ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

RESULTS OF CONTINUING OPERATIONS
SALES
Sales for the three months ended September 30, 2009 were $409.4 million, a decrease of $234.0 million, or 36 percent, from $643.4 million in the prior year quarter. Sales declined organically by 36 percent while the favorable impact of 3 percent from a business acquisition made in the prior fiscal year was offset by a 3 percent decrease from unfavorable foreign currency effects. Global industrial production and the corresponding demand in most industry and markets were well below the levels of the prior year quarter due to the ongoing impact of the global recession.
GROSS PROFIT
Gross profit for the three months ended September 30, 2009 decreased $97.3 million to $117.8 million from $215.1 million in the prior year quarter. This decrease was primarily due to lower organic sales volume, reduced absorption of manufacturing costs due to lower production levels, unfavorable foreign currency effects of $5.3 million and unfavorable business unit mix. The impact of these items was partially offset by increased permanent savings from restructuring programs and one-time benefits from certain labor negotiations in Europe as well as lower raw material costs and higher price realization. The gross profit margin for the three months ended September 30, 2009 was 28.8 percent as compared to 33.4 percent in the prior year quarter.
OPERATING EXPENSE
Operating expense for the three months ended September 30, 2009 was $116.2 million, a decrease of $34.8 million, or 23 percent, compared to $151.0 million in the prior year quarter. The decrease is attributable to a $26.5 million decrease in employment expenses driven by restructuring programs and cost management activities as well as lower provisions for incentive compensation programs, favorable foreign currency effects of $5.6 million and the impact of other cost reductions, partially offset by the unfavorable impact of a prior year business acquisition.
RESTRUCTURING CHARGES
Over the past eighteen months, the Company has undertaken a series of restructuring programs to reduce cost and improve operating efficiencies. These actions relate to facility rationalizations and employment reductions. Restructuring and related charges recorded in the three months ended September 30, 2009 amounted to $8.5 million, including $7.8 million of restructuring charges. Restructuring-related charges of $0.5 million and $0.3 million were recorded in cost of goods sold and operating expenses, respectively, for the three months ended September 30, 2009. See Note 8 to our consolidated financial statements set forth in Part I Item 1 of this Form 10-Q. Total restructuring and related charges recorded since the inception of the restructuring programs through September 30, 2009 were $90 million. Including these charges, the Company expects to recognize approximately $115 million of pre-tax charges related to its restructuring initiatives. The majority of the remaining charges are expected to be incurred over the next six to nine months, most of which are expected to be cash expenditures. We realized pre-tax benefits from restructuring programs of $30 million in the current quarter most of which were incremental to the same quarter one year ago. As a result, the Company is nearing its target to achieve approximately $125 million in annual pre-tax benefits from these initiatives.
AMORTIZATION OF INTANGIBLES
Amortization expense was $3.3 million for the three months ended September 30, 2009, a decrease of $0.1 million from $3.4 million in the prior year quarter.
INTEREST EXPENSE
Interest expense for the three months ended September 30, 2009 of $6.4 million decreased $0.7 million, or 10.1 percent, from $7.1 million in the prior year quarter. This decrease was primarily due to repayment of outstanding indebtedness under our revolving credit facility with proceeds from our issuance of capital stock in July 2009, partially offset by higher interest rates related to the amended credit agreement.

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

OTHER (INCOME) EXPENSE, NET
Other income, net for the three months ended September 30, 2009 was $3.0 million. Other expense, net for the three months ended September 30, 2008 was $1.1 million. The change was primarily driven by a favorable change in foreign currency transaction results of $4.3 million.
INCOME TAXES
The effective income tax rate for the three months ended September 30, 2009 and 2008 was 39.6 percent (benefit on a loss) compared to 19.0 percent (provision on income), respectively. The current year rate reflects a benefit from certain favorable tax settlements in the United States and Europe. The prior year rate reflects a benefit from the release of a valuation allowance in Europe that was driven by further expansion of our Pan-European business strategy.
BUSINESS SEGMENT REVIEW
Our operations are organized into two reportable operating segments consisting of Metalworking Solutions & Services Group (MSSG) and Advanced Materials Solutions Group (AMSG), and Corporate. The presentation of segment information reflects the manner in which we organize segments for making operating decisions and assessing performance. Corporate represents certain corporate shared service costs, certain employee benefit costs, certain employment costs, including performance-based bonuses and stock-based compensation expense, and eliminations of operating results between segments.

METALWORKING SOLUTIONS & SERVICES GROUP

                                               Three Months Ended
                                                  September 30,
                  (in thousands)               2009          2008

                  External sales            $ 230,991     $ 405,395
                  Intersegment sales           30,694        50,690
                  Operating (loss) income     (12,766 )      42,379

For the three months ended September 30, 2009, MSSG external sales decreased $174.4 million, or 43 percent, from the prior year quarter. This decrease was the result of an organic sales decline of 39 percent and unfavorable foreign currency effects of 4 percent. On a regional basis, Europe, North America and Asia Pacific reported organic sales declines of 42 percent, 39 percent and 39 percent, respectively. Latin America and India also experienced organic sales declines of 31 percent and 25 percent, respectively.
For the three months ended September 30, 2009, MSSG operating loss was $12.8 million compared to operating income of $42.4 million for the prior year quarter. The primary drivers which led to the lower operating performance were reduced sales volume and the related impact of reduced manufacturing cost absorption due to lower production levels. The impact of these items was partially offset by increased permanent savings from restructuring programs and one-time benefits from certain labor negotiations in Europe as well as other cost reduction actions and higher price realization.

ADVANCED MATERIALS SOLUTIONS GROUP

                                             Three Months Ended
                                                September 30,
                     (in thousands)          2009          2008

                     External sales       $ 178,404     $ 237,979
                     Intersegment sales       3,842         6,953
                     Operating income        23,107        29,990

For the three months ended September 30, 2009, AMSG external sales decreased $59.6 million, or 25 percent, from the prior year quarter. This decrease was the result of 30 percent organic decline and a 2 percent decrease from unfavorable foreign currency effects, partially offset by the favorable impact of acquisitions of 7 percent. The organic decline was primarily driven by lower sales in the engineered products business as well as reduced demand for energy related products.
For the three months ended September 30, 2009, AMSG operating income was $23.1 million compared to operating income of $30.0 million for the prior year quarter. Operating results for the current quarter were impacted by lower sales and production volumes in the engineered products and energy related businesses as compared to the prior year quarter. A considerable portion of the impact on these items was offset by increased permanent savings from restructuring programs as well as other cost reduction actions and lower raw material costs.

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

CORPORATE

For the three months ended September 30, 2009, operating loss was essentially level with the prior year quarter.
LIQUIDITY AND CAPITAL RESOURCES
Cash flow from operations is our primary source of funds for financing our capital expenditures and internal growth. During the three months ended September 30, 2009, cash flow provided by operating activities was $17.3 million, which exceeded our investment in capital expenditures for that period. Also during the current quarter, we received remaining cash proceeds of $27.0 million from the divestiture of our high speed steel business that was completed in June 2009.
As an additional source of funds to meet our cash requirements, we have a five-year, multi currency, revolving credit facility entered into in March 2006 (2006 Credit Agreement) that extends to March 2011 and permits revolving credit loans of up to $500.0 million. Borrowings under the 2006 Credit Agreement as of September 30, 2009 were $27.9 million. In addition to our revolving credit facility, we obtain local financing through credit lines with commercial banks in the various countries in which we operate.
The 2006 Credit Agreement requires us to comply with various restrictive and affirmative covenants, including two financial covenants: a maximum leverage ratio and a minimum consolidated interest coverage ratio (as those terms are defined in the agreement).
On July 6, 2009, we entered into an amendment to our 2006 Credit Agreement. The amendment provides for the exclusion of certain cash restructuring charges from the earnings component used in the calculation of the leverage and interest ratios. In addition, the amendment provides for an increase in the permitted leverage ratio for certain quarterly measurement dates. The amendment also provides restrictions on share repurchases and securitizations as well as future acquisitions and capital leases should leverage ratios exceed the permitted ratio that prevailed prior to the amendment. Furthermore, the amendment would require security interest in our domestic accounts receivable and inventories should our leverage ratio exceed a certain threshold. The amendment includes an increase in interest rates on borrowings of approximately 200 basis points. Also during July 2009, we completed the issuance of 8.1 million shares of capital stock generating net proceeds of $120.7 million which were used to pay down outstanding indebtedness under our revolving credit facility.
At September 30, 2009, we had cash and cash equivalents of $105.1 million. Total shareowners' equity was $1,379.7 million and total debt was $367.4 million, including borrowings under the 2006 Credit Agreement, as of September 30, 2009. Our current senior credit ratings are at investment grade levels. We believe that our current financial position, liquidity and credit ratings provide access to the capital markets. We continue to closely monitor our liquidity position and the condition of the capital markets as well as the counterparty risk of our credit providers. We believe that cash flow from operations and the availability under our credit lines will be sufficient to meet our cash requirements over the next 12 months.
There have been no material changes in our contractual obligations and commitments since June 30, 2009.
Cash Flow Provided by Operating Activities During the three months ended September 30, 2009, cash flow provided by operating activities was $17.3 million, compared to $38.0 million for the prior year period. Cash flow provided by operating activities for the current year period consisted of net loss and non-cash items amounting to $19.6 million of cash generation minus cash provided by changes in certain assets and liabilities netting to $2.3 million. Contributing to the changes in certain assets and liabilities were a decrease in accounts receivable of $2.2 million and a decrease in inventories of $16.8 million, partially offset by a decrease in accounts payable and accrued liabilities of $6.7 million, a decrease in accrued income taxes of $5.3 million and a decrease in other liabilities of $9.3 million.
Cash flow provided by operating activities for the three months ended September 30, 2008 consisted of net income and non-cash items totaling $62.5 million offset somewhat by changes in certain assets and liabilities netting to $24.5 million. Contributing to the changes in certain assets and liabilities were a decrease in accounts payable and accrued liabilities of $24.1 million, due in part to a $14.3 million payment of 2008 performance-based bonuses, and an increase in inventories of $26.9 million, partially offset by a decrease in accounts receivable of $27.9 million.

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

Cash Flow Provided by (Used for) Investing Activities Cash flow provided by investing activities was $19.5 million for the three months ended September 30, 2009, an increase of $63.1 million, compared to cash flow used for investing activities of $43.6 million in the prior year period. During the three months ended September 30, 2009, cash flow provided by investing activities included $27.0 million in remaining cash proceeds from the sale of our high speed steel drills business and related product lines, partially offset by $8.9 million used for purchases of property, plant and equipment, which consisted primarily of equipment upgrades.
During the three months ended September 30, 2008, cash used for investing activities included $44.6 million used for purchases of property, plant and equipment, which consisted primarily of equipment upgrades. Cash Flow (Used for) Provided by Financing Activities Cash flow used for financing activities was $6.5 million for the three months ended September 30, 2009 compared to cash flow provided by financing activities of $4.1 million in the prior year period. During the three months ended September 30, 2009, cash flow used for financing activities included $120.7 million in net proceeds from issuance of capital stock and $1.7 million of dividend reinvestment and the effect of employee benefit and stock plans partially offset by $117.2 million net decrease in borrowings and $9.8 million of cash dividends paid to shareowners.
During the three months ended September 30, 2008, cash flow provided by financing activities included a $134.3 million net increase in borrowings and $3.4 million of dividend reinvestment and the effect of employee benefit and stock plans mostly offset by $127.3 million used for the repurchase of capital stock and $9.2 million of cash dividends paid to shareowners.
FINANCIAL CONDITION
At September 30, 2009, total assets were $2,357.6 million having increased $10.6 million from $2,347.0 million at June 30, 2009. Total liabilities decreased $122.6 million from $1,079.5 million at June 30, 2009 to $956.9 million at September 30, 2009.
Working capital was $497.7 million at September 30, 2009, an increase of $0.8 million from $496.9 million at June 30, 2009. The increase in working capital was driven primarily by an increase in cash and cash equivalents of $35.3 million and decrease in notes payable of $11.4 million, partially offset by a decrease in other current assets of $25.5 million and an increase in other current liabilities of $21.1 million. Foreign currency effects accounted for $5.1 million, $2.0 million, $1.0 million and $0.1 million of the change in cash and cash equivalents, other current liabilities, other current assets and notes payable, respectively.
Property, plant and equipment, net decreased $3.5 million from $720.3 million at June 30, 2009 to $716.8 million at September 30, 2009, primarily due to depreciation expense of $20.2 million, partially offset by the favorable impact of foreign currency effects of $9.5 million and capital additions of $8.9 million.
At September 30, 2009, other assets were $756.4 million, an increase of $5.7 million from $750.7 million at June 30, 2009. The primary drivers for the increase were an increase in goodwill, deferred tax asset and other assets of $3.9 million, $1.4 million and $1.7 million, respectively, partially offset by a decrease in intangible assets of $1.5 million. The increase in goodwill and deferred tax assets were driven by favorable foreign currency effects of $3.9 million and $1.4 million, respectively. The increase in other assets was primarily driven by fees incurred in connection with the amendment to our 2006 Credit Agreement. The decrease in intangible assets was due to the amortization expense of $3.3 million, partially offset by favorable foreign currency effects of $1.8 million.
Long-term debt and capital leases decreased $111.6 million from $436.6 million at June 30, 2009 to $325.0 million at September 30, 2009, primarily due to repayment of outstanding indebtedness under our revolving credit facility with the proceeds from the issuance of capital stock.
Shareowners' equity was $1,379.7 million at September 30, 2009, an increase of $132.3 million from $1,247.4 million at June 30, 2009. The increase was primarily attributed to an increase from foreign currency translation adjustments of $24.9 million, net proceeds from issuance of capital stock of $120.7 million, partially offset by net loss attributable to Kennametal of $9.8 million and cash dividends paid to shareowners of $9.8 million.

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

ENVIRONMENTAL MATTERS
We are subject to various U.S. Federal, state and international environmental laws and regulatory requirements and are involved from time to time in investigations or proceedings of various potential environmental issues concerning activities at our facilities or former facilities or remediation efforts as a result of past activities (including past activities of companies we have acquired). From time to time, we receive notices from the U.S. Environmental Protection Agency or equivalent state or international environmental agencies that we are a potentially responsible party (PRP) under the Comprehensive Environmental Response, Compensation and Liability Act (commonly known as the "Superfund Act") and/or equivalent laws. These notices assert potential liability for cleanup costs at various sites, which include sites owned by us, sites we previously owned and treatment or disposal sites not owned by us.
Superfund Sites We are involved as a PRP at several Superfund sites, and have responded to notices for other Superfund sites as to which our records disclose no involvement or for which predecessors of certain of our acquired companies have acknowledged responsibility. We have established reserves that we believe to be adequate to cover our share of the potential costs of remediation at certain of the Superfund sites; at September 30, 2009, the total of these accruals was $0.2 million. For the remaining Superfund sites, proceedings in those matters have not yet progressed to a stage where it is possible to estimate the ultimate cost of remediation, the timing and extent of remedial action that may be required by governmental authorities or the amount of our liability alone or in relation to that of any other PRPs.
Other Environmental Issues We also maintain reserves for other potential environmental issues. At September 30, 2009, the total of these accruals was $5.5 million and represents anticipated costs associated with the remediation of these issues. We recorded unfavorable foreign currency translation adjustments of $0.2 million during the three months ended September 30, 2009 related to these reserves.
DISCUSSION OF CRITICAL ACCOUNTING POLICIES There have been no material changes to our critical accounting policies since June 30, 2009.
NEW ACCOUNTING STANDARDS
See Note 3 to our consolidated financial statements set forth in Part I Item 1 of this Form 10-Q for a description of new accounting standards.