Kennametal Inc. — Fiscal 2019 Second-Quarter Form 10-Q
Reporting period: Three and six months ended December 31, 2018; filed February 5, 2019. The filing refers to fiscal 2019, with fiscal years ending June 30.
Business Context
Kennametal manufactures tungsten carbide, ceramic and super-hard material products, including metalworking tools, wear components and metallurgical powders. Reportable segments are Industrial, Widia and Infrastructure, serving transportation, aerospace and defense, general engineering, energy and earthworks markets.
Key Financial Metrics
| Metric | Three months ended Dec. 31, 2018 | Prior year | Six months ended Dec. 31, 2018 | Prior year |
|---|---|---|---|---|
| Sales | $587.4 million | $571.3 million | $1,174.1 million | $1,113.8 million |
| Gross profit | $198.6 million | $189.5 million | $409.7 million | $371.5 million |
| Gross margin | 33.8% | 33.2% | 34.9% | 33.3% |
| Operating income | $78.9 million | $63.6 million | $162.0 million | $115.8 million |
| Operating margin | 13.4% | 11.1% | 13.8% | 10.4% |
| Net income attributable to Kennametal | $54.7 million | $41.6 million | $111.4 million | $80.8 million |
| Diluted EPS | $0.66 | $0.50 | $1.34 | $0.98 |
| Operating cash flow | Not separately provided | Not separately provided | $61.5 million | $41.1 million |
Balance sheet at December 31, 2018: Cash and equivalents were $96.3 million, total debt was $595.1 million, total assets were $2.53 billion and Kennametal shareholders’ equity was $1.27 billion. The company had no borrowings under its $700 million revolving credit facility and was in compliance with its debt covenants.
Capital allocation and liquidity: Capital expenditures were $88.1 million for the six-month period, compared with $59.5 million in the prior year. Cash dividends paid were $32.8 million. Management stated that available resources, liquidity and investment-grade credit ratings were sufficient to meet cash requirements for the next 12 months.
Material Changes Versus the Prior Comparable Period
- Second-quarter sales increased 3%, including 4% organic growth and a 3% unfavorable currency impact. Six-month sales increased 5%, including 7% organic growth and a 3% unfavorable currency impact.
- Operating income increased 24% in the quarter and 40% for the six-month period. Margin expansion reflected organic growth, price realization, lower operating expenses and simplification/modernization benefits.
- Industrial operating margin rose to 18.1% from 13.0%; Widia improved to 3.5% from 1.0%; Infrastructure declined to 9.3% from 11.3% because of higher raw material costs.
- Operating cash flow improved by $20.4 million year over year, but inventory increased $53.1 million from June 30, 2018 and working-capital outflows remained significant.
- The company redeemed its $400 million of 2.650% Senior Unsecured Notes due 2019 on July 9, 2018. It issued $300 million of 4.625% Senior Unsecured Notes due 2028 in June 2018, contributing to higher interest expense.
- Financing cash outflows were $432.7 million, primarily reflecting the $400 million debt repayment, compared with $17.3 million in the prior-year period.
- Restructuring and related charges decreased to $3.1 million for the six-month period from $8.4 million. Cumulative charges under the program were approximately $13.9 million through December 31, 2018.
Guidance, Outlook, Commentary and Risks
- Management reported the eighth consecutive quarter of sales growth and approximately $12 million of annualized run-rate pre-tax benefits from simplification and modernization initiatives. Incremental benefits in the quarter were approximately $3 million.
- Management cited continued demand strength in aerospace and defense, energy and general engineering. Transportation and earthworks were weaker, including transportation weakness in China and earthworks disruptions in South African coal production and construction markets.
- Higher raw material costs, temporary manufacturing expenses related to modernization activities and foreign currency volatility remain pressures on margins.
- The company finalized its accounting for the Tax Cuts and Jobs Act. The total toll tax charge was reduced to $78.0 million, with no expected cash payment. A $6.1 million tax charge was recognized for changes to the permanent reinvestment assertion, partly offset by a $3.9 million toll-tax benefit in the quarter.
- Environmental reserves were $12.5 million at December 31, 2018. Management believes reserves are adequate for probable and reasonably estimable obligations, but noted that environmental costs could change substantially.
- Principal disclosed risks include economic and business-cycle downturns, foreign-exchange and international-market exposure, raw material availability and pricing, competition, product liability, intellectual property, environmental matters, potential goodwill or intangible impairment, labor relations, cybersecurity and execution of restructuring, modernization and acquisition initiatives.
- The company adopted the revenue recognition standard effective July 1, 2018 without a material financial statement impact. Lease accounting guidance is scheduled to become effective July 1, 2019; the impact was still being assessed.
- The company corrected the presentation of certain prior-year cash-flow items, reducing previously reported six-month 2017 operating cash flow by $25.7 million and correspondingly reducing investing cash outflows. Management determined the correction was not material to previously issued interim financial statements.
Investor Verification Priorities
- Verify whether organic sales growth and simplification/modernization benefits continue to offset raw material inflation, currency pressure and temporary manufacturing costs.
- Monitor cash conversion, inventory growth, capital expenditures and liquidity following the $400 million debt redemption.
- Review the maturity, pricing and covenant terms of the remaining debt and the $700 million revolving credit facility.
- Assess sustainability of Industrial’s margin improvement and the continued recovery of Widia, while tracking Infrastructure’s exposure to energy, earthworks and raw material costs.
- Confirm the cash and future tax implications of the finalized Tax Cuts and Jobs Act accounting, including the $78.0 million toll tax and $6.1 million reinvestment-assertion charge.
- Evaluate environmental reserves, Superfund obligations, restructuring accruals and any potential impairment or contingency developments.