UNITED STATESSECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2005
Commission file number 1-5318
KENNAMETAL INC.
World Headquarters1600 Technology WayP.O. Box 231Latrobe, Pennsylvania 15650-0231(Address of principal executive offices)
Website: www.kennametal.com
Registrant’s telephone number, including area code: (724) 539-5000
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES þ NO o
Indicate by check mark whether the registrant is an accelerated filer (as defined by Rule 12b-2 of the Exchange Act). YES þ NO o
Indicate the number of shares outstanding of each of the issuer’s classes of capital stock, as of the latest practicable date:
KENNAMETAL INC.FORM 10-QFOR THE QUARTER ENDED MARCH 31, 2005
TABLE OF CONTENTS
Forward-Looking Information
This Form 10-Q contains “forward-looking” statements within the meaning of Section 21E of the Securities Exchange Act of 1934. You can identify these forward-looking statements by the fact they use words such as “should,” “anticipate,” “estimate,” “approximate,” “expect,” “may,” “will,” “project,” “intend,” “plan,” “believe” and other words of similar meaning and expression in connection with any discussion of future operating or financial performance. One can also identify forward-looking statements by the fact that they do not relate strictly to historical or current facts. These statements are likely to relate to, among other things, our goals, plans and projections regarding our financial position, results of operations, cash flows, market position and product development, which are based on current expectations that involve inherent risks and uncertainities, including factors that could delay, divert or change any of them in the next several years. Although it is not possible to predict or identify all factors, they may include the following: global economic conditions; future terrorist attacks; epidemics; risks associated with integrating and divesting businesses and achieving the expected savings and synergies; demands on management resources; risks associated with international markets such as currency exchange rates, and social and political environments; competition; labor relations; commodity prices; demand for and market acceptance of new and existing products; and risks associated with the implementation of restructuring plans and environmental remediation matters. We can give no assurance that any goal or plan set forth in forward-looking statements can be achieved and readers are cautioned not to place undue reliance on such statements, which speak only as of the date made. We undertake no obligation to release publicly any revisions to forward-looking statements as a result of future events or developments.
PART I. FINANCIAL INFORMATION
The accompanying notes are an integral part of these condensed consolidated financial statements.
- 1 -
- 2 -
- 3 -
- 4 -
- 5 -
- 6 -
- 7 -
- 8 -
- 9 -
- 10 -
- 11 -
- 12 -
- 13 -
- 14 -
RESULTS OF OPERATIONS
EXECUTIVE SUMMARY
Sales for the quarter ended March 31, 2005 were $597.4 million, an increase of $73.1 million or 14.0 percent from $524.2 million in the prior year quarter. Sales for the nine months ended March 31, 2005 were $1,685.0 million, an increase of $255.4 million or 17.9 percent from $1,429.6 million in the prior year period. Gross profit for the quarter ended March 31, 2005 increased $35.4 million, or 20.1 percent, from $175.9 million in the prior year quarter to $211.3 million. Gross profit for the nine months ended March 31, 2005 increased $98.5 million, or 21.1 percent, from $467.6 million in the prior year quarter to $566.1 million. Net income for the quarter ended March 31, 2005 was $30.7 million, or $0.80 per diluted share, compared to $24.1 million, or $0.66 per diluted share in the same quarter last year. Net income for the nine months ended March 31, 2005 was $81.6 million, or $2.15 per diluted share, compared to $43.7 million, or $1.20 per diluted share, in the same period last year. Earnings benefited from continued market growth, new product introduction, the effect of acquisitions, better pricing, increased capacity utilization and favorable foreign currency effects. These benefits were partially offset by increased raw material costs, a higher effective tax rate, increased employment costs and increased professional fees. Foreign currency exchange rate fluctuations have materially impacted earnings in the past two years increased and may impact future earnings in the short term and long term.
SALES
Sales for the quarter ended March 31, 2005 were $597.4 million, an increase of $73.1 million or 14.0 percent from $524.2 million in the prior year quarter. The increase in sales is primarily attributed to 12.0 percent organic growth as well as favorable foreign currency effects and the effects of acquisitions. These increases were slightly offset by a reduction in workdays. The increase in organic sales is attributed to new product introduction, further penetration in several markets, particularly in North America and in Asia, and continued economic expansion in the manufacturing sector.
Sales for the nine months ended March 31, 2005 were $1,685.0 million, an increase of $255.4 million or 17.9 percent from $1,429.6 million in the prior year period. The increase in sales is primarily attributed to 14.0 percent in organic growth as well as favorable foreign currency effects and the effects of acquisitions.
GROSS PROFIT
Gross profit for the quarter ended March 31, 2005 increased $35.4 million, or 20.1 percent, to $211.3 million. The increase in gross profit is primarily due to increased sales volume, which positively impacted gross profit by $15.6 million. Improved price realization, the effects of acquisitions, greater capacity utilization, a reduction in benefit plan expenses of $0.9 million and favorable foreign currency effects of $7.8 million positively impacted gross profit during the quarter. Such benefits were partially offset by higher raw material costs. We believe our raw material costs will continue to increase during the fourth quarter as certain supply arrangements are renewed. Such cost increases are expected to be mitigated by increased product pricing to be implemented throughout fiscal 2005 and further production efficiencies.
Gross profit margin for the quarter ended March 31, 2005 increased from 33.5 percent last year to 35.4 percent in the current quarter. The gross profit margin benefited from improved price realization, the effects of prior year and current year acquisitions, greater capacity utilization, a reduction in benefit plan expenses and favorable foreign currency effects. Such benefits were partially offset by an unfavorable effect from higher raw material prices.
- 15 -
Gross profit for the nine months ended March 31, 2005 increased $98.5 million, or 21.1 percent, to $566.1 million compared to the prior year period. The increase in gross profit is primarily due to increased sales volume, which positively impacted gross profit by $78.5 million. Improved price realization, greater capacity utilization, the effects of acquisitions, a reduction in benefit plan expenses of $6.4 million, favorable foreign currency effects of $21.9 million and the absence of prior year restructuring and integration charges of $3.0 million positively impacted gross profit during the period. Such benefits were partially offset by higher raw material costs and costs related to a plant closure during the period.
Gross profit margin for the nine months ended March 31, 2005 increased from 32.7 percent last year to 33.6 percent in the current period. The gross profit margin benefited from improved price realization, greater capacity utilization, a reduction in benefit plan expenses, favorable foreign currency effects and the absence of restructuring charges in the current period. Such benefits were partially offset by an unfavorable effect from higher raw material prices and costs related to a plant closure during the current period.
OPERATING EXPENSE
Operating expenses for the quarter ended March 31, 2005 were $146.4 million, an increase of $14.2 million, or 10.7 percent, compared to $132.2 million of a year ago. The increase in operating expense is primarily attributed to $4.3 million related to increased employment costs excluding performance based bonuses, $3.7 million related to increased performance based bonuses, unfavorable foreign currency effects of $3.3 million, $3.0 million related to acquisitions and a $1.8 million increase of professional fees. These increases were partially offset by reductions in benefit plan expense, bad debt expense, and group insurance.
Operating expenses for the nine months ended March 31, 2005 were $416.9 million, an increase of $38.7 million, or 10.2 percent, compared to $378.2 million of a year ago. The increase in operating expense is primarily attributed to $17.1 million related to increased employment costs excluding performance based bonuses $6.6 million related to increased performance based bonuses, unfavorable foreign currency effects of $10.5 million, $5.7 million related to acquisitions and a $4.8 million increase of professional fees. These increases were partially offset by a reduction in benefit plan expenses of $4.3 million, a prior year non-recurring $1.8 million charge related to a reserve for a note receivable from a divestiture of a business and $1.4 million of Widia integration costs incurred in the prior year.
RESTRUCTURING AND ASSET IMPAIRMENT CHARGES
In conjunction with approval of the divestiture of FSS, the Company completed an impairment analysis in accordance with Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets,” as the estimated selling price was below the fair value of the business absent the sale. For the quarter and nine months ended March 31, 2005, we recorded an impairment charge related to Full Service Supply (FSS) goodwill of $4.7 million as a result of this analysis.
The Company did not record any restructuring or asset impairment charges during the quarter ended March 31, 2004.
The Company recorded $3.7 million of restructuring charges for the nine months ended March 31, 2004. These charges related to the 2003 Facility Consolidation Program and the Kennametal Integration Restructuring Program.
See discussion of cash expenditures for the quarter and nine months ended March 31, 2005 related to our restructuring programs in the Liquidity and Capital Resources section of Item 2.
- 16 -
LOSS ON ASSETS HELD FOR SALE
During the quarter ended March 31, 2005, Kennametal approved a plan to divest of our FSS segment. In accordance with SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we recorded the assets of the business as held for sale at their estimated fair market value less cost to sell. As a result, we recorded a loss on assets held for sale of $1.5 million.
INTEREST EXPENSE
Interest expense for the quarter ended March 31, 2005 increased to $6.8 million from $6.3 million a year ago. The increase in interest expense is due to an increase in the average domestic borrowing rate for the quarter to 4.8 percent in 2005 from 4.4 percent in 2004. This increase is offset by total debt, including capital leases and notes payable, declining from $494.3 million at March 31, 2004 to $485.2 million at March 31, 2005.
Interest expense for the nine months ended March 31, 2005 declined to $19.4 million from $19.5 million in the prior year period. The decrease in interest expense is due to reduction in total debt noted above. This decrease is offset by an increase in the average domestic borrowing rate for the period to 4.7 percent in 2005 from 4.3 percent in 2004.
OTHER EXPENSE (INCOME), NET
Other expense for the quarter ended March 31, 2005 is $0.0 million compared to other expense of $0.5 million in prior year quarter. No items of significance were noted.
Other income for the nine months ended March 31, 2005 is $2.8 million compared to other income of $2.0 million in prior year. The prior year other income includes a gain on the sale of the Toshiba Tungaloy investment of $4.4 million. The current period other income includes an increase in foreign exchange gains of $5.2 million.
INCOME TAXES
The effective tax rate for the quarter ended March 31, 2005 was 37.1 percent versus 32.0 percent for the comparable period a year ago. The increase from last year was due primarily to an unfavorable change in German tax law, and to a lesser extent, an impairment charge related to FSS goodwill and accrual adjustments related to audit settlements.
On October 22, 2004, the American Jobs Creation Act of 2004 (the Act) was enacted. The Company is currently evaluating what effect this legislation will have on its effective tax rate, including the effect of a provision within the Act that provides for a special one-time tax deduction of 85.0 percent of foreign earnings that are repatriated to the United States, as defined by the Act. The Company expects to complete this evaluation during the second quarter of 2006. The Company is considering repatriating, under the Act, an amount between $0.0 and $200.0 million, which would result in an estimated tax cost between $0.0 and $19.0 million. Until its evaluation is completed, the unremitted earnings of the Company’s foreign investments continue to be considered permanently reinvested, and accordingly, no deferred tax liability has been established.
The Company continues to review its tax planning initiatives in an effort to optimize its overall global effective tax rate.
The Company is implementing an enhanced pan-European centralized business model, which will involve the establishment of a Principal company. In this structure, key management decision-making and responsibility will be centralized in the Principal company that will have the responsibility to drive all strategic and operational initiatives of the European business. Current manufacturing and sales operations will be transformed into toll manufacturers and limited risk distributors. Service functions will also be organized into separate units. This will allow these functions to intensify their focus on and increase their efficiency in production, sales growth and supporting services, following clearly defined and uniform processes as directed by the Principal company. This strategy is expected to be complete in the first quarter of fiscal 2006.
- 17 -
NET INCOME
Net income for the quarter ended March 31, 2005 was $30.7 million, or $0.80 per diluted share, compared to $24.1 million, or $0.66 per diluted share, in the same quarter last year. The increase in earnings is primarily attributable to continued market growth, new product introduction, the effect of acquisitions, better pricing, increased capacity utilization, a reduction in benefit plan expense and favorable foreign currency effects. These benefits were partially offset by increased raw material costs, employment costs and professional fees.
Net income for the nine months ended March 31, 2005 was $81.5 million, or $2.15 per diluted share, compared to $43.7 million, or $1.20 per diluted share, in the same period last year. The increase in earnings is primarily attributable to continued market growth, new product introduction, the effect of acquisitions, better pricing, increased capacity utilization, a reduction in benefit plan expense and favorable foreign currency effects. These improvements were offset in part by higher raw material costs, increased employment costs and increased professional fees in the current year and a prior year non-recurring gain on the sale of an investment.
BUSINESS SEGMENT REVIEW
Our operations are currently organized into four global business units consisting of Metalworking Solutions & Services Group (MSSG), Advanced Materials Solutions Group (AMSG), J&L Industrial Supply (J&L) and Full Service Supply (FSS), and Corporate. The presentation of segment information reflects the manner in which we organize segments for making operating decisions and assessing performance.
METALWORKING SOLUTIONS & SERVICES GROUP
MSSG external sales increased 12.5 percent or $39.7 million to $357.2 million from $317.5 million in the March 2004 quarter. The increase in sales for the quarter was driven primarily by growth in Europe, North America and our industrial products group, which were up 10.5 percent, 9.9 percent and 9.6 percent, respectively. This growth is attributed to new product introduction, growth in milling and hole making products, better pricing and accelerated growth of Widia products in the Americas and Europe. MSSG experienced growth across several sectors such as, aerospace, energy, automotive and light engineering. Favorable foreign currency effects accounted for $12.7 million of the increase in external sales for the quarter.
For the quarter ended March 31, 2005, operating income of $53.6 million increased 45.7 percent or $16.8 million from $36.8 million in the prior year quarter. Operating income was leveraged as a result of sales growth, a continued focus on cost containment, a reduction in benefit plan expense and favorable foreign currency effects. These benefits were partially offset by an increase in raw material costs and higher employment costs.
- 18 -
For the nine months ended March 31, 2005, MSSG external sales increased 15.7 percent or $137.2 million to $1,009.3 million from $872.1 million in the prior year period. The increase in sales for the period was driven primarily by continued improvements in Europe, North America and our industrial products group, which were up 14.2 percent, 14.3 percent and 15.3 percent, respectively. This growth is attributed to the introduction of new products, continued market share gains, better pricing and industry growth across several sectors such as, aerospace, energy, automotive and light engineering. Favorable foreign currency effects accounted for $35.9 million of the increase in external sales for the period.
Operating income of $135.2 million increased 63.0 percent or $52.2 million from $82.9 million last year. Operating income was leveraged as a result of sales growth, a continued focus on cost containment, a reduction in restructuring and integration costs of $6.5 million, a reduction in benefit plan expense and favorable foreign currency effects. These benefits were partially offset by an increase in raw material costs and higher employment costs.
ADVANCED MATERIALS SOLUTIONS GROUP
AMSG external sales increased 21.5 percent or $24.0 million to $135.5 million for the quarter ended March 31, 2005 from $111.5 million in the prior year quarter. The increase in sales is attributed to new product introduction, better pricing and improved market conditions. The increase in sales was achieved primarily in mining and construction products and engineered products, which were up 12.0 percent and 13.8 percent, respectively, and the addition of Conforma Clad Inc. (Conforma Clad) and Extrude Hone Corporation (Extrude Hone).
Operating income was $22.2 million for the quarter ended March 31, 2005, an increase of $7.1 million or 46.6 percent, over the prior year quarter. The increase is attributed to sales growth and the addition of Conforma Clad and Extrude Hone. These benefits were partially offset by an increase in raw material costs and higher employment costs.
For the nine months ended March 31, 2005, AMSG external sales increased 25.3 percent or $75.8 million to $375.7 million from $299.9 million in the prior year period. The increase in sales is attributed to new product introduction, better pricing and improved market conditions. The increase in sales was achieved primarily in mining and construction products, engineered products and energy products, which were up 17.6 percent, 19.2 percent and 18.6 percent, respectively, and the addition of Conforma Clad and Extrude Hone.
Operating income was $50.6 million for the nine months ended March 31, 2005, an increase of $14.2 million or 39.1 percent, over the prior year period. The increase is attributed to sales growth, prior year non-recurring restructuring and integration costs of $1.5 million and the addition of Conforma Clad and Extrude Hone. These benefits were partially offset by an increase in raw material costs, higher employment costs and charges related to a plant closure.
- 19 -
J&L INDUSTRIAL SUPPLY
J&L external sales increased $7.0 million or 11.6 percent to $67.1 million for the quarter ended March 31, 2005. The increase in sales is attributable to new customer growth and increased e-commerce. Operating income was $7.9 million compared to $6.4 million in the prior year quarter. The increase in operating income is a result of the improvement in sales growth and continued cost containment.
For the nine months ended March 31, 2005, J&L external sales increased $31.3 million or 19.7 percent to $189.8 million from $158.6 million in the prior year period. The increase in sales is attributable to new customer growth and increased e-commerce sales. Operating income was $19.5 million compared to $13.4 million in the prior year. The increase in operating income is a result of the improvement in sales growth and continued cost containment.
FULL SERVICE SUPPLY
FSS external sales increased $2.5 million or 7.0 percent to $37.6 million for the quarter ended March 31, 2005 from $35.1 million for the prior year quarter. The increase in sales is primarily associated with organic growth. Operating expense of $5.0 million in the current year quarter is driven by a goodwill impairment charge of $4.7 million and a loss on assets held for sale of $1.5 million. These charges are partially offset by improved sales volume.
For the nine months ended March 31, 2005, FSS external sales increased $11.2 million or 11.3 percent to $110.2 million from $99.1 million for the prior year period. The increase in sales is primarily associated with organic growth. Operating expense of $4.4 million is driven by a goodwill impairment charge of $4.7 million and a loss on assets held for sale of $1.5 million. These charges are partially offset by improved sales volume.
- 20 -
CORPORATE
Corporate represents corporate shared service costs, certain employee benefit costs and eliminations of operating results between segments. For the three months ended March 31, 2005, the operating expense increased $5.1 million or 32.6 percent compared to the prior year quarter. The increase is attributed to an increase in professional fees and employment expenses.
For the nine months ended March 31, 2005, the operating expense increased $11.4 million or 23.5 percent compared to the prior year period. The increase is attributed to an increase in professional fees and employment expenses. The prior year period included a charge of $1.8 million related to a reserve for a note receivable from a divestiture of a business.
DISCUSSION OF CRITICAL ACCOUNTING POLICIES
There have been no material changes to our critical accounting policies since June 30, 2004.
Included below is additional disclosure related to certain of our critical accounting policies. Reference should be made to our 2004 Annual Report on Form 10-K for a complete description of all of our critical accounting policies.
PENSION AND OTHER POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS
The following is a discussion of how management determines each of our pension and OPEB plan assumptions and estimates and has not been previously disclosed.
We determine our discount rate based on an investment grade bond yield with a life that approximates the benefit payment timing of each plan. This rate can fluctuate based on changes in investment grade bond yields.
The long-term rate of return on plan assets is estimated based on an evaluation of historical returns for each asset category held by the plans, coupled with the current and short-term mix of the investment portfolio. The historical returns are adjusted for expected future market and economic changes. This return will fluctuate based on actual market returns and other economic factors.
The rate of future health care costs is based on historical claims and enrollment information projected over the next fiscal year and adjusted for administrative charges. This rate is expected to continue to decrease until fiscal 2007.
Future compensation rates, withdrawal rates, and participant retirement age are determined based on historical information. These assumptions are not expected to significantly change. Mortality rates are determined based on review of published mortality tables.
PRINCIPLES OF CONSOLIDATION
Investments in entities over which we have significant influence are accounted for on the equity basis. The following is a discussion on how management determines significant influence and has not been previously disclosed.
- 21 -
The factors used to determine significant influence include, but are not limited to, the Company’s management involvement in the investee, such as hiring and setting compensation for management of the investee, the ability to make operating and capital decisions of the investee, representation on the investee’s board of directors, and purchase and supply agreements with the investee. Investments in entities of less than fifty percent of the voting stock in which we do not have significant influence are accounted for on the cost basis.
REVENUE RECOGNITION
The following disclosure related to various revenue recognition policies have not been previously disclosed.
General
We recognize revenue upon shipment of our products. Our general conditions of sale explicitly state that the delivery of our products is FOB shipping point and that title and all risks of loss and damages pass to the buyer upon delivery of the sold products to the common carrier.
We warrant that products and services sold are free from defects in material and workmanship under normal use and service when correctly installed, used and maintained. This warranty terminates thirty days after delivery of the product to the customer, and does not apply to products that have been subjected to misuse, abuse, neglect or improper storage, handling or maintenance. Products may be returned to Kennametal only after inspection and approval by Kennametal and upon receipt by customer of shipping instructions from Kennametal.
Our general conditions of sale explicitly state that acceptance of the conditions of shipment are considered to have occurred unless written notice of objection is received by Kennametal within ten calendar days of the date specified on the invoice. We do not ship product unless we have documentation authorizing shipment to our customers. Our products are consumed by our customers in the manufacture of their products. Historically, we have experienced very low levels of returned product and do not consider the effect of returned product to be material. We have recorded an estimated returned goods allowance to provide for any potential product returns.
Full Service Supply
FSS management contracts contain two major deliverables, product procurement and inventory management. Under the fixed fee contracts, we recognize revenue evenly over the contract term. Revenue is recognized upon shipment for cost plus contracts.
LIQUIDITY AND CAPITAL RESOURCES
Our cash flow from operations is the primary source of financing for capital expenditures and internal growth. During the nine months ended March 31, 2005, we generated $149.7 million in cash flows from operations, an increase of $40.3 million from $109.5 million for the prior year period. Cash flows provided by operations for the period ended March 31, 2005 consists of net income and non-cash items totaling $146.7 million and changes in certain assets and liabilities netting to $3.1 million. Contributing to this change was an increase in inventory of $21.5 million resulting from the increase in production to meet sales demand. The increase in accounts receivable of $18.0 million was a result of increased sales and was more than offset by the increase in accounts payable, accrued liabilities and accrued income taxes of $26.7 million. Cash flows provided by operations for the nine months ended March 31, 2004 consisted of net income and non-cash items totaling $107.9 million offset by changes in certain assets and liabilities of $1.5 million. The most significant components of this change were a decrease in inventories of $13.5 million and a decrease in accrued income taxes payable of $13.5 million, partially offset by an increase in accounts receivable of $12.8 million.
- 22 -
Net cash used for investing activities was $186.9 million for the nine months ended March 31, 2005, an increase of $115.1 million, from $71.9 million in the prior year period. During nine months ended March 31, 2005, cash used for investing activities includes $136.1 million of acquisitions, $57.3 million of purchases of property, plant and equipment, and $0.8 million of purchases of subsidiary stock. During the prior year period, cash used for investing activities included $64.6 million of acquisitions, $36.1 million of purchases of property, plant and equipment, $17.4 million of proceeds from the sale of marketable equity securities, $12.3 million of proceeds from divestiture of assets held for sale and $5.0 million of purchases of subsidiary stock. We have projected our capital expenditures for 2005 to be $70.0 to $80.0 million and to be primarily used to support new strategic initiatives, new products and to upgrade machinery and equipment. We believe this level of capital spending is sufficient to maintain competitiveness and improve productivity.
During the nine months ended March 31, 2005, net cash provided by financing activities was $38.6 million compared to net cash used for financing activities of $29.0 million in the same period last year. During the current year period, cash provided by financing activities includes a $33.0 million net increase in borrowings, $27.3 million of dividend reinvestment and the effects of employee benefit and stock plans, and cash dividends paid to shareowners of $19.0 million. During the prior year period, cash used for financing activities includes a $30.5 million net increase in borrowings, $21.4 million of dividend reinvestment and the effects of employee benefit and stock plans, and cash dividends paid to shareowners of $18.6 million. As of March 31, 2005, we were in compliance with all debt covenants.
During the nine months ended March 31, 2005, cash expenditures related to our restructuring programs discussed in Note 15 were $6.0 million. The remaining cash payments for certain lease and severance costs of approximately $5.3 million are expected to be substantially complete by June 30, 2005.
On October 29, 2004 we entered into a five-year, multi-currency, revolving credit facility with a group of financial institutions (2004 Credit Agreement), which amends, restates and replaces our 2002 Credit Agreement. The 2004 Credit Agreement permits revolving credit loans of up to $500.0 million for working capital, capital expenditures and general corporate purposes. This transaction contains significant improvements in terms and conditions relative to the 2002 Credit Agreement reflecting Kennametal’s improved credit profile and more favorable bank market conditions. Interest payable under the 2004 Credit Agreement is based upon the type of borrowing under the facility and may be (1) LIBOR plus an applicable margin, (2) the greater of the prime rate and the Federal Funds effective rate plus 0.50 percent or (3) fixed as negotiated by the Company. The 2004 Credit Agreement contains various restrictive and affirmative covenants including some requiring the maintenance of certain financial ratios. The financial covenants contained in the 2004 Credit Agreement include: a maximum leverage ratio and a minimum consolidated interest coverage ratio (as those terms are defined in this agreement). Borrowings under the 2004 Credit Agreement are guaranteed by our significant domestic subsidiaries.
Effective March 1, 2005, Kennametal completed the purchase of Extrude Hone for approximately $133.6 million, net of acquired cash and estimated direct acquisition costs and subject to customary post-closing adjustments. We funded this acquisition through our 2004 Credit Agreement. This increase in borrowings was offset primarily by cash flows from operations leading to a net increase in borrowings for the current year period of $33.0 million. Extrude Hone supplies engineered component process technology, focused on component deburring, polishing, and producing controlled radii, to improve manufacturing processes and end products of its customers in a variety of industries around the world.
There have been no other material changes in our contractual obligations and commitments since June 30, 2004.
- 23 -
OFF-BALANCE SHEET ARRANGEMENTS
On July 3, 2003, the Company entered into a new three-year securitization program (2003 Securitization Program), which permitted us to securitize up to $100.0 million of accounts receivable. The 2003 Securitization Program was amended on September 19, 2003, permitting the Company to securitize up to $125.0 million of accounts receivable. The 2003 Securitization Program provides for a co-purchase arrangement with two financial institutions that participate in the purchase of the Company’s accounts receivable. As of March 31, 2005, the Company had securitized $120.7 million in accounts receivable. In April 2005, approximately $20.0 million of FSS accounts receivable were removed from the 2003 Securitization Program as a condition of the agreement to sell the FSS segment.
FINANCIAL CONDITION
Total assets were $2,199.1 million at March 31, 2005, compared to $1,938.7 million at June 30, 2004. Goodwill and intangible assets increased $119.9 million due primarily to the acquisition of Extrude Hone. Working capital increased $116.9 million to $427.4 million at March 31, 2005 from $310.4 million at June 30, 2004. The increase in working capital is primarily driven by an increase in inventories of $20.6 million related to the increase in production to meet sales demand and the effects of the Extrude Hone acquisition coupled with the reduction of current maturities of long-term debt and capital leases of $72.7 million. Total liabilities increased $123.0 million from June 30, 2004 to $1,158.3 million, primarily due to an increase in total debt of $45.0 million, an increase in deferred income taxes of $24.5 million and an increase in accrued pension and postretirement benefits of $11.9 million. Stockholders’ equity increased $134.0 million to $1,021.2 million as of March 31, 2005 from $887.2 million as of June 30, 2004. The increase is primarily a result of translation adjustments of $31.7 million, net income of $81.6 million and the effect of employee benefit and stock plans of $36.7 million partially offset by cash dividends paid to shareowners of $19.0 million.
Total debt, including notes payable and capital leases, increased from $440.2 million at June 30, 2004 to $485.2 million at March 31, 2005. The increase in total debt is related primarily to fund net cash flows used by investing activities for capital expenditures and acquisitions.
RECENTLY ISSUED ACCOUNTING STANDARDS
In July 2004, the Company adopted FASB Staff Position (FSP) No. 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” (the Act). FSP 106-2 provides guidance on the accounting for the effects of the Act for employers that sponsor postretirement health care plans that provide prescription drug benefits and requires those employers to provide certain disclosures regarding the effect of the federal subsidy provided by the Act. See Note 8 to these condensed consolidated financial statements for discussion of the effect of adoption of this FSP and required disclosures.
In December 2004, the FASB issued SFAS 123(R), “Share-Based Payment (revised 2004).” This standard requires companies to measure and recognize the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value. The Company is currently evaluating pricing models and the transition provisions of this standard. SFAS 123(R) is effective for the Company beginning July 1, 2005.
In December 2004, the FASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4.” This standard clarifies the accounting for abnormal amounts of certain manufacturing costs and is not expected to have a material impact on the Company. SFAS 151 is effective for the Company beginning after July 1, 2006.
- 24 -
In December 2004, the FASB issued FSP No. 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision with the American Jobs Creation Act of 2004.” FSP 109-2 allows companies evaluating the repatriation provision of the Act to apply the SFAS 109 provisions as it decides on a plan for reinvestment or repatriation of its unremitted foreign earnings. This FSP requires certain disclosures for companies that have not completed evaluation of the repatriation provision of the Act. See Note 11 to these condensed consolidated financial statements for discussion of the effect of adoption of the Act and required disclosures.
We have experienced certain changes in our exposure to market risk from June 30, 2004.
The fair value of our interest rate swap agreements was a liability of $6.3 million as of March 31, 2005 compared to a liability of $8.3 million as of June 30, 2004. The offset to this liability is a corresponding increase to long-term debt, as the instruments are accounted for as a hedge of our long-term debt. The $2.0 million decrease in the recorded value of these agreements was non-cash and was the result of marking these instruments to market.
As of the end of the period covered by this quarterly report on Form 10-Q, the Company’s management evaluated, with the participation of the company’s Chief Executive Officer and Chief Accounting Officer, the effectiveness of the company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)). The Company’s disclosure controls were designed to provide a reasonable assurance that information required to be disclosed in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. It should be noted that the design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote. However, the controls have been designed to provide reasonable assurance of achieving the controls’ stated goals. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer, have concluded that the Company’s disclosure controls and procedures are effective at March 31, 2005 to ensure that information required to be disclosed in the reports that we file or submit under the Securities Exchange Act of 1934 was (i) accumulated and communicated to management, including the Company’s Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure and (ii) recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. There were no changes in the Company’s internal control over financial reporting that occurred during the Company’s most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Management will exclude Extrude Hone Corporation from its assessment of internal control over financial reporting as of June 30, 2005 because Extrude Hone Corporation was acquired by the Company through a purchase business combination effective March 1, 2005.
On May 1, 2005, the Company implemented a global financial consolidation tool. The implementation of this tool is expected to enhance our internal control over financial reporting. This implementation was not made in preparation of our first management report on internal control over financial reporting as required by Section 404 of the Sarbanes-Oxley Act of 2002 as of June 30, 2005 nor was it made in response to an identified significant deficiency or material weakness in our internal control over financial reporting.
- 25 -
PART II. OTHER INFORMATION
- 26 -
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
- 27 -