Kennametal's Long-Term Prospects Solid, Runs Near-Term Risks

We have issued an updated research report on Kennametal Inc. KMT on Jul 4. Though the company has strong growth prospects in the near and long term, we believe that exposure to headwinds might restrict its growth momentum in the quarters ahead. It currently carries a Zacks Rank #3 (Hold).

It is one of the leading companies in the Zacks categorized Machine Tools & Related Products industry, currently ranked among the top 30% of the 256 industries. In the last six months, Kennametal’s shares have returned 19.28%, outperforming the industry’s gain of roughly 18.96%.

One of the major strengths of Kennametal is its diversified customer base in the industrial and infrastructure end markets. Healthy business in general engineering, oil & gas, transportation and aerospace markets have boosted the company’s industrial results. Operations in underground mining have also improved. To enhance its business activities, the company makes meaningful acquisitions and disposes non-core assets. For instance, it divested certain non-core assets, comprising 18 facilities including 11 manufacturing and seven small facilities from castings, steel-plate fabrication and deburring operations in fiscal 2016.

In addition, Kennametal aims profitability improvement through its restructuring programs. By Dec 2018, the company anticipates these efforts to yield pre-tax savings of approximately $165−$180 million. Of the total, the company predicts its headcount reduction initiatives to result in estimated annualized savings of $90 million by Dec 2017 while other programs are likely to generate savings of $75−$90 million by Dec 2018. Also, over the next three years, the company is anticipated to start realizing benefits from its modernization and end-to-end initiatives as well as from ongoing product and process simplification initiatives.

On the back of these positives, we believe that Kennametal holds solid potential to achieve its long-term targets. In the 2017−2019 timeframe, the company anticipates total revenue growth to be in a range of 2−3% (Compound Annual Growth Rate – CAGR), earnings before interest and tax margin to improve 400−500 basis points (bps), earnings per share to grow above 20% (CAGR), free cash flow to be greater than 10% of sales and return on invested capital to improve 400−500 bps.

Talking about fiscal 2017, Kennametal increased its adjusted earnings guidance to $1.50−$1.60 per share from the previous forecast of $1.20−$1.50. Its Zacks Consensus Estimate is predicted to grow 42.1% year over year in 2017 and 36.5% in 2018.

Despite these positives, we believe that Kennametal faces risks from its high debt levels. Exiting third-quarter fiscal 2017, its long-term debt and capital leases was roughly $695 million. We believe that a rise in the debt level, if unchecked, will increase the company’s financial obligations and hence hurt profitability.   

Kennametal’s geographical expansion has exposed it to risks from adverse movement in foreign currencies and geo-political issues. In third-quarter fiscal 2017, unfavorable foreign currency movements negatively impacted revenues by 1%. In addition, the company secures a major portion of its raw materials from non-U.S. countries, thus raising concerns over its availability and price fluctuations.

Moreover, Kennametal faces stiff competition from other players in the industry, including Lincoln Electric Holdings, Inc. LECO and Stanley Black & Decker, Inc. SWK. These two stocks carry a Zacks Rank #2 (Buy). Another stock with the same rank in the machinery industry is Parker-Hannifin Corporation PH. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Lincoln Electric Holdings’ earnings estimates for 2017 and 2018 have been revised upward over the last 60 days. Also, it pulled of an average positive earnings surprise of 4.66% in the last four quarters.

Stanley Black & Decker reported better-than-expected results in the last four quarters, with an average positive earnings surprise of 5.38%. Also, its earnings estimates for 2018 improved over the last 60 days.

Parker-Hannifin’s average earnings surprise for the last four quarters was a positive 14.94%. Also, earnings expectations for fiscal 2018 improved over the past 60 days.

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