Q2 2021 Kennametal Inc Earnings Call
[music].
This morning, I would like to welcome everyone to Kennametal 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.
If you would like to ask a question. During this time simply press Star then the number one on your telephone keypad.
I 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. Please go ahead. Thank.
Thank you operator, welcome everyone and thank you for joining us to review Kennametal second quarter fiscal 2021 results.
Yesterday evening, we issued our earnings press release.
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.
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.
And Keith are detailed in Kennametal 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 on 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 strategic initiatives.
We will then go over the quarterly financial results in more detail.
Finally, I'll make some summary comments before opening the call for questions.
Moving on slide two 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 improvements and growth from our strategic initiatives as well as increasing benefits from simplification modernization.
Yeah.
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 total 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.
Never through disciplined execution of our strategic initiatives and cost control actions, we were able to improve profitability.
Spite 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 cost increasing benefits from simplification 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 decreased 9% our target for operating expense remains at 20%.
Adjusted EPS of <unk> 16 was essentially flat versus 17 in the prior year quarter, reflecting the factors I just mentioned.
Looking ahead visibility on 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 'twenty one.
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 FX.
We expect the underlying organic growth, excluding the effect of FX 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 modernization initiatives delivered $23 million this quarter, 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 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.
We'll 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 modernization is essentially complete and as such will result in more normalized capex levels going forward.
Total capex is expected to be between 110 and $130 million this year.
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 focus on working capital without compromising customer service base.
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 <unk>.
As you recall at the end of fiscal year, 'twenty, We announced two important changes as part of our commercial excellence strategy.
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 video brand and portfolio to address the multibillion 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 operating 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 and fit for purpose applications as we roll the program out globally.
Please turn to slide three.
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 a sales decline close to the one we are currently experiencing was during the great recession in 2009.
Brass show trailing 12 months 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 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 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.
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.
Summary, I am 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 Damien who will review the second quarter numbers in more detail. Thank.
Thank you, Chris and good morning, everyone. It.
I will begin on slide four 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 contribute 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.
<unk> rolling back many temporary cost control actions in the quarter, which should amount to close to $10 million. Our adjusted EBITDA margin improved by 170 basis points due to the improving market conditions and continued simplification modernization savings.
Adjusted operating margin of five 3% was up 50 basis points year over year, and 240 basis points sequentially.
The improved year over year performance on our margin was primarily due to the positive effect of raw materials as expected, which contributed approximately 590 basis points incremental simplification monetization benefits and temporary cost control actions, partially offset by lower volumes and associated under absorption.
The adjusted effective tax rate in the quarter of 24, 7% was 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 'twenty one.
We reported a GAAP earnings per share of <unk> 43 versus an earnings per share loss of <unk> <unk> in the prior year period.
On an adjusted basis EPS was <unk> 16 per share versus <unk> 17 in the prior year.
The main drivers for our adjusted EPS performance are highlighted on the bridge on slide five.
The effect of operations this quarter amounted to negative 20.
This compares positively to both the negative <unk> 62 in.
In the prior year quarter, and the negative 28 last quarter.
The largest factor contributing to the 20 <unk> was the effect of lower volumes and associated under absorption, partially offset by positive raw materials of 25 and.
And temporary cost control actions.
The negative effect of operations. This quarter was basically offset by 19 or $23 million of benefits from simplification monetization of <unk>.
<unk> increased from 10 in the prior year quarter.
This brings the cumulative benefits of simplification modernization to $145 million since inception.
As Chris mentioned, our expectation continues to be that simplification monetization 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.
Slide six and seven detail the performance of our segments 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 are triple.
Sequentially the increase in metal cutting was mainly driven by the transportation and associated General engineering end markets.
Adjusted operating margin of six 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 modernization benefits temporary cost control actions and raw materials that contributed 230 basis points.
Turning to slide seven 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 FX of 1%.
Regionally again, the largest decline was in the Americas at 18% than EMEA, 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 increase 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 four 4% was up 620 basis points year over year.
This increase was mainly driven by favorable raw materials, which contributed 1230 basis points as expected.
Application 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 in Q4, given the tungsten prices have been relatively stable for around six quarters.
Now turning to slide eight to review, our balance sheet and free operating cash flow.
We continue to believe that maintaining a conservative financial profile as 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 U S $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 30%.
Capital expenditures were $29 million, a decrease of 46 million from the prior year as expected as our capital spending on simplification monetization 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 a $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 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 'twenty, one EPS and free operating cash flow drivers for the second half.
Please turn to slide nine.
As a reminder, this slight details how we expect key factors to affect EPS and free operating cash flow. This.
This 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 monetization as we already mentioned, we expect to achieve benefits of approximately $80 million in FY, 'twenty, one 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 to $55 million with 40% 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 year over year leverage will be distorted and not accurately reflect the underlying improved operational performance.
Based on current material prices, particularly tungsten, we do not expect raw materials 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 on line.
Lastly.
For the EPS drivers, we have lowered our adjusted effective tax rate expectations for fiscal year 'twenty, one 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 Christopher I 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% to $25 million versus the approximate $40 million spent in FY 'twenty. 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 will 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 digits sequentially with part of the sequential sales growth coming from FX.
We expect the underlying organic growth, excluding the effect of ex FX 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, David turning to Slide 10, let me take a few minutes to summarize.
I am 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 modernization nearing completion.
As shown in the margin grass 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 reached the targeted range of two five 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. If you would like to ask a question. During this time simply price.
Alright, then the number one on your telephone keypad.
If you would like to withdraw your question. Please.
Then the number two.
The first question today comes from Steve Volkmann.
<unk> 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 out fairly well, but I don't want to put words in your mouth I am 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.
Steve Good morning.
Yes.
In terms of the stocking level on my comment I said, we saw a modestly.
Just evidence on that and that was primarily in Asia Pacific and China or there was clearly some restocking going on.
But as it relates to the Americas, we're just sort of seeing some some month over month improvement in stocking orders.
And in EMEA, we see we haven't really seen anything so I think.
My key takeaway here is that we're starting to see modest restocking activity, but ill let.
Steve frankly customers still remain cautious so I don't think its really in a meaningful way other than what I said in China, but as you know regardless of the customer inventory levels. We are managing our inventory to be able to take share in this recovery by having this sort of high value high moving parts and inventory and then we've also move to this sort of weekly sales and op.
<unk> planning meeting to allow us to react quickly to <unk>.
Any changes in the demand signals as.
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 on December.
And it's consistent with the sort of that mid single digit that we told you excluding FX for growth.
For growth in the quarter.
Great. Okay. I appreciate that and then just on the energy specifically I mean, the rig counts look like they've kind of turned up a little bit how long until that sort of flows through.
Sure.
To your business do you think.
Yes, as it relates to energy.
Good news is we're seeing an uptick in the.
The rig count and that will that will equal some modest some modest growth, but frankly.
We're off such a low base in the Americas that were we're thinking that we're going to see some growth there, but not 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's that's.
And then it takes it takes it takes maybe three to six months for that to kind of flow through to us if you will.
Okay fair enough I appreciate it.
Is it on.
The next question is from Julian Mitchell of Barclays. Please go ahead.
Hi, good morning.
Maybe just.
Just the first question trying to understand in the infrastructure business.
What happens with the debt.
Margins, just trying to understand sequentially those were down.
Alright.
This revenue increase.
So just wondered if you could help us understand sort of what the main headwinds were better sequentially and then.
When we're thinking about the second half operating leverage in that business.
The higher revenues.
Kind of.
Price holder should we have for that.
Sure Julian.
I think I'll comment on the sequential decline and then David maybe you can focus on the operating leverage and add anything regionally.
But as you pointed out infrastructure had a slight increase in sales sequentially.
As we turn as Damon talked about these temporary cost actions that came off.
That had a big a big effect as well as some some of the variable comp elements.
And frankly, there was a bit of a mix issue.
Oil and gas is profitable business and is that is that has that declined even further from Q1 to Q2 that also drove some of that decline.
On all of 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 is we did have a.
Slight increase in an environmental reserve that Youll see in our 10-Q added probably about a call a little bit over $1 billion of cost in the quarter. So that would have influenced the margin a little bit as well.
On to your question about the second half leveraged Julien as I alluded to in my call 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.
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 from fixed cost absorption, but it's again.
Just sort of caution you as the second half here with all of these changes are being implemented 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 may be looking at.
Metal cutting perhaps thats a bit simpler in terms of that operating leverage point.
When we're looking year on year range in.
In that piece do.
Do you think we can get closer to that.
Maybe the.
Not 40% as such but.
And sort of 30% year on year leverage.
As you see the revenues start to return to growth during the second half.
I think leverage in the second half remember, we have $50 to $55 million.
Cost headwinds in theory coming back in year over year.
So as you think about even the improvements that were referring to with the sequential sales growth from Q2 to Q3, and hopefully we'll see that something improvement in Q4, its still going to be distorted by these level of cost control actions that won't repeat here.
In the second half so I am not optimistic that when you do the math on on leverage year over year Youre going to see anything thats, even really reflective of our prior prior sort of downturn of recoveries given what we did last year and the changes year over year. So.
It's not hard to give you a specific answer because I don't think theyre going to look good when you look at them on paper given what we did last year to control costs.
And I might add maybe an easier way to look at it is sequentially.
Sort of the way I think about the margins is there going to be pretty similar to what we saw in Q2.
So as we've got we've got the sort of mid single digits sequential growth.
Excluding FX and.
You said, you said of a levered at 50% I think was kind of your number.
And we've got some additional simplification and modernization benefits.
On a take off at $10 million headwind on on.
Cost actions and is a little bit more depreciation in the third quarter than we had in the second quarter and so all of that gets you sort of in the neighborhood of what we saw in Q2, and maybe an easier way to look at it.
That's very helpful. Thank you.
Your next question comes from Ian.
J P. Morgan. Please go ahead.
Yes on.
Metal cutting also I think you said that mix was a negative which surprises me given debt automotive our transportation and general engineering are such a.
Significant portion of your sales. So could you just talk about that as it also energy is higher margin or.
Are either automotive or general engineering, particularly on the low margin businesses.
And when I was talking about mix I was talking about the infrastructure infrastructure business.
The oil and gas businesses and higher profitability.
Right.
But I think on.
Our mix was a negative headwind for us year over year. If you think about the markets that were down the most aerospace which as we've said is one of our most profitable end markets, which is why we focused our growth over the last several years was down 43% year over year transportation, which as you know as part of our.
Portfolio simplification years ago that was one of the markets, we sort of moved away from because it was on the lower end of that profitability was the best performing so when you think about the year over year changes, it's definitely the lower aerospace energy, which has a higher profit margin business per metal cutting was also Donald 18%. So that's.
There is a mix effect here in metal cutting but it was more end market mix that was driving it.
Okay. That's helpful. Because it was specifically metal cutting in the opening remarks.
You call that lower volume and mix on I, just wanted to make sure I understood that.
And then.
China 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, 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.
Asia Pacific China.
In terms of transportation, we did see an uptake in transportation business, there and also energy which is around wind turbines.
On an increase.
So when I was talking about flat, we think that debt is sort of.
Okay.
Driven to the markets recovered pretty well, but we're expecting it to maybe improve just a little bit better, but not not significantly beyond what it is already done.
Again, and I think again, comparing every company is a little bit different but on the mix of what we have in Asia as Chris alluded to we did see good growth in automotive are transportation and energy Aerospace, which is a good part of the business there in.
In China was down significantly I think a very high percentage. So again for us that was probably a negative mix issue in China, which led us to be about flat year over year.
Okay, Yes, because you did specifically say in China. It was flat. So I just wanted to make sure I understood that okay. That's my question my follow up I appreciate that on debt.
Your next question comes from Ross Gilardi Bank of America. Please go ahead.
Good morning, guys.
Morning Ross.
I was just wondering if you could just talk about your capacity a little bit and just how youre thinking about the right amount over the next cycle.
You talk about EBITDA margin target is getting back to.
Yeah.
Yeah.
The.
Being achieved.
Net margin target be achievable when you get back from two five to $2 6 billion in revenue, which was the peak.
2012 to 15, I think it's clearly debatable on some of your end markets get back to those levels, particularly on the infrastructure side. Some on my question is really how much revenue do you think your capacity is for on on a normalized basis over the cycle.
And if you come to conclusion of the next peak is going to be below that two five to $2 6 billion how would you address.
Capacity.
Yeah.
Yes, so Ross the way, we're thinking about the capacity as you know we've done a lot of footprint consolidation.
Belted in about seven plants as part of our original.
Program.
No.
Yes.
Size of the capacity on 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 are using temporary workers in the U S. We think that our capacity and assist 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 we feel pretty good about our sort of low end capacity and be able to flex with that and then because a lot of this is automated and 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. Thank you Chris and then maybe you could just talk about.
Raw material costs, a little bit beyond the second half I mean, it really didn't have a lot of visibility right now, but we've seen pretty pretty dramatic spikes in a lot of.
Industrial metals and.
Thompson on cobalt or a little bit harder to follow from from the outside but.
What day, what are you thinking there and do you have the ability to.
Stock up on additional raw material going into fiscal 'twenty two on the event of a spike is that a potential risk to the margin recovery beyond the second half of this year.
And then just.
On a little background, the big material driver for us, especially on the infrastructure side not so much on on the metal cutting is the AP.
Those prices have been sort of stable between this 210 to $2 40.
Net price over.
Over the last six quarters I think in Q2 on average around $2 20.
So we expect to see a slight uptick on that.
Thats, usually that usually is indicative of.
Well, we're going to see which is demand coming back right.
That's a positive.
And then.
So when that happens we've got a long history in the company in both the infrastructure side and metal cutting to be able to manage the price raw calculation.
We're ahead of the curve, sometimes behind the changes it changes by quarter, but overall, we've demonstrated a history that we can.
We maintain the right balance there.
So I see APG prices going up as an indication of higher demand and I am very confident in our ability to sort of manage that.
Cycle.
Whether.
These prices off to our to our customers. We don't do so much buying the raw material inventory in advance.
On a case of infrastructure there is a lot of the oil and gas contracts are as an industry. There. So we're covering as those prices go up.
And like I said, we've been able debt, we've been able to any changes on the APG price we've been able to.
Push that off to our customers that's kind of what's expected in the industry.
Thank you.
Your next question is from Walter Liptak Seaport.
Hey, good morning, guys.
One day I wanted 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 could 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.
So we.
We said there'll be about 50 to 55 million of incremental cost headwinds year over year and about 40 to 45 of that in Q4, so that.
Let's call it about 10 of a headwind in Q3.
That's true year over year for the back half of this year as we look at the first half of FY 'twenty, two we will see again.
First half of FY 'twenty two headwinds due to the first half cost actions that we've had in place here in Q1, and Q2 of FY 'twenty, one and those are around $15 million or so per quarter. So I think it was around 15 in Q1, and maybe just a little bit less than that as we roll started the roll off some of those <unk>.
Cost actions here in the second quarter, so let's call it call it $25 million or so of incremental cost headwinds in the first half of 'twenty two versus the first half of 'twenty, one and then all else being equal we should be neutral year over year in Q3, and Q4 of 'twenty two assuming theres nothing that we do this balance.
This fiscal year.
Okay great.
And I wanted to.
To switch topics.
And talked a little bit about Europe.
I think you made a comment in the opening remarks.
Europe is still pretty town I Wonder if you could talk about.
Some of the recent trends and as they begin to reopen.
Vaccines coming out what you're expecting for <unk>.
Inventories and poor production going on.
Like I said overall, it's flat.
<unk> engineering.
That there could be an uptick in.
As as things start to recover there, but you kind of hit it Walter there is still uncertainty about maybe potential shutdowns, but if that doesn't happen. We would start to see expect to see an increase from Q2 to Q3 on general engineering, but aerospace and energy would sort of be flat debt there.
At their current levels.
And I think transportation will.
We will stay flat at least through Q3.
Okay, Alright, great. Thank you.
The next question comes from Ronny Scardino Goldman Sachs. Please go ahead.
Hey, good morning, guys. Thanks for taking the question.
So just a just a clarifying question I heard you correctly, you mentioned <unk> in the neighborhood of <unk>.
On a margin comment or an EPS comment.
The margin comment.
Got it thank you.
And then are there any puts and takes we should just keep in mind and <unk> outside of what you've already outlined on a temporary costs and material inflation side.
No I think as Chris said, we will pick up incremental EBIT related to the volume that he has alluded to so again the mid single digits. When you adjust for FX, improving your overall EBIT, but directionally speaking that would be offset by the sequential increase in cost.
These temporary cost actions have rolled off now at the end of the second quarter.
Got it thanks guys.
Question from day, one coming of Morgan Stanley.
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.
And I guess more tangibly it actually it 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 thats a result on some of the debt for purpose efforts or if there is some other kind of share dynamics going on there.
Yes, I think when you look at the share.
Any given quarter I think you've got to kind of look at it over over a longer period of time.
Kind of move around especially when you are coming out of this type of.
Market situation on.
That being said where we.
We are focused on this fit for purpose segment, which basically opens up about 40% metal cutting segmentation that we've never really focused on before and it happens to be right inside our existing customers. We have been a lot of our customers, especially those buying kennametal tooling were looking to or towards us or.
Sort of high performance tooling and even though they had these sort of fit for purpose.
Applications inside the same factories, they didn't really turned to us. So now that we've repositioned the video brand than we thought.
But the two organizations together and are on.
Our selling it.
As if we can cover their entire broad application base, we see that we're starting to win a lot of business there and they are coming to us for things that they never came to us before.
We are very.
Very encouraged by some of the things that we've seen.
As we roll this out globally, we've seen some good opportunities in France, and Spain with existing customers, where they are now giving us these fit for purpose applications.
During early wins with customers as I said previously had looks look to us for the high performance stuff, but not the fit for purpose. So when we see those types of things where no. We know we're getting a larger share of wallet and so thats actually a pretty easy weighted to definitely debt indicated that youre picking up share.
We know we've gained share with that particular customer so very good feedback from our distributors I think that is.
It is clear our brand strategy and positioning actually.
A full kennametal portfolio to their to their customers and net net it's a win for for the channel and it's a net net net win for our customers. So we feel very good about the traction we're getting.
I would absolutely say that as you.
As the organic growth numbers come in it's going to start to even more reflect this traction that we're getting and fit for purpose.
Okay got it that's helpful color. Thanks, Chris maybe just on another question to wrap up here.
Just wanted to level set what youre seeing in earthworks between the underground mining business on construction.
On the construction customers.
On a bit more positive on kind.
On where calendar 'twenty, one is going to shake out. So first of all just wanted to kind of.
Triangulate, where the more acute pressure is within earthworks and then on to that you've mentioned before you wanted to start getting more into the international opportunities on the mining side I'm. Just wondering if you can kind of update us on your efforts there.
Yes.
What sort of broadly mining from Q2 to Q3, we expect to be sort of flat across all regions.
Production flat across all regions.
But let me just maybe make some.
Deeper comments on construction like I said expected to be flat road continues to be affected basically by state budgets and COVID-19.
<unk>.
That is sort of putting a damper on some of the road. The road projects you can't physically get on site or the states are running out of running on a budget.
So that's what's kind of going on there that we think will persist at least through at least through Q2.
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 on this area China's rebounded from Covid, but there is trade.
Conflict with Australia, and U S and that's affecting some of the market dynamics.
In America has rebounded somewhat off the bottom.
Appalachian coal was down I think around 19% year over year.
But it is expected to recover by by Q4.
So.
Those those are sort of the high levels on.
On the current business and then as you said, we also wanted to move internationally.
And to get some good traction in.
In places like South Africa.
On that regard and then also we were expanding into mining Jason sees.
And that actually is starting to get some good traction where we are trying to use our tooling portfolio, that's well suited for coal if you will with similar at materials, such as potash and we continue to get traction there.
Okay, great. Thanks for the time guys.
The next question is from Adrian day.
Of Cleveland Research. Please go ahead.
Hey, guys good morning.
Yes, I wanted to go back to the.
Discussion about working capital earlier, you mentioned that it can be a use of cash on the second half of the year.
Honestly, but.
Beyond that how should we think about working capital as we get further into a sustainable revenue recovery.
Given all the investments.
He has made in <unk>.
On the factories and processes any kind of metrics that you could share with us along those lines.
Yes, I would say our target is still to be somewhere in the ballpark of 30%.
As David said, the second half is expected to be a modest use of cash so until volumes return, we're going to probably be above that 30%, but we're constantly looking for ways to reduce the primary working capital further.
And one of those ways is to rationalize our footprint. So the footprint reduction is going to help and also we're still ramping up a lot of these modernized cross.
Sse's in factories.
And as those become as those ramp up and wed.
We've become more efficient and we think that that will actually have an impact on the working capital in particular on.
Not only finished goods inventory because it takes us less time to manufacture things, but also on the working process sales.
30% is the target, but I believe with modernized factories, we should be able to do better than that and thats, what well covering to do.
Okay got you and then.
Could 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 is going to be dependent on volume but.
Im curious if you have any updated thoughts to share along those lines.
So I think Adam we've done just over 40 about $45 million year to date.
From what we said it will be just around another 40 here in the back half of the year over year.
We haven't given any specific numbers for FY 'twenty two.
There is actions that we have put in place this year or that we are you got to put in place like the closure of Johnson city on that will happen in the latter part of this year that will drive incremental savings in FY 'twenty, two and beyond and to your point as volumes ramp up from from where we are today.
We will drive an incremental savings beyond just the plant closures and other actions that are currently in place, but we havent 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 $1 80 and.
And we have given you a range of 180 to $2 20 based on certain revenue. So you can start to see that theres, probably more savings that will come as volumes continue to pick up here hopefully in FY 'twenty two and beyond.
Okay. Thank you.
The next question is from Steven Fisher of UBS. Please go ahead.
Great. Thanks, Good morning, Keith.
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 are seeing any broadening of.
Net market.
And Mark that's recovering really versus just automotive it seems like automotive.
A nice big driver here is that broadening out with it on general engineering.
Yes, Youre absolutely right.
The increase in general Engineering, and we've seen is in large part we think is driven by by transportation.
So transportation saw a nice increase.
From Q1 to Q2.
And most of the manufacturers, it's kind of a return to sort of pre COVID-19 levels.
The price stay there for Q3, we will see and we'll see we'll see some trickle down effect continuing in general engineering, but so far Stephen we haven't actually seen sort of a broader recovery in that space quite yet and.
And Thats whats thats part of whats governing our expectations for Q3.
We're hopeful that it's going to improve especially as.
GDP starts to return and the economy start to return to normal with the for the vaccine, but that's the timing of that is still a little bit on certain but youre absolutely right its been largely driven by by transportation.
Let's see what happens on the broader broader sense.
Got it and then just bigger picture here longer term, obviously volumes are 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.
The 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 youre going to be relying on market share was for.
Yes.
I think the way I would look at it is I mean of course it depends on how quickly the markets recover.
But.
When we do our strategic planning, we're sort of thinking of this thing as the market piece, we can't really control and we've got all kinds of models as to how these businesses commodity cycles.
We're challenging ourselves to pick up pick up share gain.
Ill.
Yes.
We're focused on and happy to have the market rebound, it's really to share gain.
After.
I wouldn't it wouldn't surprise me if that's a 50 50 split depending on dip.
Pending on the timeframe were talking about.
That's what we're that's what we're about coming to work every day to do is pick up that share gain and not just simply.
Follow the market's up and file the market's down now obviously it is a cyclical business and the markets do move so that's going to affect our numbers.
But we can help dampen that effect by by picking up share.
Making sure that we have a higher higher a higher share regardless of what point in the cycle. We're at.
Very helpful. Thank you.
Your next question comes from Steve Barger of Keybanc capital markets. Please go ahead.
Hey, good morning, guys.
Good morning.
I know, it's tough to call here in January but when you look at the <unk> revenue comp of negative 37% just in the context of the sequential improvements in end markets Youre seeing how are you thinking about <unk> growth just to just to help people calibrate.
Should we be thinking it's over 25% under 25%, what's what's your kind of thought on that.
Okay growth, you're talking about revenue growth revenue growth in <unk> year over year against the negative 37% comp from last year.
Got it yeah, I think maybe.
Well it might be helpful to look at is.
Now the markets the market staying largely the way they are right now this business would normally we would see a seasonality.
<unk> growth from Q3 to Q4 sort of in the 2% to 3% range.
So you can make you can make whatever assumptions you want if you want to take it higher than that because you think the recovery.
It's going to accelerate but.
I would think that you'd want to at least think about that that normal seasonality of 2% to 3%.
Sequential GAAP differential from.
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 modernization versus cost coming back just as a base case are you thinking the two half EPS. This year is above the 60.
<unk> the kennametal earned in two half 'twenty.
We haven't we're not giving a specific EPS guidance as we said, there's a lot of different variables.
About the absorption and the volume we're trying to we haven't even given your Q4 as Chris said, we're giving you an indication of what historical seasonality would look like so I think that coupled with the fluctuation in the tax rate.
We are giving you the best we can right now we haven't given any sort of full year guidance given the level of uncertainty that we're dealing with so I think we're going to keep it at that right now on just to give you the Q.
Understandable I guess ill just try it one more way if the three key operating margin look similar to <unk> would you expect.
A significant step up in <unk> or that's not likely because of the $40 to $45 million of incremental costs rolling back in even if you have a better volume.
Hello.
Again, Steve I think it goes back to what is the incremental volume that we're going to see from <unk> <unk> sequentially from incremental costs 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 cost would be relatively flat sequentially.
Some sort of an EBIT growth related to that top line again to $45 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 BMO.
BMO capital markets. Please go ahead.
I appreciate you guys staying on to squeezing me in.
I missed a little bit on the beginning but I don't know if you talked at all about.
Inventory levels at the distribution side.
Any any customer color.
Wanting to increase their inventory levels or kind of keep them about where they are where they are now.
Net Joel.
We had talked about.
The modest restocking activity that made that in my opening remarks on there was there was a question.
But what I said was the customers I think are pretty much remaining cautious so not a meaningful increase in restocking that we're seeing we did see that probably the most meaningful area was in China, which maybe doesn't surprise me because they're kind of ahead of the curve on the recovery otherwise a little bit a little little indication in the Americas and maybe.
Really nothing yet on the EMEA side.
Alright, Okay I'm sorry.
Go ahead, Joe what was the other part of the question.
I just I just wanted to I was wondering if you could give us a kind of a normalized free cash flow, maybe when we get past all this noise and just say maybe in your fiscal 2022.
Sort of.
How you guys are thinking about it or how should we be thinking about.
I think Joe 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've said is as we've moved through the heavy investment here with simplification monetization and our capital expenditures are now back into what we'll call more normalized range. In this 110 to 130 as these markets recover we.
Work through the working capital sort of rebuild of our we would expect cash flow to be about 100% of net income on an ongoing basis that sort of our long term expectations, whether we get there in 2020, we're now a lot will depend on how the markets move here, but that's our longer term goal.
Okay, Alright very helpful. Thank you.
The next question is from Chris Dankert on.
Please please go ahead.
Hey, good morning, guys. Thanks for fitting me in.
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 its national account signings, whether its 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.
Well from.
From an outside perspective.
We'll have to figure out something that.
I think it would be hard for you guys to triangulate that on on your own because like I said, it's inside of.
It's already inside the current segments that we reported externally.
I think the way we're looking at it as we we will we will be commenting on.
Basically the growth rate that we're seeing in certain end markets and then in a fit for purpose space, which is largely.
Has a lot to do with general engineering.
We can probably measure ourselves and we plan to measure ourselves against the.
What the overall market growth rate is versus what we're how we're actually growing so that will give us one indication.
And then we also have better indication specifically by customer we have the ability to sort of understand what the share of wallet is and thats, a better indication for us, but that is not something that we would necessarily disc.
Discuss externally.
So I guess from an external perspective, we can you can look at and Ipi and sort of how fast we're growing and.
Maybe the general engineering space versus that Ipi market index.
But.
But we will continue to give you guys commentary on how we're doing relative to.
What I said, which is measuring the sort of one client at a time.
Got it no that's helpful and just the very last thing from me.
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 or it would be really helpful.
Yes, there is a few things going on there we're focused on commercial excellence and infrastructure.
We brought a new leader body.
A year ago.
He has really brought a lot of discipline to the selling process in particular value selling and increasing the number of customer interactions.
So what we're finding is that that will that increase coverage we're going to.
Customers that we haven't really called on in a long time reminding them, who we are on a great value proposition and we're starting to get a larger share of their wallet just by being more disciplined with that sales process.
Focused on value selling.
And then we're also we've been doing simplification modernization inside infrastructure.
So our ability to ship on time and the ship with better quality.
We're leveraging that in fact, we just got a large order from a customer on the <unk>.
Supporting the U S government business.
And they gave us a huge order.
Because they said basically year on year the supplier that we can count on the ship on time on the right quality and Thats. All a result of simplification modernization. So I would say leveraging commercial exits excellence and operational excellence are helping us to grow there and then as I said, we're trying to expand in some adjacent spaces, such as potash and those type of things we continue fracture.
<unk>.
So it is true that infrastructure markets are down and maybe not growing as fast as.
As other markets, but there still is opportunity for us to gain share and grow in those spaces.
With the right business processes around commercial excellence and operational excellence and that's what we're that's what we're doing is when we come to work every day to day.
Got it got it well thanks, so much for the color, Chris and Beth of luck guys.
Thank you thanks, Chris.
This concludes our question and answer your question 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 transportation on our transformation is really well underway.
Permanently improve 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 <unk>.
Have a great day everyone.
Thanks.
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