Q2 2020 Earnings Call
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Good morning, I would like to welcome everyone to Kennametal second quarter fiscal 2020, <unk> earnings Conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question. During this time simply for.
Our Star then the number one on your telephone keypad, if you would like to withdraw your question. Please press Star then the number two.
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 Mr. Blair. Please go ahead.
Thank you operator, welcome everyone and thank you for joining US tribute Kennametal second quarter fiscal 2020 ever itself.
Yesterday evening, we issued our earnings press release and posted a presentation slides on our website, we will be referring to that slide deck throughout today's call and a recording of the call will be available for replay through March that.
I'm, Kelly Boyer Vice President of Investor Relations.
Joining me on the call today, our Chris Strozzi, President and Chief Executive Officer.
Damon Audia, Vice President and Chief Financial Officer.
Patrick Watson, Vice President Finance and corporate controller.
Alexander Burrows President video business segment, Pete Dragovich, President industrial business segment, and Ron cord, President infrastructure business segments.
After christened damons prepared remarks.
We will open the line up for questions.
At this time I would like to direct your attention to our forward looking disclosure statement.
Today's discussion contains comments that constitute forward looking statements as defined under the private Securities Litigation Reform Act of 1995.
Such forward looking statements involve a number of assumptions risks and uncertainties that could cause the companys 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 FCC filings.
In addition, we will be discussing non-GAAP financial measures on the call today.
Reconciliations to GAAP financial measures that we believe our 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 apart.
Thank you Kelly good morning, everyone and thank you for joining the call today.
We began by making some general comments before reviewing the corridor.
So we are currently experiencing the downturn across all our end markets. We remain focused on the things that we can control.
You're seeing results for the simplification monetization actions completed to date and these actions as well as those still to be completed will drive improved profitability and leverage when our end markets begin to strengthen.
Starting on slide two in the presentation deck.
Organic sales declined by 12% in the quarter.
Versus 4% growth in the second quarter last year.
This is the second consecutive quarter of double digit organic decline and highlights the weakened state of our end markets.
While we had expected end markets and the second quarter two declined sequentially a few countries, specifically, the U.S., Germany and India.
Declined more significantly than we had anticipated.
Furthermore, the challenges in the aerospace end market related to the 737, Max and trickle down effect in the supply chain exacerbated the already weak market conditions.
Adjusted EBITDA margin decreased 740 basis points to 11.4%, but improved 50 basis points sequentially. Despite lower sales this quarter.
Adjusted EPS decreased to 17 cents versus 71 cents in the prior year quarter.
The decreases in margin and EPS were the result of three main factors.
First the decline in volume was a significant contributor as all our end markets decline year over year.
Second the negative volume effect and the associated under absorption, we're magnified by manufacturing inefficiencies related to the recent plant closures from our simplification monetization efforts.
That said the disruptive effect of plant closures is expected to decrease in the second half of this fiscal year.
Third as we discussed on our last earnings call raw material headwinds continued to temporarily depressed our margins in the quarter.
Although as expected the magnitude of the effect improved sequentially from the first quarter.
It's still represented 130 basis points of the year over year decline in our margins or seven cents of EPS.
This situation will reverse in the second half since the higher cost raw material inventory work through the PNM out in the first half of fiscal year 2000.
And our expectation is that the full year effect will be roughly neutral.
These negative factors were partially offset by the progress we're making on simplification modernization.
Which contributed an incremental 10 cents EPS year over year.
This quarter, we achieved an incremental $11 million in savings from simplification monetization.
$19 million year to date, bringing the total since inception of the program to $69 million.
As a reminder, we still expect our full year savings this fiscal year to be modestly higher than the $40 million achieved last year.
Reflecting increased savings in the second half from footprint rationalization and manufacturing monetization.
We closed two manufacturing facilities in the second quarter.
The savings from these closures are part of the fiscal year 2008 restructuring actions, which are expected to deliver $35 million to $40 million in run rate annualized savings by the end of fiscal year 20.
We also remain on track with our fiscal year 21 restructuring actions.
That are expected to contribute an additional 25, the $30 million of annualized run rate savings by the end of fiscal year 21.
And we now expect achieved these savings at a lower cost.
We've decided to downsize the aesynt operation rather than closing that after reaching a compelling agreement with local employee representatives to improve profitability driven by increased required work hours per week and lower operating costs.
We're also evaluating the acceleration of other facility closures as part of our ongoing restructuring activities.
Have you heard me say before in an unpredictable market environment such as this one it's important to stay focused on the things that we can control such as disciplined cost management.
Our adjusted operating expense of 21.3% represents a decrease of 6% year over year in dollar terms.
And we will continue to look for opportunities to reduce costs, especially in the current market environment.
Looking ahead.
The lower end market demand, we experienced in Q2 as well as our current expectations for further weakness through the remainder of the fiscal year have necessitated a reduction in our total year outlook.
Let's turn to slide three to discuss some of the changes since our last earnings call that have lowered our expectations.
As you can see on this slide.
Many macroeconomic indicators for our key end markets have changed significantly.
Over this last quarter versus what was forecasted at the end of the first quarter.
US manufacturing production was positive in the first quarter and unexpectedly turned negative in the second quarter.
Similarly, India was indicating signs of recovery with September industrial production forecasted to be positive 4%.
However, actual performance was negative 4% and consistent with the further deterioration that we saw in Q2.
The transportation end market continued to weaken further than expected in the quarter with a decrease in German industrial production of negative 5% versus the forecast of negative 3% at the start of the quarter.
The developments with a 737, Max effected our second quarter and full year outlook is well.
At the time of our last call Boeing's actual monthly production levels were 42.
There were forecasting an increased to 52 by fiscal year end.
And of course, the subsequent production Hall also affected the associated supply chain.
Finally, the energy end market was significantly lower as seen in the drop in us land only rig count.
Which was forecasted to stabilize around 850 at the time of our last call and is now around 800 and expected to stay at approximately these levels for the balance of the fiscal year.
Despite these challenges across our end markets, we continue to improve our long term profitability as seen on slide four.
Part of simplification modernization is reduction in our manufacturing footprint.
To reduce structural costs as well as leveraging our modernized manufacturing processes for improved productivity.
Since the start of this journey, we've reduced the footprint by five and require considerably less employees to operate the business.
Note that the reduction in footprint does not include the significantly downsize aesynt operation or other facility closures currently under evaluation.
These actions today are reflected in the improvement in our cash flow from operations as shown in the chart comparing the first half of this year to a similar revenue period.
As you can see Theres, a significant improvement in our cash flow as we focused on simplification monetization, including simplifying and value based pricing our product portfolio and services.
Improving productivity through automation, and modernize manufacturing processes, and removing structural costs through footprint rationalization.
Overall, we're making good progress to date, we've reduced our footprint by five versus the December 2017, Investor day projection of five to seven.
And expect to spend approximately 90% of the incremental $300 million in monetization capex by the end of this fiscal year.
This will complete the $300 million of incremental capital spend required for our simplification modernization program, except for approximately 10%, which we expect will be needed to add capacity once markets recover.
It's important to note that much of the productivity improvements from the monetization capital are still the comp.
As we've discussed the plant closures would happen toward the end of our simplification monetization program and we're on track with that.
The productivity of the modernized processes that enable consolidation of entire plants into a smaller footprint are significant.
And these benefits of monetization are still ahead of us as we bring the new processes online and complete the transfer of products throughout fiscal year 20 and 21.
So in summary, I remain confident that we will deliver the savings needed to achieve our adjusted EBITDA target of 24% to 26%.
Since our sales are within the two and a half to $2.6 billion range.
Before I turn the call over the Damon I'd like to discuss the executive changes announced last week.
Ron for who is currently leading our infrastructure business segment has moved into the newly created role of Chief commercial officer for our metal cutting businesses.
And this new role Rob will drive best practices across our metal cutting segments to improve sales and marketing effectiveness and accelerate growth with target customers by leveraging the company's full metal cutting portfolio.
Franklin car Dania us is joining our team as of February 10th and will lead the infrastructure business segment.
Comes to us from Donaldson company, where he held various business in general management positions with responsibility for commercial and operations.
Was most recently VP of Asia Pacific.
Welcome Franklin to the Kennametal team and with that I'll turn it over to Damon.
Thank you, Chris and good morning, everyone I will begin on slide five with a review of our operating results on both reported and adjusted basis.
As Chris mentioned demand trends deteriorated more significantly than previously expected across our end markets.
These trends were magnified by recent headwinds in the aerospace end market following changes to 737 mass production.
This resulted in sales declining 14% year over year or negative, 12% on organic basis to 505 million.
Foreign currency had a negative effect of 1% as well as a divestiture the contributed another negative 1%.
Adjusted gross profit margin of 26.8% was down 710 basis points year over year.
The year over year performance was largely result will be effect of lower volumes and higher price inventories still working its way through the piano.
The negative effect of raw materials. This quarter was roughly 130 basis points down from 360 basis points in the first quarter.
The effect of higher priced inventory will reverse in the second half of the year and be roughly neutral for the full year.
Adjusted operating expenses were down 6% year over year and represented 21.3% of sales and improvement of 70 basis points sequentially.
Taken together adjusted operating margin was 4.8% down 900 basis points year over year against tough margin comparisons.
Reported loss per share was seven cents versus positive EPS of 66 cents in the prior year period.
There are some onetime items in the reported loss per share this quarter, but I'd like to highly.
First discrete tax benefits accounted for 18 cents due primarily to transition provisions of Swiss tax reform.
Despite this change we do not expect the material change on our long term adjusted tax rate.
Second we recorded pretax noncash video intangible asset impairment charges of 15 million this quarter as the result of deteriorating market conditions, primarily in general engineering and transportation applications in India in China. In addition to overall global weakness in the manufacturing sector.
The after tax effect on EPS was negligible.
This action does not change your view of video, but as simply reflective of the current weak macro environment.
Third we completed the divestiture of a non core specialty alloy business and infrastructure for 24 million in cash proceeds as part of simplification monetization, which amounted to three cents per share.
On an adjusted basis EPS was 17 cents per share versus 71 cents per share in the previous year. The main drivers for our adjusted EPS performance are highlighted on slide six.
The effective operations this quarter amounted to negative 62 cents.
The largest factor contributing to the 62 cents was the effect of significantly lower volumes.
Also reflected within the operations category is the temporary effects of higher raw material costs of approximately seven cents. This.
This is down from negative 19 cents last quarter and expected to reverse in the second half such that it will be roughly neutral for the full year.
Another factor was the temporary manufacturing inefficiencies related to our plant closures.
Although improving these headwinds continued as expected this quarter.
We expect this to diminish as we proceed through the year.
Simplification monetization contributed 10 cents in the quarter up from seven cents last quarter, three cents of which is from restructuring actions.
As Chris mentioned, we expect these benefits to increase as we progress through the second half of the fiscal year.
Slide seven through nine provide detail on the performance of our segments of this quarter.
Industrial sales in Q2 declined 11% organically on top of 3% growth in Q2 of the prior year.
From a regional standpoint, the largest decline was anemia at negative 14%, followed by the Americas, and Asia Pacific down, 10% and 4% respectively.
From an end market perspective, the weakness in demand remains broad based with the biggest challenges in transportation and general engineering down, 13% and 10% respectively.
This was primarily driven by decelerating global manufacturing in auto production activity as well as extended holiday plant shutdowns by customers.
Sales in the aerospace end market fell short of expectations affected by the ongoing developments surrounding the 737, Max and the corresponding effects of the supply chain.
Adjusted operating margins came in at 10.7% compared to 18.6% in the prior year.
The decrease was primarily driven by the decline in volume.
The effects of higher raw material costs represented approximately 70 basis points of the year over year decline.
However, on a sequential basis, the adjusted operating margin increased approximately 90 basis points on roughly flat sales.
Turning to slide eight for video.
Sales declined 8% organically against a positive 4% in the prior year period.
Video face similar macro challenges as the industrial segment during the quarter.
Regionally both EMEA in the Americas were down 6% year over year with the largest declined this quarter was in Asia Pacific down 17%.
It should be noted that the decline in Asia Pacific was due primarily to the significant slowdown in India, specifically in the transportation sector that slowdown is also affecting the general engineering end market as well.
Adjusted operating margins for the quarter was a loss of 2.4%.
Similar to the other business segments higher raw material cost effective use operating margin by approximately 230 basis points. This quarter down from 430 basis points last quarter and those headwinds will reverse in the second half.
During the infrastructure on slide nine.
Organic sales declined 14% against the positive 4% in the prior year period.
Regionally sales were up 2% EMU, while Asia Pacific in the Americas were down 5% from 22% respectively.
By end market. These results were primarily driven by energy, which was down 33% year over year, reflecting significant declines in the us land only rig count.
General Engineering, and earthworks were down, 6% and 3% respectively.
Infrastructure recorded an operating margin loss of 1.8% this quarter compared to a profit of 9.6% in the prior year period.
Remember infrastructure is significantly more sensitive to changes in raw material costs in two ways.
First raw materials are a larger percentage of infrastructures cost of goods sold.
Second certain customer prices adjust based on spot market prices of materials and create a temporary timing difference further affecting operating margins.
Those higher raw material cost effective margins by approximately 180 basis points year over year.
Again, this was down sequentially from 660 basis points last quarter and will reverse such that we expect to see an improvement in infrastructures profitability in the second half.
Furthermore, as part of the simplification monetization initiatives, we expect to see additional benefits and infrastructure margins. Following the recent closure of our Irwin, Pennsylvania facility as well as the divestiture of our new Castle business.
Now turning to slide 10 to review, our balance sheet and cash flow.
Primary working capital decreased both sequentially and year over year to 660 million.
On a percentage of sales basis, our primary working capital was 32.7%.
A slight increase year over year is the result of more modest inventory reductions compared to the sales decline in the quarter.
Net capital expenditures increased to 75 million compared to 43 million in the prior year period, as Chris mentioned, our simplification monetization spending and results are on track.
Our second quarter free operating cash flow was negative $15 million consistent with normal seasonal patterns.
This represents a year over year decline of 24 million on increased net capital expenditures of 32 million and increased cash restructuring cost.
In the context of our updated outlook, we expect our free operating cash flow to improve in the second half, resulting in roughly breakeven free cash flow for the full year.
Our cash balance remains strong ending the quarter at 105 million and we remain well positioned with our debt and overfunded us pension plans.
We have no borrowings on our 700 million dollar revolver at quarter end and have no significant debt maturities until February 2022.
Dividends were approximately flat year over year at 17 million and we remain committed to our dividend program.
Overall I'm confident in the strength of our balance sheet, our cash position in unutilized revolver, coupled with our cash flow generation allows us to drive forward with our simplification modernization initiatives, which will improve our financial performance and cash flows throughout the economic cycle.
The full balance sheet can be found on slide 15 in the appendix.
Turning to slide 11 for our fiscal year 20 outlook.
Our updated outlook reflects the change in several factors since our last call many of which Chris mentioned.
First we are now assuming further end market deterioration in the second half.
Secondly, our outlook encompasses the recent developments of the 737, Max and the related effect on supply chain.
Also the US land only rig count has declined more rapidly than expected and the projections have been reduced affecting the results across all business segments.
Together these headwinds are expected to steer our second half revenues off the course of normal seasonality, which is what we had assumed in our prior outlook.
Our revised organic outlook is known the range of negative 12 to negative 9% down from negative nine to negative 5%.
Our adjusted effective tax rate is expected to increase to being the range of 25% to 28%.
The increase in our adjusted effective tax rate is a result of lower taxable earnings in geographic mix.
Our two additional points related to this and I'd like to highlight.
First the current outlook is reflective of lower taxable earnings and we would expect a more normalized adjusted effective tax rate in the low twentys as profitability improves.
Second the change in this rate is not expected to have a material effect on the amount of cash taxes paid in fiscal year 20.
In fiscal year 19, we paid approximately 50 million in cash taxes, and expect to pay up modestly lower amounts in fiscal year 20.
Given these changes we are updating the adjusted EPS outlook to $1.20 to $1.50.
Moving on to free operating cash flow.
As Chris mentioned, we're proceeding with our simplification modernization plans and maintaining our prior capital spending forecast of 240 to 260 million.
Our updated outlook assumes free operating cash flow to be roughly breakeven for the year reflective of our lower earnings expectations.
Remember this reflects current weak demand environment, but is also inclusive of capex that is $120 million to $140 million higher than historical levels and significant cash restructuring charges.
Our expectation is that cash flow conversion will be 100% once we're through the simplification modernization initiatives.
And with that I'll turn the call back over to Chris.
Thank you Damon.
Turning to slide 12, let me take a few minutes to summarize a quarter and the fiscal year 20 outlook.
As we discussed already the slowdown across our end markets and recent developments in aerospace has affected our quarterly results and we're not anticipated in our prior outlook.
Nevertheless, we continue to focus on what we can control.
And expect profitability to improve in the second half driven by the progress, we're making and simplification monetization and the improvement in raw material costs.
With continuing focus on strong execution combined with our emphasis on improving customer service I remain confident in achieving our adjusted EBITDA target on sales reached range of $2.5 billion to $2.6 billion.
And with that operator, let's open it up for questions.
Thank you.
I'd like to ask a question join this time simply press Star then the number one and your telephone keypad. If you would like to withdraw your question. Please press star and the number two.
The first question today comes from Stephen Volkmann with Jefferies. Please go ahead.
Hey, good morning, guys.
Steve.
Maybe Chris can May go back to something you said I think in your opening comments about how your incremental margins would be sort of well positions when things started to get better and I guess I've been surprised at how large the decrementals have been even adding back the raw materials. So I don't know.
There's a way for you to maybe put some brackets around what you would expect.
For incremental margins when things actually turn up that would be helpful.
Yes, let me just say on the decremental margins as we sort of do the math and we we back out the effects of.
The material costs.
These and all the segments, we're not surprise and they basically are falling in line with what we what we've talked about out now they are a little bit elevated as you as we've talked about because we have these sort of manufacturing efficiencies associated with the plant closures and those type of things, but when you Peel that stuff away, which I think is your question sort of longer term windows.
Please go away, we think the decremental margins are sort of in line with our expectations.
I think the other thing to look forward to lists.
Where we really Atwood simplification and modernization and as I said, we feel good that we're on track to to hit those targets once the volume recovers.
We've made good progress we've got about $69 million a savings to date, we've talked about the restructuring actions and fly 20, net by 21, which are a subset of modernization and the way the way monetization was done Steve as you know as.
A lot of the.
The heavy lifting was associated with plant closures, which are now starting to happen and we're transferring product from the closed facilities to to the lower cost facilities and that process is ongoing right. Now. So this notion of a ramp up starting in the second half of fly 24.
Simplification monomer bet monetization benefits and then also more benefits come at 21 that all equal as and we feel like we're on track.
Just waiting for the volume to come back.
Okay. That's helpful. And then maybe switching just a little bit kit is it possible to maybe damons question any numbers around the Max I mean, how much of your exposure to the Max and.
How much do you think that was actually.
Factor in the guide down in the second half.
Yes.
I guess, we're not going to go into specifics on any given customer I will tell you, though that we did sort of it was an impact on the overall change on our outlook given what we expected to beyond the overall supply chain.
In the second half of the year.
If I could just add to though.
It was as Damon said, there was an impact on the full year and also the second quarter, but part of our strategy has been to grow in aerospace and.
It's a big market, including all the sub tier suppliers beyond the 737, Max and Weve I think we've been very successful since the start of Fyeighteen to redirect our engineering resources that have been really servicing the transportation industry quite well, we redirected a lot of those resources to arrow and we feel like given the number of new customers we've added.
And.
Across the board across the supply chain, whether it be tier one tier two and actually with the direct.
Oems that we are gaining market share in this space and feel pretty good about being able to grow and Errol. So I just wanted to add that.
Okay. Thanks offensive.
The next question comes from any human with Jpmorgan. Please go ahead.
Oh My God This is bandwagon.
Idea, but may not was.
Let me just ask your along those lines you talked about gaining share in aerospace.
Have you been losing market share anywhere regionally our by segment as you think chewed all a bit simplification and.
Just a disruption that it's having to your businesses.
We don't believe sell.
Where you're at in terms of market share at any given point.
The challenge is a challenge to measure, but when we look at for example, our competitors, where we have publicly available data certain sort of like with Sandvik. If we look at their third drop in revenue over the last two years, it's very consistent where we are.
And then the only bill here I would say that we actually have lost share would be in transportation, but as we talked about and that was by design as a lot of that business that we weren't very it wasn't very profitable for us and we want to shift those resources to more profitable segments. So when we look at the the data and Peel back the onion, we don't believe.
Or losing we're losing share at all.
Our volumes have come down commensurate with with our competitors and also aware we are actually keeping track of new customers were adding to the segments that were targeting sort of general engineering in Aero just based on the fact, we're adding new customers and not not losing business with existing ones that gives us confidence and we're gaining share.
Yes, I would suggest that maybe going forward genvec is not the only competitor there may be new competitors at there that I could take that offline. My follow up question is really.
I've asked this before but on infrastructure.
Yes, how did you end up in a situation whereby you re pricing based on spot prices I mean generally even in automotive you may be repricing to spot within lag given that everybody understand do you have inventory. So im just curious how your business ended up in a situation, where you're giving up pricing.
Incident with raw material changes.
Yes, I think and you're honing in on one part of our business and infrastructure I think we have our traditional business, which we price for the value of the products that we're selling in where components in other parts. We do have an index based pricing for some of our oil and gas customers in that does lag.
It depends on the individual customers I think the specific point you are referencing is our powder business, where we do sell powders into the third into the marketplace and again that piece is adjusted based on current market prices and so we do deal with our inventory costs versus where the spot price, but it's only ace of subset of our overall infrastructure.
Business.
Okay. Thank you I appreciate the color I'll get back in line.
Your next question comes from Joe Ritchie with Goldman Sachs. Please go ahead.
Thanks, Good morning, everyone Fine Joe just just a few clarifying questions I think the first one on the on just the Max or you guys, assuming eight zero in revenue in your fiscal second half.
Our assumption in the second half is that the production is going up.
This is not going to come back to.
I'm going to come back online I guess as the simplest way to say it.
Okay.
Alright.
So.
Production not coming back online.
And.
Having a full impact on your on your revenue base or is it or is there still from potential incremental revenue coming from the Max in the second half.
Yes, I think that.
Given given all the uncertainties in the pluses and minuses in this current macro environment.
I think that any potential upside that there might be for the Max starting up which by the way it's difficult to its difficult to sort of figure out when does that start to translate in people starting to cut more chips and ultimately buying consumable tools from us. So that's a difficult thing to predict but I would be I would be cautious about looking for our sort of positive in one area.
Given all the uncertainties. So we've tried to do the best we can in terms of our outlook for the second half of factoring all these variables in.
And so that that would be my guidance to you is is if you find if youve cherry picked some positive potentials.
In this environment there could easily be some offset so we've tried to take a balanced view on our current outlook.
Okay. That's now that's that's fair, Chris and I guess as like the Kevin I think about the puts and takes.
I'd like the midpoint of your second half guide versus versus what transpired in the first first half.
Clearly you guys have called out the raw material headwinds abating sense, roughly 26 cents, you've got incremental simplification monetization benefits, which I have kind of in that like call. It five to seven cents type range I guess.
Given that the backdrop is still expected to be pretty muted in the second half I guess, how Hello, My Hello, My bridging then to the call. It 70, plus sense that is necessary to get to better second half profitability versus the first half.
Yes, let me, let me kind of walk you through the way I'm thinking about it if you look at our EPS guidance range. It implies 86 cents incremental improvement to $1.16 incremental improvement in second half. So if you start with a 34 cents that we've got so far for the first half you're correct on the raw materials Thats, a 26 cents sub.
I would I would say that the increase.
Publication in Monterrey monetization.