Kennametal May Return To Growth This Quarter, But The Longer-Term Opportunity Isn't So Exciting

Apr. 05, 2021 1:44 PM ETKennametal Inc. (KMT)CMCO, PH, SDVKY
Stephen Simpson profile picture
Stephen Simpson
17.77K Followers

Summary

  • Short-cycle recoveries in autos and manufacturing have picked up steam, and Kennametal could post organic growth in FQ3'21, but the margin outlook remains cloudy on meaningful mix volatility (lower aerospace).
  • Self-help should pay dividends in the coming quarters as the manufacturing restructuring wraps up, but there are still longer-standing issues regarding tool demand growth in the company's core markets.
  • Short-cycle names like Kennametal have historically underperformed once the PMI breaks through 55, but this cycle has all new drivers, including the pandemic and unprecedented government stimulus efforts.
  • Kennametal's long-term revenue growth, margins, and FCF generation potential all still look lackluster, relegating it to more of a cyclical trading idea than core holding.

Short-cycle industrial markets are definitely in recovery mode now, and that has driven a much improved outlook for companies leveraged primarily to shorter-cycle markets, including Kennametal (NYSE:KMT). Kennametal also has the advantage of an ongoing restructuring initiative that actually seems to be bearing fruit after numerous less successful restructuring attempts in years past, and between cyclical recoveries and self-improvement, double-digit operating margins don't seem too far away.

My feelings on Kennametal were decidedly mixed when I wrote about the company in May. While I did believe the shares were undervalued on near-term recovery potential, the weaker long-term outlook tempered my enthusiasm and I preferred other short-cycle names like Parker-Hannifin (PH) and Columbus McKinnon (CMCO). Since then, Kennametal has outperformed the S&P 500 and the broader industrial space, rising almost 70%, but Parker and Columbus McKinnon have done better still.

I'm still not looking to add Kennametal as a long-term holding. I'm a little more bullish on the likelihood of management hitting its restructuring-driven margin goals, and I'm looking for a 30% trough-to-peak revenue improvement that could still leave upside (a 50% move is possible), but I have longer-term structural and competitive concerns here, and I think getting to double-digit FCF margins, let alone beyond that, is going to be challenging.

The Shape Of The Recovery Is Still Evolving … And That Matters For Margins

Accurately modeling Kennametal's margins in the short term has proven challenging for the Street, with the company missing by a wide margin two quarters ago, beating in the last quarter, but then guiding weaker for this upcoming quarter.

I believe some of this is a byproduct of a lumpy recovery that hasn't really played into Kennametal's strengths. For instance, until very recently U.S. machine tool and underlying fabrication demand was running pretty cold, and you can see that in the weak U.S./North America sales posted by companies like Kennametal, Lincoln Electric (LECO), Sandvik (OTCPK:SDVKY), and so on.

Machine tool sales have improved noticeably, though, as has actively in important end-markets like autos, heavy-duty-trucks, and "general manufacturing", and with that I do expect to see an improving baseline for Kennametal.

Now for another "but" - those aren't historically the best margin-generators for Kennametal. In response to strong demand, Kennametal leaned harder into higher-margin opportunities in markets like aerospace and oil/gas, only to see those markets get hammered in the pandemic. Aerospace was down 43% in the last quarter for Kennametal, and Energy was down 18%, and its going to take a couple of quarters for both to return to growth, and a couple of years to return to pre-pandemic levels. In the meantime, that's going to create some mix-driven lumpiness in results.

There is likewise some meaningful uncertainty over what leverage Kennametal may see to federal stimulus for infrastructure projects. Kennametal's Infrastructure segment sells components for cutting and wear parts, including road grader blades and continuous miner shearers, and while the company is almost certainly going to see some lift from increased infrastructure activity, the final details of the plan (including the skew between infrastructure repair and new-build) are still meaningful unknowns.

Manufacturing Restructuring Near Completion

I've noted in the past that Kennametal has been in some form of restructuring for most of the past 13 years, including past attempts to exit lower-margin businesses, right-size manufacturing, adopt more efficient manufacturing processes, and improve areas like new product development and distribution.

This latest plan has involved a footprint reduction (closing six plants) and reinvesting in upgraded capacity that includes labor-saving automation, and I'm cautiously bullish that the company is going to see a meaningful uplift in its core profitability. Management's target of mid-20%'s EBITDAs on $2.5B-plus revenue may yet prove too optimistic, but I do think 20%-plus margins on that sort of revenue base is at least possible.

There are issues, though, that go beyond this that concern me. For starters, the markets that Kennametal serves are seeing a lot of change. Additive manufacturing is a well-known (if overestimated at present) trend, but a less-appreciated issue is the growth of near-net-shape forging, which meaningfully reduces the amount of tooling work companies have to do. This has been an issue for Sandvik as well, and has led that company to start looking for opportunities in areas like round/finish tools, additive manufacturing, and metrology.

Another issue is emerging shift toward EVs. As has been echoed by companies like Sandvik and Atlas Copco (OTCPK:ATLKY), EVs will require far less machining than conventional powertrains, as well as a different portfolio of assembly tools, and I'm not confident that Kennametal can offset that pressure. On a more positive note, there have been meaningful changes in the aerospace industry over time, including changes in the materials used, and Kennametal has been able to adapt to those changes, so I won't just write them off with respect to being able to adapt to ongoing end-market changes.

The Outlook

One of the bigger issues facing Kennametal, or at least the shares, is arguably more of a technical or trading issue than a fundamental issue. By and large, early-cycle stocks like Kennametal tend to flatten out and underperform once the PMI gets to 55 or above. Manufacturing PMI has now been at 60 or above for two straight months, and in past cycles PMI of more than 60 usually predicts a nearly double-digit decline in Kennametal's share price.

Every cycle has its own quirks and we haven't seen a pandemic-driven recession before, so who knows what this cycle will hold - particularly with aerospace and oil/gas not likely to really contribute positively until 2022. Still, it's something to consider.

Looking at the fundamentals, I'm expecting a 30% trough-to-peak move that is about 6% higher than what the Street currently expects. With the possibility of a stronger aerospace and oil/gas cycle, as well as infrastructure stimulus, I don't think a 50% move is impossible.

Either way, though, I think long-term revenue growth above the low single-digits is going to be tough for Kennametal - I just see too many headwinds with how the end-markets are changing and not enough on Kennametal's side in terms of adapting or positioning for new/emerging growth opportunities. Margin improvement should still be possible, though, and I do expect double-digit operating margin in FY'22 and FCF margins improving into the high single-digits over time.

The Bottom Line

Neither long-term discounted cash flow nor short-term margin/return-driven EV/EBITDA suggest Kennametal is an exceptional opportunity today. I'll grant the possibilities/opportunities of outperforming on the cyclical recovery, including a longer-term aerospace recovery, but I just don't see a high enough ceiling to take on the cyclical risks for this name.

This article was written by

Stephen Simpson profile picture
17.77K Followers
Stephen Simpson is a freelance financial writer and investor. Spent close to 15 years on the Street (sell-side, buy-side, equities, bonds); now a semi-retired raccoon rancher. That last part isn't entirely true. Probably.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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