Kennametal Inc. Fiscal 2017 Second-Quarter Form 10-Q Summary
Business context and reporting period
Kennametal is a global manufacturer and supplier of tooling, engineered components and advanced materials used in industrial, transportation, aerospace and defense, earthworks, energy, construction and related markets. The filing covers the three and six months ended December 31, 2016. Fiscal 2017 introduced a new operating structure with three reportable segments: Industrial, Widia and Infrastructure; prior-period segment data was restated accordingly.
Key financial metrics
| Metric | Three months ended Dec. 31, 2016 | Prior-year quarter | Six months ended Dec. 31, 2016 | Prior-year period |
|---|---|---|---|---|
| Sales | $487.6 million | $524.0 million | $964.7 million | $1,079.4 million |
| Gross profit | $147.6 million | $140.8 million | $291.2 million | $292.0 million |
| Gross margin | 30.3% | 26.9% | 30.2% | 27.1% |
| Operating income (loss) | $24.0 million | $(234.0) million | $14.8 million | $(227.3) million |
| Net income (loss) | $7.9 million | $(168.8) million | $(13.3) million | $(174.5) million |
| Net income (loss attributable to Kennametal) | $7.3 million | $(169.2) million | $(14.4) million | $(175.5) million |
| Diluted EPS | $0.09 | $(2.12) | $(0.18) | $(2.20) |
| Operating cash flow | Not separately provided | Not separately provided | $46.6 million | $104.5 million |
Quarterly sales declined 7%, primarily reflecting divestiture effects, fewer business days and unfavorable currency, partly offset by 2% organic growth. Six-month sales declined 11%, including an 8% divestiture impact and a 1% organic decline.
- Segments: Second-quarter Industrial sales were $267.5 million with $18.1 million of operating income; Widia sales were $42.9 million with a $2.7 million operating loss; Infrastructure sales were $177.2 million with $10.3 million of operating income.
- Cash and liquidity: Cash and cash equivalents were $102.0 million at December 31, 2016, down from $161.6 million at June 30, 2016. Working capital was $581.6 million, compared with $648.1 million at fiscal year-end.
- Debt: Total debt, including notes payable, was approximately $696.6 million. Long-term debt and capital leases were $694.3 million. The company had no borrowings under its $600 million revolving credit facility and was in compliance with all debt covenants.
- Cash uses: Six-month capital expenditures were $70.6 million, cash dividends were $32.0 million, and financing cash outflows included a $6.6 million payment of remaining contingent acquisition consideration.
- Dividends: Quarterly dividends remained $0.20 per share, or $0.40 per share for the six-month period.
Material changes versus the prior comparable period
- Results improved substantially because the prior-year quarter included a $133.3 million loss on divestiture and $108.5 million of non-cash goodwill and intangible impairment charges. Neither item recurred in the current quarter.
- Gross margin increased 340 basis points in the quarter and 310 basis points for the six-month period, aided by productivity, higher fixed-cost absorption, lower raw-material costs and restructuring benefits.
- Operating expense declined 10.2% in the quarter and 8.7% for the six-month period, primarily due to restructuring savings, divestiture effects and favorable currency impacts.
- Restructuring and related charges increased to $11.8 million in the quarter and $43.4 million for the six-month period, compared with $8.9 million and $24.0 million, respectively, in the prior-year periods.
- Operating cash flow declined to $46.6 million from $104.5 million, primarily because of lower cash earnings and less favorable working-capital changes.
- Infrastructure sales remained weak, with six-month sales down 24%; however, Infrastructure returned to operating income after substantial prior-year impairment and divestiture charges.
- Accumulated other comprehensive loss attributable to Kennametal increased to $382.2 million from $352.5 million, primarily due to approximately $40.3 million of unfavorable foreign-currency translation.
Guidance, outlook, risks and unusual items
- Management expects restructuring actions to be completed by December 2019. Total pre-tax charges are expected to be $155 million to $175 million, with anticipated ongoing annual pre-tax savings of $147 million to $162 million once completed. Charges are expected to be mostly cash expenditures.
- As of December 31, 2016, management had identified 85% of a targeted 1,000 employment reduction, representing approximately 72% of estimated annualized savings from that initiative.
- Management reported organic growth in the quarter for the first time since the September 2015 quarter. Aerospace and defense, general engineering and energy showed improvement, while earthworks and underground mining remained challenging.
- Management stated that North American energy markets were stabilizing, but underground mining weakness was expected to continue for the foreseeable future.
- The company is exploring strategic alternatives for a non-core Infrastructure business with an estimated net book value of approximately $30 million. Additional impairment charges may result, but the company could not determine the amount.
- Goodwill assigned to the new Widia reporting unit was $27.0 million, and its fair value approximated carrying value, increasing sensitivity to changes in projected cash flows, discount rates, cost savings and market multiples.
- Environmental reserves were $12.1 million. Management believes reserves are adequate for probable and reasonably estimable matters, but environmental liabilities may change materially as facts, regulations, remediation requirements or other parties’ financial condition change.
- Forward-looking risks include economic downturns, foreign currency and international-market exposure, raw-material and energy costs, competition, restructuring execution, demand weakness, impairment risk, environmental matters, litigation, product liability, labor relations, cybersecurity and acquisition or divestiture execution.
- A $1.4 million inventory-reserve error was recorded in the December quarter that related to the September quarter; management determined it was not material to previously issued interim financial statements and it had no impact on six-month cost of goods sold or December 31 inventory.
Most important facts for investors to verify
- Whether organic sales improvement continues, particularly in Industrial and Widia, and whether Infrastructure energy stabilization offsets persistent earthworks and mining weakness.
- Progress toward the remaining employment reductions, restructuring charges and stated annual savings, including the cash cost and timing of implementation.
- Widia’s ability to improve profitability given that its fair value approximated carrying value in the goodwill assessment.
- Operating cash-flow conversion relative to capital expenditures and the effect of working-capital requirements on liquidity.
- Debt covenant compliance, availability under the $600 million revolver and the company’s ability to maintain dividends while restructuring expenditures continue.
- Potential impairment or divestiture consequences for the non-core Infrastructure business with approximately $30 million of net book value.
- Currency effects, environmental remediation exposure and other contingencies that could materially affect equity and future earnings.