A Bearish Take on This Toolmaker

Erik Kobayashi-Solomon: Hi, I'm Erik Kobayashi-Solomon, co-editor of Morningstar's OptionInvestor. And today it's my great pleasure to welcome David Manger, who is a stock analyst here at Morningstar covering industrials. Hi, Dave.

David Manger: Thanks for having me Erik.

Kobayashi-Solomon: Thanks for coming. A couple of weeks ago I wrote this piece about Kennametal, a company that you cover. And it's a bearish piece, taking a bearish position using options. I don't think a lot of investors are familiar with this company. Can you tell us a little bit about it?

Manger: Kennametal is a small supplier of metal cutting and wear-resistant tools used in industrial activities, usually you would see in end markets such as aerospace, automotive, and mining.

Kobayashi-Solomon: So this is really kind of industrial-use products?

Manger: Yes. Exactly, and they're highly commoditized products. Even though Kennametal is usually the first- or second-largest player in their markets, it really struggles getting pricing power given the customers they're selling to.

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Kobayashi-Solomon: So you have a commodity market, you would expect a lot of pricing pressure.

Manger: Yes.

Kobayashi-Solomon: You know, after reading through your report, recommending this bearish position. I wondered is this bearish call basically just saying industrial production is not going to rebound? Is that what you're assuming in your model?

Manger: Well, it's actually quite the opposite. We expect a strong recovery in the industrial production. It has really begun and since June, industrial production has picked up. And Kennametal is in a perfect position to benefit from that. Around 80% of its products are consumables, so these are low purchase price components that should really pick up as...

Kobayashi-Solomon: And they should be pretty early in the cycle as well, right?

Manger: Exactly.

Kobayashi-Solomon: I mean if these guys want to order, they're going to order a Kennametal product.

Manger: Exactly. And we've seen that in their orders. They've really gone up since mid-2009, and typically their orders lag industrial production by about two months. So as that increased we've seen that come through in their orders. So you'd really expect that increase. But the big difference in our view comes in the profitability assumptions. Management has outlined the ability to get to 15% margin based on...

Kobayashi-Solomon: 15%? It is pretty rich.

Manger: Yeah. It is very rich, considering historically they have been around 10% or a little less. Our view is that there are several things that are going to creep back into their cost structure. First of all, the rising raw material costs and employments costs. Their products contain large amounts of raw materials, specifically steel and other hard metals.

Kobayashi-Solomon: And they can't pass those costs through to the customers?

Manger: Yes. And even worse, in the past they've been late to pass those costs on like their competitors, so that's really impacting their margins there. And we also expect as production ramps back up, we question management's ability to hold down the costs as they add shifts back to the plants that they have in place.

Kobayashi-Solomon: Because you need the guys to actually build these things, right?

Manger: Exactly. I guess another point would be that as you look at the potential to get to that 15% margin, even if they are able to--at peak demand, we're looking at is a sustainable level through this cycle, not just the early part of the cycle where production increases. So we think a more likely scenario is that they get to kind of 10% to 11% range, which is still slightly above historical levels given the cost they have taken out. But to get to that 15% level, which is something that we don't really think is attainable.

Kobayashi-Solomon: Or to get to that 15% and stay at that 15%, right?

Manger: Exactly. Yeah, through the whole cycle.

Kobayashi-Solomon: Maybe they can pop up to 15% for a quarter ot two, but hard to make it sustained, right?

Manger: Exactly.

Kobayashi-Solomon: So in looking at Kennametal, we like to look at things kind of from bearish points of uncertainty and bullish sources of uncertainty. Where do you think the real uncertainties around Kennametal lie?

Manger: Well, I think the uncertainty comes down to that profitability assumption. I think the consensus is that production will increase, volumes will come back, but it's just a matter of them being able to hold down those costs.

You also have headwinds in the dollar. If the dollar strengthens, around half of their sales come internationally, comes from international markets.

Kobayashi-Solomon: Oh, that's right. This is China and India, places like that, right?

Manger: Exactly. And they have benefited from that growth recently, but if the dollar strengthens, their products become more expensive and in turn volumes could fall.

Kobayashi-Solomon: And their competitiveness in foreign markets just drops with that.

Manger: Exactly.

Kobayashi-Solomon: I see. Well, Dave, thanks a lot. Terrific explanation. Nice to talk to you about it.

Manger: Thanks for having me, Erik.

Kobayashi-Solomon: And thank you for joining us. Please stop by the OptionInvestor website where you'll find many more great option ideas based on Morningstar's fundamental research.