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Edited Transcript of CRS earnings conference call or presentation 31-Jan-19 3:00pm GMT

Q2 2019 Carpenter Technology Corp Earnings Call

WYOMISSING Feb 1, 2019 (Thomson StreetEvents) -- Edited Transcript of Carpenter Technology Corp earnings conference call or presentation Thursday, January 31, 2019 at 3:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Brad Edwards

Brainerd Communicators, Inc. - MD

* Timothy Lain

Carpenter Technology Corporation - VP & CFO

* Tony R. Thene

Carpenter Technology Corporation - President, CEO & Director

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Conference Call Participants

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* Gautam J. Khanna

Cowen and Company, LLC, Research Division - MD and Senior Analyst

* Jeremy David Kliewer

Deutsche Bank AG, Research Division - Research Associate

* Joshua Ward Sullivan

Seaport Global Securities LLC, Research Division - Director & Senior Industrials Analyst

* Philip Ross Gibbs

KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst

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Presentation

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Operator [1]

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Good day, everyone, and welcome to the Carpenter Technology Corporation Second Quarter Fiscal 2019 Conference Call. (Operator Instructions) And please note that today's event is being recorded.

And now I would like to turn the conference over the Brad Edwards of Investor Relations. Please go ahead with your presentation.

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Brad Edwards, Brainerd Communicators, Inc. - MD [2]

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Thank you, operator. Good morning, everyone, and welcome to Carpenter Technology's earnings conference call for the second quarter ended December 31, 2018. This call is also being broadcast over the Internet, along with presentation slides. Please note, for those of you listening by phone, you may experience a time delay in slide movement.

Speakers on the call today, are Tony Thene, President and Chief Executive officer; and Tim Lain, Vice President and Chief Financial Officer.

Statements made by management during this earnings presentation that are forward-looking statements are based on current expectations. Risk factors that could cause actual results to differ materially from those forward-looking statements can be found in Carpenter Technology's most recent SEC filings, including the company's report on Form 10-K for the year ended June 30, 2018, Form 10-Q for the quarter ended September 30, 2018 and the exhibits attached to those filings. Please also note that in the following discussion, unless otherwise noted, when management discusses sales or revenue, that reference excludes surcharge. When referring to operating margins, that is based on operating income and sales, excluding surcharge.

I will now turn the call over to Tony.

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [3]

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Thank you, Brad, and good morning to everyone on the call today. Let's begin on Slide 4 with an update on our safety performance. Our total case incident rate, or TCIR, was 1.4 through the second quarter of fiscal year 2019, up from 1.2 during fiscal year 2018. Although the safety performance in our SAO business has not improved as expected in fiscal year 2019, our PEP business has improved dramatically. The group has achieved 3 injury-free performance months through the first half of fiscal year 2019, an indicator that 0 is possible. Our continued passion for hazard elimination, employee engagement and proper work procedures is key to achieving our core value of a 0 injury workplace.

Moving to Slide 5 and review of our second quarter performance. Our second quarter results reflect strong operating performance as well as the continuation of 2 key trends. First, we continue to capitalize on strong market conditions through the execution of our solutions-focused strategy. Second, we are gaining incremental market share across our end-use market by deepening our customer relationships and unlocking new opportunities for our advanced materials. As a result, we are building meaningful year-over-year and sequential backlog growth.

Market demand remains healthy, and we generated year-over-year sales growth in 4 of our 5 end-use markets. Our commercial execution remained strong, and we are capturing growing demand for our solutions. In fact, the second quarter marked the 8th consecutive quarter of year-over-year sales growth in our Aerospace and Defense end-use market. We continue to strengthen our position through market share gain, most recently in aerospace jet engines, medical devices and heavy-duty powertrain applications. Robust backlog growth continues, up 16% on a sequential basis and up 49% compared to last year. The second quarter marked our 10th consecutive quarter of sequential backlog growth.

Looking deeper, we generated sequential double-digit backlog growth in 4 of our 5 end-use markets, including Aerospace, which was up 21%. Specifically, within Aerospace, backlog increased in every major submarket. This speaks to the strength of our solutions across multiple attractive Aerospace submarkets and positions us to quickly capture emerging demand.

Concerning our Athens facility, the level of urgency among our customers remained high, given current industry lead times and projected increases in engine build rates. For the first quarter of fiscal year 2019, I noted that we were experiencing a noteworthy increase in customer activity and dialogue concerning qualifications.

In the second quarter, we are pleased to report that we have received 3 additional specific product type approvals from 2 significant customers. Specifically, we just completed negotiating a new long-term agreement in principle that positions Carpenter Technology as one of the major suppliers of specialty material solutions to Safran. Our Athens facility will be used for the bulk of the supply assuring continuous material availability to Safran for the manufacture of engines and other products. We also continue to place strategic emphasis on investing for the future, particularly in the areas of additive manufacturing and soft magnetics. We are having productive conversations with customers across all of our end-use markets about our complete active manufacturing platform and how we can help them create and design AM parts and components. These conversations accelerated following our acquisition of LPW Technology, which added software and hardware-based AM powder management solutions to our portfolio. The investment in our soft magnetics portfolio remains on track. We see steady growth potential for our solutions in this market, given our auxiliary power unit application leadership as well as an expected impact of electrification in the global transportation industry. I'll speak more about these exciting growth opportunities for Carpenter Technology later in the presentation.

Finally, our financial position remains strong. We have no major pension contributions or debt maturities until fiscal 2022. This gives us the strategic flexibility to strengthen our long-term growth profile by investing in targeted areas like additive manufacturing and soft magnetics, while also providing direct returns to shareholders via our quarterly dividend.

Now let's move to Slide 6 and the end-use market update. Looking first at Aerospace and Defense, where sales were up 6% compared to last year as we continue to benefit from our broad industry participation and higher demand across the majority of our submarkets. The second quarter marked our 8th consecutive quarter of year-over-year revenue growth in Aerospace market.

On a sequential basis, sales were down 2%, primarily due to timing of orders. There will be lumpiness quarter-to-quarter, particularly given our submarket diversity, but overall demand environment remained strong. In terms of Aerospace submarket, sales, engine, avionics, distribution and defense were up year-over-year, while fasteners and structural were down again due more to shipment timing versus any negative market demand signal. It is important to note that where possible we will continue to fulfill expedited order request from our OEM partners across our Aerospace submarkets.

Now moving to the energy market and our oil and gas and power generation submarkets. Total energy sales increased 26% year-over-year, but were down 3% on a sequential basis. The sequential decline was attributable to reduced rental and replacement activity at Amega West due mostly to specific tool utilization among North American service providers. While the North American directional and horizontal rig count has leveled off, we remain enthusiastic about our opportunities in the oil and gas submarket. We have strong customer relationships and our solutions address critical challenges operators face today, including corrosion resistance, durability and thermal and pressure variations. In the power generation submarket, we are beginning to see signs of increased activity although it is coming off a very low base.

In the Transportation market, sales were down 6% sequentially due mostly to the weakening of the global light vehicle market. We partially offset that decline by positive gains in the North America light vehicles and heavy-duty truck applications. While the global Transportation market is facing some headwinds, we are working hard to expand further into attractive adjacent markets where our solutions can help customers address critical performance needs, including light weighting as well as heat and corrosion resistance.

Moving on to the Medical market, where sales were up 3% year-over-year due to higher demand for titanium solutions at Dynamet. We continue to generate steady growth in key submarkets, including orthopedic and cardiology, given the high value of our titanium and cobalt offerings. We continue to have success expanding our customer relationships beyond traditional distributors and enhancing direct OEM relationships.

In the industrial and consumer end-use market, revenues were up 11% compared to last year and 4% sequentially. Growth in both periods was driven by increased demand for select industrial and consumer applications.

Now I'll turn it over to Tim for the financial review.

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Timothy Lain, Carpenter Technology Corporation - VP & CFO [4]

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Thank you, Tony. Good morning, everyone. I'll start on Slide 8, the income statement summary. Net sales in the second quarter were $556.5 million, or $449 million, excluding surcharge. Sales, excluding surcharge, decreased 2% sequentially on roughly 3% lower volume due primarily to the timing of customer order deliveries. On a year-over-year basis, sales excluding surcharge increased 8% on 6% higher volume. Our year-over-year results continue to reflect the benefit of a favorable product mix.

As Tony mentioned, we continue to see solid demand across most of our end-use markets, as evidenced by our growing backlog. Our total backlog grew by 16% sequentially and 49% compared to the same period last year. SG&A expenses increased by approximately $5 million on a sequential basis, primarily due to strategic investments in our additive manufacturing platform, the addition of LPW's SG&A and the LPW acquisition-related costs. We expect our SG&A to be in the range of $50 million to $55 million per quarter for the balance of fiscal year 2019.

As Tony mentioned, we delivered solid operating performance in our fiscal second quarter. Our results include both a $4.7 million benefit associated with an insurance recovery we received this quarter as well as $1.4 million of losses generated by LPW since the acquisition in October. I'll cover those separately later in my remarks. Operating income as a percentage of sales was 12.6% in the quarter. Operating margin improved 270 basis points on a sequential basis due to the improved product mix and the continued progress we are having implementing the Carpenter Operating Model across our facilities.

In the quarter, we reported $3.2 million of other expense below operating income, mainly related to unfavorable market returns on certain investments. Our effective tax rate for the second quarter was 21.5%, which was below our expected rate of 24% to 26%. The lower rates primarily is a result of a favorable termination of certain tax positions on our prior year tax returns. We expect our effective tax rate to be in the range of 24% to 26% for the balance of fiscal year 2019. Second quarter net income was $35.5 million or $0.73 per share, excluding the impact of the special items, namely the LPW acquisition-related costs, adjusted diluted earnings per share was $0.76 per share for the quarter, compared to $0.55 in the second quarter of last year.

Now turning to Slide 9 and review of free cash flow. Free cash flow in the second quarter was negative $91 million. It's important to note that our current quarter results include $79 million of cash used to acquire LPW which strengthens our market position by adding lifecycle management solutions to our additive manufacturing platform. Excluding the impact of the LPW acquisition, free cash flow would have been negative $12 million in the quarter.

During the current quarter, we increased inventory by $100 million. The increase is consistent with our historic pattern of building inventory in the first half of the year to support the higher sales volumes in the second half of our fiscal year. We continue to align inventory levels with our increasing backlog. We spent $82 million in capital expenditures year-to-date, consistent with our expectations. This included investments in our strategic growth areas of additive manufacturing and soft magnetics.

Our liquidity position remains solid. As of the close of the recent second quarter, we had $322 million of total liquidity, including $29 million of cash and $293 million available under our credit facility. Our healthy balance sheet is critical to supporting financial flexibility as we invest in strategic growth initiatives, while also providing direct return to our shareholders.

Now turning to Slide 10 and our SAO segment results. Net sales, excluding surcharge were $356 million, which is down 1% on a sequential basis on 2% lower shipment volume. On a year-over-year basis, sales excluding surcharge increased $24 million or 7% on 3% higher shipment volume. The increase reflects continuing strong demand across our key end-use markets combined with an improving product mix as we execute our solutions-focused strategy. Operating income was $69 million in the second quarter, up $16 million sequentially and $19 million year-over-year.

As I mentioned earlier, the current quarter's operating income includes a $4.7 million insurance recovery benefit related to funds received to settle a claim for a fire at an SAO facility during fiscal year 2018. Aside from the insurance recovery, the strong sequential operating performance was driven by a favorable product mix and lower operating cost, partially offset by the impacts of lower volumes. The cost performance in the current quarter was driven by an improving trend and reducing quality-related costs as well as improving efficiencies across the overall SAO mill system.

Operating margin was 19.4% compared to 14.6% in the first quarter and 15% in last year's second quarter. Even when excluding the insurance recovery, operating margin for the quarter would have been 18.1%, which represents the second best quarterly margin for SAO since the first quarter of 2014.

Looking ahead to Q3, we continue to see strong demand trends across our key end-use markets as reflected in our significant backlog growth. We currently expect operating income to increase 5% to 10% sequentially from Q2 to Q3, after adjusting for the insurance recovery benefit of $4.7 million. This would represent the highest third quarter operating income for SAO since fiscal year 2012.

Now turning to Slide 11 and our PEP segment results. Net sales, excluding surcharge were $109 million, operating income was $4.4 million in the second quarter, which includes a $1.4 million loss attributable to LPW. The PEP results were below our expectations as a result of our Dynamet and Amega West business units. Our Dynamet business was negatively impacted in the quarter by the timing of customer orders, more specifically certain customers manage their inventory closely as they closed out the calendar year. We believe that order patterns for these customers will normalize in the third quarter.

Results at Amega West were impacted by challenges associated with lower-than-anticipated rentals for certain new tools that we've introduced recently. It is clear that service providers are looking for new technologies and solutions to improve efficiency and ultimately reduce their operating costs. We believe that our differentiated solutions can help our customers achieve their goals. We remain confident in the long-term growth profile for this business. We expect PEP third quarter operating income inclusive of LPW to improve sequentially by 60% to 70%. Our expectations for the PEP segment's operating income trajectory, excluding LPW includes 10% to 15% growth in excess of amounts planned for Q2.

With that, I will now turn the call back over to Tony.

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [5]

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Thanks, Tim. In today's environment, it can be difficult to balance a long-term vision with short-term demands. At Carpenter Technology, we are committed to achieving that balance. We understand the urgency to deliver quality earnings every quarter. Supported by our commercial solutions approach and the implementation of the Carpenter Operating Model, we have delivered 8 consecutive quarters of year-over-year earnings growth. We also understand that we must plan for the future as sustained profitable revenue growth is the most significant driver of total shareholder return. So we focused on 3 areas to deliver sustained profitable revenue growth. First is our attractive core business, which is supported by solid market fundamentals. Here we continue to unlock productivity in our existing work centers and move forward on the qualifications at Athens. Second, we are acting on high-value adjacencies by increasing our current capabilities to serve a much bigger share of markets that could grow significantly in the near future, such as electric vehicles and consumer electronics applications.

In this area, we are aggressively moving forward with investments to expand our soft magnetics footprint. For example, as you recall in March of 2018, we announced the planned construction of a hot strip mill in Reading. We see numerous growth opportunities with soft magnetic applications via our current leadership in supporting auxiliary power units for aircrafts and the growing penetration in high-value applications consumer electronics. In addition, the expected rise in electric vehicle adoption over the coming years presents an attractive and expanding market for our solutions. We see the total addressable market for our soft magnetic offerings being in the billions, compared to our current annual sales of less than $100 million. This includes opportunities in power conversion where our solutions can deliver improved induction and reduce core loss in motors and generators. OEMs developing EV motors have critical needs such as delivering extended range, weight reduction, improved performance and decrease charging time. Our solutions include the highest induction alloys in the world and will provide designers increased flexibility as they look to meet future performance needs. The power distribution market is another area where we believe our solutions can serve unmet needs in applications such as transformers and inductors. The benefits we can bring include higher induction, improved permeability and reduce core loss at high-frequency levels. And the third area we are focusing on to deliver sustained profitable revenue growth is what we call new frontiers. These are disruptive technologies emerging in our core industry. What is important to note is that key customers based on our current relationship, technical expertise and market reputation will rely upon us to help with step-change performance improvement. As such, we are pursuing additive manufacturing as well as other technologies.

Today, Carpenter Technology operates a leading end-to-end additive manufacturing platform to ensure we are positioned at the forefront of the disruptive change expected to reshape our industry. Over the last several years, we have transitioned from being solely a powder supplier to having extensive additive manufacturing product design and part production capabilities as well as Powder Lifecycle Management solutions. Carpenter Technology can provide an integrated additive manufacturing solution from feedstock through design and component production, all supported by powder management and recyclability capabilities. The conversations we are having with customers around additive manufacturing have been steadily increasing and accelerated further following our acquisition of LPW Technology in October. The addition of LPW significantly strengthened our additive platform and team.

LPW software measures moisture and oxygen levels during various stages of the printing process. This can help identify and mitigate potential problems that could lead to compromise or failed integrity or suboptimal performance. LPW's technology has the potential to improve the recyclability and lifecycle cost of powder and drive meaningful cost savings. In addition, the construction of our emerging technology center on our Athens, Alabama campus remains on track. We are excited about this project and the opportunities it will provide us to further collaborate with customers and develop and implement new additive manufacturing based solutions. In all 3 of the key areas I just noted, the goal is to be the preferred solutions provider and an irreplaceable partner in the supply chain.

In summary, Carpenter Technology is delivering on the short term with quarter-over-quarter earnings growth, while taking current innovative action in significant growth areas like soft magnetics and additive manufacturing to accelerate profitable revenue growth into the future. Despite being 130 years old, we believe Carpenter Technology is a company of the future.

Let's turn to Slide 14 and my closing comments. In closing, we continue to execute at a high level and capitalize on the positive demand trends we are seeing across our end-use markets. I believe the key takeaways from our second quarter results are clear. Our solutions-focused strategy is clearly working as we are gaining market share and growing our year-over-year revenues. Our backlog continues to show solid growth. Total company backlog was up 16% sequentially and 49% year-over-year. This includes 21% sequential increase in Aerospace and Defense, driven by increases in all major submarkets, as we further benefit from our diverse industry participation. We are operating in a high demand environment, and we see many opportunities to further implement the Carpenter Operating Model and unlock incremental capacity across our facilities. We continue to make progress with VAP qualifications at Athens with 3 recent approvals. Our customers remain highly engaged and motivated to secure approvals for their engine materials, and our team is working diligently with them every day.

You've heard me talk on prior calls about our drive to become an irreplaceable supply chain partner for our customers. Our established and trusted position in the Aerospace supply chain is demonstrated by the recent long-term partnership with Safran that I mentioned earlier. The partnership also speaks to the value and capabilities of our Athens facility and the benefit this new capacity can provide the Aerospace industry.

While Athens will be an important growth driver for Carpenter, we are also strengthening our foundation for long-term sustainable growth by enhancing our capabilities in innovative technology that will significantly impact the future of our industry and our customers. In the soft magnetic space, we see several attractive long-term growth opportunities given our leadership in auxiliary power unit application as well as the global market disruption expected to come from vehicle and aircraft electrification.

In additive manufacturing, we moved quickly to build a platform that offers customers materials expertise, powder development, design and production capabilities, Powder Lifecycle Management solutions and improved recyclability. Lastly, we remain committed to maintaining a healthy balance sheet. This enables us to invest in our future and that of our customers, while also delivering direct returns to our shareholders.

Thank you for your attention, and I'll turn it back to the operator to field your questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first questioner today will be Gautam Khanna with Cowen and Company.

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Gautam J. Khanna, Cowen and Company, LLC, Research Division - MD and Senior Analyst [2]

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Tony, I was wondering if you could just give us a little bit more color on the Safran agreement? And if you could talk a little bit about the pace of Athens qualifications and whether you're close to having some high value or high volume aerospace parts being qualified and when we should expect that to hit the P&L?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [3]

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Yes. Sure. Well, certainly the last qualifications that we picked up, I think, will qualify as high volume. Those are very important ones, specifically on Safran. I can't get into all the contract details, but a couple important bullets is one, it's a long-term agreement. The bulk of that material will come out of Athens. I would say that approximately 50% of the total volume over that period of time is incremental to where we are at today. And as a sidenote, we've also agreed that we'll have a partnership on additive manufacturing going forward. So from our standpoint, the combination of all those are quite positive, and I think it speaks to the increased progress we're making now at Athens.

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Gautam J. Khanna, Cowen and Company, LLC, Research Division - MD and Senior Analyst [4]

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And when would you anticipate that product to start to flow through the facility and into the income statement, if you will?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [5]

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I think it's -- that's a good question. I think over the next 6 months, you can see product starting to move to Athens. We have to make sure that we do everything in coordination with the qualification. And I think what's important for a customer like this is with backlogs continuing to grow, it gives them an opportunity to pull in some of that material that's out in the backlog now. Because quite frankly, those orders -- majority of those customers will take that product today, right, as opposed to in that long-lead time.

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Gautam J. Khanna, Cowen and Company, LLC, Research Division - MD and Senior Analyst [6]

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That make sense. And, Tony, can you give us some context for what we should be expecting? Or what you guys are pursuing in terms of additional qualifications for product at Athens, you got the big Safran one. Is there -- how do we track whether there is another sizable chunk of products that get qualified? Or are you even expecting a whole lot more or is this the big one, if you will?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [7]

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No, this was a significant one. There are other significant ones that we're working on that I hope to come here in the near future. Obviously, we don't talk about specific customers. In this case here, Safran was willing to allow us to do that. We appreciate that very much. So I see those qualifications continuing. We still have a couple larger product types with significant customers that we're working through. As you all know, better than most that each one of these customers have their own specific qualification cycle, right. And -- so we'll work with each of them individually.

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Operator [8]

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And the next questioner today will be Josh Sullivan with Seaport Global.

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Joshua Ward Sullivan, Seaport Global Securities LLC, Research Division - Director & Senior Industrials Analyst [9]

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Tony, on LPW, how should we be thinking about the contributions just over the next maybe 6 to 12 months just going forward?

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Timothy Lain, Carpenter Technology Corporation - VP & CFO [10]

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Yes. This is Tim. I'll take that. We talked about in our prepared remarks, LPW being about $1.4 million of a loss in Q2. I think on a go-forward basis, it will be similar. There is a lot of work to do around transition and building on synergies and going -- building out the whole go-to-market approach. So there is upside there, but I think for now we're expecting kind of a consistent run rate for the balance of the year.

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [11]

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Josh, this is Tony, if I could just add. In the additive manufacturing field, I think the debate is over on whether this is going to be a game changer or not. The main outstanding question is, when do you robustly move from prototyping stage into mass production and that -- and therefore earnings right from additive manufacturing. Someone told me not too long ago that the only people making money in additive manufacturing right now are the consultants. So it is important to realize, if you're going to go down the additive manufacturing road and put time and effort in there and make some of these acquisitions that all of them right now are actually in a negative cash flow position. And that's why you see a lot of these service bureaus being purchased by larger companies that can support that negative cash flow and that's exactly what we're doing at Carpenter. We've worked really hard to establish our core business to get these types of earnings that we're in a strong balance sheet that we are able to go out and do this now in additive manufacturing that we know over the next couple of years will be significant from a growth standpoint.

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Joshua Ward Sullivan, Seaport Global Securities LLC, Research Division - Director & Senior Industrials Analyst [12]

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And then just one on the Medical market, are you taking share of those new products? Where do you think you are relative to the share that you can maybe take over the next 12 months?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [13]

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Yes, I appreciate you asking that question, because obviously Aerospace is 50% of our revenue, but Medical is an area we've been growing quite a bit. So yes, we've been gaining share across multiple large customers, and I would say that's really been over the last 12 months one of our bright spot as far as being able to increase our capabilities, increase the supply that we can put into the market and pick up share. I'll tell you as you talk to those Medical customers, not only are you talking about traditional products, but in almost every case our position in additive manufacturing is quite attractive to them, and we've been working with each one of them on steps going forward in the AM field.

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Joshua Ward Sullivan, Seaport Global Securities LLC, Research Division - Director & Senior Industrials Analyst [14]

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And then just one last one on the soft magnetics investment, have any customers began to commit to any capacity at this point?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [15]

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No, I think we're still little early there. We're still probably a year out as far as getting that in place. I don't see any issue whatsoever of utilizing that mill.

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Operator [16]

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(Operator Instructions) And the next question will come from Phil Gibbs with KeyBanc.

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Philip Ross Gibbs, KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst [17]

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Tony, in terms of the engine business, can you give us some color there in terms of how much that business grew relative to last year?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [18]

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Year-over-year, it was up a couple of percentage points, Phil, on the submarket engines alone. I think what, I mean, I'm glad that you asked that question, because I think what's important for the engine market, which is half of our overall aerospace market the demand there remains high. If you look at over the last 8 or 9 quarters, really when we had the dip in Aerospace, right, the pause right before the ramp started. Since that time we've had sequential -- the sequential number for engines has been up a couple of times, it's been down, but almost of it's up year-over-year. So even though we were up just couple of percentage points, down sequentially in this quarter, I believe it was the highest quarterly bookings for engines that we've had. So it's really not about, you're couple of points high or low. And the second point I'll make, Phil, that I think is important is, I said engines is half of our overall Aerospace portfolio. We have very strong business in structural, fasteners, defense, avionics, in most cases to the same customer. So we are working with that customer to prioritize what is their top product that they want out. So we might make a decision to ship another one of those products versus engine based on a customer preference. So that drives some of the up and down quarter-over-quarter as well.

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Philip Ross Gibbs, KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst [19]

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Okay. And then there is -- at least, in terms of my purview, this is an area where you all have been and are going in the future as well, but maybe in some different applications, but on the powder side, can you just remind us where you all play in that supply chain? And how you -- you may be looking to create some synergies with your recently acquired business and that position that you have?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [20]

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We're really trying to develop an end-to-end process, especially when it comes to additive manufacturing. We've been in the powder business for quite some time. So we still are not just into additive manufacturing, we're into a lot of other markets whether it'd be metal injection molding or other areas. We have currently 5 powder facilities. Our real goal is to connect the dots from that feedstock being the powder to the end customer and that's why you see the acquisitions that we made. We bought a titanium powder facility as opposed to building it on our own. We have bought a parts producer so we can design and produce finished parts. And then with the acquisition of LPW, that's really the middle where we can from a software and hardware standpoint, recyclability, analyzing the powder from a properties standpoint that it runs most efficiently through the machine. So now we can go to our customer and really don't need anyone else. We can go from start to finish, design a product, make the powder, produce the part and do all the post processing. That's really where we want to go where we have that type of relationship with the customer from end to end.

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Philip Ross Gibbs, KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst [21]

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Most of your powder sales right now basically merchant sales, I mean, they're going to somebody else that's going to process that into something versus being able to use it on your own meaning...

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [22]

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Yes. Sorry, Phil, that's correct.

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Philip Ross Gibbs, KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst [23]

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Okay. And in the future, you want to move more towards using that supplier on your own as you go end-to-end, is that what you're trying to communicate?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [24]

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Yes, especially, in additive manufacturing, I think there'll be customers that we will sell bulk powder to on the AM side and we all want to do that. That will make sense to do that depending on their size and their breadth and what their capabilities are. I think there'll be other customers that will do an end-to-end solution for them. So I think it will range based on where that certain customer is and what they would like to keep in-house versus letting someone like Carpenter do, and I think it'll be -- there will be some of every one of those options.

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Philip Ross Gibbs, KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst [25]

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And then just a last follow-up if I could. I appreciate all this. I think you mentioned that the PowerGen has picked up slightly off of low levels and everyone has been impacted by that malaise the last couple of years. Maybe any color in terms what you're seeing and whether or not you think that balance is sustained?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [26]

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Yes, Phil, I think that we've seen some positive signs there from an order intake standpoint. Remember from our standpoint, power generation is maybe 1%, 1.5% of our total revenues, so it is relatively small. But we have seen -- and it's at a very low level right now, but we have seen an uptick here over the last, I would say, for surely the last quarter or maybe 2 quarters.

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Operator [27]

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And this will conclude our question-and-answer session. I would now like to turn the conference back over to Brad Edwards for any closing remarks. Actually, we did have someone jump in. It is Josh Sullivan with Seaport Global with a follow-up.

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Joshua Ward Sullivan, Seaport Global Securities LLC, Research Division - Director & Senior Industrials Analyst [28]

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I was just curious, if the Aerospace OEMs were to -- like to take up production rates beyond some of these announced levels. How would we see that flow through to Carpenter? We see a rush of qualifications? And then what's the typical timeline from -- when the metals made at Carpenter to when we get on a jet engine just so we -- delivery rather, just so we kind of underline if we do see rates go up here?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [29]

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Yes. So listen, I think the interest in qualifying Athens is at -- on a scale from 1 to 10, is a 10. So, I don't know what -- I don't think that interest can get any higher than Athens now. Every one of those OEMs are working with us quite closely. When you say how does that impact, I think from a very simplistic standpoint, whatever rate increase you see in net increase in engines at the very least that's what Carpenter will receive. So whatever share they have today will increase from a volume standpoint with the increase in net engines. And on top of that, I think there is even increased opportunity and you saw it in the Safran contract where we increased our incremental piece there. So from our standpoint, you have a capacity-tight industry. Athens is the only capacity that's coming online. We're going to move at the very minimum with the market going up and as a accelerator hopefully gain some business because we're able to supply.

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Operator [30]

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And the next questioner today will be Jeremy Kliewer with Deutsche Bank.

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Jeremy David Kliewer, Deutsche Bank AG, Research Division - Research Associate [31]

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The rate of growth, I guess, of your Aerospace and Defense sales has slowed to about 6%, which is still good, but should we anticipate this getting back up to double digits following the contracts or the qualifications down at Athens?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [32]

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I think the answer to that question is much like what I just said. Take whatever rate, the overall Aerospace business is growing, and we're going to be right in line with that. I mean, the math has to work, right. There's -- you're not going to be able to increase the engines build rate without it impacting Carpenter in a positive manner. So I think they'll go hand-in-hand though certainly not a 100% alignment, but that's what you're going to see going forward for us.

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Jeremy David Kliewer, Deutsche Bank AG, Research Division - Research Associate [33]

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All right. And then, I guess, free cash flow, you built about $150 million worth of inventory over the first half, do you anticipate getting most of that back in the second half?

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Timothy Lain, Carpenter Technology Corporation - VP & CFO [34]

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Jeremy, this is Tim Lain. I don't -- we're not going to give any specific guidance on free cash flow or inventory levels. I think what we said is, we are following historical trends. We tend to build inventory in the first half of the year and then take it out in the second half, just given the second half is generally stronger than the first half. All our comments were on the market continuing to get stronger, backlogs are growing, lead times are pushing out. So again going back to our comments, we got a strong balance sheet that gives us the flexibility to invest in some kind of very strategic inventory, staged in the right spot and we can take available some short-term wins and gains with customers. So it's a very deliberate process, but we're not going to give any necessarily guidance about the value of inventory that's going to come out in the second half other than it seems very natural that inventory should come out in the second half.

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Jeremy David Kliewer, Deutsche Bank AG, Research Division - Research Associate [35]

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All right. Could you comment maybe on how long you think it will take to pay back the revolver?

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Timothy Lain, Carpenter Technology Corporation - VP & CFO [36]

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Yes. I think, so a fair amount of that balance is really related to the LPW acquisition, about $80 million. So I mean, we do have the opportunity to reduce inventory, like I said, naturally in the second half. So I think at least for the next couple of quarters, we will have some borrowings on the revolver.

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Operator [37]

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And our next questioner today will be Gautam Khanna with Cowen and Company.

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Gautam J. Khanna, Cowen and Company, LLC, Research Division - MD and Senior Analyst [38]

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Yes, just a quick follow-up, Tim, on that question of inventory and, but more specifically on SAO segment operating margins, excluding surcharge, as you mentioned 18.1% in the quarter. I'm just curious you built a lot of inventory, but presumably production -- so that helped absorption. But in the second half that would continue, the absorption would be really good I would think. So is there a chance we actually hit 20% in one of the remaining 2 quarters of the fiscal year or do you think mix was unusually good in Q2 or something else that might kind of even out as we move into the second half?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [39]

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Gautam, this is Tony. I'll take it. Yes, I mean, you and I talked about this multiple times, that's the goal. I think we can get to those types of margins, inventory going up and down. If you look at our full year for the most part balance is out. So any benefit you get from inventory build will have the opposite impact when you take it out, but that's really not the point in this whole discussion. The point is that we're at excellent market, a tight demand market. And as you all know, to make an Aerospace in this particular case product, it's not going through 1 or 2 work centers, it's going through hundreds of work centers. All of those centers aren't perfectly aligned. So in an area or in a time, where I want to meet every demand I can for my customers, I'm going to produce where I can produce. And sometimes that means overproducing in one work center knowing that, that next work center can absorb it in that quarter. But if I don't do that I can't get it back the next quarter. So I'm going to do that every day and I'm -- we worked hard to put our balance sheet in a position that it's in to give us the flexibility to do that. And I'm certainly not going to apologize that my inventory went up when I'm really doing that to make sure I can capture every sale and satisfy every customer I can. That's the way we view it.

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Gautam J. Khanna, Cowen and Company, LLC, Research Division - MD and Senior Analyst [40]

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Yes, no, it makes complete sense. I guess, I just want to make sure that there wasn't anything in fiscal Q2 SAO segment margins outside of the $4.7 million?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [41]

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Yes, no it's very -- I think you should take -- obviously that $4.7 million was a negative several quarters ago, right. I mean, that's real. We got that insurance because -- for a reason. But I think it's fair to take that out and that puts you in that 18.1%, as you all know, because you keep track of it, that's a pretty good margin. But when you look at from a productivity standpoint, there is still opportunities out there that I can go get even if volumes stays the same. I can go get that and drive those margins up a couple of more points. So that's the goal over the next several quarters to push towards that.

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Operator [42]

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And this concludes our question-and-answer session. I would now like to turn the conference back over to Brad Edwards for any closing remarks.

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Brad Edwards, Brainerd Communicators, Inc. - MD [43]

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Thanks, William. We appreciate everybody joining us today for our second quarter conference call, and we'll connect with everybody on our third quarter call. Have a great day.

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Operator [44]

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The conference is now concluded. Thank you for attending today's presentation, and you may now disconnect your lines.