Why Are So Many Gurus Buying Kennametal?

GuruFocus's Guru Hot Picks page shows that nine guru investors bought shares of Kennametal (KMT, Financial), an industrial small-cap, in the third quarter of 2022, and only two sold during that same period. As of the third quarter's end, 11 gurus hold shares of the stock. The collective guru buy/sell behaviour looks like a solid endorsement for the stock by the "smart money." Kennametal is also buying back its own stock and the insider buying looks favorable. Let's take a look at just what gurus and insiders might like about the stock.

Guru buying summary

Below, I have laid out the GuruFocus information on recent guru buys of Kennametal stock. This information comes from 13F filings and mutual fund reports for the third quarter of 2022. Investors should be aware that 13F reports and mutual fund reports do not provide a complete picture of a guru’s holdings. The 13F reports include only a snapshot of long equity positions in U.S.-listed stocks and American depository receipts as of the quarter’s end. They do not include short positions, non-ADR international holdings or other types of securities. The mutual fund data is sourced from the quarterly updates on the website of the fund(s) in question. This usually consists of long equity positions in U.S. and foreign stocks. However, even these limited reports can provide valuable information.

Last year, John Rogers (Trades, Portfolio), one of the gurus in the list above, commented on the company as follows:

"Specialty cutting tool insert maker, Kennametal, Inc. (KMT, Financial) also weighed on results in the period, as investors were concerned about near-term challenges for automotive production due to semiconductor constraints. In our view, these headwinds are short-term in nature and we remain focused on KMT’s improving sales and free cash flow profile, solid operating discipline, as well as its continued execution on simplification/modernization initiatives. We believe the scale, scope, quality, low-cost production and the value proposition of the cutting tools themselves will continue to mitigate pricing pressure in recovering markets. Additionally, KMT is executing on its strategic plan to improve economies of scale and generate margin improvement, while gaining share in the marketplace."

About the company

Kennametal is a company that develops and applies advanced materials, including tungsten carbides and ceramics, for use in metal cutting and extreme wear applications. It operates through the Metal Cutting and Infrastructure segments. The company provides a range of standard and custom products and services to manufacturers in various industries, including transportation, machine tools, aerospace and energy. It also offers product design, selection, application and support services, as well as standard and custom metal cutting solutions to aerospace, general engineering, energy and transportation customers. Kennametal's products are sold under the following brands: Kennametal, WIDIA, WIDIA Hanita and WIDIA GTD.

The company was founded in 1938 by metallurgist Philip M. McKenna and has grown to become a global leader in the metalworking industry. It was originally named the McKenna Metals Company and was based in Latrobe, Pennsylvania. McKenna developed a tungsten-titanium carbide alloy for cutting tools that increased productivity in the machining of steel. The company experienced significant growth during World War II, with annual sales reaching nearly $10 million and employment totaling almost 900.

In the mid-1940s, it expanded into the mining industry and developed the continuous mining machine, as well as finding applications for tungsten carbide in specialty areas such as valves, dies, drill bits and snowplow blades, where resistance to wear was important.

Some of the company's notable achievements include the development of the Kendex line of indexable insert systems, the patented thermit process for producing impact-resistant tungsten carbide, the introduction of tungsten carbide-tipped tire studs, leadership in the development of silicon-nitride based "sialon" ceramics, the creation of cobalt-enriched substrates for coated inserts, the introduction of physical-vapor-deposition (PVD) coated cemented carbide cutting tools and the development of quick-change tooling systems.

Recent results

Kennametal experienced 10% organic sales growth in the first quarter of its fiscal year 2023, with total sales of $195 million. Growth was seen in all regions, with the Americas experiencing favorable demand trends, China being affected by Covid-19 lockdowns, other Asia-Pac countries seeing strong growth and the EMEA region being impacted by the Russian exit in the third quarter of 2022. The adjusted operating margin decreased by 70 basis points to 9.5%. This was due to volume increases resulting in typical operating leverage, macroeconomic headwinds from foreign exchange, inflation and temporary supply chain disruptions.

Despite these challenges, the underlying demand from customers remained strong, with growth in all end markets including aerospace, general engineering, transportation and energy. The aerospace market was boosted by strategic initiatives and rebounding demand, while the general engineering market was primarily driven by strength in the Americas. The transportation market improved but was still constrained by supply chain issues, and the energy market was primarily driven by growth in oil and gas in the Americas.

Kennametal is cyclical

Looking at the longer term stock chart, we can see that this company is quite cyclical. In the last 20 years, the stock has gone over $40 four times and below $20 three times. The peaks and valleys are about three to five years apart. It seems to trade in a pretty tight range between $20 and $40. Currently the stock is trading not too far from the lower part of the range.

Competitive analysis

The company's closest competitor is Sandvik AB (OSTO:SAND, Financial). However, the latter is 10 times the size in market cap as compared to Kennametal, which is worth keeping in mind. Even so, Kennametal stock looks like decent value on a enterprise-value-to-Ebitda basis, appearing over 25% cheaper than the median for the industry. On a return on invested capital (five-year median) basis, Kennametal scores lower than its peers.

You can find an extensive table that compares Kennametal to a wide variety of industrial tool companies around the world in Appendix A at the end of this article.

Financial strength

GuruFocus has ranked the financial strength of the company a 6 out of 10. The company has a cash-debt ratio of 0.09 and an equity-to-asset ratio of 0.48, which is good for an industrial company. The interest coverage ratio of 7.99 is very comfortable, and a Piotroski F-Score of 7 out of 9 means the financial situation is strong.

The following is a diagram of Kennametal's balance sheet.

The company has a debt structure with two $300 million notes that mature in June 2028 and March 2031. The company also has a $700 million revolver (i.e., a line of credit) that has been amended and extended until June 2027, with $80 million outstanding at the end of the quarter. The covenant ratio for the company is within limits.

Dividends and repurchases

Kennametal has been paying dividends since 1990. However, dividends have levelled off since about 2016 and have not increased. The company currently has a dividend yield of 3.2%.

The company also has a $200 million three-year share repurchase program. During the first quarter, $19 million worth of shares were purchased, equivalent to 824,000 shares. Since the inception of the program, $105 million worth of shares have been purchased, representing 3.5 million shares.

Valuation

The GuruFocus valuation panel does not indicate anything egregious or outstanding. The GF Value indicates the company is undervalued by about 30%. However, other valuation models like Earnings Power Value and Projected FCF are not showing anything encouraging.

Conclusion

Overall I don't see Kennametal as a deep value stock right now. However, it does look like a solid company which pays a good dividend while you wait for the cycle to turn. It's a cyclical industrial stock and there are good chances a recession is coming given the inverted yield curve and the Federal Reserve's interest rate hiking cycle. If the economy weakens, I believe this stock will likely go down further.

So why are so many gurus buying? I am guessing they might be positioning themselves because, following a recession, there is recovery, and industrial stocks like Kennametal are likely to do very well. In fact, my experience is that they start recovering even when the economy is still in recession, for the simple reason that markets are forward looking. Kennametal's financial position is strong so it should easily handle a run-of-the-mill recession.

For a small investor like myself, I won't buy till I see blood in the water. Looking at the historical price chart, this would be below $20 - maybe even in mid to high teens, if investors panic. I would rather keep my powder dry and won't fire until I see the whites of their eyes. My motto is simple, buy fear and sell greed.

Another possibility is that the gurus might see the company as a takeover target. It would make a nice tuck-in acquisition for a larger industrial tools company, but that is pure speculation on my part.

Appendix A