SEC Filing | Kennametal Inc.

1 ================================================================================ FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2000 Commission file number 1-5318 KENNAMETAL INC. (Exact name of registrant as specified in its charter) PENNSYLVANIA 25-0900168 (State or other jurisdiction (I.R.S. Employer of incorporation) Identification No.) WORLD HEADQUARTERS 1600 TECHNOLOGY WAY P.O. BOX 231 LATROBE, PENNSYLVANIA 15650-0231 (Address of registrant's principal executive offices) Registrant's telephone number, including area code: (724) 539-5000 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 the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: Title Of Each Class Outstanding at April 28, 2000 - ---------------------------------------- ----------------------------- Capital Stock, par value $1.25 per share 30,412,715 ================================================================================

2 KENNAMETAL INC. FORM 10-Q FOR THE QUARTER ENDED MARCH 31, 2000 TABLE OF CONTENTS Item No. Page - -------- ---- PART I. FINANCIAL INFORMATION 1. Financial Statements: Condensed Consolidated Statements of Income (Unaudited) Three and nine months ended March 31, 2000 and 1999................ 1 Condensed Consolidated Balance Sheets (Unaudited) March 31, 2000 and June 30, 1999................................... 2 Condensed Consolidated Statements of Cash Flows (Unaudited) Nine months ended March 31, 2000 and 1999.......................... 3 Notes to Condensed Consolidated Financial Statements (Unaudited)... 4 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.......................................... 11 3. Quantitative and Qualitative Disclosures about Market Risk......... 21 PART II. OTHER INFORMATION 6. Exhibits and Reports on Form 8-K................................... 22

3 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS KENNAMETAL INC. CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) - -------------------------------------------------------------------------------- (in thousands, except per share data) Three Months Ended Nine Months Ended March 31, March 31, ------------------ ---------------------- 2000 1999 2000 1999 ---- ---- ---- ---- OPERATIONS Net sales $483,019 $479,051 $1,379,890 $1,444,291 Cost of goods sold 294,567 305,654 859,242 910,816 -------- -------- ---------- ---------- Gross profit 188,452 173,397 520,648 533,475 Operating expenses 125,830 127,381 375,019 396,840 Restructuring and asset impairment charges 13,323 13,937 17,304 13,937 Amortization of intangibles 6,517 6,485 20,117 19,151 -------- -------- ---------- ---------- Operating income 42,782 25,594 108,208 103,547 Interest expense 13,668 17,992 41,948 53,248 Other expense, net 1,269 668 1,521 861 -------- -------- ---------- ---------- Income before provision for income taxes and minority interest 27,845 6,934 64,739 49,438 Provision for income taxes 12,067 2,900 28,485 21,000 Minority interest 1,681 1,854 3,733 4,828 -------- -------- ---------- ---------- Income before extraordinary item 14,097 2,180 32,521 23,610 Extraordinary loss on early extinguishment of debt, net of tax of $178 -- -- (267) -- -------- -------- ---------- ---------- Net income $ 14,097 $ 2,180 $ 32,254 $ 23,610 ======== ======== ========== ========== PER SHARE DATA Basic earnings per share before extraordinary item $ 0.46 $ 0.07 $ 1.08 $ 0.79 Extraordinary item -- -- (0.01) -- -------- -------- ---------- ---------- Basic earnings per share $ 0.46 $ 0.07 $ 1.07 $ 0.79 ======== ======== ========== ========== Diluted earnings per share before extraordinary item $ 0.46 $ 0.07 $ 1.07 $ 0.79 Extraordinary item -- -- (0.01) -- -------- -------- ---------- ---------- Diluted earnings per share $ 0.46 $ 0.07 $ 1.06 $ 0.79 ======== ======== ========== ========== Dividends per share $ 0.17 $ 0.17 $ 0.51 $ 0.51 ======== ======== ========== ========== Basic weighted average shares outstanding 30,320 29,912 30,201 29,882 ======== ======== ========== ========== Diluted weighted average shares outstanding 30,418 29,923 30,307 29,921 ======== ======== ========== ========== See accompanying notes to condensed consolidated financial statements. 1

4 KENNAMETAL INC. CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED) - -------------------------------------------------------------------------------- (in thousands) March 31, June 30, 2000 1999 ---- ---- ASSETS Current assets: Cash and equivalents $ 21,552 $ 17,408 Marketable equity securities available-for-sale 9,173 13,436 Accounts receivable, less allowance for doubtful accounts of $13,322 and $15,269 245,002 231,287 Inventories 417,333 434,462 Deferred income taxes 44,103 44,182 Other current assets 13,254 9,673 ---------- ---------- Total current assets 750,417 750,448 ---------- ---------- Property, plant and equipment: Land and buildings 230,377 235,375 Machinery and equipment 718,568 756,917 Less accumulated depreciation (444,521) (452,492) ---------- ---------- Net property, plant and equipment 504,424 539,800 ---------- ---------- Other assets: Investments in affiliated companies 1,248 844 Intangible assets, less accumulated amortization of $86,894 and $64,096 665,397 685,695 Deferred income taxes 34,096 33,996 Other 36,536 32,865 ---------- ---------- Total other assets 737,277 753,400 ---------- ---------- Total assets $1,992,118 $2,043,648 ========== ========== LIABILITIES Current liabilities: Current maturities of long-term debt and capital leases $ 4,387 $ 117,217 Notes payable to banks 64,984 26,222 Accounts payable 122,166 89,339 Accrued vacation pay 29,380 27,323 Accrued payroll 20,370 19,730 Other current liabilities 127,429 97,035 ---------- ---------- Total current liabilities 368,716 376,866 ---------- ---------- Long-term debt and capital leases, less current maturities 667,632 717,852 Deferred income taxes 53,478 53,108 Other liabilities 90,878 97,186 ---------- ---------- Total liabilities 1,180,704 1,245,012 ---------- ---------- Minority interest in consolidated subsidiaries 54,338 53,505 ---------- ---------- SHAREOWNERS' EQUITY Preferred stock, no par value; 5,000 shares authorized; none issued -- -- Capital stock, $1.25 par value; 70,000 shares authorized; 33,083 and 32,903 shares issued 41,354 41,128 Additional paid-in capital 331,785 325,382 Retained earnings 494,449 477,593 Treasury shares, at cost; 2,711 and 2,836 shares held (55,634) (57,199) Unearned compensation (2,436) (3,330) Accumulated other comprehensive loss (52,442) (38,443) ---------- ---------- Total shareowners' equity 757,076 745,131 ---------- ---------- Total liabilities and shareowners' equity $1,992,118 $2,043,648 ========== ========== See accompanying notes to condensed consolidated financial statements. 2

5 KENNAMETAL INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) - -------------------------------------------------------------------------------- (in thousands) Nine Months Ended March 31, ---------------------------- 2000 1999 ---- ---- OPERATING ACTIVITIES Net income $ 32,254 $ 23,610 Adjustments for noncash items: Depreciation 56,333 52,746 Amortization 20,117 19,151 Restructuring and asset impairment charges 8,143 17,119 Loss on early extinguishment of debt, net of tax 267 -- Other 5,133 6,308 Changes in certain assets and liabilities, net of effects of acquisitions and divestiture: Accounts receivable (23,161) 910 Proceeds from securitization of accounts receivable 2,700 -- Inventories 9,808 (23,002) Accounts payable and accrued liabilities 55,847 (81) Other (2,186) (6,816) --------- --------- Net cash flow from operating activities 165,255 89,945 --------- --------- INVESTING ACTIVITIES Purchases of property, plant and equipment (34,123) (83,226) Disposals of property, plant and equipment 6,788 8,947 Purchase of marketable equity securities -- (12,162) Other 277 (4,593) --------- --------- Net cash flow used for investing activities (27,058) (91,034) --------- --------- FINANCING ACTIVITIES Increase (decrease) in short-term debt 38,809 (13,637) Increase in long-term debt 117,806 131,330 Decrease in long-term debt (281,950) (104,860) Dividend reinvestment and employee stock plans 7,925 2,769 Cash dividends paid to shareowners (15,398) (15,237) Other (1,017) (1,014) --------- --------- Net cash flow used for financing activities (133,825) (649) --------- --------- Effect of exchange rate changes on cash (228) (732) --------- --------- CASH AND EQUIVALENTS Net increase (decrease) in cash and equivalents 4,144 (2,470) Cash and equivalents, beginning 17,408 18,366 --------- --------- Cash and equivalents, ending $ 21,552 $ 15,896 ========= ========= SUPPLEMENTAL DISCLOSURES Interest paid $ 40,757 $ 51,425 Income taxes paid 14,417 18,808 See accompanying notes to condensed consolidated financial statements. 3

6 KENNAMETAL INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - -------------------------------------------------------------------------------- 1. The condensed consolidated financial statements should be read in conjunction with the Notes to the Consolidated Financial Statements included in the company's 1999 Annual Report. The condensed consolidated balance sheet as of June 30, 1999 has been derived from the audited balance sheet included in the company's 1999 Annual Report. These accompanying interim statements are unaudited; however, management believes that all adjustments necessary for a fair presentation have been made and all adjustments are normal, recurring adjustments. The results for the three and nine months ended March 31, 2000 are not necessarily indicative of the results to be expected for the full fiscal year. Certain amounts in the prior years' consolidated financial statements have been reclassified to conform with the current year presentation. 2. Inventories are stated at lower of cost or market. Cost is determined using the last-in, first-out (LIFO) method for a significant portion of domestic inventories and the first-in, first-out (FIFO) method or average cost for other inventories. The company used the LIFO method of valuing its inventories for approximately 45 percent of total inventories at March 31, 2000. Because inventory valuations under the LIFO method are based on an annual determination of quantities and costs as of June 30 of each year, the interim LIFO valuations are based on management's projections of expected year-end inventory levels and costs. Therefore, the interim financial results are subject to any final year-end LIFO inventory adjustments. 3. The major classes of inventory as of the balance sheet dates were as follows (in thousands): March 31, June 30, 2000 1999 ---- ---- Finished goods $316,916 $318,736 Work in process and powder blends 96,678 117,987 Raw materials and supplies 36,169 32,619 -------- -------- Inventory at current cost 449,763 469,342 Less LIFO valuation (32,430) (34,880) -------- -------- Total inventories $417,333 $434,462 ======== ======== 4. The company has been involved in various environmental cleanup and remediation activities at several of its manufacturing facilities. In addition, the company is currently named as a potentially responsible party (PRP) at several Superfund sites in the United States. In the December 1999 quarter, the company recorded a remediation reserve of $3.0 million with respect to its involvement in these matters, which is recorded as a component of operating expenses. This represents management's best estimate of its future obligation based on its evaluations and discussions with outside counsel and independent consultants, and the current facts and circumstances related to these matters. The company recorded this liability in the December quarter because certain events occurred, including sufficient progress made by the government and the PRPs in the identification of other PRPs and review of potential remediation solutions, that clarified the level of involvement in these matters by the company and its relationship to other PRPs. This led the company to conclude that it was probable that a liability had been incurred. In addition to the amount currently reserved, the company may be subject to loss contingencies related to these matters estimated to be up to an additional $3.3 million. The company believes that such unreserved losses are reasonably possible but are not currently considered to be probable of occurrence. The reserved and unreserved liabilities may change substantially in the near term due to 4

7 KENNAMETAL INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- 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 and the identification of new PRPs. The company maintains a Corporate Environmental, Health and Safety (EH&S) Department, as well as an EH&S Policy Committee, to ensure compliance with environmental regulations and to monitor and oversee remediation activities. In addition, the company has established an EH&S administrator at its domestic manufacturing facilities. The company's financial management team periodically meets with members of the Corporate EH&S Department and the Corporate Legal Department to review and evaluate the status of environmental projects and contingencies. On a quarterly and annual basis, management establishes or adjusts financial provisions and reserves for environmental contingencies in accordance with Statement of Financial Accounting Standards (SFAS) No. 5, "Accounting for Contingencies." 5. For purposes of determining the number of dilutive shares outstanding, weighted average shares outstanding for basic earnings per share calculations were increased due to the dilutive effect of unexercised stock options by 98,394 and 11,723 for the three months ended March 31, 2000 and 1999, respectively, and 105,231 and 38,637 for the nine months ended March 31, 2000 and 1999, respectively. 6. Comprehensive income for the three and nine months ended March 31, 2000 and 1999 is as follows (in thousands): Three Months Ended Nine Months Ended March 31, March 31, ------------------ ------------------ 2000 1999 2000 1999 ---- ---- ---- ---- Net income $14,097 $ 2,180 $ 32,254 $23,610 Unrealized loss on marketable equity securities available-for-sale, net of tax (348) (66) (3,674) (66) Minimum pension liability adjustment 53 -- 100 -- Foreign currency translation adjustments (7,519) (5,619) (10,425) (5,220) ------- ------- -------- ------- Comprehensive income (loss) $ 6,283 $(3,505) $ 18,255 $18,324 ======= ======= ======== ======= The components of accumulated other comprehensive loss consist of the following (in thousands): March 31, June 30, 2000 1999 ---- ---- Unrealized gain (loss) on marketable equity securities available-for-sale, net of tax $ (2,514) $ 1,160 Minimum pension liability adjustment (1,165) (1,265) Foreign currency translation adjustments (48,763) (38,338) -------- -------- Total accumulated other comprehensive loss $(52,442) $(38,443) ======== ======== 7. In June 1998, SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," was issued. The company must adopt the standard by the beginning of the first quarter of fiscal 2001. SFAS No. 133 establishes accounting and reporting standards requiring all derivative instruments (including certain derivative instruments imbedded in other contracts) be recorded in the balance sheet as either an asset or liability measured at their fair value. SFAS No. 133 requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting 5

8 KENNAMETAL INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- criteria are met. Accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the income statement, and requires that a company must formally document, designate and assess the effectiveness of transactions that receive hedge accounting. The company is currently evaluating the effects of SFAS No. 133 and is preparing a plan for implementation. 8. In March 1999, the company's management implemented restructuring plans, including several programs to reduce costs, improve operations and enhance customer satisfaction. The costs accrued for these plans were based on management estimates using the latest information available at the time that the accrual was established. The costs charged against the accrual as of March 31, 2000 were as follows (in thousands): June 30, Cash March 31, 1999 Expenditures Adjustments 2000 -------- ------------ ----------- --------- Plant closure $2,200 $(1,546) $-- $ 654 Voluntary early retirement program 1,367 (627) -- 740 ------ ------- --- ------ Total $3,567 $(2,173) $-- $1,394 ====== ======= === ====== Additional period costs of $0.1 million and $2.1 million resulting from the relocation of employees, hiring and training new employees and other costs associated with the temporary duplication of certain operations and other inefficiencies related to the Solon, Ohio plant closure were included in cost of goods sold during the three and nine months ended March 31, 2000, respectively. 9. During the September 1999 quarter, the company entered into two interest rate swap agreements that effectively convert a notional amount of $50.0 million from floating to fixed interest rates. This increased the total notional amount of floating-to-fixed interest rate swaps to $100.0 million. These new agreements mature in July 2002. At March 31, 2000, the company would have received $2.6 million to settle all interest rate swap agreements, representing the excess of fair value over the carrying cost of these agreements. The effect of all interest rate swaps on the company's composite interest rate on long-term debt was not material at March 31, 2000. At March 31, 2000, the company had outstanding foreign exchange forward contracts to sell foreign currency with notional amounts translated into U.S. dollars of $29.9 million. These contracts mature before June 30, 2000. The net unrealized loss on these contracts was $1.1 million at March 31, 2000. In February 2000, the company completed a short-term foreign exchange hedging program to protect a portion of the company's currency exposure from unfavorable exchange rate movements. This exposure arises from anticipated cash collections from foreign subsidiaries on transactions between domestic and foreign subsidiaries during the remainder of fiscal 2000. This program involves the purchase of a series of options that permit the company to sell the foreign currency at specific rates contained in the contracts. The cost of this program, $0.6 million, is being amortized to Other Expense over the life of the options. At March 31, 2000, the unamortized cost of $0.5 million is recorded in Other Current Assets and approximates the fair value of the options then outstanding. The notional amounts of the option contracts translated into U.S. dollars at March 31, 2000 rates is $27.2 million. 6

9 KENNAMETAL INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- In April and May 2000, the company began to implement a foreign exchange hedging program to protect a portion of the company's currency exposure from unfavorable exchange rate movements. This exposure arises from anticipated cash collections from foreign subsidiaries on transactions between domestic and foreign subsidiaries during fiscal 2001. This program utilizes purchased options, written options and forward exchange contracts. The cost of this program, $1.9 million, will be amortized to Other Expense based on the life of the contracts, until SFAS 133 is adopted on July 1, 2000; thereafter, the contracts will be accounted for and reported under this new Statement. The notional amounts of the hedging instruments translated into U.S. dollars at March 31, 2000 rates is $117.6 million. 10. In November 1999, the company announced plans to close, consolidate or downsize several plants, warehouses and offices, and associated workforce reductions as part of its overall plan to increase asset utilization and financial performance, and to reposition the company to become the premier tooling solutions supplier. The company expects to record total one-time charges of $25 to $30 million related to these programs by its fiscal 2000 year-end. Additional period costs are estimated to be $5 to $6 million and are expected to be incurred through fiscal 2000 and 2001. Management implemented several of these programs through the March 2000 quarter. The costs accrued for the implemented programs were based upon management estimates using the latest information available at the time that the accrual was established. The components of the charges are as follows (in thousands): Incremental Initial Total Asset Pension Restructuring Charge Write-Downs Obligation Liability ------ ----------- ----------- ------------- Asset impairment charges $ 4,958 $(4,958) $ -- $ -- Employee severance 5,765 -- (467) 5,298 Product rationalization 100 (100) -- -- Facility rationalizations 6,581 (3,085) -- 3,496 ------- ------- ----- ------ Total $17,404 $(8,143) $(467) $8,794 ======= ======= ===== ====== In conjunction with the company's ongoing review of underperforming businesses, certain assets are reviewed for impairment pursuant to the provisions of SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." An asset impairment charge of $1.7 million was recorded, related to a metalworking manufacturing operation in Shanghai, China. This operation became fully operational in fiscal 1998 and to date, has not generated the performance that was expected at the time the company entered into this market. Management performed an in-depth review of the operations, capacity utilization and the local management team, and engaged a consultant to perform an independent review of the same. These reviews enabled management to determine that the market served by this operation is not expected to develop to the extent originally anticipated, but that the operations were in good working order and utilized modern technology, and that the management team in place was competent. Management also determined that this facility had excess capacity given the level of market demand. Accordingly, management updated its operating forecast to reflect the current market demand. In comparing the projected cash flows of the updated forecast to the net book value of the assets of this operation, management determined that the full value of these assets would not be recoverable. Accordingly, a charge was recorded to adjust the carrying value of the long-lived assets of this operation to fair value. The estimated fair value of these assets was based on various methodologies, including a discounted value of estimated future cash flows. 7

10 KENNAMETAL INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- The product rationalization charge of $0.1 million represents the write-down of certain discontinued product lines manufactured in these operations. The company manufactured these products specifically for the market served by these operations and management has determined that these products are no longer salable. This charge has been recorded as a component of cost of goods sold. The company recorded an asset impairment charge of $3.0 million related to the write-down of equipment in its North American metalworking operations and $0.3 million in its Engineered Products operations. In connection with the repositioning of the company, management completed an assessment of the assets currently being used in these operations and determined that these assets were not going to be further utilized in conducting these operations. This amount represents the write-down of the book value of the assets, net of salvage value. The charge for facility rationalization relates to employee severance for 131 employees and other exit costs associated with the closure or downsizing of a metalworking manufacturing operation in Kingswinford, United Kingdom, a circuit board drill plant in Janesville, Wisconsin, a German warehouse facility, and several offices in the Asia Pacific region and South America. The charge also includes $3.4 million for employee severance for 41 employees and other exit costs associated with the closure of a mining and construction manufacturing operation in China and the exit of the related joint venture. The company accrued $5.8 million related to severance packages provided to 122 hourly and salaried employees terminated in connection with a global workforce reduction. Included in this charge is incremental pension obligation of $0.5 million, incurred by the company as a result the severance packages provided. This amount is included in the pension obligation and presented as a component of other liabilities. The costs related to the asset impairment charges, employee severance and facility rationalizations of $17.3 million have been recorded as a component of restructuring and asset impairment charges. The costs charged against the restructuring cost accrual as of March 31, 2000 were as follows (in thousands): Initial Cash March 31, Liability Expenditures Adjustments 2000 ------------- ------------ ----------- -------- Employee severance $5,298 $(1,839) $-- $3,459 Facility rationalizations 3,496 (150) -- 3,346 ------ -------- --- ------ Total $8,794 $(1,989) $-- $6,805 ====== ======= === ====== Through March 31, 2000, the company has incurred period costs of $1.7 million related to these initiatives. The company continues to review its business strategies and pursue other cost-reduction activities, some of which could result in future charges. 11. In November 1999, the company repaid its term loan under the Bank Credit Agreement. This resulted in an acceleration of the amortization of deferred financing fees of $0.4 million, which was recorded as an extraordinary item of $0.3 million, net of tax. 12. In the December 1999 quarter, the company engaged an investment bank to explore strategic alternatives regarding its 83 percent-owned subsidiary, JLK Direct Distribution Inc. (JLK), including a possible divestiture. At that time, management believed a divestiture might enhance growth prospects for both the company and JLK by allowing each company to focus on its core competencies. The company completed a thorough and disciplined process of evaluating strategic 8

11 KENNAMETAL INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- alternatives and on May 2, 2000, decided to terminate consideration of a possible divestiture at this time, although management continues to believe there may be better owners for JLK. 13. On December 16, 1999, the company determined that certain performance measurements in the accounts receivable securitization program agreement were not met due to an increase in the aging of the accounts receivable of one of the participating subsidiaries as a result of a system implementation at that subsidiary. The program sponsor waived this condition and the agreement was amended to temporarily revise the performance measurements until May 2000, at which time these performance measurements revert to the original terms of the agreement. 14. In November 1999, management reorganized the financial reporting of its operations to focus on global business units consisting of Metalworking, Engineered Products, Mining & Construction and JLK/Industrial Supply, and corporate functional shared services. The results for all periods presented have been restated to conform to the new reporting structure. The company's external sales, intersegment sales and operating income by business unit for the three and nine months ended March 31, 2000 and 1999 are as follows (in thousands): Three Months Ended Nine Months Ended March 31, March 31, --------------------- ----------------------- 2000 1999 2000 1999 ---- ---- ---- ---- External sales: Metalworking $265,878 $259,354 $ 761,492 $ 788,081 Engineered Products 46,258 43,240 129,367 133,577 Mining & Construction 39,556 42,285 124,183 129,179 JLK/Industrial Supply 131,327 134,172 364,848 393,454 -------- -------- ---------- ---------- Total external sales $483,019 $479,051 $1,379,890 $1,444,291 ======== ======== ========== ========== Intersegment sales: Metalworking $ 32,330 $ 25,106 $ 102,800 $ 76,056 Engineered Products 5,029 6,638 14,792 17,585 Mining & Construction 1,382 1,284 5,117 3,754 JLK/Industrial Supply 2,197 4,134 6,720 10,349 -------- -------- ---------- ---------- Total intersegment sales $ 40,938 $ 37,162 $ 129,429 $ 107,744 ======== ======== ========== ========== Total sales: Metalworking $298,208 $284,460 $ 864,292 $ 864,137 Engineered Products 51,287 49,878 144,159 151,162 Mining & Construction 40,938 43,569 129,300 132,933 JLK/Industrial Supply 133,524 138,306 371,568 403,803 -------- -------- ---------- ---------- Total sales $523,957 $516,213 $1,509,319 $1,552,035 ======== ======== ========== ========== Operating income (loss): Metalworking $ 34,658 $ 24,045 $ 89,964 $ 88,353 Engineered Products 5,965 6,655 15,223 18,550 Mining & Construction 2,036 (995) 11,342 8,227 JLK/Industrial Supply 10,363 10,684 24,431 26,035 Corporate & Eliminations (10,240) (14,795) (32,752) (37,618) -------- -------- ---------- ---------- Total operating income $ 42,782 $ 25,594 $ 108,208 $ 103,547 ======== ======== ========== ========== 9

12 KENNAMETAL INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) - -------------------------------------------------------------------------------- Metalworking operating income for the three and nine months ended March 31, 2000 was reduced by $7.7 million and $11.2 million, respectively, related to asset impairment charges, and costs associated with facility and product rationalizations and employee severance. Engineered Products operating income for the three and nine months ended March 31, 2000 was reduced by $1.3 million related to costs associated with facility rationalizations and employee severance, and asset impairment charges. Mining & Construction operating income for the three and nine months ended March 31, 2000 was reduced by $3.1 million and $3.4 million, respectively, related to costs associated with a facility rationalization, including costs to exit the related joint venture, asset impairment charges and employee severance. Corporate operating income for the three and nine months ended March 31, 2000 was reduced by $1.2 million and $4.5 million, respectively, related to environmental remediation costs and costs associated with employee severance. Metalworking operating income for the three and nine months ended March 31, 1999 was reduced by $11.1 million related to the product rationalization program and to close a drill manufacturing plant in Solon, Ohio. Mining & Construction operating income for the three and nine months ended March 31, 1999 was reduced by $5.8 million related to a write-down of an investment in, and net receivables from, certain international operations in emerging markets. Corporate operating income for the three and nine months ended March 31, 1999 was reduced by $7.7 million related to a voluntary early retirement benefit program and a one-time charge incurred in the acquisition of 4.9 percent of Toshiba Tungaloy. The company's assets by business unit at March 31, 2000 and June 30, 1999 are as follows (in thousands): March 31, 2000 June 30, 1999 -------------- ------------- Assets: Metalworking $ 979,246 $1,039,854 Engineered Products 335,411 363,739 Mining & Construction 135,346 146,295 JLK/Industrial Supply 305,171 274,989 Corporate 236,944 218,771 ---------- ---------- Total assets $1,992,118 $2,043,648 ========== ========== 10

13 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - -------------------------------------------------------------------------------- RESULTS OF OPERATIONS OVERVIEW Sales for the March 2000 quarter were $483.0 million, an increase of one percent from $479.1 million in the year-ago quarter. Sales were up four percent excluding unfavorable foreign exchange effects of two percent and the effect of the divestiture of the Strong Tool Co. steel mill supply business of one percent. This increase is attributed to increased demand in the company's end markets. Net income for the quarter ended March 31, 2000 was $14.1 million, or $0.46 per share, compared to net income of $2.2 million, or $0.07 per share, in the same quarter last year. The March 2000 results were reduced by $13.3 million, or $0.25 per share, related to restructuring and asset impairment charges. The performance for the quarter reflects the company's growing success in implementing operational improvement programs and strong cost controls. The results for the March 1999 quarter were reduced by approximately $24.6 million, or $0.51 per share, including $20.8 million, or $0.44 per share, related to special charges for operational improvement programs, and $3.8 million, or $0.07 per share, related to a one-time charge incurred in the acquisition of 4.9 percent of Toshiba Tungaloy stock. Sales for the nine months ended March 31, 2000 were $1,379.9 million compared to $1,444.3 million in the same period a year ago, a decline of four percent. Unfavorable foreign currency effects and the divestiture accounted for two and one percent, respectively, of the sales decline from last year. Net income for the nine months ended March 31, 2000 was $32.3 million, or $1.06 per share, compared to $23.6 million, or $0.79 per share, in the same period last year. Earnings were affected by the factors mentioned above. BUSINESS SEGMENT REVIEW In November 1999, management reorganized the financial reporting of its operations to focus on global business units consisting of Metalworking, Engineered Products, Mining & Construction and JLK/Industrial Supply, and corporate functional shared services. The results for all periods presented have been restated to conform to the new reporting structure. METALWORKING Three Months Ended Nine Months Ended March 31, March 31, ------------------------ ------------------------ 2000 1999 2000 1999 ---- ---- ---- ---- External sales $265,878 $259,354 $761,492 $788,081 Intersegment sales 32,330 25,106 102,800 76,056 Operating income 34,658 24,045 89,964 88,353 External sales in the Metalworking segment increased six percent during the March 2000 quarter, compared to the same quarter a year ago, excluding unfavorable foreign currency effects of three percent. Sales in North America were up eight percent compared to last year due predominately to strong demand in the automotive and truck markets and, to a lesser extent, increased demand in the oil field services and machine tool end markets. Sales in the European Metalworking market increased two percent over the same quarter last year, excluding unfavorable foreign currency translation effects of 11 percent. The increase in sales also was due predominately to strong demand in the German automotive market. Sales in Asia continued to grow and were up 12 percent, in local currency, compared to the prior year. 11

14 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) - -------------------------------------------------------------------------------- Operating income of $34.7 million was affected by restructuring and asset impairment charges of $7.7 million in the March 2000 quarter. The March 1999 quarter included restructuring costs associated with the Solon, Ohio drill plant closure and product rationalization charges of $11.1 million. Excluding these charges in each period, operating income increased $7.3 million, or 21 percent largely due to the increase in overall sales levels. Continued strong cost controls resulted in a reduction in operating expenses that contributed to the remainder of the operating income improvement. Period costs associated with the Solon, Ohio plant closure were $0.1 million for the quarter ended March 31, 2000. For the nine months ended March 31, 2000, external sales declined one percent compared to last year excluding unfavorable foreign currency effects of two percent. Operating income increased to $90.0 million and was affected by the same factors mentioned above. Period costs associated with the Solon, Ohio plant closure were $2.1 million for the nine months ended March 31, 2000. ENGINEERED PRODUCTS Three Months Ended Nine Months Ended March 31, March 31, ----------------------- ------------------------ 2000 1999 2000 1999 ---- ---- ---- ---- External sales $46,258 $43,240 $129,367 $133,577 Intersegment sales 5,029 6,638 14,792 17,585 Operating income 5,965 6,655 15,223 18,550 Compared to last year, external sales in the Engineered Products market increased 11 percent, excluding unfavorable foreign exchange effects of four percent, due to increased demand for electronic circuit board drills. Sales to the oil field services end market improved sequentially during the March 31, 2000 quarter, however, these sales did not significantly affect the year-over-year growth in sales. Operating income of $6.0 million for the March 31, 2000 quarter includes restructuring costs of $1.3 million related the rationalization of the Janesville, Wisconsin circuit board drill plant, employee severance, and asset impairment charges. Excluding these charges, operating income increased nine percent due primarily to lower manufacturing variances, higher sales levels, continued cost controls and lean manufacturing techniques. Compared to a year ago, external sales for the nine months ended March 31, 2000 declined three percent due entirely to unfavorable foreign exchange effects. Operating income declined to $15.2 million due to the restructuring costs mentioned above and due to the decline in sales levels. MINING & CONSTRUCTION Three Months Ended Nine Months Ended March 31, March 31, ----------------------- ------------------------ 2000 1999 2000 1999 ---- ---- ---- ---- External sales $39,556 $42,285 $124,183 $129,179 Intersegment sales 1,382 1,284 5,117 3,754 Operating income (loss) 2,036 (995) 11,342 8,227 External sales in this segment declined five percent from the March 1999 quarter, excluding one percent unfavorable foreign exchange effects. The decline in sales is due to continued weak demand for mining tools in North America and metallurgical powders as a result of weakness in the underground coal and oil and gas exploration end markets. Operating income for the March 2000 quarter includes $3.1 million of restructuring costs associated with the closure of a manufacturing operation in China and the exit of the related joint venture. In the March 1999 quarter, restructuring costs of $5.8 million were recorded related to 12

15 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) - -------------------------------------------------------------------------------- the write-down of an investment in, and net receivables from, other international operations in emerging markets as a result of changing market conditions in the regions these operations serve. Excluding these charges in each period, operating income increased to $5.1 million from $4.8 million due to continued strong cost controls, despite the decline in sales. Sales for the nine months ended March 31, 2000 declined three percent, excluding unfavorable foreign exchange effects of one percent, compared to the year-ago period due to the factors mentioned above. Excluding restructuring costs of $3.4 million and $5.8 million for the nine months ended March 31, 2000 and 1999, respectively, operating income increased $0.7 million to $14.7 million due to continued cost controls, despite lower sales volumes. JLK/INDUSTRIAL SUPPLY Three Months Ended Nine Months Ended March 31, March 31, ------------------------ ---------------------- 2000 1999 2000 1999 ---- ---- ---- ---- External sales $131,327 $134,172 $364,848 $393,454 Intersegment sales 2,197 4,134 6,720 10,349 Operating income 10,363 10,684 24,431 26,035 In this segment, external sales increased one percent from the same quarter a year ago, excluding the effects of the divestiture of the Strong Tool Co. steel mill business unit. The addition of new Full Service Supply (FSS) programs in the current year contributed two percent to the overall sales growth. This growth was reduced by one percent due to continued weakness in the catalog business end markets, predominately oil field services. The company provided FSS programs to 162 customers covering 252 different facilities at March 31, 2000, compared to 139 customers covering 220 different facilities at March 31, 1999. Operating income declined to $10.4 million due to lower sales, partially offset by continued operating cost controls. The gross margin was 32.2 percent compared to 31.9 percent due to the elimination of the lower-margin sales from the divested business unit. Operating expenses declined $0.8 million to $32.6 million due primarily to the implementation of several cost-reduction initiatives since March 1999. For the nine months ended March 31, 2000, sales declined four percent compared to a year ago, excluding the affect of the divestiture of three percent. Of the overall decline, the catalog business contributed five percent, partially offset by incremental FSS sales, both due to the factors mentioned above. Operating income declined to $24.4 million due to the factors mentioned above. GROSS PROFIT MARGIN The consolidated gross profit margin for the March 2000 quarter was 39.0 percent, compared to 36.2 percent in same quarter in the prior year. The gross margin in 1999 was affected by a $6.9 million charge related to the implementation of a new program to streamline and optimize the global metalworking product offering. Excluding this charge, the gross margin would have been 37.6 percent. The majority of the increase in gross margin is due to improved manufacturing variances as a result of lean manufacturing techniques and strong cost controls, despite lower production levels. Consolidated gross profit margin was 37.7 percent for the nine months ended March 31, 2000, compared with 37.4 percent in same period a year ago, excluding the $6.9 million product rationalization charge. 13

16 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) - -------------------------------------------------------------------------------- Included in fiscal 2000 results are period costs of $2.1 million related to the Solon, Ohio plant closure. Excluding these effects, the increase in the gross profit margin is due to the factors mentioned above. OPERATING EXPENSES Operating expenses for the March 2000 quarter were $125.8 million, a reduction of one percent from $127.4 million in the same quarter last year. Operating expenses for 1999 include a charge of $3.8 million recorded on the purchase of 4.9 percent of Toshiba Tungaloy stock due to the difference between the cost and the fair market value of the securities on the date the securities were purchased. Excluding this charge, operating expenses for the current quarter were two percent above the prior year quarter. This increase is due to higher research and development spending and the full reinstatement of salary reductions imposed in November 1998. For the nine months ended March 31, 2000, operating expenses of $375.0 million were five percent below 1999 levels despite a $3.0 million charge for environmental remediation costs recorded in December 1999 and the charge on the purchase of Toshiba Tungaloy stock recorded last year. Operating expenses improved due to ongoing cost and productivity improvement programs in effect throughout fiscal 2000. RESTRUCTURING AND ASSET IMPAIRMENT CHARGES In November 1999, the company announced plans to close, consolidate or downsize several plants, warehouses and offices, and associated workforce reductions as part of its overall plan to increase asset utilization and financial performance, and to reposition the company to become the premier tooling solutions supplier. The company expects to record total one-time charges of $25 to $30 million related to these programs by its fiscal 2000 year-end. Additional period costs are estimated to be $5 to $6 million and are expected to be incurred through fiscal 2000 and 2001. Management implemented several of these programs through the March 2000 quarter. The costs accrued for the implemented programs were based upon management estimates using the latest information available at the time that the accrual was established. The components of the charges are as follows (in thousands): Incremental Initial Total Asset Pension Restructuring Charge Write-Downs Obligation Liability ------- ----------- ----------- ------------- Asset impairment charges $ 4,958 $(4,958) $ -- $ -- Employee severance 5,765 -- (467) 5,298 Product rationalization 100 (100) -- -- Facility rationalizations 6,581 (3,085) -- 3,496 ------- ------- ----- ------ Total $17,404 $(8,143) $(467) $8,794 ======= ======= ===== ====== In conjunction with the company's ongoing review of underperforming businesses, certain assets are reviewed for impairment pursuant to the provisions of SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." An asset impairment charge of $1.7 million was recorded, related to a metalworking manufacturing operation in Shanghai, China. This operation became fully operational in fiscal 1998 and to date, has not generated the performance that was expected at the time the company entered into this market. Management performed an in-depth review of the operations, capacity utilization and the local management team, and engaged a consultant to perform an independent review of the same. These reviews enabled management to determine that the 14

17 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) - -------------------------------------------------------------------------------- market served by this operation is not expected to develop to the extent originally anticipated, but that the operations were in good working order and utilized modern technology, and that the management team in place was competent. Management also determined that this facility had excess capacity given the level of market demand. Accordingly, management updated its operating forecast to reflect the current market demand. In comparing the projected cash flows of the updated forecast to the net book value of the assets of this operation, management determined that the full value of these assets would not be recoverable. Accordingly, a charge was recorded to adjust the carrying value of the long-lived assets of this operation to fair value. The estimated fair value of these assets was based on various methodologies, including a discounted value of estimated future cash flows. The product rationalization charge of $0.1 million represents the write-down of certain discontinued product lines manufactured in these operations. The company manufactured these products specifically for the market served by these operations and management has determined that these products are no longer salable. This charge has been recorded as a component of cost of goods sold. The company recorded an asset impairment charge of $3.0 million related to the write-down of equipment in its North American metalworking operations and $0.3 million in its Engineered Products operations. In connection with the repositioning of the company, management completed an assessment of the assets currently being used in these operations and determined that these assets were not going to be further utilized in conducting these operations. This amount represents the write-down of the book value of the assets, net of salvage value. The charge for facility rationalization relates to employee severance for 131 employees and other exit costs associated with the closure or downsizing of a metalworking manufacturing operation in Kingswinford, United Kingdom, a circuit board drill plant in Janesville, Wisconsin, a German warehouse facility, and several offices in the Asia Pacific region and South America. The charge also includes $3.4 million for employee severance for 41 employees and other exit costs associated with the closure of a mining and construction manufacturing operation in China and the exit of the related joint venture. The company accrued $5.8 million related to severance packages provided to 122 hourly and salaried employees terminated in connection with a global workforce reduction. Included in this charge is incremental pension obligation of $0.5 million, incurred by the company as a result the severance packages provided. This amount is included in the pension obligation and presented as a component of other liabilities. The costs related to the asset impairment charges, employee severance and facility rationalizations of $17.3 million have been recorded as a component of restructuring and asset impairment charges. The costs charged against the restructuring cost accrual as of March 31, 2000 were as follows (in thousands): Initial Cash March 31, Liability Expenditures Adjustments 2000 --------- ------------- ----------- --------- Employee severance $5,298 $(1,839) $-- $3,459 Facility rationalizations 3,496 (150) -- 3,346 ------ ------- --- ------ Total $8,794 $(1,989) $-- $6,805 ====== ======= === ====== 15

18 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) - -------------------------------------------------------------------------------- Through March 31, 2000, the company has incurred period costs of $1.7 million related to these initiatives. The company continues to review its business strategies and pursue other cost-reduction activities, some of which could result in future charges. INTEREST EXPENSE Interest expense for the March 2000 quarter declined to $13.7 million due to reduced debt levels, partially offset by higher borrowing rates. Average U.S. borrowing rates of 6.88 percent were 51 basis points higher compared to a year ago due to the rising interest rate environment, partially offset by improved pricing under the company's Bank Credit Agreement. Interest expense for the nine months ended March 31, 2000 declined to $41.9 million due to reduced debt levels. The average U.S. borrowing rate increased to 6.62 percent from 6.45 percent in the same period a year ago, due to the factors mentioned above. OTHER EXPENSE, NET Other expense for the March 2000 quarter included fees of $1.3 million incurred in connection with the accounts receivable securitization program initiated in June 1999. For the nine months ended March 31, 2000, other expense included fees of $3.7 million related to the accounts receivable securitization program. This was partially offset by gains of $1.4 million from sales of underutilized assets. INCOME TAXES The effective tax rate for the March 2000 quarter was 43.3 percent compared to 41.8 percent in the prior year. The increase in the effective tax rate is attributable to non-recurring tax benefits from costs to repay senior debt in fiscal 1999. For the nine months ended March 31, 2000, the effective tax rate was 44.0 percent compared to 42.5 percent in the prior year. The increase in the effective tax rate is attributable to the factor mentioned above. EXTRAORDINARY LOSS ON EARLY EXTINGUISHMENT OF DEBT In November 1999, the company repaid its term loan under the Bank Credit Agreement. This resulted in an acceleration of the amortization of deferred financing fees of $0.4 million, which has been recorded as an extraordinary item of $0.3 million, net of tax. LIQUIDITY AND CAPITAL RESOURCES The company's cash flow from operations is the primary source of financing for capital expenditures and internal growth. During the nine months ended March 31, 2000, the company generated $165.3 million in cash flow from operations. Compared to the prior year, cash flow increased $75.3 million primarily due to improvement in working capital and higher net income. The working capital improvement reflects management's initiatives to reduce working capital and generate strong cash flow. Net cash used for investing activities was $27.1 million for the nine months ended March 31, 2000. Compared to the prior year, net cash used for investing activities declined by $64.0 million due largely to a reduction in capital expenditures of $49.1 million and the purchase of the shares of Toshiba Tungaloy for $12.2 million in 1999. The reduction in capital expenditures reflects management's enhanced capital expenditure approval process. 16

19 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) - -------------------------------------------------------------------------------- Net cash used for financing activities was $133.8 million for the nine months ended March 31, 2000, compared to $0.6 million last year. The increase in net cash used for financing activities was due to the reduction in debt of $125.3 million in 2000, compared to additional borrowings in 1999 of $12.8 million. The reduction in debt is attributable to the increase in operating cash flows. Through the new management incentive program, management is reinforcing the focus on cash flow and working capital improvement. Management believes free operating cash flow (FOCF) is an appropriate measure of the company's cash flow. The company generated FOCF of $56.3 million and $30.3 million for the quarters ended March 31, 2000 and 1999, respectively. The company generated $158.2 million and $4.3 million for the nine months ended March 31, 2000 and 1999, respectively. The improvements in FOCF are due to improved working capital, lower capital expenditures, and higher net income. FOCF is defined as funds from operations minus capital expenditures, plus the change in working capital (excluding changes in cash, marketable securities and short-term debt). Funds from operations is defined as net income from continuing operations plus depreciation, amortization, deferred income taxes and other non-cash items. Cash flows from operating activities, as defined by generally accepted accounting principles (GAAP), may be used as a measure of cash flow. While FOCF is not a GAAP alternative measure of cash flow and may not be comparable to other similarly titled measures of other companies, the company's management believes FOCF is a meaningful measure of the company's cash flow. On December 16, 1999, the company determined that certain performance measurements in the accounts receivable securitization program agreement were not met due to an increase in the aging of the accounts receivable of one of the participating subsidiaries as a result of a system implementation at that subsidiary. The program sponsor waived this condition and the agreement was amended to temporarily revise the performance measurements until May 2000, at which time these performance measurements revert to the original terms of the agreement. FINANCIAL CONDITION Total assets were $2.0 billion at March 31, 2000, a three percent decline from June 30, 1999. Net working capital was $381.7 million, up two percent from $373.6 million at June 30, 1999. The ratio of current assets to current liabilities at March 31, 2000 remained at 2.0 compared to June 30, 1999. The increase in net working capital since June 30, 1999 is due to the repayment of short-term debt. The total debt-to-total capital ratio declined to 47.6 percent at March 31, 2000 from 51.9 percent at June 30, 1999 and 55.3 percent at March 31, 1999 due to the FOCF generated by the company. One of the features of the new management incentive program is the focus on the more efficient use of working capital to generate sales. Management believes the ratio of primary working capital as a percentage of sales (PWC%) is appropriate for measuring the company's efficiency in utilizing working capital to generate sales. The company's PWC% at March 31, 2000 was 30.0 percent, compared to 34.9 percent at June 30, 1999 and 35.6 percent at March 31, 1999. The improvement in PWC% is due to lower primary working capital, partially offset by lower sales levels. Primary working capital (PWC) is defined as inventory plus accounts receivable, less accounts payable. PWC% is calculated by averaging beginning of the year and quarter-end balances for PWC, divided by annualized sales. While PWC% is not a GAAP alternative measure of asset utilization efficiency and 17

20 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) - -------------------------------------------------------------------------------- may not be comparable to other similarly titled measures of other companies, the company's management believes PWC% is a meaningful measure of the company's efficiency in utilizing working capital to generate sales. STRATEGIC ALTERNATIVES In the December 1999 quarter, the company engaged an investment bank to explore strategic alternatives regarding its 83 percent-owned subsidiary, JLK Direct Distribution Inc. (JLK), including a possible divestiture. At that time, management believed a divestiture might enhance growth prospects for both the company and JLK by allowing each company to focus on its core competencies. The company completed a thorough and disciplined process of evaluating strategic alternatives and on May 2, 2000, decided to terminate consideration of a possible divestiture at this time, although management continues to believe there may be better owners for JLK. ENVIRONMENTAL The company has been involved in various environmental cleanup and remediation activities at several of its manufacturing facilities. In addition, the company is currently named as a potentially responsible party (PRP) at several Superfund sites in the United States. In the December 1999 quarter, the company recorded a remediation reserve of $3.0 million with respect to its involvement in these matters, which is recorded as a component of operating expenses. This represents management's best estimate of its future obligation based on its evaluations and discussions with outside counsel and independent consultants, and the current facts and circumstances related to these matters. The company recorded this liability in the December quarter because certain events occurred, including sufficient progress made by the government and the PRPs in the identification of other PRPs and review of potential remediation solutions, that clarified the level of involvement in these matters by the company and its relationship to other PRPs. This led the company to conclude that it was probable that a liability had been incurred. In addition to the amount currently reserved, the company may be subject to loss contingencies related to these matters estimated to be up to an additional $3.3 million. The company believes that such unreserved losses are reasonably possible but are not currently considered to be probable of occurrence. The reserved and unreserved liabilities may change substantially in the near term 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 and the identification of new PRPs. The company maintains a Corporate Environmental, Health and Safety (EH&S) Department, as well as an EH&S Policy Committee, to ensure compliance with environmental regulations and to monitor and oversee remediation activities. In addition, the company has established an EH&S administrator at its domestic manufacturing facilities. The company's financial management team periodically meets with members of the Corporate EH&S Department and the Corporate Legal Department to review and evaluate the status of environmental projects and contingencies. On a quarterly and annual basis, management establishes or adjusts financial provisions and reserves for environmental contingencies in accordance with Statement of Financial Accounting Standards (SFAS) No. 5, "Accounting for Contingencies." 18

21 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) - -------------------------------------------------------------------------------- YEAR 2000 Management believes that the company substantially mitigated its exposure relative to year 2000 issues for both information and non-information technology systems. The transition into the year 2000 resulted in no significant impact to the financial position or operations of the company. The company initiated a program beginning in 1996 to assess the exposure to the year 2000 issue, and to prepare its computer systems, computer applications and other systems for the year 2000. A management committee actively monitored the status of the readiness program of each of the company's business units. The company completed the tasks identified to remediate its mission critical systems and processes. Year 2000 exposure related to information systems was mitigated throughout key metalworking and mining and construction operations through the implementation of SAP R3 for most business processes. The company completed the process of modifying existing non-compliant business systems in its industrial product and engineered product operations to ensure these operations are supported by a year 2000 compliant information system. These modifications were completed and tested by September 1999. At JLK, HK Systems' Enterprise Information System was implemented and tested by August 1999 in the FSS business to address the year 2000 issue. The company modified the existing non-compliant systems in the catalog business to ensure that J&L is supported by a year 2000 compliant information system. Testing of these modifications was performed in September 1999. The company also completed an assessment of the impact of this issue on its non-information technology systems, including the company's personal computers, embedded technology in manufacturing and processing equipment, and other non-information technology items. All non-year 2000 compliant systems were identified and remediated through replacement of or modification to the existing systems. Such remedies were tested for year 2000 compliance in September 1999. Contingency plans included shifting production processes to year 2000 compliant manufacturing operations. The company was not required to employ this contingency plan. The company estimates the total year 2000 expenditures were approximately $53.0 million, approximately half of which were for computer hardware to replace non-compliant computer systems and the other half to replace non-compliant computer software, including software implementation and employee training. These costs included both internal and external personnel costs related to the assessment and remediation processes, as well as the cost of purchasing certain hardware and software. The majority of these costs were incurred in 1997 and 1996. Expenditures incurred to date in fiscal 2000 approximate $3.5 million. The company does not anticipate incurring additional expenditures related to year 2000 issues. Cash flows from operations provided funding for these expenditures. Management believed the most significant impact of the year 2000 issue would have been an interrupted supply of goods and services from the company's vendors. The company had an ongoing effort to gain assurances and certifications of suppliers' readiness programs. To date, the company's suppliers continue to provide the company with sufficient goods and services in the year 2000. There were no failures by major third-party businesses and public and private providers of infrastructure services, such as utilities, communications services and transportation that affected the company during the transition to the year 2000. Contingency plans included purchasing raw materials and supplies from alternate 19

22 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) - -------------------------------------------------------------------------------- certified vendors and a further increase of safety stock of critical materials and supplies. The company was not required to employ these contingency plans. There can be no guarantee that the efforts of the company or of third parties, whose systems the company relies upon, will completely mitigate any year 2000 problem that could have a material adverse affect on the company's operations or financial results. While such problems could affect important operations of the company and its subsidiaries, either directly or indirectly, in a significant manner, the company cannot at present estimate either the likelihood or the potential cost of such failures. However, the company will continue to aggressively pursue remediation of any newly discovered year 2000 problem. OUTLOOK In looking to the fourth quarter of fiscal 2000, management expects to see year-over-year growth driven by growth initiatives and the gradual recovery in our markets. The automotive end market continues to be strong and the oil and gas market is improving. Management will continue to focus on operational improvement programs and cost discipline. FORWARD-LOOKING STATEMENTS This Form 10-Q contains "forward-looking statements" as defined by Section 21E of the Securities Exchange Act of 1934. Actual results may differ materially from those expressed or implied in the forward-looking statements. Factors that could cause actual results to differ materially include, but are not limited to, the extent that the economic conditions in the United States and Europe, and to a lesser extent, Asia Pacific are not sustained, risks associated with integrating businesses, demands on management resources, risks associated with international markets such as currency exchange rates, competition, risks associated with the implementation of restructuring actions and environmental remediation, the effect of third party or company failures to achieve timely remediation of year 2000 issues, and the effect of the conversion to the Euro on the company's operations. The company undertakes no obligation to publicly release any revisions to forward-looking statements to reflect events or circumstances occurring after the date hereof. 20

23 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK - -------------------------------------------------------------------------------- During the September 1999 quarter, the company entered into two interest rate swap agreements that effectively convert a notional amount of $50.0 million from floating to fixed interest rates. This increased the total notional amount of floating-to-fixed interest rate swaps to $100.0 million. These new agreements mature in July 2002. At March 31, 2000, the company would have received $2.6 million to settle all interest rate swap agreements, representing the excess of fair value over the carrying cost of these agreements. The effect of all interest rate swaps on the company's composite interest rate on long-term debt was not material at March 31, 2000. At March 31, 2000, the company had outstanding foreign exchange forward contracts to sell foreign currency with notional amounts translated into U.S. dollars of $29.9 million. These contracts mature before June 30, 2000. The net unrealized loss on these contracts was $1.1 million at March 31, 2000. A hypothetical 10 percent change in the applicable March 31, 2000 quarter-end forward rates would result in an increase or decrease in pretax income of approximately $3.1 million related to these positions. In February 2000, the company completed a short-term foreign exchange hedging program to protect a portion of the company's currency exposure from unfavorable exchange rate movements. The exposure arises from anticipated cash collections from foreign subsidiaries on sales between domestic and foreign subsidiaries during the remainder of fiscal 2000. This program involves the purchase of a series of options that permit the company to sell the foreign currency at specific rates contained in the contracts. The cost of this program, $0.6 million, is being amortized to Other Expense over the life of the options. At March 31, 2000, the unamortized cost of $0.5 million is recorded in Other Current Assets and approximates the fair value of the options then outstanding. The notional amounts of the option contracts translated into U.S. dollars at March 31, 2000 rates is $27.2 million. In April and May 2000, the company began to implement a foreign exchange hedging program to protect a portion of the company's currency exposure from unfavorable exchange rate movements. This exposure arises from anticipated cash collections from foreign subsidiaries on transactions between domestic and foreign subsidiaries during fiscal 2001. This program utilizes purchased options, written options and forward exchange contracts. The cost of this program, $1.9 million, will be amortized to Other Expense based on the life of the contracts, until SFAS 133 is adopted on July 1, 2000; thereafter, the contracts will be accounted for and reported under this new Statement. The notional amounts of the hedging instruments translated into U.S. dollars at March 31, 2000 rates is $117.6 million. There were no other material changes in the company's exposure to market risk from June 30, 1999. 21

24 PART II. OTHER INFORMATION ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K - -------------------------------------------------------------------------------- (a) Exhibits (10) Material Contracts 10.1 Amendment to Executive Employment Agreement between Kennametal Inc. and Markos I. Tambakeras dated March 3, 2000. Filed herewith. (27) Financial Data Schedule for the nine months ended March 31, 2000, submitted to the Securities and Exchange Commission in electronic format. Filed herewith. (b) Reports on Form 8-K No reports on Form 8-K were filed during the quarter ended March 31, 2000. 22

25 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. KENNAMETAL INC. Date: May 12, 2000 By: /s/ FRANK P. SIMPKINS ------------------------------------ Frank P. Simpkins Corporate Controller and Chief Accounting Officer 23

1 EXHIBIT 10.1 March 3, 2000 Mr. Markos I. Tambakeras 77 North Woodland Road Pittsburgh, PA 15232 Re: Pension Benefits Dear Mr. Tambakeras: Reference is hereby made to your Executive Employment Agreement dated as of May 4, 1999 with Kennametal Inc. Each of the amounts set forth in Column B on Schedule I, the Supplemental Benefit Table, of your Executive Employment Agreement is hereby increased by $96,896. Your Executive Employment Agreement remains in full force and effect in all other respects. Please indicate your acceptance to this change in your Executive Employment Agreement by signing below. Very truly yours, KENNAMETAL INC. By: /s/ William R. Newlin ------------------------------------- Authorized Officer /s/ Markos I. Tambakeras ---------------------------------- Markos I. Tambakeras

5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE MARCH 31, 2000 CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 9-MOS JUN-30-2000 JUL-01-1999 MAR-31-2000 21,552 9,173 258,324 13,322 417,333 750,417 948,945 444,521 1,992,118 368,716 0 0 0 41,354 715,722 1,992,118 1,379,890 1,379,890 859,242 859,242 34,813 1,970 41,948 64,739 28,485 32,521 0 267 0 32,254 1.07 1.06