us to advance our technology and looking for opportunities to still grow. So while it is cyclical, there are still opportunities for us to gain share even in the current configuration.

Okay, got it. That's helpful. Thanks for the time Chris.

Our next question comes from Joel Tiss with BMO. Please go ahead.

Hey guys, how's it going?

Hey, Joel.

I wonder if since as companies go under all this stress and anything coming out of that, that gets you to think about sort of the next round of restructuring and simplification or any product lines that may not be as strong as others or anything that kind of comes out of this experience, positive or negative.

In terms of portfolio shaping, we typically do this as standard practice. However, regarding the current environment, I don’t believe there was anything specific that led us to reevaluate our approach. It’s just good business practice, and we would engage in these activities regardless. One significant outcome of this crisis is that it has allowed us to expedite several initiatives. We've discussed how we accelerated our simplification and modernization efforts, pulling forward plans initially set for later in FY21 to take advantage of the current situation. This also entails making substantial changes to our manufacturing footprint in Europe, particularly in Germany, which can be challenging to implement. However, our workers’ council representatives have been very cooperative and open-minded. They understand the broader economic context, which has created a strong impetus for necessary changes. Thus, this situation has actually given us a platform to accelerate initiatives we intended to pursue anyway.

Okay, great. Can you provide any examples of how we are succeeding in the recovery compared to succeeding during the downturn? Other companies have mentioned strategies for being proactive and coming out of this situation stronger than we anticipated a year ago.

Yes. I believe that expanding into fit-for-purpose tools presents a significant opportunity for us. We've been discussing this with customers for quite some time. Prior to our physical consolidation, we assembled Ron Port and an ad-hoc team to engage with some of these customers in advance of the structural change. From that experience, we discovered that customers are very interested and perhaps a bit concerned about their need to ramp up quickly. They appreciate having Kennametal available not only for our usual offerings but also for new areas where we can support them, adding another substantial supplier to their operations. As everyone becomes busy, they want to ensure they have sufficient supply chain capabilities to facilitate a rapid ramp-up. This insight is valuable for us and represents a significant opportunity, which is why, although I didn't create COVID-19, if there were any benefits, this is a great chance for us to enter this market.

All right, thanks very much. You definitely cleared something up for us. We were all wondering if you were the one who created this illness. Thank you.

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

Hi, guys. Good morning. Just a follow up on the Widia change here. Is there going to be a change in the distribution strategy at all to execute this plan? And then can you also speak to the profitability implications from, it sounds as if you're shifting more towards mid-market or at least lower market than what you had been targeting before. Could you maybe share any thoughts on that?

Yes, our approach to distribution, we have a direct and an indirect model. And through simplification, we obviously kind of rebalance that thing. But we've also always said there, it wasn't a particular number we were looking for, like so much percent direct, so much percent indirect. Our philosophy there from a commercial excellence perspective is to look at a potential market segment or region and figure out how to get as much share as we can. And that requires the proper connectivity in the sales channel. So we'll continue to optimize the direct versus indirect equation based on that type of philosophy. In terms of the margin issue, I would just make one point first before I talk about it in more general terms is if there's a low-cost segment of that market, which is really provided by people that are just selling on price. There's not much of a value proposition to other than we've got the lowest price. And customers get what they pay for, and there's some customers that have a need for that type of area. But that's not an area that we're talking about. So there's still differentiation that can happen in this fit-for-purpose. And we had set some targets for margins for the Industrial and Widia segment in our Investor Day, some three years ago. And so the way we're looking at it is we believe that we can still grow in this fit-for-purpose segment, and still maintain those margin targets that we had set back at our last Investor Day. So this is not necessarily a just lower the price and get the business, it's a little more nuanced the risk value proposition that has to happen there, which is why we want to play in that space and not in the low-cost competing on price-only space.

Okay, I understand. Thank you. Returning to your comments on the first quarter, I know that visibility is quite limited. You mentioned that July sales were somewhat less disappointing. Could you provide more details on that? If the quarter aligns closely with typical seasonality, do you think you'll be able to stay profitable, or is that an unrealistic expectation?

In July, when looking at the numbers alone, we need to consider what that means in terms of transitioning from Q4 to Q1. The July figures, when viewed alongside the month-to-month trends we observed in Q4, suggest that many markets have stabilized or are showing slight improvements. Therefore, analyzing the July data in isolation may not provide much insight since there is a seasonal pattern within a quarter. It's important to view it in a broader context. Overall, the signs indicate some markets are improving while others are stabilizing. Regarding profitability, we are managing the company prudently through cost control. Our approach to planning for liquidity and ensuring that the company can withstand the challenges posed by COVID-19 involves continuing strong cost management. We are confident in our viability even if current volumes persist. We believe we will emerge from this situation eventually, but we are also preparing for a scenario where conditions remain challenging for a while to ensure the company's survival.

Okay, all right. Thanks.

Our next question comes from Andy Casey with Wells Fargo Securities. Please go ahead.

Thanks a lot. Thanks for squeezing me in and good morning, everybody. A couple more questions on this video repositioning. First, are the competitors in this incremental whitespace for Kennametal your traditional competitors or other companies? And then a couple other questions. Would these fit-for-use products go through a third-party kiosk or do they really require direct sales support to, as you put it, reshape customer opinion of your products? And then lastly, if direct sales, will you really be increasing your commercial presence or relying on the existing network of salespeople? And then do you expect SKU counting expansion to cover the market?

Okay. And you might have to remind me of all those questions. Let me try to knock them off here. In terms of the competitors, it would be the traditional competitors, I guess you could argue. So you've got Sandvik has some different brand segments that are targeting that fit-for-purpose, the IMC Group also does. So I think they're the traditional competitors. In terms of the direct versus indirect. Again, we're optimizing around. What is the best thing for that particular customer in that particular region? So the fit-for-purpose, a lot of small general engineering type of customers are in that sort of require that broader application portfolio, which is perfect for fit-for-purpose. So in that sense, a lot of that will be through distribution. But there are also a number of customers that are currently direct that we also sell that portfolio to, once they realize that we can make that kind of an offering. And Damon, what about the SKU count? I don’t have any comment on the SKU.

I don't see any significant change in the number of SKUs. As we progress through product lifecycle management and begin to introduce new products while retiring some older ones, you're not going to observe a significant change in the total number.

Okay, thank you very much.

Our next question comes from Walter Liptak with Seaport. Please go ahead.

Hey, good morning, guys.

Good morning, Walt.

Want to ask about just some of the trends that you might be seeing in the cutting tool metalworking markets. I think, from my perspective, as we were going into June, some of the virus cases were coming down and then things seem to have gotten worse here as we go into the summer. Are your customers kind of following that trend with maybe recoveries that are to happen, some green shoots and then with the viruses going out they’re pulling back and that resulting in some of the tone that we're hearing on the call today?

If I focus on transportation, especially in the Americas, the automotive companies appear to be dedicated to increasing their production. Despite a rise in COVID-19 cases, particularly in the U.S., they don't seem to be slowing down their efforts. I believe this holds true for aerospace and energy sectors as well. We anticipate that for aerospace, transportation, and energy, market demand will remain flat from Q4 to Q1. The situation is more reflective of macroeconomic conditions rather than them reducing their ramp-up efforts. In contrast, the general engineering sector, which includes smaller machine shops, might see some pullback as they adjust their production levels amidst rising case numbers. However, this seems to be driven more by macroeconomic factors rather than direct impacts from COVID-19. They are concerned about the situation and uncertain, which complicates their ability to make predictions beyond the first quarter. As a result, it’s challenging to extract definitive insights since many are unsure of the outlook.

Okay, thanks. I appreciate the color. Now, I wonder, early in the presentation, you talked about the long-term goals and how they're on track. I wonder if you could just review those for us and then maybe talk about the competitive situation. Has anything changed with your competitors or are they just similarly suffering through, the virus and the volumes going down? And as the markets heal up, at some point that the market returns to prior levels?

Yes, I'll address the latter part of your question first. Sandvik, being a publicly traded company, provides us with some insight into their current situation. The IMC Group, which is a larger competitor in metal cutting, is another source of competitive intelligence for us. In summary, all suppliers, including some of the smaller ones, are experiencing similar declines overall. We are all facing the same challenges and seeing comparable year-over-year downturns. In terms of our opportunities, we have concentrated our capital and management efforts on enhancing our manufacturing capabilities to regain competitiveness. This focus is critical, and we are determined to overcome obstacles in our path. Now, we are excited to leverage our improved capabilities in areas like fit-for-purpose tools. Throughout this period, the company has remained committed to investing in R&D and launching new products. We transitioned some of our engineering focus from transportation, where it was challenging to capture value, to aerospace, where there is better potential for value realization. Although the aerospace market is currently down and may remain so for a while, we believe this strategic shift was wise due to its promising long-term growth and improved profitability compared to transportation. As a technology-driven company, we will capitalize on our investment, taking advantage of our modernized operations that offer lower costs and enhanced performance. Coupled with a strong commercial and sales strategy, we believe there are significant growth opportunities ahead. We are fully engaged in this market and ready to capture market share.

Okay, great. Thanks. And just the goals again for EBITDA the target that you want to get to? And that's it for me. Thank you.

We have set an EBITDA target of 24% to 26% when sales reach approximately $2.5 billion to $2.6 billion. We remain quite confident that we will achieve these goals. In fact, we have already secured about $180 million in EBITDA savings, even with a lower volume profile than we initially expected when we established these targets. It's important to note that the $180 million is at the lower end of our total range. Taking all of this into account, I am very confident that we will meet our EBITDA targets once the volumes return.

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

Hi. Good morning.

Good morning.

Chris, first, just a clarification. Did Kennametal participate in this fit-for-purpose market in the past and exited, because of service levels or you've never been in that market, even though you have the tools in the portfolio?

Yes, I think that we've participated in a little bit. If you look at my diagram and the slides, it indicates that we've been sort of touching or skirting that area. But I think they really have largely focused on the performance end. And in fact, when you look at some of the acquisitions they've done over the years, including Widia, which was done quite some time ago, their strategy seemed to be to pull those brands into this performance segment. So we haven't really focused on it like we're setting the organization up to do now. Even though to your point we actually had product to penetrate that market.

Outside of imagining the short-term demand ramp, whenever that happens. Can you tell us again, what the competitive advantage is per video, given you'll be the new entrant into a market defined by established competitors?

Yes. We've been engaging with our existing customers and when we ask them why they aren't using our products, they say it's because we don't have offerings that fit their needs. They recognize us for our expertise in addressing challenging machining applications and providing reliable technical support. However, we do have a diverse portfolio that aligns with their interest in minimizing their supplier count. Customers trust Kennametal for high precision and well-defined processes that are critical in their manufacturing operations. They are open to allowing us to explore broader applications that still demand exceptional quality. They already see our capability to fulfill these demands; it's just that we haven't been top of mind for them in that area. This presents us with a significant opportunity. I believe gaining traction will be relatively straightforward since we already have a presence in their business; we won't need to pursue a vast number of new customers aggressively. While there will be some new customer acquisition, our current objective is to remove any internal barriers and let things progress organically, allowing customers to fully utilize our capabilities. With our unified organization and commercial excellence strategy led by Ron Port, we will be agile enough to seize these opportunities that already exist for us. We just need to position ourselves effectively to pursue them.

So, if you're selling some of the Widia tools into performance tools right now and you're going downstream for lack of a better word to fit-for-purpose, will that affect pricing on the current sales to the performance tool customers?

No, we need to be careful that doesn’t happen. In our pricing discipline process that we initiated in 2018, which is based on a value proposition, I believe those controls are in place. Therefore, simply lowering the price would not be beneficial and is not something we intend to pursue.

Yeah, I agree.

Yeah, and we're even going to price the fit-for-purpose based on value but, it's reasonable for customers to, when they look at the broader applications, there’s still a great value proposition. You got a tool that can cut three or four different metals. You don't have to buy a different tool for each specific type of metal. Now that may make sense in the performance and the things because that addition, that specialized tool gives you so much productivity on a critical part that it's worth it, but there’s still a great value proposition. And we only use one tool for multiple services, and we plan on pricing that accordingly.

Understood and one quick one Damon. Slide 13, do you expect to have positive free cash flow for FY21 after CapEx and cash restructuring?

Thanks Steve. I guess I would tell you, a lot of that it's going to depend on how the markets unfold. I think our sales, is going to be the biggest driver, as I look at what we tried to explain to you guys the areas on the chart that talk about cash flow between lower capital expenditures next year, lower cash taxes, higher depreciation, and slightly higher cash restructuring. Those numbers in total, are about $115 million better year-over-year. The bigger driver is going to be what the sales are for the full year and then what the corresponding impact is on working capital. But I'm going to leave that one to you.

Okay, thank you.

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

Thanks operator. Thanks everyone for joining the call. As I said, we really feel quite good about the progress we made this year, despite the challenging environment. And our efforts on simplification and modernization and cost controls as you can see from our numbers have allowed us to protect margins and put us in a good liquidity position. And also, we're focused on executing our strategy and preparing the company for growth as markets recover. So we certainly appreciate your interest and support for Kennametal and reach out to Kelly if you have any follow-up questions. Thank you very much.

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