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Edited Transcript of CRS earnings conference call or presentation 25-Apr-19 2:00pm GMT

Q3 2019 Carpenter Technology Corp Earnings Call

WYOMISSING May 1, 2019 (Thomson StreetEvents) -- Edited Transcript of Carpenter Technology Corp earnings conference call or presentation Thursday, April 25, 2019 at 2:00:00pm 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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* Adam Elliot Friedman

Seaport Global Securities LLC, Research Division - Associate Analyst

* Christopher David Olin

Longbow Research LLC - Analyst

* Gautam J. Khanna

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

* Jeremy David Kliewer

Deutsche Bank AG, Research Division - Research Associate

* 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, and welcome to the Carpenter Technology Corporation's Third Quarter Fiscal Year 2019 Conference Call. (Operator Instructions) Please note this event is being recorded.

I would now like to turn the conference call over to Mr. Brad Edwards, Investor Relations. Mr. Edwards, the floor is yours, sir.

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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 third quarter ended March 31, 2019. 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 quarters ended September 30, 2018 and December 31, 2018, and the exhibits attached to those filings. Please also note that in the following discussion, unless otherwise noted, when the 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. I'll start on Slide 4 with an update of our safety performance. Through the third quarter, our total case incident rate, or TCIR, remained at 1.4, up from 1.2 during fiscal year 2018. While some of our business units are operating at 0 injuries for the year, clearly we expect improvement. We are placing additional focus on several key areas such as: hand safety, hand injuries currently represent 49% of our total recordable injuries, and we are intensifying our efforts in this area; human performance, we continue to provide training to employees to recognize and stop unsafe work; hazard elimination and action tracking team, which is focused on operator engagement or improvement plans and recommendations; leadership development initiatives, centered on engaging our supervisors to drive accountability; and recently, we initiated a fork truck elimination initiative, where we identified immediate countermeasures to reduce injury risk of interacting with fork trucks. As always, our goal is a 0 injury workplace.

Now let's turn to Slide 5 and a review of our third quarter performance. Overall, our third quarter results reflect the ongoing momentum we are driving across all our core business, as we generate strong operational results and delivered our ninth consecutive quarter of year-over-year earnings growth. We continue to capitalize on the solid demand patterns across our end-use markets by winning incremental market share and expanding our customer relationships.

Our success drove year-over-year and sequential sales growth. In fact, it is also the ninth consecutive quarter of year-over-year sales growth. In addition, our backlog increased for the 11th straight quarter, growing 9% sequentially and 44% compared to last year.

In our largest end-use market, Aerospace and Defense, demand remains robust, and our submarket diversity continues to drive solid growth. Sales increased 17% sequentially and 5% year-over-year. Backlog increased 12% sequentially.

The results speak to the continued strong underlying demand and our established and diversified presence in the Aerospace and Defense end-use market. Obviously, the 737 MAX developments are important. We recognize this is a significant industry event and a dynamic situation. We continue to engage directly with our customers on this issue. Each has affirmed to us that they have no current plans to reduce their production rates or alter their material needs. Accordingly, we have no planned changes to our production schedules. We will continue to monitor the situation, but at this time, we do not expect a material adverse impact to Carpenter Technology.

Our Medical end-use market is another meaningful source of sales growth, up 25% year-over-year and 23% sequentially. Backlog increased 5% sequentially. Growth within our Medical end-use market is a result of 2 primary factors: one, our market-facing organization gaining share through meeting the needs of our Medical OEMs, contract manufacturers and distributors. These needs are successfully supported by Carpenter's leading portfolio of titanium, cobalt and stainless solutions for implantables and instrumentation. And second, the Carpenter Operating Model increasing capacity, especially in our premium titanium bar products. We look forward to further improvements in titanium capacity, supported by a planned expansion of our Dynamet business unit within our next fiscal year.

In terms of an update on the qualifications of our Athens facility, we continue to generate positive momentum, and we received 4 additional specific Aerospace VAP approvals during the third quarter. The Athens facility is well positioned to provide critical incremental capacity for the industry. To realize the full value of the facility, we must obtain the necessary Aerospace VAP qualifications.

As we have mentioned on previous calls, the qualification process is specific to each OEM and approval will be incremental, meaning the qualifications will be obtained one at a time, for example, a specific diameter of a specific product type made across a specific set of assets. We are working closely with the business and technical teams of our customers as they work through their individual processes to obtain the necessary qualifications for the facility.

A good indication of the progress we are making are the additional qualifications we received this quarter combined with a long-term agreement we announced with Safran last quarter. As we stated on our last quarter call, the bulk of the supply into that agreement will come from Athens, which we believe demonstrates our customers' confidence and the value and capabilities of the facility.

Earlier in my remarks, I mentioned the success we are having running our core business and generating consistent near-term earnings growth. We continue to balance that focus with strategically investing for the longer term and positioning Carpenter Technology for continued transformative growth. We believe these investments are necessary to ensure our position as a solutions provider for our customers and to strengthen our foundation for long-term sustainable growth.

With a focus on the longer-term growth prospects, we have built a leading end-to-end additive manufacturing platform. In addition, we recognize the disruptive nature of electrification across multiple end-use markets. We see several attractive growth opportunities for our proprietary soft magnetics portfolio in high-value areas, including electric vehicles, consumer electronics and auxiliary power units for Aerospace. I'll speak more about these long-term strategic investments later in my remarks.

Lastly, we have no major pension contributions or debt maturities until fiscal year 2022. Our financial position and flexibility are critical as we look to enhance our market position while also delivering direct returns to our shareholders via a 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 5% compared to last year and 17% on a sequential basis. As I noted earlier, demand levels in the Aerospace and Defense end-use market remain strong, and we continue to benefit from our diverse solutions portfolio and leading presence across multiple attractive submarkets.

In the engine submarket, demand remains high and customers continue to seek long-term supply agreements to fill their material needs. While faster demand increased in the current quarter, future demand signals remain mixed. Lastly, defense sales were up both year-over-year and sequentially, driven by program-specific demand.

Moving on to the Medical market, where we generated strong sales growth on both a year-over-year and sequential basis. Sales increased 25% compared to last year and 23% sequentially. This solid performance was driven by steady demand in orthopedics and cardiology markets. Looking ahead, we see the potential for continued solid growth in Medical, given our high-value titanium products and the expected growth in the orthopedic and cardiology markets. It's worth noting our Medical backlog is up 50% year-over-year, which demonstrates solid forward demand for our solutions.

Now moving to the energy market and our oil and gas and power generation submarkets. Total energy sales increased 23% year-over-year and 12% on a sequential basis. Oil price volatility continues to be a theme in the oil and gas submarket, with North America rig counts down 1% year-over-year and down 3% sequentially. The reduced activity levels continue to intensify pricing pressures, especially in services and rentals. These market dynamics continue to impact new tool adoption rates of our Amega West business. Outside of North America, we are seeing an uptick in the international and offshore markets, driving demand in the current quarter.

In the power generation submarket, we continued to see signs of increase in activity although off a low base. In the Transportation market, sales were down slightly year-over-year, mainly due to global macroeconomic and trade-related issues. On a sequential basis, Transportation sales increased 14%, driven primarily by stronger mix and notable share gains in high-temperature applications. Sales into the heavy-duty truck market showed a healthy increase in the quarter, and we also made further inroads into attractive adjacent markets, including off-road and marine. It's also worth noting we generated healthy backlog growth in Transportation during the third quarter via share gains with customers primarily in North America and select high-value applications or high-temp resistant alloys.

In the industrial and consumer end-use market, revenues were flat year-over-year and down 7% sequentially. This was mostly due to lower demand for selected industrial applications as well as ongoing portfolio prioritization towards higher-value products.

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. Our results for the quarter reflect continued momentum in our operations, combined with strong market demand. Net sales in the third quarter were $609.9 million or $503 million excluding surcharge. Sales excluding surcharge increased 12% sequentially on 6% higher volume with double-digit growth in all our end-use markets except for industrial and consumer, as Tony just covered. On a year-over-year basis, sales excluding surcharge increased 6% on 1% lower volume driven by growth in several key end-use markets.

As Tony mentioned, we continued to see solid demand across most of our end-use markets as evidenced by our growing backlog. Our total backlog grew 9% sequentially and 44% year-over-year. Our current third quarter gross profit includes an $11.4 million benefit related to an insurance recovery associated with a fire that occurred at our Dynamet operations in the third quarter of fiscal year 2018.

SG&A expenses decreased by $1.6 million on a sequential basis, mainly due to costs associated with the LPW acquisition that was completed in our second quarter. For the fourth quarter, we expect SG&A expense to be in the range of $50 million to $53 million. Operating income as a percent of sales was 14.6% in the current quarter compared to 12.6% in Q2 of this fiscal year. When normalizing for the insurance recovery benefit in PEP's results in Q3 and the insurance recovery benefit in SAO's results in Q2, operating income margin improved by 80 basis points sequentially. Year-over-year, again normalizing for the insurance recovery benefit, operating income margin improved by 260 basis points.

Our effective tax rate for the third quarter was 24.9%. We expect our tax rate to be in the range of 24% to 26% for the fourth quarter.

We reported net income of $51.1 million or $1.05 per share. For clarity, $0.18 of EPS within the quarter is attributable to the insurance recovery benefit.

Now turning to Slide 9 and a review of free cash flow. Free cash flow in the third quarter was negative $37 million. During the current quarter, we increased inventory by $17 million. Over the last several quarters, we have generated a marked improvement in our primary operations, more specifically in areas such as melting, due to focused efforts implementing the Carpenter Operating Model in these key operations. The increased throughput in our primary operations is critical to aligning our inventory levels with our increasing backlog. However, this improvement has put pressure on our finishing operations, creating certain constraints.

Using the concepts of the Carpenter Operating Model, our emphasis has shifted to key finishing operations where we believe there is a significant opportunity to alleviate current bottlenecks and improve productivity and throughput rates in these areas. We've seen some early success with these efforts and have realized gains at certain key constrained work centers. There is still work to be done, but we view this as a significant opportunity to reduce inventory in the near term.

Working capital other than inventory increased by $53 million in the quarter, mostly related to an increase in accounts receivable driven by higher sales levels. We spent $49 million in capital expenditures in the current quarter and $131 million year-to-date, consistent with our expectation. As we talked about in prior quarters, the capital spending in fiscal year 2019 includes several large projects in our strategic growth areas of additive manufacturing and soft magnetics. The largest of these projects is the multiyear spend associated with our $100 million investment in a hot-strip mill on our Reading campus. We expect the fourth quarter capital spending to be in line with the third quarter.

Overall, our financial position remains solid with $286 million of total liquidity at the close of the quarter, including $19 million of cash and $267 million available under our credit facility. Our financial position is important as it allows us the flexibility to invest in our future growth.

Now turning to Slide 10 and our SAO segment results. SAO delivered another solid quarter, with net sales of $498.3 million or $393 million excluding surcharge. This represents an increase of $37 million or 10% on a sequential basis on 6% higher shipment volume. On a year-over-year basis, sales excluding surcharge increased $12 million or 3% on 2% lower shipment volume. Both sequentially and year-over-year, the sales increase outpaced volume growth, which demonstrates the impact of driving an improving product mix. In addition, demand signals remain strong. As we have highlighted, our backlog increased on both a sequential and year-over-year basis. SAO operating income was $73.6 million, up $4.6 million compared to the second quarter and up $15.6 million year-over-year. The year-over-year improvement in operating income is primarily a result of the improving product mix.

As we pointed out last quarter, our recent second quarter operating income results included a $4.7 million insurance recovery benefit related to a claim for a fire at an SAO facility during fiscal year 2018. When excluding the insurance recovery in Q2, operating income improved $9.3 million sequentially. The sequential increase in operating income was primarily driven by the higher volumes and favorable product mix.

SAO's reported operating income margin was 18.7%, which is up about 60 basis points sequentially when adjusting for the Q2 insurance recovery and up 350 basis points relative to the same quarter last year. This performance marks the highest third quarter margin for SAO in the last 7 years. We continue to benefit from the Carpenter Operating Model, as we capture manufacturing improvements and identify opportunities to unlock capacity. This is becoming increasingly important given current market conditions, our growing backlog and our strategic focus on a richer and more-complex solutions portfolio.

Looking ahead to Q4, we continue to see strong demand trends in most of our end-use markets. We are currently expecting operating income to increase 5% to 10% sequentially from Q3 to Q4.

Now turning to Slide 11 and our PEP segment results. Net sales excluding surcharge were $125.9 million, representing growth of 17% year-over-year and 15% on a sequential basis. Operating income for the quarter was $16.6 million, which again includes the $11.4 million insurance recovery related to our Dynamet business unit. While increasing sequentially, again, excluding the impact of the insurance recovery, PEP's performance fell short of expectations due primarily to our Amega West business unit.

Amega West continues to be challenged by lower-than-anticipated adoption rates for certain new tools that have been recently introduced to the market. As we previously stated, service providers are looking for new technologies and solutions to improve efficiency and ultimately reduce their operating costs. We believe our differentiated products and services can help our customers achieve their goals. We remain confident in the long-term growth potential for Amega West despite the recent short-term headwinds.

It's important to note that the PEP segment includes the results of the recent investments we've made in additive manufacturing, specifically our Powder's, CalRAM and LPW business units. As we said, these businesses represent investments in our long-term growth profile as the market for additive manufacturing is expected to grow significantly over the coming years, and we intend to maintain our growing leadership position in this area.

For the fourth quarter, we expect PEP operating income to be similar to the third quarter excluding the insurance recovery as we will continue to invest in our additive manufacturing platform and are currently expecting a more gradual progression in the adoption of the newer tools at Amega West.

With that, I'll 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. As noted with our strong quarterly results, we are focused on delivering year-over-year earnings growth. In addition, we are identifying key trends on horizon that have the potential to meaningfully impact our industry and our end-use markets. Positioning Carpenter Technology at the forefront of these trends requires investing in high-value market adjacencies as well as building a leadership position in critical emerging technologies.

As you'll recall, in March of 2018, we announced the planned construction of a precision strip mill on our Reading campus to expand our soft-magnetics' production capability. Today, we are a leading supplier of soft-magnetic alloys within Aerospace and consumer end-use markets. Electrification is becoming an increasingly critical area of focus and investment for global automotive OEMs. While projections might differ with respect to timing, all expect a rapid increase in electric vehicle adoption over the coming years. This presents an attractive addressable market opportunity for our Hiperco and proprietary Hypocore soft-magnetic alloys.

Today, OEMs are facing performance- and durability-related challenges, including range, battery life, weight, portability and charging times, to name a few. Our soft-magnetic solutions are among the highest-induction alloys in the world, and we believe they can provide significant performance improvement compared to current applications. At the same time, we will continue to expand our leadership in Aerospace auxiliary power units as well as to further penetrate the consumer electronics market via smartphones, smart watches and other applications.

Our second long-term growth driver is building on our leadership position in additive manufacturing. Over the last several years, we have significantly expanded our additive manufacturing capabilities and today operate a leading end-to-end platform. Through a series of recent strategic acquisitions, we added titanium powder production, additive manufacturing part design and production capability as well as Powder Lifecycle Management to our existing metallurgical expertise and feedstock production.

Today, we can work alongside the customers starting from feedstock development all the way through part design and production and support those efforts with critical powder reliability solutions. In addition, we've added significant additive manufacturing industry talent to our team.

In the fall of this year, we expect to open our emerging technology center on our Athens campus, where we will develop and implement future solutions for our customers ranging from new alloys to 3D-printed parts. The dialogue and conversations we are having with customers around additive manufacturing are increasing every day and include customers across all of our end-use markets. We are working alongside customers in process parameter development, characterization analysis as well as the printing of numerous AEM parts.

Our efforts in soft magnetics and additive manufacturing are consistent with our strategic mandate of being a complete solutions provider for our customers, an irreplaceable supply chain partner and a trusted collaborator as they look to elevate their products and build their technology roadmaps for the future.

Let's turn to Slide 14 and my closing comments. In closing, we are capitalizing on strong demand across our end-use markets, executing our strategy at a high level and delivering strong operational and financial results. The third quarter marked our ninth consecutive quarter of year-over-year sales and earnings growth, and our 11th straight quarter of total company backlog growth, which finished up 9% sequentially and 44% compared to last year.

We offer a broad portfolio of leading solutions, and we are well positioned across attractive end-use markets. The aerospace and defense market continues to demonstrate fundamental long-term growth demand signals, as our sales and backlog grew year-over-year and sequentially. We are an established supply chain partner in critical submarkets, including engines, fasteners and structural.

Looking internally, we remain committed to the Carpenter Operating Model and unlocking incremental capacity as well as securing operating efficiencies and reducing waste. The impressive growth we generated in the Medical end-use market this past quarter speaks to the power of the Carpenter Operating Model and the transformational impact it can have on our work centers and facilities. We continue to make progress with Aerospace VAP qualifications at Athens with 4 recent approvals.

Customer engagement remain high, and we are working closely with them to bring a much-needed incremental capacity for the industry. We continue to successfully balance near-term earnings growth with the need to invest for the long term and secure a position at the forefront of transformative change facing our industry, specifically in additive manufacturing and electrification. We believe the end-to-end additive manufacturing platform that we have built is unmatched. This is evident as we continue to engage with customers across all of our end-use markets on strategy discussions in this space.

Our soft magnetics investment remains on track, and we see an attractive and expansive addressable market for our proprietary soft-magnetic solutions and applications such as electric vehicles, consumer electronics and Aerospace. Lastly, our financial position remains healthy and gives us the opportunity to build long-term value creation for Carpenter Technology.

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 the first question we have will come from Gautam Khanna of 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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Wondering if you could just expand upon the 4 additional Athens part qualifications. Were they with different OEMs than Safran? Or anything you can characterize about the parts, if they're high volume, if -- who they're with and what that might mean for the utilization of Athens and in what time frame.

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

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I can say, Gautam, they were significant approvals for us just in our -- where we're at in the process. There were other OEMs other than Safran in that -- in those 4.

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

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And in terms of are they high-volume parts? And when do you -- like, where is the Athens now in terms of kind of utilization? I know it's hard to measure depending on mix and what have you, but -- and where do you anticipate it would be a year from now?

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

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Tough question. I anticipate it being much stronger a year from now than it is now. As I said, I've kind of gotten away from saying what the utilization is of Athens, just because we don't operate as a stand-alone mill. I will say these 4 are significant, not just from a -- we don't look just from a volume standpoint, but from who we're working with and what that particular product was and the challenges that we overcame to get that qualified. So this is a -- those 4 are significant. They're very important to us. I think it's a major step forward.

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

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And, Tony, one of your competitors has talked about challenges in the nickel powdered billet supply chain. I'm curious are you guys working towards being part of the solution in that more challenged part of the supply chain?

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

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Well, Gautam, as you might know, we're in the final stages of receiving qualification to produce an atomized [disquality] powder and sell that powder. And that's it, to sell the powder. We do not participate in the next steps of that specific supply chain, which is billetizing that powder and then ultimately forging that into a disk. We do not play in that piece of the supply chain.

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Gautam J. Khanna, Cowen and Company, LLC, Research Division - MD and Senior Analyst [8]

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Right. But up in the powder, you do. And I just wonder do you guys have an opportunity to pick up some market share with roles in that constrained part of the supply chain?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [9]

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Well, if my understanding is right, the constrained piece isn't on the powder atomization.

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Gautam J. Khanna, Cowen and Company, LLC, Research Division - MD and Senior Analyst [10]

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Okay. I think it was both, but maybe I'm wrong. That's okay. And then the last one from me, just on cash flow. I know usually the second half of the fiscal year, you guys generate cash as you work down some inventory. What do you anticipate happens in fiscal Q4, just given we're a little bit out of normal seasonality through the 3 quarters?

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Timothy Lain, Carpenter Technology Corporation - VP & CFO [11]

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Yes, Gautam, this is Tim. So as we talked about in our remarks, I think we've been pretty deliberate about managing our inventory, in certain cases, building inventory to meet the growing backlog. But as I said, I think we recognize inventory as a pretty significant opportunity for us to deliver some cash flow here in Q4 as we work through the constraints and get more out the back end of the mill. We've done some work in the front end of the operations, namely in melting and improving capacity and throughput and productivity there, now we're working through that in the back end of the facility in the finishing operations to get more out of the door. So we view the inventory as a significant opportunity for cash flow in Q4.

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Operator [12]

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And next we have Josh Sullivan of Seaport Global.

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Adam Elliot Friedman, Seaport Global Securities LLC, Research Division - Associate Analyst [13]

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This is actually Adam Friedman on for Josh. Just assuming that volume eventually gets to the 57 per month rate, either it's sort of late this year or early next year, how should we think about sort of the long-term margin potential for SAO? I guess, just following on to that, do your long-term assumptions assume 57 per month in the 737 and on the A320 eventually getting to that 63 per month rate?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [14]

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Well, I mean, your main question is, what do we think SAO margins can go? And I've talked about this several times over the last couple of quarters. I believe, we can do better than we are now. Think about being at 18.7%, I think it's the third time that we've -- in the last 4 quarters that we've been above 18%. The last time we'd really seen 18% was back in fiscal year 2014. But I can tell you there's a lot more productivity that we can go achieve in our SAO facilities. And you see that, quite frankly, in some of the reasons for the inventory build. I think it's great internal competition that the front end of our process now has gained such significant productivity improvement. That's putting pressure on the back end of our process now, and they're up to the challenge to say, "We need to increase our rates as well so we can increase the overall shipments out of that facility." So I think SAO can do better than what they're doing now. Great performance this quarter and the last couple of quarters, but we still have much more in the tank when it comes to productivity.

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Adam Elliot Friedman, Seaport Global Securities LLC, Research Division - Associate Analyst [15]

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Okay. Great. And then just given sort of the volatility that you talked about in the oil prices. I guess, how are you thinking about the oil and gas business over the next, call it, like 3 to 4 quarters or 2 to 3 quarters? Whatever sort of color you can give would be great.

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Timothy Lain, Carpenter Technology Corporation - VP & CFO [16]

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I think, Adam, we're cautiously optimistic. We talked about we see the oil price volatility continue to play a factor in how companies are making decisions on where they're investing. I think we're -- in this quarter, we saw some uptick in activity internationally, which has kind of not been the case for the last several quarters. So I'd say, it's fair to say we're cautiously optimistic, but I think it's going to be a rising waterline as opposed to any big wins here in the next couple quarters.

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Operator [17]

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(Operator Instructions) The next question we have will come from Chris Olin of Longbow Research.

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Christopher David Olin, Longbow Research LLC - Analyst [18]

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My question is, when companies within the industry or even yourselves talk about constrained capacity within the nickel-based alloy or, call it, the premium alloy markets, does that refer to the actual melting capacity, call it, like the VAR or VIM furnaces? Or does that refer to the limited, I guess, downstream supply such as like the Athens forge?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [19]

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I think, from our standpoint, when we speak about constrained capacity in the nickel billet area, it would include the primary and secondary melting as well as the press or the forge operations.

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Christopher David Olin, Longbow Research LLC - Analyst [20]

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Okay. I guess I was curious, so when you talk about applying the Carpenter Operating Model to downstream fabrication, is that what we're talking about here as well, is loosening up some volume on a go-forward basis? Or is that more of a cost item?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [21]

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Well, I think, it's opening up volume. I mean, if you look at the downstream for Carpenter or any comparable company, there's hundreds of work centers there. And right now, from a productivity standpoint, we've seen bigger increases in the upstream. For us, that's good. Those are the most recognizable constraints, and we're pushing that constraint downstream. That's good news for Carpenter and that's good news for the industry.

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Christopher David Olin, Longbow Research LLC - Analyst [22]

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Okay. And then just lastly, I want to make sure I understand the strategy here. When we see the approvals come in on the jet engine businesses, should I assume that, that is volume that could already be done at Reading or maybe Latrobe that will ultimately be shifted to Athens so then you can have a more flexible mix at the legacy mills? Is that how you think about it?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [23]

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Not 100%. I mean, it is true that the qualifications that we're receiving, that we now produce those products at our existing facilities, but this market isn't about shifting a pound from Reading to Athens. As you well know, this is about making 2 pounds instead of 1. I mean, we're increasing the amount of engines that are being made, not keeping them flat. So therefore, the premise that all it is shifting from one plant to another doesn't -- isn't logical.

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Christopher David Olin, Longbow Research LLC - Analyst [24]

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Okay. And just lastly before I forget too, your Aerospace distribution business, I was curious approximately roughly how big that is. And could there be any risk that, that part of the business gets weaker because of the uncertainty surrounding Boeing?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [25]

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I think, that's a great question. The distribution business is, for a total amount, it's in single digits. But I think, if you saw any noise there, it would be across the distribution channel as they're playing -- they're very focused on inventory turns, you could potentially see a pause there. I don't think that will be an overall material impact of Carpenter, but I do think that that's where you would see some potential issue there.

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Operator [26]

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Next we have Phil Gibbs of KeyBanc Capital Markets.

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Philip Ross Gibbs, KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst [27]

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Tony, how did the -- I may have missed the comments early, because I was jumping from the Reliance call, but -- excuse me, not Reliance, but the close call. But did you say what the engine subsegment did in terms of either quarter-over-quarter or year-over-year revenue growth?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [28]

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Yes. Sorry about that Phil. I don't think I did mention that specifically. Engines quarter-over-quarter were up 15% from a sales standpoint.

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Philip Ross Gibbs, KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst [29]

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Okay. Perfect. And I think you talked a little bit about it just now, Tim, but you said international is showing some life, which we're hearing from others. But are you seeing a pickup in your order book on the oil and gas side moving forward, given the improvement in pricing?

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Timothy Lain, Carpenter Technology Corporation - VP & CFO [30]

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Yes. I guess there, Phil. I may go back to saying we're cautiously optimistic. I mean, there's -- we would even say there's early signs of this international growth. We did see that demand pick up in the quarter. But in terms of outlook, I'm not sure that we're prepared to say anything more than that, just being cautiously optimistic about that improvement.

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Philip Ross Gibbs, KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst [31]

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Do you participate much in the offshore side?

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Timothy Lain, Carpenter Technology Corporation - VP & CFO [32]

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We do. I guess, we're more concentrated in the Permian right now, but just because that's where all the activity is. But historically, we have participated in the offshore side as well.

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Philip Ross Gibbs, KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst [33]

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Okay. And I think you all did better than your guidance in the third quarter and in SAO on margins at least relative to what we were thinking, but PEP was a little bit light maybe by a couple of million dollars, if you exclude the insurance gain. So what missed perhaps relative to your expectations there?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [34]

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Yes. You're right. So that -- that was a couple million dollars. So in the whole scheme of things, not that large compared to we had almost $80 million in 2 segments combined. But we are, I guess, the positive to that is that I think, it's very specific to our Amega West business, primarily. It's not a market issue. It's a specific new tool that we've developed and the adoption of that tool has not been what we would like it to be. So that's one specific. We had great expectations for that and we've fallen flat, and we need to make that correction, but it's not a market issue. And if you look at the other businesses inside of PEP, Dynamet, quite frankly, is doing very well. They did a great job recovering from the fire that we had, did our best to take care of all of our customers, and I'm very proud of how they've done that. And now we're investing money in both of our Dynamet locations to increase capacity because of the share gains that we've added, particularly on the Medical side. So PEP is a pretty strong business for us, and we need to get after, on the Amega West side, those specific tools that we take to market and make sure we have the appropriate marketing plan to take advantage of their capabilities. And in this case here, we did not do it.

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Philip Ross Gibbs, KeyBanc Capital Markets Inc., Research Division - VP and Equity Research Analyst [35]

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Okay. Perfect. And one more question, if I could, because, I think it's important for what we're all seeing right now. Boeing has cut production, as everyone knows at this point in time. So is there any change in cadence that you're hearing from either the structural side or the engine side? Or is there any difference in terms of what you're hearing from both of those supply chains, meaning does one feel tighter or looser than another?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [36]

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Thanks, Phil. We speak with all of our customers on a daily basis and we engage directly with all of them on this issue, and none of us -- none of them have told to us to slow down. So we are not changing any production plans at this time based on that specific incident with the 737 MAX.

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Operator [37]

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The next question will come from Jeremy Kliewer of Deutsche Bank.

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Jeremy David Kliewer, Deutsche Bank AG, Research Division - Research Associate [38]

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Regarding your soft magnetics program up at Reading, can you remind us how much of that is already [cut] down with the new capacity that you'll add on there?

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Timothy Lain, Carpenter Technology Corporation - VP & CFO [39]

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Sorry, Jeremy. Repeat the question. We didn't -- we lost you.

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Jeremy David Kliewer, Deutsche Bank AG, Research Division - Research Associate [40]

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With the capacity addition up at Reading, how much of that is contracted, if any?

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

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I would say, none of it is actually under a long-term contract today. We supply into that industry now so we have contracts in place across multiple customers. This piece of equipment is put in for 2 reasons. One, it's a significant cost savings, because it brings the entire process in-house. So we do not -- we're not as reliant on external support. And two, we see this as a significantly growing market that we will pick up that business as we go. So those contracts will come. Some existing customers, their demand will increase, because it's much like the engine market. As you see the electrification of the world increase, the demand is going to increase. So we built that facility based on a better cost base and on the fact that this is a market that we believe is going to grow significantly over the next couple years.

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Jeremy David Kliewer, Deutsche Bank AG, Research Division - Research Associate [42]

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All right. And then regarding the SAO, you guys have about $3 million to $7 million coming in 4Q compared to both 3Q and 4Q last year. How much of that is a market share gain versus just the overall markets in general increasing?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [43]

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Jeremy, can you ask that question again, please?

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Jeremy David Kliewer, Deutsche Bank AG, Research Division - Research Associate [44]

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So in your SAO, your guidance, you have a 5% to 10% growth coming in 4Q. That's roughly $3 million to $7 million. How much of that is market share gains and clients coming to you for more product versus just the overall markets increasing production rates?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [45]

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Well, I think, it's a combination. I mean, I haven't broken that down specifically externally. But it's a combination of market share, of course. I think the market's going to continue to grow quarter-over-quarter as you see engine manufacturers increase their production schedules, and we're going to continue to work on productivity. We'll take inventory out in the fourth quarter just because from a sales standpoint that's required and that won't be a positive from an earnings standpoint. But I would say it's a combination of all of those that you mentioned.

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Operator [46]

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Next we have a follow-up from Chris Olin, Longbow Research.

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Christopher David Olin, Longbow Research LLC - Analyst [47]

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Question on Medical. Actually, a couple of questions on Medical. But my first one was, any of the business you have today, would it be considered cobalt alloys? And was there any impact from the kind of surcharge movement?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [48]

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The answer to the first question is, yes, and the second part of your question, the answer is no.

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Christopher David Olin, Longbow Research LLC - Analyst [49]

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Okay. And then I'm still trying to understand the strength in this business. It's been a strong grower for like 4 or 5 quarters now. And I was under the assumption there weren't very many competitors in, call it, titanium fabrication, I guess. I'm just wondering, is there a way to look at what the underlying market is growing? And how much is actually benefit from market share movement?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [50]

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Well, I don't think there's a lot of players that do what we do from the titanium standpoint. Our big focus really is on the orthopedic side and the cardiology side. And that is primarily the reason why we're expanding both of our Dynamet locations, is on the titanium side. I think you see a move from Medical into additive manufacturing because it can improve patient outcomes, which is the ultimate goal. So titanium wire becomes very attractive that -- you turn that into a powder and then make the eventual part. So we see ourselves there growing with specific influential customers in that area.

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Christopher David Olin, Longbow Research LLC - Analyst [51]

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Okay. But most of the growth came from another competitor?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [52]

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When you say, "most of the growth came from another competitor," I don't follow.

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Christopher David Olin, Longbow Research LLC - Analyst [53]

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The volumes you want, it was a market share or a contract movement, basically?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [54]

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Well, I think, the market's getting larger. I think in Medical, you see them moving more and more to additive manufacturing parts. I think they're on the front end of that. So it's a market that's getting larger as people have more procedures just because the outcome of those procedures are much more positive because of the increase in technology.

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Christopher David Olin, Longbow Research LLC - Analyst [55]

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Okay. And then just lastly, in that whole Dynamet environment, have we seen the full impact from Airbus canceling the A380? Is there any issues there?

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Tony R. Thene, Carpenter Technology Corporation - President, CEO & Director [56]

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Well, the A380, obviously, is a large plane. So there's a lot of content on that. However, there's a lot of -- that's not going to change the overall planes that are manufactured over the next 2, 3, 5 years. So although that was a profitable plane for us, there's many other places where our material's going to go, and we don't so that being an adverse impact on us whatsoever.

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Operator [57]

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I'm showing no further questions. We will conclude our question-and-answer session. I would now like to turn the conference call back over to Brad Edwards of Investor Relations for the closing remarks. Sir?

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Brad Edwards, Brainerd Communicators, Inc. - MD [58]

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Thanks, Mike. And thanks, everyone, for joining us today for our third quarter earnings call. We look forward to speaking with all of you on our fourth quarter call. Have a great day.

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Operator [59]

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And we thank you, sir, and to the rest of management team also for your time today. Again, the conference call is now concluded. At this time, you may disconnect your lines. Thank you. Take care, everyone, and have a great day.