Oct 29, 2009
Operator
Good morning, my name is Regina and I will be your conference operator today. I would like to welcome everyone to Kennametal's First Quarter Fiscal Year 2010 Earnings Call.
All lines have been placed on mute to prevent any background noise. After the speaker's remarks there will be a question-and-answer session.
(Operator Instructions). I'll now turn the call over to Quynh McGuire, Director of Investor Relations.
Quynh McGuire
Thank you, Regina. Welcome everyone.
Thank you for joining us to review Kennametal's first quarter fiscal 2010 results. We issued our quarterly earnings press release earlier today.
You may access this announcement via our website at www.kennametal.com. Consistent with our practice in prior quarterly conference calls, we've invited various members of the media to listen to this call.
It is also being broadcast live on our website and a recording of this call will be available on our site for replay through November 28, 2009. I'm Quynh McGuire, Director of Investor Relations for Kennametal.
Joining me for our call today are Chairman, President and Chief Executive Officer, Carlos Cardoso; Vice President and Chief Financial Officer, Frank Simpkins and Vice President, Finance and Corporate Controller, Wayne Moser. Carlos and Frank will provide details on the quarter's financial performance.
After their remarks, we'll be happy to answer your questions. At this time I'd like to direct your attention to our forward-looking disclosure statement.
The discussion we'll have today contains comments that may constitute forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve a number of assumptions, risks and uncertainties that could cause the company's actual results, performance or achievements to differ materially from those expressed in or implied by such forward-looking statements.
Additional information regarding these risk factors and uncertainties is detailed in Kennametal's filings with the Securities and Exchange Commission. In addition, Kennametal provided the SEC with a Form 8-K, a copy of which is currently available on our website.
This enables us to discuss non-GAAP financial measures during this call in accordance with SEC Regulation G. This 8-K presents GAAP financial measures that we believe are most directly comparable to those non-GAAP financial measures and it provides a reconciliation of those measures as well.
I'll now turn the call over Carlos.
Carlos Cardoso
Thank you, Quynh. Good morning everyone.
Thank you for joining us today. Let me start by saying that I believe that sales levels have generally reached bottom and we have begun to see some positive trends in our orders rates.
For September quarter, our sales increased sequentially by 6% from the June quarter. This was driven by higher industrial production activity and follows three consecutive quarters of sharp sequential decline during the global economic downturn.
Compared to the record level set for September quarter one year ago, sales were lower by 36%. Daily order rates are showing that underlying business environment is improving globally.
Also it is important to note that customer inventories remain low as they are still cautious and are buying only what they need for the short-term. Clearly customers will need to replenish some of their inventories from direct and indirect channels as the recovery begins.
In the mean time, we continue to capitalize on value selling approach. Customers recognize the value proposition of our products, so we are holding pricing levels strategically.
Overall, we exceeded our expectations and are encouraged by our performance for the September quarter. Sales, operating results and earnings per share increased on a sequential basis.
In addition to the positive impact of higher sequential sales, results benefit from increased permanent cost savings from our restructuring programs. We also continue to focus sharply on generating strong cash flow and maintaining a solid financial position.
Our September quarter performance demonstrates the positive effects and future potential of the many difficult actions that we took during the global economic downturn. From a macro prospective, I will like to discuss our view of certain end markets served.
In the transportation sector the Cash for Conquest program was a success. Over the next several months we expect to see buying for inventory replacements.
We are seeing some pull through at OEMs and integrators as they are likely low on tooling inventory. In aerospace, the market is still soft but passenger traffic is picking up in certain parts of the world.
OEMs are starting to prepare for the upturn. Currently, the industry forecast that demand is expected to rebound mid-year calendar 2011.
We could see a benefit six to nine months in advance for engineering components. In the energy market, North American drilling rates are typically related to the gas industry.
With the reduced rig counts and current high level of supply for liquefied natural gas, increased drilling rate is now expected until late in calendar year 2010. Power generation suppliers have solid book orders, but are reporting a slowdown of new orders due to some financing challenges.
We continue to focus on equipment and component manufacturers as well as various renewable energy projects. In underground coal mining, production and demand for steam coal has been consistently decreasing.
However, production in China has been robust. Steam coal represents 80% of the coal mines globally.
Regarding [Magerkohle] coal production increases have been reported as steel prices continue to increase. In highway construction, we saw some benefit from stimulus plans in Asia as the funds will release quickly.
In US we experienced higher demand in the summer months as contractors needed our products for the job they had won. However, customers are buying only what they need and remaining cautious.
The road construction season is ending, but we may some extended activity into November and December depending on the weather. During the September quarter, we continued to focus on permanently reducing costs to implementing our restructuring programs to reach our target of $125 million annual cost benefits.
As part of restructuring, we have closed seven facilities already and currently expect to close a total of nine manufacturing facilities to lower fixed costs. By continually deploying Lean, we have identified additional capacity in certain larger manufacturing facilities which can absorb production from plants that are being closed.
In addition, we have reduced our salary workforce by 20% globally. Also, we took additional cost reduction measures on a temporary basis.
To adjust our production workforce and cost inline with demand, we made appropriate reductions in our hourly employment levels. Further, we have implemented short time reduced work weeks in many areas.
As a reminder, we implemented one week furloughs from March through June of 2009. In fiscal year 2010, we have reduced salaries by 10% on average.
We expect salary reductions to provide approximately $28 million in cost savings this fiscal year although those costs will return when customer demand increases. Regarding our portfolio management actions, we continued to divest non-core lower margin business over the past 18 months.
We sold our high speed steel operations in Europe and North America and recently completed the sale of our gage product lines. Those included the divestiture of seven manufacturing facilities and generated approximately $50 million in that proceeding.
The combination of restructuring initiatives and divestitures were resolved in a permanent reduction of 16 facilities from our manufacturing footprints and represent significant cost savings. While we added facilities as part of our acquisitions, we will have reduced our base manufacturing footprint by more than 40% since fiscal year 2003.
Those collective efforts will help position Kennametal to realize stronger operating leverage in the coming upturn. For fiscal year 2010 and over the near-term we have two key objectives; both are designed to help Kennametal further navigate through current economic conditions and position our company for growth as the recovery gains momentum.
Our first priority is to continue to reduce our cost structure and size the company to operate profitably at a $2 billion in sales. And we believe that we can achieve double digit EBIT margins at sales levels of $2.1 billion to $2.2 billion.
Our second priority is to leverage our existing infrastructure to be able to scale up to $3 billion in sales without adding much of our fixed cost base or making substantial additional capital investments. We believe that we have the manufacturing capacity to handle any upturn in these volumes.
I will now turn the call over to Frank, so he can discuss our financial results for the quarter in a greater detail. Frank?
Frank Simpkins
Thank you, Carlos. I'll provide further comments on our performance for the September quarter then I'll move to the outlook for our December quarter and our fiscal 2010 year.
Some of my comments will exclude some of the special items that Carlos referred to. So, please refer to the reconciliation schedules that we provided in our earnings release and related Form 8-K.
So to start, to summarize September quarter, our sales were down year over year by 36% on an organic basis. That came in at the better end of our sales guidance of minus 35% to minus 40%.
Furthermore, as Carlos mentioned it's important to note that our sales did improve sequentially by 6% compared to the June quarter. Our loss per share for September quarter was $0.04 and was ahead of our expectations driven by a better than anticipated sales, higher permanent savings from our restructuring programs and ongoing cost discipline.
We also have three operating cash flow of $9 million, driven by our operating performance and continued focus on our working capital and balance sheet. The quarter also reflected the completion of our 8 million share equity issuance which raised a $120 million of proceeds, the amendment to our $500 million revolving credit facility and the completion of the divestiture of our high speed steel business.
Additionally, as Carlos mentioned on October 9th, we also completed the sale of our gage business further reduced in our manufacturing footprint by two facilities. Now, I'll walk you through the key items in our income statement.
Sales for the quarter came in at $409 million, this compares with $643 million in the September quarter last year. Change in sales represents the 36% year-over-year decrease and was driven by a 36% organic decline, its favorable 3% effect from acquisitions and a 3% decrease from unfavorable flowing currency effects.
The prior year September quarter was a record quarter for Kennametal. As I previously noted, sales for the September quarter were up sequentially from the June quarter by $23 million or 6% and the last time this occurred was 25 years ago in fiscal 1984 as the economy was coming out of a recession in that period.
Looking at the performance of the business units; MSSG sales decreased by 43% from the prior year quarter and that was driven by organic sales decline of 39% in unfavorable foreign currency effects of four. On a regional basis, Europe and North America reported organic sales declines of 42% and 39% respectively while Latin America, India and Asia Pacific also experienced year-to-year declines of 31%, 25% and 39% respectively.
MSSG sales also increased sequentially by 6% from the June quarter as global investor production began to show some slight improvement. Sequential sale gains were made in North America, India and Latin America while sales in Europe and Asia Pacific were near the same levels as the June quarter.
AMSG sales decreased 25% from the September quarter one year ago and that was driven by a 30% organic decline and a 2% unfavorable impact from foreign currency effects partly offset by the favorable impact of a prior acquisition of 7%. The organic decline was primarily driven by lower sales in the engineered products business as well as reduced demand for energy related products.
Sequentially, AMSG sales increased by 7% from the June quarter. All units in AMSG posted sequential growth with the exception of our surface finishing machines capital goods business.
Turning to our gross profit margin that came in at 29% for the quarter as compared to 33% in the prior year September quarter and restructuring related charges recorded in cost of good sold in both periods were not material. Lower production levels on the related reduced capacity utilization continued to be the reason for the year-to-year decline in gross profit margin.
However, the increased run rate in benefits from our restructuring initiatives and other cost reduction actions continued to offset an increasing portion of the capacity utilization impact. In addition, our gross profit margin further benefited from continued positive momentum with price realization as well as stabilization in our raw material costs, also helping to medicate the impact of lower production levels during the quarter for one-time benefits from certain labor negotiations in Europe.
This is all evidenced by the sequential improvement in our gross profit margin of over 200 basis points from the first quarter of 2010 which normally is our weakest period for us to do the seasonality. Our decremental margin for the September quarter came in at 24% which was 200 basis points above the June quarter and improved by 100,000 basis points over the last two quarters.
The margin performance validates our restructuring initiatives are delivering real permanent cost savings. Our operating expense decreased by 23% or $35 million to $116 million.
The decrease was mainly attributable to lower employment costs as a result of the impact of our restructuring and cost management activities, lower incentive compensation as well as the impact of foreign currency exchange rate fluctuations. Other cost reductions offset somewhat by an increase from acquisitions.
Now, let me provide you an update on our restructuring programs. In the September quarter, we realized approximately $30 million in pre-tax benefits most of which were incremental to the same quarter one year ago.
We are now very close to our targeted run rate that will yield $125 million in annual ongoing pre-tax savings. During the quarter, we recorded pre-tax charges related to these initiatives of $9 million or about $0.06 a share.
We now have recorded $90 million of the $115 million of pre-tax charges related to these programs. The remaining $25 million were expected to be incurred over the next six to nine months and our programs are on track or slightly ahead.
So to summarize our permanent cost reductions from our combined programs showing investment of $115 million to realize a $125 million of savings annually this will represent the closure of seven manufacturing plants, lowering operating expenses and reducing salaried employment levels by 20% globally. In addition, we have also been actively managing our product portfolio by divesting loan margin non-core businesses as Carlos mentioned such as our high speed steel business and our gage business and these actions will also yield the reduction of an additional seven manufacturing plants.
These actions combined will remove a total 14 facilities to-date from our manufacturing footprint and our permanent cost reductions. And lastly as Carlos mentioned we took temporary cost reduction measures including one week furloughs in the prior year as well as salary reductions in fiscal '10.
The salary cuts in fiscal '10 will generate approximately $28 million in cost savings for this year. These costs will comeback as demand returns.
Our operating loss was $10 million for the current quarter compared to operating income of $52 million last year. Absent restructuring related charges reported in both periods, the operating loss for the current quarter was $1 million compared to operating income of $61 million in the prior year quarter.
I believe that appears repeating here that this is a sequential improvement in adjusted operating results from the June quarter. Looking at the business unit performance, MSSG had an operating loss of $13 million for the September quarter compared to operating income of $42 million in the same period.
Excluding restructuring related charges record in both periods MSSG's operating loss was $8 million compared with operating income of $49 million in the prior year quarter. The primary drivers of the decline in operating income were reduced sales volumes and the related unfavorable absorption of manufacturing costs.
This was offset in part by restructuring benefits and other cost reduction actions including the one-time savings of certain European labor negotiations as well as higher price realization. MSSG reduced its operating loss by almost 50% from the June quarter.
AMSG's operating income was $23 million in the quarter compared to operating income of $30 million in the same quarter in the prior year. Absent restructuring related charges in both periods AMSG's operating income of $24 million in the current quarter compared to $31 million in the prior year quarter and was up 35% on a sequential basis from the June quarter.
The decline in operating income was primarily due to lower sales in production volumes in the engineered products and energy related businesses. However, considerable portion of the sales decline was offset by a combination of restructuring benefits and continued cost reduction actions as well as lower raw material costs.
As a result AMSG again achieved the double digit operating margin in the September quarter which was also slightly higher than for the same quarter last year. This again demonstrates the importance of this business segment to our strategy and our overall product portfolio.
Corporate operating loss of $20 million was level with the same quarter a year ago and sequentially higher by $11 million from the June quarter, the sequential change was due to higher stock compensation expense related to our normal annual [award] process at this time of the year as well as increase in certain employee benefit cost and the fact that certain favorable items were recorded in the June quarter. Our interest expense was $6.4 million and decreased by $700,000 or 10% compared to last years comparable quarter.
The decrease was due to lower borrowings due impart to the July equity issuance offset in part by higher interest rates related to the amended revolving credit facility. The reported effective tax rate for the September quarter was 39.6% on a pre-tax loss.
Excluding the impact of restructuring related charges the adjusted effective tax rate was a negative 41.8 on a pre-tax loss compared to 19% on a pre-tax income in the prior year quarter. Relatively, high percentage of tax benefit on the pre-tax loss for the current quarter was driven by a certain favorable tax settlements which amounted to $1.5 million this year.
Additionally, we are on track with the wind down activities related to our June 2009 divestiture of a high speed steel business. During the current quarter, we reported $2 million of pre-tax charges related to this divestiture most of which was associated with employee severance.
These charges along with related tax effects were reported in discontinued operations. We expect to incur the remaining pre-tax charges related to this divestiture of $2 million to $3 million over the next three to six months and all cash proceeds related to divestiture have been received.
Net loss was $10 million for the current quarter compared to net income of $35 million in the prior year. Absent of charges related to restructuring and divestiture, the net loss for the current quarter was $3 million compared to net income of $43 million from the prior year quarter.
Lastly, reported fiscal 2010 first quarter diluted loss per share was $0.12 compared to the prior year quarter EPS of $0.47. The adjusted loss per share was $0.04 compared to the prior year quarter adjusted EPS of 57.
Turning to our balance sheet; we had a strong balance sheet to continuing weathering the current economic conditions and we continue to invest in our business, shape our portfolio and streamline our manufacturing footprints. We have reduced our inventory for four consecutive quarters, while maintaining high product availability and service levels.
Specifically, we drew down our inventory by $17 million in the September quarter and by $80 million over the last 12 months. We also continue to remain extremely focus and diligent on receivable collections.
Our capital expenditures were reduced to $9 million as compared to capital spending of $45 million in the same quarter one year ago. And at September 30, 2009 our total debt was $367 million that was down a $119 million from the June 30, 2009 period.
This was driven by the application of the proceeds from our equity issuance in July as well as from the divestiture of our high speed steel business. Lastly, our debt-to-capital ratio at September 30, 2009 was 20.8 which is significantly improved from the 27.7% at June 30, 2009 and our US defined benefit pension plan remains over 100% funded.
Cash-flow from operating activities from the current quarter was $17 million, this compares to $38 million in the prior year quarter and as I previously mentioned free operating cash flow for the current quarter was $9 million. This compares to an outflow of $5 million in the prior year quarter.
The year-over-year improvement was driven by a reduction of working capital and lower capital expenditures. Looking ahead toward our outlook, global industrial activity has recently exhibited some stability following the severe economic downturn and turbulence experienced during the previous fiscal year.
However, the development at present is considerably uneven and does not yet [entail] broad based momentum. Certain market sectors and region have begun to strengthen, while others look to remain flat or trend further downward in the short to medium [churns].
While there are some overall positive signs in the improving global economy, it remains difficult to predict with any certainly the timing, magnitude or duration of a sustainable recovery. We presently believe that the global industrial activity and the corresponding demand for our products will continue to moderately improve through the remainder of the current fiscal year.
Under these assumed conditions we would expect our earnings per share for fiscal 2010 to be in the range of $0.50 to $0.70 per share excluding restructuring and divestiture related charges on sales that would be 5% to 10% lower year-over-year on an organic basis. And this 5% increase on EPS is from the mid points that we provided back in July.
Cash flow from operations would be expected to be in the range of $65 million to $75 million for our fiscal year as a considerable portion of the cash generated is expected to be needed to fund higher working capital requirements as business improves. Based on capital expenditures of approximately $60 million, free operating cash flow would be in the range of $5 million to $15 million for fiscal 2010.
For the second quarter of fiscal 2010, we expect organic sales to be 20% to 25% lower than the same quarter of the previous fiscal year and expect EPS to be at or slightly above breakeven excluding restructuring and divestiture related charges. At this time I'll turn it back to Carlos for some closing comments.
Carlos Cardoso
Thank you, Frank. As Kennametal moves forward our long-term strategies remain consistent.
We are staying committed to our management operating system to Kennametal value business systems. We continue to balance our geographic presence to achieve sales of one-third each from North America, Western Europe and the rest of the world.
We are also continued to balance our business mix to generate sales equally from our metalworking and advanced materials segments. We are also continued to strengthen our balance sheets by focusing on working capital and maximizing liquidity.
While we expect the first half of fiscal 2010 to continue to be challenging, we are well positioned. We also believe that we will see an upturn in the second half of fiscal year based on leading economic indicators.
For Kennametal, we expect some recovery at the top line and we think, we will benefit from better operating leverage that we resolved from permanent cost savings. In summary, we are sizing Kennametal to operate profitably at $2 billion in sales.
We can leverage the company's existing infrastructure to be able to scale up to $3 billion in sales without adding much of our fixed cost basis or making substantial additional capital investments. Thank you for your time and your interest in Kennametal.
We'll now take your questions.
Operator
(Operator Instructions). Our first question comes from the line of Adam Uhlman with Cleveland Research.
Adam Uhlman
I guess first with a clarification. Frank could you talk about what the one-time labor negotiation benefit was in Europe?
Frank Simpkins
Yeah, the bottom line is we're able to get some further concessions with our European and we had put that at an incremental amount from the guidance that we provided of about $3 million.
Adam Uhlman
And then do you have any sense of how much your distributor partners have de-stocked their inventories through this down cycle and what the benefit Kennametal might be able to capture as it start to sell to the level of retail sales going forward. Have you been able to dimensionalize that at all?
Carlos Cardoso
We know that the distribution channel has de-stocked, but we also know that the end user in other words our customers have de-stocked even further. So, we really have two opportunities in de- stocking is one, is in the distribution channel, the other one is at the customer themselves.
But we can't quantify that at this point.
Operator
Our next question comes from the line of Ann Duignan with JPMorgan.
Ann Duignan
Good morning. Could you talk a little bit about the $30 million in restructuring savings, where the lion share of those savings have taken place?
I'm trying to get a sense of what kind of volume the metalworking business is going to need to return to profitability and then as a follow-up could you talk a little about sequentially which business you would expect to start to see positive organic growth year-over-year as we go forward into the back half of the year?
Frank Simpkins
Yeah Ann, as far as the restructuring right now the bulk of it I should say a majority of it is in MSSG. Probably give or take two-thirds of it right now because if you go back to the number of manufacturing facilities we had more in MSSG as opposed to advance materials.
So, two-thirds or one-third will [fall park] right that I expect that trend to continue to go as we go in the out periods or sequentially. And that from an organic perspective that's a tough one I would expect probably advance materials given some of the mix and there it maybe be the first one that would show some organic as opposed to metalworking given the guidance that we've talked, but the one area from an MSSG that's probably a little bit softer than what we provided in the month of July, I would say would Europe which is a bigger component of MSSG and on the advanced material side the one area that I think we referenced on the energy side.
So that's obviously a smaller part of the company, but they would be the drivers and that's why I'd say it would be probably first advanced materials as we see it going forward.
Ann Duignan
Yeah, that's interesting, I might have expected MSSG to potentially show organic growth positive before advanced materials so that's definitely interesting. And then…
Frank Simpkins
And I think one of the reasons for that is we feel that the European recovery is running above a quarter behind than what we expected. As planed they would have been having organic growth first.
Its going to be close, let me say it that way Ann.
Ann Duignan
Okay, that's great color. Just and a follow-up on that then given those comments, would you expect MSSG to breakeven in fiscal Q2 or still lag?
Frank Simpkins
I think they'll lag a little bit but I think directionally that's kind of where we are going for the whole organization to be at breakeven. Obviously, both business units need to be in that trajectory.
So, we think we're moving towards that area.
Ann Duignan
Okay. I'll get back in the line just in the interest of time.
Thanks. Thanks for the color.
Operator
Our next question comes from the line of Andy Casey with Wells Fargo Securities.
Andy Casey
Frank on the tax rate for Q2, what are you expecting there within the guidance that you provided?
Frank Simpkins
You know how that moves around, [excluded] I would say it's going to be about in the mid thirties and then for the rest of the year I'd probably put it around 25% given how it's been moving. So, the second half would be in that 24%, 26% range and I think we'll finish the year towards that 25% then it will step down as we start gain a little bit more profitability out of our European business in the second half.
Andy Casey
Okay. So, with that are we looking at pretty much a breakeven operating profit line and if so that kind of brings your decrement year-over-year at the mid point down to around 17%, 18% is that about right?
Frank Simpkins
From a decrement, say that again Andy.
Andy Casey
Yes.
Frank Simpkins
I mean you're close, let me say that way.
Andy Casey
Okay. And then on the free cash flow guidance that of $5 million to $15 million you pretty much got the midpoint of that range in Q1.
Are you looking at that, I know you had talked about the inventory build and a recovery, but are you looking at that right now as being fairly conservative?
Frank Simpkins
I would think that's safe. We'll probably add some strategic raw material; some input cost here in the second quarter, but nothing significant but at this point I would say that's a fair comment.
Operator
Our next question comes from the line of Eli Lustgarten with Longbow Securities
Eli Lustgarten
Just a quick clarification corporate expense which was [19] change, does that continue with that rate for the rest of the year?
Frank Simpkins
Not. Eli, I had put that around going forward about $15 million give or take a little bit there, because we won't have the annual granting of the stock option and some related cost like that.
We have some one-time cost in there and course so going forward it should be in that range.
Eli Lustgarten
And the profitability improvement in AMSG was quite started to see the strong double digit. When is that sustainable?
Can you talk about what really contributed that to (inaudible) cost reduction and how do we look at that for the rest of the year? Is that a sustainable number or is there some variability around it?
Frank Simpkins
Yeah, I would say its obviously the cost reduction and then I would say lower raw material cost on some of the areas on and then its just the ongoing discipline the organization I think a couple of business units that were dragging, I think we're seeing some improvements in the surface finishing business Extrude Hone and some of the industrial areas that in the past were lagging. So, I think we've done a better of a job of looking at those businesses.
Eli Lustgarten
We should be able to sustain that profitability for the rest of the year at that level?
Carlos Cardoso
Yes, yes. This is Carlos, Eli; we feel that the business is in really good shape for that.
Eli Lustgarten
And with some seasonality in the second quarter?
Carlos Cardoso
Yes.
Eli Lustgarten
And can you say with kind of with raw material starting to go to the other way, are we going to see some pressures in MSSG in the second quarter or is that have your pricing built in to offset the cost pressures in a building?
Carlos Cardoso
Yeah, the pricing is built based on pressures and I continue to remind people that we suffered last year because our standard cost reflected a higher price. It takes us above six months, so we have benefit of raw material that we processed a year ago and so forth so that that raw material price increase is not a big concern for us during this year.
Operator
Our next question comes from the line of Mark (inaudible) with Goldman Sachs.
Unidentified Analyst
Good morning. What was the impact of currency on an EPS basis in the quarter and what's your expectation for 2Q in 2010, is that swings to a positive?
Frank Simpkins
We don't break it down to that level. Currency as I said on the call was a negative 3% but it was probably a negative given our exposure in Europe when you translate kind of a cost over there, it was a slight drag.
We had some hedges in there that were a positive from a transaction perspective but that was in the other income and [deductionaries] but from an overall business perspective it wasn't significant.
Unidentified Analyst
And do you see balance of the weaker dollar versus the hedges swing to a benefit in 2Q in for the balance of the year, what's implied in the guidance?
Frank Simpkins
Yes. The guidance we provided was organic because it's always obviously tough to predict where the currencies are with the big one for us being the year-over-year was down year-over-year in our first quarter, but we expect that to be up anywhere from 3% to 5% from where it was last year.
So, we will get a slight benefit going forward.
Unidentified Analyst
Okay and then just a follow-up on the cash flow. The inventories are down year-over-year but not as much as 36% organic decline in revenues.
I guess it's not clear why the current inventory level is not sufficient to satisfy the early re-stock and up tick in demand. Are customers offloading any of the inventory risk on to you or is there any change going on that dynamic.
Can you talk about why the working capital built even as inventories are only down 20% year-over-year and versus a 36% top line decline?
Frank Simpkins
We made an acquisition last year and we have foreign currency which are artificially inflating the absolute value of it, but I am not talking about adding anything significant but we think we are balanced where we need to be at this point.
Unidentified Analyst
So, you consider that 2010 level on appropriate level of working capital for the business, kind of thinking longer term over the cycle?
Carlos Cardoso
I think longer term over the cycle, we want to improve inventory turns but at this inflection point or going from where we are at a $2 billion rate to a higher rate. I would say that in the next 12 months it is going to be difficult for us to make a major improvement in our inventory turns.
We will once we get at the full run rate.
Operator
Our next question comes from the line of Alex Blanton with Ingalls & Snyder.
Alex Blan
When you are looking at 2010 how do you currently think about the capital goods outlook for 2010? You said that the economy is recovering but its going to be very volatile and uncertain.
Do you think there is a possibility of another leg down in the economy? Because inventory adjustments can take pace despite the fact that final demand continues to fall and then you have the potential for another inventory adjustment later.
Carlos Cardoso
We're talking calendar year. So, our fiscal year ends in the middle of calendar year '10, so you got to keep that in mind but talking calendar year capital equipment what we call machinery, we see from an IPI perspective we see calendar year '09 to be minus like 14% and we see calendar year '10 to go to 3.3 positive.
So, is there a possibility there is going to be an inventory correction down the road in 2010, I mean we are not sure I mean nobody knows that but where we find right now is one of the positive things is that we have had an inventory depletion throughout all the industries that its been greater than ever before. So, I think there is going to be demand coming out of there that is going to stay; number one.
And number two is I want to continue to emphasize because of the cost stake in our business we are not counting on a big growth, top line growth for us to be able to deliver this promise that we have made.
Alex Blan
Yes.
Carlos Cardoso
We still are looking at a 5% to 10% negative year-over-year growth on a top line in our fiscal year 2010 which half of it is in calendar year 2010. So, I think that from what we can see I think we are in very good position.
Alex Blan
Well, ultimately the demand for capital business depends on consumption. So, what I am suggesting is that unless consumption turns around and goes up in 2010, it's hard to see any recovery in the capital goods market other than an inventory adjustment?
Carlos Cardoso
Alex I mean who knows and again my point to you is that this is why we sized this business to be profitable with $2 billion is with what if things don't turn around, we are in good shape, we also have the capability of getting this business to deliver $3 billion and if that happens I think that I certainly would be smiling at myself here but it'll be a great. We're positioned for either case at this point.
Alex Blan
Yeah. And how quickly can you have raised production if things do turn around?
Carlos Cardoso
Today, fast, fast.
Alex Blan
Very fast?
Carlos Cardoso
Yes.
Alex Blan
Because I know that the OEMs like Caterpillar and others are concerned about the suppliers being able to respond to recovery because of the very big inventory adjustments that have taken place, there could be some very big increases on the other side. You are ready for that?
Carlos Cardoso
Yes, its Caterpillar, John Deere, I think this has been the whole strategy that we deploy during this downturn is the fact that even though we closed a number of facilities to take this fixed cost. We did not remove capacity from our business and this is another reason that instead of laying off further people, we did a reduction in salary of 10%.
So, what we were doing is we have people in place to take at least the first wave of increased production.
Operator
Our next question comes from the line of Henry Kirn with UBS.
Henry Kirn
Quick question about stimulus expectation. When are you expecting that to start to hit and how big could it be for you guys?
Carlos Cardoso
Well, Henry, I mean I tell you what; we are not counting on the stimulus. Let me say it this way, we are not counting on the stimulus of the US, okay.
We have seen benefits from this stimulus elsewhere like China. We have an experienced really any positive growth from the stimulus program in US and we're not counting on them.
So, we're still looking for it, when we get it, will be an upside to what we are providing to you. But we just cannot see what's going to do for our business at this point.
Henry Kirn
Okay and in terms of M&A, how are you thinking about maybe strategic acquisitions as we get deeper through the downturn and are there anymore businesses that you are reviewing to see if they are non-core?
Carlos Cardoso
I mean we have pretty much identified the major non-core business and how that did on it, I mean you obviously need to continue to look at product lines I mean whether you are down or up, reviewing that how strategic private lines are I would say a normal course of businesses. We at this point until we see the upturn and we feel good about where we are going with a lot of certainty are inclined not to make any acquisitions.
We're going to make sure we keep a strong balance sheet, manage cash flow and until we have a good, a very good feel about the future in the economic future.
Operator
Our next question comes from the line of Chuck Murphy with Sidoti & Company
Chuck Murphy
Just wondering new sales are pretty much inline with your guidance but the net loss wasn't quite as bad. And I was just wondering if there was anything in particular that provided that outside?
Carlos Cardoso
I think it's the one item that we had and a little bit acceleration was the first question we had from Cleveland Research was not an incremental $3 million in Europe and I think the tax rate, obviously that $1.5 million that we've talked about but then it's basically kind of the restructuring programs delivering the permanent benefits and kind of the mindset in watching the cost and the business. Well, I need to continue to emphasize, I'm extremely pleased that our progress on the cost reduction in this company is ahead of our expectations.
We were ahead last quarter, we are ahead this quarter and that's really validates our belief that this costs are gone and we are going to really benefit from the upturn with very good leverage.
Chuck Murphy
All right. And how should we be thinking about gross margins and operating expenses going forward?
Are they kind of stable right now and just kind of tick up with sales as the year goes by or is there still something moving around in those items?
Carlos Cardoso
I think, that continued to improve as we go out and we expect a much better leverage on the top line and our second half of the fiscal year where we talked about leverage north of 40% and we think we're on track to deliver that in the second half with a lot of the cost that we've taken out of the business.
Chuck Murphy
Okay. And my last question was could you just talk about the rationale for separating the [VDN] the Kennametal brands and what do you expect from the two going forward?
Carlos Cardoso
I mean the fundamental view is that we are going to have a distribution brand for distribution with a value a proposition that benefits from distribution and we are going to make sure that the Kennametal brand is a direct brand and helps us with our value sale proposition and I think that we have been very, very good in the direct sales arena, and we have been building the momentum with the distribution and this is really the next step to grow our distribution and this I think will allow us to grow the distribution channel at a higher rate.
Operator
Our next question comes from the line of Walt Liptak with Barrington Research.
Walt Liptak
Talking about the inventory builds for this year what sectors are you expecting that in and specifically with Caterpillars power up program that alluded to earlier. Have to talked to Caterpillar and does that ripple through your customer's inventory in a meaningful way?
Carlos Cardoso
Yes, I mean certainly Caterpillar, John Deere just announced hiring another 600 people I think close to 600 people. We would expect to see that ripple through our sales basically in the next quarter.
Walt Liptak
Okay. And then what kind of leverage do you initially get on that inventory build?
Carlos Cardoso
I mean this is what we talk about 40% plus in our incremental sales. I mean I think we've experienced that this quarter and we'll continue to experience that plus going forward.
Walt Liptak
Okay and with the $3 billion number that you talked about. You mentioned if you go out a couple of years to get to the $3 billion the leverage becomes less than the 40% plus?
Carlos Cardoso
Yes, I mean typically if you look back historically we will get 30% to 35% leverage. 35% would be a good leverage.
Again I keep on saying that if you look at our 2008 results and take $125 million of our cost there it puts us at 16.4% EBIT margin. So, I mean we are well positioned going forward, obviously depending on the economic turnaround but we don't need a lot of top line growth.
Walt Liptak
Okay. And then I want to ask you talked about the manufacturing footprint down 40% from '03 which is impressive but I think you've got shareholders that have been I guess expecting that footprint was going to get reduced faster knowing the cost structure and the way especially the US has set up.
What are the plans beyond? I know you've done a lot of heavy lifting this year and I don't want to take away from that but what are the plans beyond the $125 million of cost out of the plants, the 14 plants that you've taken out?
Carlos Cardoso
Walt all I can tell you is that there continues to be opportunity for us to do that, but we need to see sort of what the next year brings. I mean we need to see what the growth is, we need to start generating cash and I mean and so forth to be able to do those things.
And that's something that we're going to think about when we put our 2011 plan down the road but clearly to me it depends on the top line obviously at a $2 billion, 2.5 billion I would say that we are 60% there. I mean if you think about a $3 billion company, our 70% or 80% is done.
So, there is opportunity but we need to understand what the top line is going to be in the out years.
Walt Liptak
Okay.
Carlos Cardoso
But we are not done by any means.
Operator
Our next question comes from the line of Andrew Obin with Bank of America-Merrill Lynch.
Andrew Obin
Most of my questions have been answered but just if you could give us more color as to what are you seeing from distributors in terms of this inventory or re-stocking? Can you talk about just the magnitude of the sequential pickup you saw in September and we are almost done with October what you are seeing there?
Carlos Cardoso
It has been the growth between the distributors and the direct sales. It has been about even, I mean and that is for reasons.
I think the distributors are building up, starting to have sales, especially the integrators that are associated with the auto industry. They are beginning to see strong pull and in the direct sides we've seen a lot of activity in special (inaudible) programs and so forth that are been put in place.
So, its really hard for us to be able to tell you exactly not only because its different things driving one channel versus the other, the other one is competitively we just don't typically disclose those numbers.
Andrew Obin
And what about just October versus September any discernible difference between the two months?
Carlos Cardoso
I mean all I can tell you is that as we look through our sales I think our sales are aligned with the guidance that we are providing.
Andrew Obin
And just in terms of thinking about steel cost and raw material cost that you are experiencing. How you are thinking about this versus first half of this fiscal year versus the second half?
Any difference there given what's happening in the market?
Carlos Cardoso
At this point, Andrew I would say nothing significant at this point. Our steel cost [buy] will be down because unlike a lot of the divestitures we did in those areas.
So, we wouldn't have a significant impact in there. So, we continue to watch tungsten trends and the way we're looking out with our contracts, we feel there is not going to be a significant change going forward at this point.
Andrew Obin
So, you don't think that steel cost is going to be a bigger variance for the annual results?
Carlos Cardoso
It's smaller in composition; unless something gets way out of line then we'll have to react with price increases. But the way we see it right now with our visibility, we don't have a concern at this point.
Operator
Our next question comes from the line of Nico Dil with JPMorgan
Nico Dil
Good afternoon gentlemen. It's Nico Dil from JP Morgan in London.
I was just wondering whether you could give us the implied organic growth you are looking forward to Jan-June period next year, so H2 2010 as far as I can understand. As related to the first question that was asked on the conference call, but how much do you feel the implied growth here is due to an end to de-stocking and how much is due to economic recovery?
Frank Simpkins
Well, from an organic we gave in the press release and let me just reiterate what the percents were. From an organic in the second quarter we said negative 20% to 25% organic and then for the full year a minus 5% to minus 10% for the full year.
So, you have the first and the second and we don't give it out by quarter, but you can [please] imply with the second half would be some growth on the top line. And your second question, I couldn't quite hear it.
Nico Dil
Yes, sure. As far as I thought the calculations, I get to about 25% - 30% or so for the second half of 2010.
I was wondering how much of that is due to de-stocking and how much is due to economic recovery?
Frank Simpkins
I would say for the most part, I think the de-stocking has somewhat stabilized or a little bit behind us. So, I don't think that's going to be a drag on for them and as Carlos said in his call, I mean people are still a little bit cautious.
So, hopefully we're planning for the worst and then if we get a little bit of an upside on the re-stocking, that will obviously fall to the bottom line and you'll see the organic order rates that we put out very single month.
Carlos Cardoso
My opinion is the growth that we have seen or the deceleration of decrease that we've seen is through demands, because people are very cautious. They are buying what they need right now.
I think as we build confidence going forward, I think that there will be a stocking portion. So, when I look at our second half, right now I would say that the majority of it is going to be demand and because I don't think that people are going to start increasing their stocks, this calendar year, 2009 calendar year.
I think that everyone needs to see a sustained growth for a longer period of time before they start building inventories.
Operator
Our next question comes from the line of Steve Barger with KeyBanc Capital Markets.
Steve Barger
I had to hop off for a minute, just tell if you covered this, but you've done a good job on keeping or gaining price through the severity, the worst part of this downturn. Is that sustainable going forward or do you think competitors may start seeking out increased market share to put through there, you know everybody has got a smaller cost base now.
Carlos Cardoso
I think that we have come from a place where we were increasing prices during the most severe times and I think that what we guided for this year is that we are going to basically be even. So, we're now going increase their prices increases or the decreases and I think that is for 2010 fiscal year.
I think that's very achievable.
Steve Barger
And Frank you had talked about the idea that as you see sequential revenue increases, given your cost initiatives and the fact that you're probably on top of raw material inflation, you should be able to get gross margin increases sequentially throughout your fiscal year, right?
Frank Simpkins
Right.
Steve Barger
SG&A has bounced around a lot because of some of the cost cutting initiatives. How should I think about the absolute level of SG&A in 2Q going forward?
Is that up down from 1Q plus or minus?
Carlos Cardoso
At this time, I'd say it's up slightly going from the [116] base. It will be the variable components, that will drive off that because we continue to watch the restructuring programs where at that run rate, we'll probably pickup a little bit there between cost of sales and OpEx, but its maintained in that discipline.
So, it's not going to go up substantially, but you're right. When you go from the fourth quarter to the first quarter, when you have the furlough salary increase, that's the one anomaly period but the salary cuts will be consistent through all periods going forward.
So, I don't expect anything significant.
Steve Barger
And is the $6.4 million plus or minus the right interest expense number to think about for the next quarter or two given where interest rates are and the fact you've paid that down?
Frank Simpkins
I can't see it going one way or the other. It's not going to change that much, let me say it that way.
Steve Barger
So, if you have improving gross margin from here on rising revenue, flattish SG&A, flattish interest expense, is it fair to say you're taking a fairly conservative approach to 2Q EPS given, what we know should be a lot better operating leverage going forward?
Frank Simpkins
Well, I think you'll definitely see the operating leverage in the second half; it gets to, what's going to happen in December, at the holidays and the plant shutdowns.
Steve Barger
Right.
Frank Simpkins
And I expect, not everything is going to be exactly flat. There'll be some increases.
So, but I think until we get further down the road and, the other issue is kind of some of the mix of the business. So, I think with Europe being a little bit softer in some of the energy business, we do have some sort of a mix in the, I call it different business units, Europe and MSSG, Energy and AMSG.
So that will play a little part of it. And then in the second quarter, if you remember the first question that we had when we got that incremental $3 million budget...
Steve Barger
Right.
Frank Simpkins
That's not going to be in next period. So, that will be a little bit of a takeaway.
Steve Barger
And just last question, generally speaking from some of the comments you had, it seems like if anything ahead of schedule of where you expected to be given some of your cost takeouts, anything other than some of the issues that you just talked about that should reverse that trend. Do you have a lot of positive momentum on these initiatives going in to 2Q?
Frank Simpkins
Yes, we do.
Operator
Our next question comes from the line of Joel Tiss with Buckingham Research
Joel Tiss
I wonder, do you think that MSSG is going to be on the operating line? You think our second quarter is when we get pretty close to breakeven?
Carlos Cardoso
Yes.
Joel Tiss
Okay. So, that makes sense.
And then the overall sales year-over-year return positive sounds like the third quarter is a reasonable guess?
Carlos Cardoso
From a year-over-year growth?
Joel Tiss
Yeah.
Carlos Cardoso
Yes.
Joel Tiss
Yeah, okay.
Carlos Cardoso
Don't forget there is…
Frank Simpkins
Very favorable comps.
Carlos Cardoso
Yeah, yeah, well the fourth quarter they get really, really favorable.
Frank Simpkins
Exactly.
Joel Tiss
And then the swing in other income, I'm sorry I don't know if you've covered that or not, maybe you did. It was the $3 million positive in other income.
Can you just give us what was in there?
Carlos Cardoso
Yeah, year-over-year or sequentially, Joel?
Joel Tiss
The year-over-year?
Frank Simpkins
Yeah, that's some FX hedging gains that we have.
Joel Tiss
Okay. So, is that a clean up or…
Carlos Cardoso
That goes back to another question, so to Steve Barger, he'll probably have a little less than a sequential basis there. That was some options that expired on Europe currencies.
Operator
Our last question will come from the line of Dana Walker with Kalmar Investments.
Dana Walker
We've now been through a full cycle with a fairly full AMSG portfolio. Could you comment on how you believe that portfolio has performed against your expectations and how your effort to perhaps keep the price cost relationships more [current] on a more real time basis might play assuming that that's possible?
Carlos Cardoso
I'll start that and then Frank can add some color, but I would say that during the AMSG has not in the last 12 months has actually suffered has not met their potential because they suffered from increased raw materials that take us typically a year to recover and the markets were beginning to decline at the time at we needed to recover those raw material price increase. So, I would say that AMSG's profitability or margins whatever you want look at it from what perspective are as we always said had great business that will have higher margins than metalworking and we haven't in the last 12 months been at that point.
Frank Simpkins
Yes. I would add to that, I think I call it our mining construction, (inaudible) well I think those guys have done a phenomenon job.
The Tricon acquisition has been right there in their sweet spot and really leveraging that across the organization. The energy business it's sometimes its down, sometimes its up, we think that's a great business.
We like it a lot and that eventually will comeback and it's very profitable as you know and I think we've made some pretty good inroads with some of the industrial businesses or the engineered products related and with our surface finishing capital good side. So, I think we've come a long way I think the good businesses have continued to do well and some of the units that were underperforming I think we've made some hard decisions and we tried to point them in the right direction.
Dana Walker
Are you in a position though given that we have a new cycle unfolding unknown as to what shape it will take to try to gain price on a more real-time basis or is it just what it is?
Carlos Cardoso
Well I think that as it depends what happens with the raw materials at this point, I think that if the energy part of that business is the question mark of when is that going to turn up? But we believe that business has tremendous upside opportunity from this point.
Dana Walker
Another reflection question. What is your observation as to what's happened to competitive capability?
I suspect the majors probably have not done much other than try to adjust their structural cost, but how would you comment about what the majors have done versus what the remaining smaller players in the market have done?
Carlos Cardoso
I think we have taken cost out without taking capacity out which is a benefit for us in the upturn, we believe; number one. Number two is during this time we continue to invest in new product development and we introduced a number of new products like BEYOND are outperforming, outfacing any compensation at this point.
So, to the event that company's demand our customers are meant to go up. I think we have a very good opportunity for an upsize from that prospective.
I would say that (inaudible) probably has done what they needed to do to cope with the cost. I don't think there is a lot has changed.
I think that we'll probably by the time this is over seen some of the smaller competitors that probably have lost ground and will not be there during the upturn. They will not have enough of working capital to stay in business.
Dana Walker
Have you been able to take steps though that would enforce your customer relationships in a way that you don't believe the market has been able to keep pace with?
Carlos Cardoso
I think in some customers we have I mean but when you have a global business and we have 80,000 active customers, it's hard to make that assertion across the board.
Dana Walker
Finally question from me about late in the cycle you were taking steps to work the channel more than your direct business that you would have some of both. How has your channel business performed versus your direct business and how strongly do you feel about that today versus how you thought you might two years ago?
Carlos Cardoso
I still believe this strategy is the right strategy I think that our indirect channel may have performed slightly better, but because those folks don't take, they tend to carry inventory more than the end users. The end users I think did more of a de-stocking than the distributors, but everything is relative I mean we still believe is the right strategy, we still believe that we are going to continue to invest in the distribution channel and I think that long-term we are going to see a good up tick from that.
Operator
This concludes our question-and-answer period for today. I'll turn the conference back to Ms.
McGuire for any closing remarks.
Quynh McGuire
This concludes our discussion. Please contact to me Quynh McGuire at 724-539-6559 if you have any follow-up questions.
Thanks for joining us.
Operator
Today's call will be available for replay beginning at 1o'clock p.m. Eastern Time today and will run through midnight on November 28, 2009.
The number to dial to access the replay is 800-642-1687 or 706-645-9291. The conference id number for the replay is 34761535.
This concludes today's call. Thank you for your participation.
You may now disconnect.