What Little-Known Stock is Atlantic Investment Management Buying?

Billion-dollar fund Atlantic Investment Management filed with the SEC to disclose that it had raised its equity stake in Kennametal (KMT) to 5.2 million shares, up from 4.3 million that it had owned in the middle of June and 3.4 million shares at the end of March (see more stocks Atlantic owned at the end of March). Atlantic started investing in Kennametal in the fourth quarter of 2011, and the most recent increase in shares places Atlantic and its manager Alexander Roepers with nearly 6.5% of the shares outstanding. Kennametal produces machine tools used by metalworking customers in its Industrial (including aerospace and defense) and Infrastructure segments (including energy and mining).

Alexander Roepers

Roepers likes to focus on value stocks, with much of his holdings in industrials. As KMT has fallen about 25% in the last three months, he appears to be doubling down on a trade he is confident in and believes that the market will eventually recognize. The company’s trailing price-to-earnings ratio is just under 9; on a forward basis, this ratio slips to under 8. With KMT beating earnings estimates for each of the past four quarters, growing its revenue 13% in the first quarter of 2012 compared to the first quarter of 2011, and also increasing its margins to finish with net earnings that were 17% higher, on the surface Kennametal could prove to be a hidden gem.

Looking more closely at Kennametal’s business, the three quarters ending March 31, 2012 (Kennametal has a June fiscal year end) resulted in 17% revenue growth and a 55% net income growth. If the company is able to continue this growth performance in the future the stock price should benefit both from the increase in earnings and the recognition that it deserves a higher multiple on its earnings. The company generated much of its growth in these three quarters from its Industrial segment, though the smaller Infrastructure segment grew its operating income by 19%.

Another manager with an investment in KMT is Chuck Royce with Royce and Associates. Royce is a graduate of Columbia Business School’s renowned value investing program and probably has chosen to own 6.5 million shares of Kennametal for much of the same reason that Roepers has increased his holdings: it can be seen as a neglected value company (find other stocks owned by Royce and Associates). Royce’s stake has fluctuated for the past few quarters but has owned about 6 million shares at least since the end of 2010.

Two of Kennametal’s larger peers are Caterpillar (CAT) and Illinois Tool Works (ITW) with market caps of $53 billion and $24 billion respectively compared to KMT’s $2.6 billion. These companies also trade at fairly low P/E multiples. The multiple is 10 for Caterpillar- close to KMT’s despite it being a larger cap company which earned higher growth in the first quarter- and just under 13 for ITW. ITW and CAT do trade at EBITDA multiples between 8 and 9, compared to KMT trading at just above 6x. So far this year Caterpillar and Kennametal have tracked each other very closely in the stock market; ITW moved much in line with the other companies until late April, when it began to fall in price more slowly and now actually sits up about 8% for the year. We think KMT is an attractive long-term investment but this may not be the best time to buy the stock. The recent declines were in anticipation of a global slowdown and we haven’t seen the end of that yet.

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