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Kennametal, Inc. (NYSE:KMT)

F3Q09 (Qtr End 3/31/09) Earnings Call

April 24, 2009 10:00 am ET

Executives

Quynh McGuire – Director of Investor Relations

Carlos M. Cardoso – Chairman, President & Chief Executive Officer

Frank P. Simpkins – Vice President & Chief Financial Officer

Analysts

Eli Lustgarten – Longbow Securities

Jack Hain – Barrington Research Associates, Inc.

Henry Kirn – UBS

Mark Koznarek – Cleveland Research Company

Steve Barger – KeyBanc Capital Markets

Andrew Casey – Wachovia Securities

Holden Lewis – BB&T Capital Markets

Dana Walker – Kalmar Investments

Operator

Good morning. My name is Regina, and I will be your conference operator today. At this time, I would like to welcome everyone to Kennametal’s Third Quarter Fiscal Year 2009 Earnings 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. (Operator Instructions). Thank you. I would now like to turn the call over to Quynh McGuire, Director of Investor Relations. Please go ahead.

Quynh McGuire

Thank you, Regina. Welcome everyone. Thank you for joining us to review Kennametal’s third quarter of fiscal 2009 results. We issued our quarterly earnings press release earlier today. You may access this announcement via our website at www.kennametal.com. Consistent with our practice in prior quarterly conference calls, we’ve invited various members of the media to listen to this call. It’s also being broadcast live on our website, and a recording of this call will be available on our site for replay through May 24, 2009.

I’m Quynh McGuire, Director of Investor Relations for Kennametal. Joining me for our call today are Chairman, President, and Chief Executive Officer, Carlos Cardoso; Vice President and Chief Financial Officer, Frank Simpkins; and Vice President of Finance and Corporate Controller, Wayne Moser. Carlos and Frank will provide details on the quarter’s financial performance. After their remarks, we’ll be happy to answer your questions.

At this time, I’d like to direct your attention to our forward-looking disclosure statement. The discussion we’ll have today contains comments that may constitute forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve a number of assumptions, risks, and uncertainties that could cause the company’s actual results, performance, or achievements, to differ materially from those expressed in or implied by such forward-looking statements.

Additional information regarding these risk factors and uncertainties is detailed in Kennametal’s filings with the Securities and Exchange Commission. In addition, Kennametal provided the SEC with a Form 8-K, a copy of which is currently available on our website.

This enables us to discuss non-GAAP financial measures during this call, in accordance with SEC Regulation G. This 8-K presents GAAP financial measures that we believe are most directly comparable to those non-GAAP financial measures and it provides a reconciliation of those measures as well.

I will now turn the call over Carlos.

Carlos M. Cardoso

Thank you, Quynh. Good morning everyone. Thank you for joining us today. The third quarter of fiscal 2009 was exceptionally challenging for Kennametal, as well as most companies in the industrial sector. The downturn in the global markets, particularly in Europe was more rapid and significantly steeper than anticipated.

In fact, the current downturn has been broader, faster, and more pronounced than any we have witnessed in Kennametal’s history. Credit markets continued to be difficult and the recession deepened. Capital spending and industrial production both slowed. Customers and distributors continued de-stocking and are using their inventories on hand.

On a geographic basis, North America, Europe, Asia and India all experienced lower sales volumes. The March manufacturing report from the Institute of Supply Management, or ISM underscored the environment in the North American marketplace. The report stated that economic activity in manufacturing sector failed to grow for the 14th consecutive month and the overall economy contracted for the 6th consecutive month.

In Europe, industrial activity essentially fell off the cliff in the March quarter. Germany and other major European economies are in deep recession. Production in our served end markets in Asia and India was also down considerably year-over-year. While certain sectors in Asia are starting to show some slightly positive signs. We do not yet see any concrete indicators of stabilization on a global basis. Therefore, we do not know whether economic conditions have reached bottom, or when the recovery will begin.

As we announced last week, the highly unfavorable economic environment had a considerable negative impact on our business for the quarter, resulting in sales decline of 32% on an organic basis and an operating loss of $6 million before charges related to [restruction] and impairment. In response, we reacted quickly with additional measures during the March quarter, as we saw the economy turn further downward. As a result, we have already significantly reduced our costs and we will further reduce our costs going forward.

Our management team is fully engaged in navigating Kennametal through those turbulent times. We have a specific emphasis on maximizing cash flow, maintaining financial flexibility and focusing on our balance sheet.

During the quarter, we continue to execute our strategies and apply our disciplined approach to running the business. At the same time, we took aggressive measures to collect accounts receivable, lower inventory levels and reduce costs. In addition, we are continuing with many other programs in which we have been engaged throughout the fiscal year. Those include accelerating our restructuring plans, streamlining our manufacturing footprints and right-sizing our business.

Now, let’s discuss some metrics that show progress that our global team has made as we manage through the economic downturn. As I mentioned, we have been intensifying collection efforts for our accounts receivable. We are closely following discipline processes related to customer payment terms and are focusing on our accounts receivable aging balances.

As a result, we’ve been able to avoid any meaningful deterioration in our accounts receivable aging. For the March quarter, we have maintained our days' sales outstanding or DSO at 63 days, which is within our historical range. Second, we have been closely managing our production schedules to manufacturing at or below demand levels.

We continue to rely on our lean principles and work proactively on demand planning. We have reduced our inventory by $31 million over the past two quarters, while maintaining high customer service levels. Third, we have been reducing capital spending as March 31, our year-to-date total was $93 million. This represents a decrease in CapEx of $38 million or 29% compared with the same period last year.

Finally, we have continued to lower our overall cost structure by streamlining our manufacturing footprint, reducing our manufacturing costs, and decreasing operating expenses. We also took some temporary measures such as implementing unpaid employee furloughs, suspending matching company contributions to certain defined contribution employee benefit plans, and applying other related actions across our global enterprise.

As a result of those efforts, we generated cash flow from operating activities for the first nine months of a $164 million. In addition, we expect our combined cost reduction programs to result in a pre-tax savings of a $125 million annually, once fully implemented.

As we manage through the current environment, we continue to diligently work with our customers to reinforce the value proposition of Kennametal's products and services.

We are demonstrating the performance of our products and validating productivity savings realized by our customers. For example, in Tooling & Production magazines 2009 cutting tools survey 72% of respondents named Kennametal as their tooling provider of choice, while our nearest competitor was 15% lower at 57%. In addition, 89% of those surveys put Kennametal at the very top of their name recognition list for tooling providers. Clearly, this survey that was just released shows that Kennametal is first for tooling in customer mind share as well as first in business share.

By increasing touch time with customers in this difficult economy, we are able to retain or penetrate existing accounts, gain market share and identify new long-term opportunities in certain developed industry segments.

I will now turn the call over to Frank. So he can discuss our financial results for the quarter in greater detail. Frank?

Frank P. Simpkins

Thank you, Carlos. I’ll provide further comments on our performance for the March quarter and then I’ll move on to the outlook for the remainder of fiscal 2009. Some of my comments will exclude special items, so please refer to the reconciliation schedules we provided in our earnings release and related 8-K.

As Carlos mentioned, the impact of the global economic downturn on our markets and business has been more rapid and steep than anticipated. Those of you who closely follow our monthly-published order rates have certainly observed that trend. It's striking to think just six short months ago, we reported record organic sales for our September quarter. Even as late as October, our organic sales were flat with the prior year. We saw a modest decline in November, and then in December was considerably weaker with organic sales down 24% from the prior year. Organic sales in January and February were down about the same as December. Then in March, our organic sales fell by 43% from the prior year.

The speed, descent and impact of this downturn are unprecedented in our company's 70-year history. This is a tremendous challenge of which we will and continue to aggressively respond. Against this background, we considered ourselves fortunate that we started our restructuring programs about one year ago. We are now realizing benefits from those actions and the savings will continue to accelerate. Over the past 12 months, we added to those programs and continued to implement additional cost reduction actions including further measures this past quarter.

As one measure of the degree of favorable impact of our cost reduction actions, our year-over-year decremental EBIT margin for the March quarter was 34% on an organic sales decline of 32%. This is an improvement in decremental EBIT margin of 700 basis points from the December quarter, which had a year-over-year organic sales decline of 10%.

Maximizing cash flow and ensuring adequate liquidity remain our top focus and priority, as business conditions deteriorated further in the quarter, we reacted with additional measures to reduce cost and support cash flow. The steps included one, we terminated our interest rate swap agreements and received the cash payment of $13 million, we implemented a one-week employee furlough in March and we implemented another one-week furlough in April and we're evaluating further actions in the next two months. Also in March, we converted our basic employer contribution to our 401K plans from cash to stock. And also in March, we suspended our 401K employee matching contribution. And we implemented equivalent actions in our non-U.S. operations.

We also continued to take advantage of short time work programs and non-U.S. operations as available, whereby employees are scheduled to be off work and not paid by us for one or more days per week, but receive government assistance for those off days. And last week, we announced further restructuring actions that we intend to take.

We continue to employ other specific and targeted actions to maximize cash flow and liquidity, tremendous intention and focus efforts continue to be place on collecting receivables with particular emphasis on aging and actions on past due accounts. We have managed to avoid any meaningful deterioration on our accounts receivable aging.

We are constantly managing our production levels, and now have reduced inventory for the second consecutive quarter, despite the rapid and steep drop off in sales volumes. And at the same time, we have maintained high off-the-shelf inventory availability for our customers. And purchases of capital equipment are reduced to maintenance level until further notice. As a result of our cash flow management initiatives, we generated $48 million in cash flow from operating activities and free operating cash flow of $25 million for the March quarter.

Our debt-to-cap ratio was 28.4% at March 31, 2009. Total debt was $502 million at quarter end, down $21 million from December 31, 2008. Another positives that we are not experiencing asset declines in our U.S. pension funds due to the successful implementation of our LDI strategy a few years ago. Our U.S. pension funds remain over a 100% funded and we do not anticipate any U.S. pension fund in needs in the foreseeable future. Now, let me walk you through the income statement.

Our sales for the quarter were $441 million, this compares with $690 million in the same quarter last year. The 36% year-to-year decrease in sales was comprised of the 32% organic decline and a 5% decrease from unfavorable foreign currency effects partly offset by the net favorable impact of acquisitions and divestitures of 1%. Sequentially, sales for the March quarter were down 22% from the December quarter as the severe economic downturn impacted all geographies in most of our end markets.

Turning to the business units, MSSG sales decreased by 43% from the prior year quarter driven primarily by an organic sales decline of 35% unfavorable foreign currency effects of 6% and 2% from the impact of divestitures. On a global basis, industrial production declined sequentially and in comparison to the prior year quarter. Demand in most industry and market sectors has weakened substantially.

On a regional basis Europe, India and North America reported organic sales declines of 40%, 38% and 34% respectively for the March quarter. Asia-Pacific and Latin America also experienced organic sales declines of 31% and 21% respectively. AMSG sales decreased 22% from March, one year ago, driven primarily by a 24% organic decline; and a 3% decrease from unfavorable foreign currency effects partly offset by the impact of acquisitions of 5%. The organic decline was primarily driven by lower sales in the surface finishing machines and services business, as well as the engineered products business.

Our gross profit margin was 23.5% for the quarter, as compared to 34.5% in the prior year. Restructuring and related charges of $2 million were recorded in cost of goods sold for the quarter. Absent these charges, gross profit margin was 24%, compared to 34.5% in the prior year.

In short, the primary driver contributing to the decline in gross margin percentage was reduced absorption of manufacturing costs due to lower production levels. To compensate for this, we continue to substantially reduce our manufacturing costs in response to the steep and rapid downturn in business levels. And our price realization exceeded the increase in raw material costs for the third consecutive quarter.

Our operating expenses decreased 28% or $42 million to $108 million from the prior year quarter. The decrease is mainly attributable to lower employment costs, as a result of the impact of restructuring and cost management activities, as well as the impact of foreign currency rate fluctuations and other cost reduction actions, offset somewhat by a net increase from acquisitions and divestitures.

We also recognized restructuring charges of $33 million during the March quarter and we also recorded a net $1 million of restructuring related in cost of goods sold and operating expense during the quarter. As such, total restructuring and related charges recorded in the March quarter were $34 million, which was the equivalent to $0.51 a share. These charges relate to the previously announced restructuring plans, which involve the closure of five manufacturing facilities as well as workforce and other cost reduction actions.

Pre-tax charges recorded to date for these initiatives were $61 million, included in these charges and those associated with additional actions that we announced last week. We expect to recognize a total of $115 million of pre-tax charges related to all these restructuring plans. The remaining charges are expected to be incurred over the next six to nine months. And then the annual ongoing benefits of these actions once fully implemented are expected to be $125 million and we are on track with these initiatives.

In view of the severe downturn in the global markets during the March quarter, we made an assessment of the possible impairment of goodwill and other long-lived assets of our various reporting units. As a result of this assessment, we determined impairment existed for our surface finishing machines and services businesses, Extrude Hone, as well as our engineered products business.

These businesses are both part of our AMSG segments. And we ended up reporting a non-cash pre-tax impairment charge of a $111 million as a result of this test. Pre-tax charge for Extrude Hone was $48 million and no goodwill remains on the books for Extrude Hone and the pre-tax charge for engineered products business was $63 million and goodwill of $40 million remains on the books for this business.

Our operating loss was $151 million for the quarter. Absent of the impairment and restructuring, the operating loss for the quarter was $6 million compared to operating income of $84 million in the prior year quarter. The performance was impacted by the significant decline in sales volume and related lower manufacturing cost absorption.

As I mentioned earlier, we continue to adjust our manufacturing cost and operating expense in response to the rapid and steep downturn in business levels. MSSG’s operating loss was $40 million for the quarter, compared to operating income of $76 million in the prior year. During March, MSSG recognized restructuring related charges of $25 million. Absent these charges, MSSG’s operating loss was $15 million, compared to the prior year reported operating income of $76 million. The primary drivers of the decline in operating income are reduced volumes and related unfavorable absorption of manufacturing costs due to the lower production.

AMSG’s operating loss on a reported basis of a $103 million in the current quarter, compared to an operating loss of $6 million in the prior year. As I said earlier, AMSG recognizes charges related to impairment and restructuring of $121 million. And during the prior year quarter, AMSG recognized an impairment charge of $35 million. Absent these charges, AMSG’s operating income was $18 million in the current quarter, compared to $29 million in the prior year. The decline was primarily due to lower sales and production volumes in the engineered products business.

The corporate operating loss decreased 59% or $12 million. The decrease was driven by lower provisions for performance-based employee compensation programs, as well as the impact of cost reduction actions. And our net loss was $138 million, compared to net income of $23 million in the prior year quarter. Absent the charges related to impairment and restructuring, net income for the quarter decreased to $0.5 million from $58 million in the prior year quarter.

Lastly, reported fiscal 2009 third quarter diluted loss per share was $1.90 compared to prior year quarter EPS of $0.30. And adjusted EPS for the quarter was a $0.01 a share compared to the prior year quarter adjusted EPS of $0.75.

I mentioned previously, our positive cash flow generation for the March quarter, for the first nine months of the current fiscal year, cash flow from operating activities was a $164 million, compared to $159 million in the same period one year ago. And free operating cash flow for the current nine-month period was $73 million, compared to $30 million in the prior year period.

Turning to the outlook, due to the present high level of uncertainty in the global economy, visibility is very limited regarding demand in our served end markets and ultimately our sales levels, earnings, and cash flows.

Based on our best judgment in this uncertain environment, we expect organic sales for the June quarter to be lower by more than 40% from last year’s June quarter in which we set all-time quarterly records for sales as well as adjusted EPS. And sequentially, we expect our June quarter sales to be down from the March quarter by at least 10%. As I mentioned earlier, sales for the March quarter were down 22% sequentially from the December quarter.

We continue to take aggressive actions to reduce costs, including streamlining our manufacturing infrastructure. In further implementing these actions, we expect to recognize the remaining $54 million in charges related to the previously announced restructuring initiatives over the next six to nine months. We are positioned to respond quickly to any changes in the global markets and we will continue to sharply focus on cash flow.

At this time, I’d like to turn it back to Carlos for some closing comments.

Carlos M. Cardoso

Thank you, Frank. Again it’s difficult to gauge whether this downturn has reached bottom, when an economic recovery will begin and what the pace of that recovery will be. The North American economy continues to face challenges, including rising unemployment, tight credit markets and lagging consumer confidence. The slowdown in Europe has been so pronounced that we believe it will take longer for that region to recover.

Asia may be the first major economic region to rebound. For signs of such a recovery, we will look to certain sectors as leading indicators such as general engineering, automotive, and oil and gas exploration. An increase in industrial production, GDP, consumer conference and employment figures will be positive signals of an improvement in the economic activity.

In the meantime, we'll continue to manage through the challenging times. We remain committed to the Kennametal Value Business System, or KVBS, the management operating system that continues to guide all of the decisions we make relative to strategic planning, product development, sales growth, portfolio management and lean enterprise processes. KVBS provides the roadmap for a team as we implement a necessary restructuring programs to streamline our business and reduce our costs.

At Kennametal, we are constantly building a better business. This focus is helping to position the company for growth, once we begin to see the eventual upturn in the customer demand for our products.

We are a market leader in tooling and solutions, engineered components and advanced materials. As such, we are a consumables business and supply tools and components that are used in everyday production. We are also out balanced across geographic and end markets. We are financially sound. Those solid fundamentals give us confidence that we will be able to manage through this global economic downturn, while providing customers with quality service and maintaining our competitive strength in the marketplace.

Thank you for your time and your interest in Kennametal. We will now take your questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Eli Lustgarten with Longbow Securities.

Eli Lustgarten – Longbow Securities

Good morning.

Carlos M. Cardoso

Hello, Eli.

Frank P. Simpkins

Hi, Eli.

Eli Lustgarten – Longbow Securities

I guess, the only good news today is the cash flow was pretty decent. Can we talk a little bit about your demand outlook for fourth quarter? I mean if you look at your third quarter, you had a decline in metalworking that was almost twice to decline in advanced materials. When you’re talking about a 40% organic decline and probably, north of 45% on with currency, is that equally split between the two or is that still more heavily, we’re going to see over 50% metalworking and somewhat less in advanced material. So give me some guidance of how you’re thinking about that?

Carlos M. Cardoso

Well. The metalworking is going to decline less this quarter. And we are going to see less than last quarter in relative numbers. And we anticipate to see a bigger decline than before on the AMSG side of it. We see the rig counts being down for the gas and the natural gas and we see the backing of the supplies. There is plenty of supply out there for gas. So, that has been holding pretty well for us throughout the year-to-date basis.

Eli Lustgarten – Longbow Securities

That’s sort of saying that you’re looking at metalworking, the advanced material decline almost doubling at this point?

Carlos M. Cardoso

Well. I mean, again we still anticipate a significant decline in metalworking. Because I mean, all the indicators currently, the industrial production continues to be down and so forth. I mean every company that has announced so far in industrial space has announced a lower worst scenario for the next quarter than they had before. So we're in the same boat.

Frank P. Simpkins

Yeah. Eli, I'll just to directionally point you there. From advanced material, I wouldn’t say it’s double the number that you talked about. I would say it’s much, it deteriorated from the second quarter below kind of guidance we had in the press release and I’d say North America sequentially is down a little bit more, not substantial and that’s really due to the drop off in Europe, which we have to watch closely and it’s tough to gauge what’s going on in April right now, because of the Easter holiday. I would say it’s a little bit softer in the metalworking side, because of Europe, number one and then to some of the factors that Carlos mentioned, I expect AMSG to be below where metalworking was, but softer sequentially.

Eli Lustgarten – Longbow Securities

Okay, so we are, now the big thing if you look at your incremental margin why it got to 34%, it was really made up of two different worlds you hadn’t. I guess, back to the envelope, it looks metalworking was down like 47% and advanced materials down 22%. So, I mean I assume the goal is to reduce the metalworking incremental, decremental margin. How bad does an advanced materials sort of match it and we get to similar numbers, because it seems like there will be a very tough quarter to match incremental, decremental margin?

Carlos M. Cardoso

Yeah. I would expect the decremental margin to improve slightly. And I expect AMSG to be in that vicinity and with further benefits for metalworking through a combination of additional restructuring benefits kicking in. And some of the short-time programs we have in the international non-U.S. locations.

Eli Lustgarten – Longbow Securities

Yeah. And one of the wild cards we had, generated a $15 million tax credit on a $6 million operating loss. I assume you're going to have tax credit in this quarter, or so is the magnitude the same, because it’s very difficult to predict mathematically given where this quarter turned out?

Frank P. Simpkins

You're exactly right. First of all, we will have a tax benefit in the fourth quarter, nowhere near the magnitude, because in the third quarter as you know you have the cumulative view. Basically you’re trueing up your forecast, and we did earn income in the first half, and you’re catching up in the second half, but I would put the tax benefit in the range excluding special items anywhere from 12% to 15% in the fourth quarter, but as you know…

Eli Lustgarten – Longbow Securities

The operating loss, you mean?

Frank P. Simpkins

Yeah, and that could move significantly one where the other when you have such a low base as you know.

Eli Lustgarten – Longbow Securities

Yeah. And in corporate expense, drop $10 million bucks or so, can we hold the current levels or near the current levels in corporate expense?

Frank P. Simpkins

It will be tough. I would expect it to be up slightly, but nothing substantial.

Eli Lustgarten – Longbow Securities

It will be up a little bit. And cash flow was very good in the quarter, despite the downward. Are we looking at similar cash flow kinds of numbers in the fourth quarter that we saw in the third quarter? [Inaudible] free cash flow generation?

Frank P. Simpkins

The two factors on the cash flow, which will be, I will call them temporary, because we will pay more cash out the door related to some of the restructuring programs. Whereas we book some of the charges so they're kind of one-time type cash payments out the door and then given the operating performance being somewhat lower in the third quarter. We won’t have anywhere near the performance we had in the March quarter.

Eli Lustgarten – Longbow Securities

The cash flow sort of is half the goal or something like that of Q3, something to that effect?

Quynh McGuire

Eli, this is Quynh. Afraid, we are not going to be able be comment on that, but I think there is drivers that Frank had outlined gives you a sense of where we’re heading.

Eli Lustgarten – Longbow Securities

Okay. Then one final question, the fiscal year is coming down. Our biggest problem is guessing 2010 and is everything being put in place to sort of make sure that even if volume doesn’t change dramatically next year that will be considerably more profitable next year that we shouldn’t see much better earning leverage than we're seeing this year, from wherever we wined up this year?

Carlos M. Cardoso

Yeah. I mean obviously at this point, I mean we have a hard visibility for the fourth quarter, nevertheless that 2010. I mean we are assuming, we have to assume as a management team that 2010 worst-case scenario is going to be just like 2009, or even slightly worse. So we are looking at all of those possibilities, so to put the company in a better position. So, we are assuming the worst case at this point.

Eli Lustgarten – Longbow Securities

All right. Thank you.

Operator

Your next question comes from the line of Jack Hain with Barrington Research.

Jack Hain – Barrington Research Associates, Inc.

Good morning.

Frank P. Simpkins

Good morning.

Carlos M. Cardoso

Good morning. How are you?

Jack Hain – Barrington Research Associates, Inc.

It seems like the culprit in this quarter and going forward it’s really being Europe. So I going to sort of focus my questions there, and maybe this is more granular than you usually get, but could you just provide some qualitative remarks about how operating margins in Europe are trending relative to North America and rest of the world, I mean is it really day and night, or is it more shades of gray in terms of the impact of the cost under absorption in Europe?

Frank P. Simpkins

Profitability, it’s very similar on the metalworking side. They’re both very profitable type businesses and Europe for the most part was hanging in there up pretty well until really this last quarter. So when you have, the last shoe falling or as Carlos said falling off the cliff that put additional pressure on the quarter. But from an overall profitability standpoint, very much similar and that's what we've experienced this last drop off here in the March quarter.

Jack Hain – Barrington Research Associates, Inc.

Okay. And also Carlos in your prepared remarks, you said that there are some sectors in Europe that are starting to show some positive signs of recovery? I was wondering if you wouldn’t mind being a bit more specific in terms of where you are starting to see some strength reappearing?

Carlos M. Cardoso

Actually, my comment was relative to Asia, what we are seeing in Asia, we see there is stimulus package really starting to take hold. We see, we starting to see a lot of activity for example, in railroads. We have gotten quite a few orders in that area and the automotive is picking up. Again, their stimulus is giving people that are buying smaller, more gas efficient cars, they are coming to production. Those two areas are the first areas that we see a comeback, but my comments were relative to Asia. And we do see Asia coming out of the chute first, at this point, China in particular.

Jack Hain – Barrington Research Associates, Inc.

Okay, and last question. I have to believe that some of the sales drop has to be, due to inventory de-stocking. Just wondering how much more de-stocking do you feel that there is to go and, would a trough margin impact look like?

Carlos M. Cardoso

I mean, the de-stocking is really hard for us to see how much more, because I mean, we don’t, we never believe that there was that much stock, first of all the distributors don’t carry that much stock for us. The de-stocking is about the enduser and we have very little visibility to that, but as companies like industrial companies cut their inventories, they cut their production, obviously they don’t buy the tooling. So, it's really hard for us to know at this point.

Frank P. Simpkins

Yeah, the only thing I would add to that is, and as you know it's tough to figure out de-stocking, because you've got two issues there. As everybody is watching everything they can and then we’ve actually improved our fill rates. So, our customer service metric throughout the door, customers don’t have to carry as much inventory the basic inline on efficient manufactures since goes back to our Kennametal Value Business System by focusing on lean, we're able to get our products much faster to our customers. And then from a trough margin, I don’t know how to answer that question, but I would tell you we're shooting for the decremental margin of 30% or less and that’s kind of the goal that we have internally.

Jack Hain – Barrington Research Associates, Inc.

All right. Thank you very much.

Carlos M. Cardoso

Thank you.

Operator

Your next question comes from the line of Henry Kirn with UBS.

Henry Kirn – UBS

Question about pricing discipline in the market. Have you seen any competitors trying to undercut you and gain some share in the downturn?

Carlos M. Cardoso

Actually the pricing discipline has been very good. We have really with the major players I mean there is thousands of people, thousands of companies in this marketplace, but the major competitors have maintained the discipline as far as we can tell at this point. And we have, we went with the price increase as late this January and we have been able to get price at this point. So, the environment relative to price has been pretty favorable. There is a lot of pressure, there is a lot of pushback, but so far we are doing fine.

Henry Kirn – UBS

Right. And without giving guidance, could you give some of the factors as to how we should think about margins in MSSG and AMSG over the next few quarters at least relative to each other?

Quynh McGuire

Generally, Henry we do not provide any margin information on the individual segments. It’s always on a consolidated Kennametal basis.

Henry Kirn – UBS

Okay. That’s fair. Abnormal times, so I was hoping to get something. As far as raw material costs, could you talk a little about what you are seeing there and how they are trending?

Frank P. Simpkins

Yeah, I would say, from an overall materials, when I look at it on a year-to-date basis in both periods, I would say they are actually up the same amount. However, the trend that we are experiencing this year as they are still up slightly in this last quarter, but they’ve come down substantially from the first quarter to the second to the third. So that, we are doing good on the price recovery, but the raw materials are still a little bit high year-over-year, and we expect that to neutralize itself potentially in the fourth quarter as we had originally anticipated with the culprits being steel predominantly and that’s coming down and on a year-over-year basis, it still year-to-date cobalt, but that has subsided in the third quarter, and we are just seeing some tungsten or APT some slight increases there.

Henry Kirn – UBS

Hey, thanks a lot. That’s helpful.

Frank P. Simpkins

Thank you.

Operator

Your next question comes from the line of Mark Koznarek with Cleveland Research.

Mark Koznarek – Cleveland Research Company

Hi, good morning.

Frank P. Simpkins

Hey, Mark.

Carlos M. Cardoso

Good morning, Mark.

Mark Koznarek – Cleveland Research Company

On the price related comment, I think last well, initially in the year, you were shooting for 2% price realization. I think last quarter, you said you’ve got that, was the price contribution similar to this quarter?

Frank P. Simpkins

Actually, Mark it was 3%.

Mark Koznarek – Cleveland Research Company

3%, well. Okay.

Carlos M. Cardoso

Yeah, we continue to do very well. I mean it shows that our brand has value. It shows that the value proposition, although, one other things we have actually seen customers placing higher number of orders, but they are just buying less. So the order number, the dollar of those orders is less. So, it shows that the customers are watching their spends, but they are going for product like our value-added products and Kennametal, because they need the cost reductions that we can offer.

Mark Koznarek – Cleveland Research Company

Well, that’s pretty impressive.

Frank P. Simpkins

Mark, that’s consistent with metalworking; they had a last round, most of the competition followed there in October. And then, our major competitor in Europe also increased prices in January, and I think a lot of the competition followed as well.

Mark Koznarek – Cleveland Research Company

Okay. Given that your guidance for revenue has a sequential decline in the fourth quarter. I don’t imagine you are seeing any degree of stabilization so far in April. Would that be correct?

Carlos M. Cardoso

I mean, it’s hard to tell in April, especially because of the holiday. The holiday fell in April. So, we really have not had as many working days that we can really feel, have a good feeling one way or the other at this point.

Mark Koznarek – Cleveland Research Company

Okay. And this final question might be a little unfair, given the lack of visibility right now. But the question really revolves around Kennametal performance in the recovery, once the recovery gets here, whenever that is. And one thing I observe in the last recovery is, in North America the ISM, went above 50 in February of '02. Kennametal orders began to get positive in January '03. So, there is kind of a surprising lag. And then Kennametal core revenues didn’t begin to go positive until almost the end of calendar 2003. So, there was actually kind of surprising late cycle, performance of the company's actual fundamentals. Even though your consumable operation and I'm wondering if is the business structurally different now that you would expect that behavior to be much more coincident with the economic recovery?

Carlos M. Cardoso

Yes. I believe it is, I think, we have one, we’ve sold a number of businesses to the magnitude of $500 million in sales plus, that were more commodity business. If you recall, we had just bought Widia a couple of years before the recovery. During the downturn, we were in the midst of the integration of that business. And through the 2001, 2002 timeframe, we were really in the midst of that, which today we don’t have I mean everything that we have has been integrated. So, there is a number of factors that I believe will put us in a better situation coming out of us. I think, we have done more in the cost structure. We have closed more facilities. So I think, there is a number of things and everything that I mentioned is not includes that we have done that makes us feel that we can do a much better job coming out of this downturn.

Mark Koznarek – Cleveland Research Company

Okay.

Carlos M. Cardoso

Whenever that is.

Mark Koznarek – Cleveland Research Company

Yeah. All right. We will keep our fingers crossed. Thank you.

Carlos M. Cardoso

Thank you.

Operator

Your next question comes from the line of Steve Barger with KeyBanc Capital Markets.

Steve Barger – KeyBanc Capital Markets

Good morning.

Frank P. Simpkins

Hey, Steve.

Carlos M. Cardoso

How you are doing Steve?

Steve Barger – KeyBanc Capital Markets

Good. I hear what you are saying about planning for the worst case in FY ’10. But presumably you’re also thinking about how to run the business if volumes come back a quarters out. How should we think about incremental margins? Should you get back to a single-digit growth rate against some of these easy comps relative to your new cost structure? What's kind of possible there, do you think?

Frank P. Simpkins

Well, again, I don’t want to get into fiscal '10, but they should be much better than the last cycle that we had where we have always shot for 35% in the past, say average 30, 35, but when we're coming out of this, Steve, I would expect those to have a number above that given the restructuring that we've taken out, some of the divestitures we’ve had over the years.

Steve Barger – KeyBanc Capital Markets

Right, yeah if you just…

Carlos M. Cardoso

I'll emphasize the fact that we are, I mean, I answered a question about preparing, being ready to the business to be worse case scenario. You are absolutely right, we are also preparing to be ready when the business, when the economy turns. I mean that’s a challenge that we have is that we have a broadband that we have to look at.

Steve Barger – KeyBanc Capital Markets

Right, right. If you just do the math on the $125 million in pre-tax savings, that’s more than $1 in earnings, I know some of that falls into FY ‘09, but if you have flat to up sales in FY ‘10, would you expect to see an EPS recovery similar to that of what you saw in '04 over '03, where EPS, I think pretty much doubled?

Carlos M. Cardoso

I don’t remember that, I mean I don’t have that data in front of us right now, but...

Frank P. Simpkins

But directionally, I think that's where you would think. I mean, if next year it's going to be tough being at June 30 year-end, it’s going to be kind of a tale of two halves.

Steve Barger – KeyBanc Capital Markets

Right.

Frank P. Simpkins

We are going into decent comps in the first half and then the second half it really goes up, calendar '10, we think it’s going to be really good. And it’s just getting through it, then on run rate, I think directionally your comments are valid.

Steve Barger – KeyBanc Capital Markets

Okay, that's yeah, that’s helpful. One last question, I'll get back in line. On a dollar basis, SG&A was down $20 million sequentially on that mid 30% decline. How should we think about SG&A on a dollar basis for the fourth quarter, given the revenue guidance that you've talked about?

Frank P. Simpkins

I can't see it varying much.

Steve Barger – KeyBanc Capital Markets

So, inline with what you put up in 3Q?

Frank P. Simpkins

Yeah, again if anything it should be, maybe down a little bit.

Steve Barger – KeyBanc Capital Markets

Okay.

Frank P. Simpkins

That's fine.

Steve Barger – KeyBanc Capital Markets

That's great. Thanks a lot.

Carlos M. Cardoso

Thank you.

Operator

Your next question comes from line of Andy Casey with Wachovia Securities.

Andrew Casey – Wachovia Securities

Good morning everybody.

Carlos M. Cardoso

How are you doing, Andy?

Andrew Casey – Wachovia Securities

I'm doing okay. It sounds like you guys are too.

Carlos M. Cardoso

Yes.

Andrew Casey – Wachovia Securities

With your comment about customers buying less, but paying more, does that imply a mix shift up to gain tooling productivity, despite the general economic uncertainty?

Carlos M. Cardoso

Yeah, I mean my comment was that the transactions, we have more transactions, more orders placed, but the value of those orders are lower in general and yes, the customers are, I mean yeah, when you say the customers, it's a broad brush here, but the good companies are actually looking at our new product and our best products. So they can reduce cost in their factory floors. So, we are definitely seeing that, which would be very, very positive. The positive to us coming out, because we will have been better establish with those customers, we have been with them during the tough times. So, when they are looking to increase production, we will be right there with them.

Andrew Casey – Wachovia Securities

Okay thanks. And then on the Q4 MSSG revenue guidance implied, if I look directly at North America given some fairly large steel consumers are saying they're taking unusual shutdown periods in Q3. How much of the Q4 might be related to de-stocking in advance of actions like that?

Carlos M. Cardoso

It’s really hard for us to really.

Frank P. Simpkins

We anticipate, we anticipated I should say. In our forecast, the further weakening in some of the automotive plants and as far as extended shutdown and so forth, we try to build in as realistic or pessimistic as we can related to the automotive manufacturers, but it’s really hard on that Andy.

Andrew Casey – Wachovia Securities

And just based on your history Frank would it be, would that impact occur in your fourth fiscal quarter, or would it be first fiscal quarter of next year?

Frank P. Simpkins

Yeah, I think it is straddle. It would probably more in the July period given the fourth of July. So when, it depends when if they start earlier and how long they extend it, but we will see that both domestically with the Detroit 3 and then you have the European situation with August. So, we typically see a stronger impact in the first quarter, but it could straddle both this period.

Andrew Casey – Wachovia Securities

Okay. One last one, another market question. You commented on the natural gas rigs, have you seen any inflection in your exposure to the coal mining area?

Frank P. Simpkins

Well, actually, as you know our coal mining is, we have a good market share in the Appalachian and that area has actually kind of held up fairly good so far. And so the Appalachian core production is down 5% year-over-year for the period ending this quarter. So but, the 52-week trend is still positive. So we have been doing okay, that’s been good for us at this point, been a bright spot.

Andrew Casey – Wachovia Securities

Okay. Thank you very much.

Operator

Your next question comes from the line of Holden Lewis with BB&T.

Holden Lewis – BB&T Capital Markets

Great. Thank you, good morning.

Frank P. Simpkins

Good morning.

Carlos M. Cardoso

Hey, Holden how are you.

Holden Lewis – BB&T Capital Markets

Well, thank you. First can you just, I may have missed this, but the corporate expense I think that going into this quarter you were expecting something again sort of $15 to $20 million range, and then you sort of came up with the $8.5 million number and it looks like that’s come in lower. Can you give us a little more detail of how that number has come in as low it is, what it might stay at and at what point does it return to that $20 million level. What do we need to see or just sort of new sort of paradigm for you?

Frank P. Simpkins

It’s a combination of additional cost reductions relative to the plans that we accelerated and then some of the compensation programs, we actually did worse than we had anticipated. So, we didn’t need as much for the compensation program. So, it’s a combination of those two.

Carlos M. Cardoso

And the compensation part, obviously is the only part that will comeback up.

Holden Lewis – BB&T Capital Markets

Going forward, right.

Carlos M. Cardoso

Going forward, so the structural costs. Whatever we reduce our SG&A and corporate by we're going to keep those.

Holden Lewis – BB&T Capital Markets

Okay. And then do you have a sense of how and I guess the next question was I think you are looking at about $35 million in restructuring benefits for the second half. Can you talk about where you were in the quarter and for the half; and maybe talk about how much of that benefit is coming at the corporate side versus within the segment?

Frank P. Simpkins

Yeah, year-to-date little over $20 million we expect that to ramp up in the fourth quarter. Almost 20% more in the fourth quarter, but the big drivers of the benefits we're seeing will be in MSSG we will have the largest given some other facilities that we’ve closed and some of the headcount reductions then AMSG and the corporate’s still the laggard, compared to the other two because of the just the sheer numbers of people involved.

Holden Lewis – BB&T Capital Markets

Okay. You had about $20 million in savings year-to-date and you expect that to be…

Frank P. Simpkins

We expect anywhere from, at the end of the year anywhere from put a broad range out here $40 to $50 million.

Holden Lewis – BB&T Capital Markets

With realized benefit?

Frank P. Simpkins

Correct, for the full year and all the incremental as we talked about falling into FY ’10.

Holden Lewis – BB&T Capital Markets

Okay. And the incremental being the 125. Okay, so you are actually a little bit ahead of pace in terms of squeezing those into this year.

Frank P. Simpkins

The other wild card in corporate is kind of the FX activity. So, we have gains on some of the derivative contracts, I think reflected in corporate not the business units. So that could skew a quarter one-way or the other.

Holden Lewis – BB&T Capital Markets

Okay. Thinking strategically, I mean you have long said that your goal was obviously to reduce the number of SKUs and reduced the number of plants in long-term do so reasonably, substantially. When you look at the environment being as poor as it is, earnings obviously kind of being a basket case here, is there any interest in maybe taking these difficult conditions and accelerating the plant closings and the sort of shutting off some of the SKUs, I know you have six announced, but any interest in may be working towards your long-term goals on the plant side at an accelerated pace?

Carlos M. Cardoso

That’s we are doing right now, is accelerating all of those actions and again is a balance between although things are down the sales are down. So balance between cash, between capacity from how many plants we have something like six plants in the hopper right now. So they were closing.

Holden Lewis – BB&T Capital Markets

Right. And I understand you're accelerating sort of the closing of those six plants, but I was just curious, you have more plants that you would like to in the long-term plan, does that 6 become 12 in the very near term, as you just sort of focus internally or other resources just not available to sheer number of plants that you might shut?

Carlos M. Cardoso

Yeah, I mean, we continue to look at how to accelerate that further, I mean, we continue to look at the potential of the divesting some product lines that would help with the sites and so forth. So all of that is sort of a day-to-day environment here.

Holden Lewis – BB&T Capital Markets

Okay.

Carlos M. Cardoso

We are getting more aggressive. We like to get more aggressive.

Holden Lewis – BB&T Capital Markets

Great, thank you.

Operator

And in the interest of time, your last question will come from the line of Dana Walker with Kalmar Investments.

Dana Walker – Kalmar Investments

I hope that doesn't mean I have five seconds, and no more.

Carlos M. Cardoso

You can have all the time you want Dana.

Dana Walker – Kalmar Investments

In the interest of time, Carlos thank you. I may have missed a couple of responses. So if I cover something that's been covered, just tell me to go back and read the transcript. But, when you have as many restructuring programs as you have going on presently, how complicated is it to do them right?

Carlos M. Cardoso

I mean, as you know, the restructuring programs are always challenging. Everything has bad news and good news; the bad news is the sales are down. The good news is the sales are down and gives us a lot more confidence in getting these things done right. And the proof is that year-to-date with all these activities, we are actually ahead of our plan. So that demonstrates that we have been able to do them or we can do them right.

Dana Walker – Kalmar Investments

Since your CapEx spiked last year after having been at a lower level for many years, is that helping or hurting your ability to take your footprint into a smaller ink blot?

Carlos M. Cardoso

Well, I mean is actually helping because as we go through this new processes with the new equipment. We need the last equipment typically is more efficient and we typically have put that capital investment. In facilities that we see those facilities being the long-term facilities that we will have. In other words, we basically did maintenance in the plants that we felt that they are not going to be here a long-term and invested in the plants that we think that we're going to be here for the long-term. So, the CapEx has really not hurt us at all.

Dana Walker – Kalmar Investments

I presume that’s a way of saying that you did not put a lot of money into the six locations that you are shutting down?

Carlos M. Cardoso

Yes, exactly.

Dana Walker – Kalmar Investments

Did you comment earlier maybe I missed this, on your revenue comparisons in tooling versus consumables?

Carlos M. Cardoso

No, I mean 80% of our business is consumable. So I mean the, we don’t look at the growth in consumables versus non-consumables. We look at growth by market segments and by products.

Dana Walker – Kalmar Investments

There was no interesting metric to look at though that might say that your tooling revenue is down more sharply than your consumable revenue?

Carlos M. Cardoso

Well, I mean, we don’t, the consumables are tooling. I'm not sure that I understand. You are talking about tool holders, maybe.

Dana Walker – Kalmar Investments

Yes, something that would be more of a capital item.

Carlos M. Cardoso

The capital item for us is definitely lower.

Quynh McGuire

Dana, that would be the Extrude Hone business, as well as some of the machine building in MSSG in India. But even the tool holders are part of that 80% consumables.

Carlos M. Cardoso

Yes, so in general, anything that we have that which is a smaller percentage of our business that is in any fashion close to a machine tool is down more than the consumables.

Dana Walker – Kalmar Investments

As busy as you are focusing on your right-sizing to what degree is there a flow of either products or small businesses that would be available on more advantageous terms now than a year or two years ago that you would be reviewing?

Carlos M. Cardoso

Well, I mean we are always reviewing opportunities and we are staying in talks with people. However, there is a number of elements, I think people saw their business at a very high value. I think are still in shock at how low the value has gotten. So, we are trying to see that they can recover some other value on the way up. Although, I think most of them have accepted the fact that some of their business never be at the ultimate value they were at one time. But, I don’t feel that people are at that level yet, they are willing to give up any upturn opportunity, but right now our focus has been around liquidity and cash. I mean that’s going to be, until we see the bottom, I mean we must stay very focus on that.

Dana Walker – Kalmar Investments

Two last quickies, when you made a strategic judgment to better favor distribution over company controlled selling; in some markets you probably didn’t conceive that this type of a weak environment would be part of your future. How does that decision hold up in this environment? What degree are your distribution partners maintaining the resources, so that you don’t lose share?

Carlos M. Cardoso

They are I mean I think that decision was still proven to be a good decision. I mean, we always believed that there was going to be downturn in the economy. We just didn’t believe that was going to be this dramatic. So that was always part of the equation, but as far as I can tell at this point, our distribution has performed at equal levels as our direct sales and vice versa.

Dana Walker – Kalmar Investments

Final question is this and it relates to aerospace, you were of the mind that the new manufacturing techniques that would be evident in the Dreamliner or in the comparable products at Airbus would allow your types of products and services to gain relevance? What if any decisions have been taken in the meanwhile that bear that out?

Carlos M. Cardoso

From Kennametal's perspective?

Dana Walker – Kalmar Investments

Yes.

Carlos M. Cardoso

I mean, we continue to be bullish about that opportunity, I mean even in the sales comps that we have. Our sales to Boeing and the aerospace continue to be positive. In other words, year-over-year growth. So, it’s still the right decision.

Dana Walker – Kalmar Investments

Very well, thank you. Good luck.

Carlos M. Cardoso

Thank you.

Quynh McGuire

This Q&A period is complete and it concludes our discussion. Please contact me Quynh McGuire at 724-539-6559 for any follow-up questions. And thank you for joining us. Operator?

Operator

Today’s call will be available for replay, beginning at 1'o clock p.m. Eastern Time today and lasting through mid night on May 24, 2009. The conference ID number for the replay is 911-701-07. The number to dial for the replay is 1800-642-1687 or 706-645-9291.

This concludes today's discussion. Thank you for your participation. You may now disconnect.

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Source: Kennametal, Inc. F3Q09 (Qtr End 3/31/09) Earnings Call Transcript

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