KMT

Kennametal Inc. 10-Q Summary: Quarter Ended September 30, 2006

Business Context and Reporting Period

This Form 10-Q covers the three-month period ended September 30, 2006. Kennametal Inc. is a global manufacturer of tooling, engineered components, and advanced materials serving industries such as aerospace, automotive, mining, and energy. During this fiscal year, the company divested its J&L Industrial Supply segment and is in the process of divesting non-core businesses (Kemmer Praezision Electronics and consumer retail products), which are reported as discontinued operations.

Key Financial Metrics

Material Changes vs. Prior Period

• Sales: Decreased 1.0% year-over-year. This decline reflects an 8.0% negative impact from acquisitions and divestitures (specifically the loss of J&L sales), partially offset by 6.0% organic growth driven by favorable conditions in energy and mining markets.
• Profitability: Gross profit decreased 5.2% due to higher raw material costs and the net impact of divestitures. Gross margin contracted by 170 basis points. However, Net Income increased 8.1% due to lower operating expenses and a reduced effective tax rate (31.7% vs. 34.7%).
• Operating Expenses: Decreased 6.8% to $135.0 million, driven by a $2.8 million reduction in professional fees (Sarbanes-Oxley compliance) and the impact of divestitures.
• Cash Flow: Operating cash flow turned negative ($18.8 million used) compared to a positive $20.5 million in the prior year. This was primarily due to a $72.3 million decrease in accrued income taxes resulting from tax payments related to the J&L divestiture gain and cash repatriation under the American Jobs Creation Act.
• Investing Activities: Net cash used for investing activities increased significantly to $75.8 million, driven by $73.9 million in business acquisitions and $22.7 million in capital expenditures, partially offset by $20.2 million in divestiture proceeds.

Guidance, Outlook, and Risks

Management Commentary: Management attributes organic sales growth to favorable market conditions in energy, mining, and developing economies. The company completed two acquisitions in the Advanced Materials Solutions Group (AMSG) segment for $73.9 million. Corporate operating losses decreased due to reduced employment costs and compliance fees.

Subsequent Events: On October 24, 2006, the Board authorized a new share repurchase program for up to 3.3 million shares and shareholders voted to increase authorized capital stock from 70 million to 120 million shares.

Risks and Contingencies:

• Divestitures: The company is finalizing the sale of the J&L segment, with $3.5 million in proceeds expected by year-end. There is an ongoing arbitration regarding post-closing adjustment claims, which management believes are without merit.
• Environmental: Kennametal is a potentially responsible party (PRP) at the Li Tungsten Superfund site (accrual of $1.0 million) and has been named a PRP at the Alternate Energy Resources Inc. site in Georgia, where liability is currently indeterminable.
• Market Risks: Exposure to raw material costs, foreign currency exchange rates, and global economic conditions.

Investor Verification Checklist

• Divestiture Proceeds: Verify the collection of the remaining $3.5 million from the J&L sale and the resolution of the post-closing arbitration claims.
• Acquisition Integration: Monitor the integration of the two AMSG acquisitions ($73.9 million) and their contribution to future organic growth.
• Environmental Liabilities: Track the status of the Alternate Energy Resources Inc. site in Augusta, Georgia, for potential future accruals.
• Raw Material Costs: Assess the sustainability of gross margins given the cited pressure from higher raw material costs.
• Share Repurchases: Monitor the execution of the new 3.3 million share repurchase program authorized in October 2006.