Kennametal Inc. 2016 Q1 Form 10-Q Summary
Business context and reporting period
Kennametal is a global manufacturer of tooling, engineered components and advanced materials serving industrial, transportation, aerospace and defense, earthworks, energy, construction and related markets. This unaudited report covers the three months ended September 30, 2016, the first quarter of fiscal 2017, with comparisons to the three months ended September 30, 2015.
The company implemented a new operating structure, separating the former Industrial business into Industrial and WIDIA. Reportable segments are now Industrial, WIDIA and Infrastructure.
Financial performance and key metrics
| Metric | Q1 FY2017 | Q1 FY2016 | Change |
|---|---|---|---|
| Sales | $477.1 million | $555.4 million | Down 14% |
| Gross profit | $143.5 million | $151.2 million | Down $7.7 million |
| Gross margin | 30.1% | 27.2% | Up 290 basis points |
| Operating income (loss) | $(9.2) million | $6.6 million | Down $15.8 million |
| Net loss attributable to Kennametal | $(21.7) million | $(6.2) million | Loss increased |
| Diluted loss per share | $(0.27) | $(0.08) | Higher loss |
| Operating cash flow | $21.9 million | $38.7 million | Down $16.8 million |
| Capital expenditures | $42.3 million | $37.2 million | Up $5.1 million |
Gross margin improved primarily because of lower raw material costs, restructuring benefits and improved productivity, but these benefits were offset by lower sales, unfavorable mix, divestitures and currency effects. The quarter included $31.7 million of restructuring and related charges, including $28.6 million of restructuring charges. Management stated that restructuring charges reduced diluted earnings by approximately $0.38 per share.
At September 30, 2016, cash and cash equivalents were $119.4 million, total debt was approximately $695.4 million, and Kennametal shareholders’ equity was $937.1 million. The company had $694.0 million of long-term debt and capital leases, no borrowings under its $600 million revolving credit facility, and was in compliance with its debt covenants. Working capital was $589.3 million.
Cash used in investing activities was $41.0 million, primarily for capital expenditures. Cash used in financing activities was $23.4 million, including $16.0 million of dividends and $6.6 million paid for remaining contingent consideration related to a prior acquisition. Cash decreased by $42.2 million during the quarter.
Material changes versus the prior comparable period
- Sales declined $78.2 million, driven by a 9% divestiture impact, a 3% organic decline and a 2% unfavorable currency effect.
- Excluding currency and divestitures, earthworks sales declined approximately 21% and energy sales declined 8%, while aerospace and defense increased 4% and general engineering and transportation each increased 1%.
- Industrial sales were broadly flat at $269.0 million, but operating income fell to $5.6 million from $21.5 million. The decline reflected additional restructuring charges, higher employment-related costs and unfavorable mix.
- WIDIA sales declined 5% to $41.0 million, and its operating loss widened to $5.8 million from $1.7 million.
- Infrastructure sales declined 31% to $167.1 million, primarily because of divestitures and weak earthworks and energy markets. Its operating loss improved modestly to $7.6 million from $8.4 million.
- Operating expenses declined 7.3% to $119.9 million, reflecting divestiture effects, restructuring benefits and favorable currency effects, partly offset by higher employment-related costs.
- Operating cash flow declined to $21.9 million from $38.7 million, primarily because of lower cash earnings and less favorable working-capital changes.
- The effective tax rate was 29.9% on a pretax loss, compared with 292.8% in the prior-year quarter. The current period included a U.S. loss for which no tax benefit was recorded because of a full valuation allowance on U.S. deferred tax assets.
Guidance, outlook, risks and unusual items
Management expects restructuring actions to continue through December fiscal 2019. Total pretax restructuring charges are expected to be $155 million to $175 million, with annual ongoing pretax savings of $140 million to $155 million when completed. Through September 30, 2016, cumulative restructuring and related charges totaled $102.8 million. Management identified 75% of the targeted 1,000 employment reductions, representing approximately 65% of estimated annualized savings.
Management reported that results were generally in line with expectations, that Industrial achieved organic growth for the first time since December fiscal 2015, and that Infrastructure comparisons should become easier. WIDIA requires improvement, and management is focused on rebuilding the brand globally. Energy and mining conditions remained weak, including a reported year-over-year decline of more than 40% in U.S. rig counts and a 36% decline in North American underground mining sales.
The new WIDIA reporting unit had goodwill of approximately $27.0 million and fair value approximating carrying value, increasing sensitivity to adverse changes in forecasts, discount rates or market multiples. The company reported no goodwill impairment during the quarter but is exploring strategic alternatives for a non-core Infrastructure business with an estimated net book value of approximately $30 million; additional impairment charges cannot be determined at this time.
Environmental reserves were $12.5 million. The company remains subject to environmental remediation uncertainties and Superfund-related obligations. Other principal risks include economic weakness, foreign exchange, commodity and raw-material costs, restructuring execution, demand in energy and earthworks markets, potential goodwill impairment, environmental matters, product liability, intellectual property, cybersecurity and international operating risks.
Important facts for investors to verify
- Whether restructuring savings and the targeted employment reductions are achieved without disrupting operations or requiring charges above the stated $155 million to $175 million range.
- Whether WIDIA stabilizes its sales and operating performance, given its operating loss margin of 14.0% and goodwill fair value near carrying value.
- The pace of recovery, if any, in Infrastructure end markets, particularly energy, earthworks and mining.
- Whether operating cash flow improves relative to capital expenditures and dividends, given negative quarterly free cash flow before financing activities.
- The sustainability of the $119.4 million cash balance and access to the unused $600 million revolving credit facility under applicable covenants.
- Potential changes in U.S. deferred tax asset valuation allowances, effective tax rates and cash taxes.
- Potential impairment or divestiture effects related to the non-core Infrastructure business and other strategic actions.