Stock Stories: 4Q16

Kennametal: Unlocking True Earnings Power

Kennametal Inc. is one of three leading global manufacturers of advanced, impact-resistant cutting tools and engineered components.

  • In November 2015, KMT cuts FY 2016 adjusted EPS guidance by roughly 15%, as its end markets, particularly those serving customers in the energy sector, contract significantly.

  • The evening prior to its 12/15/15 analyst day, KMT issues a press release lowering FY 2016 adjusted EPS guidance a further 30%-60%, due to intensifying weakness in its end markets and macroeconomic challenges.

    We upgraded KMT and bought significantly after this. Dec 2015 – Jan 2016 @ $18.74

  • In addition to marketing and savings initiatives already announced by new CEO Ron DeFeo (appointed 02/04/2016), in August 2016, KMT announces a workforce reduction plan it believes will result in annual run rate savings of $100-$110M. In the same press release, KMT announces its 3rd consecutive quarter of above-consensus quarterly adjusted EPS results.

  • November 2016, KMT sets out a positive outlook for revenue and margin expectations over the next few years, and highlights progress it has made on the plan it announced earlier in the year to reduce structural operating expenses.

Founded in 1938, and headquartered in Latrobe, Pennsylvania, Kennametal is one of three leading global manufacturers of advanced, impact-resistant cutting tools and engineered components. Customers rely on Kennametal’s products for quality assurance, cost efficiency, and advanced machining in a diverse set of end markets, including general engineering, aerospace, road construction, mining, and energy. Kennametal holds roughly 10-12% global market share, the third largest of a consolidated market in which the top three companies represent 45-50%. The dramatic decline of energy prices during 2014 and 2015 diverted investor attention from Kennametal’s ability to unlock its true earnings power through expense controls, greater efficiencies and automation. Investors are now coming to appreciate this potential just as energy prices have improved. Additionally, Kennametal would be a prime beneficiary of a renewed public commitment to U.S. infrastructure.

Impact of Declining Oil Prices

Kennametal’s prior management made ambitious acquisitions just as energy prices neared $100. Then, oil fell from $108 in June of 2014 to $25 in February 2016. The shock of a 77% price decline left Kennametal with under-utilized facilities, low productivity, and steeper sales declines than its top two competitors. Many investors concluded that the company’s franchise and economics were permanently impaired. In reality, Kennametal’s revenues were concentrated in North America, where the shale industry was hit particularly hard. Its revenues slid further relative to its top two peers, who are concentrated in the Eastern Hemisphere (especially in automotive and aerospace). Exploration and Production (E&P) and services companies, especially those in the U.S. shale industry, cut spending, causing the machining, engineering, and others that serve E&Ps to follow suit, leaving little incentive for any participant in the ecosystem to order Kennametal’s “short-cycle” consumable products. However, over the next year or two, Kennametal should fill this pent-up demand, rewarding long-term investors.

Unlocking True Earnings Power

To tackle the perfect storm of volatile energy prices, under-utilized assets, and low productivity, Kennametal dramatically changed its cost structure, unlocking the company’s true normalized earnings power, which we believed the market undervalued. The company announced plans to reduce complexity, modernize and automate production, and reduce redundancies. New CEO Ron DeFeo estimates these actions will save approximately $300 to $350 million, annually, by 2020. Over the longer-term, cost controls are likely to increase EPS substantially, while reducing the capital required to operate the business.

Conviction & Patience

While many investors base their judgement on short-term energy and commodity uncertainty, we remain focused on the intrinsic value of Kennametal’s high-margin, recurring revenue business.The company’s cost containment, the stabilization of energy prices, and the outcome of the U.S. Presidential election have driven some correction in Kennametal’s share price.

As of December 30, 2016, shares traded at $31.26, still a 28% discount to our private market value of $43.25.

Snap-on: Improving Operating Margins

Snap-on Incorporated is a leading manufacturer of tools, equipment, diagnostics, repair information and systems solutions primarily for independent automotive vehicle repair centers.

  • We initiated our position in the first quarter of 2012, when investors were concerned about the company bringing its financial service business back on its books after terminating an agreement with CIT a few years prior.

  • Snap-on has reported strength in its core tools business as independent garages — Snap-on's primary customers — continue to gain market share.

  • The decision to bring the financial services business back has resulted in solid returns on the capital deployed to this segment of the business.

  • Our expectations of the operating margins has increased by over 500 bps since our initiation in Snap-on as the management team continues to find ways to maximize the returns on this differentiated business.

Founded in 1920 by Joseph Johnson and William Seideman, Snap-on was created from a simple but ingenious idea - interchangeable wrench handles with sockets that would “snap on” - a revolutionary idea for the tool industry at the time. Snap-on has continued to focus on innovation and today is a leading manufacturer of tools, equipment, diagnostics, repair information and systems solutions primarily for independent automotive vehicle repair centers. Snap-on has a market capitalization of nearly $10 billion and its products can be found in more than 130 countries around the world.

Demand for New Tools

The Snap-on brand is known by mechanics for it reliability and quality, allowing the company to charge more for its goods. For example, a Snap-on wrench sells for nearly 10x the price of a comparable Craftsman wrench. The company posits that superior materials and design result in unmatched durability for its products. Since Snap-on tools end up lasting decades, some investors are pondering the drivers of future growth. Ongoing innovation in the auto industry, such as hybrid and electric cars, generates demand for new tools with unique capabilities and safety features. We think Snap-on is the right company to fill that need.

Solid Customer Relationships

Snap-on utilizes a franchise structure in the sale and distribution of a large portion of its products. These franchisees carry their inventory in approximately 4,800 customized vans and make weekly visits to their current and prospective customers. The frequent interaction between the franchisee and mechanics has proven invaluable in understanding customer tool needs. It also establishes a unique relationship between Snap-on and its customer base versus competitors.

Improving Operating Margins

Snap-on has done a tremendous job of improving its operating margin. Over the past decade, operating margins have increased from 7 percent to over 22 percent recently. Even with these impressive gains, management still points to changes that will lead to even higher levels in the future. Additionally, expanding demand from Europe and the defense sectors could provide additional tailwinds.

Long Term Opportunity

The market continues to underestimate Snap-on’s ability to grow revenue with its sustainable demand drivers. Meanwhile, the company has maintained a conservative balance sheet, which the market also overlooks. This combination makes Snap-on the type of company we hope to own for the long run as investors benefit from the growth in the company’s intrinsic value.

As of December 30, 2016, shares traded at $171.27, a 10% discount to our current private market value of $189.52.

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