Kennametal Inc. — Fiscal 2018 Second-Quarter Form 10-Q Summary
Business context and reporting period
Kennametal is a global manufacturer of tungsten carbide, ceramic, super-hard material, metal-cutting tools and wear-resistant solutions. Its reportable segments are Industrial, Widia and Infrastructure, serving transportation, aerospace, general engineering, energy, mining and construction markets. This unaudited Form 10-Q covers the three and six months ended December 31, 2017, representing the second quarter and first six months of fiscal 2018.
Financial performance and liquidity
| Metric | Three months ended Dec. 31, 2017 | Prior year | Six months ended Dec. 31, 2017 | Prior year |
|---|---|---|---|---|
| Sales | $571.3 million | $487.6 million | $1,113.8 million | $964.7 million |
| Gross profit | $192.5 million | $147.6 million | $377.5 million | $291.2 million |
| Gross margin | 33.7% | 30.3% | 33.9% | 30.2% |
| Operating income | $68.2 million | $24.0 million | $124.7 million | $14.8 million |
| Operating margin | 11.9% | 4.9% | 11.2% | 1.5% |
| Net income attributable to Kennametal | $41.6 million | $7.3 million | $80.8 million | $(14.4) million |
| Diluted EPS | $0.50 | $0.09 | $0.98 | $(0.18) |
- Second-quarter sales increased 17.2%, including 15% organic growth and a 3% favorable currency effect, partly offset by 1% fewer business days. Six-month sales increased 15.5%.
- All segments, regions and end markets reported sales growth and improved profitability. Second-quarter segment margins were 13.9% for Industrial, 1.8% for Widia and 12.1% for Infrastructure.
- Six-month operating cash flow was $66.8 million, versus $48.7 million in the prior-year period. Capital expenditures were $85.2 million, compared with $70.6 million.
- Cash and cash equivalents were $159.9 million at December 31, 2017, compared with $190.6 million at June 30, 2017. Working capital was $720.8 million, up from $652.4 million.
- Total debt was approximately $697.1 million, including $695.7 million of long-term debt and capital leases. The company had no borrowings under its $600 million revolving credit facility and was in compliance with all debt covenants. The facility matures in April 2021.
- Cash dividends paid during the first six months were $32.5 million; dividends were $0.20 per share per quarter.
Material changes versus the prior comparable period
- Profitability improved substantially due to organic volume growth, restructuring benefits, productivity, fixed-cost absorption, favorable mix and lower restructuring charges.
- Second-quarter gross margin rose 340 basis points and operating margin rose 700 basis points. Six-month gross margin rose 370 basis points and operating margin rose approximately 970 basis points.
- Industrial operating income increased to $43.3 million from $18.1 million; Infrastructure increased to $25.5 million from $10.3 million; and Widia returned to operating profitability at $0.9 million versus a $2.7 million loss.
- Restructuring and related charges declined to $1.5 million in the quarter and $8.4 million year to date, from $11.8 million and $43.4 million, respectively. Existing restructuring actions were substantially completed in the first quarter of fiscal 2018 and generated approximately $165 million of annualized pre-tax savings.
- Operating expenses increased to $120.6 million in the quarter and $240.0 million year to date, primarily due to higher compensation and unfavorable currency effects, partially offset by restructuring benefits.
- Operating cash flow improved, but increased capital expenditures, inventory and other working-capital needs resulted in a $30.7 million decrease in cash during the first six months.
Guidance, outlook, commentary, risks and unusual items
- Management stated that end-market demand was stronger than previously anticipated, with growth initiatives taking hold and modernization expected to provide additional margin benefits over the next several years.
- Management expects the full-year effective tax rate to be higher than previously anticipated because U.S. income is no longer sheltered by a valuation allowance. Beyond fiscal 2018, the company expects its tax rate to decline from the mid-20% range to the low-20% range.
- The Tax Cuts and Jobs Act resulted in a provisional $77 million toll-tax charge on previously untaxed foreign earnings. The charge was offset by releasing the U.S. deferred-tax valuation allowance, and the company does not expect a related cash payment. The accounting remains subject to refinement during the applicable measurement period.
- Second-quarter diluted EPS included an estimated $0.07 per-share adverse effect from an out-of-period tax adjustment and a $0.05 per-share benefit from releasing the U.S. valuation allowance. The company identified an $8.2 million historical deferred-tax-asset calculation error; $5.3 million was recorded as an out-of-period tax provision, which management determined was not material to prior financial statements or estimated fiscal-year results.
- Key risks include economic and business-cycle downturns, execution of restructuring and modernization initiatives, foreign-exchange and international-market exposure, raw-material availability and cost, competition, product liability, intellectual property, information technology security, environmental compliance and remediation, goodwill or intangible-asset impairment, labor relations and acquisition or divestiture execution.
- Environmental reserves were $12.7 million at December 31, 2017. Management believes reserves are adequate for probable and estimable matters but cautions that costs could change materially as facts, remediation requirements, responsible parties or government involvement evolve.
- The company expects to adopt the new revenue-recognition standard, ASC 606, on July 1, 2018, but had not yet determined its complete financial-statement impact.
- Management concluded that disclosure controls and procedures were effective, with no material changes to internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether strong organic growth in energy, transportation, aerospace, general engineering and earthworks markets persists and converts into sustained margins.
- The durability and timing of restructuring savings and the incremental benefits expected from the modernization program.
- The final accounting for the Tax Cuts and Jobs Act, including the provisional $77 million toll tax, deferred-tax valuation allowance release and permanent-reinvestment assessment.
- Cash conversion, working-capital requirements and capital expenditures relative to operating cash flow.
- Debt maturities, interest coverage and compliance with the revolving-credit agreement’s leverage and interest-coverage covenants.
- Potential changes in environmental reserves, restructuring accruals, held-for-sale assets and goodwill or intangible-asset impairment exposure.
- The effect of ASC 606 adoption on revenue timing, performance obligations and marketing programs, particularly in the Industrial and Widia segments.