Kennametal: Valuation Analysis Using The Dividend Points To Lower Prices Over The Near-Term

Intro

Kennametal Inc. (NYSE:KMT) is an Industrial US company with a rich history where it sells its products & services in both its 'Metal Cutting' & 'Infrastructure' segments. The company's larger 'Metal Cutting' segment provides traditional cutting tool services through the likes of its threading & milling operations, whereas the latter segment provides the likes of tungsten carbide and related ceramic products which fill a void in engineering & energy markets.

If we pull up an intermediate chart of Kennametal, we see that shares seem to be undergoing a double-top reversal formation which commenced in February of this year. The reversal pattern is definitely in play now as shares in recent months have lost support, which most likely will bring more sellers into the frame here. Furthermore, recent bearish share-price action has resulted in a death cross (crossing over of the stock's 10-week moving average below its corresponding 40-week average) which is another strong sign that lower prices are in store for Kennametal at least over the near-term.

However, given the stock yields well over 3% currently and has paid out a dividend to shareholders for the past 33 years, value investors may be looking to scale into Kennametal especially if the stock drops significantly below these levels. Shares at present trade with a forward GAAP earnings multiple of 13.63, so the stock looks cheap (sector median of 19.84) and more importantly remains healthily profitable both from an earnings and cash-flow basis (forward cash-flow multiple of 7.03).

However, ignoring a potentially strong bearish trend is always risky because it is very difficult to ascertain when the underlying trend will change in earnest. Therefore, let's see if we can calculate Kennametal's downside risk by trying to stamp a valuation on the stock. We will use the following dividend discount model, where we see the formula below.

Expected Dividend Per Share

Kennametal has left its quarterly dividend unchanged at $0.20 a share since mid-2015. Now, some may say that the lack of sustained dividend growth is simply not good enough in today's elevated inflationary environment. While this may be true in one sense, the most important factor for investors in today's climate is the respective stock's 'total return potential'. Suffice it to say, whether it is elevated dividend growth or strong capital return potential, the investor in today's climate must stay ahead of inflation to ensure purchasing power remains intact.

Therefore, when we divide the company's trailing 12-month dividend payments into Kennametal's 12-month trailing GAAP earnings, we get a trailing dividend payout ratio of 55.17%. This means the retention ratio (earnings not paid as a dividend) comes to 44.83%. Now, to get a solid gauge on how much Kennametal's dividend can grow going forward, we use the company's retention ratio in conjunction with its return on equity.

To calculate ROE, we divide trailing GAAP earnings of $118.5 million by shareholder equity on the balance sheet ($1.314 billion). This calculation gives us a trailing ROE of 9.02%. Therefore, by multiplying both of these metrics together (retention ratio x ROE), we can get a very solid insight into how much potential Kennametal has in growing its dividend going forward. This calculation comes to 4.04%.

Therefore, by multiplying KMT's present dividend of $0.80 a share by 1.04 (Long-term 4%+ running dividend growth rate), we get an expected dividend per share of $0.83 per share going forward per year.

Cost Of Equity

This metric is very important in the current investing climate, given how bond yields have soared in recent times. Just remember, investors now require more of a return from their investment dollars, as fixed-rate investments now provide guaranteed mid-single-digit nominal returns. To calculate Kennametal's cost of equity (where we look to discount the value of KMT's net profits), we use the following formula.

Cost of equity = Risk-Free Rate + (Beta) x (Equity Risk Premium)

For the risk-free rate, we use the prevailing rate of the 10-year US treasury, which currently comes in at 4.71%. The company's beta (fear-based readout or expected move) comes in at 1.87 & equity risk premium is a minimum third-party (Damodaran equity risk premium) return projection for the stock. The Damodaran equity risk premium currently comes in at 5% flat in the US. Plugging all of our numbers into the formula, we get a cost of equity of 14.06%.

Therefore, when we go back to our original valuation formula above, we get the value of Kennametal = EDPS / CCE - DGR = 0.83/ (0.142 - 0.04) = $8.13 a share.

Recent Trends Point To An Improved Valuation

However, after perusing the company's balance sheet trends and expected earnings growth (16% in this present fiscal year), there are some changes to the above formula that could be made to reflect Kennametal's near-term improvements. When deciphering the capacity for example for the company to grow its dividend over time, the return on equity calculation (trailing net profit/shareholder equity) can be a tad misleading due to how debt for example can muddle the equity number. The company's long-term debt number remained just below $600 million at the end of Kennametal's most recent quarter, where we saw promising trends in the company's cash balance, receivables, and inventory. Therefore, we want to be able to incorporate these trends into our calculation, which we do by the following method.

In effect, when we use the following formula to calculate an adjusted form of the company's ROC, by using EBIT instead of net profit, we are able to eliminate the effect of the company's interest expense on Kennametal's income statement. Furthermore, the formula's denominator (where we also strip out KMT's growing cash balance on the current assets side) literally only focuses on the resources needed to actually run the business. In effect, we can then use this adjusted ROC (return on capital) number instead of the more general return on equity number reviewed above.

Therefore, by dividing KMT's trailing EBIT of $199.1 million by ($486.8 + $1012.1), we get an adjusted ROC of 13.28%. Multiplying this number by our improved forward-looking retention ratio of 55%, we get an improved long-term dividend growth rate of 7.24%. Therefore, our new adjusted value of Kennametal = EDPS / CCE - DGR, which now equates to 0.86/ (0.142 - 0.0724) comes in at $12.36 per share.

Conclusion

Although this exercise is not bullet-proof, it is how the above formulas value the stock. The initial valuation of $8+ is based more on what has been (trailing) whereas the latter projection ($12.36 per share) is based more on a forward-looking stance. Growth may be coming for KMT but after evaluating our projections as well as the technicals discussed earlier, we deem a stock a 'sell' at this juncture. We look forward to continued coverage.