Kennametal Inc Q2 FY2021 Earnings Call

Good morning. I would like to welcome everyone to Kennametal's Second Quarter Fiscal 2021 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. Please go ahead.

Thank you, operator. Welcome everyone and thank you for joining us to review Kennametal's second quarter fiscal 2021 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; and Damon Audia, Vice President and Chief Financial Officer. After Chris and Damon's prepared remarks, we will open the line for questions. At this time, I would like to direct your attention to our forward-looking disclosure statement. Today's discussion contains comments that constitute forward-looking statements and as such, 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 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.

Thanks, Kelly. Good morning everyone and thank you for joining us today. I'll start today's call with some general comments and a brief review of the quarter and then discuss our expectations for Q3 and our strategic initiatives. Damon will then go over the quarterly financial results in more detail. And finally, I'll make some summary comments before opening the call for questions. Beginning on Slide 2 in the presentation. We recorded a strong margin improvement and free operating cash flow this quarter, despite ongoing year-over-year market headwinds. These solid results were driven by improving sequential sales, reflecting both market improvement and growth from our strategic initiatives, as well as increasing benefits from simplification and modernization. Sales this quarter increased sequentially by 10%, outpacing the 1% to 2% increase from Q1 to Q2 that we typically see. Transportation and general engineering end markets, although still declining year-over-year, continue to show the highest levels of recovery. As a reminder, those two end markets totaled more than 65% of our sales. Energy and aerospace, as you know, continue to be challenged. On a year-over-year basis, organic sales declined 14% on top of a 12% decline in the prior year. However, through disciplined execution of our strategic initiatives and cost control actions, we were able to improve profitability, despite the drop in volume and associated under absorption. Adjusted EBITDA margin improved by 160 basis points to 13% versus 11.4% in the prior year quarter. The year-over-year improvement in EBITDA margin was driven by lower raw material costs, increasing benefits from simplification and modernization, and effective cost control actions. Operating expense as a percentage of sales increased year-over-year to 22% due to lower sales; however, in dollar terms, it decreased by 9%. Our target for operating expense remains at 20%. Adjusted EPS of $0.16 was essentially flat versus $0.17 in the prior year quarter, reflecting the factors I just mentioned. Looking ahead, visibility in this environment continues to be limited. However, there are some reasons for optimism, such as recent end market momentum and some modest indications of restocking as well as the early stages of the vaccine rollout. Nevertheless, with possible additional shutdowns being contemplated in some regions due to recent spikes in COVID-19 cases, it remains difficult to forecast how end markets and our customers will be affected. Therefore, similar to the last couple of quarters, we will not be providing a full year outlook for fiscal year '21. However, I will provide some color on what we expect in the third quarter. Based on monthly sales in Q2, early indications from our January sales, and assuming that there are no additional significant COVID-19 related shutdowns in the quarter, we expect Q3 sales to see mid to high single digit growth sequentially, with part of the sequential sales growth coming from foreign exchange. We expect the underlying organic growth, excluding the effect of foreign exchange, to be in the mid single digits, which is modestly above our typical sequential growth pattern of 3% to 4%. But regardless of the pace and trajectory of the recovery, we will continue to focus on the things we can control, such as executing our operational and commercial excellence initiatives to gain share and improve profitability levels throughout the economic cycle. On the operational excellence side, simplification and modernization initiatives delivered $23 million this quarter, a 117% year-over-year increase, and are on track to deliver approximately $80 million in benefits this year as expected. As a reminder, we expect to complete our original footprint rationalization activities with the closure of the Johnson City, Tennessee plant and downsizing the Essen, Germany plant by the end of this fiscal year. Total cumulative savings from the inception of the program are expected to be 180 million by the end of this fiscal year, which is within the original target range we laid out in December 2017, and will be achieved despite much lower volume levels than originally planned. This is a major accomplishment and sets us up well for the recovery. Capital spending associated with simplification and modernization is essentially complete and as such will result in more normalized CapEx levels going forward. Total CapEx is expected to be between $110 million and $130 million this year, a 50% reduction year-over-year. Free operating cash flow was $29 million for the quarter, bringing the year-to-date figure to approximately breakeven. This was excellent performance by the team as they remained focused on working capital without compromising customer service. Based on the year-to-date performance and current second half outlook, we now expect positive free operating cash flow for the second half and total year, which Damon will go into more detail on. As you recall, at the end of fiscal year '20, we announced two important changes as part of our commercial excellence strategy. First, the combination of our two metal cutting business segments to better direct our commercial resources, products, and technical expertise on capturing a larger share of wallet. And second, repositioning the WIDIA brand and portfolio to address the multi-billion dollar fit for purpose application space within metal cutting that we had not previously focused on. This approach opens up a 40% increase in served market opportunity while offering better service and tooling options for our customers. Overall, progress on these initiatives is tracking with our expectations and I'm very encouraged by the wins we are seeing in fit for purpose applications as we roll the program out globally. Please turn to Slide 3. We presented this slide on the last earnings call and have updated the graphs to reflect this quarter's results. As a reminder, the last time the company experienced the sales decline close to the one we are currently experiencing was during the Great Recession in 2009. Graphs show trailing 12-month sales on the left and the corresponding adjusted operating margin on the right. As you can see, we have been able to maintain significantly higher levels of profitability throughout this downturn. And in this quarter, the 12-month profitability level is approximately the same but on much lower revenue. This is due to the benefits of simplification and modernization that we've already captured, combined with stronger and more timely cost control actions. Two additional points to note. First, the present day numbers do not yet include the full run rate effect of simplification and modernization. We are anticipating an additional approximately $40 million in savings by the end of this fiscal year. And secondly, we have not yet exited the downturn. The previous downturn lasted about five quarters. This downturn has already lasted seven quarters. And we are just now starting to see early signs of recovery. In summary, I'm very encouraged by these results. We have maintained higher profitability throughout this downturn and are well-positioned to outperform as markets recover due to the initiatives we've executed over the last several years. And with that, I'll turn the call over to Damon who will review the second quarter numbers in more detail.

Thank you, Chris, and good morning, everyone. I will begin on Slide 4 with a review of Q2 operating results both on a reported and an adjusted basis. As Chris mentioned, the sequential performance of our sales outpaced our expectations and the typical seasonal pattern. On a year-over-year basis, total sales declined 13% and 14% organically. Foreign currency and business days each contributed approximately 1%, and a business divestiture had a negative effect of 1% in the quarter. Adjusted gross profit margin of 28.2% was up 140 basis points year-over-year. Adjusted operating expenses of $98 million were down $10 million or 9% year-over-year. Adjusted EBITDA margin of 13% was up 160 basis points from the previous year quarter. Sequentially, despite rolling back many temporary cost control actions in the quarter, which should have amounted to close to $10 million, our adjusted EBITDA margin improved by 170 basis points due to the improving market conditions and continued simplification and modernization savings. Adjusted operating margin of 5.3% was up 50 basis points year-over-year and 240 basis points sequentially. The improved year-over-year performance in our margin was primarily due to the positive effect of raw materials as expected, which contributed approximately 590 basis points, incremental simplification and modernization benefits, and temporary cost control actions partially offset by lower volumes and associated under absorption. The adjusted effective tax rate in the quarter was 24.7%, lower year-over-year due to the effect of higher pre-tax income and geographical mix. Our current expectation is for the adjusted effective tax rate for the fiscal year to be approximately 30%. Longer term, we continue to expect our adjusted effective tax rate to be in the low 20% range as profitability levels increase beyond fiscal year '21. We reported a GAAP earnings per share of $0.23 versus an earnings per share loss of $0.07 in the prior year period. On an adjusted basis, EPS was $0.16 per share versus $0.17 in the prior year. The main drivers for our adjusted EPS performance are highlighted on the bridge on Slide 5. The effective operations this quarter amounted to a negative $0.20. This compares positively to both the negative $0.62 in the prior year quarter and the negative $0.28 last quarter. The largest factor contributing to the $0.20 was the effect of lower volumes and associated under absorption, partially offset by positive raw materials of $0.25 and temporary cost control actions. The negative effect of operations this quarter was basically offset by $0.19 or $23 million of benefits from simplification and modernization, a significant increase from $0.10 in the prior year quarter. This brings the cumulative benefits of simplification and modernization to $145 million since inception. As Chris mentioned, our expectation continues to be that simplification and modernization benefits for the total year will be approximately $80 million driven by actions already taken or announced, bringing the total expected cumulative savings to $180 million by the end of fiscal year 2021. Slides 6 and 7 detail the performance of our segments in this quarter. Metal cutting sales in the quarter declined 14% organically on top of a 10% decline in the prior year period. All regions posted year-over-year sales decreases with the largest decline in the Americas at negative 20%, followed by EMEA at 12% and Asia Pacific at 6%. Sequentially, however, we saw improvement across all regions. The performance in Asia Pacific relative to other regions reflects more positive economic activity led by China, which was flat year-over-year and an improvement in India, which was down low single digits. From an end market perspective, we experienced the best performance in transportation and general engineering, which declined 4% and 12%, respectively. Energy declined 18% year-over-year with the declines in the oil and gas portion of the energy end market more than offsetting continued strength in renewable energy, mainly in Asia Pacific. Aerospace continues to be our most challenging market, with sales down 43% in Q2, as COVID-19 continues to affect production levels and air travel. Sequentially, the increase in metal cutting was mainly driven by the transportation and associated general engineering end markets. Adjusted operating margin of 6.1% was down 280 basis points year-over-year but well above the 1% we experienced in the first quarter. Year-over-year decrease was primarily driven by a decline in volume and mix, partially offset by incremental simplification and modernization benefits, temporary cost control actions, and raw materials that contributed 230 basis points. Turning to Slide 7 for infrastructure. Organic sales declined 14% on top of a 14% decline in the prior year period. Other factors affecting infrastructure sales were a divestiture of 1%, partially offset by a benefit from business days of 1% and foreign exchange of 1%. Regionally, again, the largest decline was in the Americas at 18%, then EMEA at 12%, followed by 1% growth in Asia Pacific. By end market, the results were primarily driven by energy, which declined 24% year-over-year, due mainly to the roughly 60% decline in the U.S. land only rig count. Sequentially, our sales in the energy end market improved as customers increased their orders with the increasing rig count. Earthworks was down 10% year-over-year, driven by underground mining and construction weakness in the U.S. General engineering was down 7% year-over-year, an improvement from the 14% decline we experienced in Q1. Adjusted operating margin of 4.4% was up 620 basis points year-over-year. This increase was mainly driven by favorable raw materials, which contributed 1,230 basis points as expected, simplification and modernization benefits, and temporary cost control actions, partially offset by lower volumes and associated under absorption. Our expectation is that raw materials will be neutral year-over-year for Q3 and Q4 given that tungsten prices have been relatively stable for around six quarters. Now turning to Slide 8 to review our balance sheet and free operating cash flow. We continue to believe that maintaining a conservative financial profile is appropriate to ensure the company has ample liquidity, particularly in this environment, as well as the ability to continue to execute on our strategy. Our current debt profile is made up of two $300 million notes, maturing in February of 2022 and June of 2028, as well as the US$700 million revolver that matures in June of 2023. At quarter end, we had $25 million outstanding on the revolver with combined cash and revolver availability of approximately $780 million, and we were well within our financial covenants. Primary working capital decreased year-over-year to $638 million given our continued focus on inventory. On a percentage of sales basis, primary working capital increased to 37.3% as sales remained depressed. Our target primary working capital to sales ratio remains at 30%. Capital expenditures were $29 million, a decrease of $46 million from the prior year as expected as our capital spending on simplification and modernization is substantially complete. Year-to-date, we have spent $69 million and continue to expect capital expenditures for the year to be in the range of $110 million to $130 million. Free operating cash flow for the quarter improved year-over-year to $29 million. Sequentially, free operating cash flow also improved due to lower CapEx and stronger profitability. Year-to-date, our free operating cash flow is approximately breakeven and $59 million more favorable compared to last year. Consistent with prior quarters, we've paid the dividend of $17 million. The full balance sheet can be found on Slide 13 in the appendix. Before I turn the call back over to Chris, I want to discuss the FY '21 EPS and free operating cash flow drivers for the second half. Please turn to Slide 9. As a reminder, this slide details how we expect key factors to affect EPS and free operating cash flow. The slide has been updated to show how these factors will affect the second half on a year-over-year basis and highlights meaningful sequential differences where appropriate. Starting with simplification and modernization. As we already mentioned, we expect to achieve benefits of approximately $80 million in FY '21, which implies around $40 million of incremental year-over-year savings in the second half. Temporary cost control actions, unlike in the first half, will be a significant year-over-year headwind of $50 million to $55 million, with $40 million to $45 million in the fourth quarter. These headwinds are reflective of the aggressive cost control actions implemented last year that are not expected to repeat this year. Given the phase-out of cost control actions in the second quarter, Q3 will face a sequential headwind of approximately $10 million relative to Q2. Due to the significant level of temporary cost control actions in place last year in the second half, the year-over-year leverage will be distorted and may not accurately reflect the underlying improved operational performance. Based on current material prices, particularly tungsten, we do not expect raw material to have a material effect either year-over-year or sequentially in the second half. Although depreciation and amortization were only modestly higher year-over-year in the first half, we still expect them to be approximately $10 million higher for the full year as new equipment comes online. Lastly, for the EPS drivers, we have lowered our adjusted effective tax rate expectations for fiscal year '21 to approximately 30% from our previous estimate of 33%, which was also the effective tax rate last year. This improvement is reflective of the higher pre-tax income and geographical mix. In terms of free operating cash flow drivers, as Chris and I have already mentioned, capital spending for the year is expected to be in the range of $110 million to $130 million. This implies lower CapEx both year-over-year and sequentially in the second half. We expect cash restructuring to be slightly higher both year-over-year and sequentially in the second half. And we now expect the full-year cash restructuring to be higher by $20 million to $25 million versus the approximate $40 million spent in FY '20. This represents a modest decrease versus our original expectation. Given our strong inventory reductions year-to-date and continued improving market conditions, we now expect working capital to be a modest use of cash in the second half. With our focus on working capital, combined with the improved market conditions, we now expect free operating cash flow to be positive in the second half and the full year. Finally, as it relates to Q3, as Chris mentioned, we expect sales to be up mid to high single digit sequentially, with part of the sequential sales growth coming from foreign exchange. We expect the underlying organic growth, excluding the effect of foreign exchange, to be in the mid single digits and above our typical sequential growth pattern of 3% to 4%. And with that, I'll turn the call back over to Chris.

Thanks, Damon. Turning to Slide 10, let me take a few minutes to summarize. I'm encouraged by our results this quarter, despite the ongoing challenges in our end markets. Our commercial excellence initiatives are progressing well to drive growth and market share gain, and our operational excellence initiatives are on track with simplification and modernization nearing completion. As shown in the margin graphs earlier in the presentation, the benefits of these initiatives, which we began three years ago, are evident with more benefits to come as volumes return, further reaffirming our expectation that we will meet our adjusted EBITDA target of 24% to 26% when sales reach the targeted range of $2.5 billion to $2.6 billion. The strength of our balance sheet and cash flow allows us to continue to optimize capital allocation while further improving profitability and customer service throughout the economic cycle. And with that, operator, please open the line for questions.

We will now begin the question-and-answer session. The first question today comes from Steve Volkmann of Jefferies. Please go ahead.

Great. Thank you, guys. I appreciate the question. So, Chris, you talked a little bit about some modest restocking that you were seeing. And I think you also said something in your prepared remarks about how January had started off fairly well, but I don't want to put words in your mouth. I'm just hoping you could maybe give us a little bit more color on kind of what you're seeing sequentially through the quarter into January and whatever restocking might be sort of poking its head up, would love to hear about that? Thanks.

Sure, Steve. Good morning. In terms of the stocking level in my comment, I said we saw modest evidence of that. And that was primarily in Asia Pacific and China where there was clearly some restocking going on. But as it relates to the Americas, we're just sort of seeing some month-over-month improvement in stocking orders. And in EMEA, we haven't really seen anything. So I think my key takeaway here is that we're starting to see modest restocking activity. But, Steve, customers still remain cautious. So I don't think it's really in a meaningful way other than what I said in China. But as you know, regardless of the customer inventory levels, we're managing our inventory to be able to take share in this recovery by having this sort of high value, high mover parts in inventory. And then we've also moved to this sort of weekly sales and operation planning meeting to allow us to react quickly to any changes in the demand signals. As it relates to sort of January activity, I think it's safe to say we've seen an uptick in sort of the average daily sales versus kind of the average that we saw in December. And it's consistent with the sort of that mid single digit that we told you, excluding foreign exchange, for growth in the quarter.

Great. Okay. I appreciate that. And then just on the energy specifically, the rig counts look like they've kind of turned up a little bit. How long until that sort of flows through into your business do you think?

As it relates to energy, the good news is we are seeing an uptick in the rig count. And that will equal some modest growth, but frankly, we're on such a low base in the Americas that we're thinking that we're going to see some growth there, but not a huge amount. So it might start to benefit maybe in the fourth quarter, Steve, but maybe not so much in the third quarter. That takes maybe three to six months for that to kind of flow through to us, if you will.

Okay, fair enough. I appreciate it. I’ll pass it on.

The next question is from Julian Mitchell of Barclays. Please go ahead.

Hi. Good morning. Maybe just the first question trying to understand in the infrastructure business what happened with the margins just trying to understand sequentially. Those were down despite modest revenue increase. So just wondered if you could help us understand sort of what the main headwinds were there sequentially? And then when we're thinking about the second half operating leverage in that business off the higher revenues, what kind of placeholder should we have for that?

Julian, I think I'll comment on the sequential decline. Then, Damon, maybe you can focus on the operating leverage and add anything that you like. But as you point out, infrastructure had a slight increase in sales sequentially. But as we – Damon talked about these temporary cost actions that came off, that had a big effect as well as some of the variable comp elements. And frankly, there was a bit of a mix issue. The oil and gas was a profitable business, and as that declined even further from Q1 to Q2; that also drove some of that decline. And all that was partially offset by better manufacturing performance, volumes, and raw materials. So we saw a decline, unlike we did in metal cutting, because it was largely dominated by those temporary cost actions and a little bit of mix.

I would add for infrastructure for the quarter as we did have a slight increase in environmental reserve that you'll see in our 10-Q added probably about a little bit over $1 million of cost in the quarter. So that would have influenced the margin a little bit as well. To your question about the second half leverage, Julian, as I alluded to in my comments, I think looking at leverage in the second half is going to be very challenging as you think about the year-over-year changes of the temporary cost increases flowing back in. As we've said in the past, historically, our average leverage is around 40%. Metal cutting usually is above that, infrastructure is slightly below that, plus some fixed cost absorption. But again, I would just sort of caution you, as of second half here with all of these changes, the implemented cost control actions last year really skew it when you try to do it in a year-over-year basis this year.

Got it. Thank you. And maybe looking at metal cutting, perhaps that's a bit simpler in terms of that operating leverage point. When we're looking year-on-year in that piece, do you think we can get closer to that, maybe not 40% as such, but closer to sort of 30% year-on-year leverage as you see the revenues start to return to growth during the second half?

I think in the second half, we have $50 million to $55 million of cost headwinds coming back year-over-year. As you consider the improvements we're discussing with sequential sales growth from Q2 to Q3, and hopefully something better in Q4, this will still be affected by the level of cost control actions we implemented last year that won't happen again in the second half. Therefore, I'm not optimistic that the year-over-year leverage calculations will reflect our previous downtrend for recoveries, considering what we did last year and the year-over-year changes. It's difficult to provide a specific answer because I don't think the numbers will look promising on paper, given our past cost control measures.

And I might add, maybe an easier way to look at it is sequentially. Sort of the way I think about the margins is they're going to be pretty similar to what we saw in Q2, because we've got this sort of mid single digit sequential growth, excluding foreign exchange. And you said a bit levered at 50% I think was kind of your number. And we've got some additional simplification and modernization benefits, got to take off at $10 million headwind on cost actions. And there's a little bit more depreciation in the third quarter than we had in the second quarter. And so all that gets you sort of in the neighborhood of what we saw in Q2. That may be an easier way to look at it.

That's very helpful. Thank you.

The next question comes from Ann Duignan of JPMorgan. Please go ahead.

Yes. On metal cutting also I think you said that mix was a negative, which surprises me given that automotive or transportation and general engineering are such a significant portion of your sales. So, could you just talk about that? Is it also energy is higher margin or are either automotive or general engineering particularly low margin businesses?

Ann, when I was talking about mix, I was talking about the infrastructure business. The oil and gas business is higher profitability than metal cutting.

I believe, Ann, our mix had a negative impact on us compared to last year. If you consider the markets that declined the most, aerospace, which we have mentioned is one of our most profitable markets, fell by 43% year-over-year. Transportation, which we shifted away from during our portfolio simplification due to its lower profitability, turned out to be the best performer. So when looking at the year-over-year changes, it's clear that the decline in aerospace was significant. Energy, which is a higher profit margin area for metal cutting, also experienced an 18% decline. Therefore, while there was a mix effect in metal cutting, it was primarily the end market mix that contributed to the decline.

Okay, that's helpful because it was specifically metal cutting in the opening remarks, but you called out lower volume and mix. I just wanted to make sure I understood that. And then China's sales flat year-over-year. There's really been no end market in China where we've seen flat year-over-year. And I think you said there was some restocking in the region, maybe again not specifically metal cutting. So could you address that? Are you losing market share? Is there anything we need to know about why your sales in China were flat?

Yes. In Asia Pacific, China in terms of transportation, we did see an uptake in transportation business there. And also energy, which is around wind turbines, was an increase. So when I was talking about flat, we think that is sort of driven to the markets recovered pretty well. But we're expecting it to maybe improve just a little bit better, but not significantly beyond what it's already done.

And I think, again, comparing every company is a little bit different. But the mix of what we have in Asia, as Chris alluded to, we did see good growth in automotive. Our transportation and energy, aerospace, which is a good part of the business there in China was down significantly, I think down a very high percentage. So again, for us, that was probably again a negative mix issue in China, which led us to be about flat year-over-year.

Okay, yes, because you did specifically say China was flat. So I just wanted to make sure I understood that. Okay, that's my question, my follow up. I appreciate it. I’ll get back in the queue.

The next question is coming from Ross Gilardi of Bank of America. Please go ahead.

Good morning, guys.

Good morning, Ross.

I was just wondering if we could just talk about your capacity a little bit and just how you're thinking about the right amount over the next cycle. You talked about EBITDA margin targets getting back to being achieved, your EBITDA margin targets being achieved when you get back to $2.5 billion to $2.6 billion in revenue, which was the peak in 2012, '15. I think it's clearly debatable as some of your end markets get back to those levels, particularly on the infrastructure side. So my question is really how much revenue do you think you're capacitized for on a normalized basis over the cycle? And if you come to the conclusion that the next peak is going to be below that $2.5 billion to $2.6 billion, how would you address capacity?

So, Ross, the way we're thinking about the capacity is, as you know, we've done a lot of footprint consolidation that resulted in about seven plants as part of our original program. So the size of the capacity at the low end of the volume, we think that because we've modernized the factories and have taken a huge amount of labor out, that coupled with being able to do furloughs or using temporary workers in the U.S., we think that our capacity as it sits today is actually sized for what turns out to be one of the all-time cycle lows that we've seen. We've been able to actually do better in this down cycle than we have in the previous Great Recession, if you will. So I feel pretty good about our sort of low end capacity and being able to flex with that. And then because a lot of this is automated, we also feel good about our ability to ramp up. So I think we've protected ourselves on the downside and we're positioning ourselves to be able to ramp that capacity up at higher volume levels. That's the way I see the current footprint.

Okay, got it. Thank you, Chris. And then maybe you could just talk about raw material costs just a little bit beyond the second half. It really didn't have a lot of visibility right now, but we've seen pretty dramatic spikes in a lot of industrial metals and tungsten and cobalt are a little bit harder to follow from the outside. But what are you thinking there? And do you have the ability to stock up on additional raw material going into fiscal '22 in the event of a spike, and is that a potential risk to just the margin recovery beyond the second half of this year?

The main material driver for us, particularly on the infrastructure side rather than metal cutting, is the APT. Prices have been relatively stable, ranging from $210 to $240 over the last six quarters, with an average of around $220 in Q2. We anticipate a slight increase in that, which typically indicates a rebound in demand. This is a positive sign for us. Historically, our company has demonstrated the ability to effectively manage price raw calculations for both infrastructure and metal cutting, adjusting as needed from quarter to quarter. I believe that rising APT prices signal increased demand, and I am confident in our capacity to navigate that cycle, whether that means passing costs onto our customers or not. We do not usually stockpile raw material inventory in advance. For infrastructure, we have numerous oil and gas contracts that provide indices, which protects us as those prices rise. Any fluctuations in APT prices have been manageable, and we have successfully transferred those changes to our customers, as is customary in the industry.

Thank you.

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

Good morning, guys. I want to ask about the temporary costs and make sure that we understand fully how these temporary costs are coming back. So I wonder if you can split the costs returning in the third quarter and fourth quarter. And then maybe talk about the first half of 2022 a little bit. Are there more costs that are going to be coming back then?

Yes, Walt. So we said there will be about $50 million to $55 million of incremental cost headwinds year-over-year, and about $40 million to $45 million of that would sit in Q4. So that – let’s call it about $10 million of the headwind in Q3. That's your year-over-year for the back half of this year. As we look at the first half of FY '22, we will see again first half of FY '22 headwinds due to the first half cost actions that we had in place here in Q1 and Q2 of FY '21, and those are around $15 million or so per quarter. So I think it was around $15 million in Q1 and maybe just a little bit less than that as we started the roll-off of some of those temporary cost actions here in the second quarter. So let's call it $25 million or so of incremental cost headwinds in the first half of '22 versus the first half of '21. And then all else being equal, we should be neutral year-over-year in Q3 and Q4 of '22, assuming there's nothing that we do in the balance of this fiscal year.

Okay, great. And I want to switch topics and talk a little bit about Europe. And I think you made a comment in the opening remarks that Europe is still pretty down. I wonder if you can talk about some of the recent trends. And as they begin to reopen with vaccines coming out, what you're expecting for inventories and for production going up?

EMEA is generally flat. In the engineering sector, we anticipate a possible improvement as things begin to recover, but there is still some uncertainty regarding potential shutdowns. If those do not occur, we expect to see an increase from Q2 to Q3 in general engineering, while aerospace and energy are likely to remain stable at their current levels. Additionally, we believe transportation will also stay flat at least through Q3.

Okay. All right, great. Thank you.

The next question comes from Ronny Scardino of Goldman Sachs. Please go ahead.

Hi. Good morning, guys. Thanks for taking the questions. So just a clarifying question. If I heard you correctly, you mentioned Q3 in the neighborhood of Q2. Was that a margin comment or an EPS comment?

Margin comment.

Got it. Thank you. And then are there any puts and takes we should just keep in mind in Q3 versus Q2 outside of what you already outlined on temporary cost and material inflation side?

No. I think as Chris said, we'll pick up incremental EBIT related to the volume that he's alluded to. So again, the mid single digits when you adjust for FX, improving the overall EBIT, but directionally speaking that would be offset by the sequential increase in costs as these temporary cost actions have rolled off now at the end of the second quarter.

Got it. Thanks, guys.

The next question comes from Dillon Cumming of Morgan Stanley. Please go ahead.

Great. Good morning, guys. Thanks for the question. First, I just wanted to kind of frame some of the comments you made around fit for purpose. You mentioned the positive feedback from the distributor channel. But I guess more tangibly, it actually looks like you've managed to narrow the gap on organic growth versus one of your larger competitors. So I'm just wondering whether you think that's a result of some of the fit for purpose efforts or if there's some other kind of share dynamics going on there?

Yes. When examining the share in any given quarter, it's important to consider it over a longer timeframe. The share can fluctuate, especially in the current market situation. However, we are concentrating on the fit for purpose segment, which represents about 40% of the metal cutting market that we have not addressed before, and it's right within our existing customer base. Many of our customers, particularly those purchasing Kennametal tooling, are looking for high-performance tooling from us. Even though they had fit for purpose applications at their factories, they didn't previously seek us out for those needs. Now, with the repositioning of the WIDIA brand and the integration of our two organizations, we are presenting ourselves as capable of meeting their entire application requirements, and we are beginning to win a significant amount of new business. Customers are reaching out to us for needs they hadn't considered us for in the past. We are very encouraged by the results we're seeing. As we implement this strategy globally, we have identified promising opportunities in France and Spain with existing customers who are now looking to us for these fit for purpose solutions. Initially, they were interested only in our high-performance offerings, but now we're capturing a larger share of their spending. This improvement is a clear indication that we are gaining market share. We have received excellent feedback from our distributors. Our refined brand strategy brings the full Kennametal product line to our customers, which is beneficial for both our channel partners and our clients. We are optimistic about the momentum we are generating. As the organic growth figures come in, they will increasingly reflect the progress we are making with fit for purpose offerings.

Okay, got it. It’s helpful color. Thanks, Chris. Maybe just an end market question to wrap up here. Just wanted to level set what you're seeing in earthworks between the underground mining business and construction. It feels like some of your construction customers have started to sound a bit more positive on kind of where calendar '21 is going to shake out. So first of all, it's one to kind of triangulate where the more acute pressure is within earthworks. And then onto that, you've mentioned before you wanted to start getting more into the international opportunities in the mining side. I'm just wondering if you can kind of update us on your efforts there.

I would just start with sort of broadly, mining from Q2 to Q3 we expect to be sort of flat across all regions and production flat across all regions. But let me just maybe make some deeper comments on construction. Like I said, expected to be flat but the road continues to be affected basically by state budgets and COVID-19. So, that is sort of putting a damper on some of the road projects. You can't physically get on site or the states are running out of budget. So that's what's kind of going on there and that we think will persist at least through Q3. And in terms of mining, as you know, we're tied to metallurgical coal, which is more stable than thermal. And there does seem to be an uptick in global surface mining. Regionally, we think EMEA is fairly stable in this area. China's rebounded from COVID. But there is trade conflict with Australia and U.S. that’s affecting some of the market dynamics. And Americas has rebounded somewhat off the bottom. Appalachian coal was down I think around 19% year-over-year. But it's expected to recover by Q4. So those are sort of the high levels on the current business. And then, as you said, we also wanted to move internationally to get some good traction in places like South Africa in that regard. And then also we were expanding into mining adjacencies and that actually is starting to get some good traction, where we're trying to use our tooling portfolio that's well-suited for coal, if you will, with similar materials such as potash and we continue to get traction there.

Okay, great. Thanks for the time, guys.

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

Hi, guys. Good morning.

Good morning.

I wanted to go back to the discussion about working capital. Earlier you mentioned it’s going to be a use of cash in the second half of the year I think modestly. But beyond that, how should we think about working capital as we get further into a sustainable revenue recovery, given all the investments that the company has made in the factories in processes, any kind of metrics that you could share with us along those lines?

Our target is still around 30%. As Damon mentioned, we anticipate a modest cash use in the second half. Therefore, we may remain above that 30% until buyers return. However, we are continuously exploring ways to enhance our primary working capital, one of which is optimizing our footprint. This reduction will be beneficial. Additionally, we are still in the process of modernizing many of our factory operations. As these improvements take effect and we become more efficient, we believe this will positively impact working capital, especially for finished goods inventory, since it will shorten manufacturing times and also affect work in progress. While 30% is our target, I am confident that with our modernized factories, we can improve beyond that, and this is what we are aiming to achieve.

Okay, got you. And then can you remind us how we should expect the cadence of modernization savings to kick in over the next year or two? I know there's a big chunk of that's going to be dependent on volume. But I'm curious if you have any updated thoughts to share along those lines.

Yes. So I think, Adam, we've done just over $40 million year-to-date. What we said is we’ll be just around another $40 here in the back half year-over-year. We haven't given any specific numbers for FY '22, but there are actions that we have put in place this year or that we are yet to put in place like the closure of Johnson City that will drive incremental savings in FY '22 and beyond. And to your point, as volumes ramp up from where we are today, there we’ll drive an incremental savings beyond just the plant closures and other actions that are currently in place. But we haven't given any specific numbers as to how big or what more that would contribute to the bottom line, other than to say by the end of this year we're going to be at $180 million. And we have given you a range of $180 million to $220 million based on certain revenue. So you can start to see that there's probably more savings that will come as volumes continue to pick up here hopefully in FY '22 and beyond.

Okay. Thank you.

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

Great. Thanks. Good morning. Can you guys just remind us of how much of the general engineering market is driven by automotive and demand and the extent to which you're seeing any broadening of that end market that’s recovering really versus just automotive? It seems like automotive has been a nice big driver here. Is that broadening out within general engineering?

You're absolutely right. The increase in general engineering that we've seen is in large part we think is driven by transportation. So transportation saw a nice increase from Q1 to Q2 and most of the manufacturers have kind of returned to sort of pre-COVID levels and they’ll probably stay there for Q3. We'll see some trickledown effect continuing in general engineering. But so far, Steven, we haven't actually seen sort of a broader recovery in that space quite yet. And that's part of what's governing our expectations for Q3. We're hopeful that it's going to improve, especially as GDP starts to return and the economy starts to return to normal with the vaccine. But the timing of that is still a little bit uncertain. But you're absolutely right. It's been largely driven by transportation. We’ll have to see what happens in the broader sense.

Got it. And then just bigger picture here longer term, obviously volumes are a very critical factor to your model. So just kind of high level as we think about the potential for getting to that $2.5 billion or so of revenues that really drives the margin upside, how much do you think you can do from a growth perspective on company specific initiatives versus what you're going to be relying on market growth for?

Yes. I think it depends on how quickly the markets recover. In our strategic planning, we view the market as something we can't control, and we have various models for how these businesses recover from cycles. We are challenging ourselves to capture market share. While we are focused on and pleased to see the market rebound, our primary goal is to gain that market share. It wouldn’t surprise me if there's a 50-50 split based on the timeframe we’re discussing. Our daily objective is to gain market share and not just react to market fluctuations. Of course, it’s a cyclical business and market movements will impact our numbers. However, we can mitigate that impact by increasing our share and ensuring we maintain a higher share regardless of where we are in the cycle.

Very helpful. Thank you.

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

Hi. Good morning, guys.

Good morning.

I know it's tough to call here in January, but when you look at the Q4 revenue comp of negative 37% just in the context of the sequential improvements and end markets you're seeing, how are you thinking about Q4 growth? Just to help people calibrate, should we be thinking it's over 25%, under 25%, what's your kind of thought on that?

The growth you’re talking about revenue growth?

Revenue growth in Q4 year-over-year, yes, against the negative 37% comp from last year.

Yes, got it. I think maybe what might be helpful to look at is the markets staying largely the way they are right now. This business would normally we would see a seasonality bunch of growth from Q3 to Q4 sort of in the 2% to 3% range. You can make whatever assumptions you want, if you want to take it higher than that, because you think the recovery is going to accelerate. But I would think that you'd want to at least think about that normal seasonality of 2% to 3%.

Understood. Okay. And I know revenue is going to be a huge swing factor over the next few quarters and it's really hard to gauge that. But just as I'm thinking about the margin conversation that we've had today, simplification and modernization versus cost coming back, just as a base case, are you thinking that two half EPS this year is above the $0.61 that Kennametal earned in two half '20?

We're not providing specific EPS guidance. As mentioned, there are many variables to consider regarding absorption and volume. We haven't given any information for Q4. As Chris pointed out, we're indicating what historical seasonality typically looks like. Coupled with the variations in the tax rate, we’ve provided the best insights we can at this time. Given the level of uncertainty we are facing, we are not offering any full-year guidance right now. We will maintain this approach for the moment.

Understandable. I guess I'll just try it one more way. If the Q3 operating margin looks similar to Q2, would you expect a significant step up in Q4 or that's not likely because of the $40 million to $45 million of incremental costs rolling back in even if you have better volume?

Well, again, Steve, I think it goes back to what is the incremental volume that we're going to see from Q3 to Q4 sequentially from incremental cost going from Q3 to Q4, we don't see a significant or a material headwind in sequential costs. So all else being equal, if you see revenue growth, generally speaking, I think costs would be relatively flat sequentially. I would expect some sort of an EBIT growth related to that top line. Again, the $45 million to $55 million headwind is a year-over-year comment. Sequential cost increases should be relatively muted from Q3 to Q4.

Got it. Thanks so much.

The next question is from Joel Tiss of BMO Capital Markets. Please go ahead.

I appreciate you guys staying on to squeeze me in. I missed a little bit in the beginning, but I don't know if you’ve talked at all about inventory levels at the distribution side and any customer color about wanting to increase their inventory levels or kind of keep them about where they are now?

Yes, we discussed some modest restocking activity earlier. However, I want to emphasize that our customers seem to be remaining cautious, so we're not seeing a significant increase in restocking. The most notable activity was in China, which makes sense given their lead in recovery. In the Americas, there was only a slight indication of restocking, and we haven't seen much activity on the EMEA side yet. And go ahead, sorry.

I was wondering if you could provide a normalized free cash flow outlook for fiscal 2022 once we move past the current situation, and share how you're thinking about it or how we should approach it.

Joel, we're not going to give the specific for 2022, because, again, a lot of uncertainty with how the markets are going to recover. But I think what we have said is as we've moved through the heavy investment here with simplification and modernization and our capital expenditures are now back into what we'll call more normalized range in this $110 million to $130 million, as these markets recover, we work through the working capital sort of rebuild of AR, we would expect cash flow to be about 100% of net income on an ongoing basis. That's sort of our long-term expectations. Whether we get there in 2022 or not, a lot will depend on how the markets move here. But that's our longer-term goal.

Okay, all right. Very helpful. Thank you.

The next question is from Chris Dankert of Longbow Research. Please go ahead.

Hi. Good morning, guys. Thanks for fitting me in. I guess just circling back to fit for purpose, I know it's still early days, but will there be a metric going forward that we can kind of track whether it's national account signings, whether it's average sales per order bidding level? Is there a metric that we on the outside can look at to just kind of see what that traction is or is it just too difficult to peel apart?

From an outside perspective, we need to find a way to measure something that might be challenging for you to determine independently. As mentioned, this information is already included in the segments we report externally. Our approach will involve commenting on the growth rate we observe in specific end markets. In the fit for purpose area, which is mainly related to general engineering, we will likely evaluate our performance by comparing our growth to the overall market growth rate. This provides one way to gauge our progress. Additionally, we can better assess our situation by analyzing customer-specific data to understand our share of wallet, which serves as a more accurate indicator. However, this data is not something we would typically share externally. Therefore, from an outside viewpoint, you could examine our growth relative to the IPI and how we are performing in the general engineering sector compared to that IPI market index. We will continue to provide updates on our progress, focusing on measuring performance on a client-by-client basis.

Got it. That's helpful. And just the very last thing from me. I guess in the slide deck, you guys mentioned the growth initiatives within infrastructure are also driving share gains. I guess maybe if you could highlight what those growth initiatives inside of infrastructure are, that would be really helpful?

Yes, there are several things happening. We are concentrating on commercial excellence within infrastructure. About a year ago, we appointed a new leader who has instilled a lot of discipline into our selling process, especially in terms of value selling and increasing customer interactions. We've noticed that by expanding our outreach, we are reconnecting with customers we haven't engaged with in a long time, reminding them of our value proposition, and we are beginning to capture a greater share of their spending simply by being more disciplined in our sales approach and emphasizing value selling. Additionally, we have been simplifying and modernizing our infrastructure operations, which enhances our ability to deliver on time and improve quality. Recently, we received a significant order from a client in the U.S. government sector who expressed confidence in us as the dependable supplier that delivers on time with the right quality. This is entirely due to our efforts in simplification and modernization. Therefore, the combination of commercial and operational excellence is aiding our growth in this area. We are also exploring expansion into related sectors like potash and making progress there. While it is true that infrastructure markets are currently slow and not growing as quickly as other sectors, there remain opportunities for us to gain market share and grow by implementing effective business processes focused on commercial and operational excellence, and that's our ongoing strategy.

Got it. Thanks so much for the color, Chris, and best of luck, guys.

Thank you.

Thanks, Chris.

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, and thank you everyone for joining the call today. We certainly appreciate your interest and support for Kennametal. You can tell from our Q2 results, our transformation is really well underway. We permanently improved the cost structure as demonstrated by our higher profitability levels this downturn versus prior downturns. Remember that as volumes increase, we will continue to get incremental benefits from these initiatives. Improvements will serve us well as markets recover throughout the entire market cycle. If you have any follow-up questions on today's call, please don't hesitate to call Kelly. Have a great day, everyone. Thanks.

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