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Kennametal, Inc. (NYSE:KMT)

F4Q09 (Qtr End 6/30/09) Earnings Call

July 30, 2009 9:00 am ET

Executives

Quynh McGuire – Director of Investor Relations

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

Frank P. Simpkins – Vice President and Chief Financial Officer

Analysts

Eli Lustgarten – Longbow Securities

Walter Liptak – Barrington Research

Henry Kirn – UBS

Chip Miller – JPMorgan

Mark Koznarek – Cleveland Research Company

Charles Murphy – Sidoti & Company

Andrew Casey – Wells Fargo Securities

Joel Tiss – Buckingham Research

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 fourth 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 fourth quarter and 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 teleconference 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 August 30, 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, 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. Fiscal year 2009 was the most challenging time in our company's seven-year history as we dealt with the impact of the most severe and rapid downturn in global manufacturing. From North America to Western Europe and even emerging markets like India and China.

We addressed the economic crisis head-on just as Kennametal have successfully done during past down cycles. We responded aggressively by taking a number of measures to reduce costs, maximize cash flow and liquidity and preserve our competitive strengths. We began by implementing key strategic initiatives throughout the organization using the principles of our Kennametal Value Businesses System or KVBS.

We identified opportunities to accelerate cost-reduction initiatives. We focused on aligning our portfolio with core competencies, streamlining our manufacturing footprint and making structural changes to our business. In April 2008 even before the global economic downturn begun to have a substantial impact in our business, we initiated a restructuring program to reduce costs and improve efficiencies in our operations. As business conditions deteriorated during the past fiscal year, we quickly implemented additional actions, which included reducing our global salaried work force.

We are taking cost out of our business on a permanent basis by lowering manufacturing costs and reducing operating expenses. We realized approximately $50 million in pretax benefits from our restructuring programs in 2009 and expect to realize approximately $75 million of additional pre-tax benefits in fiscal 2010. In total, we expect to achieve approximately a $125 million annually in permanent cost savings. Also we implemented certain temporary cost savings measures during the later part of the fiscal year such as employee furloughs.

We have continued the certain temporary cost reductions in our new fiscal year, which began on July 1. Those actions includes a 15% reduction in my base salary and the base salaries of the executive officers, a 15% reduction in the cash compensation of our Board of Directors. Salary reductions of our salaried workforce of 10% or 5% depending on the level of the position. Those actions will remain in effect until business conditions improve to a level that will permit partial or full restoration of the previous compensation levels.

In addition to cost reductions, we maintain a consistent focus on cash flow as demonstrated by our cash flow from operating activities of a $192 million for the year. We continued to execute our strategy of portfolio shaping to further reduce our manufacturing footprint and number of SKUs. In June, we completed the previously announced divestitures of our high-speed steel drills business. The cash proceedings from this transaction as well as the recent amendment of our revolving credit facility and the just completed equity offering have further strengthen our financial position and liquidity.

As a result of those collective actions, we offset a considerable portion of the impact of the decline in sales volume, achieved a modest profit for fiscal year on an adjusted basis. Generated strong cash flow and further enhanced our financial position. For the June quarter, our operating results reflect a positive impact of the increasing momentum of benefits from our restructuring and other permanent cost reductions as well as the effect of the temporary measures that were implemented.

At the same time, we continue to capitalize on our competitive strengths through working with customers to reinforce the value proposition of our products. Kennametal has a long history of solid relationships with our customers. We have strong and respected brands. We have an experienced and diversified management team that is capable of leading the company through difficult periods. We have talented and dedicated employees worldwide, a corporate culture that builds on its excellence a reputation of innovation and approving operating disciplines that guide management decisions. Those values form the solid foundation as we continue to build and even better business one that will be substantially leaner, stronger, and even more competitive during this period. As always we will continue to build on our core business, shape our portfolio and balance our global infrastructure

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 will provide further comments on our performance for the June quarter and fiscal 2009. And then I will move to the outlook for our fiscal 2010. Some of my comments will exclude special items and please refer to the reconciliation schedules we provided in our earnings release and the related Form 8-K.

From a top line perspective the June quarter developed pretty much as we expected the strong and deep grip of the global economic downturn continuing unabated throughout the quarter. And as a result our sales were down 43% organically from the record level that we enjoyed in the June quarter just one short year ago. In anticipation of this, we took further steps to reduce our cost both on a temporary basis with actions such as a one-week employee furloughs during each month of the quarter, as well as more permanent cost reduction action including additional restructuring initiatives that we announced at the offset of the quarter.

Also helping our results during the quarter was a higher run rate of benefits from perviously restructuring actions some of which we started more than a year ago. For our restructuring program in total, we realized approximately $50 million in pre-tax benefits from these actions in fiscal 2009. And we expect to realize approximately $75 million of additional pre-tax benefits in fiscal 2010. This will bring the total annual ongoing pre-tax benefits from restructuring initiatives to approximately $125 million.

Results of our additional cost reduction initiatives as well as the run rate of restructuring benefits turned out to be somewhat better than we had anticipated. As a result our operating results for the June quarter improved sequentially by $3 million from the March quarter despite a sequential decline in sales of $38 million. This represents an incremental margin of 107% on a sequential basis. The challenging business conditions over the past several quarters certainly required a sharp focus on cash flow generation and liquidity and we are relatively pleased with our results in this regard. We have free operating cash flow of $17 million for the June quarter and $90 million for the entire fiscal year.

These results remain possible through persistent diligence with receivable collection inventory reduction and close management of our production levels and reduced capital expenditures. We now have reduced inventory for the third consecutive quarter despite the rapid and steep drop off in sales volumes. Specifically, we drew down our inventory by $32 million in the June quarter and by $60 million over the last six months of fiscal 2009. And at the same time, we have maintained high off-the-shelf inventory availability and capital expenditures reduced to $12 million for the June quarter, which is the lowest quarterly capital spending level since December 2003 quarter.

Also providing us with additional cash as well as taken another positive step and shape in our business portfolio was the completion of our divestiture of the high-speed steel drill business including the related product lines and assets on June 30, 2009. The cash proceeds from the deal were $29 million, we received $2 million prior to closing and another $24 million in July. And we expect to receive the remaining balance in the December quarter. For fiscal 2009 the divested business generated sales of $81 million with EBIT that was essentially at break-even excluding special items.

In the previous fiscal year, the business had sales of $115 million and EBIT margin of slightly less than 5%. We are stating that prior fiscal year from continuing operations for discontinued operation as required by financial reporting standards yields a 30-basis point improvement in EBIT margin excluding special items. As of June 30, our total debt was $486 million, which was down $16 million from the March quarter, and our U.S. defined benefit pension plan remains over a 100% funded. Our debt-to-capital ratio at June 30, 2009 was 27.7, which also has improved from 28.4 in the prior quarter.

We are also pleased with the recent amendment to our revolving credit facilities, as well as our equity issuance, both of which transpired in July. The amendment to our $500 million revolving credit facility provides additional flexibility with our financial covenants while maintaining the size and maturity of the facility. And we received net proceeds of approximately $120 million from our $8 million share equity issuance, which we used to pay down revolver borrowings. As Carlos mentioned these actions substantially improve our financial position and liquidity as well as provide us with additional financial flexibility going forward.

Now I am going to walk through the key items in the income statement. From a sales perspective, we came in at $386 million and this compared with $724 million in the record June quarter sales that we had last year, this represents a 40% year-over-year decrease, which was driven by 43% organic decline and a 4% decrease from unfavorable foreign currency effects. A slight net favorable impact from acquisitions and divestitures was offset by the effect of one less workday. As I previously mentioned sales in the June quarter were down sequentially from the March quarter by $38 million or 9%.

Turning to the business units. MSSG sales decreased by 52% from the prior year quarter and that was driven by an organic sales decline of 45%. Unfavorable foreign currency effects of 5% and a 2% decrease from the combined impact of divestitures and one less workday. Global industrial production remained extremely weak and substantially below the prior year continuing the further downturn in industrial activity experienced in the March quarter.

Consequently, demand in most market sectors remained at very low levels. And from a regional basis, Europe and North America reported organic sales declines of 47% and 46% respectively. Latin America, India, and Asia-Pacific also experienced organic sales declines of 44%, 43%, and 37%, respectively.

AMSG sales decreased 37% during the June quarter that was driven by a 38% organic decline, 3% unfavorable impact from foreign currency effects, a 1% decrease from one less workday and that was partly offset by the favorable impact of acquisitions of 5%. The organic decline was primarily driven by lower sales in the engineered products business, as well as reduced demand for energy related products and surface finishing machines and services.

Turning to our gross margin for the company. Our gross profit margin was 25.6% for the quarter, compared to 34.2% in the prior year quarter. Absent restructuring related charges recorded in cost of sales of both periods, our gross profit margin for the current quarter was 26.6%, compared to 34.4% in the same quarter last year. Lower production levels and related reduced capacity utilization continue to be the reason for the year-to-year decline in gross profit margin.

However, the increased run rate and benefits from our restructuring initiatives and other cost reduction actions are now offsetting an increasing portion of the capacity utilization impact. In addition, our gross profit margin in the June quarter further benefit from continued positive momentum with price realization and stabilization in our raw material cost. This was all evidenced by a sequential improvement in our gross profit margin.

Operating expense decreased year-over-year by 34% or $55 million to 104 million. The decrease is mainly attributable to lower employment cost 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 by a net increase from the acquisitions in the prior year or the current year. We recognized restructuring charges of $16 million in the June quarter and we also recognized a total of $5 million of restructuring related charges and costs of good sold and operating expenses during the quarter.

As such total restructuring and related charges recorded in the June quarter were $21 million, which is equivalent to $0.08 per share. Pre-tax charges recorded to-date for these initiatives were $82 million. Including these charges, we expect to recognize approximately $115 million of pre-tax charges. The majority of the remaining charges are expect to be incurred by December 31, 2009, most of which are expected to be cash expenditures. And as Carlos and I both previously mentioned we expect to realize pre-tax benefits of approximately $50 million from these actions in fiscal 2009 and we expect to realize $75 million of additional pre-tax benefits in fiscal 2010. And this will bring the total annual ongoing pre-tax benefits to approximately $125 million.

Our operating loss was $25 million for the current quarter, compared to operating income of $80 million in the prior year. Absent the restructuring related charges recorded in both periods, our operating loss for the current quarter was $3 million, compared to the operating income of $88 million in the prior year quarter. I believe it bears repeating here that this is a sequential improvement in our adjusted operating results in March quarter despite a sequential decline of $38 million.

MSSG operating loss was $29 million for the quarter, compared to operating income of $66 million in the same quarter last year. Excluding restructuring and related charges in both period, MSSG’s operating loss was $16 million, compared with operating income of $71 million in the prior year quarter. The primary drivers of the decline in operating income were reduced sales volumes and the related unfavorable absorption of manufacturing costs. This was offset in part by restructuring benefits other costs reduction actions, including employee furloughs, as well as higher price realization.

AMSG's operating income was $14 million in the current quarter, compared to operating income of $33 million last year. Absent restructuring related charges recorded in both periods, AMSG's operating income was $18 million in the current quarter, compared to $36 million in the prior year. The decline in operating income was primarily due to lower sales and production volumes in the engineered products and energy related businesses. A considerable portion of these impacts was offset by a combination of restructuring benefit other cost reduction actions including employee furloughs as well as higher price realization and lower raw material cost.

As a result AMSG achieved a double-digit operating margin in the June quarter, which demonstrates the relative importance of this business segment to our strategy and overall product portfolio. Corporate operating loss decreased by 54% or $10 million. This decrease was primarily driven by lower provisions for performance-based employee compensation programs as well as the impact of cost reduction actions. Reported effective tax rate for the quarter was 39.1% excluding the impact of the restructuring and related charges the adjusted effective tax rate was a negative 116.4% on an adjusted basis and we recorded a provision for income taxes of $5 million despite having a pre-tax loss of $4 million and this was driven by the jurisdictional mix of pre-tax results.

Concerning the recent divestiture that I discussed earlier, the pre-tax loss on that sale and related charges of 26 million as well as the related tax effects were recorded in discontinued operations and we expect to incur pre-tax charges related to this divestiture of $4 million to $7 million over the next six months. And as I said earlier in accordance with the applicable financial reporting standards, this divested business will be reflected in discontinued operations. Our financial statements for prior quarters and fiscal years will be restated accordingly as required. And then the net loss was $33 million for the current year quarter, compared to net income of $60 million last year. Absent the charges related to restructuring and the divestiture the net loss for the current quarter was $10 million, compared to net income of $66 million.

And lastly our reported fiscal 2009 fourth quarter diluted loss per share was $0.45, compared to the prior year earnings per share of $0.77. Adjusted loss per share was $0.13, compared to the prior year adjusted EPS of $0.85. I'd like to conclude my remarks about the June quarter by referring again to our cash flow performance for the fiscal year that we just completed. Despite the huge impact on our results from a global economic downturn, our cash flow from operating activities in fiscal 2009 was a $192 million, compared to $280 million in prior fiscal year and free operating cash flow was $90 million, compared to $119 million a year earlier.

And then turning to our outlook again given the magnitude of the global economic downturn and ongoing related uncertainty, visibility remains quite limited regarding global industrial activity and the corresponding demand for our products. While recognizing the difficulty at this time of looking forward with any relative degree of certainty, we presently believe that global industrial activity may be at or close to a bottom. Assuming that is the case, we would expect global demand for our products for the first half of fiscal year 2010 to remain around the levels experienced in the June quarter. We would then expect to see the effects of an economic recovery reflected in our sales and financial results during the second half of the fiscal year.

Under these economic assumptions, we would expect earnings per share for fiscal 2010 to be in a range of $0.45 to $0.65 per share excluding restructuring and divestiture related charges, on related sales that would be 5% to 10% lower year-to-year on an organic basis. Cash flow from operations would be expected to be in the range of $65 million to $75 million for fiscal 2010, as a considerable portion of the cash we generate is expected to be needed to fund higher working capital requirements as the business improves. And based on capital expenditures of approximately $60 million, free operating cash flow would be in the range of $5 million to $15 million for fiscal 2010.

Should global economic conditions develop in line with our assumptions, we expect to continue to experience the adverse effects of the global recession during the first half of fiscal 2010 followed by year-over-year sales growth and positive earnings performance in the second half of the fiscal year. As such for the first quarter of fiscal 2010 we expect organic sales to be 35% to 40% lower than the same quarter of the previous fiscal year and we expect to record a loss per diluted share excluding the restructuring related charges that will be greater than the loss per diluted share for the June 2009 quarter, excluding divestiture and related charges.

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

Carlos M. Cardoso

Thank you, Frank. As we move into a new fiscal year, we will continue to be relentless in our efforts to reduce costs, maximize cash flows, and further strengthen our balance sheet. We are well positioned to take advantage of the eventual economic upturn. While we are implementing appropriate measures to manage through the cycle in the near-term, we will also remain focused on longer-term opportunities to increase shareholder value. We will continue investing strategically in our core business developing new products and expanding in growing new markets.

We will also continue to deliver innovation. This is a Kennametal strength that has increased our competitive advantage and helped us to consistently generate sales from new products of 40% or more each year. Kennametal was found on innovation it is our legacy and we continue to set the pace in our industry. Not more than ever customers are seeking knowledgeable supplier partners capable of helping them to increase their productivity. They recognize that this is a key differentiator for Kennametal. As evidenced market research surveys consistently show Kennametal leaving the industry in terms of most innovative, best range of services and first-in customer services. We will continue aggressively applying our strengths to further growing our market share globally.

In summary, we are now more prepared to and better positioned than ever before to perform well in the economic recovery. We have a worldwide infrastructure, our management team has a proven track record our customer relationships are as stronger than ever and our global team is dedicated to serving customers. This world-class team is another one of our key competitive advantages. And it continues to demonstrate this commitment to helping customers increase productivity when it's needed the most.

We also continue to adhere to our proven disciplines and principles outlined under KVBS, the management operating system that guides our enterprise and directs the decisions we make related to strategic planning, product development, sales growth, talent development, portfolio management and LEAN enterprise properties. As we enter the start of fiscal 2010, we believe we are prepared to meet the challenges ahead. Our products are consumed in the manufacturing process. So, we have a business with repeatable revenues. As we enter the upturn, we expect to realize stronger operating leverage. As a result we look forward to higher growth and profitability for the long-term.

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

Hey, Eli.

Frank P. Simpkins

Good morning, Eli

Eli Lustgarten – Longbow Securities

You actually had a nice quarter…

(Multiple Speakers)

Eli Lustgarten – Longbow Securities

One for a moment that the tax counting is sort of very crazy, do have any suggestion for fiscal 2010 tax rate?

Frank P. Simpkins

Yeah Eli. Again as you know, when you have a loss and you have a provision, it creates pre-mathematics, but….

Eli Lustgarten – Longbow Securities

Yeah. You got a tax charge on the royalty?

Frank P. Simpkins

Yeah. What I'd say the tax rate next year will be in the 24% to 26% range in that area because the way we finished the year at 17% we had a couple one-time benefits last year during the first quarter the Spanish a valuation allowance and we had the second quarter pick-up if you take those out of the equation, it basically put you out above the 25% range in fiscal 2010.

Eli Lustgarten – Longbow Securities

You've got 25% I said is tax stuff is very crazy, you gave we have orders for June, can you give us any sign, what we are seeing over the summer so far as far, the order rate was still declining for you guys, did that continue through the July period we are seeing stabilization, you are getting comment, you sort of indicated you're getting closer stabilization, have you seen it or, and you feel the de-stocking is sort of coming to an end where we are still going to go through this summer at least in de-stocking?

Frank P. Simpkins

We’re, I mean I’m not sure about the de-stocking at this point, but we are seeing some small incremental sequential improvement from month-to-month and to-date, from July our orders are inline with our guidance.

Eli Lustgarten – Longbow Securities

Okay. I mean profitability of AMSG was very impressive the double-digit given the seasonality at that, particularly the any market is that a sustainable double-digit margin or do we get some seasonality, within the first half before we go back to it?

Frank P. Simpkins

Yeah, I will start with that. I think shorter term we will have some pressure with the energy business given some of the natural gas levels there, but then I think in the second half again I think will be pretty good, they have done a great job on selling on value from a pricing perspective and they have done a good job on maintaining the pricing discipline and then we should get some tailwinds as we move forward with some of the raw material input costs. So, I think given the top line with some of the industries shorter-term, but I think it will be a very good second half for them.

Eli Lustgarten – Longbow Securities

Right. And metalworking will probably continue in the red for quite a while until we get some upturn in industrial product and utilization?

Frank P. Simpkins

Yeah, I think the first quarter I think they will start to see some improvement with some of the automotive either tail end here and I think they have done a good job when we are talking about the number of facilities we took out, we took a lot of manufacturing facilities out of MSSG and then just the divestiture of the high-speed steel business was, there is four facilities in the sub. So we are talking double-digit facilities so from a overall cost reduction I think we will have a much stronger earnings improvement than we will see on the top line, but I think those two will go hand-in-hand and then we will see a pickup in the second half.

Operator

Your next question comes form Walt Liptak with Barrington Research.

Walter Liptak – Barrington Research

Hi, good morning guys.

Carlos M. Cardoso

Good morning, Walt.

Frank P. Simpkins

Hi.

Walter Liptak – Barrington Research

The first question I guess is on the issue comes up about market share and the volumes, your volumes were down a lot more than industrial production and the de-stocking issue I mean why is it that the revenue is down as much as it is?

Frank P. Simpkins

Well. I mean we will go with industrial production less computers, but you know if you want to look at market share, if you're talking about market share specifically, Sandvick our largest competitor just announced last week and their sales were down by exactly the same percentage as ours. So it really shows you that the de-stocking is taking really taking a hold on this consumer tools. So relative to market share if you are very, very comfortable, if you are very confident that we are maintaining our market share during this period of time.

Walter Liptak – Barrington Research

Okay. And if could ask one more just in the negative leverage on – on gross margin is really extreme I wondered if you could talk about if the under absorption that you are experience is it because of excess facilities, or is it because this is a capital intensive business you've got machinery and when you idle machines you get under absorption?

Frank P. Simpkins

Yeah. Well I think its all the above, and it obviously depends on kind of the market share, but the decremental margin, we had was much improved over the past two quarters we have gone from 44% to 34% to about 26%. So, I think we've done a pretty good job of controlling cost as we said in the call the restructuring benefits continue to provide incremental benefits to the bottom line. We had to do some temporary actions, which we are going to continue to look at, we have gone from furloughs to salary reductions and we're not done with restructuring programs. So we expect those to continue, but again leverage works both ways, when you have the volumes on the downside, you feel that I think we have controlled it. And then when you get a little volume, the incremental margins will be much greater this cycle than we experienced in the past.

Walter Liptak – Barrington Research

Okay. In the past you were north of 40% at least initially can you go above 50%?

Frank P. Simpkins

It depends on how quick the volumes come back.

Walter Liptak – Barrington Research

Okay. Okay. Thank you.

Carlos M. Cardoso

Thank you, Walt.

Operator

Your next question comes from Henry Kirn with UBS.

Henry Kirn – UBS

Good morning guys,

Frank P. Simpkins

Hi, Henry.

Carlos M. Cardoso

Hi, Henry, how are you?

Henry Kirn – UBS

Good. Wondering if you could chat a little bit about some of the factors that led you to do the equity issuance and how you are looking at the capital structure going forward?

Frank P. Simpkins

I think, and I will start off here, Henry, I think when we looked out we expected as you see with a lot of industrial companies some short-term pressure related to the global economics we felt that we were going to bump up against our covenants in the upcoming two quarters given the sales projections that we have. So we felt if the economy does slip a little bit or there is, a little bit delay, we want to make sure that we have the financial flexibility to weather the economic downturn. And hence we went out there and basically amended the bank amendment or a revolver and issued the equity to give us the flexibility from a cash flow, because we do expect some the – I will call it some of the global markets to begin the pick up in the second half of fiscal 2010 and we are going to need to focus on some working capital so that's also going to be a driver. So, when you take a step back, when you're going to have some short-term issues the way the covenants are working and this gave us the flexibility to operate the business from both a restructuring take additional cost out from the working capital for growth.

Henry Kirn – UBS

Okay. And could you talk a little bit about where in your portfolio you would look to for a recovery first and some of the indicators outside of that – that might lead you to start to forecast your recovery in your second half of the fiscal year?

Carlos M. Cardoso

Yeah. I will address that Henry, let me start by a world looking at from a world perspective. From a world perspective we believe the first industry to come out is motor vehicle, so when we look at a sequence year-over-year growth, we see them coming up first we see the metalworking coming out second, machinery third, construction fourth, aerospace fifth, and energy, mining sixth that's from – from worldwide. From Asia-Pacific we see again motor vehicles are going to the number one, metalworking machinery number two; machinery number three; construction number four; aerospace fifth and energy and mining sixth. From Europe, again sequence is motor vehicles, metal working machinery, machinery, construction, aerospace, and mining. Although in Europe in metalworking machinery, machinery, construction, and mining we will see still negative growths through calendar year '10. In the U.S. motor vehicles again are going to come out probably the strongest again sequential growth than anywhere in the world or any other industry, followed by machinery, and then metalworking machinery, construction, aerospace, energy and mining. And in U.S. we see machinery, metalworking machinery, and construction still have negative growth throughout the year for calendar year 2010. So, again we look at a number of indicators as we put this thing together and as we compare what we see relative to other companies, we feel that we are pretty consistent. I don’t know if that answer all of your questions.

Henry Kirn – UBS

Yeah, that's very helpful. Thanks a lot.

Carlos M. Cardoso

Okay.

Operator

Your next question comes from Chip Miller with JPMorgan.

Chip Miller – JPMorgan

Hey guys. Thanks very much for that end market color. If I could just drill that into auto a little bit, obviously things are getting better around the world. Can you just talk about, especially in U.S. where you think inventory levels are at given, we've just been through some plant shutdowns and how quickly you think newer volumes will recover versus overall auto volumes?

Carlos M. Cardoso

Well our, this the way that you should be looking at our business, there is a lot of discussions around about early cycle versus a late cycle, but I will just give you an example that you can think through. So, if the manufacturers have depleted their inventories, finished inventories and then I think most of our customers have depleted their work in process as well. They have depleted their tool cribs, so when the market starts turning around before they can ship anything, they have to buy tools from us. So that intuitively tells you that before the automotive company start increasing their volumes they have to be buying sales from us at least three months in advance of that. So, we believe that we are starting to see right now in North America an uptick in orders for the automotive tooling as we speak.

Chip Miller – JPMorgan

Okay. And if I can just ask, we are looking at, first quarter versus fourth quarter just reported, you are saying earnings in the first quarter going to be down sequentially, but there is a couple of things going on in the quarter, one being the, salary reductions versus furloughs and secondly you have the European plant shutdowns. So, I know its probably tough to estimate, but excluding those two things would we be up in 1Q versus 4Q, what I am trying to get at is kind of like the underlying decrementals and how much better they're actually getting?

Carlos M. Cardoso

Again I would say the decrementals would be in our first quarter a little bit higher around the 30% range, potentially in the first quarter, but the normal seasonality I think we will experience typically the fourth to first you have a typical lower, a profitability because of the extend plan shutdowns, which they have been there. And, the furlough effect the differential could be about a $11 million. So, you can do the math for the first quarter on those.

Chip Miller – JPMorgan

Okay. That's great. Thank you very much for the time.

Frank P. Simpkins

Thank you, Chip.

Carlos M. Cardoso

Thanks Chip.

Operator

Your next question comes from Mark Koznarek with Cleveland Research.

Mark Koznarek – Cleveland Research Company

Hi, good morning.

Carlos M. Cardoso

Hi, Mark.

Frank P. Simpkins

How are you doing Mark?

Mark Koznarek – Cleveland Research Company

I am doing good. Frank could you, Frank clarify that statement you just made the furlough effective a 11 million is that in the quarter or for the full year-over-year?

Frank P. Simpkins

It's just the quarter, let me say it this way, we had three months with the furlough effects in the June quarter. So call that $80 million and I am saying the benefit of the salary reductions all in the first quarter is about 7. So there is a differential of about a 11.

Mark Koznarek – Cleveland Research Company

Okay.

Frank P. Simpkins

So for the full year at that run rate you're going to get basically 28 million assuming that everything would stay in the place basically 7 million a quarter, while last year we had four months because we actually did one in March it was just 24. So, that's they kind of watch with the full year, but it's just the timing issue of when one starts, when one ends.

Mark Koznarek – Cleveland Research Company

Okay, great. That's really helpful. I was like really impressed with the AMSG margins and you mentioned both price and raw materials can you talk about what price realization overall was in the quarter and then the raw material benefit and then, directionally how much will continue to flow into FY'10?

Frank P. Simpkins

Yeah. For the quarter Mark we had about 2% price realization for the quarter. And I will say raw materials, we were chasing that there is lot of other companies where they were up year-over-year, I'd say there were flat to down slightly, so we didn't have that challenge in the fourth quarter. Now, we should have some tailwinds going into next year and when you pull it altogether pricing given this environment we are going to say it will about flat, we don't expect anything significant one way or the other, but we should get a slight benefit on some of the raw materials.

Mark Koznarek – Cleveland Research Company

Okay. And then finally what was the operating income impact of inventory reduction on a year-to-date basis and when you start rebuilding inventories as you indicated later in FY'10, you mentioned that working capital requirement is, should we just reverse that out and sort of the expense that you absorbed in this FY'09 add that back as a supplement to income in FY'10?

Frank P. Simpkins

Yeah. That's a tough one Mark, let me get back to you with that.

Carlos M. Cardoso

It is a good question so..

Frank P. Simpkins

Yeah.

Mark Koznarek – Cleveland Research Company

Okay. I will circle back to you guys. Thanks.

Frank P. Simpkins

Thank you, Mark.

Operator

Your next question comes from Chuck Murphy with Sidoti & Company.

Charles Murphy – Sidoti & Company

Good morning guys.

Frank P. Simpkins

Hi Chuck.

Carlos M. Cardoso

Hi Chuck. How are you?

Charles Murphy – Sidoti & Company

Doing all right. Just wondering, if you were going to be modeling fiscal 2010 organic sales down that 5% to 10% what should we be using as the base for fiscal 2009?

Frank P. Simpkins

It should be in the press release.

Charles Murphy – Sidoti & Company

Okay

Frank P. Simpkins

Was about $2 billion.

Charles Murphy – Sidoti & Company

Okay. My other question was with the organic sales being down like that I mean any sense on where gross margin would fall out?

Frank P. Simpkins

Well I would expect them to be up for the full year given the restructuring benefits that we've been talking about and in divestiture activity that's obviously lower and by the way just for everybody on the phone, the numbers in the press release are restated to pull out the divestiture of the high speed steel business, so its like-for-like comparison there.

Charles Murphy – Sidoti & Company

Okay. All right. That’s all I had. Thanks.

Carlos M. Cardoso

Thank you, Chuck.

Operator

Your next question comes from Andy Casey with Wells Fargo Securities.

Andrew Casey – Wells Fargo Securities

Good morning everybody.

Carlos M. Cardoso

How are you doing, Andy?

Frank P. Simpkins

Hi Andy.

Andrew Casey – Wells Fargo Securities

Doing all right. It sounds like you guys are too.

Carlos M. Cardoso

Yeah.

Andrew Casey – Wells Fargo Securities

Just a follow up on I think it was Mark's question on the cash flow should we think about on a pattern basis, where you're still flushing some inventory in the first half of the fiscal year before you, potentially have to start to build for the recovery that you're talking about?

Frank P. Simpkins

Yeah, I would say, both receivables and inventory and receivables obviously will probably be a bigger component in the calendar year.

Andrew Casey – Wells Fargo Securities

Okay. And then I think somebody asked this on the last call, I can't remember, who but if we go back to kind of the recovery in the last cycle and I understand the business is significantly different with divestitures and acquisitions. The performance seem to track the changing capacity utilization on the, top line versus that. Is that something similar or did you have to work through some inventory back then that you don't going forward?

Frank P. Simpkins

Yeah, I think we definitely had a little bit too much inventory back then and then I think with the divestitures and the reduction of the SKUs and we've taken out double-digit facilities are in process of wrapping them up. I think we're going to have a much stronger leverage on when we get the volume.

Carlos M. Cardoso

Yeah I'll add to that that by December of this year from the fiscal year '08 to December of this year we are going to have 12 facilities that will no longer be in our portfolio. That's a 20% reduction in facilities in 18 months. So we always talked about the fact that we had those lever and so forth and once we did not have the growth to maintain this facility, as we told everyone that we would be very aggressive on that. So I think its pretty aggressive to reduce our number of facilities by 20% in 18 months.

Andrew Casey – Wells Fargo Securities

Okay. Very good. Thank you.

Operator

Your next question comes from Joel Tiss with Buckingham Research.

Joel Tiss – Buckingham Research

How is it going?

Frank P. Simpkins

Hi Joe.

Carlos M. Cardoso

How are you doing Joe?

Joel Tiss – Buckingham Research

All right. I am going to glue sort of three related questions together, but I just wondered if you could give us ballpark in the 2010 guidance the mix of the revenue and the cost savings that you have baked in there, because it just feels like cost cutting is biting it's going to accelerate and the sequential volume is flat, but the loss in the first quarter is going to be a little bit higher. So, I am having trouble understanding that and maybe if you explain the shape of the economic recovery that you have baked in it might help me?

Carlos M. Cardoso

Again from the restructuring benefits Joe you know that this year we realized approximately $15 million and next year we are going to get an incremental $75 million. So, we will hit that 125 million run rate then I think you need to factor in, the furlough effect that's in some non-recurring items that occurred in fiscal 2009 that obviously don't come into 2010 offset in part by the – the reduction in salaries.

Frank P. Simpkins

Yeah. The biggest challenge in the first quarter I mean is the fact that when you have one week furlough per month is a 20% reduction on the, 25% reduction on the salaries. Right now, we have stopped doing that and replaced that with salary cuts. Although, by year-end, the benefits of the salary cuts are being similar to the furloughs in 2010 we take it the whole year to recover the quarter plus the one-month that we had in the second year in the second half of this year. And that's really the difference between the first quarter and Q4 that's the number one driver.

Joel Tiss – Buckingham Research

Okay. And then the shape of the economic recovery you think we're going to get something closer to a V as we move into calendar 2010?

Frank P. Simpkins

No, right now I mean God knows where we are going to get, but we are planning pretty much on a U, U shape I think that we – our view is that the rest of this calendar year is going to be pretty flat I mean – I think we're going to bounce around the bottom with some small sequential growth and then things will start improving in Q3, and then Q4 but pretty much moderately.

Joel Tiss – Buckingham Research

And then last one just on a little bit of a gap between the free cash flow generation was pretty strong, receivables inventories down about $300 million, but your overall debt year-over-year has gone up by more than a 100 million can you just square that for me a little bit?

Frank P. Simpkins

Yeah the drivers of the increase at the beginning of the year we acquired Tricon for $64 million in October then we did the share repurchase in the first quarter, which was 127, 128 million and then the free operating cash flow, so that was the main drivers.

Joel Tiss – Buckingham Research

Okay. All right. Thank you so much.

Carlos M. Cardoso

Thank you, Joe.

Operator

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

Holden Lewis – BB&T Capital Markets

Good morning thank you.

Carlos M. Cardoso

Hi Holden. How are you?

Holden Lewis - BB&T Capital Markets

I'm fine.

Frank P. Simpkins

Good morning. How are you doing?

Holden Lewis – BB&T Capital Markets

Fine. Thanks. You commented, it looks like sequentially the gross margins stepped up quite a bit, can you comment about specifically what drove that company wide and then also just in terms of what role does production play in all this where is the production sort of system wide and when would you expect to begin moving production upwards and I guess related to that when you look at your guidance if you didn't get any sort of recovery scenario, I mean what would that guidance look like if the only thing you had was a step-up in production as you work through the inventories and you sort of stripped out the volume recovery?

Frank P. Simpkins

It would be good, but again the sequential improvement in the gross margin again, as I said in the call we actually reduced inventories $32 million in the quarter. So we're not increasing inventory or building inventory of any significance there will be some product lines in certain parts of the business, but again it’s the restructuring benefits and its some of the furlough effects coming into it. Now we expect as we get towards the end of the calendar year that we are going to need some inventory for certain items from our beyond products and we expect to have a combination of volume and some inventory to replace that hence we will have some nice gross margins in the second half of our fiscal year. And then the other driver will be that we didn't face this year there will be some tailwinds from some raw material input cost later in the fiscal year for us.

Holden Lewis – BB&T Capital Markets

Okay. Then what trajectory are you expecting in terms of your production, presumably you kept your production pretty low this quarter like you noted the inventories I mean when do you expect the inventories to be down where you need them and you need to be stepping at a minimum production backup to demand levels?

Frank P. Simpkins

I would say we are not going to increase production there much until third-quarter.

Holden Lewis – BB&T Capital Markets

Okay.

Frank P. Simpkins

Yeah. In the first quarter we had the seasonal effects with Europe. And then as Carlos said late second quarter, third quarter is when we would start looking at it.

Holden Lewis – BB&T Capital Markets

Right. And on that I mean you mentioned before I think that sort of your dollar orders per month were actually ticking up slightly I mean, does that includes July because when would you expect to see the seasonal impact of those beginning to come up. That seems unusual seasonally?

Frank P. Simpkins

Yeah. Again in the each month in the quarter starting with March was the real big drop that we have where, things really fell down. So, the following months out we are all up sequentially. Now, we will adjust for the seasonal effect a little bit here in the month of July and then I mean it seems like we're basically bouncing around the bottom.

Carlos M. Cardoso

Yeah. That's what I would say.

Holden Lewis – BB&T Capital Markets

Thanks.

Frank P. Simpkins

And August is always the worst month for us so, again, the good news is that we are tracking so far to our guidance the bad news that, we're really in the fourth week into the year, so…

Operator

This concludes our question and answer session of today's conference.

Quynh McGuire

This concludes our discussion. Please contact me Quynh McGuire at 724-539-6559 for any follow-up questions that you may have. Thank you for joining us.

Operator

Today's call will be available for replay beginning at 12 o'clock p.m. Eastern Time today and lasting through mid night on August 30, 2009. The conference ID number for the replay is 16017841. 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. F4Q09 (Qtr End 6/30/09) Earnings Call Transcript

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