KENNAMETAL INC Q3 2026 earnings call

Thank you, operator. Welcome, everyone, and thank you for joining us to review Kennametal's third quarter fiscal 2026 results. This morning, we issued our earnings press release and posted our presentation slides on our website. We will be referring to that slide deck throughout today's call. I'm Michael Pici, Vice President of Investor Relations. Joining me on the call today are Sanjay Chowbey, President and Chief Executive Officer, and Patrick Watson, Vice President and Chief Financial Officer. After Sanjay and Pat's prepared remarks, we will open the line for questions. At this time, I'd like to direct your attention to our forward-looking disclosure statement. Today's discussion contains comments that constitute forward-looking statements and, as such, 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 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 in our Form 8-K on our website. With that, I'll turn the call over to Sanjay.

Thank you, Mike. Good morning, and thank you for joining us. I will begin with an overview of the quarter, including end market commentary, followed by a discussion on unit volume trends. From there, Pat will cover the quarterly financial results and the fiscal year 2026 outlook, along with an early look at fiscal 2027. Finally, I'll make some summary comments, and then we'll open the line for questions. Turning to slide three. Let me begin by addressing some of the highlights from our strong third quarter. Our global commercial teams continued to advance our strategic growth initiatives. The Infrastructure team delivered solid growth. In construction, we saw volume growth from strong product performance and the advantage we have as a secure source of tungsten in a tight supply environment.

Additionally, we received large orders in our defense business, further securing ongoing growth in this market as we head into fiscal 2027. In Metal Cutting, we continue to increase our share of wallet with key accounts, especially in aerospace and defense, and build upon our momentum in energy from AI power generation initiatives. In general engineering, we have been winning new customers through targeted promotional campaigns and improvements to our digital customer experience, especially for our small to medium-sized customers. As you know, we continue to prioritize above-market growth as a strategic imperative, and these wins position us well in our key end markets. Turning now to the broader tungsten environment. Prices continued their unprecedented increase throughout the quarter, rising from approximately $900 per metric ton to $3,000 as the supply of material continued to be constrained.

This tungsten price and supply environment have created both challenges and opportunities. On the challenges front, we have seen a highly competitive market for material, but our supply chain has held up relatively well. We have and will continue to implement pricing actions in response to these rising tungsten costs and remain confident in our ability to secure that price. We are also focused on managing the primary working capital and balance sheet implications of higher tungsten costs. In terms of opportunities, our vertical integration has been a real strength in this market, providing us better supply chain control and flexibility compared to some competitors. For example, as competitors are turning away orders or extending lead times, we are well-positioned to capture business that is aligned with our strategic priorities.

During the quarter, we capitalized on these opportunities in each of our business segments, specifically Earthworks within Infrastructure and aerospace & defense in Metal Cutting. These new opportunities also facilitate shaping our product portfolio away from lower margin to higher margin solutions. As such, we are seeing a unique combination of three factors that are opening the door to sales opportunities. First, continued market recovery. Second, solid execution on our strategic growth initiatives. Third, a window of opportunity from the current tungsten market, which is likely to persist in the near term. Given those dynamics, we are prioritizing our time and attention on growth opportunities over restructuring initiatives in the near term. We are shifting the timeline for facility closure actions we had previously planned to complete in fiscal 2027. We will provide additional detail on the restructuring timeline as appropriate.

Even with that shift, we are still targeting approximately $110 million in savings from cost takeout actions by the end of fiscal 2027, which is $10 million above what we outlined at Investor Day. Let's move to our quarterly results, which once again exceeded our sales and EPS outlook. Compared to outlook, sales were mostly driven by increased price realization and better than expected volume in both segments. EPS benefited from the additional price raw timing of $0.09, positive volume, and lower than anticipated tax rate. Year-over-year, sales increased 19% organically. Please note, this was our third consecutive quarter of organic growth, driven by additional price realization, strategic growth initiatives, and continued recovery in several end markets. Adjusted EPS increased to $0.77 compared to $0.47 in the prior year quarter.

Adjusted EBITDA margin was 20.8% compared to 17.9% in the prior year quarter. Cash from operating activities year-to-date was $70 million compared to $130 million in the prior year period. Free operating cash flow year-to-date was $18 million compared to $63 million in the prior year. Free operating cash flow was adversely impacted by increased working capital requirements related to tungsten prices. Finally, we returned $15 million to shareholders through dividends. As it relates to our outlook, today we are raising our sales and EPS outlook for fiscal 2026. This update reflects the additional price due to the continued rise in tungsten and additional volume. Patrick will provide more details on our updated outlook shortly. In summary, we are pleased with this quarter's results and how the team is navigating these unique business conditions.

As I mentioned, there are opportunities and challenges in this market, and we remain focused on delivering on our commitments throughout fiscal 2026 and setting ourselves up for a successful fiscal 27. Now let's turn to slide four for an end market update. As a reminder, our full year outlook reflects forecasts of specific market drivers and general market conditions. The top half of this slide reflects our sales outlook at the midpoint and includes price, volume, and market factors. My comments will focus on the bottom half of the slide and address transportation and energy, which are the only end markets that changed since our last call. IHS estimates for transportation slightly improved from the previous estimate. Up in the low single-digit range, mostly driven by improvements in Asia-Pacific market. Energy improved slightly relative to our prior outlook as customer sentiment improved.

The tone is now cautiously optimistic, which is an improved stance compared to what customers were previously signaling. Turning to slide five. As we have talked about over the last several years, customer activity rates and our sales volumes have been below the pre-COVID peak. I want to take some time to provide insight into unit volume and how those trends have improved over the last few quarters. This chart uses units sold volume and excludes the impact of price and foreign exchange. It also excludes Infrastructure defense sales, as these are lumpy and not tied to industrial production metrics. Let me spend a moment on what is driving the volume recovery, and just as importantly, why we believe it's sustainable. As the call-out indicates, we are now experiencing the second consecutive quarter of year-over-year trailing 12-month unit volume growth.

Despite a macro backdrop that has been uneven, volumes are strengthening in the Americas and Asia Pacific. EMEA continues to lag, and that is consistent with what we are seeing in PMI and industrial production data. A key driver continues to be aerospace and defense, which remains strong across both Metal Cutting and Infrastructure. Importantly, this strength isn't simply tied to OEM build rates, which are still roughly 20% below pre-COVID levels, but rather to share gains and deeper penetration with tier suppliers. That gives us confidence there is still additional runway as production rates normalize over time. We are also starting to see early signs of stabilization in general engineering and energy, even while headline indicators remain soft. In energy, power generation continues to see meaningful momentum.

While U.S. land rig counts are still about 30% below pre-COVID levels, we are seeing enough stabilization to suggest we are past the trough. In Infrastructure, Earthworks has delivered volume gains for two consecutive quarters, driven by share gains. Stepping back, if you look at the chart, global volumes are now up approximately 3% from the Q1 fiscal 2026 trough, following 36 months of stagnant industrial production. Our performance is not just the result of a market recovery. It's shaped by where we compete, how we allocate resources, and where we are winning share. We know we operate in cyclical end markets, but we are quite confident in the long-term growth potential of these markets and our ability to capture share within them. Let me turn the call over to Pat, who will review the third quarter financial performance and the outlook.

Thank you, Sanjay, good morning, everyone. I will begin on slide six with a review of our Q3 operating results. Sales were up 22% year-over-year, with an organic increase of 19% and favorable foreign currency exchange of 5%, which was slightly offset when adjusting for the divestiture we concluded last year. Sales volume in the quarter was up low single digits. At the segment level, organic sales increased 30% in Infrastructure and 12% in Metal Cutting. On a constant currency basis, America sales increased 27%, Asia Pacific sales increased 25%, and EMEA was up 2%. The sales performance this quarter exceeded the expectations we provided last quarter on higher sales volumes from better market conditions and share capture. We also had higher than expected price, primarily in Infrastructure, from the continued rapid increase in tungsten prices.

By end market, on a constant currency basis, Earthworks grew 43%, energy increased 28%, aerospace & defense grew 23%, general engineering grew 14%, and transportation increased 1%. I will provide more color when reviewing the segment performance in a moment. Adjusted EBITDA and operating margins were 20.8% and 13.8% respectively, versus 17.9% and 10.3% in the prior year quarter. The margin increase was driven by favorable price raw of $39 million within the Infrastructure segment, pricing and tariff surcharges in Metal Cutting, increased sales and production volumes, and year-over-year restructuring benefits of $7 million.

These are partially offset by higher compensation costs, which are mostly performance-based, tariffs and general inflation, and a prior year benefit from an advanced manufacturing tax credit of approximately $8 million that did not repeat in the current year. Adjusted earnings per share was $0.77 in the quarter versus $0.47 in the prior year period. The main drivers of our EPS performance are highlighted on the bridge on slide seven. The year-over-year effective operations this quarter was positive $0.36. This reflects approximately $39 million of favorable timing of price/raw material costs, price and tariff surcharges in Metal Cutting, higher sales and production volume, and incremental restructuring benefits of $7 million. These are partially offset by higher compensation costs, tariffs, general inflation, and higher raw material costs in Metal Cutting.

There was a headwind of $0.08 related to the net prior year manufacturing tax credit. You can also see the $0.02 of transaction gains related to preferential Bolivia exchange rates. Currency, other, and pension impacts offset each other. Slides eight and nine detail the performance of our segments this quarter. Reported Metal Cutting sales were up 18% compared to the prior year quarter, with 12% organic growth and favorable foreign currency exchange of 6%. Regionally, excluding currency exchange, Asia Pacific increased 18%, the Americas increased 17%, and EMEA increased 3%. Looking at sales by end market on a constant currency basis, aerospace & defense increased 27% year-over-year due to improved build rates in Americas and easing supply chain pressures in EMEA, combined with our global focus on deeper market penetration.

Energy grew 17% this quarter from data center power generation wins. General engineering increased 13% year-over-year due to price, volume gains in Asia Pacific, and stronger distribution sales in the Americas. Lastly, transportation increased 1% year-over-year due to price and market softness, primarily in EMEA. Metal Cutting adjusted operating margin of 11.2% increased 160 basis points year-over-year, primarily due to higher price and tariff surcharges, higher sales and production volumes, and incremental year-over-year restructuring savings of approximately $5 million. These factors were partially offset by higher compensation, tariffs and general inflation, and higher raw material costs. Turning to slide nine for Infrastructure.

Reported Infrastructure sales increased 29% year-over-year, with organic growth of 30% and favorable foreign currency exchange of 4%, partially offset by a divestiture effect of -5%. Regionally, on a constant currency basis, America sales increased 42%, Asia Pacific increased 35%, and EMEA sales were flat. Looking at sales by end market on a constant currency basis, Earthworks increased 43% from higher demand in construction, as we were able to provide product to customers who were unable to source product from other players and share gain in underground mining. Energy increased 34%, mainly driven by price. General engineering increased 18% due to price and higher powder demand in Asia Pacific, partially offset by lower demand in EMEA.

Lastly, aerospace and defense increased 17% due to defense orders driven by continued focus on growth initiatives and timing in the Americas. Adjusted Operating Margin increased 680 basis points year-over-year to 18.3%, primarily from the favorable timing of pricing compared to raw material costs of $39 million and year-over-year restructuring savings of $2 million. These items were partially offset by higher compensation costs and a prior year manufacturing tax credit of $8 million that did not repeat in the current year. Turning to slide 10 to review our Free Operating Cash Flow and balance sheet. Our third quarter year-to-date net cash flow from operating activities was $70 million compared to $130 million in the prior year period.

This change was driven primarily by higher working capital from higher tungsten prices and increased volumes of tungsten to secure our supply chain. Our third quarter year to date Free operating cash flow decreased to $18 million from $63 million in the prior year, primarily due to the increased primary working capital changes I just referenced, partially offset by lower capital expenditures. On a dollar basis, year over year, primary working capital increased to $819 million from $654 million. On a percentage of sales basis, primary working capital increased to 32.4%. It's important to note that from both an earnings and cash flow perspective, the business is operating as it normally would when the price of tungsten rises.

In periods of rising tungsten prices, we always experience favorable price raw timing effects in sales and earnings while we experience headwinds to cash flow as primary working capital grows based on tungsten valuation. What is unique about the current circumstance is the magnitude of the rise in tungsten prices. In no recent time have we experienced a nine-fold increase. Due to the uncertain nature of tungsten pricing and the corresponding pressure it has placed on working capital, we once again made the decision not to repurchase shares. Net capital expenditures decreased to $52 million compared to $67 million in the prior year quarter. In total, we returned $15 million to shareholders through our dividends. Inception to date, we have repurchased $70 million or 3 million shares under our $200 million authorization.

We remain committed to returning cash to shareholders while executing our strategy to drive growth and margin improvement. We continue to maintain a healthy balance sheet and debt maturity profile. At quarter end, we had ample liquidity to support the business with combined cash and revolver availability of approximately $742 million. As always, we remain well within our financial covenants. The full balance sheet can be found on slide 16 in the appendix. Now on slide 11, regarding our full year outlook. We now expect FY 2026 sales to be between $2.33 billion and $2.35 billion with volume ranging from 2%-3%, net price and tariff surcharge combined of approximately 16%. We anticipate an approximate 2% tailwind from foreign exchange.

The increased outlook reflects additional pricing actions related to the increase in cost of tungsten since our February call. Specifically, within the fourth quarter, we expect net price and tariff surcharges combined of approximately 35% compared to the prior year quarter. We now expect Adjusted EPS in the range of $3.75-$4.00. This outlook includes approximately $2.45 related to the timing of price raw benefit due to the rise in tungsten prices, the significant majority of which affects the Infrastructure segment. This effect increased $1.50 from the prior outlook.

On the cash side, the full year outlook for capital expenditures is now anticipated to be approximately $85 million, and Free operating cash flow is expected to be approximately negative 30% of adjusted net income, reflecting the working capital pressure from the rise in cost of tungsten as discussed earlier. It's important to note our outlook does not include any effects from the conflict in the Middle East. The other assumptions in our outlook are noted on the slide. While it is earlier than normal, I would like to take a moment to provide a bit of a framework to help you think about FY 2027. First off, our current assumption is that tungsten prices will remain elevated for some period of time going forward. That implies there will be significant carryover pricing given the 35% price expectation for the fourth quarter.

Thank you, Pat. Turning to slide 12. Let me take a few minutes to summarize. We have delivered three strong quarters so far in fiscal 2026, driven by price and modest improvements in various end markets, project wins on the commercial side, and productivity and cost improvement actions. Going forward, we will remain focused on the strategic growth initiatives and lean transformation we have underway, while also exploring ways to strengthen our portfolio over time. Additionally, we will continue to actively manage our tungsten supply chain. In summary, we remain confident in our plan for long-term value creation for shareholders. With that, operator, please open the line for questions.