The Case For Kennametal Is Getting No Less Complicated

 

This is a tough time in the cycle for stocks like Kennametal (KMT). As I mentioned in my last article on this metalworking tools and components company, these shares are in a group of shorter-cycle industrials (including Gates (GTES), 3M (MMM), and Parker Hannifin (PH)) that tend to underperform when the PMI goes above 60. That happened back in April, and all of these stocks have lagged the broader industrial space since then, with Kennametal being among the weakest of the group.

Still, I wonder if the market has overshot the mark and whether fundamental performance can drive a second look. I am concerned about a slowdown from here in shorter-cycle business, but autos should be recovering from here, aero and energy are just starting their recoveries, and Kennametal's earthworks business should fare well with improving greenfield mining activity and upcoming infrastructure work.

I don't love Kennametal, and I'll discuss why a little later, but the valuation has drifted to a "yes, but …" point where I'm starting to see more opportunities in a stock that the sell-side doesn't like all that much.

 

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The Case For Kennametal Is Getting No Less Complicated

Kennametal A Battleground Between Cycle And Self-Help

 

Writing about Kennametal (KMT) in early April, I noted that in the past these shares saw double-digit declines when the manufacturing PMI hit 60. Well, the manufacturing PMI went over 60 in April and the shares have declined about 14% since my last article, underperforming the broader industrial group by close to 20%. That comes despite two more quarters in which Kennametal posted significantly better than expected segment-level earnings and reaffirmed not only improving end-market conditions but significant operating leverage in FY’22.

I look at Kennametal as a battleground between how short-cycle stocks typically behave and what the company can do for itself in terms of delivering on past margin improvement efforts. While I do expect growth from industrial end-markets to decelerate, decelerate is not the same as contract, and Kennametal should also benefit from its exposure to longer-cycle markets like aerospace and energy, as well as cutting and wear parts used in infrastructure projects (like road and tunnel construction).

Kennametal shares now look pretty undervalued. I remain worried, though, about the short-term sentiment challenges (“sell short-cycle stocks when the PMI hits 60”), as well as longer-term challenges to the business from reduced tooling demand.

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Kennametal A Battleground Between Cycle And Self-Help

Kennametal May Return To Growth This Quarter, But The Longer-Term Opportunity Isn't So Exciting

 

Short-cycle industrial markets are definitely in recovery mode now, and that has driven a much improved outlook for companies leveraged primarily to shorter-cycle markets, including Kennametal (KMT). Kennametal also has the advantage of an ongoing restructuring initiative that actually seems to be bearing fruit after numerous less successful restructuring attempts in years past, and between cyclical recoveries and self-improvement, double-digit operating margins don't seem too far away.

My feelings on Kennametal were decidedly mixed when I wrote about the company in May. While I did believe the shares were undervalued on near-term recovery potential, the weaker long-term outlook tempered my enthusiasm and I preferred other short-cycle names like Parker-Hannifin (PH) and Columbus McKinnon (CMCO). Since then, Kennametal has outperformed the S&P 500 and the broader industrial space, rising almost 70%, but Parker and Columbus McKinnon have done better still.

I'm still not looking to add Kennametal as a long-term holding. I'm a little more bullish on the likelihood of management hitting its restructuring-driven margin goals, and I'm looking for a 30% trough-to-peak revenue improvement that could still leave upside (a 50% move is possible), but I have longer-term structural and competitive concerns here, and I think getting to double-digit FCF margins, let alone beyond that, is going to be challenging.

 

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Kennametal May Return To Growth This Quarter, But The Longer-Term Opportunity Isn't So Exciting

Covid-19 Just The Latest Of Many Challenges For Kennametal

It’s been a while since I’ve written on the perpetually-restructuring Kennametal (KMT), partly because it gets tedious writing about an underperforming company with serious long-term structural and competitive challenges. There have been some periods of outperformance since that last article, but for the last year or so, it’s been a rough go for the company and its shareholders.

It’s almost three and a half years later, but my investment conclusion hasn’t changed much. The shares do look undervalued even based on what I think are fairly conservative assumptions, but it’s hard to get excited about owning a company that you don’t believe in on a long-term structural basis. Does Kennametal have potential as a way to play the coming short-cycle recovery? Definitely. Would I be surprised if the shares were 10% to 25% higher a year from now? Not at all. But is this a name I’d buy and just lock away in the vault for five or more years? Also “not at all”.

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Covid-19 Just The Latest Of Many Challenges For Kennametal

IPG Photonics Already Seeing A Strong Recovery

Buying good companies when they are beaten up a bit by disappointed growth-oriented investors continues to be a sound strategy, provided that the underlying market drivers are only going through a temporary patch of trouble. So it has been with IPG Photonics (NASDAQ:IPGP). I thought the slowdown in the metalworking markets, and the pressure it was creating on IPG's valuation, were an opportunity back in the summer of 2016, and the shares have moved up about 60% since then. To be fair, investors would have done even better in rival laser company Coherent (NASDAQ:COHR), or turnaround metalworking play Kennametal (NYSE:KMT), but IPG's performance stacks up pretty well with other metalworking stories like Lincoln Electric (NASDAQ:LECO) and Colfax (NYSE:CFX).

IPG Photonics continues to do a commendable job of moving the goal posts out in terms of what can be accomplished with its high-power lasers. That is creating new opportunities to take share away from non-laser systems as well as to replace old non-fiber laser installations. Looking ahead, there are still attractive opportunities in areas like cutting and welding, as well as drilling, not to mention newer applications like theater projection, OLED production, and 3D manufacturing. IPG also continues to move forward with new(er) technologies like UV and ultrafast lasers that can still add more hundreds of millions of dollars to the long-term addressable market.

With a strong recovery in revenue and strong recent growth in machine tool orders in China, I'm not surprised that investors have come back to this name. I still believe in the prospects for high-single-digit revenue growth and mid-teens FCF growth, but the high-single-digit implied total return isn't as compelling relative to the prospects a year ago.

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IPG Photonics Already Seeing A Strong Recovery

A Significant Recovery Already Being Factored Into MSC Industrial Shares

Cyclical stocks have a way of surprising on both ends. When things get bad, some sell-side analysts (and institutional investors) turn tail and declare that the sector can never come back. Of course, when things do recover and valuations start baking in "permanent prosperity" we are all treated to those memorable "it's different this time..." notes.

I certainly didn't think MSC Industrial (NYSE:MSM) was going to see the huge post-election run that it had. While the most manufacturing-exposed of the major distributors (which includes names like Grainger (NYSE:GWW) and Fastenal (NASDAQ:FAST)), the run in the sector already reflects a lot of optimism about the impact of lower corporate taxes, greater infrastructure spending, improved pricing, and a strong all-around recovery in the U.S. economy. I'm reluctant to completely bail out of a long-held position, but the valuation now seems to reflect a strong rebound with high single-digit FCF growth this year forward for quite some time.

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A Significant Recovery Already Being Factored Into MSC Industrial Shares

Perpetually Restructuring Kennametal Tries To Recapture Lost Glory

Kennametal (NYSE:KMT) has been in a state of almost perpetual restructuring since 2007, but there's little to show for it as revenue and margins are both lower today than back in 2007. While the shares are up over the last 10 years, they are only by about 10% (versus a greater than 60% gain for the S&P 500) and due in part to the strong run that stocks have enjoyed since the U.S. presidential election.

New management is going about things in a much smarter way, and I think it is reasonable to think that the returns from this latest restructuring program will be more significant. On the other hand, Kennametal has lost a lot of shares (and a lot of credibility with the Street), its end markets are changing, and management's projections may be bold to the point of unrealistic. While I do think recovering end markets and a better strategy can drive above-market growth and double-digit FCF growth, today's valuation already seems to give a pretty hefty benefit of the doubt to the company.

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Perpetually Restructuring Kennametal Tries To Recapture Lost Glory

Seeking Alpha: MSC Industrial's Struggles Shouldn't Be Ignored

As of this summer, I've been following MSC Industrial (NYSE:MSM) in one capacity or another for 20 years. That's a long time to pay attention to any one company, but throughout that time I have been impressed with MSC Industrial's business plan and the ability of its executives to execute to plan even across multiple management transitions.

What that boils down to is that I do have a lot of respect for this company and I think it is relatively well-run. That said, there are worrying signs regarding the health of this business that I think investors should carefully consider. This may well prove to be one of those rough patches along another positive long-term trajectory, but I do believe the challenges that MSC is facing are growing bigger, not smaller, and that the valuation is not such that the risk-reward balance is inarguably compelling.

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MSC Industrial's Struggles Shouldn't Be Ignored

Seeking Alpha: MSC Industrial May Be Getting Ahead Of Itself

I like MSC Industrial (NYSE:MSM), one of the largest industrial distributors in the country, but that doesn't mean I think it's worth paying any price to own. The shares have done pretty well since my last update, but then so have other distributors like Grainger (NYSE:GWW) and Fastenal (NASDAQ:FAST), as well as Kennametal (NYSE:KMT), a large manufacturer of metalworking tools and a significant MSC supplier. Some of this optimism makes sense as a reaction to the significant pessimism around industrial companies around the turn of the year, as well as the recent upward trends in the Purchasing Manager's Index and Metalworking Business Index.

Management didn't have a lot to say on the call that I considered encouraging, but I do believe that 2016 is still likely to be the low point for the company in terms of revenue performance, and management is doing well with margins. I still believe that MSC can deliver long-term growth of 5% on the top line and around 10% in FCF, but that means the shares are more or less fairly valued today.

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MSC Industrial May Be Getting Ahead Of Itself

Seeking Alpha: Should Investors Go With The Flow?

If you follow the earnings reports of machine tool companies like Hurco (HURC), Hardinge (HDNG), and Gildemeister, these are not happy-fun-times in the machine tool industry, though there seems to be a big difference between companies that address high-volume and low-volume markets (the smaller the target company, the worse things appear to be). Likewise, companies with big exposure to metal-cutting, including Kennametal (KMT), Atlas Copco (ATLKY.PK), and MSC Industrial (MSM), have been reporting pretty challenging market conditions in North America and Europe.

As Flow International (FLOW) sells metal-cutting machine tools, you can probably guess where this is going. While Flow is a leader in waterjet cutting equipment, a business that seems under-penetrated, weak capex demand in the U.S. has made it difficult for this company to make real headway. I do believe there may be a worthwhile opportunity in these shares, but investors considering them are going to need patience (and maybe a buyout) to see this story work out.

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Should Investors Go With The Flow?

Seeking Alpha: Weak Metalworking Corroding MSC Industrial's Growth

When I last wrote on MSC Industrial (MSM) about a month ago, I suggested that the solid average daily sales growth being reported by Grainger (GWW) and Fastenal (FAST) on a monthly basis was threatening to put the company in the penalty box with some investors. See, the challenge for MSC Industrial has long been in proving that it's more than a cyclical industrial supplier and that it can grow consistently, albeit even if not on the same level as Fastenal.

Unfortunately for investors, MSC Industrial's fiscal third quarter earnings were decidedly mediocre in that respect. Although the company did as it said it would in terms of revenue and exceeded its own guidance for operating efficiency, the relatively weak daily growth highlights the challenges of the company's focus on the metalworking industry and puts even more pressure on management to exploit the BNDA acquisition for all its worth in terms of broadening its addressed markets.

The question for investors now is one of time horizon and patience. I do believe the company is making considerable investments today that will underpin above-average growth in the coming years (likely starting around the second half of 2014). I likewise believe that U.S. manufacturing (and particularly metalworking businesses) can and will recover in 2014. So while I continue to find MSC Industrial undervalued on a long-term basis, the exposure to the clearly underperforming metalworking industry could make it harder for these shares to outperform in the meantime.

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Weak Metalworking Corroding MSC Industrial's Growth

Seeking Alpha: MSC Industrial - Good Growth, Great Returns, And Rich Valuation

Sooner or later, every investor will find a company that challenges his or her beliefs on the proper trade-off between quality and value. For me, that company is MSC Industrial Direct (NYSE: MSM). This industrial supply company has posted excellent growth over the past decade and boasts full-cycle returns that many far larger companies in less cyclical businesses never approach. While this company has ample potential to grow its footprint and top line, as well as expand those margins even further, today's valuation seems already predicated on those assumptions.

Carving A Niche In A Huge Market
Figuring out MSC Industrial's market potential is no easy task; my first job on the Street was with an analyst team that covered this company and that was a constant struggle. A good estimate, though, is probably in the $140 billion neighborhood – suggesting that MSC has less than 2% share.

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MSC Industrial - Good Growth, Great Returns And Rich Valuation

Investopedia: Fastenal Not Slowing Down Yet

There is ample fodder for a dour outlook on the U.S. economy. Politicians in Washington, D.C. continue to play chicken with the budget. Debt discussions, economic statistics like employment, wage growth and ISM are not terribly encouraging, and indicators like rail traffic look sluggish.


Nevertheless, plenty of companies with strong correlations to the health of manufacturing are still performing well. Growth at industrial supplier Grainger (NYSE:GWW) has slowed but is still pretty solid, while other industrial input companies like Lincoln Electric (Nasdaq:LECO) and Praxair (NYSE:PX) have strong stocks and good earnings estimate momentum.

With that backdrop, then, it is perhaps not so surprising that Fastenal (Nasdaq:FAST) reported solid top-line growth for the second quarter. Though it was not a perfectly clean quarter and the stock is quite expensive, Fastenal's results suggest underlying business activity is not so terrible. (For related reading, see Profit By Understanding Fundamental Trends.)


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http://stocks.investopedia.com/stock-analysis/2011/Fastenal-Not-Slowing-Down-Yet-FAST-GWW-LECO-PX-KMT-AXE-AIT-WCC0713.aspx

Seeking Alpha: Are Smaller Industrials Pointing To A Broader Recovery?

It is no great surprise that today's earnings report from machine tool manufacturer Hurco (HURC) is largely going unnoticed. Even though sales jumped 92% from last year, orders more than doubled (and the book-to-bill is over 1), and the company handily beat its estimate, only one analyst follows this stock and the company booked only $224M in revenue in its best year. In other words, it is a very small company that just falls through the cracks, more often than not.

My objective here is not to sing the praises of Hurco (though I do believe it is a fine company and currently undervalued), but rather to try and connect a few dots that the earnings from companies like Hurco might be telling us.

The Return of the Small/Mid-Sized Business?
Much of the recovery story so far has been dominated by the improved performance at major companies. Corporate earnings have clearly recovered, and the major North American stock indexes have rebounded as well.

At the same time, though, there has been a great deal of hand-wringing about the state of the job market. Small and mid-sized businesses (SMB) normally employee a large percentage of people in this country, and those businesses have not been hiring all that many people. Likewise, those who follow bank stocks have no doubt noticed that the pace of commercial lending has been poor as well, and it is largely SMBs that do that sort of borrowing.

These industrial earnings, though, may be a sign that things are getting better in this important segment of the economy.

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Are Smaller Industrials Pointing to a Broader Recovery?