OREANDA-NEWS. Fitch Ratings has affirmed its 'BBB' Long-term Issuer Default Rating (IDR) on Kennametal Inc., and its 'BBB' rating on the company's bank credit facility and senior unsecured notes. The Rating Outlook has been revised to Negative from Stable. The company had $751 million of debt outstanding as of Sept. 30, 2015.

KEY RATING DRIVERS
Kennametal's business is under considerable pressure from a sharp drop-off in oil and gas markets together with declines in its coal mining and general engineering businesses and softer conditions in emerging markets, especially China. The Negative Outlook reflects the expected decline in the company's sales and earnings, which will constrain its free cash flow (FCF) and credit metrics, and likely persist beyond the current fiscal year ending June 2016 into fiscal 2017, and perhaps beyond.

Weak results are concentrated in the company's infrastructure segment, which accounts for 44% of sales, and saw a 9.7% sales decline in fiscal 2015 (ending June) and an 11% decline in organic sales (excluding net acquisitions and forex changes). In the industrial segment (56% of sales), fiscal 2015 sales were down 4.1%, but were flat on an organic basis. Operating margins were up slightly in industrial and down sharply in infrastructure, continuing a three-year downward trend.

Trends worsened in the first quarter of fiscal 2016 (ending Sept. 2015), when organic sales in the industrial segment were down 8% and the infrastructure segment was down 19%. Operating margins were also down sharply, with the infrastructure operating margin turning negative. These trends are expected to continue through fiscal 2016 and 2017, with the company focusing during this time on self-help measures to rationalize its manufacturing base and its cost structure.

These restructuring efforts generated $32 million of savings in fiscal 2015, and are expected to achieve $50 million of incremental benefits in fiscal 2016. In addition, in December 2015, the company disposed of several lower margin businesses that had sales of $220 million, or around 20% of the infrastructure segment. The proceeds totalled $70 million, and the dispositions are expected to be neutral to EPS and FCF in fiscal 2016. These efforts will position the company to generate better margins as end markets improve.

The projected decline in EBITDA together with higher capex will lead to lower FCF over the medium term. Fitch's base case shows FCF potentially dropping to around a breakeven level in fiscal 2016, though this is sensitive to the amount of cash generated from working capital. FCF could be flat to negative for the next couple of years, after averaging $100 million-$150 million over the past five years. Any cash flow from operations and asset sales will be focused on debt reduction. Bolt-on acquisitions will continue longer term, but will take a backseat to debt reduction over the intermediate term. Share repurchases are on hold until the company's operations stabilize.

A decline in EBITDA is expected to drive debt/EBITDA from 2.0x in fiscal 2015 to the high-2x in fiscal 2016 and 2017. Funds from operations (FFO)-adjusted leverage increases from 3.3x in fiscal 2015 to the high 3x in fiscal 2016, and EBITDA/interest is projected to drop from 11.8x to at or under 9x over that period.

Kennametal will use a portion of cash for modest pension contributions over the next few years. Kennametal's pension plans were underfunded by $127 million at year-end 2015, up from $86 million a year ago. As of June 30, 2015, the company's pension plans were 87% funded compared to 91% in the prior year. Kennametal plans on contributing $16.8 million in fiscal 2016.

The ratings incorporate Kennametal's:

--Leading market positions due to solid product diversification and engineering leadership.
--Conservative financial policies, including expectations for the use of FCF for debt reduction.
--Restructuring program which should yield higher margins as end markets improve.

Concerns reflect Kennametal's:

--Exposure to cyclical end markets, given the company derives much of its revenue from consumable, short-cycle products (80% of sales) that can be sensitive to economic conditions. ---Weak end markets likely to persist in fiscal 2017.
--Volatile commodity prices, resulting in uneven gross profit margins.
--Integration risks related to acquisitions.

KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:

--Sales decline around 20% in fiscal 2016, followed by a 3% decline in fiscal 2017, before recovering beginning in fiscal 2018.
--EBITDA margins drop from 14.1% in fiscal 2015 to 12% in fiscal 2016, recovering gradually thereafter.
--The company pays off its revolver during fiscal 2016 and debt levels are flat thereafter.
--FCF is neutral in fiscal 2016, and moderately negative in fiscal 2017.
--Debt/EBITDA increases from 2.0x in fiscal 2015 to around 2.8x in fiscal 2016 and 2017.

RATING SENSITIVITIES
Future developments that may, individually or collectively, lead to a negative rating action include:

--Kennametal sustains total debt-to-operating EBITDA (total leverage) at or above 2.5x due to a sustained downturn in end-markets or incremental debt-financed acquisitions.
--Further profit margin erosion resulting in operating EBIT margin sustained below 10%, driven by reduced competitiveness or inadequate restructuring in the face of structurally lower demand.
--A FCF margin consistently below 3%.

Future developments that may individually or collectively lead to a Stable Outlook include:

--A stabilization and expected recovery in Kennametal's sales and operating margins.
--A reduction in debt/EBITDA to below 2.5x.
--Positive FCF generation, with expectations that the FCF margin will recover to over 3%.

LIQUIDITY
Kennametal had $97.2 million of cash and equivalents at Sept. 30, 2015. Of this amount $38.1 million is considered permanently reinvested outside of the U. S. Liquidity is further supported by the $600 million revolver, of which $558 million was available as of Sept. 30, 2015. FCF has historically been a support to liquidity, but it is expected to be neutral in fiscal 2016, and potentially moderately negative in fiscal 2017.

FULL LIST OF RATING ACTIONS

Fitch affirms Kennametal as follows:

Kennametal Inc.
--Long-term IDR at 'BBB';
--Senior unsecured credit facilities at 'BBB';
--Senior unsecured notes at 'BBB';

The Rating Outlook has been revised to Negative from Stable.