XNYS:KMT Kennametal Inc Annual Report 10-K Filing - 6/30/2012

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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED JUNE 30, 2012

Commission File Number 1-5318

KENNAMETAL INC.

(Exact name of registrant as specified in its charter)

 

Pennsylvania   25-0900168
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification No.)

 

World Headquarters

 

1600 Technology Way

 

P.O. Box 231

 

Latrobe, Pennsylvania

  15650-0231

(Address of Principal Executive Offices)

  (Zip Code)

Registrant’s telephone number, including area code: (724) 539-5000

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class   Name of each exchange on which registered
Capital Stock, par value $1.25 per share   New York Stock Exchange
Preferred Stock Purchase Rights   New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act: None.

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes [X] No [  ]

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes [  ] No [X]

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 [X] No [  ]

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES [X] NO [  ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer [X]      Accelerated filer [  ]  
Non-accelerated filer [  ]  (Do not check if smaller reporting company)    Smaller reporting company [  ]  

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act). Yes [  ] No [X]

As of December 31, 2011, the aggregate market value of the registrant’s Capital Stock held by non-affiliates of the registrant, estimated solely for the purposes of this Form 10-K, was approximately $2,325,200,000. For purposes of the foregoing calculation only, all directors and executive officers of the registrant and each person who may be deemed to own beneficially more than 5% of the registrant’s Capital Stock have been deemed affiliates.

As of July 31, 2012, there were 80,106,781 shares of the Registrant’s Capital Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the 2012 Annual Meeting of Shareowners are incorporated by reference into Part III.

 

 

 


Table of Contents

Table of Contents

Item No.    Page  

PART I

  

1.    Business

     1   

1A. Risk Factors

     4   

1B. Unresolved Staff Comments

     6   

2.    Properties

     7   

3.    Legal Proceedings

     8   

4.    Mine Safety Disclosures

     8   

PART II

  

5.     Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

     8   

6.    Selected Financial Data

     11   

7.     Management’s Discussion and Analysis of Financial Condition and Results of Operation

     12   

7A. Quantitative and Qualitative Disclosures About Market Risk

     22   

8.    Financial Statements and Supplementary Data

     24   

9.     Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

     58   

9A. Controls and Procedures

     58   

9B. Other Information

     58   

PART III

  

10.  Directors, Executive Officers and Corporate Governance

     59   

11.  Executive Compensation

     60   

12.   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

     60   

13.  Certain Relationships and Related Transactions, and Director Independence

     60   

14.  Principal Accounting Fees and Services

     60   

SIGNATURES

     61   

PART IV

  

15.  Exhibits, Financial Statement Schedules

     62   

FORWARD-LOOKING INFORMATION

This Annual Report on Form 10-K contains “forward-looking” statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are statements that do not relate strictly to historical or current facts. For example, statements about Kennametal’s outlook for earnings, sales volumes, and cash flow for its fiscal year 2013, its expectations regarding future growth and any statements regarding future operating or financial performance or events are forward-looking. We have also included forward looking statements in this Form 10-K concerning, among other things, our strategy, goals, plans and projections regarding our financial position, liquidity and capital resources, results of operations, market position, and product development. These statements are based on current estimates that involve inherent risks and uncertainties. Should one or more of these risks or uncertainties materialize, or should the assumptions underlying the forward-looking statements prove incorrect, our actual results could vary materially from our current expectations. There are a number of factors that could cause our actual results to differ from those indicated in the forward-looking statements. They include: economic recession; availability and cost of the raw materials we use to manufacture our products; our foreign operations and international markets, such as currency exchange rates, different regulatory environments, trade barriers, exchange controls, and social and political instability; changes in the regulatory environment in which we operate, including environmental, health and safety regulations; our ability to protect and defend our intellectual property; competition; our ability to retain our management and employees; demands on management resources; potential claims relating to our products; integrating acquisitions and achieving the expected savings and synergies; business divestitures; global or regional catastrophic events; energy costs; commodity prices; labor relations; demand for and market acceptance of new and existing products; and implementation of environmental remediation matters. We provide additional information about many of the specific risks we face in the “Risk Factors” Section of this Annual Report on Form 10-K. 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 development.


Table of Contents

PART I

ITEM 1 – BUSINESS

OVERVIEW From its founding in 1938, the McKenna family incorporated Kennametal Inc. in Pennsylvania in 1943. As a global enterprise, we deliver productivity to customers seeking peak performance in demanding environments by providing innovative custom and standard wear-resistant solutions. To provide these solutions, we harness our knowledge of advanced materials and application development with a commitment to environmental sustainability. Our solutions are built around industry-essential technology platforms. These include metalworking tools, engineered components and surface technologies that are mission-critical to the performance of our customers battling extreme conditions such as fatigue wear, corrosion and high temperatures. We believe that our reputation for manufacturing excellence, as well as our technological expertise and innovation we deliver in our products and services, help us to achieve a leading position in our primary markets. End users of our products include metalworking and machinery manufacturers and suppliers across a diverse array of industries, including the aerospace, defense, transportation, machine tool, light machinery and heavy machinery, as well as producers and suppliers in a number of equipment-intensive industries such as coal mining, road construction and quarrying, as well as oil and gas exploration, refining, production and supply. Our end users’ applications range from airframes to mining operations, engines to oil wells and turbochargers to processing.

Our product offering includes a wide selection of standard and customized technologies for metalworking, such as sophisticated metal cutting tools, tooling systems and services, as well as advanced, high-performance materials, such as cemented tungsten carbide products, super alloys, coatings and investment castings to address customer demands. We offer these products through a variety of channels to meet customer-specified needs. We are a leading global supplier of tooling, engineered components and advanced materials consumed in production processes. We believe we are one of the largest global providers of consumable metal cutting tools and tooling supplies.

We specialize in developing and manufacturing metalworking tools and wear-resistant engineered components and coatings using a specialized type of powder metallurgy. Our metalworking tools are made of cemented tungsten carbides, ceramics, cermets and super-hard materials. We also manufacture and market a complete line of tool holders, tool-holding systems and rotary-cutting tools by machining and fabricating steel bars and other metal alloys. In addition, we produce specialized compacts and metallurgical powders, as well as products made from tungsten carbide or other hard materials that are used for custom-engineered and challenging applications, including mining and highway construction, among others. Further, we develop, manufacture and market engineered components and surface technology solutions with proprietary metal cladding capabilities, as well as process technology and materials that focus on component deburring, polishing and effecting controlled radii. The recent addition of the Deloro Stellite Holdings 1 Limited (Stellite) organization to our portfolio brings new capabilities in engineered components and surface technologies, extending our offering of investment casting, coatings and super alloy solutions.

Unless otherwise specified, any reference to a “year” refers to a 12-month fiscal year ending on June 30.

BUSINESS SEGMENT REVIEW Our operations are organized into two reportable operating segments; Industrial and Infrastructure. Segment determination is based upon internal organizational structure, the manner in which we organize segments for making operating decisions and assessing performance, the availability of separate financial results and materiality considerations. Sales and operating income by segment are presented in Management’s Discussion and Analysis set forth in Item 7 of this annual report on Form 10-K (MD&A). Additional segment data is provided in Note 20 of our consolidated financial statements set forth in Item 8 of this annual report on Form 10-K (Item 8) which is incorporated herein by reference.

INDUSTRIAL In the Industrial segment, we focus on customers in the aerospace, defense, transportation and general engineering market sectors, as well as the machine tool industry. Our customers in these end markets use our products and services in the manufacture of engines, airframes, automobiles, trucks, ships and other various types of industrial equipment. The technology and customization requirements we provide vary by customer, application and industry. The value we deliver to our Industrial segment customers centers on knowledge of our customers processes, application expertise and our diverse offering of products and services.

INFRASTRUCTURE In the Infrastructure segment which includes the Stellite acquisition, we focus on customers in the energy and earthworks sectors who support primary industries such as oil and gas, power generation and process industries such as food and beverage and chemicals; underground, surface and hard-rock mining; highway construction and road maintenance. Our success is determined by our associates gaining an in-depth understanding of our customers’ engineering and development needs, to be able to offer complete system solutions and high-performance capabilities to optimize and add value to their operations.

 

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INTERNATIONAL OPERATIONS During 2012, we generated 57 percent of our sales in markets outside of the United States of America (U.S), with principal international operations in Western Europe, Asia Pacific, India, Latin America and Canada. In addition, we operate manufacturing and distribution facilities in Israel and South Africa, while serving customers through sales offices, agents and distributors in Eastern Europe and other parts of the world. While geographic diversification helps to minimize the sales and earnings impact of respective demand changes in any one particular region, our international operations are subject to normal risks of doing business globally, including fluctuations in currency exchange rates and changes in social, political and economic environments.

Our international assets and sales are presented in Note 20 of the Company’s consolidated financial statements, set forth in Item 8 and are incorporated herein by reference. Further information about the effects and risks of currency exchange rates is presented in the Quantitative and Qualitative Disclosures About Market Risk section, as set forth in Item 7A of this annual report on Form 10-K.

GENERAL DEVELOPMENT OF BUSINESS We continue to engage in balancing our geographic footprint between North America, Western Europe, and the rest of the world markets. This strategy, together with steps to enhance the balance of our sales among our served end markets and business units, has helped to create a more diverse business base and thereby provide additional sales opportunities, as well as limit reliance on and exposure to any specific region or market sector.

In fiscal 2012, we experienced year-over-year quarterly sales growth in every quarter. Our sales for the year ended June 30, 2012 were $2,736.2 million, 46 percent of which were in North America, 28 percent in Western Europe and 26 percent in the rest of the world. Our restructuring programs completed in fiscal 2011 are delivering annual ongoing pre-tax savings of approximately $170 million.

For fiscal 2012, global industrial production increased by 2.9 percent, demonstrating that a number of end markets continued to grow. While the global economy continues to improve, we remain confident in our ability to respond quickly to changes in global markets while continuing to serve our customers and preserve our competitive strengths. At the same time, we continue to focus on maximizing cash flow and priority uses of cash. Further discussion and analysis of the developments in our business is set forth in MD&A.

ACQUISITIONS AND DIVESTITURES During 2012, we completed the acquisition of Deloro Stellite Holdings 1 Limited (Stellite) in the Infrastructure segment for a purchase price of approximately $383 million, net of cash acquired. The Stellite acquisition resulted in approximately $243 million of goodwill, based on the final purchase price allocations, which is not deductible for tax purposes and is attributable to the operating synergies we expect to gain from the acquisition.

We continue to evaluate new opportunities for the expansion of existing product lines into new market areas where appropriate. We also continue to evaluate opportunities for the introduction of new and/or complementary product offerings into new and/or existing market areas where appropriate. We expect to continue to evaluate potential acquisitions to continue to grow our business and further enhance our market position.

MARKETING AND DISTRIBUTION We sell our products through the following, distinct sales channels: (i) a direct sales force; (ii) a network of independent distributors and sales agents in North America, Europe, Latin America, Asia Pacific and other markets around the world; (iii) integrated supply chain channels; and (iv) via the Internet. Application engineers and technicians directly assist our customers with specified product design, selection, application and support.

To market our products, we maintain two premium brands: Kennametal and Widia. These master brands also include sub-categories with various trademarks and trade names combining the Kennametal master brand with identifying categorical names such as: Kennametal Conforma Clad; Kennametal Tricon; Kennametal Extrude Hone; Kennametal Sintec; Kennametal International Specialty Alloys; and Kennametal Camco. Similarly, we combine the Widia master brand with other identifying names, such as: Widia GTD; Widia Ruebig; Widia Circle; Widia Manchester; Widia Hanita; Widia Clappdico; Widia Metal Removal; and Widia Metcut; as well as select product names such as ToolBoss, Kyon, Fix-Perfect and Mill1™. We own these names and trademarks via Kennametal Inc. or Kennametal subsidiaries. On a very limited basis, we offer certain products to customers for resale under their own names or private labels.

RAW MATERIALS AND SUPPLIES Major metallurgical raw materials consist of ore concentrates, compounds and secondary materials containing tungsten, tantalum, titanium, niobium and cobalt. Although an adequate supply of these raw materials currently exists, our major sources for raw materials are located abroad and prices fluctuate at times. We have entered into extended raw material supply agreements and will implement product price increases as deemed necessary to mitigate rising costs. For these reasons, we exercise great care in selecting, purchasing and managing availability of raw materials. We also purchase steel bars and forgings for making toolholders and other tool parts, as well as for producing rotary cutting tools and accessories. We obtain products purchased for use in manufacturing processes and for resale from thousands of suppliers located in the U.S. and abroad.

 

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RESEARCH AND DEVELOPMENT Our product development efforts focus on providing solutions to our customers’ manufacturing challenges and productivity requirements. Our product development program provides discipline and focus for the product development process by establishing “gateways,” or sequential tests, during the development process to remove inefficiencies and accelerate improvements. This program speeds and streamlines development into a series of actions and decision points, combining efforts and resources to produce new and enhanced products faster. This program is designed to assure a strong link between customer requirements and corporate strategy, and to enable us to gain full benefit from our investment in new product development. We hold a number of patents which, in the aggregate, are material to the operation of our businesses.

Research and development expenses included in operating expense totaled $38.3 million, $33.3 million and $28.0 million in 2012, 2011 and 2010, respectively.

SEASONALITY Our business is not materially affected by seasonal variations. However, to varying degrees, traditional summer vacation shutdowns of customers’ plants and holiday shutdowns often affect our sales levels during the first and second quarters of our fiscal year.

BACKLOG Our backlog of orders generally is not significant to our operations.

COMPETITION As one of the world’s leading producers of engineered cemented carbide products and solutions, we maintain a leading competitive position in major markets worldwide. Our recent acquisition of Stellite further strengthens our competitive position providing innovative surface and wear solutions, while also adding super-alloy materials and investment casting capabilities. We actively compete in the sale of all our products with approximately 30 companies in the United States, with many more offering similar capabilities to customers in 60 countries around the world. While several of our competitors are divisions of larger corporations, our industry remains largely fragmented, with several hundred fabricators and toolmakers. Many of our competitors operate relatively small shops, producing a limited selection of tools while buying cemented tungsten carbide components from original producers of cemented tungsten carbide products, including Kennametal. We also supply coating solutions and other engineered wear-resistant products to such shops. Given the fragmentation, significant competition and opportunities for consolidation exist from both U.S.-based and internationally-based firms, as well as among thousands of industrial supply distributors.

The principal competitive differentiators in our businesses include service, product innovation, performance, quality, selection and availability, pricing and productivity ascribed to our brands. We derive competitive advantage from our premium brands; global presence; application expertise and ability to address customer needs with new and improved tools; innovative surface and wear solutions; highly engineered components; consistent quality; integrated customer service capabilities; state-of-the-art manufacturing; and multiple sales channels. With these strengths, we are able to sell products based on the value-added productivity we deliver to our customers, rather than competing on price.

REGULATION From time to time, we are a party to legal claims and proceedings that arise in the ordinary course of business, which may relate to our operations or assets, including real, tangible, or intellectual property. While we currently believe that the amount of ultimate liability, if any, with respect to these actions will not materially affect our financial position, results of operations or liquidity, the ultimate outcome of any litigation is uncertain. Were an unfavorable outcome to occur or if protracted litigation were to ensue, the impact could be material to us.

Compliance with government laws and regulations pertaining to the discharge of materials or pollutants into the environment or otherwise relating to the protection of the environment did not have a material effect on our capital expenditures or competitive position for the years covered by this report, nor is such compliance expected to have a material effect in the future.

We are involved as a potentially responsible party (PRP) at various sites designated by the United States Environmental Protection Agency (USEPA) as Superfund sites. For certain of these sites, we have evaluated the claims and potential liabilities and have determined that neither are material, individually or in the aggregate. For certain other sites, proceedings are in the very early stages and have not yet progressed to a point where it is possible to estimate the ultimate cost of remediation, the timing and extent of remedial action that may be required by governmental authorities or the amount of our liability alone or in relation to that of any other PRPs.

 

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Reserves for other potential environmental issues at June 30, 2012 and 2011 were $5.1 million and $5.4 million, respectively. The reserves that we have established for environmental liabilities represent our best current estimate of the costs of addressing all identified environmental situations, based on our review of currently available evidence, and take into consideration our prior experience in remediation and that of other companies, as well as public information released by the USEPA, other governmental agencies, and by the PRP groups in which we are participating. Although the reserves currently appear to be sufficient to cover these environmental liabilities, there are uncertainties associated with environmental liabilities, and we can give no assurance that our estimate of any environmental liability will not increase or decrease in the future. The reserved and unreserved liabilities for all environmental concerns could change substantially due to factors such as the nature and extent of contamination, changes in remedial requirements, technological changes, discovery of new information, the financial strength of other PRPs, the identification of new PRPs and the involvement of and direction taken by the U.S. government on these matters.

We maintain a Corporate Environmental, Health and Safety (EHS) Department to monitor compliance with environmental regulations and to oversee remediation activities. In addition, we have designated EHS coordinators who are responsible for each of our global manufacturing facilities. Our financial management team periodically meets with members of the Corporate EHS Department and the Corporate Legal Department to review and evaluate the status of environmental projects and contingencies. On a quarterly basis, we review financial provisions and reserves for environmental contingencies and adjust these reserves when appropriate.

EMPLOYEES We employed approximately 12,900 persons at June 30, 2012, of which approximately 4,700 were located in the U.S. and 8,200 in other parts of the world, principally Europe, Asia Pacific and India. At June 30, 2012, approximately 3,700 of the above employees were represented by labor unions. We consider our labor relations to be generally good.

AVAILABLE INFORMATION Our Internet address is www.kennametal.com. On the SEC Filings page of our Web Site, which is accessible under the Investor Relations tab, we post the following filings as soon as reasonably practicable after they are electronically filed with or furnished to the Securities and Exchange Commission (SEC): our annual report on Form 10-K, our annual proxy statement, our quarterly reports on Form 10-Q, our current reports on Form 8-K and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (Exchange Act). Our SEC Filings Web page also includes Forms 3, 4 and 5 filed pursuant to Section 16(a) of the Exchange Act. All filings posted on our SEC Filings Web page are available to be viewed on the Web page free of charge. On the Corporate Governance page of our Web site, which is under the Investor Relations tab, we post the following charters and guidelines: Audit Committee Charter, Compensation Committee Charter, Nominating/Corporate Governance Committee Charter, Kennametal Inc. Corporate Governance Guidelines and Kennametal Inc. Stock Ownership Guidelines. On the Ethics and Compliance page of our Web site, which is under Company Profile tab, we post the Code of Business Ethics and Conduct. All charters and guidelines posted on our Web pages are available to be viewed on our Web page free of charge. Information contained on our Web site is not part of this annual report on Form 10-K or our other filings with the SEC.

ITEM 1A – RISK FACTORS

Kennametal’s business, financial condition or results of operations may be materially affected by a number of factors. Our management regularly monitors the risks inherent in our business, with input and assistance from our Enterprise Risk Management department. In addition to real time monitoring, we conduct a formal, annual, enterprise-wide risk assessment to identify factors and circumstances that might present significant risk to the company. Many of these factors are discussed throughout this report. In addition, the following list details some of the important factors and uncertainties that we believe could cause Kennametal’s actual results to differ materially from those projected in any forward-looking statements:

Downturns in the business cycle could adversely affect our sales and profitability. Our business has historically been cyclical and subject to significant impact from economic downturns. The recent global economic downturn that occurred, coupled with the global financial and credit market disruptions has had a negative impact on our sales and profitability. These events contributed to weak end markets, a sharp drop in demand and higher costs of borrowing and/or diminished credit availability. While the economy has recovered from the crisis of the economic downturn and we believe that the long-term prospects for our business remain positive, we are unable to predict the future course of industry variables or the strength, pace or sustainability of the economic recovery and the effects of government intervention. We implemented restructuring and other actions to reduce our manufacturing costs and operating expenses over the past several years. However, there is no assurance that these actions, or any others that we have taken or may take, will be sufficient to counter any future economic or industry disruptions.

 

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Our international operations pose certain risks that may adversely impact sales and earnings. We have manufacturing operations and assets located outside of the U.S., including those in Brazil, Canada, China, Europe, India, Israel and South Africa. We also sell our products to customers and distributors located outside of the U.S. During the year ended June 30, 2012, 57 percent of our consolidated sales were derived from non-U.S. markets. A key part of our long-term strategy is to increase our manufacturing, distribution and sales presence in international markets. These international operations are subject to a number of special risks, in addition to the risks of our domestic business, including currency exchange rate fluctuations, differing protections of intellectual property, trade barriers, exchange controls, regional economic uncertainty, differing (and possibly more stringent) labor regulation, labor unrest, risk of governmental expropriation, domestic and foreign customs and tariffs, current and changing regulatory environments (including, but not limited to, the risks associated with the importation and exportation of products and raw materials), risk of failure of our foreign employees to comply with both U.S. and foreign laws, including antitrust laws, trade regulations and the Foreign Corrupt Practices Act, difficulty in obtaining distribution support, difficulty in staffing and managing widespread operations, differences in the availability and terms of financing, political instability and unrest and risks of increases in taxes. Also, in some foreign jurisdictions, we may be subject to laws limiting the right and ability of entities organized or operating therein to pay dividends or remit earnings to affiliated companies unless specified conditions are met. To the extent we are unable to effectively manage our international operations and these risks, our international sales may be adversely affected, we may be subject to additional and unanticipated costs, and we may be subject to litigation or regulatory action. As a consequence, our business, financial condition and results of operations could be seriously harmed.

Changes in the regulatory environment, including environmental, health and safety regulations, could subject us to increased compliance and manufacturing costs, which could have a material adverse effect on our business.

Health and Safety Regulations. Certain of our products contain hard metals, including tungsten and cobalt. Hard metal dust is being studied for potential adverse health effects by organizations in several regions throughout the world, including the U.S., Europe and Japan. Future studies on the health effects of hard metals may result in our products being classified as hazardous to human health, which could lead to new regulations in countries in which we operate that may restrict or prohibit the use of, and/or exposure to, hard metal dust. New regulation of hard metals could require us to change our operations, and these changes could affect the quality of our products and materially increase our costs.

Environmental Regulations. We are subject to various environmental laws, and any violation of, or our liabilities under, these laws could adversely affect us. Our operations necessitate the use and handling of hazardous materials and, as a result, we are subject to various federal, state, local and foreign laws, regulations and ordinances relating to the protection of the environment, including those governing discharges to air and water, handling and disposal practices for solid and hazardous wastes, the cleanup of contaminated sites and the maintenance of a safe workplace. These laws impose penalties, fines and other sanctions for noncompliance and liability for response costs, property damages and personal injury resulting from past and current spills, disposals or other releases of, or exposure to, hazardous materials. We could incur substantial costs as a result of noncompliance with or liability for cleanup or other costs or damages under these laws. We may be subject to more stringent environmental laws in the future. If more stringent environmental laws are enacted in the future, these laws could have a material adverse effect on our business, financial condition and results of operations.

Regulations affecting the mining and drilling industries or utilities industry. Some of our principal customers are mining and drilling and utility companies. Many of these customers supply coal, oil, gas or other fuels as a source for the production of utilities in the U.S. and other industrialized regions. The operations of these mining and drilling companies are geographically diverse and are subject to or affected by a wide array of regulations in the jurisdictions where they operate, such as applicable environmental laws and regulations governing the operations of utilities. As a result of changes in regulations and laws relating to such industries, our customers’ operations could be disrupted or curtailed by governmental authorities. The high cost of compliance with mining, drilling and environmental regulations may also induce customers to discontinue or limit their operations, and may discourage companies from developing new opportunities. As a result of these factors, demand for our mining- and drilling-related products could be substantially affected by regulations adversely impacting the mining and drilling industries or altering the consumption patterns of utilities.

 

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Our continued success depends on our ability to protect and defend our intellectual property. Our future success depends in part upon our ability to protect and defend our intellectual property. We rely principally on nondisclosure agreements and other contractual arrangements and trade secret law and, to a lesser extent, trademark and patent law, to protect our intellectual property. However, these measures may be inadequate to protect our intellectual property from infringement by others or prevent misappropriation of our proprietary rights. In addition, the laws of some foreign countries do not protect proprietary rights to the same extent as do U.S. laws. If one of our patents is infringed upon by a third party, we may need to devote significant time and financial resources to attempt to halt the infringement. We may not be successful in defending the patents involved in such a dispute. Similarly, while we do not knowingly infringe on patents, copyrights or other intellectual property rights owned by other parties, we may be required to spend a significant amount of time and financial resources to resolve any infringement claims against us. We may not be successful in defending our position or negotiating an alternative remedy. Our inability to protect our proprietary information and enforce or defend our intellectual property rights in proceedings initiated by or against us could have a material adverse effect on our business, financial condition and results of operations.

We operate in a highly competitive environment. Our domestic and foreign operations are subject to significant competitive pressures. We compete directly and indirectly with other manufacturers and suppliers of metalworking tools, engineered components and advanced materials. Some of our competitors are larger than we are and may have greater access to financial resources or be less leveraged than us. In addition, the industry in which our products are used is a large, fragmented industry that is highly competitive.

If we are unable to retain our qualified management and employees, our business may be negatively affected. Our ability to provide high quality products and services depends in part on our ability to retain our skilled personnel in the areas of management, product engineering, servicing and sales. Competition for such personnel is intense, and our competitors can be expected to attempt to hire our management and skilled employees from time to time. In addition, our restructuring activities and strategies for growth have placed, and are expected to continue to place, increased demands on our management’s skills and resources. If we are unable to retain our management team and professional personnel, our customer relationships and level of technical expertise could be negatively affected, which may materially and adversely affect our business.

Our future operating results may be affected by fluctuations in the prices and availability of raw materials. The raw materials we use for our products include ore concentrates, compounds and secondary materials containing tungsten, tantalum, titanium, niobium and cobalt. A significant portion of our raw materials is supplied by sources outside the U.S. The raw materials industry as a whole is highly cyclical and at times pricing and supply can be volatile due to a number of factors beyond our control, including natural disasters, general economic and political conditions, labor costs, competition, import duties, tariffs and currency exchange rates. This volatility can significantly affect our raw material costs. In an environment of increasing raw material prices, competitive conditions can affect how much of the price increases in raw materials that we can recover in the form of higher sales prices for our products. To the extent we are unable to pass on any raw material price increases to our customers, our profitability could be adversely affected. Furthermore, restrictions in the supply of tungsten, cobalt and other raw materials could adversely affect our operating results. If the prices for our raw materials increase or we are unable to secure adequate supplies of raw materials on favorable terms, our profitability could be impaired.

Product liability claims could have a material adverse effect on our business. The sale of metalworking, mining, highway construction and other tools and related products as well as engineered components and advanced materials entails an inherent risk of product liability claims. We cannot give assurance that the coverage limits of our insurance policies will be adequate or that our policies will cover any particular loss. Insurance can be expensive, and we may not always be able to purchase insurance on commercially acceptable terms, if at all. Claims brought against us that are not covered by insurance or that result in recoveries in excess of our insurance coverage could have a material adverse affect on our business, financial condition and results of operations.

Natural disasters or other global or regional catastrophic events could disrupt our operations and adversely affect results. Despite our concerted effort to minimize risk to our production capabilities and corporate information systems and to reduce the effect of unforeseen interruptions to us through business continuity planning, we still may be exposed to interruptions due to catastrophe, natural disaster, pandemic, terrorism or acts of war, which are beyond our control. Disruptions to our facilities or systems, or to those of our key suppliers, could also interrupt operational processes and adversely impact our ability to manufacture our products and provide services and support to our customers. As a result, our business, our results of operations, financial position, cash flows and stock price could be adversely affected.

ITEM 1B – UNRESOLVED STAFF COMMENTS

No unresolved comments from the Securities and Exchange Commission Staff.

 

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ITEM 2 – PROPERTIES

Our principal executive offices are located at 1600 Technology Way, P.O. Box 231, Latrobe, Pennsylvania, 15650. A summary of our principal manufacturing facilities and other materially important properties is as follows:

 

Location    Owned/Leased      Principal Products    Segment
United States:           
Irondale, Alabama    Owned      Custom Fabricated Wear Plate Solutions and Pins    Infrastructure
Rogers, Arkansas    Owned/Leased      Carbide Products and Pelletizing Die Plates    Infrastructure
University Park, Illinois    Owned      Custom Fabricated Wear Plate Solutions    Infrastructure
Rockford, Illinois    Owned      Indexable Tooling    Industrial
Goshen, Indiana    Leased      Powders, Welding Rods and Wires and PTA Machines    Infrastructure
New Albany, Indiana    Leased      High Wear Coating for Steel Parts    Infrastructure
Greenfield, Massachusetts    Owned      High-Speed Steel Taps    Industrial
Shelby Township, Michigan    Leased      Thermal Deburring and High Energy Finishing    Industrial
Traverse City, Michigan    Owned      Wear Parts    Industrial
Walker, Michigan    Leased      Thermal Energy Machining    Industrial
Elko, Nevada    Owned      Custom Fabricated Wear Plate Solutions    Infrastructure
Fallon, Nevada    Owned      Metallurgical Powders    Infrastructure
Asheboro, North Carolina    Owned      High-Speed Steel and Carbide Round Tools    Industrial
Henderson, North Carolina    Owned      Metallurgical Powders    Infrastructure
Roanoke Rapids, North Carolina    Owned      Metalworking Inserts    Industrial
Cleveland, Ohio    Leased      Distribution    Industrial
Orwell, Ohio    Owned      Metalworking Inserts    Industrial
Solon, Ohio    Owned      Metalworking Toolholders    Industrial
Whitehouse, Ohio    Owned      Metalworking Inserts and Round Tools    Industrial
Bedford, Pennsylvania    Owned/Leased      Mining and Construction Tools and Wear Parts and
Distribution
   Infrastructure
Irwin, Pennsylvania    Owned/Leased      Carbide Wear Parts and Abrasive Flow Machining    Industrial
Latrobe, Pennsylvania    Owned      Metallurgical Powders    Infrastructure
New Castle, Pennsylvania    Owned/Leased      Specialty Metals and Alloys    Industrial
Johnson City, Tennessee    Owned      Metalworking Inserts    Industrial
Lyndonville, Vermont    Owned      High-Speed Steel Taps    Industrial
Chilhowie, Virginia    Owned      Mining and Construction Tools and Wear Parts    Infrastructure
New Market, Virginia    Owned      Metalworking Toolholders    Industrial
International:           
Indaiatuba, Brazil    Leased      Metalworking Carbide Drills and Toolholders    Industrial
Belleville, Canada    Owned      Casting Components, Coatings and Powder Metallurgy
Components
   Infrastructure
Victoria, Canada    Owned      Wear Parts    Industrial
Baotou, China    Leased      Mining Tools    Infrastructure
Fengpu, China    Owned      Intermetallic Composite Ceramic Powders and Parts    Infrastructure
Shanghai, China    Owned      Powders, Welding Rods and Wires and Casting
Components
   Infrastructure
Tianjin, China    Owned      Metalworking Inserts and Carbide Round Tools    Industrial
Xuzhou, China    Leased      Mining Tools    Infrastructure
Kingswinford, England    Leased      Distribution    Industrial
Ebermannstadt, Germany    Owned      Metalworking Inserts    Industrial
Essen, Germany    Owned      Metallurgical Powders and Wear Parts    Industrial
Koblenz, Germany    Owned      Casting Components and Coatings    Infrastruture
Koenigsee, Germany    Leased      Metalworking Carbide Drills    Industrial
Lichtenau, Germany    Owned      Metalworking Toolholders    Industrial
Mistelgau, Germany    Owned      Metallurgical Powders, Metalworking Inserts and Wear Parts    Infrastructure
Nabburg, Germany    Owned      Metalworking Toolholders and Metalworking Round
Tools, Drills and Mills
   Industrial
Nuenkirchen, Germany    Owned      Distribution    Industrial
Vohenstrauss, Germany    Owned      Metalworking Carbide Drills    Industrial

 

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Location    Owned/Leased      Principal Products    Segment
Bangalore, India    Owned      Metalworking Inserts and Toolholders and Wear Parts    Industrial
Gurgaon, India    Leased      Coatings    Infrastructure
Shlomi, Israel    Owned      High-Speed Steel and Carbide Round Tools    Industrial
Milan, Italy    Owned     

Investment Castings Components and Metalworking

Cutting Tools

   Infrastructure/ Industrial
Zory, Poland    Leased      Mining and Construction Conicals    Infrastructure
Barcelona, Spain    Leased      Metalworking Cutting Tools    Industrial
Newport, United Kingdom    Owned      Intermetallic Composite Powders    Infrastructure

We also have a network of warehouses and customer service centers located throughout North America, Europe, India, Asia Pacific and Latin America, a significant portion of which are leased. The majority of our research and development efforts are conducted in a corporate technology center located adjacent to our world headquarters in Latrobe, Pennsylvania, U.S., as well as in our facilities in Rogers, Arkansas, U.S.; Fuerth, Germany and Essen, Germany.

We use all of our significant properties in the businesses of powder metallurgy, tools, tooling systems, engineered components and advanced materials. Our production capacity is adequate for our present needs. We believe that our properties have been adequately maintained, are generally in good condition and are suitable for our business as presently conducted.

ITEM 3 - LEGAL PROCEEDINGS

The information set forth in Part I, Item 1, of this annual report on Form 10-K under the caption “Regulation” is incorporated into this Item 3. From time to time, we are party to legal claims and proceedings that arise in the ordinary course of business, which may relate to our operations or assets, including real, tangible, or intellectual property. Although certain of these actions are currently pending, we do not believe that any individual proceeding is material or that our pending legal proceedings in the aggregate are material to Kennametal.

ITEM 4 - MINE SAFETY DISCLOSURES

Not applicable.

EXECUTIVE OFFICERS OF THE REGISTRANT

Incorporated by reference into this Part I is the information set forth in Part III, Item 10 under the caption “Executive Officers of the Registrant” of this annual report on Form 10-K.

PART II

ITEM 5 - MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our capital stock is traded on the New York Stock Exchange (symbol KMT). The number of Shareowners of record as of July 31, 2012 was 2,106. Stock price ranges and dividends declared and paid were as follows:

 

                                                                                                       
Quarter ended   September 30     December 31     March 31     June 30  

Fiscal 2012

       

High

  $ 45.66      $ 41.15      $ 47.82      $ 46.24   

Low

    30.53        29.30        37.04        30.65   

Dividends

    0.12        0.14        0.14        0.14   
                                 

Fiscal 2011

       

High

  $ 31.80      $ 39.81      $ 44.11      $ 43.48   

Low

    24.08        30.35        36.57        37.38   

Dividends

    0.12        0.12        0.12        0.12   
                                 

The information incorporated by reference in Part III, Item 12 of this annual report on Form 10-K from our 2012 Proxy Statement under the heading “Equity Compensation Plans – Equity Compensation Plan Information” is hereby incorporated by reference into this Item 5.

 

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PERFORMANCE GRAPH

The following graph compares cumulative total shareowner return on our capital stock with the cumulative total shareowner return on the common equity of the companies in the Standard & Poor’s Mid-Cap 400 Market Index (S&P Mid-Cap 400), the Standard & Poor’s Composite 1500 Market Index (S&P Composite), and the peer group of companies determined by us for the period from July 1, 2007 to June 30, 2012.

The Peer Group consists of the following companies: Allegheny Technologies Incorporated; Ametek Inc.; Barnes Group Inc.; Carpenter Technology Corporation; Crane Co.; Donaldson Company, Inc.; Dresser-Rand Group Inc.; Flowserve Corp.; Greif Inc.; Harsco Corporation; Joy Global Inc.; Lincoln Electric Holdings, Inc.; Pall Corporation.; Parker-Hannifin Corporation; Pentair Inc.; Sauer-Danfoss, Inc.; Teleflex, Incorporated; and The Timken Co.

 

LOGO

Assumes $100 Invested on July 1, 2007 and All Dividends Reinvested

 

      2007        2008        2009        2010        2011        2012  

Kennametal

     $100.00           $80.37           $48.44           $65.50           $110.24           $87.76   

Peer Group Index

     100.00           101.18           60.66           78.11           124.67           109.15   

S&P Mid-Cap 400

     100.00           92.66           66.70           83.32           116.14           113.43   

S&P 1500 Composite

     100.00           87.28           64.29           74.30           97.81           102.34   
                                                                 

 

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ISSUER PURCHASES OF EQUITY SECURITIES

 

Period    Total Number of
Shares
Purchased 
(1)
     Average Price
Paid per Share
     Total Number of Shares
Purchased as Part of
Publicly Announced
Plans or Programs
     Maximum Number
of Shares that May
Yet Be Purchased
Under the Plans or
Programs
(2)
 

April 1 through April 30, 2012

     -           $      -           -             4,505,100   

May 1 through May 31, 2012

     2,557         35.12         -             4,505,100   

June 1 through June 30, 2012

     160         33.99         -             4,505,100   

Total

     2,717         $35.05         -          
                                     
                                     

 

(1) 

During the current period, 2,552 shares were purchased on the open market on behalf of Kennametal to fund the Company's dividend reinvestment program. Also, during the current period employees delivered 165 shares of restricted stock to Kennametal, upon vesting, to satisfy tax withholding requirements.

(2) 

On July 26, 2012, the Company publicly announced an amended repurchase program for up to 12 million shares of its outstanding capital stock. As of the amendment date, there were approximately 8.5 million shares available to be purchased under the amended authorization.

 

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ITEM 6 - SELECTED FINANCIAL DATA

 

             2012      2011      2010     2009     2008  

OPERATING RESULTS (in thousands)

              

Sales

     $ 2,736,246       $ 2,403,493       $ 1,884,067      $   1,999,859      $   2,589,786   

Cost of goods sold

       1,741,996         1,519,102         1,256,339        1,423,320        1,682,715   

Operating expense

       561,490         538,530         477,487        489,567        594,187   

Restructuring and asset impairment charges

     (1)        -         12,586         43,923        173,656        39,891   

Interest expense

       27,215         22,760         25,203        27,244        31,586   

Provision (benefit) for income taxes

       79,136         63,856         26,977        (11,205     62,754   

Income (loss) from continuing operations attributable
to Kennametal

       307,230         229,727         47,842        (102,402     163,666   

Net income (loss) attributable to Kennametal

     (2     307,230         229,727         46,419        (119,742     167,775   

FINANCIAL POSITION (in thousands)

              

Working capital

     $ 704,340       $ 446,064       $ 522,926      $ 469,935      $ 630,675   

Total assets

       3,034,188         2,754,469         2,267,823        2,346,974        2,784,349   

Long-term debt, including capital leases, excluding
current maturities

       490,608         1,919         314,675        436,592        313,052   

Total debt, including capital leases and notes payable

       565,745         312,882         337,668        485,957        346,652   

Total Kennametal shareowners’ equity

             1,643,850         1,638,072         1,315,500        1,247,443        1,647,907   

PER SHARE DATA ATTRIBUTABLE TO KENNAMETAL

  

           

Basic earnings (loss) from continuing operations

     $ 3.83       $ 2.80       $ 0.59      $ (1.40   $ 2.13   

Basic earnings (loss)

     (3)        3.83         2.80         0.57        (1.64     2.18   

Diluted earnings (loss) from continuing operations

       3.77         2.76         0.59        (1.40     2.10   

Diluted earnings (loss)

     (4)        3.77         2.76         0.57        (1.64     2.15   

Dividends

       0.54         0.48         0.48        0.48        0.47   

Book value (at June 30)

       20.53         20.19         16.06        17.03        21.44   

Market Price (at June 30)

             33.15         42.21         25.43        19.18        32.55   

OTHER DATA (in thousands, except number of employees)

              

Capital expenditures

     $ 103,036       $ 83,442       $ 56,679      $ 104,842      $ 163,489   

Number of employees (at June 30)

       12,932         11,612         11,047        11,584        13,673   

Basic weighted average shares outstanding

       80,216         82,063         80,966        73,122        76,811   

Diluted weighted average shares outstanding

             81,439         83,173         81,690        73,122        78,201   

KEY RATIOS

              

Sales growth

       13.8%         27.6%         (5.8%     (22.8%     14.3%   

Gross profit margin

       36.3         36.8         33.3        28.8        35.0   

Operating profit (loss) margin

             15.2         13.4         4.9        (5.0     10.0   

 

(1) In 2011 and 2010, charges related to restructuring activity. In 2009, the charges related to an impairment of $111.0 million for Industrial goodwill and an Industrial indefinite-lived trademark as well as restructuring charges of $62.6 million. In 2008, the charges related to an Industrial goodwill impairment of $35.0 million as well as restructuring charges of $4.9 million.
(2) Net income (loss) attributable to Kennametal includes (loss) income from discontinued operations of ($1.4) million, ($17.3) million and $4.1 million for 2010, 2009 and 2008, respectively.
(3) Basic earnings (loss) per share includes basic (loss) earnings from discontinued operations per share of ($0.02), ($0.24) and $0.05 for 2010, 2009 and 2008, respectively.
(4) Diluted earnings (loss) per share includes diluted (loss) earnings from discontinued operations per share of ($0.02), ($0.24) and $0.05 for 2010, 2009 and 2008, respectively.

 

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ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

The following discussion should be read in connection with the consolidated financial statements of Kennametal Inc. and the related financial statement notes. Unless otherwise specified, any reference to a “year” is to a fiscal year ended June 30. Additionally, when used in this annual report on Form 10-K, unless the context requires otherwise, the terms “we,” “our” and “us” refer to Kennametal Inc. and its subsidiaries.

OVERVIEW Kennametal Inc. delivers productivity to customers seeking peak performance in demanding environments by providing innovative custom and standard wear-resistant solutions. To provide these solutions, we harness our knowledge of advanced materials and application development with a commitment to environmental sustainability. Our solutions are built around industry-essential technology platforms. These include metalworking tools, engineered components and surface technologies that are mission-critical to the performance of our customers battling extreme conditions such as fatigue wear, corrosion and high temperatures. We believe that our reputation for manufacturing excellence, as well as our technological expertise and innovation we deliver in our products and services, help us to achieve a leading position in our primary markets. We believe that we are one of the largest global providers of consumable metalcutting tools and tooling supplies.

In 2012, the Company achieved year-over-year sales growth each quarter, with an organic sales increase of 9 percent for the year. Organic sales growth includes both volume and price. The Company had strong earnings per diluted share (EPS) of $3.77 as a result of sales growth and solid operating margins due to price realization and operating expense control. We have also reduced our cost structure by approximately $170 million annually, due to our previous restructuring programs.

For 2012, sales were $2,736.2 million, an increase of 14 percent compared to prior year sales of $2,403.5 million. Operating income was $416.4 million, an increase of $94.7 million compared to operating income of $321.7 million in 2011. The increase in operating income was driven by higher sales volume, pricing and lower employment and restructuring costs, partially offset by higher raw material costs and acquisition-related costs. Operating income included $5.5 million of net acquisition-related costs.

We consumed higher cost raw materials in 2012, as raw material costs significantly increased during the first half of the year. The price of raw materials has remained stable throughout the second half of the fiscal year. We executed appropriate pricing earlier in the year and have continued to maintain our cost discipline throughout 2012. Realized raw materials costs generally lag the fluctuation in market prices by a quarter. We continue to monitor changes in raw materials costs to ensure appropriate pricing.

In March 2012 we acquired all of the shares of Deloro Stellite Holdings 1 Limited (Stellite) for a purchase price of approximately $383 million, net of cash acquired. The United Kingdom based Stellite is a global manufacturer and provider of alloy-based critical wear solutions for extreme environments involving high temperature, corrosion and abrasion. Stellite’s proprietary metal alloys, materials expertise, engineering design and fabrication capabilities complement Kennametal’s current business in the oil and gas, power generation, transportation and aerospace end markets. The Stellite acquisition generated approximately $243 million of goodwill, based on the final purchase price allocations, which is not deductible for tax purposes and is attributable to the operating synergies we expect to gain from the acquisition. This acquisition is in alignment with our growth strategy and positions us to further achieve geographic and end market balance.

The Company’s restructuring programs completed in fiscal 2011 are delivering annual ongoing pre-tax savings of approximately $170 million.

We generated cash flow from operating activities of $289.6 million in the current year. We have actively managed our business portfolio by investing approximately $383 million in the Stellite acquisition, returning over $110 million to shareholders through share repurchases and dividends, repurchasing approximately 2 million shares, and increasing our dividend by 17 percent in October 2011. In addition we made capital expenditures of $103.0 million during the year.

In addition, we invested further in technology and innovation to continue delivering a high level of new products to our customers. Research and development expenses included in operating expense totaled $38.3 million for 2012. In 2012, we generated approximately 40 percent of our sales from new products.

RESULTS OF CONTINUING OPERATIONS

SALES Sales of $2,736.2 million in 2012 increased 14 percent from $2,403.5 million in 2011 as a result of strong organic growth of 9 percent, business acquisition contribution of 4 percent and 1 percent more business days in 2012. Organic sales increased in both segments and across most regions. Organic sales growth drivers were energy markets of 13 percent, aerospace and defense of 13 percent, earthworks of 10 percent, general engineering of 8 percent and transportation of 6 percent.

 

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Sales of $2,403.5 million in 2011 increased 27.6 percent from $1,884.1 million in 2010 as a result of strong organic growth. Organic sales increased in both segments and across all regions. Organic sales growth drivers were general engineering of 40 percent, transportation of 30 percent and energy of 26 percent.

GROSS PROFIT Gross profit increased $109.9 million to $994.3 million in 2012 from $884.4 million in 2011. This increase was primarily due to an organic sales increase of $218.4 million, $17.8 million related to the Stellite acquisition and cost reduction benefits, partially offset by higher raw material costs and unfavorable business segment mix. The gross profit margin for 2012 decreased to 36.3 percent from 36.8 percent in 2011 due primarily to the Stellite acquisition.

Gross profit increased $256.7 million to $884.4 million in 2011 from $627.7 million in 2010. The increase was primarily due to increased organic sales of $523.9 million, improved absorption of manufacturing costs due to higher production levels, cost reduction benefits, favorable business mix and favorable foreign currency effects of $3.5 million. The impact of these items was partially offset by higher raw material costs and one-time benefits in the prior year from certain labor negotiations in Europe that did not occur in the current period. The gross profit margin for 2011 increased to 36.8 percent from 33.3 percent in 2010.

OPERATING EXPENSE Operating expense in 2012 was $561.5 million, an increase of $23.0 million, or 4.3 percent, compared to $538.5 million in 2011. The increase is primarily due to additional operating expenditures related to the Stellite acquisition of $11.6 million, acquisition-related costs of $8.9 million, and higher depreciation of $4.1 million due to a full year of depreciation related to the enterprise resource planning (ERP) system upgrade in 2011, partially offset by a decrease in restructuring related charges of $3.4 million and lower employment costs.

Operating expense in 2011 was $538.5 million, an increase of $61.0 million, or 12.8 percent, compared to $477.5 million in 2010. The increase is primarily driven by higher employment costs of $31.9 million due to the reinstatement of salaries and other temporary employment cost reductions and a higher provision for incentive compensation of $18.7 million, as a result of better operating performance. Foreign currency unfavorably impacted operating expense by $2.1 million.

RESTRUCTURING CHARGES During 2012, there were no restructuring charges.

During 2011, we completed our restructuring programs to reduce costs and improve operating efficiencies. These programs related to the rationalization of certain manufacturing and service facilities, as well as other employment and cost reduction programs. We recognized $21.5 million, which included $13.7 million of restructuring charges of which $1.1 million were related to inventory disposals and recorded as cost of goods sold. Restructuring related charges of $4.4 million were recorded in cost of goods sold and $3.4 million in operating expense during 2011. We realized pre-tax benefits from these restructuring programs of approximately $165 million during 2011.

During 2010, we continued to implement restructuring actions and recognized $48.9 million of restructuring charges of which $44.3 million were recorded as restructuring charges including $0.4 million related to inventory disposals and recorded in cost of goods sold.

AMORTIZATION OF INTANGIBLES Amortization expense was $16.4 million, $11.6 million and $13.1 million in 2012, 2011 and 2010, respectively. The increase of amortization expense in 2012 of $4.8 million or 40.9 percent was primarily due to the Stellite acquisition.

INTEREST EXPENSE Interest expense increased $4.4 million to $27.2 million in 2012, compared with $22.8 million in 2011 due to increased borrowings to fund the Stellite acquisition, primarily under our revolving credit facility, as well as the new $300 million bond issuance in February 2012 which overlapped the maturity date of June 2012 for the old bond issuance. The portion of our debt subject to variable rates of interest was approximately 46 percent and 2 percent at June 30, 2012 and 2011, respectively.

Interest expense decreased $2.4 million to $22.8 million in 2011, compared with $25.2 million in 2010. This decrease was due to a decrease in the average interest rates on domestic borrowings to 4.8 percent, compared to 5.0 percent in 2010, partially offset by higher borrowings. The portion of our debt subject to variable rates of interest was approximately 2 percent and 6 percent at June 30, 2011 and 2010, respectively.

OTHER (INCOME) EXPENSE, NET In 2012, other income, net was $0.8 million compared to other expense, net of $2.8 million in 2011. The change was primarily due to favorable foreign currency transactions gains of $3.9 million.

In 2011, other expense, net decreased by $11.4 million to other expense, net of $2.8 million compared to other income, net of $8.6 million in 2010. The decrease was primarily due to a $10.2 million unfavorable change in foreign currency transaction results, primarily driven by the euro.

 

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INCOME TAXES The effective tax rate from continuing operations for 2012 was 20.3 percent compared to 21.6 percent for 2011. The change in the effective rate from 2011 to 2012 was primarily driven by the release of a valuation allowance in the Netherlands and effective settlement of uncertain tax positions in the U.S., Europe and Asia. The effect of these items was partially offset by increased income in the U.S. where the tax rate is higher than most international locations and non-deductible acquisition-related costs.

The effective tax rate from continuing operations for 2011 was 21.6 percent compared to 35.2 percent for 2010. The change in the effective rate from 2010 to 2011was primarily driven by increased income in international locations where the tax rate is lower than the U.S. as well as restructuring charges in the prior year in jurisdictions where no tax benefit could be recognized. The 2011 effective rate was favorably impacted by a $21.5 million release of a valuation allowance in the United Kingdom, but that impact was offset by the tax cost of approximately $22.0 million, predominately U.S., associated with dividends of current year net income from some of our international subsidiaries. The 2010 effective rate was unfavorably impacted by the expiration of the research, development and experimental tax credit as well as the impact of restructuring charges in jurisdictions where no tax benefit could be recognized.

During 2011, we generated taxable income in other jurisdictions where we have valuation allowances recorded against our net deferred tax assets. The corresponding impact on the 2011 effective tax rate was immaterial. In conjunction with our annual planning process during the fourth quarter of 2011, we determined that sustainability of future income in the United Kingdom is likely, and as a result, we believe that it is more likely than not that we will be able to realize the net deferred tax assets in this jurisdiction. Accordingly, we recorded a valuation allowance adjustment of $21.5 million that reduced tax expense. With respect to the other jurisdictions, we believe sustainability of future income remains uncertain. We therefore have not adjusted the valuation allowance in these jurisdictions. We will continue to monitor our ability to realize the net deferred tax assets in these jurisdictions, and if appropriate, will adjust the valuation allowance. Such an adjustment would likely result in a material reduction to tax expense in the period the adjustment occurs.

INCOME FROM CONTINUING OPERATIONS ATTRIBUTABLE TO KENNAMETAL SHAREOWNERS Income from continuing operations attributable to Kennametal Shareowners was $307.2 million or $3.77 per diluted share in 2012, compared to $229.7 million, or $2.76 per diluted share, in 2011. The increase in income from continuing operations was a result of the factors previously discussed.

Income from continuing operations attributable to Kennametal Shareowners was $229.7 million, or $2.76 per diluted share in 2011, compared to $47.8 million, or $0.59 per diluted share, in 2010. The increase in income from continuing operations was a result of the factors previously discussed.

DISCONTINUED OPERATIONS We had no discontinued operations in 2012 or 2011.

On June 30, 2009, we divested our high speed steel business (HSS) from our Industrial segment as part of our continuing focus to shape our business portfolio and rationalize our manufacturing footprint. This divestiture was accounted for as discontinued operations. Cash proceeds from this divestiture amounted to $28.5 million. We incurred pre-tax charges related to the divestiture of $2.3 million during 2010.

BUSINESS SEGMENT REVIEW We operate two reportable operating segments consisting of Industrial and Infrastructure. Corporate expenses that are not allocated are reported in Corporate. Segment determination is based upon internal organizational structure, the manner in which we organize segments for making operating decisions and assessing performance, the availability of separate financial results and materiality considerations.

INDUSTRIAL

 

                                                                    
(in thousands)    2012      2011      2010  

External sales

   $ 1,667,434       $ 1,528,672       $ 1,166,793   

Operating income

     283,233         209,663         31,210   

 

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External sales of $1,667.4 million in 2012 increased by $138.8 million, or 9 percent, from 2011. The increase in sales was attributed to an organic sales increase of 9 percent and the impact of more business days of 1 percent, offset by unfavorable foreign currency effects of 1 percent. On an organic basis, sales increased in all served market sectors led by strong growth in aerospace and defense, general engineering and transportation sales of 13 percent, 8 percent and 6 percent, respectively. The aerospace and defense end markets’ sales growth is due to a significant increase in commercial aircraft production. Sales growth in the general engineering end markets is attributable to new orders for industrial machinery as manufacturers have increased their capital spending, as well as increased metalworking machinery production driven by a reaccelerating economy. The transportation end markets sales growth was due to an overall increase in vehicle sales and production in the U.S. While we still saw growth in European transportation sales, many European markets have begun to decline due to the recent economic environment in Europe. On a regional basis, sales increased by approximately 12 percent in Europe and 12 percent in the Americas and were relatively flat in Asia due to strong comparisons to the prior year. The sales increase in Europe and the Americas was driven by growth in the general engineering and transportation end markets.

In 2012, Industrial operating income was $283.2 million and reflects an increase in operating performance of $73.6 million from 2011. The primary drivers of the increase in operating income were higher organic sales of $134.8 million, operating expense control and lower restructuring costs, partially offset by higher raw material costs. Industrial operating margin increased to 17.0 percent from 13.7 percent in the prior year.

External sales of $1,528.7 million in 2011 increased by $361.9 million, or 31.0 percent, from 2010. The increase in sales was attributed to an organic sales increase of 32 percent and favorable foreign currency effects of 1 percent, offset by the impact of fewer business days. On an organic basis, sales increased in all served market sectors led by strong growth in general engineering and transportation sales of 40 percent and 30 percent, respectively. Sales growth in general engineering end markets was due to increased metalworking activities and manufacturers increased capital spending. In the transportation market sales growth increased due to strong production volumes in North America, globally light vehicle sales increased and there was growth in the mass transit market as new railroad infrastructure was built or expanded maintenance occurred. On a regional basis, sales increased by approximately 40 percent in Asia, 29 percent in Europe and 28 percent in the Americas. The increase in Asia was fairly evenly split between growth in the transportation markets and general engineering. The growth in Europe and the Americas was driven by general engineering.

Operating income for 2011 was $209.7 million and reflects an increase in operating performance of $178.5 million from 2010. The primary drivers of the increase in operating income were higher organic sales of $369.7 million, improved capacity utilization and incremental restructuring benefits. These benefits were partially offset by higher raw material costs. Industrial operating income included restructuring and related charges of $12.9 million and $35.5 million in 2011 and 2010, respectively. Industrial operating margin increased to 13.7 percent from 2.7 percent in the prior year.

INFRASTRUCTURE

 

                                                                    
(in thousands)    2012      2011      2010  

External sales

   $ 1,068,812       $ 874,821       $ 717,274   

Operating income

     141,640         121,733         79,899   

External sales of $1,068.8 million in 2012 increased by $194.0 million, or 22 percent, from 2011. The increase in sales was attributed to organic sales increase of 11 percent, acquisition growth of 10 percent and the impact of more business days of 1 percent. The organic increase was driven by higher sales in the energy and earthworks markets of 13 percent and 10 percent, respectively. Sales in the earthworks end markets increased due to strong mining demand from Asia in the first half of 2012, increased road maintenance in parts of Europe and Asia, and price actions partially offset by softening mining and construction market conditions in North America. Energy related product sales grew due to increased shale production and increased natural gas production, partially offset by a decline in natural gas prices and reduced drilling activity. On a regional basis, sales excluding acquisition increased by approximately 21 percent in Asia, 14 percent in Europe and 9 percent in the Americas. The sales increase in Asia was driven by performance in the earthworks markets, while the growth in Europe and the Americas was driven by earthworks markets and to a slightly lesser degree, the energy markets.

In 2012, Infrastructure operating income increased $19.9 million. The primary drivers of the increase in operating income were higher organic sales of $99.4 million, operating expense control and lower restructuring costs, partially offset by higher raw material costs. Operating income included $8.9 million of acquisition related charges. Infrastructure operating margin decreased to 13.2 percent from 13.9 percent in the prior year due to the recent Stellite business acquisition.

 

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External sales of $874.8 million in 2011 increased by $157.5 million, or 22.0 percent, from 2010. The increase in sales was attributed to organic sales increase of 21 percent and favorable foreign currency effects of 1 percent. The organic increase was driven by higher sales in the energy and earthworks markets of 26 percent and 18 percent, respectively. The sales growth in the energy related products market was due to globally increased oil rig counts as well as high natural gas storage. Sales increased in the earthworks end markets due to mining capacity expansion, while construction activity varies by region. In developed economies construction varies as it is governed by available funding, while in the emerging markets construction activity grew. On a regional basis, sales increased by approximately 27 percent in Asia, 22 percent in the Americas and 13 percent in Europe. The sales growth in all regions was driven by earthworks markets.

Operating income for 2011 was $121.7 million and reflected an increase of $41.8 million from 2010. Operating income improved primarily due to higher organic sales of $153.1 million, increased capacity utilization and incremental restructuring benefits, partially offset by higher raw material costs. Infrastructure operating income included restructuring and related charges of $6.2 million and $13.4 million in 2011 and 2010, respectively. Infrastructure operating margin increased from the prior year to 13.9 percent from 11.1 percent.

CORPORATE

 

                                                              
(in thousands)    2012     2011     2010  

Corporate unallocated expense

   $ (8,464   $ (9,723   $ (17,881

In 2012, unallocated expense decreased $1.3 million, or 12.9 percent from 2011. The decrease was driven by $6.0 million of lower strategic project spending, partially offset by $1.2 million of lower foreign government subsidy income for certain research projects and the impact of a non-recurring reversal of an environmental liability in 2011.

In 2011, unallocated expense decreased $8.2 million, or 45.6 percent from 2010. The decrease was driven by $4.2 million of lower strategic project spending, $4.1 million higher allocation of Corporate expense to the segments than in the prior year, $1.2 million of higher foreign government subsidy income for certain research projects and a $1.1 million reversal of an international environmental liability, partially offset by a charge of $2.4 million recorded to write-off our pre-existing ERP system.

LIQUIDITY AND CAPITAL RESOURCES Cash flow from operations is our primary source of funding for capital expenditures. During the year ended June 30, 2012, cash flow provided by operating activities was $289.6 million, driven by our operating performance.

On February 14, 2012, we issued $300 million of 3.875 percent Senior Unsecured Notes due in 2022. Interest will be paid semi-annually on February 15 and August 15 of each year. We applied the net proceeds from this notes offering to the repayment of our 7.2 percent Senior Unsecured Notes on their June 15, 2012 maturity date.

On October 21, 2011, we entered into an amendment to our five year, multi-currency, revolving credit facility (2010 Credit Agreement), which is used to augment cash flow from operations and as an additional source of funds. The new five-year, multi-currency, revolving credit facility (2011 Credit Agreement) extends to October 2016. The 2011 Credit Agreement permits revolving credit loans of up to $600 million for working capital, capital expenditures and general corporate purposes. The 2011 Credit Agreement allows for borrowings in U.S. dollars, euro, Canadian dollars, pound sterling and Japanese yen. Interest payable under the 2011 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 or the Federal Funds effective rate plus an applicable margin, or (3) fixed as negotiated by us.

The 2011 Credit Agreement requires us to comply with various restrictive and affirmative covenants, including two financial covenants: a maximum leverage ratio and a minimum consolidated interest coverage ratio (as those terms are defined in the agreement). We were in compliance with these financial covenants as of June 30, 2012. We had $212.2 million of borrowings outstanding under the 2011 Credit Agreement as of June 30, 2012. For the year ended June 30, 2012, average borrowings outstanding under the 2010 and 2011 Credit Agreements were approximately $143.8 million.

Borrowings under the 2011 Credit Agreement are guaranteed by our significant domestic subsidiaries.

Additionally, we obtain local financing through credit lines with commercial banks in the various countries in which we operate. At June 30, 2012, these borrowings amounted to $41.6 million of notes payable and $12.3 million of term debt, capital leases and other debt. We believe that cash flow from operations and the availability under our credit lines will be sufficient to meet our cash requirements over the next 12 months.

 

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Based upon our debt structure at June 30, 2012 and 2011, approximately 46 percent and 2 percent of our debt, respectively, was exposed to variable rates of interest. The increase in the portion of our debt subject to variable rates was due to the increase in the balance outstanding on our 2011 Credit Agreement, as previously mentioned.

We consider the unremitted earnings of our non-U.S. subsidiaries that have not previously been taxed in the U.S., to be permanently reinvested. As of June 30, 2012, cash and cash equivalents of $112 million and short term intercompany advances made by our foreign subsidiaries to our U.S. parent of $134 million would not be available for use in the U.S. on a long term basis, without incurring U.S. federal and state income tax consequences. These short term intercompany advances are in the form of intercompany loans made over each quarter end to repay borrowings under our revolving credit agreement and have a duration of not more than fourteen days. We have not, nor do we anticipate the need to, repatriate funds to the U.S. to satisfy domestic liquidity needs arising in the ordinary course of business, including liquidity needs associated with our domestic debt service requirements.

At June 30, 2012, we had cash and cash equivalents of $116.5 million. Total Kennametal Shareowners’ equity was $1,643.9 million and total debt was $565.7 million. Our current senior credit ratings are at investment grade levels. We believe that our current financial position, liquidity and credit ratings provide us access to the capital markets. We continue to closely monitor our liquidity position and the condition of the capital markets, as well as the counterparty risk of our credit providers.

The following is a summary of our contractual obligations and other commercial commitments as of June 30, 2012 (in thousands):

 

Contractual Obligations            Total      2013      2014-2015      2016-2017      Thereafter  

Long-term debt

     (1)       $       594,963       $       47,582       $       27,860       $   208,250       $ 311,271   

Notes payable

     (2)         42,590         42,590         -             -             -       

Pension benefit payments

        (3)         40,941         85,379         94,277         (3)   

Postretirement benefit payments

        (3)         2,261         4,328         4,037         (3)   

Capital leases

     (4)         6,914         803         4,232         1,680         199   

Operating leases

        72,208         19,056         19,571         8,275         25,306   

Purchase obligations

     (5)         912,350         311,345         439,571         113,688         47,746   

Unrecognized tax benefits

     (6)         9,497         5,532         -             -             3,965   

Total

                     $ 470,110       $ 580,941       $ 430,207            
                                                       

 

(1) Long-term debt includes interest obligations of $77.0 million. Interest obligations were determined assuming interest rates as of June 30, 2012 remain constant.
(2) Notes payable includes interest obligations of $1.0 million. Interest obligations were determined assuming interest rates as of June 30, 2012 remain constant.
(3) Annual payments are expected to continue into the foreseeable future at the amounts noted in the table.
(4) Capital leases include interest obligations of $0.7 million.
(5) Purchase obligations consist of purchase commitments for materials, supplies and machinery and equipment as part of the ordinary conduct of business. Purchase obligations with variable price provisions were determined assuming market prices as of June 30, 2012 remain constant.
(6) Unrecognized tax benefits are positions taken or expected to be taken on an income tax return that may result in additional payments to tax authorities. These amounts include interest of $1.9 million and penalty of $0.3 million accrued related to such positions as of June 30, 2012. The amount included for 2013 is expected to be settled within the next twelve months. The remaining amount of unrecognized tax benefits is included in the ‘Thereafter’ column as we are not able to reasonably estimate the timing of potential future payments. If a tax authority agrees with the tax position taken or expected to be taken or the applicable statute of limitations expires, then additional payments will not be necessary.

 

Other Commercial Commitments    Total      2013      2014-2015      2016-2017      Thereafter  

Standby letters of credit

   $ 4,819       $ 4,819       $ -           $ -           $ -       

Guarantees

     36,461         22,741         242         -             13,478   

Total

   $       41,280       $     27,560       $ 242         $ -           $ 13,478   
                                              

The standby letters of credit relate to insurance and other activities. The guarantees are non-debt guarantees in foreign locations with financial institutions required primarily for security deposits, product performance guarantees and advances.

 

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Cash Flow Provided by Operating Activities

During 2012, cash flow provided by operating activities was $289.6 million, compared to $230.8 million in 2011. Cash flow provided by operating activities for the current year consisted of net income and non-cash items amounting to $452.3 million, offset by changes in certain assets and liabilities netting to $162.7 million. These changes were primarily driven by an increase in inventory of $63.8 million, due to increased demand and higher raw material costs. As well as, a decrease in accounts payable and accrued liabilities of $57.0 million, primarily driven by lower accounts payable and a decrease in accrued bonus, an increase in other of $16.8 million, a decrease in accrued income taxes of $14.2 million and an increase in accounts receivable of $10.9 million, driven by higher sales volumes.

During 2011, cash flow provided by operating activities was $230.8 million, compared to $164.8 million in 2010. Cash flow provided by operating activities for 2011 consisted of net income and non-cash items amounting to $329.8 million, offset by changes in certain assets and liabilities netting to $99.0 million. These changes were primarily driven by an increase in inventory of $124.1 million, due to increased demand and higher raw material costs, and an increase in accounts receivable of $89.2 million, driven by higher sales volumes, partially offset by an increase in accounts payable and accrued liabilities of $100.3 million, driven by higher accounts payable balances related to increased production and an increase in accrued income taxes of $22.2 million.

During 2010, cash flow provided by operating activities was $164.8 million. Cash flow provided by operating activities for 2010 consisted of net income and non-cash items amounting to $158.4 million and changes in certain assets and liabilities, netting to $6.5 million. These changes were driven by an increase in accounts receivable of $58.2 million, driven by higher sales volumes in the latter part of the year, partially offset by an increase in accounts payable and accrued liabilities of $41.0 million, driven by increased accounts payable related to increased production and an increase in accrued income taxes of $19.2 million.

Cash Flow Used for Investing Activities

Cash flow used for investing activities was $487.3 million for 2012, an increase of $415.5 million, compared to $71.8 million in 2011. During 2012, cash flow used for investing activities included the Stellite acquisition for $382.6 million and capital expenditures, net of $96.2 million, which consisted primarily of equipment upgrades, and $10.0 million for the purchase of a technology license in our Infrastructure segment.

Cash flow used for investing activities was $71.8 million for 2011, an increase of $31.4 million, compared to $40.4 million in 2010. During 2011, cash flow used for investing activities included $83.4 million used for purchases of property, plant and equipment, which consisted primarily of upgrades of equipment and our ERP system.

Cash flow used for investing activities was $40.4 million for 2010. During 2010, cash flow used for investing activities included $56.7 million used for purchases of property, plant and equipment, which consisted primarily of equipment upgrades, and $17.0 million used for the acquisition of business assets, primarily the deferred purchase price of $16.0 million for a 2007 acquisition, as well as $27.8 million of cash proceeds from divestitures.

Cash Flow Provided by (Used for) Financing Activities

Cash flow provided by financing activities was $131.3 million for 2012, compared to cash flow used for financing activities of $96.0 million in 2011. During the current year, cash flow provided by financing activities included a $250.7 million net increase in borrowings, which included the issuance of $300 million of 3.875 percent Senior Unsecured Notes due in 2022 and $212.2 million of borrowings outstanding under our 2011 Credit Agreement, partially offset by the repayment of $300 million of 7.2 percent Senior Unsecured Notes in June 2012. Cash flow provided by financing activities also included $24.6 million of dividend reinvestment and the effect of employee benefit and stock plans. These cash flows were partially offset by $66.9 million used for the purchase of capital stock, $43.6 million of cash dividends paid to Shareowners and payments of $22.4 million related to the settlement of forward starting interest rate swap contracts.

Cash flow used for financing activities was $96.0 million for 2011, compared to $58.2 million in 2010. During 2011, cash flow used for financing activities included $57.9 million used for the purchase of capital stock, $39.8 million of cash dividends paid to Shareowners and a $17.6 million net decrease in borrowings, partially offset by $18.3 million of dividend reinvestment and the effect of employee benefit and stock plans.

Cash flow used for financing activities was $58.2 million for 2010. During 2010, cash flow used for financing activities included a $143.0 million net decrease in borrowings and $39.3 million of cash dividends paid to Shareowners, partially offset by $120.7 million in net proceeds from our equity offering and $10.7 million of dividend reinvestment and the effect of employee benefit and stock plans.

 

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FINANCIAL CONDITION At June 30, 2012, total assets were $3,034.2 million, an increase of $279.7 million from $2,754.5 million at June 30, 2011. Total liabilities increased $270.2 million from $1,095.8 million at June 30, 2011 to $1,366.0 million at June 30, 2012.

Working capital was $704.3 million at June 30, 2012, an increase of $258.2 million, or 57.9 percent from $446.1 million at June 30, 2011. The increase in working capital was primarily driven by a decrease in current maturities of long-term debt and capital leases including notes payable of $235.8 million driven by the repayment of the $300 million of 7.2 percent Senior Unsecured Notes in June 2012, an increase in inventories of $65.9 million driven by the impact of higher production to meet demand and the Stellite acqusition, an increase in accounts receivable of $31.2 million due to higher sales and accounts receivable acquired in the business acquisition and a decrease in other current liabilities of $19.6 million driven primarily by lower incentive compensation accrual, partially offset by a decrease in cash and cash equivalents of $88.1 million. Foreign currency effects accounted for $73.7 million of the working capital change.

Property, plant and equipment, net increased $45.1 million from $697.1 million at June 30, 2011 to $742.2 million at June 30, 2012, primarily due to capital additions of $103.0 million, consisting of equipment upgrades and acquired business assets of $76.1 million, partially offset by depreciation expense of $87.7 million, unfavorable foreign currency impact of $36.5 million and capital disposals of $6.9 million.

At June 30, 2012, other assets were $1,009.0 million, an increase of $239.2 million from $769.8 million at June 30, 2011. The driver for the increase was an increase in goodwill of $208.0 million and an increase in other intangible assets of $91.2 million, partially offset by a decrease in various other assets of $55.2 million. The change in goodwill was primarily due to an increase of $242.6 million related to the business acquisition and unfavorable foreign currency effects of $34.6 million. The change in other intangible assets was due to an increase of $103.8 million related to the intangibles acquired as part of the Stellite acquisition, technology license intangible assets acquisition in our Infrastructure segment for $15.0 million, offset by amortization expense of $16.4 million and unfavorable foreign currency translation adjustments of $11.1 million. The decrease in other assets was primarily driven by higher pension liabilities from lower return on plan assets, which were partially offset by higher prepaid charges.

Long-term debt and capital leases increased $488.7 million to $490.6 million at June 30, 2012 from $1.9 million at June 30, 2011. The increase was driven by the issuance of $300 million of senior unsecured notes which are due in 2022 and borrowings on the 2011 Credit Agreement for the acquisition of Stellite.

Kennametal Shareowners’ equity was $1,643.9 million at June 30, 2012, an increase of $5.8 million from $1,638.1 million in the prior year. The increase was primarily due to net income attributable to Kennametal of $307.2 million and capital stock issued under employee benefit and stock plans of $42.0 million, partially offset by foreign currency translation adjustments of $137.1 million, the effect of amortization of employee benefit plan gains into other comprehensive (loss) income of $84.7 million, purchase of capital stock of $66.9 million and cash dividends paid to Shareowners of $43.6 million.

ENVIRONMENTAL MATTERS The operation of our business has exposed us to certain liabilities and compliance costs related to environmental matters. We are involved in various environmental cleanup and remediation activities at certain of our locations.

Superfund Sites We are involved as a PRP at various sites designated by the USEPA as Superfund sites. For certain of these sites, we have evaluated the claims and potential liabilities and have determined that neither are material, individually or in the aggregate. For certain other sites, proceedings are in the very early stages and have not yet progressed to a point where it is possible to estimate the ultimate cost of remediation, the timing and extent of remedial action that may be required by governmental authorities or the amount of our liability alone or in relation to that of any other PRPs.

Other Environmental Issues We establish and maintain reserves for other potential environmental issues. At June 30, 2012 and 2011, the total of accruals for these reserves was $5.1 million and $5.4 million, respectively. These totals represent anticipated costs associated with the remediation of these issues. We recorded additional reserves of $0.6 million and $1.5 million in 2012 and 2011, respectively. Additional reserves recorded in 2012 primarily relate to the business acquisition. We recorded favorable foreign currency translation adjustments of $0.5 million during 2012 and unfavorable foreign currency translation adjustments of $0.6 million during 2011. Cash payments of $0.4 million and $0.8 million were made against these reserves during 2012 and 2011, respectively. In 2011, we also had a $1.1 million reversal of an international environmental liability and payment of a civil penalty of $0.2 million related to our Chestnut Ridge, Pennsylvania facility closure. We maintain a Corporate EHS Department to monitor compliance with environmental regulations and to oversee remediation activities. In addition, we have designated EHS coordinators who are responsible for each of our global manufacturing facilities. Our financial management team periodically meets with members of the Corporate EHS Department and the Corporate Legal Department to review and evaluate the status of environmental projects and contingencies. On a quarterly basis, we review financial provisions and reserves for environmental contingencies and adjust these reserves when appropriate.

 

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EFFECTS OF INFLATION Despite modest inflation in recent years, rising costs, including the cost of certain raw materials, continue to affect our operations throughout the world. We strive to minimize the effects of inflation through cost containment, productivity improvements and price increases.

DISCUSSION OF CRITICAL ACCOUNTING POLICIES In preparing our financial statements in conformity with accounting principles generally accepted in the U.S. (U.S. GAAP), we make judgments and estimates about the amounts reflected in our financial statements. As part of our financial reporting process, our management collaborates to determine the necessary information on which to base our judgments and develops estimates used to prepare the financial statements. We use historical experience and available information to make these judgments and estimates. However, different amounts could be reported using different assumptions and in light of different facts and circumstances. Therefore, actual amounts could differ from the estimates reflected in our financial statements. Our significant accounting policies are described in Note 2 of our consolidated financial statements set forth in Item 8. We believe that the following discussion addresses our critical accounting policies.

Revenue Recognition We recognize revenue upon shipment of our products and assembled machines. Our general conditions of sale explicitly state that the delivery of our products and assembled machines is F.O.B. shipping point and that title and all risks of loss and damages pass to the buyer upon delivery of the sold products or assembled machines to the common carrier.

Our general conditions of sale explicitly state that acceptance of the conditions of shipment is considered to have occurred unless written notice of objection is received by Kennametal within 10 calendar days of the date specified on the invoice. We do not ship products or assembled machines 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 products and assembled machines and do not consider the effect of returned products and assembled machines to be material. We have recorded an estimated returned goods allowance to provide for any potential returns.

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 30 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 the customer of shipping instructions from Kennametal. We have included an estimated allowance for warranty returns in our returned goods allowance discussed above.

We recognize revenue related to the sale of specialized assembled machines upon customer acceptance and installation, as installation is deemed essential to the functionality of a specialized assembled machine. Sales of specialized assembled machines were immaterial for 2012, 2011 and 2010.

Stock-Based Compensation We recognize stock-based compensation expense for all stock options, restricted stock awards and restricted stock units over the period from the date of grant to the date when the award is no longer contingent on the employee providing additional service (substantive vesting period). We utilize the Black-Scholes valuation method to establish the fair value of all stock option awards.

Accounting for Contingencies We accrue for contingencies when it is probable that a liability or loss has been incurred and the amount can be reasonably estimated. Contingencies by their nature relate to uncertainties that require the exercise of judgment in both assessing whether or not a liability or loss has been incurred and estimating the amount of probable loss. The significant contingencies affecting our financial statements include environmental, health and safety matters and litigation.

Long-Lived Assets We evaluate the recoverability of property, plant and equipment and intangible assets that are amortized whenever events or changes in circumstances indicate the carrying amount of such assets may not be fully recoverable. Changes in circumstances include technological advances, changes in our business model, capital structure, economic conditions or operating performance. Our evaluation is based upon, among other things, our assumptions about the estimated future undiscounted cash flows these assets are expected to generate. When the sum of the undiscounted cash flows is less than the carrying value, we will recognize an impairment loss to the extent that carrying value exceeds fair value. We apply our best judgment when performing these evaluations to determine if a triggering event has occurred, the undiscounted cash flows used to assess recoverability and the fair value of the asset.

 

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Goodwill and Indefinite-Lived Intangible Assets We evaluate the recoverability of goodwill of each of our reporting units by comparing the fair value of each reporting unit with its carrying value. The fair values of our reporting units are determined using a combination of a discounted cash flow analysis and market multiples based upon historical and projected financial information. We apply our best judgment when assessing the reasonableness of the financial projections used to determine the fair value of each reporting unit. We evaluate the recoverability of indefinite-lived intangible assets using a discounted cash flow analysis based on projected financial information.

Pension and Other Postretirement and Postemployment Benefits We sponsor these types of benefit plans for certain employees and retirees. Accounting for the cost of these plans requires the estimation of the cost of the benefits to be provided well into the future and attributing that cost over the expected work life of employees participating in these plans. This estimation requires our judgment about the discount rate used to determine these obligations, expected return on plan assets, rate of future compensation increases, rate of future health care costs, withdrawal and mortality rates and participant retirement age. Differences between our estimates and actual results may significantly affect the cost of our obligations under these plans.

In the valuation of our pension and other postretirement and postemployment benefit liabilities, management utilizes various assumptions. We determine our discount rate based on investment grade bond yield curves with a duration that approximates the benefit payment timing of each plan. This rate can fluctuate based on changes in investment grade bond yields. At June 30, 2012, a hypothetical 25 basis point increase or decrease in our discount rates would increase or decrease, respectively, our pre-tax income by approximately $2.1 million.

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 cost increases is based on historical claims and enrollment information projected over the next fiscal year and adjusted for administrative charges. This rate is expected to decrease until 2029. At June 30, 2012, a hypothetical 1 percent increase or decrease in our health care cost trend rates would be immaterial to our pre-tax income.

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 a review of published mortality tables.

We expect to contribute $10.4 million and $2.3 million to our pension and other postretirement benefit plans, respectively, in 2013.

Allowance for Doubtful Accounts We record allowances for estimated losses resulting from the inability of our customers to make required payments. We assess the creditworthiness of our customers based on multiple sources of information and analyze additional factors such as our historical bad debt experience, industry and geographic concentrations of credit risk, current economic trends and changes in customer payment terms. This assessment requires significant judgment. If the financial condition of our customers was to deteriorate, additional allowances may be required, resulting in future operating losses that are not included in the allowance for doubtful accounts at June 30, 2012.

Inventories Inventories are stated at the lower of cost or market. We use the last-in, first-out method for determining the cost of a significant portion of our U.S. inventories. The cost of the remainder of our inventories is determined under the first-in, first-out or average cost methods. When market conditions indicate an excess of carrying costs over market value, a lower-of-cost-or-market provision is recorded. Excess and obsolete inventory reserves are established based upon our evaluation of the quantity of inventory on hand relative to demand.

Income Taxes Realization of our deferred tax assets is primarily dependent on future taxable income, the timing and amount of which are uncertain, in part, due to the expected profitability of certain foreign subsidiaries. A valuation allowance is recognized if it is “more likely than not” that some or all of a deferred tax asset will not be realized. As of June 30, 2012, the deferred tax assets net of valuation allowances relate primarily to net operating loss carryforwards, pension benefits, accrued employee benefits and inventory reserves. In the event that we were to determine that we would not be able to realize our deferred tax assets in the future, an increase in the valuation allowance would be required. In the event we were to determine that we are able to use our deferred tax assets and a valuation allowance had been recorded against the deferred tax assets, a decrease in the valuation allowance would be required.

 

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NEW ACCOUNTING STANDARDS

Adopted

As of January 1, 2012, Kennametal adopted changes to fair value measurements and disclosure. Many of the amendments in this guidance represent clarifications to existing guidance or changes in the measurement guidance for determining fair value. The most significant change in disclosures is an expansion of the information required for Level 3 measurements. Disclosures will be required about the use of a nonfinancial asset measured or disclosed at fair value if its use differs from its highest and best use. In addition, entities must report the level in the fair value hierarchy of assets and liabilities not recorded at fair value but where fair value is disclosed. The adoption of this guidance did not have an impact on our consolidated financial statements.

Issued

In June 2012, the Financial Accounting Standards Board (FASB) issued additional guidance on testing indefinite lived intangible assets for impairment. The guidance permits an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of the indefinite lived intangible assets is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step impairment test. This guidance is effective for Kennametal beginning July 1, 2013, with early adoption is permitted.

In December 2011, the FASB deferred the requirement to present reclassifications of other comprehensive income on the face of the income statement. Companies would still be required to adopt the other requirements contained in the accounting guidance on presentation of other comprehensive income. This guidance is effective for Kennametal beginning July 1, 2012.

In June 2011, the FASB issued guidance on presentation of comprehensive income. This guidance eliminates the current option to report other comprehensive income and its components in the statement of changes in equity. An entity can elect to present items of net income and other comprehensive income in one continuous statement or in two separate consecutive statements. Each component of net income and other comprehensive income, together with totals for comprehensive income and its two parts, net income and other comprehensive income, would need to be displayed under either alternative. This guidance is effective for Kennametal beginning July 1, 2012.

In September 2011, the FASB issued additional guidance on testing goodwill for impairment. The guidance permits an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. This guidance is effective for Kennametal beginning July  1, 2012.

ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

MARKET RISK We are exposed to certain market risks arising from transactions that are entered into in the normal course of business. As part of our financial risk management program, we use certain derivative financial instruments to manage these risks. We do not enter into derivative transactions for speculative purposes and, therefore, hold no derivative instruments for trading purposes. We use derivative financial instruments to provide predictability to the effects of changes in foreign exchange rates on our consolidated results and to achieve our targeted mix of fixed and floating interest rates on outstanding debt. Our objective in managing foreign exchange exposures with derivative instruments is to reduce volatility in cash flow, allowing us to focus more of our attention on business operations. With respect to interest rate management, these derivative instruments allow us to achieve our targeted fixed-to-floating interest rate mix as a separate decision from funding arrangements in the bank and public debt markets. We measure hedge effectiveness by assessing the changes in the fair value or expected future cash flows of the hedged item. The ineffective portions are recorded in other (income) expense, net. See Notes 2 and 16 set forth in Item 8.

We are exposed to counterparty credit risk for nonperformance of derivative contracts and, in the event of nonperformance, to market risk for changes in interest and currency rates, as well as settlement risk. We manage exposure to counterparty credit risk through credit standards, diversification of counterparties and procedures to monitor concentrations of credit risk. We do not anticipate nonperformance by any of the counterparties.

The following provides additional information on our use of derivative instruments. Included below is a sensitivity analysis that is based upon a hypothetical 10 percent weakening or strengthening in the U.S. dollar compared to the June 30, 2012 foreign currency rates and the effective interest rates under our current borrowing arrangements. We compared the contractual derivative and borrowing arrangements in effect at June 30, 2012 to the hypothetical foreign exchange or interest rates in the sensitivity analysis to determine the effect on interest expense, pre-tax income or accumulated other comprehensive (loss) income. Our analysis takes into consideration the different types of derivative instruments and the applicability of hedge accounting.

 

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CASH FLOW HEDGES Currency A portion of our operations consists of investments in foreign subsidiaries. Our exposure to market risk for changes in foreign exchange rates arises from these investments, intercompany loans utilized to finance these subsidiaries, trade receivables and payables and firm commitments arising from international transactions. We manage our foreign exchange transaction risk to reduce the volatility of cash flows caused by currency fluctuations through natural offsets where appropriate and through foreign exchange contracts. These contracts are designated as hedges of transactions that will settle in future periods and otherwise would expose us to foreign currency risk.

Our foreign exchange hedging program minimizes our exposure to foreign exchange rate movements. This exposure arises largely from anticipated cash flows from cross-border intercompany sales of products and services. This program utilizes range forwards and forward contracts primarily to sell foreign currency. The notional amounts of the contracts translated into U.S. dollars at June 30, 2012 and 2011 rates were $69.9 million and $37.6 million, respectively. We would have received immaterial amounts at June 30, 2012 to settle these contracts, which represent the fair value of these contracts. We would have paid immaterial amounts at June 30, 2011 to settle these contracts, which represent the fair value of these contracts. At June 30, 2012, a hypothetical 10 percent strengthening or weakening of the U.S. dollar would have changed accumulated other comprehensive (loss) income, net of tax, by $2.2 million.

In addition, we may enter into forward contracts to hedge transaction exposures or significant cross-border intercompany loans by either purchasing or selling specified amounts of foreign currency at a specified date. At June 30, 2012 and 2011, we had outstanding forward contracts to purchase and sell foreign currency with notional amounts, translated into U.S. dollars at June 30, 2012 and 2011 rates, of $125.7 million and $39.3 million, respectively. At June 30, 2012, a hypothetical 10 percent change in the year-end exchange rates would have resulted in an increase or decrease in pre-tax income of $14.6 million related to these positions.

Interest Rate Our exposure to market risk for changes in interest rates relates primarily to our long-term debt obligations. We seek to manage our interest rate risk in order to balance our exposure between fixed and floating rates, while attempting to minimize our borrowing costs. To achieve these objectives, we primarily use interest rate swap contracts to manage exposure to interest rate changes related to these borrowings. We had forward starting interest rate swap contracts outstanding for forecasted transactions that effectively converted a cumulative notional amount of $150.0 million from floating to fixed interest rates as of June 30, 2011. In February 2012, we settled forward starting interest rate swap contracts to convert this $150.0 million of our floating rate debt to fixed rate debt. Upon settlement, we made a cash payment of $22.4 million. The loss is being amortized as a component of interest expense over the term of the related debt using the effective interest rate method. We would have paid $2.4 million at June 30, 2011 to settle these interest rate swap contracts, which represented the fair value of these contracts.

DEBT AND NOTES PAYABLE At June 30, 2012 and 2011, we had $565.7 million and $312.9 million, respectively, of outstanding debt, including capital leases and notes payable. Effective interest rates as of June 30, 2012 and 2011 were 4.1 percent and 4.8 percent, respectively, including the effect of termination/settlement of interest rate swaps. A hypothetical change of 10 percent in interest rates from June 30, 2012 levels would increase or decrease annual interest expense by approximately $0.4 million.

On February 14, 2012, we issued $300 million of 3.875 percent Senior Unsecured Notes due in 2022. Interest will be paid semi-annually on February 15 and August 15 of each year. We settled forward starting interest rate swap contracts related to the bond issuance as further discussed in Note 7 set forth in Item 8. We applied the net proceeds from this notes offering to the repayment of our 7.2 percent Senior Unsecured Notes on their June 15, 2012 maturity date.

On October 21, 2011, we entered into an amendment to our 2010 Credit Agreement. The new five-year, multi-currency, revolving credit facility (2011 Credit Agreement) permits revolving credit loans of up to $600.0 million for working capital, capital expenditures and general corporate purposes and extends to October 2016. We had $212.2 million of borrowings outstanding under the 2011 Credit Agreement as of June 30, 2012.

Also during July 2009, the Company completed the issuance of 8.1 million shares of its common stock generating net proceeds of $120.7 million which were used to pay down outstanding indebtedness under the revolving credit facility.

FOREIGN CURRENCY EXCHANGE RATE FLUCTUATIONS Foreign currency exchange rate fluctuations materially decreased diluted earnings per share by $0.05 in 2012 and by $0.06 in 2011 and materially increased diluted earnings per share in 2010 by $0.07. Foreign currency exchange rate fluctuations may have a material impact on future earnings in the short term and long term.

 

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ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

Management is responsible for establishing and maintaining adequate internal control over financial reporting. Management has conducted an assessment of the Company’s internal controls over financial reporting as of June 30, 2012 using the criteria in Internal Control – Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

We acquired all of the shares of Deloro Stellite Holdings 1 Limited (Stellite) on March 1, 2012, and it represented approximately 17 percent of our total assets and 3 percent of our total revenues as of June 30, 2012. As this acquisition occurred during the last 12 months, the scope of our assessment of the effectiveness of internal control over financial reporting does not include Stellite. This exclusion is in accordance with the SEC’s general guidance that an assessment of a recently acquired business may be omitted from the scope of our assessment in the year of acquisition.

Based on its assessment, management has concluded that the Company maintained effective internal control over financial reporting as of June 30, 2012, based on criteria in Internal Control – Integrated Framework issued by the COSO. The effectiveness of the Company’s internal control over financial reporting as of June 30, 2012 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which appears herein.

 

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Report of Independent Registered Public Accounting Firm

To the Shareowners of Kennametal Inc.:

In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, shareowners’ equity and cash flow present fairly, in all material respects, the financial position of Kennametal Inc. and its subsidiaries at June 30, 2012 and 2011, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 2012 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of June 30, 2012, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 8. Our responsibility is to express opinions on these financial statements, on the financial statement schedule, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

As described in Management’s Report on Internal Control over Financial Reporting, management has excluded Deloro Stellite Holdings 1 Limited from its assessment of internal control over financial reporting as of June 30, 2012 because it was acquired by the Company in a business combination during March 2012. We have also excluded Deloro Stellite Holdings 1 Limited from our audit of internal control over financial reporting. Deloro Stellite Holdings 1 Limited is a wholly-owned subsidiary whose total assets and total revenues represent $526.7 million and $90.1 million, respectively, of the related consolidated financial statement amounts as of and for the year ended June 30, 2012.

/s/ PricewaterhouseCoopers LLP

PricewaterhouseCoopers LLP

Pittsburgh, Pennsylvania

August 13, 2012

 

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CONSOLIDATED STATEMENTS OF INCOME

 

Year ended June 30 (in thousands, except per share data)    2012     2011      2010  

Sales

   $   2,736,246      $   2,403,493       $   1,884,067   

Cost of goods sold

     1,741,996        1,519,102         1,256,339   

Gross profit

     994,250        884,391         627,728   

Operating expense

     561,490        538,530         477,487   

Restructuring charges (Note 15)

     -          12,586         43,923   

Amortization of intangibles

     16,351        11,602         13,090   

Operating income

     416,409        321,673         93,228   

Interest expense

     27,215        22,760         25,203   

Other (income) expense, net

     (775     2,780         (8,577

Income from continuing operations before income taxes

     389,969        296,133         76,602   

Provision for income taxes (Note 12)

     79,136        63,856         26,977   

Income from continuing operations

     310,833        232,277         49,625   

Loss from discontinued operations (Note 5)

     -        -         (1,423

Net income

     310,833        232,277         48,202   

Less: Net income attributable to noncontrolling interests

     3,603        2,550         1,783   

Net income attributable to Kennametal

   $ 307,230      $ 229,727       $ 46,419   
                           

Amounts attributable to Kennametal Shareowners:

       

Income from continuing operations

   $ 307,230      $ 229,727       $ 47,842   

Loss from discontinued operations (Note 5)

     -        -         (1,423

Net income attributable to Kennametal

   $ 307,230      $ 229,727       $ 46,419   
                           

PER SHARE DATA ATTRIBUTABLE TO KENNAMETAL

       

Basic earnings per share:

       

Continuing operations

   $ 3.83      $ 2.80       $ 0.59   

Discontinued operations

     -          -           (0.02
     $ 3.83      $ 2.80       $ 0.57   
                           

Diluted earnings per share:

       

Continuing operations

   $ 3.77      $ 2.76       $ 0.59   

Discontinued operations

     -          -           (0.02
     $ 3.77      $ 2.76       $ 0.57   
                           

Dividends per share

   $ 0.54      $ 0.48       $ 0.48   
                           

Basic weighted average shares outstanding

     80,216        82,063         80,966   
                           

Diluted weighted average shares outstanding

     81,439        83,173         81,690   
                           

The accompanying notes are an integral part of these consolidated financial statements.

 

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CONSOLIDATED BALANCE SHEETS

 

                                             
As of June 30 (in thousands, except per share data)    2012     2011  

ASSETS

    

Current assets:

    

Cash and cash equivalents

   $ 116,466      $ 204,565   

Accounts receivable, less allowance for doubtful accounts of $12,530 and $20,958

     478,989        447,835   

Inventories (Note 8)

     585,856        519,973   

Deferred income taxes (Note 12)

     51,017        60,257   

Other current assets

     50,634        54,955   

Total current assets

     1,282,962        1,287,585   

Property, plant and equipment:

    

Land and buildings

     379,034        373,971   

Machinery and equipment

     1,396,359        1,396,306   

Less accumulated depreciation

     (1,033,192     (1,073,215

Property, plant and equipment, net

     742,201        697,062   

Other assets:

    

Investments in affiliated companies

     685        829   

Goodwill (Note 2)

     719,350        511,328   

Other intangible assets, less accumulated amortization of $89,886 and $78,712 (Note 2)

     243,487        152,279   

Deferred income taxes (Note 12)

     25,205        29,876   

Other

     20,298        75,510   

Total other assets

     1,009,025        769,822   

Total assets

   $ 3,034,188      $ 2,754,469   
                  

LIABILITIES

    

Current liabilities:

    

Current maturities of long-term debt and capital leases (Note 10)

   $ 33,572      $ 307,304   

Notes payable to banks (Note 11)

     41,565        3,659   

Accounts payable

     219,475        222,678   

Accrued income taxes (Note 12)

     39,270        38,098   

Accrued vacation pay

     35,987        37,311   

Accrued payroll

     61,190        65,265   

Other current liabilities (Note 9)

     147,563        167,206   

Total current liabilities

     578,622        841,521   

Long-term debt and capital leases, less current maturities (Note 10)

     490,608        1,919   

Deferred income taxes (Note 12)

     69,134        83,310   

Accrued postretirement benefits (Note 13)

     22,766        17,853   

Accrued pension benefits (Note 13)

     167,981        117,066   

Accrued income taxes (Note 12)

     3,964        3,094   

Other liabilities

     32,892        31,065   

Total liabilities

     1,365,967        1,095,828   

Commitments and contingencies (Note 19)

                

EQUITY

    

Kennametal Shareowners' Equity:

    

Preferred stock, no par value; 5,000 shares authorized; none issued

     -          -     

Capital stock, $1.25 par value; 120,000 shares authorized;
80,085 and 81,129 shares issued

     100,106        101,411   

Additional paid-in capital

     447,433        470,758   

Retained earnings

     1,246,973        983,374   

Accumulated other comprehensive (loss) income

     (150,662     82,529   

Total Kennametal Shareowners’ Equity

     1,643,850        1,638,072   

Noncontrolling interests

     24,371        20,569   

Total equity

     1,668,221        1,658,641   

Total liabilities and equity

   $ 3,034,188      $ 2,754,469   
                  

The accompanying notes are an integral part of these consolidated financial statements.

 

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CONSOLIDATED STATEMENTS OF CASH FLOW

 

                                                                    
Year ended June 30 (in thousands)    2012     2011     2010  

OPERATING ACTIVITIES

      

Net income

   $ 310,833      $ 232,277      $ 48,202   

Adjustments for non-cash items:

      

Depreciation

     87,722        81,869        83,339   

Amortization

     16,351        11,602        13,090   

Stock-based compensation expense

     21,500        18,852        16,640   

Restructuring charges (Note 15)

     -        2,914        855   

Loss on divestitures

     -        -        527   

Deferred income tax provision (benefit)

     28,602        (7,881     230   

Other

     (12,702     (9,872     (4,506

Changes in certain assets and liabilities:

      

Accounts receivable

     (10,891     (89,153     (58,245

Inventories

     (63,833     (124,082     (2,576

Accounts payable and accrued liabilities

     (57,003     100,325        40,985   

Accrued income taxes

     (14,157     22,158        19,227   

Other

     (16,842     (8,212     7,060   

Net cash flow provided by operating activities

     289,580        230,797        164,828   

INVESTING ACTIVITIES

      

Purchases of property, plant and equipment

     (103,036     (83,442     (56,679

Disposals of property, plant and equipment

     6,886        9,755        5,141   

Business acquisitions, net of cash acquired (Note 4)

     (382,562     -        (16,969

Purchase of technology license (Note 2)

     (10,000     -        -   

Proceeds from divestitures (Note 5)

     -        -        27,788   

Proceeds from sale of investments in affiliated companies

     -        1,723        23   

Other

     1,447        139        276   

Net cash flow used for investing activities

     (487,265     (71,825     (40,420

FINANCING ACTIVITIES

      

Net increase (decrease) in notes payable

     38,198        (15,992     (27,335

Net increase in short-term revolving and other lines of credit

     27,200        -        -   

Term debt borrowings

     1,509,767        450,109        564,366   

Term debt repayments

     (1,324,426     (451,748     (680,023

Purchase of capital stock

     (66,876     (57,909     (306

Settlement of interest rate swap agreement (Note 7)

     (22,406     -        -   

Net proceeds from equity offering

     -        -        120,696   

Dividend reinvestment and the effect of employee benefit and stock plans

     24,635        18,328        10,677   

Cash dividends paid to shareowners

     (43,631     (39,801     (39,316

Other

     (11,162     988        (6,926

Net cash flow provided by (used for) financing activities

     131,299        (96,025     (58,167

Effect of exchange rate changes on cash and cash equivalents

     (21,713     23,489        (17,935

CASH AND CASH EQUIVALENTS

      

Net (decrease) increase in cash and cash equivalents

     (88,099     86,436        48,306   

Cash and cash equivalents, beginning of period

     204,565        118,129        69,823   

Cash and cash equivalents, end of period

   $ 116,466      $ 204,565      $ 118,129   
                          

The accompanying notes are an integral part of these consolidated financial statements.

 

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CONSOLIDATED STATEMENTS OF SHAREOWNERS' EQUITY

 

     2012     2011     2010  
Year ended June 30 (in thousands)    Shares     Amount     Shares     Amount     Shares     Amount  

CAPITAL STOCK

            

Balance at beginning of year

     81,129      $ 101,411        81,903      $ 102,379        73,232      $ 91,540   

Dividend reinvestment

     8        10        8        10        12        15   

Capital stock issued under employee benefit and stock plans

     956        1,195        721        901        621        776   

Equity offering

     -          -          -          -          8,050        10,063   

Purchase of capital stock

     (2,008     (2,510     (1,503     (1,879     (12     (15

Balance at end of year

     80,085        100,106        81,129        101,411        81,903        102,379   

ADDITIONAL PAID-IN CAPITAL

            

Balance at beginning of year

       470,758          492,454          357,839   

Dividend reinvestment

       282          354          290   

Capital stock issued under employee benefit and stock plans

       40,758          33,980          23,986   

Equity offering

       -            -            110,630   

Purchase of capital stock

             (64,365             (56,030             (291

Balance at end of year

             447,433                470,758                492,454   

RETAINED EARNINGS

            

Balance at beginning of year

       983,374          793,448          786,345   

Net income

       307,230          229,727          46,419   

Cash dividends paid to shareowners

             (43,631             (39,801             (39,316

Balance at end of year

             1,246,973                983,374                793,448   

ACCUMULATED OTHER COMPREHENSIVE (LOSS) INCOME

            

Balance at beginning of year

       82,529          (72,781       11,719   

Unrealized loss on derivatives designated and

qualified as cash flow hedges, net of tax

       (11,623       (679       (936

Reclassification of unrealized loss (gain) on expired

derivatives designated and qualified as cash flow hedges, net of tax

       272          642          (1,482

Unrecognized net pension and other postretirement

benefit (loss) gains, net of tax

       (90,686       28,087          (17,397

Reclassification of net pension and other

postemployment benefit losses, net of tax

       5,964          7,131          2,975   

Foreign currency translation adjustments, net of tax

             (137,118             120,129                (67,660

Other comprehensive (loss) income, net of tax

             (233,191             155,310                (84,500

Balance at end of year

             (150,662             82,529                (72,781

NONCONTROLLING INTERESTS

            

Balance at beginning of year

       20,569          17,943          20,012   

Net income

       3,603          2,550          1,783   

Other comprehensive (loss) income, net of tax

       (3,679       2,229          (1,177

Purchase of noncontrolling interests

       5,211          -            (401

Cash dividends paid to noncontrolling interests

             (1,333             (2,153             (2,274

Balance at end of year

             24,371                20,569                17,943   

Total equity, June 30

           $   1,668,221              $   1,658,641              $   1,333,443   
                                                  

The accompanying notes are an integral part of these consolidated financial statements.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 — NATURE OF OPERATIONS

Kennametal Inc. delivers productivity to customers seeking peak performance in demanding environments by providing innovative custom and standard wear-resistant solutions, enabled through our advanced materials sciences, application knowledge and commitment to a sustainable environment. We believe that our reputation for manufacturing excellence, as well as our technological expertise and innovation in our principal products, has helped us to achieve a leading market presence in our primary markets. End users of our products include metalworking manufacturers and suppliers across a diverse array of industries, including the aerospace, defense, transportation, machine tool, light machinery and heavy machinery industries, as well as manufacturers, producers and suppliers in a number of other industries including coal mining, highway construction, quarrying, and oil and gas exploration and production industries. Our end users’ products include items ranging from airframes to coal mining, engines to oil wells and turbochargers to construction.

Unless otherwise specified, any reference to a “year” is to a fiscal year ended June 30. When used in this annual report on Form 10-K, unless the context requires otherwise, the terms “we,” “our” and “us” refer to Kennametal Inc. and its subsidiaries.

NOTE 2 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The summary of our significant accounting policies is presented below to assist in evaluating our consolidated financial statements.

PRINCIPLES OF CONSOLIDATION The consolidated financial statements include our accounts and those of our majority-owned subsidiaries. All significant intercompany balances and transactions are eliminated. Investments in entities of less than 50 percent of the voting stock over which we have significant influence are accounted for on an equity basis. The factors used to determine significant influence include, but are not limited to, our 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 50 percent of the voting stock in which we do not have significant influence are accounted for on the cost basis.

USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS In preparing our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, we make judgments and estimates about the amounts reflected in our financial statements. As part of our financial reporting process, our management collaborates to determine the necessary information on which to base our judgments and develop estimates used to prepare the financial statements. We use historical experience and available information to make these judgments and estimates. However, different amounts could be reported using different assumptions and in light of different facts and circumstances. Therefore, actual amounts could differ from the estimates reflected in our financial statements.

CASH AND CASH EQUIVALENTS Cash investments having original maturities of three months or less are considered cash equivalents. Cash equivalents principally consist of investments in money market funds and bank deposits at June 30, 2012.

ACCOUNTS RECEIVABLE We market our products to a diverse customer base throughout the world. Trade credit is extended based upon periodically updated evaluations of each customer’s ability to satisfy its obligations. We make judgments as to our ability to collect outstanding receivables and provide allowances for the portion of receivables when collection becomes doubtful. Accounts receivable reserves are determined based upon an aging of accounts and a review of specific accounts.

INVENTORIES Inventories are stated at the lower of cost or market. We use the last-in, first-out (LIFO) method for determining the cost of a significant portion of our United States (U.S.) inventories. The cost of the remainder of our inventories is determined under the first-in, first-out or average cost methods. When market conditions indicate an excess of carrying costs over market value, a lower-of-cost-or-market provision is recorded. Excess and obsolete inventory reserves are established based upon our evaluation of the quantity of inventory on hand relative to demand. The excess and obsolete inventory reserve at June 30, 2012 and 2011 was $55.0 million and $55.3 million, respectively.

PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are carried at cost. Major improvements are capitalized, while maintenance and repairs are expensed as incurred. Retirements and disposals are removed from cost and accumulated depreciation accounts, with the gain or loss reflected in operating income. Interest related to the construction of major facilities is capitalized as part of the construction costs and is depreciated over the facilities estimated useful life.

 

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Depreciation for financial reporting purposes is computed using the straight-line method over the following estimated useful lives: building and improvements over 15-40 years; machinery and equipment over 4-15 years; furniture and fixtures over 5-10 years and computer hardware and software over 3-5 years.

Leased property and equipment under capital leases are depreciated using the straight-line method over the terms of the related leases.

LONG-LIVED ASSETS We evaluate the recoverability of property, plant and equipment and intangible assets that are amortized, whenever events or changes in circumstances indicate the carrying amount of any such assets may not be fully recoverable. Changes in circumstances include technological advances, changes in our business model, capital structure, economic conditions or operating performance. Our evaluation is based upon, among other things, our assumptions about the estimated future undiscounted cash flows these assets are expected to generate. When the sum of the undiscounted cash flows is less than the carrying value of the asset or asset group, we will recognize an impairment loss to the extent that carrying value exceeds fair value. We apply our best judgment when performing these evaluations to determine if a triggering event has occurred, the undiscounted cash flows used to assess recoverability and the fair value of the asset.

 

GOODWILL AND OTHER INTANGIBLE ASSETS Goodwill represents the excess of cost over the fair value of the net assets of acquired companies. Goodwill and other intangible assets with indefinite lives are tested at least annually for impairment. We perform our annual impairment tests during the June quarter in connection with our annual planning process unless there are impairment indicators that warrant a test prior to that.

The carrying amount of goodwill attributable to each segment at June 30 is as follows:

 

                                                                    
(in thousands)    Industrial     Infrastructure     Total  

Goodwill

   $ 393,974      $ 246,311      $ 640,285   

Accumulated impairment losses

     (150,842     -            (150,842

Balance as of June 30, 2010

   $ 243,132      $ 246,311      $ 489,443   
                          

Translation

     17,971        3,914        21,885   

Change in goodwill

     17,971        3,914        21,885   

Goodwill

   $ 411,945      $ 250,225      $ 662,170   

Accumulated impairment losses

     (150,842     -        (150,842

Balance as of June 30, 2011

   $ 261,103      $ 250,225      $ 511,328   
                          

Acquisition

   $ -          $ 242,553      $ 242,553   

Translation

     (17,062     (17,469     (34,531

Change in goodwill

     (17,062     225,084        208,022   

Goodwill

     394,883        475,309        870,192   

Accumulated impairment losses

     (150,842     -        (150,842

Balance as of June 30, 2012

   $ 244,041      $ 475,309      $ 719,350   
                          

We recorded no goodwill or other intangible asset impairments in 2012, 2011 and 2010.

The components of our other intangible assets were as follows as of June 30:

 

                                                                                                                  
     Estimated      June 30, 2012     June 30, 2011  
(in thousands)   

Useful Life

(in years)

     Gross Carrying
Amount
     Accumulated
Amortization
    Gross Carrying
Amount
     Accumulated
Amortization
 

Contract-based

     4 to 15       $ 21,450       $ (6,423   $ 6,349       $ (5,380

Technology-based and other

     4 to 17         37,594         (24,384     39,743         (25,442

Customer-related

     10 to 20         178,500         (44,354     113,977         (38,275

Unpatented technology

     15 to 30         46,035         (6,943     19,540         (4,740

Trademarks

     5 to 20         13,977         (7,782     10,902         (4,875

Trademarks

     Indefinite         35,817         -            40,480         -       

Total

            $ 333,373       $ (89,886   $ 230,991       $ (78,712
                                             

\

 

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As of March 1, 2012 we acquired Stellite in our Infrastructure segment. As a result we increased goodwill by $242.6 million and other intangible assets by $103.8 million based on purchase price allocations. We recorded customer-related intangible assets of $73.8 million with an estimated useful life of 20 years, unpatented technology-based intangible assets of $28.3 million with an estimated useful life of 15 - 17 years and trademarks of $1.7 million with an estimated useful life of 5 years. These intangible assets will be amortized using the straight-line method over their respective estimated useful lives.

During the year ended June 30, 2012, we entered into a technology license agreement in our Infrastructure segment. This resulted in a $15.0 million increase of contract-based intangible assets. The technology license agreement will be amortized using the straight-line method over an estimated useful life of 10 years.

During 2012, we recorded foreign currency translation adjustments which decreased intangible assets by $11.1 million. During 2011, we recorded foreign currency translation adjustments which increased intangible assets by $8.5 million.

Amortization expense for intangible assets was $16.4 million, $11.6 million and $13.1 million for 2012, 2011 and 2010, respectively. Estimated amortization expense for 2013 through 2017 is $20.9 million, $19.9 million, $19.1 million, $18.8 million, and $16.9 million, respectively.

PENSION AND OTHER POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS We sponsor these types of benefit plans for certain employees and retirees. Accounting for the cost of these plans requires the estimation of the cost of the benefits to be provided well into the future and attributing that cost over the expected work life of employees participating in these plans. This estimation requires our judgment about the discount rate used to determine these obligations, expected return on plan assets, rate of future compensation increases, rate of future health care costs, withdrawal and mortality rates and participant retirement age. Differences between our estimates and actual results may significantly affect the cost of our obligations under these plans.

In the valuation of our pension and other postretirement and postemployment benefit liabilities, management utilizes various assumptions. We determine our discount rate based on investment grade bond yield curves with a duration 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 year and adjusted for administrative charges. This rate is expected to decrease until 2029.

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 a review of published mortality tables.

EARNINGS PER SHARE Basic earnings per share is computed using the weighted average number of shares outstanding during the period, while diluted earnings per share is calculated to reflect the potential dilution that occurs related to the issuance of capital stock under stock option grants, restricted stock awards and restricted stock units. The difference between basic and diluted earnings per share relates solely to the effect of capital stock options, restricted stock awards and restricted stock units.

For purposes of determining the number of diluted shares outstanding at June 30, 2012, 2011 and 2010, weighted average shares outstanding for basic earnings per share calculations were increased due solely to the dilutive effect of unexercised capital stock options, unvested restricted stock awards and unvested restricted stock units by 1.2 million, 1.1 million and 0.7 million shares, respectively. Unexercised capital stock options, restricted stock units and restricted stock awards of 0.7 million, 0.4 million and 2.3 million shares at June 30, 2012, 2011, and 2010, respectively, were not included in the computation of diluted earnings per share because the option exercise price was greater than the average market price, and therefore the inclusion would have been anti-dilutive.

 

REVENUE RECOGNITION We recognize revenue upon shipment of our products and assembled machines. Our general conditions of sale explicitly state that the delivery of our products and assembled machines is F.O.B. shipping point and that title and all risks of loss and damage pass to the buyer upon delivery of the sold products or assembled machines to the common carrier.

 

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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 10 calendar days of the date specified on the invoice. We do not ship products or assembled machines unless we have documentation from our customers authorizing shipment. Our products are consumed by our customers in the manufacture of their products. Historically, we have experienced very low levels of returned products and assembled machines and do not consider the effect of returned products and assembled machines to be material. We have recorded an estimated returned goods allowance to provide for any potential returns.

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 30 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 the customer of shipping instructions from Kennametal. We have included an estimated allowance for warranty returns in our returned goods allowance.

We recognize revenue related to the sale of specialized assembled machines upon customer acceptance and installation, as installation is deemed essential to the functionality of a specialized assembled machine. Sales of specialized assembled machines were immaterial for 2012, 2011 and 2010.

STOCK-BASED COMPENSATION We recognize stock-based compensation expense for all stock options, restricted stock awards and restricted stock units over the period from the date of grant to the date when the award is no longer contingent on the employee providing additional service (substantive vesting period). We utilize the Black-Scholes valuation method to establish the fair value of all stock option awards.

Capital stock options are granted to eligible employees at fair market value at the date of grant. Capital stock options are exercisable under specified conditions for up to 10 years from the date of grant. On October 26, 2010, the Company’s Shareowners approved the Kennametal Inc., Stock and Incentive Plan of 2010 (2010 Plan). The 2010 Plan authorizes the issuance of up to 3,500,000 shares of the Company’s capital stock plus any shares remaining unissued under the Kennametal Inc. Stock and Incentive Plan of 2002, as amended (2002 Plan). Under the provisions of these Plans, participants may deliver our stock, owned by the holder for at least six months, in payment of the option price and receive credit for the fair market value of the shares on the date of delivery. The fair value of shares delivered during 2012, 2011 and 2010 was $0.4 million, $0.8 million and $0.1 million, respectively. In addition to stock option grants, these Plans permit the award of stock appreciation rights, performance share awards, performance unit awards, restricted stock awards, restricted unit awards and share awards to directors, officers and key employees.

RESEARCH AND DEVELOPMENT COSTS Research and development costs of $38.3 million, $33.3 million and $28.0 million in 2012, 2011 and 2010, respectively, were expensed as incurred. These costs are included in operating expense in the consolidated statements of income.

SHIPPING AND HANDLING FEES AND COSTS All fees billed to customers for shipping and handling are classified as a component of sales. All costs associated with shipping and handling are classified as a component of cost of goods sold.

INCOME TAXES Deferred income taxes are recognized based on the future income tax effects (using enacted tax laws and rates) of differences in the carrying amounts of assets and liabilities for financial reporting and tax purposes. A valuation allowance is recognized if it is “more likely than not” that some or all of a deferred tax asset will not be realized.

DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES As part of our financial risk management program, we use certain derivative financial instruments. We do not enter into derivative transactions for speculative purposes and, therefore, hold no derivative instruments for trading purposes. We use derivative financial instruments to provide predictability to the effects of changes in foreign exchange rates on our consolidated results, achieve our targeted mix of fixed and floating interest rates on outstanding debt and forecasted transactions. Our objective in managing foreign exchange exposures with derivative instruments is to reduce volatility in cash flow, allowing us to focus more of our attention on business operations. With respect to interest rate management, these derivative instruments allow us to achieve our targeted fixed-to-floating interest rate mix, as a separate decision from funding arrangements, in the bank and public debt markets.

We account for derivative instruments as a hedge of the related asset, liability, firm commitment or anticipated transaction, when the derivative is specifically designated as a hedge of such items. We measure hedge effectiveness by assessing the changes in the fair value or expected future cash flows of the hedged item. The ineffective portions are recorded in other (income) expense, net. Certain currency forward contracts hedging significant cross-border intercompany loans are considered other derivatives and, therefore, do not qualify for hedge accounting. These contracts are recorded at fair value in the balance sheet, with the offset to other (income) expense, net.

 

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CASH FLOW HEDGES Currency Forward contracts and range forward contracts (a transaction where both a put option is purchased and a call option is sold) are designated as cash flow hedges and hedge anticipated cash flows from cross-border intercompany sales of products and services. Gains and losses realized on these contracts at maturity are recorded in accumulated other comprehensive (loss) income, and are recognized as a component of other (income) expense, net when the underlying sale of products or services is recognized into earnings.

Interest Rate Floating-to-fixed interest rate swap contracts, designated as cash flow hedges, are entered into from time to time to hedge our exposure to interest rate changes on a portion of our floating rate debt. These interest rate swap contracts convert a portion of our floating rate debt to fixed rate debt. We record the fair value of these contracts as an asset or a liability, as applicable, in the balance sheet, with the offset to accumulated other comprehensive (loss) income.

FAIR VALUE HEDGES Interest Rate Fixed-to-floating interest rate swap contracts, designated as fair value hedges, are entered into from time to time to hedge our exposure to fair value fluctuations on a portion of our fixed rate debt. These interest rate swap contracts convert a portion of our fixed rate debt to floating rate debt. When in place, these contracts require periodic settlement, and the difference between amounts to be received and paid under the contracts is recognized in interest expense.

FOREIGN CURRENCY TRANSLATION Assets and liabilities of international operations are translated into U.S. dollars using year-end exchange rates, while revenues and expenses are translated at average exchange rates throughout the year. The resulting net translation adjustments are recorded as a component of accumulated other comprehensive (loss) income. The local currency is the functional currency of most of our locations. Losses from foreign currency transactions included in other (income) expense, net were $2.6 million and $6.6 million for 2012 and 2011, respectively. Gains from foreign currency transactions included in other (income) expense, net were $3.5 million for 2010.

NEW ACCOUNTING STANDARDS

Adopted

As of January 1, 2012, Kennametal adopted changes to fair value measurements and disclosure. Many of the amendments in this guidance represent clarifications to existing guidance or changes in the measurement guidance for determining fair value. The most significant change in disclosures is an expansion of the information required for Level 3 measurements. Disclosures will be required about the use of a nonfinancial asset measured or disclosed at fair value if its use differs from its highest and best use. In addition, entities must report the level in the fair value hierarchy of assets and liabilities not recorded at fair value but where fair value is disclosed. The adoption of this guidance did not have an impact on our consolidated financial statements.

Issued

In June 2012, the Financial Accounting Standards Board (FASB) issued additional guidance on testing indefinite lived intangible assets for impairment. The guidance permits an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of the indefinite lived intangible assets is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step impairment test. This guidance is effective for Kennametal beginning July 1, 2013, with early adoption is permitted.

In December 2011, the FASB deferred the requirement to present reclassifications of other comprehensive income on the face of the income statement. Companies would still be required to adopt the other requirements contained in the accounting guidance on presentation of other comprehensive income. This guidance is effective for Kennametal beginning July 1, 2012.

In June 2011, the FASB issued guidance on presentation of comprehensive income. This guidance eliminates the current option to report other comprehensive income and its components in the statement of changes in equity. An entity can elect to present items of net income and other comprehensive income in one continuous statement or in two separate consecutive statements. Each component of net income and other comprehensive income, together with totals for comprehensive income and its two parts, net income and other comprehensive income, would need to be displayed under either alternative. This guidance is effective for Kennametal beginning July 1, 2012.

In September 2011, the FASB issued additional guidance on testing goodwill for impairment. The guidance permits an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. This guidance is effective for Kennametal beginning July 1, 2012.

 

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NOTE 3 — SUPPLEMENTAL CASH FLOW INFORMATION

 

                                                                    
Year ended June 30 (in thousands)    2012      2011      2010  

Cash paid during the period for:

        

Interest

   $ 27,395       $ 26,624       $ 28,626   

Income taxes

     55,728         60,459         3,788   

Supplemental disclosure of non-cash information:

        

Contribution of capital stock to employees' defined contribution benefit plans

     -             948         6,352   

NOTE 4 — ACQUISITION

On March 1, 2012, the Company acquired all of the shares of Stellite pursuant to the terms of the Share Sale and Purchase Agreement dated January 13, 2012. The U.K.-based Stellite is a global manufacturer and provider of alloy-based critical wear solutions for extreme environments involving high temperature, corrosion and abrasion. Stellite employs approximately 1,300 people across seven primary operating facilities globally, including locations in the U.S., Canada, Germany, Italy, India and China. Stellite’s proprietary metal alloys, materials expertise, engineering design and fabrication capabilities complement Kennametal’s current business in the oil and gas, power generation, transportation and aerospace end markets. This acquisition is in alignment with Kennametal’s growth strategy and positions us to further achieve geographic and end market balance.

Kennametal acquired Stellite for a purchase price of $382.6 million; net of cash acquired, and funded the acquisition through existing credit facilities and operating cash flows. As part of the acquisition of Stellite, Kennametal incurred $8.9 million of acquisition related costs, which are included in operating expense.

Purchase Price Allocation

This acquisition was accounted for under the acquisition method of accounting and accordingly, the purchase price has been allocated to the assets acquired and liabilities assumed based on fair values at the date of the acquisition. The Consolidated Balance Sheet as of June 30, 2012 reflects the allocation of the purchase price.

 

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The allocation of the total purchase price to the fair values of the assets acquired and liabilities assumed is as follows:

 

(in thousands)    Total

ASSETS

  

Current assets:

  

Accounts receivable

   $        44,414  

Inventories

   42,270  

Other current assets

   5,094  

Total current assets

   91,778  

Property and equipment

   76,146  

Goodwill

   242,553  

Other intangible assets

   103,793  

Deferred income taxes

   22,392  

Other

   70  

Total assets

   $      536,732  
      

LIABILITIES

  

Current liabilities:

  

Short term debt and current maturities of long-term debt

   $          4,685  

Accounts payable

   43,534  

Accrued income taxes

   24,688  

Other current liabilities

   17,487  

Total current liabilities

   90,394  

Long-term debt and capital leases

   5,379  

Deferred income taxes

   48,537  

Other long-term liabilities

   4,649  

Total liabilities

   148,959  

Noncontrolling interest

   5,211  

Net assets acquired

   $      382,562  
      

In connection with this acquisition, we identified and valued certain intangible assets, including existing customer relationships, technologies and trademarks, as discussed in Note 2. The goodwill recorded of $242.6 million is not deductible for tax purposes and is attributable to the operating synergies we expect to gain from the acquisition. These intangible assets are part of the Infrastructure segment.

The accompanying Consolidated Statement of Income, for the year ended June 30, 2012 includes net sales of $90.1 million and a net loss of $7.1 million related to Stellite since the acquisition date. This includes $8.9 million of acquisition related pre-tax costs.

Unaudited Pro Forma Financial Information

The following unaudited pro forma summary of operating results presents the consolidated results of operations as if the Stellite acquisition had occurred on July 1, 2010. These amounts were calculated after the conversion to U.S. GAAP, applying our accounting policies and adjusting Stellite’s results to reflect increased depreciation and amortization expense resulting from recording fixed assets and intangible assets at fair value and decreasing interest expense to reflect Kennametal’s more favorable borrowing rate, together with the related tax effects. The pro forma results for the year ended June 30, 2012 included $10.1 million of acquisition and integration related pre-tax costs. The pro forma results for the year ended June 30, 2011 includes $14.3 million of acquisition and integration related pre-tax costs. The pro forma results have been presented for comparative purposes only and are not indicative of future results of operations or what would have occurred had the acquisition been made on July 1, 2010.

 

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Year ended June 30 (in thousands)    2012      2011      

Pro forma (unaudited):

     

Net Sales

   $ 3,042,987       $     2,675,119       

Net income attributable to Kennametal

   $ 333,808       $ 238,409       

Per share data attributable to Kennametal :

     

Basic earnings per share

   $ 4.16       $ 2.91       

Diluted earnings per share

   $ 4.10       $ 2.87       

NOTE 5 — DISCONTINUED OPERATIONS

Effective June 30, 2009, we divested our high speed steel business (HSS) from our Industrial segment as part of our continuing focus to shape our business portfolio and rationalize our manufacturing footprint. This divestiture was accounted for as discontinued operations. The net assets disposed of as a result of this transaction had a net book value of approximately $51 million and consisted primarily of inventory and equipment, as well as owned and leased facilities. Cash proceeds from this divestiture amounted to $28.5 million, the majority of which was received in 2010. We incurred pre-tax charges related to the divestiture of $2.3 million and net of tax charges of $1.4 million during 2010. The pre-tax charges as well as the related tax effects were recorded in discontinued operations. No additional pre-tax charges were incurred related to this divestiture.

NOTE 6 — FAIR VALUE MEASUREMENTS

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value hierarchy consists of three levels to prioritize the inputs used in valuations, as defined below:

Level 1: Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

Level 2: Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, including quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability (e.g. interest rates); and inputs that are derived principally from or corroborated by observable market data by correlation or other means.

Level 3: Inputs that are unobservable.

As of June 30, 2012 the fair values of the Company’s financial assets and financial liabilities measured at fair value on a recurring basis are categorized as follows:

 

                                                                                           
(in thousands)    Level 1      Level 2      Level 3      Total

Assets:

           

Derivatives (1)

   $ -           $ 1,855       $ -           $      1,855  

Total assets at fair value

   $ -           $ 1,855       $ -           $      1,855  
                                 

Liabilities:

           

Derivatives (1)

   $ -           $ 193       $ -           $         193  

Total liabilities at fair value

   $ -           $ 193       $ -           $         193  
                                 

 

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As of June 30, 2011 the fair values of the Company’s financial assets and financial liabilities measured at fair value on a recurring basis are categorized as follows:

 

                                                                                           
(in thousands)    Level 1      Level 2      Level 3      Total

Assets:

           

Derivatives (1)

   $ -         $ 896       $ -         $           896  

Total assets at fair value

   $ -         $ 896       $ -         $           896  
                                 

Liabilities:

           

Derivatives (1)

   $ -         $ 3,330       $ -         $        3,330  

Total liabilities at fair value

   $ -         $ 3,330       $ -         $        3,330  
                                 

(1) Foreign currency derivatives and interest rate swap contracts are valued based on observable market spot and forward rates and are classified within Level 2 of the fair value hierarchy.

NOTE 7 — DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

As part of our financial risk management program, we use certain derivative financial instruments. See Note 2 for discussion on our derivative instruments and hedging activities policy.

The fair value of derivatives designated and not designated as hedging instruments in the consolidated balance sheets at June 30 is as follows:

 

                                             
`    2012     2011  

Derivatives designated as hedging instruments

    

Other current assets - range forward contracts

   $ 554      $ 87   

Other current liabilities - range forward contracts

     (193     (159

Other assets - range forward contracts

     3        -     

Other assets - forward starting interest rate swap contracts

     -          772   

Other liabilities - forward starting interest rate swap contracts

     -          (3,169

Total derivatives designated as hedging instruments

     364        (2,469

Derivatives not designated as hedging instruments

    

Other current assets - currency forward contracts

     1,298        37   

Other current liabilities - currency forward contracts

     -          (2

Total derivatives not designated as hedging instruments

     1,298        35   

Total derivatives

   $ 1,662      $ (2,434
                  

The following represents (gains) losses related to derivatives not designated as hedging instruments for the years ended June 30:

 

                                                                    
(in thousands)    2012     2011     2010  

Other (income) expense, net - currency forward contracts

   $ (1,149   $ (1,138   $ 1,077   
                          

FAIR VALUE HEDGES

Fixed-to-floating interest rate swap contracts, designated as fair value hedges, are entered into from time to time to hedge our exposure to fair value fluctuations on a portion of our fixed rate debt. We had no such contracts outstanding at June 30, 2012 and 2011, respectively.

In February 2009, we terminated interest rate swap contracts to convert $200 million of our fixed rate debt to floating rate debt. These contracts were originally set to mature in June 2012. This gain was amortized as a component of interest expense over the remaining term of the related debt using the effective interest rate method. During the years ended June 30, 2012, 2011 and 2010 $5.9 million, $5.9 million and $5.6 million, respectively were recognized as a reduction in interest expense.

 

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CASH FLOW HEDGES

Currency forward contracts and range forward contracts (a transaction where both a put option is purchased and a call option is sold) are designated as cash flow hedges and hedge anticipated cash flows from cross-border intercompany sales of products and services. Gains and losses realized on these contracts at maturity are recorded in accumulated other comprehensive (loss) income, and are recognized as a component of other (income) expense, net when the underlying sale of products or services is recognized into earnings. The notional amount of the contracts translated into U.S. dollars at June 30, 2012 and 2011 was $69.9 million and $37.6 million, respectively. The time value component of the fair value of range forwards is excluded from the assessment of hedge effectiveness. Assuming the market rates remain constant with the rates at June 30, 2012, we expect to recognize into earnings in the next 12 months $0.2 million of gains on outstanding derivatives.

Floating-to-fixed interest rate swap contracts, designated as cash flow hedges, are entered into from time to time to hedge our exposure to interest rate changes on a portion of our floating rate debt. These interest rate swap contracts convert a portion of our floating rate debt to fixed rate debt. We record the fair value of these contracts as an asset or a liability, as applicable, in the balance sheet, with the offset to accumulated other comprehensive (loss) income, net of tax.

In February 2012, we settled forward starting interest rate swap contracts to convert $150.0 million of our floating rate debt to fixed rate debt. Upon settlement, we made a cash payment of $22.4 million. The loss is being amortized as a component of interest expense over the term of the related debt using the effective interest rate method. During the year ended June 30, 2012, $0.7 million was recognized as interest expense. As of June 30, 2011, we recorded a liability of $2.4 million on these contracts which was recorded as a decrease to other comprehensive (loss) income, net of tax

The following represents gains (losses) related to cash flow hedges for the years ended June 30:

 

                                                        
(in thousands)    2012     2011     2010  

(Losses) gains recognized in other comprehensive (loss) income, net

   $ (11,793   $ (26   $ (962
                          

Losses (gains) reclassified from accumulated other comprehensive (loss) income into other (income) expense, net

   $ 272      $ 645      $ (1,107
                          

No portion of the gains or losses recognized in earnings was due to ineffectiveness and no amounts were excluded from our effectiveness testing for the years ended June 30, 2012, 2011 and 2010.

NOTE 8 — INVENTORIES

Inventories consisted of the following at June 30:

 

                                             
(in thousands)    2012     2011  

Finished goods

   $ 319,217      $ 303,716   

Work in process and powder blends

     252,035        202,940   

Raw materials

     135,454        109,683   

Inventories at current cost

     706,706        616,339   

Less: LIFO valuation

     (120,850     (96,366

Total inventories

   $ 585,856      $ 519,973   
                  

We used the LIFO method of valuing our inventories for approximately 49 percent and 50 percent of total inventories at June 30, 2012 and 2011, respectively.

 

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NOTE 9 — OTHER CURRENT LIABILITIES

Other current liabilities consisted of the following at June 30:

 

                                             
(in thousands)    2012      2011  

Accrued employee benefits

   $ 33,783       $ 55,833   

Payroll, state and local taxes

     14,290         15,997   

Accrued restructuring expense (Note 15)

     1,329         12,711   

Other

     98,161         82,665   

Total other current liabilities

   $ 147,563       $ 167,206   
                   
                                             

 

NOTE 10 — LONG-TERM DEBT AND CAPITAL LEASES

 

Long-term debt and capital lease obligations consisted of the following at June 30:

 

                                             
(in thousands)    2012     2011  

3.875% Senior Unsecured Notes due 2022 net of discount of $0.4 million for 2012

   $ 299,646      $ -   

Credit Agreement:

    

U.S. Dollar-denominated borrowings, 1.24% in 2012, due 2016

     212,200        -   

7.2% Senior Unsecured Notes due 2012 net of discount of $0.1 million for 2011
Also including interest rate swap adjustments of $6.1 million in 2011

     -        305,954   

Capital leases with terms expiring through 2018 at 2.3% to 5.7% in 2012 and
2.3% to 2.8% in 2011

     6,195        3,113   

Other

     6,139        156   

Total debt and capital leases

     524,180        309,223   

Less current maturities:

    

Long-term debt

     (27,200     (306,032

Other

     (5,814     -   

Capital leases

     (558     (1,272

Total current maturities

     (33,572     (307,304

Long-term debt and capital leases, less current maturities

   $ 490,608      $ 1,919   
                  

Senior Unsecured Notes On February 14, 2012, we issued $300 million of 3.875 percent Senior Unsecured Notes due in 2022. Interest will be paid semi-annually on February 15 and August 15 of each year. We settled forward starting interest rate swap contracts related to the bond issuance as discussed in Note 7. We applied the net proceeds from this notes offering to the repayment of our 7.2 percent Senior Unsecured Notes at their June 15, 2012 maturity. The 7.2 percent 10 year Senior Unsecured Notes issued in June 2002 with an aggregate face amount of $300 million were reclassified to current maturities of long-term debt as of June 30, 2011 and were repaid at their June 15, 2012 maturity.

2011 Credit Agreement On October 21, 2011, we entered into an amendment to our 2010 Credit Agreement, which is used to augment cash from operations and as an additional source of funds. The new five-year, multi-currency, revolving credit facility (2011 Credit Agreement) extends to October 2016 and permits revolving credit loans of up to $600.0 million for working capital, capital expenditures and general corporate purposes. The 2011 Credit Agreement allows for borrowings in U.S. dollars, euro, Canadian dollars, pound sterling and Japanese yen. Interest payable under the 2011 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 or the Federal Funds effective rate plus an applicable margin, or (3) fixed as negotiated by us.

The 2011 Credit Agreement requires us to comply with various restrictive and affirmative covenants, including two financial covenants: a maximum leverage ratio and a minimum consolidated interest coverage ratio (as those terms are defined in the agreement). We were in compliance with these financial covenants as of June 30, 2012. We had $212.2 million of borrowings outstanding under the 2011 Credit Agreement as of June 30, 2012. We had no borrowings outstanding under the 2010 Credit Agreement as of June 30, 2011.

Borrowings under the 2011 Credit Agreement are guaranteed by our significant domestic subsidiaries.

Future principal maturities of long-term debt are $33.3 million in 2013, $185.0 million in 2016 and $300.0 million beyond 2017.

 

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Future minimum lease payments under capital leases for the next five years and thereafter in total are as follows:

 

                      
(in thousands)        

2013

   $ 803   

2014

     2,574   

2015

     1,658   

2016

     1,079   

2017

     601   

After 2017

     199   

Total future minimum lease payments

     6,914   

Less amount representing interest

     (719

Amount recognized as capital lease obligations

   $ 6,195   
          

Our collateralized debt at June 30, 2012 and 2011 was comprised of industrial revenue bond obligations of $0.1 million and $0.2 million, respectively, and the capitalized lease obligations of $6.2 million and $3.1 million, respectively. The underlying assets collateralize these obligations.

NOTE 11NOTES PAYABLE AND LINES OF CREDIT

Notes payable to banks of $41.6 million and $3.7 million at June 30, 2012 and 2011, respectively, represents short-term borrowings under credit lines with commercial banks. These credit lines, translated into U.S. dollars at June 30, 2012 exchange rates, totaled $127.1 million at June 30, 2012, of which $85.5 million was unused. The weighted average interest rate for notes payable and lines of credit was 2.5 percent and 4.4 percent at June 30, 2012 and 2011, respectively.

NOTE 12 INCOME TAXES

Income from continuing operations before income taxes consisted of the following for the years ended June 30:

 

                                                              
(in thousands)    2012      2011     2010  

Income from continuing operations before income taxes:

       

United States

   $ 95,410       $ 69,042      $ 3,925   

International

     294,559         227,091        72,677   

Total income from continuing operations before income taxes

   $ 389,969       $ 296,133      $ 76,602   
                           

Current income taxes:

       

Federal

   $ 23,313       $ 26,234      $ 1,915   

State

     2,275         1,063        1,376   

International

     24,946         44,440        23,456   

Total current income taxes

     50,534         71,737        26,747   

Deferred income taxes

     28,602         (7,881     230   

Provision for income taxes

   $ 79,136       $ 63,856      $ 26,977   
                           

Effective tax rate

     20.3%         21.6%        35.2%   

The reconciliation of income taxes computed using the statutory U.S. income tax rate and the provision for income taxes was as follows for the years ended June 30:

 

                                                              
(in thousands)    2012     2011     2010  

Income taxes at U.S. statutory rate

   $ 136,489      $ 103,647      $ 26,811   

State income taxes, net of federal tax benefits

     4,110        1,956        2,290   

U.S. income taxes provided on international income

     8,164        21,556        1,107   

Combined tax effects of international income

     (50,574     (35,423     (4,460

Change in valuation allowance and other uncertain tax positions

     (16,243     (20,215     2,024   

Impact of domestic production activities deduction

     (3,810     (6,413     (456

Research and development credit

     (1,515     (2,685     (460

Other

     2,515        1,433        121   

Provision for income taxes

   $ 79,136      $ 63,856      $ 26,977   
                          

 

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During 2012, we recorded net valuation allowance adjustments of $6.9 million, which reduced income tax expense. The valuation allowance adjustments reflect a change in judgment about the realizability of certain deferred tax assets in the Netherlands. The effect of these tax benefits is included in the income tax reconciliation table under the caption “change in valuation allowance and other uncertain tax positions.”

During 2012, we recorded adjustments of $9.0 million related to the effective settlement of uncertain tax positions in the U.S., Europe and Asia, which reduced income tax expense. The effect of these tax benefits is included in the income tax reconciliation table under the caption “change in valuation allowance and other uncertain tax positions.”

During 2011, we recorded net valuation allowance adjustments of $20.5 million, which reduced income tax expense. The valuation allowance adjustments reflect a change in judgment about the realizability of certain deferred tax assets in the United Kingdom and Europe. The effect of this tax benefit is included in the income tax reconciliation table under the caption “change in valuation allowance and other uncertain tax positions.”

During 2011, we incurred U.S. Federal income taxes of $17.9 million associated with dividends of international subsidiary current year income. The effect of this expense is included in the income tax reconciliation table under the caption “U.S. income taxes provided on international income.”

During 2010, we recorded restructuring charges related to our engineered products business for which there was no tax benefit. The effect of this is included in the income tax reconciliation table under the caption “combined tax effects of international income.”

The components of net deferred tax assets and liabilities were as follows at June 30:

 

                                             
(in thousands)    2012     2011  

Deferred tax assets:

    

Net operating loss carryforwards

   $ 68,782      $ 65,768   

Inventory valuation and reserves

     26,363        29,646   

Pension benefits

     38,552        713   

Other postretirement benefits

     9,958        8,312   

Accrued employee benefits

     30,179        30,975   

Other accrued liabilities

     8,857        7,939   

Hedging activities

     13,338        13,528   

Tax credits and other carryforwards

     6,354        5,431   

Other

     -        2,558   

Total

     202,383        164,870   

Valuation allowance

     (19,502     (25,662

Total deferred tax assets

   $ 182,881      $ 139,208   

Deferred tax liabilities:

    

Tax depreciation in excess of book

   $ 109,948      $ 98,957   

Intangible assets

     68,806        35,965   

Other

     448        -   

Total deferred tax liabilities

   $ 179,202      $ 134,922   

Total net deferred tax assets

   $ 3,679      $ 4,286   
                  

Included in deferred tax assets at June 30, 2012 is $68.8 million associated with net operating loss carryforwards in federal, state and foreign jurisdictions. Of that amount, $8.0 million expires through June 2017, $6.9 million expires through 2022, $7.0 million expires through 2027, $12.8 million expires through 2032, and the remaining $34.1 million do not expire. The realization of these tax benefits is primarily dependent on future taxable income in these jurisdictions.

A valuation allowance of $19.5 million has been placed against deferred tax assets in Europe, China, Hong Kong, Brazil and the U.S., which $16.1 million would be allocated to income tax expense and $3.4 million would be allocated to either income tax expense or goodwill, depending if realization of the deferred tax assets occurs during the measurement period. In 2012, the valuation allowance related to these deferred tax assets decreased by $6.2 million. As the respective operations generate sufficient income, the valuation allowances will be partially or fully reversed at such time we believe it will be more likely than not that the deferred tax assets will be realized. In 2012, a change in judgment about the realizability of certain deferred tax assets in the Netherlands occurred resulting in a reduction of the valuation allowance of $6.9 million.

 

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June 30, 2012 unremitted earnings of our non-U.S. subsidiaries and affiliates of $1,428.4 million, the majority of which have not been previously taxed in the U.S., are considered permanently reinvested, and accordingly, no deferred tax liability has been recorded in connection therewith. It is not practical to estimate the income tax effect that might be incurred if cumulative prior year earnings not previously taxed in the U.S. were remitted to the U.S.

A reconciliation of the beginning and ending amount of unrecognized tax benefits (excluding interest) is as follows as of June 30:

 

                                             
(in thousands)      2012      2011  

Balance at beginning of year

     $         18,289       $         16,391   

Increases for tax positions of prior years

       946         -       

Decreases for tax positions of prior years

       -             (85

Increases for tax positions related to the current year

       116         285   

Decreases for tax positions related to the current year

       (1,635      -       

Decreases related to settlement with taxing authority

       (7,280      -       

Decreases related to lapse of statute of limitations

       (805      (794

Foreign currency translation

       (2,333      2,492   

Balance at end of year

     $ 7,298       $ 18,289   
                     

The total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate in 2012, 2011 and 2010 is $6.4 million, $18.0 million and $15.8 million, respectively. Our policy is to recognize interest and penalties related to income taxes as a component of the provision for income taxes in the Consolidated Statement of Income. We recognized a reduction in interest of $0.9 million in 2012. We recognized interest expense of $0.9 million and $0.4 million for 2011 and 2010, respectively. We also recognized $0.3 million of penalty in 2012 through goodwill. As of June 30, 2012 and 2011 the amount of interest accrued was $1.9 million and $3.2 million, respectively. As of June 30, 2012 the amount of penalty accrued was $0.3 million.

With few exceptions, we are no longer subject to income tax examinations by tax authorities for years prior to 2007. The Internal Revenue Service has audited all U.S. tax years prior to 2011 and will begin examining 2011 and 2012 during the next fiscal year. Various state and foreign jurisdiction tax authorities are in the process of examining our income tax returns for various tax years ranging from 2007 to 2010. We continue to execute and expand our pan-European business model. As a result of this and other matters, we continuously review our uncertain tax positions and evaluate any potential issues that may lead to an increase or decrease in the total amount of unrecognized tax benefits recorded. We believe that it is reasonably possible that the amount of unrecognized tax benefits could decrease by approximately $4.0 million to $5.0 million within the next twelve months as a result of the progression of various federal, state, and foreign audits in process.

NOTE 13 — PENSION AND OTHER POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS

Pension benefits under defined benefit pension plans are based on years of service and, for certain plans, on average compensation for specified years preceding retirement. We fund pension costs in accordance with the funding requirements of the Employee Retirement Income Security Act of 1974 (ERISA), as amended, for U.S. plans and in accordance with local regulations or customs for non-U.S. plans.

We have an Executive Retirement Plan (ERP) for various executives and a Supplemental Executive Retirement Plan (SERP) which was closed to future participation on July 26, 2006.

We presently provide varying levels of postretirement health care and life insurance benefits (OPEB) to certain employees and retirees. Postretirement health care benefits are available to employees and their spouses retiring on or after age 55 with 10 or more years of service. Beginning with retirements on or after January 1, 1998, our portion of the costs of postretirement health care benefits is capped at 1996 levels. Beginning with retirements on or after January 1, 2009, we have no obligation to provide a company subsidy for retiree medical costs.

In 2010, special termination benefits of $3.6 million, respectively, were recognized in the U.S.-based defined benefit pension plan due to an amendment of the plan for supplemental retirement benefits.

We use a June 30 measurement date for all of our plans.

 

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Defined Benefit Pension Plans

The funded status of our pension plans and amounts recognized in the consolidated balance sheets as of June 30 were as follows:

 

                                             
(in thousands)    2012     2011  

Change in benefit obligation:

    

Benefit obligation, beginning of year

   $ 786,572      $ 759,075   

Service cost

     6,982        7,650   

Interest cost

     42,107        40,984   

Participant contributions

     34        39   

Actuarial losses (gains)

     153,680        (4,400

Benefits and expenses paid

     (39,051     (37,082

Foreign currency translation adjustment

     (16,437     22,074   

Effect of acquired business/plan combinations

     28,296        -   

Plan amendments

     -        675   

Plan curtailments/settlements

     (3,877     (2,443

Benefit obligation, end of year

   $ 958,306      $ 786,572   
                  

Change in plan assets:

    

Fair value of plan assets, beginning of year

   $ 725,466      $ 656,516   

Actual return on plan assets

     68,082        93,570   

Company contributions

     9,683        8,536   

Participant contributions

     34        39   

Benefits and expenses paid

     (39,051     (37,082

Plan curtailments/settlements

     (3,877     (2,443

Effect of acquired business/plan combinations

     26,438        -   

Foreign currency translation adjustments

     (2,932     6,330   

Fair value of plan assets, end of year

   $ 783,843      $ 725,466   
                  

Funded status of plan

   $ (174,463   $ (61,106
                  

Amounts recognized in the balance sheet consist of:

    

Long-term prepaid benefit

   $ 2,803      $ 63,579   

Short-term accrued benefit obligation

     (9,285     (7,619

Accrued pension benefits

     (167,981     (117,066

Net amount recognized

   $ (174,463   $ (61,106
                  

The pre-tax amounts related to our defined benefit pension plans recognized in accumulated other comprehensive (loss) income were as follows at June 30:

 

                                             
(in thousands)    2012     2011  

Unrecognized net actuarial losses

   $ 191,340      $ 66,734   

Unrecognized net prior service credits

     (1,379     (1,540

Unrecognized transition obligations

     1,193        1,202   

Total

   $ 191,154      $ 66,396   
                  

Prepaid pension benefits are included in other long-term assets. The assets of our U.S. and international defined benefit pension plans consist principally of capital stocks, corporate bonds and government securities.

To the best of our knowledge and belief, the asset portfolios of our defined benefit pension plans do not contain our capital stock. We do not issue insurance contracts to cover future annual benefits of defined benefit pension plan participants. Transactions between us and our defined benefit pension plans include the reimbursement of plan expenditures incurred by us on behalf of the plans. To the best of our knowledge and belief, the reimbursement of cost is permissible under current ERISA rules or local government law. The accumulated benefit obligation for all defined benefit pension plans was $938.5 million and $772.6 million as of June 30, 2012 and 2011, respectively.

 

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Included in the above information are plans with accumulated benefit obligations exceeding the fair value of plan assets as of June 30 as follows:

 

                                             
(in thousands)    2012      2011  

Projected benefit obligation

   $ 855,697       $ 124,684   

Accumulated benefit obligation

     835,870         123,016   

Fair value of plan assets

     671,588         -   

The components of net periodic pension cost include the following as of June 30:

 

                                                                    
(in thousands)    2012     2011     2010  

Service cost

     $            6,982      $ 7,650      $ 7,949   

Interest cost

     42,107        40,984        42,437   

Expected return on plan assets

     (51,376     (48,203     (46,226

Amortization of transition obligation

     65        52        56   

Amortization of prior service credit

     (186     (281     (280

Special termination benefits

     -        -        3,577   

Curtailment Loss

     -        -        300   

Settlement loss

     1,253        18        -   

Recognition of actuarial losses

     8,259        12,277        4,447   

Net periodic pension cost

     $            7,104      $ 12,497      $ 12,260   
                          

Net periodic pension cost decreased $5.4 million to $7.1 million in 2012 from $12.5 million in 2011. This decrease was primarily the result of discount rate changes and the expected return on plan assets.

As of June 30, 2012, the projected benefit payments, including future service accruals for these plans for 2013 through 2017, are $40.9 million, $41.7 million, $43.7 million, $45.7 million and $48.5 million, respectively and $277.5 million in 2018 through 2022.

The amounts of accumulated other comprehensive loss expected to be recognized in net periodic pension cost during 2013 related to net actuarial losses and transition obligations are $14.9 million and $0.1 million, respectively. The amount of accumulated other comprehensive income expected to be recognized in net periodic pension cost during 2013 related to prior service credit is $0.2 million.

We expect to contribute approximately $10.4 million to our pension plans in 2013.

 

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Other Postretirement Benefit Plans

The funded status of our other postretirement benefit plans and the related amounts recognized in the consolidated balance sheets were as follows:

 

                                             
(in thousands)    2012     2011  

Change in benefit obligation:

    

Benefit obligation, beginning of year

   $ 19,771      $ 19,910   

Service cost

     75        77   

Interest cost

     1,029        1,037   

Actuarial loss

     7,345        2,474   

Benefits paid

     (3,408     (3,203

Plan amendment

     (238     (524

Benefit obligation, end of year

   $ 24,574      $ 19,771   
                  

Funded status of plan

   $ (24,574   $ (19,771
                  

Amounts recognized in the balance sheet consist of:

    

Short-term accrued benefit obligation

   $ (1,808   $ (1,918

Accrued postretirement benefits

     (22,766     (17,853

Net amount recognized

   $ (24,574   $ (19,771
                  

The pre-tax amounts related to our OPEB plans which were recognized in accumulated other comprehensive (loss) income were as fol