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Text: We will be referring to that slide deck throughout today's call.
I'm Kelly Boyer, Vice President of Investor Relations.
Joining me on the call today are Chris Rossi, President and Chief Executive Officer, and Damon Audia, Vice President and Chief Financial Officer.
These risk factors and uncertainties are detailed in Kennametal's SEC filings.
In addition, we will be discussing non-GAAP financial measures on the call today.
Reconciliations to GAAP financial measures that we believe are most directly comparable can be found at the back of the slide deck and on our Form 8-K on our website.
I'll start today's call with some general comments and a brief review of the quarter, and then discuss our expectations for Q3 and strategic initiatives.
These solid results were driven by improving sequential sales, reflecting both market improvement and growth from our strategic initiatives, as well as increasing benefits from simplification/modernization.
Sales this quarter increased sequentially by 10%, outpacing the 1% to 2% increase from Q1 to Q2 that we typically see.
Transportation and General Engineering end-markets, although still declining year-over-year, continued to show the highest levels of recovery.
As a reminder, those two end-markets totaled more than 65% of our sales.
Energy and Aerospace, as you know, continue to be challenged.
On a year-over-year basis, organic sales declined 14% on top of a 12% decline in the prior year.
However, through disciplined execution of our strategic initiatives and cost control actions, we were able to improve profitability despite the drop in volume and associated under-absorption.
Adjusted EBITDA margin improved by 160 basis points to 13% versus 11.4% in the prior year quarter.
The year-over-year improvement in EBITDA margin was driven by lower raw material costs, increasing benefits from simplification/modernization, and effective cost control actions.
Operating expense as a percentage of sales increased year-over-year to 22% due to lower sales, however, in dollar terms, decreased 9%.
Our target for operating expense remains at 20%.
Adjusted earnings per share of $0.16 was essentially flat versus $0.17 in the prior year quarter, reflecting the factors I just mentioned.
Looking ahead, visibility in this environment continues to be limited; however, there are some reasons for optimism, such as recent end-market momentum and some modest indications of restocking, as well as the early stages of the vaccine rollout.
Nevertheless, with possible additional shutdowns being contemplated in some regions due to recent spikes in COVID-19 cases, it remains difficult to forecast how end-markets and our customers will be affected.
Therefore, similar to the last couple of quarters, we will not be providing a full-year outlook for fiscal year '21.
However, I will provide some color on what we expect in the third quarter.
Based on monthly sales in Q2, early indications from our January sales and assuming that there are no additional significant COVID-19 related shutdowns in the quarter, we expect Q3 sales to see mid to high-single digit growth sequentially with part of the sequential sales growth coming from FX.
We expect the underlying organic growth, excluding the effect of FX, to be in the mid-single digits, which is modestly above our typical sequential growth pattern of 3% to 4%.
Regardless of the pace and trajectory of the recovery, we will continue to focus on the things we can control, such as executing our operational and commercial excellence initiatives to gain share and improve profitability levels throughout the economic cycle.
On the operational excellence side, simplification/modernization initiatives delivered $23 million this quarter, a 117% year-over-year increase and are on track to deliver approximately $80 million in benefits this year as expected.
As a reminder, we expect to complete our original footprint rationalization activities with the closure of the Johnson City, Tennessee plant, and downsizing the Essen, Germany plant, by the end of this fiscal year.
Total cumulative savings from inception of the program are expected to be $180 million by the end of this fiscal year, which is within the original target range we laid out in December 2017 and will be achieved despite much lower volume levels than originally planned.
This is a major accomplishment and sets us up well for the recovery.
Capital spending associated with simplification/modernization is essentially complete, and as such, will result in more normalized capex levels going forward.
Total capex is expected to be between $110 million and $130 million this year, a 50% reduction year-over-year.
Free operating cash flow was $29 million for the quarter, bringing the year-to-date figure to approximately breakeven.
This was excellent performance by the team as they remained focused on working capital without compromising customer service.
Based on the year-to-date performance and current second half outlook, we now expect positive free operating cash flow for the second half and total year, which Damon will go into more detail on.
As you recall, at the end of fiscal year '20, we announced two important changes as part of our commercial excellence strategy.
First, the combination of our two Metal Cutting business segments to better direct our commercial resources, products and technical expertise on capturing a larger share of wallet.
And second, repositioning the Widia brand and portfolio to address the multibillion-dollar fit-for-purpose application space within Metal Cutting that we had not previously focused on.
This approach opens up a 40% increase in served market opportunity while offering better service in tooling options for our customers.
Overall, progress on these initiatives is tracking with our expectations.
And I'm very encouraged by the wins we are seeing in fit-for-purpose applications as we roll the program out globally.
We presented this slide on the last earnings call and have updated the graphs to reflect this quarter's results.
As a reminder, the last time the Company experienced a sales decline close of the one we are currently experiencing was during The Great Recession in 2009.
Graph show trailing 12 month sales on the left and the corresponding adjusted operating margin on the right.
As you can see, we have been able to maintain significantly higher levels of profitability throughout this downturn.
And in this quarter, the 12 month profitability level is approximately the same, but on a much lower revenue.
This is due to the benefits of simplification/modernization that we have already captured combined with stronger and more timely cost control actions.
Two additional points to note.
First, the present day numbers do not yet include the full run rate effect of simplification/modernization.
We are anticipating an additional approximately $40 million in savings by the end of this fiscal year.
And secondly, we have not yet exited the downturn.
The previous downturn lasted about five quarters.
This downturn has already lasted seven quarters, and we are just now starting to see early signs of recovery.
In summary, I'm very encouraged by these results.
We have maintained higher profitability throughout this downturn and are well positioned to outperform as markets recover due to the initiatives we've executed over the last several years.
I will begin on Slide 4 with the review of Q2 operating results, both on a reported and an adjusted basis.
As Chris mentioned, the sequential performance of our sales outpaced our expectations and the typical seasonal pattern.
On a year-over-year basis, total sales declined 13% and 14% organically.
Foreign currency and business days each contribute approximately 1% and a business divestiture had a negative effect of 1% in the quarter.
Adjusted gross profit margin of 28.2% was up 140 basis points year-over-year.
Adjusted operating expenses of $98 million were down $10 million or 9% year-over-year.
Adjusted EBITDA margin of 13% was up 160 basis points from the previous year quarter.
Sequentially, despite rolling back many temporary cost control actions in the quarter, which should amounted to close to $10 million, our adjusted EBITDA margin improved by 170 basis points due to the improving market conditions and continued simplification/modernization savings.
Adjusted operating margin of 5.3% was up 50 basis points year-over-year and 240 basis points sequentially.
The improved year-over-year performance in our margin was primarily due to the positive effect of raw materials as expected, which contributed approximately 590 basis points, incremental simplification/modernization benefits, and temporary cost control actions, partially offset by lower volumes and associated under-absorption.
The adjusted effective tax rate in the quarter of 24.7% was lower year-over-year due to the effects of higher pre-tax income and geographical mix.
Our current expectation is for the adjusted effective tax rate for the fiscal year to be approximately 30%.
Longer-term, we continue to expect our adjusted effective tax rate to be in the low 20% range as profitability levels increase beyond fiscal year '21.
We reported a GAAP earnings per share of $0.23 versus an earnings per share loss of $0.07 in the prior year period.
On an adjusted basis, earnings per share was $0.16 per share versus $0.17 in the prior year.
The main drivers for our adjusted earnings per share performance are highlighted on the bridge on Slide 5.
Effective operations this quarter amounted to negative $0.20.
This compares positively to both the negative $0.62 in the prior year quarter and the negative $0.28 last quarter.
The largest factor contributing to the $0.20 was the effect of lower volumes and associated under-absorption, partially offset by positive raw materials of $0.25 and temporary cost control actions.
The negative effect of operations this quarter was basically offset by $0.19 or $23 million of benefits from simplification/modernization, a significant increase from $0.10 in the prior year quarter.
This brings the cumulative benefits of simplification/modernization to $145 million since inception.
As Chris mentioned, our expectation continues to be that simplification/modernization benefits for the total year will be approximately $80 million, driven by actions already taken or announced, bringing the total expected cumulative savings to $180 million by the end of fiscal year 2021.
Slide 6 and 7 detail the performance of our segments in this quarter.
Metal Cutting sales in the quarter declined 14% organically on top of a 10% decline in the prior year period.
All regions posted year-over-year sales decreases with the largest decline in the Americas at negative 20%, followed by EMEA at 12%, and Asia-Pacific at 6%.
Sequentially, however, we saw improvement across all regions.
The performance in Asia Pacific relative to other regions reflects more positive economic activity led by China, which was flat year-over-year and an improvement in India, which was down low-single digits.
From an end-market perspective, we experienced the best performance in Transportation and General Engineering, which declined 4% and 12%, respectively.
Energy declined 18% year-over-year with the declines in the oil and gas portion of the Energy end-market more than offsetting continued strength in renewable energy, mainly in Asia Pacific.
Aerospace continues to be our most challenged end-market with sales down 43% in Q2 as COVID-19 continues to affect production levels and air travel.
Sequentially, the increase in Metal Cutting was mainly driven by the Transportation and associated General Engineering end-markets.
Adjusted operating margin of 6.1% was down 280 basis points year-over-year, but well above the 1% we experienced in the first quarter.
Year-over-year decrease was primarily driven by a decline in volume and mix, partially offset by incremental simplification/modernization benefits, temporary cost control actions, and raw materials that contributed 230 basis points.
Turning to Slide 7 for Infrastructure.
Organic sales declined 14% on top of a 14% decline in the prior year period.
Other factors affecting Infrastructure sales were divestiture of 1%, partially offset by a benefit from business days of 1% and FX of 1%.
Regionally, again, the largest decline was in the Americas at 18%, then EMEA at 12%, followed by 1% growth in Asia Pacific.
By end-market, the results were primarily driven by Energy, which declined 24% year-over-year, due mainly to the roughly 60% decline in the US land only rig count.
Sequentially, our sales in the Energy end-market improved as customers increased their orders with the increasing rig count.
Earthworks was down 10% year-over-year driven by underground mining and construction weakness in the US.
General Engineering was down 7% year-over-year, an improvement from the 14% decline we experienced in Q1.
Adjusted operating margin of 4.4% was up 620 basis points year-over-year.
This increase was mainly driven by favorable raw materials, which contributed 1,230 basis points as expected, simplification/modernization benefits, and temporary cost control actions, partially offset by lower volumes and associated under-absorption.
Our expectation is that raw materials will be neutral year-over-year for Q3 and Q4 given the tungsten prices have been relatively stable for around six quarters.
Now turning to Slide 8 to review our balance sheet and free operating cash flow.
We continue to believe that maintaining a conservative financial profile is appropriate to ensure the Company has ample liquidity, particularly in this environment, as well as the ability to continue to execute on our strategy.
Our current debt profile is made up of two $300 million notes, maturing in February of 2022 and June of 2028, as well as the US $700 million revolver that matures in June of 2023.
At quarter end, we had $25 million outstanding on the revolver with combined cash and revolver availability of approximately $780 million and we were well within our financial covenants.
Primary working capital decreased year-over-year to $638 million, given our continued focus on inventory.
On a percentage of sales basis, primary working capital increased to 37.3% as sales remained depressed.
Our target primary working capital to sales ratio remains 30%.
Capital expenditures were $29 million, a decrease of $46 million from the prior year as expected, as our capital spending on simplification/modernization is substantially complete.
Year-to-date, we have spent $69 million and continue to expect capital expenditures for the year to be in the range of $110 million to $130 million.
Free operating cash flow for the quarter improved year-over-year to $29 million.
Sequentially, free operating cash flow also improved due to lower capex and stronger profitability.
Year-to-date, our free operating cash flow is approximately breakeven and $59 million more favorable compared to last year.
Consistent with prior quarters, we paid the dividend of $17 million.
The full balance sheet can be found on Slide 13 in the appendix.
As a reminder, this slide details how we expect key factors to affect earnings per share and free operating cash flow.
The slide has been updated to show how these factors will affect the second half on a year-over-year basis and highlights meaningful sequential differences where appropriate.
Starting with simplification/modernization, as we already mentioned, we expect to achieve benefits of approximately $80 million in FY '21, which implies around $40 million of incremental year-over-year savings in the second half.
Temporary cost control actions, unlike in the first half, will be a significant year-over-year headwind of $50 million to $55 million, with $40 million to $45 million in the fourth quarter.
These headwinds are reflective of the aggressive cost control actions implemented last year that are not expected to repeat this year.
Given the phase out of cost control actions in the second quarter, Q3 will face a sequential headwind of approximately $10 million relative to Q2.
Due to the significant level of temporary cost control actions in place last year in the second half, year-over-year leverage will be distorted and not accurately reflect the underlying improved operational performance.
Based on current material prices, particularly tungsten, we do not expect raw materials to have a material effect either year-over-year or sequentially in the second half.
Although depreciation and amortization were only modestly higher year-over-year in the first half, we still expect them to be approximately $10 million higher for the full year as new equipment comes online.
Lastly, for the earnings per share drivers, we have lowered our adjusted effective tax rate expectations for fiscal year '21 to approximately 30% from our previous estimate of 33%, which was also the effective tax rate last year.
This improvement is reflective of the higher pre-tax income and geographical mix.
In terms of free operating cash flow drivers, as Chris and I already mentioned, capital spending for the year is expected to be in the range of $110 million to $130 million.
This implies lower capex both year-over-year and sequentially in the second half.
We expect cash restructuring to be slightly higher both year-over-year and sequentially in the second half.
And we now expect the full year cash restructuring to be higher by $20 million to $25 million versus the approximate $40 million spent in FY '20.
This represents a modest decrease versus our original expectation.
Given our strong inventory reductions year-to-date and continued improving market conditions, we now expect working capital to be a modest use of cash in the second half.
With our focus on working capital, combined with improved market conditions, we now expect free operating cash flow to be positive in the second half and the full year.
Finally, as it relates to Q3, as Chris mentioned, we expect sales to be up mid to high-single digit sequentially with part of the sequential sales growth coming from FX.
We expect the underlying organic growth, excluding the effect of FX, to be in this mid-single digits and above our typical sequential growth pattern of 3% to 4%.
Turning to Slide 10, let me take a few minutes to summarize.
I'm encouraged by our results this quarter despite the ongoing challenges in our end-markets.
Our commercial excellence initiatives are progressing well to drive growth and market share gain, and our operational excellence initiatives are on track with simplification/modernization nearing completion.
The strength of our balance sheet and cash flow allows us to continue to optimize capital allocation, while further improving profitability and customer service throughout the economic cycle.

user
compname reports q2 earnings per share $0.23.
q2 earnings per share $0.23.
will not be providing an fy21 outlook at this time, outside of capital spending, which is unchanged.

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