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Kennametal Inc
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Good morning. I would like to welcome everyone to Kennametal's Third Quarter Fiscal 2018 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. Please note that this event is being recorded.
I would now like to turn the conference over to Kelly Boyer, Vice President of Investor Relations. Please go ahead, ma'am.
Thank you, Denise. Welcome everyone and thank you for joining us to review Kennametal's third quarter fiscal 2018 results. We issued our quarterly earnings press release yesterday evening, and the release along with the slide deck for today's call is posted on our website kennametal.com. This call is being broadcast live on that website and a recording of the call will be available for replay through June 2.
I'm Kelly Boyer, Vice President of Investor Relations. Joining me on the call today are Chris Rossi, President and Chief Executive Officer; Jan Kees van Gaalen, Vice President and Chief Financial Officer; Patrick Watson, Vice President Finance and Corporate Controller; Pete Dragich, President, Industrial business segment; Ron Port, President, Infrastructure business segment; and Alexander Broetz, President, Widia business segment. Chris and Jan Kees will review the March quarter's operating and financial performance, as well as our updated outlook. After their prepared remarks, we'll be happy to answer your questions.
At this time, I would like to direct your attention to our forward-looking disclosure statement. Today's discussion contains comments that constitute forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve a number of assumptions, risks and uncertainties that could cause the company's actual results, performance or achievements to differ materially from those expressed in or implied by such forward-looking statements. 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.
With that, I'll now turn the call over to Chris.
Thank you, Kelly. Hello, everyone, and thank you for your interest in Kennametal. On the call today, I'm going to go through a high level overview of our results, both at a total consolidated level as well as the segment level, after which I'll turn the call over to Jan Kees, who will discuss the financial results in detail. I'll close with some summary comments and then we'll open the call up for question and answer.
I'm really pleased to report that Kennametal had another strong operating quarter, with both sales and margins improving again this quarter in line with our long-term goals. As shown on slide 2 of the slide deck posted on our website, total sales grew by 15% this quarter on 11% organic sales growth. Of note, foreign exchange was responsible for $0.06 (sic) [6%] of the increase in sales, offset by a 2% decrease in business days.
Like last quarter, all our business segments experienced double-digit growth over the prior-year period, with Industrial and Infrastructure both growing at 15% and Widia at 13%. Also, like last quarter, all regions grew with Americas leading at 12%, followed by Asia Pacific at 8% and EMEA at 5%, excluding currency.
And finally, again like last quarter, all end-markets grew, aerospace, energy, general engineering, earthworks and transportation, they all reported continuing strong growth. Margins continue to improve significantly this quarter versus prior year. Our adjusted operating margin increased 150 basis points to 14.3%, which reflects an approximate 70 basis point increase in adjusted gross profit margin, plus approximately 70 basis point improvements in operating expense as a percentage of sales. Sequentially, the margin improved 210 basis points and we expect more margin improvement to come. Reported EPS was $0.61 for the quarter and adjusted EPS was $0.70 versus $0.60 in the prior year.
Now, it's important to note that like last quarter, adjusted EPS was affected negatively, in this case, by $0.07 due to the change in the U.S. tax law. Jan Kees will provide a detailed description of the tax effect in his section as well as an update on the toll tax estimate. The quarter's results were affected by $0.05 of additional variable compensation, similar to last quarter, due to higher-than-anticipated operating performance this year.
Also note that included in the reported and adjusted figures this quarter is $0.02 due to executive severance. Jan Kees will go through the EPS bridge in some detail later on the call. Our year-over-year quarterly organic growth of 11% is graphed on slide 3. Organic growth remained in double-digit levels this quarter even with the stronger comps this quarter versus prior year and the Easter holiday falling in the last week of March this year versus the middle of April last year. This is the sixth consecutive quarter of positive year-over-year growth and we expect to see good market demand going forward.
Also, it's important to note that we have relatively high utilization levels in some of our facilities currently due to strong market conditions. This affords us the ability to be more selective taking on certain sales, allowing us to liberate capacity to improve fill rates on our high-volume highest-profit products. Before I move on to review the segment results, there are a couple of topics that had received a lot of focus during the quarter that I would like to discuss for a moment.
The first topic is pricing ability and general raw material cost increases. I think most of you on the call know that the three main raw material costs for Kennametal are tungsten, cobalt and steel, in that order, with tungsten by far being the most important. Raw material cost increases continued in the third quarter. That said, like the first two quarters in the fiscal year, we have been able to cover the raw material cost increases year-to-date and we expect that trend to continue through the fiscal year.
The second topic that I want to discuss is the effect of or rather the possible effect of steel tariffs on Kennametal. Let me remind you that steel is a relatively small portion of the company's raw material cost and we source on a regional basis. For those reasons, based on our understanding of the tariffs being discussed at this point, we expect that the proposed tariffs would have a very small effect on the company. In fact, we estimate that effect would be in the range of approximately $1 million.
Now, let's review the segment operating results in more detail, starting with our Industrial segment on slide 4. Industrial posted very strong quarterly year-over-year sales growth of 15% on 10% organic growth with foreign exchange of 8%, offset partially by 3% negative impact of business days. This is the seventh consecutive quarter of organic growth for Industrial.
With regard to regional splits, in constant currency terms, the Americas lead at a healthy 12% year-over-year growth rate, followed by EMEA at 7%, and Asia Pacific was flat this quarter versus last year due to unusual timing of sales in the prior-year quarter. We see growth in region remaining strong.
In terms of end markets, excluding FX, we saw good strength in all of them with both our largest general engineering and transportation continue to report good growth rates at 7% and 4% respectively. Aerospace posted another strong quarter as well at 13% year-over-year, while energy grew at 4%.
Adjusted operating margin increased year-over-year to 16.2% from 15.1% in the prior-year quarter, reflecting our continuing progress on simplification and modernization. Regarding our simplification actions, we continue to pursue our SKU, coatings, and powder formulation reductions as well as the minimum order quantity program. The majority of this work is well underway and is now just an ongoing part of the efficient management of the operations of the company.
Regarding our three-year modernization plan, as mentioned during our Investor Day presentation, we've begun moving into the execution phase of these programs with the main benefits to be increasingly felt over the next few years.
In summary for Industrial, we continue to see major improvements this quarter despite the fact that we have additional variable compensation and some manufacturing inefficiencies, such as additional overtime and temporary help, while we balance our modernization efforts with the current high levels of customer demand. We continue to focus on the execution of our plans and we expect more success to come.
Turning to slide 5 which summarizes Widia's results, Widia reported 13% quarterly sales growth on year-over-year organic growth of 9% with foreign exchange of 5% offset by a negative effect of business days of 1%. This is the sixth consecutive quarter of growth for Widia.
Excluding FX, all regions again reported positive year-over-year quarterly numbers with Asia-Pacific leading at 15%, followed closely by EMEA at 14% and the Americas at 1%. Adjusted operating margin improved 90 basis points to 3.2% in the quarter versus 2.3% in the prior year, reflecting progress on both growth and cost.
Widia's strategy differs by region. In Asia Pacific, the opening of new demand streams is starting to gain traction and we are making good progress in the establishment of a brand channel for the entire Widia portfolio. India posted really strong growth and our work on modernizing our facility there is progressing quite well. In EMEA, like last quarter, we continue to see strong growth due to improved effectiveness of our channel partners in Central Europe as well as the growth we are seeing in Eastern Europe.
In the Americas, we are continuing to work on establishing a strong and effective distribution partner network. The quarter was affected by a large non-repeating order in the prior year, but we expect growth in U.S. to remain strong. Overall, I continue to be pleased with Widia's growth performance and believe margin improvement will accelerate as we move forward.
On slide 6, we update our Infrastructure business. Infrastructure sales grew 15% over the prior-year quarter on year-over-year organic growth of 14% with 3% due to foreign exchange, offset by a negative 2% due to business days. This is the fifth consecutive quarter of growth for Infrastructure.
Excluding FX, Asia Pacific posted strong sales growth at 19%, followed closely by the Americas at 14%. EMEA's growth declined 5% in the quarter due in part to accelerated sales in the prior year due to the anticipation of labor disruptions in South Africa.
With regard to end markets, all were positive during the quarter. Excluding currency, general engineering led at 16% growth for the quarter versus prior year. Energy was up 14%, affected positively by oil and gas and related process industries. The average U.S. land rig count in the quarter was up approximately 30% year-over-year with the current level being at approximately 990 rigs. Completion activity also remained strong. Earthworks, which includes construction and mining, grew at 4% for the quarter, although construction activity in Americas was affected slightly by unusually cold weather conditions.
Adjusted operating margin increased to 14.6% for the quarter. This is a significant increase of 230 basis points over the prior year, resulting from continuing execution on our initiatives. With regard to growth initiatives, we are focused on new product launches as well as expanding the portfolio of products sold through the partnership with Caterpillar.
On the cost side, with raw material cost increasing, we are working to lower raw material unit through improved product design, optimize material science as well as strategically source material. Also, operational efficiencies from previous actions such as plant closures and head count reductions continue to show in the numbers.
Overall, I'm very pleased with Infrastructure's progress. We're ahead of schedule on our multi-year improvement plan. We continue to make solid progress on our growth, simplification and modernization initiatives, which all translate into improved margins and will help keep Infrastructure profitable throughout the entire cycle.
Before I hand it over to Jan Kees, let's turn to slide 7 and look at some of the work that has been done to-date on modernization, which contributed $0.03 to EPS during the quarter. There are two examples shown on the slide. The first one is an example of modernizations which we highlighted at last year's Investor Day: the automation of insert, inspection and packaging. The photo on the top left of this slide shows the historical process, heavily dependent on labor. The new automated machines are shown at the bottom left of the slide, with increased productivity higher than expected at greater than 80%.
We were able to accelerate the timeline for the new machines such that the initial benefits were felt this quarter. There will be more benefits to come, of course, in FY 2019 as we install the equipment in six more plants across the globe.
The photos on the right-hand side of the slide are examples of modernization at an infrastructure plant, both – before the modernization initiative, our products were ground in eight stand-alone grinding operations each of which were manually fed. The new process, shown on the bottom right of the slide, reduces the number of process steps through the use of automated feed systems and improved grinding technology, yielding a 50% efficiency improvement. These are just two examples of modernization but, needless to say, we are very excited to see the modernization initiatives starting to take effect and, of course, the majority of benefits are still to come.
With that now, I'll turn it over to Jan Kees, who will begin on slide 8 with a detailed financial report.
Thank you, Chris, and good morning, everyone. Let me walk you through the income statement on slide 8 on both a reported and adjusted basis. On a reported basis, EPS for the quarter was $0.61 per share compared to $0.48 per share in the prior-year quarter. Reported EPS for the current and prior-year quarters includes restructuring and related charges of $0.01 and $0.12 per share, respectively. Reported EPS in the current quarter also includes a discrete tax charge of $0.08 per share related to U.S. tax reform. Also, as Chris noted, the reported and adjusted EPS results include a negative $0.02 effect of executive severance in the Industrial segment.
Sales in the March quarter increased 15% to $608 million, with organic sales growth posting at 11%. Currency tailwinds favorably affected sales by 6%, partially offset by 2% impact of fewer business days. As Chris mentioned, sales grew in every end market and every region.
Adjusted gross profit increased 17% to $220 million this quarter over the prior-year quarter. Adjusted gross profit margin increased by 70 basis points year-over-year to 36.2%. The main drivers for expansion at the gross margin level were organic sales growth, favorable currency exchange benefits, incremental benefits from our restructuring initiatives and favorable mix. This is partially offset by higher raw material costs and decreased manufacturing efficiency due in part to modernization efforts in progress.
Adjusted operating expenses increased to $129 million on increased volume compared to $116 million in the prior-year quarter. $6 million of that $13 million increase is due to unfavorable currency effects.
On a percentage of sales basis, adjusted operating expenses improved by 70 basis points, decreasing to 21.3%. We continue to be pleased with the progress we are making on operating expenses, particularly given the strong end-market environment and we will continue to focus further improvements as we move forward.
The improvements in both gross profit margin and operating expense margin contributed to adjusted operating income margin increasing year-on-year by 150 basis points 14.3%. For the third quarter of fiscal 2018, adjusted EBITDA was $111 million, up 21% from the prior-year period. Our reported effective tax rate for the quarter of 31.2% includes an 8.3% effect or $6 million in dollar terms charge related to U.S. tax reform.
As discussed last quarter, the Tax Cuts and Jobs Act of 2017 requires a one-time toll tax on unremitted earnings of our foreign subsidiaries. We reported an additional $6 million expense in this quarter to adjust the estimated toll tax charge based on regulatory guidance issued earlier during the quarter. The amount is provisional and we expect to finalize this in the calendar year.
The adjusted effective tax rate increased to 23.1% from 15.3% in the prior-year quarter. This was primarily due to U.S. income in the prior-year quarter not being tax affected and the current quarter U.S. income being tax affected now that the valuation allowance is no longer recorded on our U.S. deferred tax assets.
Adjusted EPS improved year-over-year to $0.70 in the third quarter of fiscal 2018 versus $0.60 in the prior-year quarter. A complete bridge of the factors affecting adjusted EPS this quarter versus the prior-year quarter is presented in the EPS bridge on the slide 9.
Now, let's examine some of these items in a bit of detail. The effect of volume, price, raw materials, mix, absorption and productivity amounted to $0.13 this quarter versus prior year. When I look through the operating results and consider the effects of items that don't level well, like foreign exchange and pricing on raw material costs, we are satisfied with the underlying operating leverage which we estimated to be in the range of 40-ish-percent.
We are relatively pleased with that line. It is worth noting, again, that the leverage number can move around each quarter due to segment mix, regionally mix and product mix. But in general, we expect it to be in that range. With regards to the restructuring benefits of $0.10 in the quarter, this is the positive impact year-over-year of our fiscal 2017 head count reduction and other restructuring initiatives. These will continue to provide year-over-year benefits in the fourth quarter as well.
Like the first two quarter in fiscal year 2018, currency provided a tailwind this quarter as well, as opposed to the headwinds that we saw in fiscal year 2017. As Chris mentioned, we are starting to see the benefits from simplification and modernization this quarter amounting to $0.03. This will increase as we move further into our modernization plan.
As we noted last quarter, the strength of our end markets is providing an additional, but welcome challenge for us while we move to our modernization plan and can manifest itself in the need for additional overtime and temporary help in order to meet customer needs at the level we demand of ourselves. In this quarter, that amounted to $0.02, a slight decrease from the $0.03 in the previous quarter. Our expectation going forward is that this will continue and we will continue to use overtime and temp help as needed until we complete our multi-year modernization plan.
Additional variable compensation this quarter of $0.05, like last quarter, is due to the stronger-than-expected operational performance. The expectation is that this will continue in Q4 of this year. Please note that the incentive plan resets each fiscal year. Salary inflation of $0.05 is related to merit and is simply a cost of doing business. I've already explained the tax headwind we are facing this fiscal year. The expectation for the longer term is that we have an effective tax rate in the low 20s. All other items amounted to $0.02 this quarter.
The detail of our segment sales by region and end markets can be found on slide 10. For the Industrial segment, general engineering sales experienced growth from the indirect channel in the Americas and EMEA. Transportation sales increased due to growth (23:17) suppliers and OEMs in EMEA and the Americas. Conditions continue to be favorable in aerospace due to growth in sales in the Americas related to engines and frames.
Oil and gas sales in the Americas continue to provide growth in energy. The Industrial segment expanded adjusted operating margins by 110 basis points to 16.2% year-over-year, reflecting primarily organic sales growth, incremental restructuring benefits and favorable currency exchange impact, partially offset by increasing manufacturing inefficiencies, while modernizing and higher variable compensation expense due to the better-than-expected operating results.
For Widia, strong sales in Asia Pacific were mainly driven by China and India, followed by EMEA growth due to primarily increases in Eastern Europe and Germany. Demand in the Americas was strong. However, a large order in the prior-year quarter did not repeat this year, thus the sales growth was lower in the Americas relative to other regions.
Widia reported adjusted operating margins up 90 basis points to 3.2% year-over-year, reflecting primarily organic sales growth, partially offset by unfavorable mix. Infrastructure saw strengths in the all end markets during the quarter. Favorability in general engineering is driven primarily by overall more robust activity in the general economy, particularly in the Americas. Additionally, increases in the process industries and oil and gas activity in the U.S. yielded strong growth in the energy end markets.
Growth in earthworks was primarily driven by mining in Asia Pacific. Infrastructure's adjusted operating margin increased by 230 basis points to 14.6% due primarily to organic sales growth, favorable mix, favorable currency exchange impact and incremental restructuring benefits. These were partially offset by higher raw material costs, decreased manufacturing efficiency from operating facilities while modernizing, and higher compensation expense.
As shown on slide 11, primary working capital was $728 million as at March 2018, an increase of $76 million from the previous fiscal year end, due to higher activity-driven inventories and receivables, partly offset by increasing payables. On a percentage of sales basis, primary working capital decreased 100 basis points to 30.4% as of March 31, 2018 from the June 2017 figure.
Slide 12 summarizes the cash flow statement. Third quarter year-to-date free operating cash flow was $54 million as compared to negative $7 million for the prior-year quarter. The change in free operating cash flow is due primarily to higher cash from operations before changes in certain other assets and liabilities and lower restructuring payments, offset partially by higher working capital and capital expenditures.
Regarding capital expenditure, net capital expenditures were $127 million year-to-date compared to $90 million for the prior year-to-date period. Dividends paid out were $49 million and we remain committed to maintaining our dividends.
Turning to slide 13 for a discussion of our balance sheet, our conservative capital structure and investment-grade ratings are of key importance to Kennametal and we continue our commitment to maintaining them. Cash on hand at March 31, 2018 increased to $222 million as compared to $191 million last June.
At the end of March, our net debt was $476 million, with no current outstanding borrowings on our revolver. We have no significant maturities until November 2019. Gross debt to adjusted EBITDA currently stands at 1.8 times. The full balance sheet can be found in the appendix of the slide deck. We are confident in our balance sheet and liquidity positions, and we'll continue to work to maintain them as we execute on our modernization initiatives.
And with that, I'll turn it back over to Chris.
Thank you, Jan Kees. Turning to slide 14, the outlook for fiscal year 2018. Our expectation for organic sales growth is to be at the top of the previously communicated range of 9% to 11%. The effective tax rate is expected to fall in the range of 23% to 25%, a slight change from the previous guidance of 22% to 25%. We're raising the midpoint and narrowing the range for adjusted EPS outlook to $2.55 to $2.65. And we expect to be at the lower end of the capital range of $210 million to $230 million. Our outlook for free operating cash flow is also increasing to $60 million to $75 million, reflecting our improved operating results.
To summarize on slide 15, we continue to show good progress on our initiatives in Q3. Looking forward, we're very much focused on executing our improvement plans to create a great – significant returns for our shareholders, great products and services for our customers, and really a great place for our team members to work.
Operator, with that, please open the call up for questions.
Thank you Mr. Rossi. Your first question will come from Ann Duignan of JPMorgan. Please go ahead.
Yeah. Hi. Good morning. Just a couple of clarification questions. First, could you tell us how much of your tungsten are you sourcing externally versus internally? And then, following that up, can you talk about pricing strategies by channel and when in the year might you be able to pass through price increases through maybe distribution versus OEM? Thank you.
Okay. Ann, in terms of the first question on tungsten, we do have a combination of internal and external sources. We believe that the ability to manage that process is actually a key to staying competitive in this business. But honestly, we don't want to disclose that type of level of detail because we think it's competitive information. But it is important to manage and we feel like how we're managing that supply chain today actually puts us in a good position to manage our costs going forward.
In terms of pricing, we've already had a few price increases that we've talked about on previous calls. But every segment is focused on making sure that as the material costs change that we try to stay ahead of that curve or pretty close to it. And then also, frankly, Ann, we realize that demand is very high and we want to focus on pricing based on the demand that's out there, but also recognizing that many of our products we haven't had price increases for many years. We've improved those products, and delivering more value to customers and we are not ashamed or bashful about going out and pointing that out to customers to push price.
So, so far, as you can tell, we've been able to stay ahead of the cost curve. And you have to be strategic about the pricing decisions. But again, the markets are cooperating with us and so far we feel pretty good about our strategy.
But in general, would you agree that it's probably easier to push through price increases through the distribution channel versus the OEM channel? Would that be a fair assessment?
Yeah. I think the distribution channel, just by nature of that business, it's easy to raise the list prices, but there still is a conversation you want to have with our distribution partners. So, I don't know that it's necessarily easier. Maybe it's facilitated by the fact that they're going off the list price. But the direct customers also require a conversation and a little hand-holding through the process.
Okay. And just a final question on that, on the list prices, when normally do you publish new list prices?
I don't know what Kennametal's history has been. But because we're watching what's happening with the demand in the market and we're keeping an eye on the material costs, we typically will adjust those list prices as needed. Now, there may be some historical basis where they may have done it once a year, but it seems to me Kennametal didn't do that for several years. So, you guys want to add anything to that, Pete or Alexander?
Well, normal history is annual basis. Typically, that would be in January. But as Chris said, we've had to adjust based on what's happening with material costs.
The same is true Widia.
Okay. I thought it might have been annual, historically speaking. Okay. I've badgered you enough on that topic, I will get back in line. Thank you.
Thank you, Ann.
Thanks Ann.
The next question will be from Steve Volkmann of Jefferies. Please go ahead.
Hi, Steve.
Hi, Steve.
Hey. Sorry. Good morning guys. Maybe just stick with this price cost one more time. Chris, I think you said – are you guys there, can you hear me?
Yeah. We can hear you.
Yeah. We hear you.
Okay. Good. Sorry about that. So Chris, I think you said that things were positive this quarter. You expect it to be positive for the remainder of the fiscal year, but of course we're halfway through the fourth quarter already. So, I'm curious if there's anything we should be focused on with respect to timing, maybe as we get into the second half of the calendar year relative to things like your inventory levels or your supply agreements. Is there any reason to think that that price cost dynamic would change as we get a couple quarters further out?
Yeah. Steve, as we've talked about before, we monitor the situation closely and try to stay ahead of it. But at any point in time within a year, we may be a little behind, we might be a little bit ahead. But given the dynamics of what we're seeing in the market, I expect us to still be able to sort of manage next year very similar to how we've managed this year.
Okay. Good. Thank you. And then there's just a lot of balls in the air for us to keep track of relative to your head count reduction, your SKU reduction, the shift to indirect, the modernization, the simplification and so forth. Can you just talk broadly about where we are relative to these? And what I'm thinking about is, as we move into FY 2019, what are going to be the key drivers of margin expansion amongst those various programs. And can we kind of think about that 40% incremental as something we can hold through FY 2019 as well?
Yeah. I think it should get easier for us to explain sort of the moving pieces, because we've – we are now moving into phase where we're going to execute the information we presented at the investment day. So, we had the simplification initiatives which are largely sourcing and sort of general productivity and some sales effectiveness type of things, and then modernization of the factories. So, we do plan on discussing the sort of simplification and modernization and giving you folks an update as we're moving through that process.
I'm sorry, what was the second part of the question?
What are going to be the key drivers of margin expansion?
Yeah. So, those will be the key drivers of modern – modernization and simplification will be the key drivers, especially as we walk through 2019, because all the benefits associated prior restructurings are sort of falling off by then.
And that 40% incremental, is that something you think you can continue to do going forward?
Steve, the leverage moves around, obviously, quarter by quarter depending on the segment, geographic and product mix. But at the end of the day, that is the target that we set ourselves.
Thank you so much.
Thanks, Steve.
The next question will be from Julian Mitchell of Barclays. Please go ahead.
Thank you. Good morning. Maybe just a question on that point on incremental margins. Overall, I guess, on a clean basis, they were in the mid-20s in Q3. They guided to move up to maybe 45%, 50% in Q4. Just maybe talk through the bigger moving pieces. I mean, I think one would be just the anniversarying of that incentive comp from Q4 last year that was very heavy. Do you also think those manufacturing inefficiencies in Industrial that you cited in Q3 start to fade as well? And anything else that you think is driving that improvement.
Yeah. I think, first of all, the manufacturing inefficiencies while modernizing that – by definition, while modernizing means those are unfortunately are going to continue through the – likely to continue through the cycle. When we – we're intensely focused on the leverage issue and we believe that Industrial, by the way, is hit the hardest by not only the variable comp and, of course, the executive severance in the quarter, which is why their EBIT leverage, I think, was below what you would normally see. But if you look at their EBIT leverage on Industrial for the third quarter and you adjust for the effects of this variable comp, which they tend to be hit with a higher piece, because there's a big sales, incentive piece of that, the executive severance and FX, we're now in the 30% kind of leverage range. And then, the manufacturing efficiencies sort of gets us back into where we'd think.
The other thing about Industrial and what there's an opportunity here is the Industrial margins, we believe, can be improved through a selectivity process. A fair amount of our business is custom engineered and quoted to order. And we have a chance to actually control that process and decide and be selective on the orders that we take. And so, by favoring orders and customers that we want to improve service on and favoring order that are more profitable, we're actually going to liberate some of our manufacturing capacity to improve our fill rates on the high-moving high-margin standard products, which will also help to drive the leverage improvement and sort of mitigate some of these operational efficiencies, while we're modernizing.
Very good. Thank you.
Yeah, Julian, I think the Industrial business has been particularly impacted over the quarter by the foreign exchange, the strong euro versus the dollar and, obviously, the raw material versus price impact. So as that starts lapping, we should see some help coming out of these two or less impact on these two matters.
Thanks. And then my follow-up would just be more of a top-line question. So, a lot of industrial companies have seen the automotive end market come in a bit light. Your own transportation revenue growth slowed from, I think, mid-teens in the second quarter to 4% in the third quarter. So, maybe just remind us how much of your transportation business is sort of light vehicle versus commercial vehicle, and whether you think that big slowdown you saw was a blip. How are you thinking about transportation revenue growth looking out the next six to nine months?
Yeah, I think, in general, it's still a very strong market across the ball. All our end markets seem to be in good shape. We don't really see anything that's going to concern us right now. Transportation, you're right. The growth rate had slowed since Q2. But when we start to canvas the salespeople and sort of the feet on the ground out there, we're not sensing that there is some macro event here that's going to slow down that sector. And one of the things you got to worry with transportation – not worry about, you've got to consider is that the pace of sales doesn't necessarily dictate the supply chain and how they're producing the parts, which we're more tied to.
So, I think maybe you need to just wait another few quarters to see what's going to happen. But our general sense – and this is really the sense not just for transportation, but we can talk about all the end markets even in Infrastructure and Industrial and Widia, we don't see a lot of weakness out there.
Great. Thank you.
The next question will be from Andy Casey of Wells Fargo Securities. Please go ahead.
Thanks a lot. Good morning.
Hi, Andy.
I'm just trying to understand your free cash flow guidance for the last quarter. It implies around – at the midpoint, around $16 million free cash, $89 million OCF. That's a downtick from what you posted in Q3 despite the higher sales and margin that are implied in the guidance for the next quarter. What is driving that? Is it increased working capital intensity or can you help us with that?
There's a little bit more cash – capital expenditure foreseen in Q4 in terms of prepayments for fixed asset orders that are going out. We also have the inventories rolling the standards once more. And obviously, if the euro stays where it is, there may be a little bit of FX in that forecast as well.
Okay. Thank you. And then, if we go back to slide 9, I just want to ask a pretty simple question, the $0.02 severance, is that in the other bucket or is that included somewhere else?
Yes, that's in the other buckets – bucket, sorry.
Okay. And then the implied margin, if I assume a 5% to 6% benefit from currency and working days for the fourth quarter on top of what seems to be about a 6% organic, and then take everything else, it looks like the expected operating margin is about mid 15% to 16%. First is, is that kind of in the ballpark? And then second, I can get there if I assume absence of the roughly $2 million of severance and then around a 40% incremental margin sequentially, is that about the right way to think about it?
You're absolutely spot on.
Okay. Thank you very much.
The next question will be from Adam Uhlman of Cleveland Research. Please go ahead.
Hi, everybody. Good morning.
Good morning, Adam.
Hey. To follow-up on the Andy's question of working capital and cash flow, as we start thinking about what fiscal 2019 looks like. Could you just talk about like kind of that medium-term plan of dealing with inventories, raw materials, finished goods? Like, do we have to step that up in the medium term to deal with new inflationary pressures and the lead times, inefficiencies, with the modernization program? And then since the CapEx outlook's kind of coming in at the low end of the range, we have another big step-up next year. I'm just trying to get to how we should think about the free cash flow outlook for next year, broadly?
So, Adam, I'll just make a couple of general comments. First, on the CapEx, we said that modernization was going to sort of be a $300 million spend over three years. So, you'll see another CapEx number, similar to this year, next year like we talked about in our Investor Day. Generally, though, as we move through next year, and I'll let Jan Kees add some detail to this, but generally as we move through last year, we expect – or next year and the following year, we expect to generally have free cash flow positive. And that's our model and that's our forecast. So, we've sort of got all that baked in. But through this modernization period, we definitely will see positive free cash flow and it should increase year-over-year. JK, you want to add anything to that?
Yeah. So, Adam – thanks, Chris. We typically don't provide guidance for 2019 fiscal on this call. But what we have been doing in terms of primary working capital is a multi-year plan in terms of working that down, in terms of a percentage of revenue. And for the moment, I would expect that plan to continue. In terms of the capital expenditure, we have quarters where the capital expenditure may be a little light and then other quarters where a capital expenditure may be a little bit heavier, depending on the scheduling of the POs, of the modernization equipment, and also our normal ongoing capital expenditure with our suppliers. Typically, I would expect the free operating cash flow to go up in line with our operating results for next year, everything else being equal, obviously.
Okay. Great. Thank you. And then just a nuance, as we think about the fourth quarter margin performance, would we expect both segments to see sequential improvement or are there some other issues that we should think about?
No other issues. All the segments would see sequential improvement.
Thank you.
The next question will be from Samuel Eisner of Goldman Sachs. Please go ahead.
Good morning, Sam.
Yeah. Good morning, guys. Good morning. Hey, just going back to some of the variable compensation stuff. When I look at the last two quarters, your restructuring benefits and modernization are barely positive relative to your variable compensation expenses in total. I think net $0.03 positive in the second quarter, $0.01 positive in the third quarter here. So I'm curious, what's the right way we should be thinking about that into the fourth quarter? And then any early indications on 2019 of those two kind of larger buckets.
Yeah, I think – well, I'm not going to give you an outlook for simplification, modernization, other than FY 2019 is the year where we start to ramp up. So, you should see that $0.03 improve over time. That would be logical to include. The additional variable comp, that will go away because that basically will reset itself when we set the plan for next year. So, that should largely go away. And then I'd just also point out on the salary inflation, because of the timing of the last rise to payroll, that will disappear in the fourth quarter also. It's also already baked into our forecast at that point.
Yeah. And Sam, remember, last year in the fourth quarter, we had a bit of a catch up. And so, this year in terms of comparison year-over-year, it should be relatively flat.
Got it. I guess, just to challenge on the variable comp, I think that was part of the expectation coming into this year that the variable compensation was going to be reset and that would be an easy comp, yet it's continued to be an issue. So, are you changing the way that you guys are thinking about setting plans for variable compensation relative to the guidance that you guys give? Maybe just kind of open up the kimono a little bit there to help us better understand the process going forward?
Yeah. I mean, the way we think about this is that the variable comp plans are set based on the guidance that we provide you folks. And if you remember – and that's what Kennametal did at the start of this year. But I don't think they anticipated that the markets were going to recover quite as fast as they did. So consequently – and that's when we raised our guidance. So consequently, people are being measured on the original plan and now we're in sort of an elevated situation, which is – it's good for the folks, but that's not our normal philosophy how to run a plan. That make sense?
Yeah. I guess, obviously, I think it's just the way the plans have been set up, so it's creating the issues here. And maybe just last one, going back to your slide 3, it looks like on a two-year stack basis – I'm looking at the quarterly organic growth chart. Looks like on a two-year stack basis, you actually saw a deceleration within either March or the overall March quarter. How should we be thinking about the two-year stack going forward? Should we anticipate that continuing to fall? Have we kind of, dare I say, reached some level of peak-ish type of two-year stack growth rates? Just any kind of color there would be great?
Yeah I think just a couple comments on the overall cycle. First, I learned a long time ago not to try to predict these things because the only thing I know for sure is I'm going to be wrong. And the other thing that I've learned is that one data point in a quarter doesn't actually equal a trend. So, it's hard to predict whether there's an inflection point here or not. That being said, the anecdotal information that we get from our salespeople is that they're kind of looking at me, like, why are you asking a quick question, Chris. The end market demand is very strong, okay. So, part of what's being reflected in chart 3 is the comps are getting more difficult as we continue through this positive cycle. But we're not sensing anything that would suggest that the demand is tapering off or anything like that.
Got it. Thanks so much.
The next question will be from Walter Liptak at Seaport Global. Please go ahead.
Hi. Thanks. I wanted to ask about the Infrastructure business, specifically for energy, and given the three buckets that you put the business into, how was the leverage with the three and is there any one of them that's getting more pricing than the other? And I guess, specifically in energy, are you able to pass along the price yet?
Yeah. I think just a couple of comments on energy, and I'll let Ron, you can add something if you like, but – on the pricing topic. Energy, generally, we see that it's sort of stabilized, but it kind of continues to take an uptick, but it's kind of stabilized. And that's the way we projected it. I know that there is opportunity to raise prices in that space, but it's probably less due to there's just a huge amount of demand and we can raise prices in that environment and more about the fact that we have excellent products. They have a very strong value proposition and we're really, I think, getting much better as a company at selling that and pushing price in that area. Ron, any color you want to add to that or...
Yeah. The only other piece that we have is, with a lot of the key customers, we have long-term contracts that we work with them, which have pricing indexes based on raw material costs.
Good point.
Okay. Great. And then if I could ask too just about the overtime expense, have you figured out a way to do the modernization and kind of mitigate that overtime expense or is that OT something that we're going to see ramping as you continue with the modernization plans?
Yeah. I don't know how much it'll necessarily ramp. Okay. It could go up in any given quarter, could go down a little bit. But the way we're – the reason we're pulling out is by definition it is as a result of doing the modernization and so it's going to continue through the cycle. Now, we try to minimize it, of course. But one of the reasons that we're sort of doing this is – and also using temporary workers, which is a little less efficient process, there's higher turnover and people aren't as skilled as your permanent workers would be – is that we anticipate that our company is going to be able to run and produce more volume with less people, and I don't really want to add a bunch of people only to have to lay them off again in the next two or three years. So, you can imagine that, that's especially a challenging situation in some countries. So, we think the better strategy is to try to continue to focus on meeting customer demand and operating the facilities with overtime and temporary workers. It is more inefficient, but once we get through the modernization phase, that inefficiency is going to come out. That's a thought.
Okay. Great. All right. Thank you.
The next question will be from Steve Fisher of UBS. Please go ahead.
Thanks. Good morning.
Good morning, Steve.
Just a clarification on the capital spending. I know you're going to be at the lower end of the range originally contemplated. Is that lower CapEx a function of timing or is it that certain things have been permanently removed from your modernization plan and you found more efficient ways of achieving it?
No, I think the modernization number that you should still have in your head is that $300 million over three years. It's really just a question of timing. And I don't want to give the impression that we think we're behind or anything like that, but there are – and if you look at the detail of this thing, there's actually 700 or 800 little projects that all add up to big projects, and it's very complex. We feel like we've got a good project management process in place to do this. And as we got more clarity and move through this thing, we're going to do a better job of sort of predicting that number. But I wouldn't read anything into it in terms of the amount being reduced or in terms of our ability to deliver where we said we'd be.
Just to add to that, Chris, the question around becoming more efficient a far as how we spend capital, I think the teams are learning quite a bit as we go through and design our future state. And we're going to be pushing ourselves to be more efficient with the capital that we do spend, ultimately, that allow us to do more modernization in the company with the $300 million we're going to spend.
Okay. Great. And just related to Widia margins, can you just give us a sense of the trajectory that you expect to get from where you are around the 3% range on margins to 18% in 2021? How confident are you in that 18% number at this point and how back-end loaded do you think it'll be?
Yeah, I think, first of all, when we look at the Widia margins in any given quarter, as a percentage of sale, they can move around a lot because the numbers are so small, all right. That's one thing. But Widia, what I think is important to remember is Widia is not actually manufactured completely independent of the industrial manufacturing footprint. So once we modernized the Industrial segment, okay, by definition, you're also modernizing Widia. And that's where a lot of the improvement is coming from is the two are happening simultaneously. So, for example, some of the equipment that we showed in our slide deck today, that equipment is packaging Industrial as well Widia products.
So, the two go kind of hand-in-hand, but that's what's largely going to drive the Widia margin improvement. And then the other thing is, is that Alexander and his team are committed to continue to grow that business. And that's also a big driver of the margin improvement.
Okay. Thank you.
Welcome.
And ladies and gentlemen, this will conclude our question-and-answer session. I would like to turn the conference back to Chris Rossi for his closing remarks.
Thank you, everyone, for your ongoing interest in Kennametal. Please follow-up with Kelly on any questions you might have. And have a great day. Thank you.
Thank you.
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