AI Power Projects And Tungsten Costs Will Restrain This Industrials Supplier

Catalysts

About Kennametal

Kennametal supplies metal cutting tools and wear resistant solutions for industrial end markets such as Aerospace and Defense, Energy, Transportation, Earthworks and General Engineering.

What are the underlying business or industry changes driving this perspective?

• Reliance on AI data center driven power generation projects concentrates growth in a relatively narrow slice of the Energy market. Any slowdown in backup generator or gas turbine build rates could leave Metal Cutting revenue exposed after pricing and surcharges roll off, pressuring overall sales and EPS.
• Higher tungsten prices and tariffs are being offset with price and surcharges today. If raw material costs stay elevated while customers resist further increases, pricing power could weaken and compress gross margin and adjusted EBITDA margin.
• Share gains in Aerospace and Defense and Earthworks are helping in a period of modest volume improvement. However, these gains are layered on top of still soft Transportation and flattish General Engineering, so a return to weaker auto builds or industrial production would reduce mix benefits and limit margin expansion.
• Restructuring actions, facility consolidations and employment cost reductions are providing about US$35 million of expected annual savings. Once these are fully realized, earnings growth will depend more on volume and mix in markets that management itself describes as only slightly improving, which could cap future EPS growth if end markets stall.
• Working capital is rising as primary working capital sits at US$660 million or 32% of sales and tungsten driven inventory investment increases. If pricing and tariff surcharges normalize before inventory is worked down, free operating cash flow conversion and balance sheet flexibility could weaken relative to earnings.

Assumptions

This narrative explores a more pessimistic perspective on Kennametal compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts. How have these above catalysts been quantified?

• The bearish analysts are assuming Kennametal's revenue will grow by 3.2% annually over the next 3 years.
• The bearish analysts assume that profit margins will increase from 4.8% today to 5.0% in 3 years time.
• The bearish analysts expect earnings to reach $108.3 million (and earnings per share of $1.56) by about January 2029, up from $94.3 million today. However, there is some disagreement amongst the analysts with the more bullish ones expecting earnings as high as $169.3 million.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 17.3x on those 2029 earnings, down from 24.8x today. This future PE is lower than the current PE for the US Machinery industry at 26.3x.
• The bearish analysts expect the number of shares outstanding to decline by 1.64% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 9.06%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• Project wins in Energy, Aerospace and Defense, Transportation and Earthworks, including increased share of wallet with military aerospace customers and two large Earthworks projects, suggest Kennametal could keep gaining share in sectors tied to long-term demand for air travel, defense and infrastructure, which would support revenue and earnings.
• Growing opportunities in Power Generation linked to AI data center build outs, large engines and utility scale gas turbines, on top of an existing position in oil and gas and wind, create a broader, long-lived demand pool across both segments that could underpin sales growth and help support margins over time.
• Consistent execution on cost reductions, including US$8 million of quarterly restructuring savings, ongoing facility consolidations and lean initiatives with a full year savings plan of US$35 million, may structurally lower the cost base, which would help adjusted EBITDA margin and net margins even if end market volumes stay modest.
• Management’s track record of offsetting tariffs and higher tungsten costs through pricing, supply chain changes and surcharges, combined with confidence in customers’ willingness to pay for performance, could limit raw material and tariff pressure on gross margin and adjusted EPS.
• Improving trends in Aerospace and Defense, gradual relief in previously weak end markets and a raised fiscal 2026 sales and EPS outlook, supported by better than expected volume across all end markets, suggest that a prolonged downturn is not currently evident, which could support revenue and earnings relative to a bearish share price view.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The assumed bearish price target for Kennametal is $20.0, which represents up to two standard deviations below the consensus price target of $26.38. This valuation is based on what can be assumed as the expectations of Kennametal's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $32.0, and the most bearish reporting a price target of just $20.0.
  
• In order for you to agree with the more bearish analyst cohort, you'd need to believe that by 2029, revenues will be $2.2 billion, earnings will come to $108.3 million, and it would be trading on a PE ratio of 17.3x, assuming you use a discount rate of 9.1%.
  
• Given the current share price of $30.72, the analyst price target of $20.0 is 53.6% lower. Despite analysts expecting the underlying business to improve, they seem to believe the market's expectations are too high.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.